Non-executive directors and how they protect the interests of shareholders

COMPANY LAW ESSAY

“You have been invited to give a lecture to a group of institutional investment managers on the role and responsibilities of non-executive directors in public companies in the United Kingdom. The title of the lecture is: “Non-executive directors in the UK, their responsibilities and the extent to which they protect the interests of shareholders.” You have been informed that in particular the managers will be interested in the following:

1. The nature of the responsibilities of non-executive directors.
2. Their potential liability to the company under the law.
3. Their enhanced responsibilities under the Combined Code of Corporate Governance.
4. Whether, in practice, non-executive directors are efficient in monitoring management.
5. Whether the role of non-executive director should be abolished and we should look for other ways in which to improve corporate governance within the company.”

In order to discuss whether non-executive directors are effective in protecting the interests of shareholders, we must first examine the nature of their role and responsibilities and the liabilities they face. After a detailed discussion of whether or not they are effective, alternative methods of protecting shareholders will be considered. The question of whether non-executive directors should be abolished will then be addressed.

Non-executive directors are generally part-time members of a board of directors, and are usually executives from other companies. Their role is to be an independent presence on the board, to uphold the interests of shareholders and to curb the excesses of the managing executive directors.

There is no statutory definition of a non-executive director. However, the law recognizes that a company cannot perform its own acts as an artificial person and must be managed by directors (Ferguson v Wilson (1866) LR 2 Ch App 77). Under s. 282, Companies Act 1985, every private company must have at least one director, and every public company at least two. A director is defined under s. 741(1) simply as “anyone occupying the position of director”.

The idea of non-executive directors (NEDs) was promoted by the Cadbury Committee in their report published in 1992. This report was commissioned by the Financial Reporting Council and London Stock Exchange after the collapse of several large corporations – such as Polly Peck and the Robert Maxwell Group – due to managerial irregularities even though they were given healthy audit reports. These failures were blamed on poor corporate governance, which the Cadbury Report defined as “the system by which companies are directed and controlled” [FN 1]. The Committee sought to improve corporate governance and make directors more accountable to shareholders. To achieve this aim, the Committee aimed to strengthen the role of NEDs in UK listed companies. The report created a voluntary Code of Best Practice, backed up with the requirement that all UK listed companies should comply with the Code, or explain why they have not in their annual reports [FN 2].

The Cadbury Report states that NEDs should bring their independent judgement to bear on issues of strategy, performance, appointments and standards of conduct [FN 3]. Therefore they are expected both to monitor executives and contribute to corporate strategy, working as part of a unified board for the benefit of the company as a whole. Non-executive directors are to be appointed by the board [FN 4] for specific periods with no automatic re-appointment once their term has expired [FN 5] and they are expected to be free of any business or financial connection with the company [FN 6], although it is for the board as a whole to decide who is “independent” [FN 7].

All boards are required to form Audit Committees to review the scope and results of internal and external audits of the company [FN 8]. These should be composed exclusively of NEDs [FN 9] with a majority of those being “independent” [FN 10]. They should meet three times a year. Executives’ pay is to be subject to recommendations made by a Remuneration Committee made up mainly of NEDs [FN 11]. The Code sets no minimum number for NEDs, but states that there should be enough to carry “significant weight” on board discussions [FN 12]. The Code also states that it is “highly desirable” if NEDs are formally trained, but this is not a requirement [FN 13]. The Code is a ‘soft law’ in that breaches do not incur criminal or civil penalties. It is a voluntary code of self-regulation. Theoretically, companies who comply with the Code will inspire more confidence in shareholders and as a result will do better than companies which do not.

However, NEDs may incur liability under statute and common law. Under statute, the Company Directors Disqualification Act 1986 allows UK courts to review the way a director has conducted a company’s affairs and disqualify them from being a director if they are unfit to hold office. Those who breach disqualification orders may incur criminal penalties. Similarly, under ss.11 and 13, Companies Act 1985, it is an offence for an undischarged bankrupt to act as a director or be concerned in the management of a company. These then are sanctions for incompetent or improper conduct by all directors.

The common law recognises that directors owe a company a duty of care. However, the law is inconsistent as to whether there is any difference between executives and NEDs…….

Click here to see the full sample paper.