Out-Law Guide | 05 Jul 2007 | 10:35 am | 6 min. read
This guide is based on UK law as at 1st February 2010, unless otherwise stated. It is part of a series on corporate governance.
According to main principle B.2 of the UK Corporate Governance Code, there should be ‘a formal, rigorous and transparent procedure’ for the appointment of new directors. In other words, the days of putting your friends from the golf club on the board are long over.
The Code gives the recruitment task to a nomination committee, a majority of whose members should be independent non-executive directors. (Note: the Code does not apply to all companies. See: The reach of the UK Corporate Governance Code, an OUT-LAW guide)
There is no ban on the chief executive being a member – as is consistent with the committee’s role in making recommendations for executive as well as non-executive appointments. The committee should be chaired by one of the independent non-executives or the company chairman, though he should stand aside when it comes to appointing his successor.
The committee is expected to:
Individuals who are non-executives in one company will often be executive directors in another – and vice versa. It is generally thought to be a good thing that an executive gets experience of the workings of another company and another industry. However, it is important that the demands on the individual are realistic – a major corporate dispute or a takeover can demand huge amounts of non-executive time. The Code says that the board should not agree to a full-time executive taking on more than one FTSE 100 company non-executive directorship or the chairmanship of such a company.
Even experienced non-executive directors need training. This means an effective induction process when the director joins the board and an ongoing programme of professional development. In the words of main principle B.4, directors should ‘regularly update and refresh their skills and knowledge’. They need both to understand the business they are running, its products, customers and suppliers, and to keep up with the pace of legislative and regulatory change.
‘The company,’ says the Code, ‘should provide the necessary resources for developing and updating its directors’ knowledge and capabilities.’ Note also the obligation in Listing Principle 1: ‘A listed company must take reasonable steps to enable its directors to understand their responsibilities and obligations as directors.’
The essential point is that directors must be given the right ‘equipment’ and get the right preparation to do their job. Their induction needs to be planned with care, with a programme over a number of months of site visits and meetings with both major shareholders and senior and middle management. The 2010 version of the Code gives the chairman responsibility for agreeing and reviewing a training plan for each director.
If the non-executives require outside advice to help with aspects of their job, the company should be prepared to pay for it. This can be especially relevant for the audit committee, where an independent view may be wanted on an abstruse accounting point. The Walker Report also emphasised the need for outside help when the non-executives are evaluating levels of risk in a complex business.
In the past few years, the idea of board-level appraisals has become increasingly accepted. Thus the Code’s main principle B.6 says that ‘the board should undertake a formal and rigorous annual evaluation of its own performance and that of its committees and individual directors’.
As with any appraisal process, the intention is that strengths are recognised and built upon and weaknesses are addressed – which may mean, ultimately, asking a director to go. Questions to ask will include:
Once a year, the board should look at itself and assess what it does, its failures and successes, and a similar process should be conducted by the board for each of its committees.
The annual report needs to explain how these appraisals are carried out. There is no guidance in the Code as to whether it can or should be done in-house, though many boards seem to be reporting the use of home-grown procedures based on one-to-one interviews between the chairman and each director. In some companies, these fireside chats may have been less ‘formal and rigorous’ than intended, and from 2010 the Code has said appraisals should be externally facilitated at least every three years. Whatever is done, there needs to be transparency as to the process, with the annual report describing what has happened and any actions that resulted.
The chairman does not escape. His or her performance should be evaluated by the non-executives as a whole, under the leadership of the senior independent director. And they should consult the executive directors and take their views into account.
A poor appraisal may result in the chairman asking a director to stand down. That will be an internal board matter. But what of the shareholders? What power do they have to get rid of directors who, in their eyes at least, have under-performed? Shareholders can pass a resolution at a general meeting to remove a director if they can muster more than half the votes cast. But in many companies, the AGM also gives the shareholders the opportunity to vote on the re-appointment of directors. Company articles will often provide that all new directors have to stand for re-election at the AGM following their appointment, and that is a provision echoed by the Code. Articles will also commonly stipulate that a third of the directors should retire and stand for re-election each year.
The Walker Report recommended that bank chairmen should stand for re-election every year. At the end of 2009, the FRC began a consultation offering two choices for all listed companies:
At the time of writing, the consultation had not closed, but several companies, BP included, had already decided on the latter option.
Examples of shareholders using their power to remove directors are few and far between. A memorable case occurred in 2004, with three Manchester United directors being shown the red card at the club’s AGM. American sports tycoon Malcolm Glazer, who owned 28.1 per cent of the club’s shares, took his revenge on those coming up for re-election after he was refused access to the company’s books. (He later launched a successful bid for the whole company.)
The shareholders may not be privy to the detail of the board’s appraisal of individual directors but the Code does require the chairman to confirm to them that, following an appraisal, the performance of the non-executive director up for re-election ‘continues to be effective and to demonstrate commitment to the role’. Indeed, the board is required to tell shareholders why it believes an individual director should be re-elected.
The non-executive’s letter of appointment needs to take account of the requirement that he or she stands for re-election at regular intervals. The Code says that two three-year terms should be the norm and a third,making nine years in all, should be ‘subject to particularly rigorous review’ and take account of the need for ‘progressive refreshing of the board’. Serving more than nine years raises the assumption of a lack of independence, which has to be rebutted each year by the board in the annual report. (See: Independent non-executive directors, an OUT-LAW guide.)
Despite this, nine-year terms are common, and there is a widely held view that the rule should be dropped. Many companies would argue that there is little point in sacrificing a director’s experience and knowledge of a group after only six years because of an unjustified fear that they may have gone stale. Once nine years are reached, the Code suggests that the director should be subject to annual re-election.