Time to abolish non-executive directors?

By Charles Mayo – Simmons & Simmons LLP

 

 

 

Corporate governance has not prevented some spectacular corporate collapses/failures. But society’s expectations of company boards are ever increasing, in part fuelled by these corporate catastrophes.

Meanwhile, the label ‘non-executive’ is, I think, no longer apt to describe the role of a non-executive director (NED): the description is not aligned with these expectations and, worse, supports a notion that the effectiveness of NEDs is limited to their conduct in the boardroom. I think NEDs would be better called ‘supervisory directors’.

NEDs: Their role in corporate collapses

Both executive and non-executive directors have, under UK law, the same duty to exercise reasonable care, skill and diligence. The scope of the duty varies according to the director’s role. The courts have accepted that the non-executive’s role requires, among other matters, independence of judgement and supervision of executive management. I think this means that describing non-executive directors as supervisory directors is closer to the substance of their role. But, whatever the label, these directors haven’t prevented various corporate collapses and won’t necessarily be able to prevent them occurring in the future. The collapses described below have been attributed to failures by the board to instil an appropriate culture throughout the organisation and, in some cases, alleged failures by the board/NEDs to supervise effectively, sometimes due to the NEDs’ lack of expertise.

Carillion

In January 2018, Carillion, the UK’s second largest construction company, went into liquidation, leaving 43,000 employees at risk of losing their jobs, a £2.6billion pension liability and £2billion of debt to its suppliers, sub-contractors and other short-term creditors.[1] Carillion’s downfall has been described as a ‘failure of a system of corporate accountability’.[2]

The joint report from the Business, Energy and Industrial Strategy Committee and Work and Pensions Parliamentary Committee concluded that Carillion’s business model was an ‘unsustainable dash for cash’[3] with a ‘rotten’ corporate culture.[4] Carillion’s board was blamed as both ‘responsible and culpable for the company’s failure’.[5] Out of Carillion’s seven-member board, five were NEDs.[6]

BHS

In 2016, BHS, the former British department store chain part of the Taveta group, went into administration, leaving 11,000 jobs at risk and 20,000 pensioners facing substantial cuts to their entitlements. The joint report from the same Parliamentary Committees concluded that Taveta’s weak corporate governance, including failure to address the pension deficit and to challenge effectively a proposal to buy BHS by Dominic Chappell, had contributed to its ultimate demise.[7]

Tesco

In September 2014, Tesco plc (Tesco), the UK’s biggest food retailer, admitted that its £1.1billion first-half profit announced a month earlier had been overstated by £250million, with a subsequent clarification that increased the overstatement to £263million. Following a criminal investigation, Tesco was fined £129million under a deferred prosecution agreement with the Serious Fraud Office.[8] It also agreed with the Financial Conduct Authority (FCA) to pay approximately £85million to investors affected by the trading statement for the market abuse of overstating its profits. The FCA found that there was knowledge of the false or misleading statement at a sufficiently high level, but below the Tesco board level, for that knowledge to constitute Tesco’s knowledge for market abuse purposes.

Tesco’s 10-member board included nine NEDs, none of whom had any previous retail executive experience at the time the scandal first hit.

RBS

In 2008, RBS in effect failed and was part nationalised. It relied on the Bank of England’s Liquidity Assistance and received more than £25billion of government funding.[9] The FSA (as the FCA then was) concluded that RBS’s failure could be attributed to various RBS-specific and market factors. It said that likely underlying deficiencies in RBS management, governance and culture made it prone to poor decisions, which could also be a key factor in explaining its downfall.[10]

RBS’s board comprised 17 members but, the regulators said, its processes met acceptable governance standards.[11] In attempting to explain the failure of the board to address the risks facing the firm, the PRA/FCA report suggests that ‘as a group, the non-executive directors (NEDs) on the board lacked sufficient experience and knowledge of banking’.[12] For example, only two of the NEDs on the board during the review period held direct banking experience.[13] The report argues that this lack of expertise hindered the ability of the NEDs to hold executive management to account.

HBOS

The PRA/FCA report attributed ultimate responsibility for HBOS’s failure to its board. In particular, the report argues that the board failed to instil an appropriate culture at HBOS or to set out a clearly defined risk appetite for the firm, both of which had significant consequences for HBOS’s business strategy.[14] The report also found that the board did not provide effective challenge to the HBOS executive during the review period. For instance, there was little evidence of the board debating the firm’s reliance on wholesale funding or the risks associated with high levels of asset growth. The outcome of this was that the risks facing HBOS at a group level were, the regulators thought, never fully explored, understood or addressed by the board.[15]

Wells Fargo

In September 2016, Wells Fargo disclosed that it had opened several million potentially unauthorised retail customer accounts. Employees said these accounts had been opened in response to demanding sales targets and incentives put in place by the bank’s senior management.[16] Afterwards, it transpired that Wells Fargo had charged hundreds of thousands of borrowers for unnecessary guaranteed auto protection or collateral protection insurance for their automobiles and was involved in other misconduct.[17] In response, the Federal Reserve restricted the bank from growing any larger than its total asset size as of the end of 2017 until it improved its governance and controls.[18]

The Federal Reserve concluded that the board’s lack of effective oversight and control of compliance and operational risks contributed to the harm suffered by the bank’s customers.[19] According to the Federal Reserve, the board also did not take steps to improve management information, which reduced its effectiveness. For example, ‘the board and certain committees of the board received from management assurances that corporate risk, human resources and the Community Bank were undertaking enhanced monitoring of sales practice misconduct and were addressing sales practice abuses. Management’s reports, however, generally lacked detail and were not accompanied by concrete action plans and metrics to track plan performance’.[20]

A separate report by Wells Fargo’s independent directors said: “Aided by a culture of strong deference to management of the lines of business (embodied in the oft-repeated ‘run it like you own it’ mantra), the Community Bank’s senior leaders distorted the sales model and performance management system, fostering an atmosphere that prompted low quality sales and improper and unethical behaviour.”[21] Ultimately, in August 2018, Wells Fargo agreed to pay over $2billion in penalties for its role in originating loans that led to its financial crisis.[22]

There is a multitude of views on these corporate collapses, some of which are the subject of on-going proceedings. Right or wrong, fair or unfair, the examples above generally underline heavily the importance of the supervisory role of NEDs.

NEDs: their role outside the boardroom

Increasingly, a NED’s role involves supervisory activities outside the boardroom, relating to culture, stakeholders and workforce engagement.

Culture

According to the FRC’s publication Corporate Culture and the Role of Boards:

• …many [NEDs surveyed] were much less comfortable about their role or ability to embed the values in the organisation, and some felt this is not the role of the non-executives. Yet, when we surveyed chairmen on how influential different individuals were on company culture in practice, 89 per cent felt the role of the chairman is influential or very influential and 54 per cent viewed the role of NEDs as influential or very influential
• It is clear that shareholders need to talk to a wide range of people involved in a company in order to build an accurate picture of its culture. This includes executives as well as NEDs and so it is important that investment houses ensure that they are avoiding a siloed approach to dialogue
• NEDs need to be aware that power differentials make it hard for a member of staff to challenge a senior executive
• NEDs will also need to be more proactive in their engagement with employees and other aspects of the business and in their modelling of company values. This will have implications for which aspects of their role NEDs prioritise and how they allocate their time.

The view expressed by the FRC (rightly in my view) is ‘… the role of the NED is changing, with inevitable implications for the skillset, diversity and experience that NEDs will add to the board in the future. Certainly, NEDs will need to become more culturally aware, more tuned in and more knowledgeable about human behaviours and relationships’.

The FRC included, for example, this good guidance about site visits: “Site visits were cited as giving a good sense of what is going on, provided they were not run as ‘state visits’, although they are not always practical in organisations with multiple global locations and operations and such visits have their limitations”.

Chairs and chief executives emphasised that site visits are not only an opportunity to find out what is going on but also demonstrate the importance and presence of the board. It is the degree of engagement and preparation of NEDs that makes the biggest difference; NEDs need to be focussed and ready to ask the right questions.

An open discussion with the chief executives to prepare the ground can guide NEDs to engage in a way that reinforces the values and culture and supports management’s message and reinforces culture. Debriefs with the chief executives on their return are also important and can provide useful insights for management.”

Rupert Soames, Serco’s chief executive, put it more directly: “It’s good for NEDs to go out into the business but they need to do it carefully. Orchestrated royal visits by herds of NEDs are in my view often not very productive, whereas individual NEDs popping in to sniff the breeze works well.”

Stakeholders

NEDs are expected to facilitate the relationship between shareholders, stakeholders and the company. ICSA[23] and the Investment Association guidance states: “When evaluating their composition and effectiveness, boards should identify what stakeholder expertise is needed in the boardroom and decide whether they have, or would benefit from, directors with directly relevant experience or understanding.” [24]

According to the guidance, there are two broad approaches to acquiring expertise that boards could consider:

• Reserving one or more board positions for directors drawn from a stakeholder group, such as the workforce; and
• Extending the selection criteria and search methods for NEDs to identify individuals with relevant experience or understanding of one or more stakeholder groups

Both these approaches, the guidance states, have their merits: “On the one hand, in cases where the contribution and buy-in of a particular stakeholder group is crucial to the company’s continuing success, there may be benefits in formalising that relationship by having one or more members of that group on the board as a director,” the report says. “On  the other, expertise in understanding and engaging with a key stakeholder group does not necessarily have to come from within that group, and there are potentially many other individuals with relevant experience and expertise.”[25]

This, I think, supports the notion that NEDs should be directly involved in aspects of the stakeholder communication outside the boardroom, as well as providing their own technical, regional or other expertise about stakeholders inside the boardroom.

Workforce engagement

The 2018 UK Corporate Governance Code, applicable for financial years beginning on or after 1 January 2019, reinforces the importance of stakeholder engagement generally and, in particular, effective engagement with the workforce.

Listed companies will have to use one or a combination of the following methods to engage with the workforce:

• A director appointed from the workforce
• A formal workforce advisory panel
• A designated NEDs

Or, the board must explain what alternative arrangements are in place and why it considers that they are effective.

It seems to me that whichever method is chosen it is likely to involve one or more NEDs being more actively engaged with the workforce outside board meetings than has generally happened and, possibly, more visibly taking workforce considerations into account inside the boardroom.

Conclusion

It will obviously take much more than a change of label. My simple point is that the label of NED sets the expectations and I think it would be better now to use the label ‘supervisory director’ and to prioritise the behaviours, systems and information most likely to enhance his/her supervisory role.

The increasing expectations of NEDs to supervise effectively, both through their conduct inside the boardroom, and their activities outside the boardroom have, I think, a growing importance for the types of skills NEDs must possess. And, all this impacts
the time commitment and professionalism required of NEDs. An increased time commitment should, I think, lead to increased remuneration for NEDs. Better, I think,
to pay more to get more time from NEDs and improve their supervision from both inside and outside the boardroom.

 

About the Author:

Charles is a partner in Simmons & Simmons LLP specialising in corporate governance/compliance and focussed on helping listed companies, banks, asset managers and public sector bodies, and their directors, officers, approved persons and senior managers stay out of legal trouble. He chairs the Next Generation NED Network, is a member of the UK CBI Company Law Committee and is a trustee of the Association of Medical Research Charities.

Footnotes:

1.Business, Energy and Industrial Strategy and Work and Pensions Committees, Carillion. Second Joint Report from the Business, Energy and Industrial Strategy and Work and Pensions Committees of Session 2017-19 (2018), 3

2.Ibid, 68

3.Ibid, 16

4.Ibid, 27

5.Ibid, 3

6.Ibid, 27

7.https://publications.parliament.uk/pa/cm201617/cmselect/cmworpen/54/5407.htm

8.https://www.fca.org.uk/publication/final-notices/tesco-2017.pdf

9.FSA, The failure of the Royal Bank of Scotland, available at <https://www.fca.org.uk/publication/corporate/fsa-rbs.pdf> p. 13

10.Ibid, 22

11.Ibid, 224

12.https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/publication/hbos-summary-and-recommendations, 14

13.Ibid, 30

14.https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/publication/hbos-complete-report, 208

15.Ibid, 212

16.Board of Governors of the Federal Reserve System, Re: Performance of the Wells Fargo & Company Directors (2018), available at <https://www.federalreserve.gov/newsevents/pressreleases/files/enf20180202a2.pdf> p. 1

17.Ibid, 1

18.https://www.ft.com/content/87378b52-086c-11e8-9650-9c0ad2d7c5b5

19.(n 1), 1

20.(n 1), 1-2

21.https://www.law.ox.ac.uk/business-law-blog/blog/2017/04/wells-fargo-and-failure-boards-and-regulators

22.https://nypost.com/2018/08/01/wells-fargo-to-pay-2-billion-for-role-in-financial-crisis/

23.ICSA: The Governance Institute

24.The Stakeholder Voice in Board Decision Making: Strengthening the business, promoting long-term success, 6

25.Ibid, 11