Worldwide, there is a growing body of opinion that a fundamental reform of the boardroom is necessary if the corporate scandals of recent times are to be avoided in the future. If the board is to be the steward of a company’s system of internal control, it is necessary to remove potential conflicts of interest that might inhibit the board’s supervisory function or distort its focus. But how is it possible to ensure that the board is not filled with what Michael McAlevey, a partner at law firm Alston & Bird and former deputy director of the SEC’s corporate finance division, calls ‘supine gatekeepers’, directors who fail to perform their regulatory tasks?
A question of independence
Recent NYSE proposals, to be phased in within between six and 24 months of SEC approval, will require the audit, compensation and nomination/governance committees of all listed companies to be made up entirely of independent, non-executive directors (I-Neds), and will require a majority of non-executive directors (Neds) on all boards. An important feature of the proposals is the strengthening of the definition of ‘independent’. Among other things, the new definition bars former employees of the company or of its present or former auditors from being considered independent. Nasdaq has put forward similar proposals, again to be phased in within between six and 24 months of SEC approval.
The proposals are generally expected to bring improvements to US board structure, although there are some misgivings. According to Bob Hotz, managing director and head of corporate governance at Houlihan Lokey Howard & Zukin, the new definition of independence will reduce prospective conflicts of interest, but unfortunately will also, in some cases, eliminate directors from the independent pool who are in reality independent.
‘With the new definition of independence, it will be tougher to get the type of people you need on boards, particularly for smaller companies,’ agrees Maria Quillard, senior director of IR at Xilinx. ‘But it is a step in the right direction.’
In its response to the Higgs review into the role and effectiveness of non-executive directors in the UK, Pensions Investment Research Consultants (Pirc) has noted that according to the Pirc criteria for independence, which closely resemble those of the recent NYSE proposals, only one fifth of FTSE 100 boards have a majority of independent directors, while among small caps only 5 percent have independent boards.
Pirc hypothesizes that all board committees should be composed entirely of independent directors if they are to respond to the interests of the company and its shareholders, rather than those of management.
Mary Dunbar, senior vice president at Dix & Eaton, offers a word of warning, however: ‘Whether boards composed of people who meet stricter criteria for independence will improve board stewardship will depend on whether board members are co-opted by the same decision-making information and systems that produced the current round of problems in corporate governance.’
‘Independent directors do have a particular relationship with the shareholders,’ says Mark Goyder, director of the UK-based think tank, Centre for Tomorrow’s Company. ‘They need to be focused on what is right for the company, today and tomorrow.’
If non-executive director independence is to mean something, it must be acted upon, adds Dunbar: ‘Board members can’t just rubber-stamp the information packets they receive before board meetings. They need to do their own independent research and thinking.’
William McDonough, president and CEO of the Federal Reserve Bank of New York, points out that in 2000, CEOs made over 500 times the average production worker, way up from 20 years before when the figure was just 42 times. Dunbar points out that this is down to the boards, since they are responsible for executive compensation. ‘This isn’t just a social justice issue,’ she says. ‘It represents a misallocation of corporate resources that could have been invested in the development of new products and services, marketing or other initiatives that would strengthen a company.’
The non-executive culture
Once independence has been defined, there is still the question of how to ensure I-Neds are competent to carry out their function as stewards of the company. Do they know the company well enough to exercise a regulatory function over executive management? Are they dedicating enough time to the role? Do they understand the risks that are typical of the company? And are they in a position to formulate views that are independent of those of the management?
‘Non-executives are people who need to have their finger on the company’s pulse,’ Goyder says. ‘I envisage them as people who from time to time make an unannounced visit, talk to managers and employees at the organization and so on.’
In practice, such directors are something of a rarity, however. ‘In far too many cases, non-executive directors aren’t sufficiently acquainted with the company,’ complains Philip Goldenberg, a senior corporate finance partner at SJ Berwin in London.
One reason for this may be the fact that many non-execs sit on multiple boards and simply don’t have enough time to dedicate to each. Recent proposals in both the UK and the US include restricting the number of an individual’s board seats, especially if they sit on, say, the auditing or remuneration committee in one or more companies.
Others take a more relaxed but equally pragmatic approach. ‘I am not in favor of restricting too tightly the number of directorships that people can hold, but directors should be appointed on their ability to do the job and dedicate the necessary amount of time to it,’ says Goldenberg.
Goyder thinks boards should meet more often, and doesn’t agree that increased contact between executive and non-executive members of the board would necessarily lead to a ‘cozy’ relationship and a consequent decline in vigilance. ‘The need is to get the unit operating at a level where they work together. You cannot get constructive levels of conflict without a high level of trust and shared goals,’ he says.
Towards two-tier?
Until the recent scandals, few observers in the US or the UK gave much thought to the two-tier board structures that exist in countries such as the Netherlands and Germany. Now, however, a growing body of opinion believes a supervisory board could provide the necessary restraint to executive power. ‘It is extremely difficult for any [unitary] board to control executives at a senior level,’ says Tim Clement-Jones, chairman of corporate reputation management firm DLA Upstream. ‘I would like to see a supervisory board in the top companies.’
For Pirc, too, a two-tier structure looks attractive. In its response to the Higgs review, the pension consultant points to the ‘tensions of the supervisory functions expected of Neds and the collegiate nature of a unitary board.’ Pirc goes on to note, ‘It may well be that some of the failures of non-executives to exercise a satisfactory oversight over executives arise from the unitary board structure.’
Clement-Jones is well aware, however, that for a body of non-executives to constitute an effective supervisory board, efficient and dedicated internal structures would need to be in place. ‘These internal structures would consist of corporate secretaries, heads
of compliance and an internal auditor who should all be answerable to the supervisory board. Such a board cannot possibly function unless it has a dedicated staff which is answerable to the board itself, not to the company management.’
Even so, a two-tier system is not a panacea for executive dominance. ‘Non-execs in many German companies complain that the system doesn’t work well,’ observes Goyder. ‘Many decisions have already been taken by the time they reach the supervisory board, which, after limited discussion, tends to rubber-stamp them.’
Gregory Maassen, assistant professor of strategic management and corporate governance at the Rotterdam School of Management, adds that a two-tier structure ‘introduces an additional level of bureaucracy that can imperil decision-making.’
With the best will in the world, no supervisory board could be functional if it didn’t have the facts to hand. For this reason Goldenberg finds himself strongly opposed to the idea of a supervisory board made up entirely of non-executives. ‘If you exclude executives from the supervisory committee, you would remove the interactive element between the Neds and those who know the company best,’ he protests. ‘You would discourage the interaction that you’re supposed to create.’
Best board practice?
So does there exist a model board structure that could guarantee the smooth running of the company and the accountability of all its executives and stewards? McAlevey doesn’t think so. ‘There is a species of hard core fraud that no amount of regulation is going to prevent,’ he says.
Goyder sums up a prevalent line of thought: ‘Principles, rather than rules, are the way to earn trust.’ He reasons that principle-based legislation gives companies the flexibility to adopt the structures that best suit them and at the same time remain responsive and accountable to their shareholders. A staffer at Nippon Keidanren, the Japanese business federation, echoes a common sentiment when he says that companies should be allowed to choose a board structure that best serves the interests of stakeholders. Goldenberg sums it up best of all, concluding, ‘The universe of companies out there is a kaleidoscope. That’s why we shouldn’t have mandatory rules – there is no one-size-fits-all.’
