AUDIT COMMITTEE:

(i) The company shall have an Audit Committee as a sub-committee of the

Board of Directors.
(ii) The Audit Committee shall assist the Board of Directors in ensuring that
the financial statements reflect true and fair view of the state of affairs of the
company and in ensuring a good monitoring system within the business.
(iii) The Audit Committee shall be responsible to the Board of Directors.
The duties of the Audit Committee shall be clearly set forth in writing.
3.1 Constitution of the Audit Committee
(i) The Audit Committee shall be composed of at least 3 (three) members.
(ii) The Board of Directors shall appoint members of the Audit Committee
who shall be directors of the company and shall include at least 1 (one)
independent director.
(iii) All members of the audit committee should be "financially literate” and
at least 1 (one) member shall have accounting or related financial
management experience.
Explanation: The term "financially literate” means the ability to read and
understand the financial statements like Balance Sheet, Income Statement
and Cash Flow Statement and a person will be considered to have
accounting or related financial management expertise if (s)he possesses
professional qualification or Accounting/ Finance graduate with at least 12
(twelve) years of corporate management/professional experiences.
(iv)When the term of service of the Committee members expires or there is
any circumstance causing any Committee member to be unable to hold
office until expiration of the term of service, thus making the number of the
Committee members to be lower than the prescribed number of 3 (three)
persons, the Board of Directors shall appoint the new Committee member(s)
to fill up the vacancy(ies) immediately or not later than 1 (one) month from
the date of vacancy(ies) in the Committee to ensure continuity of the
performance of work of the Audit Committee.
(v) The company secretary shall act as the secretary of the Committee.
 (vi)The quorum of the Audit Committee meeting shall not constitute without
at least 1 (one) independent director.
3.2 Chairman of the Audit Committee
(i) The Board of Directors shall select 1 (one) member of the Audit
Committee to be Chairman of the Audit Committee, who shall be an
independent director.
(ii) Chairman of the audit committee shall remain present in the Annual
General Meeting(AGM).
3.3 Role of Audit Committee
Role of audit committee shall include the following:
I. Oversee the financial reporting process.
II. Monitor choice of accounting policies and principles.
III. Monitor Internal Control Risk management process.
IV. Oversee hiring and performance of external auditors.
V. Review along with the management, the annual financial statements
before submission to the board for approval.
VI. Review along with the management, the quarterly and half yearly
financial statements before submission to the board for approval.
(vii) Review the adequacy of internal audit function.
VII. Review statement of significant related party transactions submitted
by the management.
VIII. Review Management Letters/ Letter of Internal Control weakness
issued by statutory auditors.
IX. When money is raised through Initial Public Offering (IPO)/Repeat
Public Offering (RPO)/Rights Issue the company shall disclose to the
Audit Committee about the uses/applications of funds by major
category (capital expenditure, sales and marketing expenses, working
capital, etc), on a quarterly basis, as a part of their quarterly
declaration of financial results. Further, on an annual basis, the
company shall prepare a statement of funds utilized for the purposes
other than those stated in the offer document/prospectus.

3.4 Reporting of the Audit Committee

3.4.1 Reporting to the Board of Directors
(i) The Audit Committee shall report on its activities to the Board of
Directors.
(ii) The Audit Committee shall immediately report to the Board of Directors
on the following findings, if any:
a) report on conflicts of interests;
b) suspected or presumed fraud or irregularity or material defect in the
internal control system;
c) suspected infringement of laws, including securities related laws, rules
and regulations;
d) any other matter which shall be disclosed to the Board of Directors
immediately.
3.4.2 Reporting to the Authorities
If the Audit Committee has reported to the Board of Directors about
anything which has material impact on the financial condition and results of
operation and has discussed with the Board of Directors and the
management that any rectification is necessary and if the Audit Committee
finds that such rectification has been unreasonably ignored, the Audit
Committee shall report such finding to the Commission, upon reporting of
such matters to the Board of Directors for three times or completion of a
period of 6 (six) months from the date of first reporting to the Board of
Directors, whichever is earlier.

3.5 Reporting to the Shareholders and General Investors

Report on activities carried out by the Audit Committee, including any
report made to the Board of Directors under condition 3.4.1 (ii) above during
the year, shall be signed by the Chairman of the Audit Committee and
disclosed in the annual report of the issuer company
4.EXTERNAL/STATUTORY AUDITORS:
The issuer company should not engage its external/statutory auditors to
perform the following services of the company; namely:
i. Appraisal or valuation services or fairness opinions.
ii. Financial information systems design and implementation.
iii. Book-keeping or other services related to the accounting records or
financial statements.
iv. Broker-dealer services.
v. Actuarial services.
vi. Internal audit services.
vii. Any other service that the Audit Committee determines.
viii. No partner or employees of the external audit firms shall possess any
share of the company they audit at least during the tenure of their
audit assignment of that company.
5. SUBSIDIARY COMPANY:
(i) Provisions relating to the composition of the Board of Directors of the
holding company shall be made applicable to the composition of the Board
of Directors of the subsidiary company.
(ii) At least 1 (one) independent director on the Board of Directors of the
holding company shall be a director on the Board of Directors of the
subsidiary company.
(iii) The minutes of the Board meeting of the subsidiary company shall be
placed for review at the following Board meeting of the holding company.
(iv)The minutes of the respective Board meeting of the holding company
shall state that they have reviewed the affairs of the subsidiary company
also.
(v) The Audit Committee of the holding company shall also review the
financial statements, in particular the investments made by the subsidiary
company.
6. DUTIES OF CHIEF EXECUTIVE OFFICER (CEO) AND CHIEF
FINANCIAL OFFICER (CFO):
The CEO and CFO shall certify to the Board that:
(i) They have reviewed financial statements for the year and that to the best
of their knowledge and belief:
a) these statements do not contain any materially untrue statement or omit
any material fact or contain statements that might be misleading;
b) these statements together present a true and fair view of the company's
affairs and are in compliance with existing accounting standards and
applicable laws.
(ii) There are, to the best of knowledge and belief, no transactions entered
into by the company during the year which are fraudulent, illegal or
violation of the company's code of conduct.
 Directors’ Performance & Remuneration
The directors’ remuneration debate:
The debate has tended to focus on 4 areas:
1. The overall level of directors’ remuneration & role of share
options.
2. The suitability of performance measures linking directors’
remuneration with performance.
3. The role played by the remuneration committee in the
setting of directors’ remuneration.
4. The influence that shareholders are able to exercise on
directors’ remuneration.
Factor influenced by the remuneration debate:
1. Principle agent should be paid aligned- well designed
compensation contracts will help to ensure that the
objectives of directors and shareholders are aligned.
2. The global financial crisis have served to highlight the
inequalities that exist between executive directors’
generous remuneration & the underperformance of the
companies that they direct and the concomitant impact on
shareholders who may lose vast sums of money.
3. Evidence suggests that developments in executive pay may
have been both in equality- enhancing & economically
inefficient.
4. Executive compensation incentives encourage some
executives and traders to take excessive risks.
5. Bonus driven remuneration structure prevalent in
investment banking , led to reckless and excessive risk-
taking. Bonus payments align the interest of senior staff
more closely with those of S. H.
6. Performance related pay should be aligned to the long term
interests of the company and to its risk policy and systems.
7. Excessive high pay damages companies is bad for our
economy and has a negative impacts on society as a whole.
Key elements of directors’ remuneration:
The Greenbury Report (1995) was set up in response to
concern about the size of directors’ remuneration packages &
their inconsistent & incomplete disclosure in companies’
annual report.
Remuneration of non-executive directors:
The remuneration of non-executive directors is decided by-
 The board
 The articles of association
 General meeting
Non-executive directors should be paid a free commensurate
with the size of the company and the amount of time that they
are expected to devote to their role. The remuneration is
generally paid in case although some advocate remunerating
non-executive directors with the company’s shares to align
their interests with those of the shareholders. However it has
not being a good idea to remunerate non-executive directors
with share option because this may give them a rather
unhealthy focus on the short term share price of the company.
According to ICGN (International CG Network) the
recommendations include that the annual fee should be the
only form of cash compensation paid to non-executive
directors and that there should not be a separate fee for
attendance at board meeting or committee meeting. Different
 fee can be paid for different workload. According to ICGN the
compensation should be performance based vesting on equity
based awards.
Importantly, the ICGN also states, separate from ownership
requirements, the ICGN believes companies should adopt
holding requirements for a significant majority of equity based
grants. These policies should require that non-executive
directors retain a significant portion of equity grants until at
least 2 years after they are retired from the broad. Such
policies would help ensure that interests remain aligned.

Directors' remuneration
In the past shareholders were concerned about the large salaries directors awarded
themselves despite poor profits. Controls were needed to reduce this risk and a number of
Reports on corporate governance have tried to address these concerns.

The Greenbury Report (1995) contributed to the existing code with regards to directors'
remuneration.

This committee was formed to investigate shareholder concerns

over director's remuneration. The report focused on providing a means of establishing a
balance between salary and performance in order to restore shareholder confidence.

Components of directors' remuneration package

Basic salary
As with most jobs all directors are promised a specific annual salary. This is
usually determined through benchmarking peer group salaries. Peer groups
should  be industry specific and should reference equivalent sized ventures.

The amount of the basic salary provides an indication of the performance

expected from the director, with salaries in the top quartile of payments
indicating higher  levels of expected performance.

Performance related pay (PRP)

Performance related elements of remuneration are defined as those elements
of remuneration dependent on the achievement of some form of
performance measurement criteria. Good corporate governance principles
state that the performance related element should form a significant part of
the total remuneration package. 

The PRP elements of remuneration should be attainable in order to

provide motivation since unattainable targets are generally demotivating.

Also, linking PRP to share price is generally thought to be inappropriate as

we cannot be expected to control market conditions; so a general decline in
market conditions is not caused by directors’ actions and so we should
not be penalized for this. Similarly, we are not responsible for favorable
market conditions and should not be rewarded for these.
 i. Bonus payments
The purpose of a bonus is to adjust pay on the basis of performance. To
award a bonus regardless of any particular effort is to make the term
meaningless as there is no set level of performance necessary to actually
obtain that bonus.

A bonus paid to a director at the end of the accounting year may be based on
any number of accounting measures including gross profit, net profit,
earnings per share and total shareholder value. Most corporate governance
systems recommend that the bonus is linked to shareholder value in some
way to show that the shareholders' and directors' interests are the same.
ii. Shares and share options
Share options are contracts that allow the executive to buy shares at a fixed
price or exercise price. Directors make a profit if the share price of the
company increases – the option is exercised to purchase at a lower price and
reselling the shares provides the profit.

Share options are good because they attempt to link company

performance to director performance in the longer term (although market
factors distort this as mentioned above).

Pension contributions
These are a common part of any remuneration package. Their level is
usually set in relation to the market conditions (i.e. amounts paid to peer
groups) and taking into account the age of the director in question. It is
possible that a proportion of these pensions contributions could be
performance related, providing a further incentive element to the overall
package.

Benefits in kind
The provision of ‘perks’ such as a company car and health insurance is a
common part of any senior level remuneration package.

These will serve to attract directors into a role, and maybe retain them in it,
but rarely have a motivational impact. As long as they are not viewed to be
excessive for the position they are widely accepted.

Factors affecting the remuneration policy:

Remuneration committees need to have a thorough understanding of their

company and the forces that shape directors' remuneration.

Understanding the business

Directors’ remuneration levels vary greatly from business to business. The
key factors in decision-making are listed below.
Business size
Size can affect all aspects of pay – base salary levels, annual bonus design,
performance measures and the type of long-term incentive plans that are
appropriate. But it is a variable concept. It can be measured in terms of
revenues, capital employed, margins or financial structures. Market
capitalization is seldom the main factor in directors' remuneration.
Performance record and prospects
Is the company a new business, an established business with a steadily
improving performance, a business that is going through a recovery or a
turnaround? Are there clear strategic challenges to address? Is it fast
growing with an unpredictable future, or stable with limited but fairly certain
prospects?
Sector
Both business sector and the position of a business within it are significant.
Internationalization, complexity and innovation
Should the companies all follow UK pay norms? How should they
accommodate US or European pay norms for their overseas directors?
Should the pay of directors in international or high-technology companies
differ from that of directors in companies of equivalent size that operate only
in the UK, or in low-technology or regulated industries?
Cash flow and debt levels
Both of these might place an important limitation on smaller organisations
where the pay of directors can be a significant proportion of business costs.
Key performance measures 
These should provide the essential underpinning when it comes to designing
incentives, be they short or long term. What are the important performance
measures associated with increasing shareholder value? How is the company
doing in comparison with its competitors on these measures? What are the
critical short-term and long-term indicators of performance?

Understanding company culture and values

Every organization has its own culture and values and these are frequently
reflected in remuneration, whether in the design of incentives, the type of
benefits available or, indeed, the level of remuneration itself. Outside
directors need to be able to recognise deeply held values that are associated
with success and to avoid cutting across these values when it comes to
remuneration arrangements.

Understanding current arrangements

Remuneration committees are rarely given the luxury of starting from a
clean slate. Before the first meeting, it is useful to get a full briefing from
fellow committee members, the chief executive or the human resources
director. In particular, the committee must know:
 The overall remuneration philosophy – the positioning of total
remuneration relative to the market place, the definition of the
market place, the approach to short-term and long-term incentives,
the benefits policy, etc.
 Contract details – notice periods, severance arrangements,
compensation for loss of office and special arrangements (if any) in
relation to changes of control.
 Details of individual directors' remuneration for the past three to five
years – including base salary, bonuses, long-term incentive grants
and exercise values.
 How far current remuneration complies with ABI and NAPF
guidelines.
  Any immediate changes planned (eg as a result of the expiry of a
share option plan, or a change in the strategy of the business).
 Any special arrangements for individual directors and why they
exist. New hires or executives approaching retirement, for example,
might have been offered something different.
 The market information provided by advisers.
 How outside advisers were appointed, who they are, and why they
were selected.

Understanding stakeholder interests

Within the confines of the law and Stock Exchange listing requirements,
directors' remuneration is chiefly a matter for the company, its shareholders
and executives. However, decisions are closely watched by a wide range of
other people and institutions. Executive pay can come under fire when an
interest group's view of the company clashes with the way the board is being
rewarded. As a result, understanding interest groups and their perceptions of
the company is vital in ensuring smooth implementation of remuneration
committee recommendations.

Understanding the market

The final element of preparation is to understand markets and market data.

Both the Greenbury and Hampel reports made much of the use and abuse of
data, and cautioned remuneration committees to take particular care in their
use of surveys.

However, market data is an important input into remuneration committee

deliberations. Market data is there to be questioned and interpreted. It
defines the parameters of normality – the boundaries of what is reasonable.

Remuneration committees
The role of the remuneration committee is to have an appropriate reward
policy that attracts, retains and motivates directors to achieve the long-term
interests of shareholders.

This definition creates a good balance between the opposing viewpoints

of stakeholders.

Objectives of the committee

The committee is, and is seen to be, independent with access to its own
external advice or consultants.

 It has a clear policy on remuneration that is well understood and has

the support of shareholders.
 Performance packages produced are aligned with long-term
shareholder interests and have challenging targets.
 Reporting is clear, concise and gives the reader of the annual report a
bird's-eye view of policy payments and the rationale behind them.

The whole area of executive pay is one where trust must be created or
restored through good governance and this is exercised through the use of a
remuneration committee.

Responsibilities of the remuneration committee

 Determine and regularly review the framework, broad policy and

specific terms for the remuneration and terms and conditions of
employment of the chairman of the board and of executive directors
(including design of targets and any bonus scheme payments).
 Recommend and monitor the level and structure of the remuneration
of senior managers.
 Establish pension provision policy for all board members.
 Set detailed remuneration for all executive directors and the
chairman, including pension rights and any compensation payments.
 Ensure that the executive directors and key management are fairly
rewarded for their individual contribution to the overall performance
of the company.
  Demonstrate to shareholders that the remuneration of the executive
directors and key management is set by individuals with no personal
interest in the outcome of the decisions of the committee.
 Agree any compensation for loss of office of any executive director.
 Ensure that provisions regarding disclosure of remuneration,
including pensions, as set out in the Directors' Remuneration Report
Regulations 2002 and the Code, are fulfilled.

From Book: Christine A. Mallin ,pg-204 & 205

Evaluating executives’ performance

Performance evaluations can take different forms, including formal, self-

and peer-assessments. How should board directors evaluate themselves?
Regular evaluations of the board and individual directors (especially CEOs
and chief financial officers) are important, as most investors review the
quality of a directorate before committing funds.  Research also reveals that
effective performance evaluations can enhance a board’s overall functioning
and the company’s subsequent financial performance. 

Companies can report on the following aspects of executives’ performance

evaluations: criteria and time frames used, the frequency of evaluations,
measurement tools used and the persons/committees conducting these
reviews. In most instances, executive performance is evaluated against
financial metrics such as return on assets (ROA), return on equity (ROE),
earnings per share (EPS), total share return (TSR), economic value added
(EVA) and market value added (MVA).
Despite being widely used, all these criteria have shortcomings. For
example, a company’s EPS should be viewed with caution as executives can
manipulate reported profits.

In addition to these financial benchmarks, individual directors can be

evaluated on their knowledge of the company, their effective fulfillment of
board tasks and their preparation, attendance and participation during
meetings. Evaluating boards of directors: What constitutes a good corporate
board?  When evaluating the board in its entirety, attention can be given to
meeting frequency.
A new category of performance benchmarks has emerged in recent years
centring on environmental, social and governance (ESG) considerations.
ESG performance can be assessed by, inter alia, examining risk audits and
the number of fines and complaints received from employees, customers
and/or suppliers in a particular year .How does your board rate? This
category of performance criteria is expected to become more important in
future as investors are increasingly incorporating ESG considerations into
their investment analyses and ownership practices. 

Disclosure of Directors’ Remuneration:

From Book: Page-210

 8 Directors and Board
Structure

Learning Objectives
● To be aware of the distinction between unitary and dual boards
● To have a detailed understanding of the roles, duties, and
responsibilities of directors
● To understand the rationale for key board committees and their functions
● To be able to critically assess the criteria for independence of non-
executive (outside) directors
● To comprehend the role and contribution of non-executive
(outside) directors
● To be aware of the importance of board evaluation, succession
planning, and board diversity

Introduction
This chapter covers the board structure of a company. The discussion encompasses
the function of a board and its subcommittees (the most common ones being the
audit, remuneration, nomination, and risk committees); the roles, duties, and
responsibilities of directors; and the attributes and contribution of a non-executive
(outside) director. Whilst the context is that of a UK company, much of the material is
appropriate to other countries that also have a unitary (one-tier) board structure and
may also be generalized to a dual (two-tier) board structure.

Unitary board versus dual board

A major corporate governance difference between countries is the board structure,
which may be unitary or dual depending on the country. As in the UK, in the majority
of EU Member States, the unitary board structure is predominant (in five states, the
dual structure is also available). However, in Austria, Germany, the Netherlands, and
Denmark, the dual structure is predominant. In the dual structure, employees may
have representation on the supervisory board (as in Germany, covered in detail in
Chapter 10) but this may vary from country to country.
166 DIRECTORS AND BOARD STRUCTURE

Unitary board
A unitary board of directors is the form of board structure in the UK and the USA, and
is characterized by one single board comprising both executive and non-executive
directors. The unitary board is responsible for all aspects of the company’s activities,
and all the directors are working to achieve the same ends. The shareholders elect
the directors to the board at the company’s annual general meeting (AGM).

Dual board
A dual board system consists of a supervisory board and an executive board of
management. However, in a dual board system, there is a clear separation between the
functions of supervision (monitoring) and that of management. The supervisory board
oversees the direction of the business, whilst the management board is responsible for the
running of the business. Members of one board cannot be members of another, so there
is a clear distinction between management and control. Shareholders appoint the
members of the supervisory board (other than the employee members), whilst the
supervisory board appoints the members of the management board.

Commonalities between unitary and dual board structures

There are many similarities in board practice between a unitary and a dual board
system. The unitary board and the supervisory board usually appoint the members of
the managerial body: the group of managers to whom the unitary board delegates
authority in the unitary system and the management board in a dual system. Both
bodies usually have responsibility for ensuring that financial reporting and control
systems are operating properly and for ensuring compliance with the law.
Usually, both the unitary board of directors and the supervisory board (in a dual
system) are elected by shareholders (in some countries, such as Germany,
employees may elect some supervisory board members).
Advocates of each type of board structure identify their main advantages as: in a one-tier
system, there is a closer relationship and better information flow as all directors, both execu-tive
and non-executive, are on the same single board; in a dual system, there is a more distinct and
formal separation between the supervisory body and those being ‘supervised’, because of the
separate management board and supervisory board structures. These aspects are dis-cussed
further in Chapter 10. However, whether the structure is unitary or dual, many codes seem to
have a common approach to areas relating to the function of boards and key board committees,
to independence, and to the consideration of shareholder and shareholder rights.

The UK Corporate Governance Code

In Chapter 3, the Cadbury Code of Best Practice was cited as having influenced the development of
corporate governance codes in many countries. The Cadbury Code clearly emphasizes, inter alia, the
central role of the board, the importance of a division of responsibilities at the
 DIRECTORS AND BOARD STRUCTURE 167

Box 8.1 The UK Corporate Governance Code

Section A: Leadership
A.1 The Role of the Board Every company should be headed by an effective board that is
collectively responsible for the long-term success of the company.
A.2 Division of Responsibilities There should be a clear division of responsibilities at the head of the
company between the running of the board and the executive responsibility for the running of the
company’s business. No one individual should have unfettered powers of decision.
A.3 The Chairman The chairman is responsible for leadership of the board and
ensuring its effectiveness on all aspects of its role.
A.4 Non-executive Directors As part of their role as members of a unitary board, non-executive
directors should constructively challenge and help develop proposals on strategy.

Section B: Effectiveness
B.1 The Composition of the Board The board and its committees should have the appropriate
balance of skills, experience, independence, and knowledge of the company to enable them
to discharge their respective duties and responsibilities effectively.
B.2 Appointments to the Board There should be a formal, rigorous, and transparent
procedure for the appointment of new directors to the board.
B.3 Commitment All directors should be able to allocate sufficient time to the company to
discharge their responsibilities effectively.
B.4 Development All directors should receive induction on joining the board, and should
regularly update and refresh their skills and knowledge.
B.5 Information and Support The board should be supplied in a timely manner with
information in a form and of a quality appropriate to enable it to discharge its duties.
B.6 Evaluation The board should undertake a formal and rigorous annual evaluation of its
own performance and that of its committees and individual directors.
B.7 Re-election All directors should be submitted for re-election at regular intervals,
subject to continued satisfactory performance.

Section C: Accountability
C.1 Financial and Business Reporting The board should present a balanced and
understandable assessment of the company’s position and prospects.
C.2 Risk Management and Internal Control The board is responsible for determining the nature
and extent of the significant risks it is willing to take in achieving its strategic objectives.
The board should maintain sound risk management and internal control systems.
C.3 Audit Committee and Auditors The board should establish formal and transparent arrangements
for considering how they should apply the corporate reporting, and risk management and internal
control principles, and for maintaining an appropriate relationship with the company’s auditor.

Section D: Remuneration
D.1 The Level and Components of Remuneration Levels of remuneration should be sufficient to
attract, retain, and motivate directors of the quality required to run the company successfully,
168 DIRECTORS AND BOARD STRUCTURE

but a company should avoid paying more than is necessary for this purpose. A
significant proportion of executive directors’ remuneration should be structured so as
to link rewards to corporate and individual performance.
D.2 Procedure There should be a formal and transparent procedure for developing policy
on executive remuneration and for fixing the remuneration packages of individual
directors. No director should be involved in deciding his/her own remuneration.

Section E: Relations with Shareholders

E.1 Dialogue with Shareholders There should be a dialogue with shareholders based on the
mutual understanding of objectives. The board as a whole has responsibility for ensuring
that a satisfactory dialogue with shareholders takes place.
E.2 Constructive Use of the AGM The board should use the AGM to communicate with
investors and to encourage their participation.

Source: The UK Corporate Governance Code, (Financial Reporting Council (FRC), 2010). © Financial
Reporting Council Limited (FRC). Adapted and reproduced with the kind permission of the Financial
Reporting Council, Aldwych House, 71–91 Aldwych, London WC2B 4HN. All rights reserved. For further
information please visit www.frc.org.uk or call +44 (0)202 7492 2300.

head of the company, and the role of non-executive directors. There have been a number
of revisions to UK corporate governance codes, as detailed in Chapter 3, culminating in
the issuance of the UK Corporate Governance Code (2010) which has its main principles
listed under five headings: Leadership, Effectiveness, Accountability, Remuneration, and
Relations with Shareholders. These are detailed in Box 8.1.
The UK Corporate Governance Code (hereafter ‘the Code’) is appended to the Listing Rules
by which companies listed on the London Stock Exchange must abide. However, companies
can conform to the Code’s provisions on a ‘comply or explain’ basis. ‘Comply or explain’ means
that the company will generally be expected to comply with the provisions of the Code, but if it
is unable to comply with a particular provision, then it can explain why it is unable to do so.
Institutional investors and their representative groups monitor carefully all matters related to the
Code, and will contact companies if they have not complied with a provision of the Code and
protest if the company does not have an appropriate reason for non-compliance.

The board of directors

The board of directors leads and controls a company and hence an effective board is
fundamental to the success of the company. The board is the link between managers
and investors, and is essential to good corporate governance and investor relations.
Given the UK’s unitary board system, it is desirable that the roles of chairman and chief
executive officer (CEO) are split because otherwise there could be too much power vested in
one individual. The chairman is responsible for the running of the board whilst the CEO is
responsible for the running of the business. The Code (2010) states that ‘the roles of chairman
and chief executive should not be exercised by the same individual’ (para A.2.1). When a CEO
retires from his/her post, he/she should not then become chairman of the same company
 DIRECTORS AND BOARD STRUCTURE 169

(exceptionally, a board may agree to a CEO becoming chairman, but in this case, the
board should discuss the matter with major shareholders setting out the reasons, and
also declare these in the next annual report). The Higgs Review (2003) reported that
only five FTSE 100 companies had a joint chairman/CEO, whilst this figure rose to 11
per cent of companies outside the FTSE 350.

Role of the board

The board is responsible for: determining the company’s aims and the strategies,
plans, and policies to achieve those aims; monitoring progress in the achievement of
those aims (both from an overview company aspect and also in terms of analysis and
evaluation of its own performance as a board and as individual directors); and
appointing a CEO with appropriate leadership qualities. Sir Adrian Cadbury (2002)
gives an excellent exposition of corporate governance and chairmanship, and the role
and effectiveness of the board in corporate governance.
In a study of the changing role of boards, Taylor et al. (2001) identified three major
chal-lenges facing company boards over the forthcoming five-year period. These
challenges were to build more diverse boards of directors, to pay more attention to
making their boards more effective, and to be able to react appropriately to any
changes in the cor-porate governance culture. By building better boards, innovation
and entrepreneurship should be encouraged and the business driven to perform
better. The board will focus on the value drivers of the business to give the firm
competitive advantage. Clearly, the composition of the board will play a key role in
whether a company can successfully meet these challenges. The presence of the
most suitable non-executive directors will help the board in this task. The role and
appointment of non-executive directors is discussed in more detail later.
Epstein and Roy (2006) state that,
high-performance boards must achieve three core objectives:

1. provide superior strategic guidance to ensure the company’s growth and prosperity;
2. ensure accountability of the company to its stakeholders, including
shareholders, employees, customers, suppliers, regulators and the community;
3. ensure that a highly qualified executive team is managing the company.

Decisions relating to board composition and structure will be of fundamental

importance in determining whether, and to what extent, the board is successful in
achieving these objectives.

Role, duties, and responsibilities

It is essential that the role, duties, and responsibilities of directors are clearly defined. The
Code (2010) states that, ‘the board’s role is to provide entrepreneurial leadership of the
company within a framework of prudent and effective controls which enables risk to
170 DIRECTORS AND BOARD STRUCTURE

be assessed and managed’ (para A.1). Directors should make decisions in an

objective way and in the company’s best interests.
The board should have regular meetings, with an agenda, and there should be a formal
schedule of matters over which the board has the right to make decisions. There should be
appropriate reporting procedures defined for the board and its subcommittees. As mentioned
earlier, the roles of chair and CEO should preferably be split to help ensure that no one indi-
vidual is too powerful. The board should have a balance between executive and non-executive
directors. All directors should have access to the company secretary and also be able to take
independent professional advice. The Code (2010) recommends that directors should receive
appropriate training when they are first appointed to the board of a listed company.
According to UK law, the directors should act in good faith in the interests of the
company, and exercise care and skill in carrying out their duties.
In November 2006 the Companies Act (2006) finally received Royal Assent after a pro-
longed period in the making. The Act updates previous Companies Acts legislation, but
does not completely replace them, and it contains some significant new provisions that will
impact on various constituents, including directors, shareholders, auditors, and company
secre-taries. The Act draws on the findings of the Company Law Review proposals.
The main features of the Act are as follows:
● directors’ duties are codified;
● companies can make greater use of electronic communications for
communicating with shareholders;
● directors can file service addresses on public record rather than their private
home addresses;
● shareholders will be able to agree limitations on directors’ liability;
● there will be simpler model Articles of Association for private companies, to
reflect the way in which small companies operate;
● private companies will not be required to have a company secretary;
● private companies will not need to hold an AGM unless they agree to do so;
● the requirement for an Operating and Financial Review (OFR) has not been reinstated,
rather companies are encouraged to produce a high-quality Business Review;
● nominee shareholders can elect to receive information in hard copy
form or electronically if they wish to do so;
● shareholders will receive more timely information;
● enhanced proxy rights will make it easier for shareholders to appoint others to
attend and vote at general meetings;
● shareholders of quoted companies may have a shareholder proposal (resolution)
circulated at the company’s expense if received by the financial year end;
● whilst there has been significant encouragement over a number of years to
encourage institutional investors to disclose how they use their votes, the
Act provides a power that could be used to require institutional investors to
disclose how they have voted.
 DIRECTORS AND BOARD STRUCTURE 171

All parts of the Act were in force by October 2008 with certain provisions taking effect
much earlier, for example, company communications to shareholders, including
electronic communications, took effect from January 2007.
Overall there seems to be an increasing burden for quoted companies whilst the burden
seems to have been reduced for private companies. In terms of the rights of shareholders
these are enhanced in a number of ways, including greater use of electronic communica-
tions, more information, enhanced proxy rights, and provision regarding the circulation of
shareholder proposals at the company’s expense. Equally, there is a corresponding
emphasis on shareholders’ responsibilities with encouragement for institutional
shareholders to be more active and to disclose how they have voted.
Given that the company is comprised of different shareholders, it may not be
possible for the directors, whilst acting in the interest of the company as a whole, to
please all share-holders at all times. In order to perform their role to best effect, it is
vital that directors have access to reliable information on a timely basis. It is an
essential feature of good corporate governance that the board will, in its turn, be
accountable to shareholders and provide them with relevant information so that, for
example, decision-making processes are transparent.
The roles of the CEO, chairman, senior independent director, and company
secretary are now discussed.

Chief executive officer (CEO)

The CEO has the executive responsibility for the running of the company’s business,
whereas the chairman has responsibility for the running of the board. The two roles
should not therefore be combined and carried out by one person, as this would give
an individual too much power.
One particular problem that arises from time to time is whether a retiring CEO
should become chairman of the same company. This is generally discouraged
because a chairman should be independent. The Code (2010) states:
A chief executive should not go on to be chairman of the same company. If exceptionally a
board decides that a chief executive should become chairman, the board should consult
major shareholders in advance and should set out its reasons to shareholders at the time
of the appointment and in the next annual report. (para. A.3.1)

As well as a lack of independence, there is a feeling that it might cause problems for any
incoming CEO if the retired CEO is still present at a senior level in the company (in the
role of chairman) because he/she may try to become more involved in the running of the
company rather than the running of the board (in his/her new role as chairman).
Various institutional bodies have made their views known on this issue: for example,
Research Recommendations Electronic Voting (RREV), a joint venture between the National
Association of Pension Funds (NAPF) and Institutional Shareholder Services (ISS), states that
‘the normal application of the NAPF policy is to vote against the re-election of a director with the
roles of both chief executive and chairman’. Hermes, in The Hermes Corporate
172 DIRECTORS AND BOARD STRUCTURE

Governance Principles, states that it is generally opposed to a CEO becoming

chairman of the board at the same company.

Chairman
The chairman is responsible for the running of the board and for ensuring that the
board meets frequently, that directors have access to all the information they need to
make an informed contribution at board meetings, and that all directors are given the
opportunity to speak at board meetings.
As Sir Adrian Cadbury (2002) observed: ‘the primary task of chairmen is to chair their
boards. This is what they have been appointed to do and, however the duties at the top of
a company may be divided, chairing the board is their responsibility alone’ (p. 78). He also
succinctly highlights an important difference between CEOs and chairmen:

the difference between the authority of chairmen and that of chief executives is that
chairmen carry the authority of the board, while chief executives carry the authority
delegated to them by the board. Chairmen exercise their authority on behalf of the
board; chief executives have personal authority in line with the terms of their
appointment. (p. 99.)

The chairman should hold meetings with the non-executive directors without the
executives present. The Combined Code (2006) stated that no individual should hold
more than one chairmanship of a FTSE 100 company, however, the Combined Code
(2008) removed this restriction. One rationale for this change is that limiting an
individual to chairing just one FTSE 100 company took no account of what other
activities he/she might be engaged in; these other activities might not be onerous in
which case it would be feasible to chair more than one FTSE 100 company. The
Code (2010) states that the board should not agree to a full-time executive director
taking on more than one non-executive directorship in a FTSE 100 company or the
chairmanship of such a company, (B.3.3).
McNulty et al. (2011), in a study of 160 chairs of 500 FTSE listed companies, find that
‘by linking board structure, board process and the exercise of influence, the study reveals
both differences amongst chairs in how they run the board, but also that chairs’ differ in
the influ-ence they exert on board-related tasks. Full-time executive chairs exert their
greatest influence in strategy and resource dependence tasks whereas part-time, non-
executive chairs seem to exert more influence over monitoring and control tasks’.

Senior independent director

The Code (2010) provides for the appointment of a senior independent director (SID) who
should be one of the independent non-executive directors. The Code (2010) states: ‘the
senior independent director should be available to shareholders if they have concerns
which contact through the normal channels of chairman, chief executive or finance director
has failed to resolve or for which such contact is inappropriate’ (para. A.4.1).
 DIRECTORS AND BOARD STRUCTURE 173

The Hermes Corporate Governance Principles also see the SID as providing an
additional communication channel to shareholders and states: ‘if the chairman of the
board is not inde-pendent, then the board should appoint a senior independent
director whose role would include reviewing the performance of the chairman’ (para.
3.4). The non-executive directors should meet without the chairman present at least
annually in order to appraise the chair-man’s performance, and on other occasions as
necessary. At these times, the SID would lead the meeting.

Company secretary
The company secretary, like the directors, must act in good faith and avoid conflicts of interest.
The company secretary has a range of responsibilities, including facilitating the work of the
board by ensuring that the directors have all the information they need for the main board and
also for the board subcommittees (commonly audit, remuneration, and nomination), and that
such information flows well between the various constituents. The company secretary advises
the board, via the chairman, on all governance matters and will assist with the professional
development needs of directors and induction requirements for new directors.
The dismissal of the company secretary is a decision for the board as a whole and
not just the CEO or chairman.

Board subcommittees
The board may appoint various subcommittees, which should report regularly to the
board, and although the board may delegate various activities to these
subcommittees, it is the board as a whole that remains responsible for the areas
covered by the subcommittees. Charkham (2005) states:
committees of the board are used for various purposes, the main one being to assist
the dispatch of business by considering it in more detail than would be convenient for
the whole board . . . the second purpose is to increase objectivity either because of
inherent conflicts of interest such as executive remuneration, or else to discipline
personal preferences as in the exercise of patronage.

The Cadbury Report recommended that an audit committee and a remuneration

committee should be formed, and also stated that a nomination committee would be
one possible way to make the board appointments process more transparent.
The Higgs Review (2003) reported that most listed companies have an audit committee
and a remuneration committee. Only one FTSE 100 company did not have an audit com-
mittee or remuneration committee, whilst 15 per cent of companies outside the FTSE 350
did not have an audit committee. Adoption of nomination committees has tended to be
less prevalent with the majority (71 per cent) of companies outside the FTSE 350 not
having a nomination committee. FTSE 100 companies have tended to adopt nomination
committees with the exception of six companies. The Code (2010) states that there should
be a nomina-tion committee to lead the board appointments process.
174 DIRECTORS AND BOARD STRUCTURE

Audit committee
The audit committee is arguably the most important of the board subcommittees.
The Smith Review of audit committees, a group appointed by the FRC, reported in
January 2003. The review made clear the important role of the audit committee: ‘while all
directors have a duty to act in the interests of the company, the audit committee has a
particular role, acting independently from the executive, to ensure that the interests of
shareholders are properly protected in relation to financial reporting and internal control’
(para. 1.5). The review defined the audit committee’s role in terms of ‘oversight’,
‘assessment’, and ‘review’, indicating the high-level overview that audit committees should
take; they need to satisfy themselves that there is an appropriate system of controls in
place but they do not undertake the monitoring themselves.
It is the role of the audit committee to review the scope and outcome of the audit,
and to try to ensure that the objectivity of the auditors is maintained. This would
usually involve a review of the audit fee and fees paid for any non-audit work, and the
general independence of the auditors. The audit committee provides a useful ‘bridge’
between both internal and external auditors and the board, helping to ensure that the
board is fully aware of all relevant issues related to the audit. The audit committee’s
role may also involve reviewing arrangements for whistle-blowers (staff who wish
confidentially to raise concerns about possible improper practices in the company). In
addition, where there is no risk management committee (discussed later), the audit
committee should assess the systems in place to identify and manage financial and
non-financial risks in the company.
The guidance was updated in 2005 and subsequently a new edition of the guidance
was issued in October 2008. A limited number of changes were made to implement some
of the recommendations of the Market Participants Group (MPG), established to provide
advice to the FRC on market-led actions to mitigate the risk that could arise in the event of
one or more of the Big Four audit firms leaving the market. The main changes to the
guidance are that audit committees are encouraged to consider the need to include the
risk of the with-drawal of their auditor from the market in their risk evaluation and planning;
and that com-panies are encouraged to include in the audit committee’s report information
on the appointment, reappointment or removal of the auditor, including supporting
information on tendering frequency, the tenure of the incumbent auditor, and any
contractual obliga-tions that acted to restrict the committee’s choice of auditor. In addition,
there have been a small number of detailed changes to the section dealing with the
independence of the aud-itor, to bring the guidance in line with the Auditing Practices
Board’s Ethical Standards for auditors. An appendix has also been added containing
guidance on the factors to be consid-ered if a group is contemplating employing firms from
more than one network to undertake the audit.
The Code (2010) states that,
the board should establish an audit committee of at least three, or in the case of smaller
companies, two, independent non-executive directors. In smaller companies the company
chairman may be a member of, but not chair, the committee in addition to the independent
non-executive directors, provided he or she was considered independent on appointment
 DIRECTORS AND BOARD STRUCTURE 175

as chairman. The board should satisfy itself that at least one member of the audit
committee has recent and relevant financial experience. (para. C.3.1.)

In September 2011 the FRC announced that it intended to consult on proposed

changes to the Code in relation to audit committees and audit retendering. It is
possible that further changes may be proposed as a consequence of the Sharman
Panel of Inquiry into ’going concern’ and the Department for Business, Innovation &
Skills consultation on narrative reporting, the outcomes of both of these being
available in 2012. Any changes agreed as a result will be incorporated into the
revised Code that will apply from 1 October 2012.
Spira (2002) provides a useful insight into the processes and interactions of audit commit-
tees, and highlights the importance of the composition of audit committees. The audit com-
mittee should comprise independent non-executive directors who are in a position to ask
appropriate questions, so helping to give assurance that the committee is functioning prop-erly.
Turley (2008) highlights how ‘the role and significance of the audit committee as a gov-ernance
structure have developed substantially during the last decade’.
Zaman et al. (2011) examine the influence of audit committee effectiveness, a proxy for
governance quality, on audit fees and non-audit services fees. They find that after controlling for
board of director characteristics, there is a significant positive association between audit
committee effectiveness and audit fees, only for larger clients. Their results indicate that

effective audit committees undertake more monitoring which results in wider audit scope and higher
audit fees. Contrary to our expectations, we find the association between audit committee
effectiveness and non-audit service fees to be positive and significant, especially for larger clients. This
suggests that larger clients are more likely to purchase non-audit services even in the presence of
effective audit committees probably due to the complexity of their activities. Overall, our findings
support regulatory initiatives aimed at improving corporate governance quality.

Remuneration committee
The area of executive remuneration is always a ‘hot issue’ and one that attracts a lot
of attention from investors and so, perhaps inevitably, the press. Indeed, since the
financial crisis there seems to be an insatiable appetite for stories about excessive
executive remuneration. Executive remuneration itself is covered in some detail in
Chapter 9, whilst the structure of the remuneration committee is detailed now.
The Code (2010) states that ‘the board should establish a remuneration committee of at
least three, or in the case of smaller companies, two independent non-executive directors’
(para. D.2.1). The remuneration committee should make recommendations to the board,
within agreed terms of reference, on the company’s framework of executive remuneration
and its cost; it should determine on their behalf specific remuneration packages for each
of the executive directors, including pension rights and any compensation payments.
The establishment of a remuneration committee (in the form recommended by the Code)
prevents executive directors from setting their own remuneration levels. The remuneration
committee mechanism should also provide a formal, transparent procedure for the setting of
executive remuneration levels, including the determination of appropriate targets for any
176 DIRECTORS AND BOARD STRUCTURE

performance-related pay schemes. The members of the remuneration committee

should be identified in the annual report. The remuneration of non-executive directors
is decided by the chairman and the executive members of the board. The company
chairman may serve on—but should not chair—the remuneration committee where
he/she is considered inde-pendent on appointment as the chairman.
However, Bender (2011) states:
The market they [remuneration committees] use to derive comparative data is not a
market as such, it is a collection of self-selected elite peers. The much-vaunted
independence of the non-executives on the remuneration committee in itself means that
they have incomplete knowledge of the company and the individuals being compensated,
and asymmetry of information leaves them at the wrong end of a power imbalance. In all,
the realities of how committees actually operate differ considerably from the rhetorics with
which they describe their compliance with the unattainable Ideal.

Nomination committee
In the past directors were often appointed on the basis of personal connections. This process
often did not provide the company with directors with appropriate business experience relevant
to the particular board to which they were appointed. The board would also not have a balance
in as much as there would be a lack of independent non-executive directors.
The Code (2010) advocates a formal, rigorous, and transparent procedure for the appoint-
ment of new directors and states that ‘there should be a nomination committee which should
lead the process for board appointments and make recommendations to the board. A majority
of members of the nomination committee should be independent non-executive directors’ (para.
B.2.1). The chair of the committee may be the chairman of the company or an independent
non-executive director but the chairman should not chair the nomination committee when it is
dealing with the appointment of a successor to the chairmanship.
The nomination committee should evaluate the existing balance of skills, knowledge,
and experience on the board, and utilize this when preparing a candidate profile for new
appointments. The nomination committee should throw its net as wide as possible in the
search for suitable candidates to ensure that it identifies the best candidates. In an often
rapidly changing business environment, the nomination committee should also be involved
with succession planning in the company, noting challenges that may arise and identifying
possible gaps in skills and knowledge that would need to be filled with new appointments.
As with the other key board committees, the members of the nomination committee should
be identified in the annual report.
It is important that the board has a balanced composition, both in terms of
executive and non-executive directors, and in terms of the experience, qualities, and
skills that individuals bring to the board.
The Institute of Directors (IoD) published some useful guidance in this area. Box
8.2 shows an extract from Standards for the Board (2006) in relation to an action list
for deciding board composition.
Guo and Masulis (2012), in a sample of 1,280 firms listed on the New York Stock Exchange
(NYSE) or Nasdaq, use the mandatory changes in board composition brought about
 DIRECTORS AND BOARD STRUCTURE 177

Box 8.2 Action list for deciding board composition

● Consider the ratio and number of executive and non-executive directors.
● Consider the energy, experience, knowledge, skill and personal attributes of current and
prospective directors in relation to the future needs of the board as a whole, and develop
specifications and processes for new appointments, as necessary.
● Consider the cohesion, dynamic tension and diversity of the board and its leadership
by the chairman.
● Make and review succession plans for directors and the company secretary.
● Where necessary, remove incompetent or unsuitable directors or the company secretary,
taking relevant legal, contractual, ethical, and commercial matters into account.
● Agree proper procedures for electing a chairman and appointing the managing director and
other directors.
● Identify potential candidates for the board, make selection and agree terms of appointment and
remuneration. New appointments should be agreed by every board member.
● Provide new board members with a comprehensive induction to board processes and
policies, inclusion to the company and to their new role.
● Monitor and appraise each individual’s performance, behaviour, knowledge, effectiveness and
values rigorously and regularly.
● Identify development needs and training opportunities for existing and potential directors
and the company secretary.

Source: Standards for the Board (IoD, 2006)

by the new exchange listing rules following the passage of the Sarbanes-Oxley Act
(SOX) to estimate the effect of overall board independence and nominating
committee independence on forced CEO turnover. Their evidence suggests that
‘greater representation of independent directors on board and/or nominating
committee leads to more effective monitoring. Our finding that nominating committee
independence significantly affects the quality of board monitoring has important policy
implications given the intense debate on the costs and benefits of mandatory board
regulations since the passage of SOX’.

Risk committee
Risk of various types features significantly in the operation of many businesses. Although
not a recommendation of the Code, many companies either set up a separate risk
committee or establish the audit committee as an audit and risk committee. Of course, it is
essential that directors realize that they are responsible for the company’s system of
internal controls and have mechanisms in place to ensure that the internal controls of the
company and risk management systems are operating efficiently.
Equally, many companies, particularly larger companies or those with significant transac-
tions overseas, may find that they have interest or currency exposures that need to be
178 DIRECTORS AND BOARD STRUCTURE

covered. The misuse of derivatives through poor internal controls and lack of monitoring
led to the downfall of Barings Bank (as detailed in Chapter 1) and other companies may
be equally at risk. A risk committee should therefore comprehend the risks involved by,
inter alia, using derivatives, and this would necessitate quite a high level of financial
expertise and the ability to seek external professional advice where necessary.
Pathan (2009), using a sample of 212 large US bank holding companies over the period
1997–2004, examines the relevance of bank board structure on bank risk-taking. He finds
that ‘strong bank boards (boards reflecting more of bank shareholders interest) particularly
small and less restrictive boards positively affect bank risk-taking. In contrast, CEO power
(CEO’s ability to control board decision) negatively affects bank risk-taking’.
Meanwhile Yatim (2010), in a study of 690 firms listed on the Bursa Malaysia for
the finan-cial year ending in 2003, finds
a strong support for an association between the establishment of a risk management committee
and strong board structures. Specifically, the result shows that firms with higher proportions of
non-executive directors on boards and firms that separate the positions of chief executive
officers and board chairs are likely to set up a stand-alone risk management committee. Firms
with greater board expertise and board diligence are also likely to establish a risk management
committee. These findings suggest that stronger boards demonstrate their commitment to and
awareness of improved internal control environment.

Ethics committee
Following the collapse of Enron more companies introduced ethics committees as a board
subcommittee. Companies may try to ensure that there is a strong organizational ethic by
cascading an ethics code throughout the company, from director level to the worker on the
shop floor. Many corporate governance codes are silent on any explicit mention of ethics
committees, although the spirit of corporate governance recommendations is to act in an
ethical way. This lack of an explicit mention is perhaps rather surprising given the frequent
‘breaches’ of perceived good corporate governance: infringement of shareholder rights,
fraud, and excessive executive remuneration. As we have seen in Chapter 6, institutional
shareholders are being exhorted to engage more fully with their investee companies, to
act more as shareowners, and hopefully to encourage companies to behave more
ethically. In Chapter 7 we saw that the management of, inter alia, ethical issues can be
seen as a form of risk management.
Stevens et al. (2005) state that
the extent to which ethics codes are actually used by executives when making strategic choices
as opposed to being merely symbolic is unknown . . . We find that financial executives are more
likely to integrate their company’s ethics code into their strategic decision processes if (a) they
perceive pressure from market stakeholders to do so (suppliers, customers, shareholders, etc.);
(b) they believe the use of ethics codes creates an internal ethical culture and promotes a
positive external image for their firms; and (c) the code is integrated into daily activities through
ethics code training programs. The effect of market stakeholder pressure is further enhanced
when executives also believe that the code will promote a
 DIRECTORS AND BOARD STRUCTURE 179

positive external image. Of particular note, we do not find that pressure from non-
market stakeholders (e.g., regulatory agencies, government bodies, court systems)
has a unique impact on ethics code use.

Crane et al. (2008) highlight that ethics programmes may involve a smaller cost now
and result in significant savings in the future: ‘In the United States, for example,
corporations can significantly reduce their fine once they have been found guilty in
criminal procedures by showing that an effective ethics program was in place’.

Non-executive directors
Non-executive directors are a mainstay of good governance. The non-executive director’s
role essentially has two dimensions. One dimension—which has been given much
emphasis in the last decade—is as a control or counterweight to executive directors, so
that the presence of non-executive directors helps to ensure that an individual person or
group cannot unduly influence the board’s decisions. The second dimension is the
contribution that non-executive directors can make to the overall leadership and
development of the company. Some argue that there may be a conflict in these two roles
because non-executive directors are expected both to monitor executive directors’ actions
and to work with executive directors as part of the board. This idea of a potential conflict in
the roles is an area discussed by Ezzamel and Watson (1997).
The Cadbury Report (1992) stated that ‘given the importance of their distinctive
contribu-tion, non-executive directors should be selected with the same impartiality and
care as senior executives’ (para. 4.15). Non-executives should ideally be selected through
a formal process and their appointment should be considered by the board as a whole.
The Cadbury Report also emphasized the contribution that independent non-executive
directors could make, stating ‘the Committee believes that the calibre of the non-executive
members of the board is of special importance in setting and maintaining standards of cor-
porate governance’ (para. 4.10). The importance of non-executive directors was echoed in
the Organisation for Economic Co-operation and Development (OECD) Principles:
‘Boards should consider assigning a sufficient number of non-executive board members
capable of exercising independent judgement to tasks where there is a potential for
conflict of interest. Examples of such key responsibilities are financial reporting,
nomination and executive and board remuneration.’
The Code (2010) also recognizes the important role to be played by independent
non-executive directors:
as part of their role as members of a unitary board, non-executive directors should
constructively challenge and help develop proposals on strategy . . . [they] should
scrutinise the performance of management in meeting agreed goals and objectives and
monitor the reporting of performance. They should satisfy themselves on the integrity of
financial information and that financial controls and systems of risk management are
robust and defensible. They are responsible for determining appropriate levels of
remuneration of executive directors and have a prime role in appointing, and where
necessary removing, executive directors, and in succession planning. (para. A.4.)
180 DIRECTORS AND BOARD STRUCTURE

Independence of non-executive directors

Although there is a legal duty on all directors to act in the best interests of the company, this
does not of itself guarantee that directors will act objectively. To try to ensure objectivity in
board decisions, it is important that there is a balance of independent non-executive directors.
This idea of independence is emphasized again and again in various codes and reports: for
example, Cadbury (1992) stated that ‘apart from their directors’ fees and shareholdings, they
[non-executive directors] . . . should be independent of management and free from any
business or other relationship which could materially interfere with the exercise of their
independent judgement’ (para. 4.12). The OECD (1999) also considered this issue: ‘Board
independence usually requires that a sufficient number of board members not be employed by
the company and not be closely related to the company or its management through significant
economic, family or other ties. This does not prevent shareholders from being board members’.
Subsequently, the OECD (2004) stated that ‘board independence . . .
usually requires that a sufficient number of board members will need to be independent of
management’. The Higgs Review (2003) stated that ‘a board is strengthened significantly
by having a strong group of non-executive directors with no other connection with the
company. These individuals bring a dispassionate objectivity that directors with a closer
relationship to the company cannot provide’ (para. 9.5).
The Code (2010) states that ‘the board should identify in the annual report each
non-executive director it considers to be independent. The board should determine
whether the director is independent in character and judgement and whether there
are relationships or circumstances which are likely to affect, or could appear to affect,
the director’s judgement’ (para. B.1.1).
‘Independence’ is generally taken as meaning that there are no relationships or
circum-stances that might affect the director’s judgement. Situations where a non-
executive direc-tor’s independence would be called into question include:
● where the director was a former employee of the company or group within the
last five years;
● where additional remuneration (apart from the director’s fee) was received
from the company;
● where the director had close family ties with the company’s other directors
and advisors;
● where he/she had a material business relationship with the company in the last
three years;
● where he/she had served on the board for more than ten years; where
he/she represented a significant shareholder.
There is some discussion as to whether the number of non-executive directorships that any one
individual can hold should be defined. Of course, if an individual were to hold many non-
executive directorships, for example, ten or more, then it is arguable whether that individual
could devote enough time and consideration to each of the directorships. On the other hand, it
may be perfectly feasible for an individual to hold, for example, five non-executive directorships.
It really depends on the time that an individual has available, on the
 DIRECTORS AND BOARD STRUCTURE 181

level of commitment, and whether any of the multiple non-executive directorships might lead to
the problem of interlocking directorships whereby the independence of their role is
compromised. An interlocking relationship might occur through any of a number of
circumstances, including family relationship, business relationship, or a previous advisory role
(such as auditor), which would endanger the fundamental aspect of independence. However,
the independence of non-executive directors is an area of corporate governance that
institutional investors and their representative groups monitor very carefully and disclosure of
biographical information about directors and increasing use of databases of director information
should help to identify potential problems in this area. The Code (2010) states that ‘non-
executive directors should undertake that they will have sufficient time to meet what is expected
of them’ and ‘their other significant commitments should be disclosed to the board before
appointment, with a broad indication of the time involved and the board should be informed of
subsequent changes’ (para. B.3.2). It is recommended that a full-time executive director should
not take on ‘more than one non-executive directorship in a FTSE 100 company nor the
chairmanship of such a company’ (para. B.3.3).
Morck (2008) discussed the fact that behavioural issues are important in corporate gover-
nance, citing Milgram’s (1974) findings that human nature includes ‘a reflexive subservience’ to
people perceived to be legitimate authorities, like corporate CEOs. Morck states that ‘effective
corporate governance reforms must weaken this reflexive subservience. Corporate governance
reforms that envision independent directors (dissenting peers), non-executive chairs (alternative
authority figures), and fully independent audit committees (absent authority figures) aspire to a
similar effect on corporate boards—the initiation of real debate to expose poor strategies before
they become fatal’.
Yeh et al. (2011), using the data of the twenty largest financial institutions from G8
coun-tries (Australia, Canada, France, Germany, Italy, Japan, UK, and USA), of
which four are common law countries and four civil law countries, find that the
‘performance during the crisis period is higher for financial institutions with more
independent directors on auditing and risk committees. The influence of committee
independence on the performance is particularly stronger for civil law countries. In
addition, the independence-performance relationships are more significant in financial
institutions with excessive risk-taking behaviors’.

Contribution of non-executive directors

The necessity for the independence of the majority of non-executive directors has been
established above, and the ‘right’ non-executive directors can make a significant contribution to
the company. When non-executive directors are being sought, the company will be looking for
the added value that a new appointment can make to the board. The added value may come
from a number of facets: their experience in industry, the City, public life, or other appropriate
background; their knowledge of a particular functional specialism (for example, finance or
marketing); their knowledge of a particular technical process/system; their reputation; their
ability to have an insight into issues discussed at the board and to ask searching questions. Of
course, these attributes should be matched by the non-executive director’s independence and
integrity. The Cadbury Code of Best Practice (1992) stated that
182 DIRECTORS AND BOARD STRUCTURE

‘non-executive directors should bring an independent judgement to bear on issues of

strategy, performance, resources, including key appointments, and standards of
conduct’ (para. 2.1).
As well as their contribution to the board, non-executive directors will serve on the key board
committees (audit, remuneration, and nomination) as described earlier. However, it is not
recommended that any one non-executive director sits on all three of these board com-mittees.
The Code (2010) refers to the benefits of ‘ensuring that committee membership is refreshed
and that undue reliance is not placed on particular individuals’ (para. B.1).

Higgs Review
The Higgs Review, chaired by Derek Higgs, was established by the Department of
Trade and Industry (DTI) in 2002 to review the role and effectiveness of non-
executive directors. The Higgs Review was discussed in more detail in Chapter 3. Its
recommendations caused much discussion but most of them were incorporated into
the Combined Code (2003, 2006, 2008) and the subsequent UK Corporate
Governance Code (2010), although some in a modified form.
In 2006 the FRC published Good Practice Suggestions from the Higgs Report. These
include guidance on the role of the chairman and the non-executive director, and a
summary of the principal duties of the remuneration and nomination committees. In 2010
the FRC pub-lished the Guidance on Board Effectiveness, which relates primarily to
Sections A and B of the Code on the leadership and effectiveness of the board. The
guidance was developed by the Institute of Chartered Secretaries and Administrators
(ICSA) on the FRC’s behalf, and replaces ‘Suggestions for Good Practice from the Higgs
Report’ (known as the Higgs Guidance), which has been withdrawn.
The Association of British Insurers (ABI) issued its first Report on Board Effectiveness
in 2011. The report focuses on three areas that the ABI believes helps ensure that the
board is effective and contributes to the company’s success. These areas are board
diversity, succes-sion planning, and board evaluation. The ABI states: ‘These issues do
not stand alone. Select-ing the best individuals from a diverse talent pool, planning for
succession and replacement, and regularly evaluating the board to determine its
effectiveness, cover the lifecycle of a board. That is why they are important’.

Director evaluation
In the Hampel Committee Final Report (1998), it was suggested that boards consider the
introduction of formal procedures to ‘assess both their own collective performance and
that of individual directors’ (para 3.13). In a widely cited report of institutional investor
opinion, McKinsey (2002) defined ‘good’ board governance practices as encompassing a
majority of outside (non-executive) directors, outside directors who are truly independent
with no management ties, and under which formal director evaluation is in place.
The evaluation of directors has two dimensions, which are the evaluation of the board as a
whole and the evaluation of individual directors serving on the board. Most annual reports are
 DIRECTORS AND BOARD STRUCTURE 183

not forthcoming on how these evaluations may be carried out in their business, and indeed
KPMG (2002) found, in a survey of corporate governance in Europe, that only 39 per cent of UK
respondents had a regular process for the evaluation of the board. However, this was consider-
ably better than the figure for the European countries as a whole, which was only 17 per cent.
In terms of the evaluation of the board as a whole, there are several approaches that
might be utilized. These approaches include, first, a structured questionnaire to evaluate
how the board is performing in key areas (such as achieving key goals that have been
set), and infor-mal discussion between the chairman of the board and the directors, which
would cover a wide range of strategic and operational issues (such as how well do the
board dynamics work, and how well do the board subcommittees work).
The evaluation of individual directors provides individual directors with the opportunity to
discuss key areas with the chairman on a one-to-one basis. It is an important process for
finding out just how comfortable an individual director is, what areas he/she might be able
to contribute to more effectively, and whether there are any barriers to full participation in
the board’s activities (for example, lack of information to enable an informed discussion).
These evaluations will contribute to the establishment of the performance criteria
that will help to achieve the corporate objectives and which are used in helping to
align the perfor-mance of directors with the interest of shareholders.
It does seem clear that, in order to determine whether boards of directors as a whole, and
directors as individuals, are performing to the best of their ability, there should be evaluation of
the board as a whole, the board leadership, and the individual directors. Many boards are silent
on this issue, indicating either that they do not have evaluation procedures in place or that they
do not wish to disclose them if they have. If the latter is the case, then one has to ask whether
the reluctance to disclose is because the evaluation process is not robust enough to stand up to
scrutiny. If the former is the case, that is, that there are no evaluation or assess-ment
procedures in place, then equally one has to ask why not. This information will be very helpful in
setting performance-related pay for directors and helping to eliminate the unease that many
investors feel about executive remuneration levels.
The area of board evaluation has been taken up by the Code (2010), which includes the
principle that ‘the board should undertake a formal and rigorous annual evaluation of its own
performance and that of its committees and individual directors’ (para. B.6). The board should
disclose in the annual report the way in which the performance evaluations have been carried
out. The Code recommends that, at least every three years, evaluation of FTSE 350 companies
should be externally facilitated. Furthermore, ‘non-executive directors, led by the senior
independent director, should be responsible for performance evaluation of the chairman, taking
into account the views of executive directors’, (para. B.6.3).
Van den Berghe and Levrau (2004), in a study of the boards of directors of thirty com-
panies listed on Euronext Brussels and Nasdaq Europe, found that there were a number
of areas where better understanding was needed of elements that determined board
effective-ness. They also found that board evaluation was not as widespread as might be
hoped. Epstein and Roy (2006) state that it is important to evaluate both the board as a
whole and individual directors, as this may help highlight deficiencies. Metrics for
evaluation should be relevant and linked to the inputs, such as attendance at board
meetings, and outputs, such as stock price. A balanced scorecard approach, derived from
the work of Kaplan and Norton (1992, 2000) is an appropriate tool for director evaluation.
184 DIRECTORS AND BOARD STRUCTURE

Wong (2011) highlights that the global financial crisis has prompted more debate
on how the effectiveness of the board might be improved. He points out that
despite considerable reforms over the past two decades, boards—particularly at financial
institutions—have been criticized recently for failing to properly guide strategy, oversee
risk management, structure executive pay, manage succession planning, and carry out
other essential tasks. This article argues that the lack of attention to behavioral and
functional considerations—such as director mindset, board operating context, and
evolving human dynamics—has hampered the board’s effectiveness.

He makes various recommendations alongside ‘establishing core building blocks

such as appropriate board size, well-functioning committees, proficient company
secretarial support, and professionally-administered board evaluation’.
The ABI (2011) find that in 2010/11, 95.9 per cent of FTSE 100 and 96.2 per cent of
FTSE 250 companies stated that they conducted a board evaluation. For companies listed
in both 2009/10 and 2010/11, 16.2 per cent of FTSE 100 companies and 5.1 per cent of
FTSE 250 companies conducted external evaluations in both years.

Succession planning
The Code (2010) describes non-executive directors as having a key role to play in the
succession planning of the company, and states: ‘The board should satisfy itself that plans
are in place for orderly succession for appointments to the board and to senior
management, so as to maintain an appropriate balance of skills and experience within the
company and on the board and to ensure progressive refreshing of the board’, (para. B.2).
Naveen (2006) found that ‘a firm’s propensity to groom an internal candidate for the
CEO position is related to firm size, degree of diversification, and industry structure. My
results also suggest that succession planning is associated with a higher probability of
inside succes-sion and voluntary succession and a lower probability of forced succession’.
Larcker and Tayan (2010) state that whilst one of the most important decisions for
a board of directors is the selection of the CEO, ‘survey data indicates that many
boards are not pre-pared for this process. In recent years, shareholder groups have
pressured boards to increase transparency about their succession plans’.
The Spencer Stuart 2011 UK Board Index, reporting on the current board trends and
prac-tices at major UK companies, finds that ‘chairman succession planning is not widely
dis-cussed in most boardrooms because there are few formal mechanisms for addressing
the issue beyond the chairman’s annual review with the senior independent director. For
such a critical appointment it is surprising how little has been written and how seldom the
chairman succession planning process is openly discussed, (Will Dawkins)’.

Board diversity
An area that is attracting increasing interest is that of board diversity whereby diversity is
defined broadly in terms of gender or nationality. It may be argued that board diversity enables
different perspectives to be taken on various issues given that men and women may
 DIRECTORS AND BOARD STRUCTURE 185

approach issues from different viewpoints and may have different behavioural
patterns as well; similarly individuals from different ethnic backgrounds may bring
additional cultural insights to the boardroom.
Concerned by the lack of progress with the representation of women on UK boards, the
UK’s Coalition Government invited Lord Davies to review the situation, to identify the bar-
riers that were preventing more women from reaching the boardroom, and to make recom-
mendations as to how this situation might be redressed. Lord Davies’ report, Women on
Boards, was published in February 2011 and reviewed the current situation on UK boards
(FTSE 350) and considered the business case for having gender-diverse boards.
A number of recommendations were made, including that the chairmen of FTSE 350
com-panies should state the percentage of women that they aim to have on their boards in
2013 and 2015, and that FTSE 100 companies should aim for a minimum 25 per cent
women in the boardroom by 2015 although many might achieve a higher figure. Quoted
companies should annually disclose the proportion of women on the board, women in
senior executive positions, and female employees in the organizations as a whole.
Furthermore, Lord Davies recommended that the FRC amend the Code to require listed
companies to establish a policy on boardroom diversity, including measurable objectives
for implementing the policy, and disclose a summary of the policy and the progress made
towards achieving the objec-tives each year. It was also recommended that executive
search firms should draw up a voluntary code of conduct addressing gender diversity and
best practice, covering the rele-vant search criteria and processes in relation to FTSE 350
board appointments. Early in 2012 there was a follow-up report published which indicated
that, over the year since the original report was published, the biggest ever reported
increase in the percentage of women on boards was evidenced.
In May 2011 the FRC began consulting on possible amendments to the Code that would
require companies to publish their policy on boardroom diversity and report against it an-nually,
as recommended by the Davies Report (2011) and to consider the board’s diversity amongst
other factors, when assessing its effectiveness. In October 2011 the FRC announced that these
changes would be implemented in a revised version of the Code, which will be issued in 2012
and will apply to financial years beginning on or after 1 October 2012.
The changes affect two sections of the Code. First, in relation to Section B.2.4, where it
is proposed that the work of the nomination committee should be described in a separate
section of the annual report, including the process used in relation to board appointments.
This section should include a description of ‘the board’s policy on diversity, including
gender, any measurable objectives that it has set for implementing the policy, and
progress on achieving the objectives. An explanation should be given if neither an external
search con-sultancy nor open advertising has been used in the appointment of a chairman
or a non-executive director.’ Secondly, in relation to Section B6 where ‘the evaluation of
the board should consider the balance of skills, experience, independence and knowledge
of the com-pany on the board, its diversity, including gender, how the board works
together as a unit, and other factors relevant to its effectiveness.’
Following on from the publication of Women in economic decision-making in the EU: Pro-
gress Report in March 2012, the European Commission is considering legislation to improve
the gender balance on the boards of listed companies. The Progress Report showed that a
number of countries in the EU—France, the Netherlands, Italy and Belgium—enacted
186 DIRECTORS AND BOARD STRUCTURE

legislative measures in 2011 aimed at improving gender balance in company boards,

and that other countries (for example, Spain since 2007 and Norway since 2003)
already had quota systems in place at 40 per cent. However, in January 2012 the
average number of female board members in the largest companies listed in the EU
was only 13.7 per cent com-pared to 11.8 per cent in 2010. Moreover, only 3.2 per
cent of chairpersons were women in January 2012 compared to 3.4 per cent in 2010.
What does the academic evidence have to say about board diversity? Carter et al. (2003)
examine the relationship between board diversity and firm value for Fortune 1000 firms. Board
diversity is defined as the percentage of women, African-Americans, Asians, and His-panics on
the board of directors. After controlling for size, industry, and other corporate governance
measures, they find significant positive relationships between the fraction of women or
minorities on the board and firm value. They also find that the proportion of women and
minorities on boards increases with firm size and board size but decreases as the number of
insiders increases. For women, there is an inverse relationship between the per-centage of
women on boards and the average age of the board.
Carter et al. (2007) analysed both the diversity of the board and of important board
com-mittees, in all firms listed on the Fortune 500 over the period 1998–2002, to gain
greater insight into the way diversity affects board functions and, ultimately, shareholder
value. Their findings support the view that board diversity has a positive effect on financial
performance. The evidence on board committees indicates that gender diversity has a
positive effect on financial performance primarily through the audit function of the board
whilst ethnic diver-sity impacts financial performance through all three functions of the
board: audit, executive compensation, and director nomination.
Erkut et al. (2008) show that, based on interviews with 50 women directors, twelve CEOs,
and seven corporate secretaries from Fortune 1000 companies, a critical mass of three or more
women directors can cause a fundamental change in the boardroom and enhance corporate
governance. The content of boardroom discussion is more likely to include the perspectives of
multiple stakeholders; difficult issues and problems are less likely to be ignored or brushed
aside; and boardroom dynamics are more open and collaborative.
Grosvold and Brammer (2011) find that ‘as much as half the variation in the
presence of women on corporate boards across countries is attributable to national
institutional systems and that culturally and legally-oriented institutional systems
appear to play the most signifi-cant role in shaping board diversity’.
Ferreira (2011) discusses the potential costs and benefits of board diversity arising from
the academic literature. The costs include conflict, lack of co-operation, and insufficient
communication; choosing directors with little experience, inadequate qualifications, or who
are overused; and conflicts of interests and agenda pushing. The benefits include
creativity and different perspectives; access to resources and connections; career
incentives through signaling and mentoring; and public relations, investor relations, and
legitimacy. From his discussion of board diversity literature, he concludes that ‘making a
business case for women in the boardroom on the basis of statistical evidence linking
women to profits obviously creates the possibility of a business case against women if the
evidence turns out to suggest that women reduce profits . . . the research on board
diversity is best used as a means to understand the costs and benefits of diversity in the
workplace and to study corporate gov-ernance issues’.
 DIRECTORS AND BOARD STRUCTURE 187

Conclusions
In this chapter the different types of board structure, unitary or dual, have been
discussed. We have seen that the UK has a unitary board structure and that the
predominant form of board structure in Europe is also the unitary board structure. The
roles and responsibilities of the board, including those of the chair, CEO, senior
independent director, and company secretary, have been reviewed.
The role and contribution to be made by key board subcommittees, including audit,
remuneration, nomination, risk, and ethics committees are discussed. The increasing
empha-sis on the importance of the role of non-executive (outside) directors is shown, and
the definition of the important criterion of the ‘independence’ of non-executive directors is
analysed, together with the role that non-executive directors play on a company’s key
board subcommittees. In future, it is likely that non-executive directors will be called upon
to play an ever more important role as investors look to the audit committees, in particular,
to restore and enhance confidence in companies.
The key areas of board evaluation, succession planning, and board diversity are
cov-ered. The impact of board diversity, in terms of gender and ethnicity, is
discussed, and the low proportion of female directors and directors from different
ethnic groups is highlighted.

Summary
● Board structure may be unitary (single tier) or dual (two tier). In a dual structure
there is a supervisory board as well as an executive board of management.
Usually, both the unitary board of directors and the supervisory board (in a dual
system) are elected by shareholders.
● The board of directors leads and controls the company, and is the link
between managers and investors.
● It is desirable to split the roles of chair and CEO so that there is not too much
power invested in one individual. The chair is responsible for the running of the
board, whilst the CEO is responsible for running the business.
● The board may delegate various activities to board subcommittees, the most
common being the audit, remuneration, nomination, risk, and ethics committees.
● The board should include an appropriate number of independent non-executive (outside)
directors. The non-executive directors bring a balance to the board, and their experience
and knowledge can add value to the board. The non-executive directors make a key
contribution through their membership of the board subcommittees.
● Boards should include due consideration of key areas including board
evaluation, succession planning, and board diversity.
● Boards should have appropriate diversity in their composition; this should strengthen boards
as they will be more capable of reflecting the views of the various stakeholder groups.
188 DIRECTORS AND BOARD STRUCTURE

Example: Statoil Hydro, Norway

Statoil Hydro is one of Norway’s largest companies. There are a number of legal requirements
in Norway relating to members of the board which Statoil Hydro is subject to. There is a
Norwegian legal requirement for at least 40 per cent of the board members to be female,
which means that its board is more diverse than is common in most other countries. Also the
companies’ employees can be represented by three board members.
Statoil Hydro was established in October 2007 following the merger between Statoil and
Hydro’s oil and gas activities. It is an international energy company primarily focused on
upstream oil and gas operations, and operates in thirty-nine oil and gas fields, whilst also being
the world’s largest operator in waters more than 100 metres deep.
In the case of Statoil Hydro, its Articles of Association provide for a board of ten members.
Management is not represented on the board, which appoints the president and CEO. The board is
subject to Norway’s rules which state that all public companies in Norway are obliged to ensure that at
least 40 per cent of their board directors are women. Of the ten members, four are female and six
male, which meets the legal requirement of at least 40 per cent of the board being female.
The board has two subcommittees: an audit committee and a compensation (remuneration)
committee. Three of the four female directors are members of either the audit committee or the
compensation committee, and a female Director, Grace Reksten Skaugen, chairs the compensation
committee. This is interesting as even where females are directors in other countries, such as the UK,
it is rare for them to be members of the key board committees, or indeed to chair such a committee.
The fourth female Director, Lill-Heidi Bakkerud, represents the employees on the board. As well as
Lill-Heidi Bakkerud, two male directors also represent the employees on the board.
Furthermore, there are another two members (both male in this case) who are in addition to
the ten board members, and they are employee-elected observers and may attend board
meetings but have no voting rights.
Statoil changed its organizational structure to reflect the ongoing globalization of Statoil,
leverage the position on the Norwegian Continental Shelf, and simplify internal interfaces to
support safe and efficient operations from 1 January 2011.
In terms of corporate governance features, the board still has 40 per cent female
composition and Marit Arnstad is now the Deputy Chair of the Board.

Example: Deutsche Bank, Germany

This is an example of a well-established German bank which has good corporate governance
but which suffered a drop in share price when its CEO was taken ill.
Deutsche Bank is a leading investment bank and, as a German company, it has a dual board. Its
system of corporate governance has four key elements: ‘good relations with shareholders, effective
cooperation between the Management Board and the Supervisory Board, a system of performance-
related compensation for managers and employees, as well as transparent and early reporting’.
Deutsche Bank’s Supervisory Board has established five standing committees: audit,
nomination, risk, mediation, and the chairman’s committee. It is the latter’s responsibility to

prepare the decisions for the Supervisory Board on the appointment and dismissal of members of the
Management Board, including long-term succession planning. It also submits a proposal to the Super-
visory Board on the compensation for the Management Board including the main contract elements
 DIRECTORS AND BOARD STRUCTURE 189

and is responsible for entering into, amending and terminating the service contracts and
other agreements with the Management Board members.

Dr Josef Ackermann is Chairman of the Management Board and the Group Executive Committee
of Deutsche Bank. He joined the Management Board of Deutsche Bank in 1996 and was
responsible for the investment banking division. In 2002 he became Spokesman of the
Management Board and Chairman of the Group Executive Committee. He was appointed
Chairman of the Management Board in February 2006.
In January 2009 he went to hospital feeling unwell. There was some uncertainty about the nature of his
illness, and combined with poor financial results that had been released just a few hours earlier, the bank’s
shares fell nearly 3 per cent, although they subsequently recovered when news was given that the illness was
attributable to a meal of sausages and sauerkraut, hastily eaten at the end of a busy day!
This episode highlights the nervousness that the market feels when it believes that a potential
successor might not have been identified for a key role. The fear of a power vacuum or a rudderless
ship sends shivers through the market. Ironically, Deutsche Bank is better prepared than many firms
in terms of succession planning. In addition, Dr Ackermann’s contract has now been extended from
ending in 2010 to 2013, which will allow additional time to identify the most appropriate successor.
In May 2012 there is still considerable unrest at Deutsche Bank’s lack of succession
planning. So much so that Hermes, the UK fund manager, together with VIP, a German
association of institutional shareholders, has filed ’counter resolutions’ at the AGM, arguing
that shareholders should withhold a usually routine confidence vote in the bank’s board. This
was after the bank’s supervisory board failed to agree on a successor and the resulting public
discussion was felt to be harmful to potential candidates and to the company itself.

Mini case study Marks and Spencer Plc, UK

This is a good example of a well-known ‘blue chip’ company that had good financial performance over a
number of years but then hit a downturn. There were several aspects of its corporate governance that were
not ideal, but the market turned a blind eye to these whilst the company was doing well. However, once the
company’s sales and profitability fell, there was more of a spotlight on Marks and Spencer’s corporate
governance. Several issues were highlighted as being less than satisfactory and, under pressure from the
City, action was taken to improve these. Subsequently, however, there was more controversy as the roles
of chair and CEO were combined in one individual.
Marks and Spencer Plc enjoyed an enviable reputation for many years, performing well and giving its
shareholders a good return on their investment. However, there was some criticism of its corporate
governance, in particular that there was a lack of sufficient independent non-executive directors. This meant
that the board lacked a real balance between executive and non-executive directors, and appropriate
questions might not be asked of the executive directors by the non-executive directors: for example, questions
relating to the strategic direction that the company was taking, and the market it was aiming for.
In the late 1990s Marks and Spencer found that its plummeting sales and declining profits resulted in a lot
of pressure to reform its corporate governance. As well as the criticism regarding non-executive directors,
there was also much criticism of the pay-offs made to departing directors in the late 1990s and early 2000/01.
The annual report for 2005 showed how Marks and Spencer’s corporate governance had improved. The
board now comprised half non-executive directors with a wide range of experience who could exercise their
independent judgement on key issues. The main board committees (audit, remuneration, and nomination)
were comprised of non-executive directors. There was also a Corporate Social Responsibility Committee to
provide an overview of the social, environmental, and ethical impacts
(continued)
190 DIRECTORS AND BOARD STRUCTURE

of the group’s activities. Given the greater emphasis on corporate governance and the appointment in 2002 of
non-executive directors, such as Paul Myners (Chair of the government-sponsored Myner’s review of
institutional investment), investors felt more confident in Marks and Spencer. Improved corporate governance
would help the company to re-establish itself and give investors the confidence that various viewpoints would
be heard on issues of strategy, performance, and resources at board meetings.
In addition to Paul Myners, a key appointment to Marks and Spencer was that of Sir Stuart Rose
who was appointed to the position of CEO in May 2004. He subsequently fought off several takeover
bids by Philip Green for the Marks and Spencer Group. Sir Stuart Rose had a rejuvenating effect on
Marks and Spencer, and in January 2007 he was named the ’2006 Business Leader of the Year’ by
the World Leadership Forum for his efforts in restoring the performance of the company. However,
whilst Marks and Spencer’s performance improved under the well-known Plan A (‘there is no Plan B’),
the company incurred the displeasure of investors when, in 2008, Sir Stuart Rose became both
Chairman and CEO until July 2011. This combination of roles goes against the UK Combined Code’s
recommendations of best practice. As a result, in 2008 some 22 per cent of the shareholders did not
support the appointment of Sir Stuart Rose as Chairman. By the time that Marks and Spencer’s annual
report 2011 was published, the situation of combining the roles of CEO and chairman was over, and
the changes in the board reflect this with Marc Bolland as the CEO, and Robert Swannell as the
Chairman. In addition there are twelve other directors, of whom five are female.

Questions
The discussion questions to follow cover the key learning points of this chapter. Reading
of some of the additional reference material will enhance the depth of the students’
knowledge and understand-ing of these areas.

1. What function does a board perform and how does this contribute to the corporate
gover-nance of the company?
2. What are the main subcommittees of the board and what role does each of these
subcommit-tees play?
3. What are the main differences between a unitary board system and a dual board system?
4. How might the ‘independence’ of non-executive (outside) directors be defined?
5. Critically discuss the importance of board evaluations, succession planning, and board
diver-sity for the effectiveness of the board.
6. ‘Non-executive directors are a waste of time. They often have little involvement with a com-
pany and are not aware of what is really going on.’ Critically discuss this statement.

References
ABI (2011), Reporting on Board ——— (2002), Corporate Governance and Chairmanship: A
Effectiveness, ABI, London. Personal View, Oxford University Press, Oxford.
Bender, R. (2011), ‘The Platonic Remuneration Carter, D.A., Simkins, B.J., and Simpson, W.G.
Committee’, 10 March 2011. Available at (2003), ‘Corporate Governance, Board Diversity,
SSRN: http://ssrn.com/abstract=1782642 or and Firm Value’, The Financial Review, Vol. 38.
http://dx.doi.org/10.2139/ssrn.1782642 ——— D’Souza, F., Simkins, B.J., and Simpson, W.G.
Cadbury, Sir Adrian (1992), Report of the (2007), ‘The Diversity of Corporate Board
Committee on the Financial Aspects of Committees and Financial Performance’, available
Corporate Governance, Gee & Co. Ltd, London. at SSRN: http:// ssrn.com/abstract=972763

Charkham, J. (2005), Keeping Better Company: Corporate

Governance Ten Years On, Oxford University Press,
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Combined Code (2003), The Combined implementation of the UK

Code on Corporate Governance, FRC,
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Corporate Governance, FRC,
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J., and Siegel, D.S. (2008), The Oxford
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Davies E.M. (2011), Women on Boards,
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London.
——— (2012), Women on Boards, One Year On,
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Epstein, M.J. and Roy, M.J. (2006), ‘Measuring the
Effectiveness of Corporate Boards and Directors’ in
M.J. Epstein and K.O. Hanson (eds), The
Accountable Corporation, Praeger Publishers,
Westport, USA.
Erkut, S., Kramer, V.W., and Konrad, A. (2008), ‘Critical
Mass: Does the Number of Women on a Corporate
Board Make a Difference?’ in S. Vinnicombe, V.
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Decision-Making in the EU: Progress Report,
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Commission, Brussels.
Ezzamel, M. and Watson, R. (1997), ‘Wearing Two
Hats: The Conflicting Control and Management
Roles of Non-Executive Directors’, in K. Keasey,
S. Thompson, and M. Wright (eds), Corporate
Governance: Economic, Management and
Financial Issues, Oxford University Press, Oxford.
Ferreira, D. (2011), ‘Board Diversity’, in H. Kent
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Governance,
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Practice, The Robert W. Kolb Series in
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Corporate Higgs, D. (2003), Review of the Role and Effectiveness
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Corporate Governance: Survey 2001/02, KPMG, London.
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Vol. 19 (2), pp. 116–35. Succession Planning: Who’s Behind Door
Guo, L. and Masulis, Number One?’ ( June 24, 2010), Rock Center
R.W. (2012), ‘Board for Corporate Governance at Stanford
Structure and University Closer Look Series: Topics, Issues
Monitoring: New and Controversies in Corporate Governance
Evidence from CEO No. CGRP-05. Available at SSRN:
Turnover’, March 12, http://ssrn.com/ abstract=1678062
2012. Available at McKinsey & Co. (2002), Investor Opinion Survey on
SSRN: Corporate Governance, McKinsey & Co., London.
http://ssrn.com/ Mc Nulty T., Pettigrew A., Jobome G., and
abstract=2021468 or Morris C. (2011), ‘The Role, Power and
http://dx.doi.org/10.2 Influence of Company Chairs’, Journal of
139/ ssrn.2021468 Management and Governance, Vol. 15, No.
Hampel, Sir Ronnie 1, pp. 91–121.
(1998), Committee on Milgram S. (1974), Obedience to Authority, Harper and
Corporate Governance: Row, New York.
Final Report, Gee & Co.
Morck R. (2008), ‘Behavioral Finance in Corporate
Ltd, London. Governance: Economics and Ethics of the Devil’s
Hermes (2006), The Hermes Corporate Advocate’, Journal of Management and Governance,
Governance Vol. 12, No. 2, pp. 179–200.
Principles, Hermes Investment Management
Naveen, L., (2006), ‘Organizational Complexity and
Ltd,
Succession Planning’, Journal of Financial and
London.
Quantitative Analysis, Vol. 41, Issue 3, pp. 661–83.
192 DIRECTORS AND BOARD STRUCTURE Decisions’, Strategic
Management Journal, Vol.
26,
OECD (1999), Principles of Corporate No. 2.
Governance, OECD, Paris. Taylor, B., Stiles, P., and Tampoe,
——— (2004), Principles of Corporate M. (2001), The Future for the
Governance, OECD, Paris. Board, Director and Board
Pathan, S. (2009), ‘Strong boards, CEO power Research, IoD, London.
and bank risk-taking’, Journal of Banking and Turley, S. (2008), ‘Developments
Finance, 33(7), pp. 1340–50. in the Framework of
Smith, Sir Robert (2003), Audit Committees Combined Auditing Regulation in the
United Kingdom’, in R.
Code Guidance, FRC, London.
Quick, S. Turley and M.
Spencer Stuart (2011), 2011 UK Board Index, Spencer Willekens (eds), Auditing,
Stuart, London. Trust and Governance,
Spira, L. (2002), The Audit Committee: Performing Regulation in Europe,
Corporate Governance, Kluwer Academic Publishers, Routledge, London.
Dordrecht.
Stevens, J., Steensma, K., Harrison, D., and Cochran,
P. (2005), ‘Symbolic or Substantive Document? The
Influence of Ethics Codes on Financial Executives’
 Yeh Y-H., Chung H., and Liu C-L. (2011),
‘Committee Independence and Financial
Institution Performance during the 2007–08
Van Den Berghe, L.A.A. and Levrau, A.P.D. (2004), ‘Evaluating Boards
Credit Crunch: Evidence from a Multi-Country
of Directors: What Constitutes a Good Corporate Board?’,
Study’, Corporate Governance: An International
Corporate Governance: An International Review, Vol. 12, No. 4,
Review, Vol. 19, No. 5, pp. 437–58.
October.
Zaman M., Hudaib M., and Haniffa R. (2011),
Wong, S. C. Y. (2011), ‘Elevating Board Performance: The Significance of
‘Corporate Governance Quality, Audit Fees and
Director Mindset, Operating Context, and Other Behavioral and Functional
Non-Audit Services Fees’, Journal of Business
Considerations’, Northwestern Law & Econ Research Paper No. 11-12.
Finance & Accounting, Vol. 38, Issue 1–2,
Available at SSRN: http://ssrn.com/ abstract=1832234 or
pp. 165–97, January/March 2011.
http://dx.doi.org/10.2139/ ssrn.1832234
Yatim, P. (2010), ‘Board structures and the establishment of a risk
management committee by Malaysian listed firms’, Journal of
Management and Governance, 14(1), pp. 17–36.

Useful websites
http://blog.thecorporatelibrary.com/ The website of the Corporate Library, which
has comprehensive information about various aspects of corporate governance
including shareholders and stakeholders (renamed the GMI blog).
www.bis.gov.uk The website of the UK Department for Business, Innovation &
Skills has a number of references to interesting material relating to directors.
www.businesslink.gov.uk The website of Business Link, the government’s online
resource for businesses, including detail of directors’ duties.
www.conference-board.org The Conference Board is a global, independent
business membership and research association working in the public interest.
www.icsa.org.uk The website of the Institute of Chartered Secretaries and Administrators has
useful references to matters relating to boards and directors including board effectiveness.
www.iod.com The website of the Institute of Directors has information relating to a wide
range of topics relating to directors.
www.nacdonline.org The website of the US National Association of Corporate Directors.

For further links to useful sources of information visit the Online

Resource Centre www.oxfordtextbooks.co.uk/orc/mallin4e/
 DIRECTORS AND BOARD STRUCTURE 193

FT Clippings

FT: Increase in overseas

directors in UK
By Alison Smith, Chief Corporate Correspondent

November 27, 2011

The proportion of overseas board members at the proportion of non-national board

the UK’s biggest companies has risen by one- members in the top 200 S&P groups has
third in the past year, according to new risen from 6 per cent in 2006 to 8 per cent
research. now.
A study by Spencer Stuart, the headhunter, At the same time, the proportion of large
shows that foreign directors now make up 32 companies where the boards remain
per cent of boards in Britain’s 150 largest resolutely domestic is falling: fewer than
quoted groups, compared with 24 per cent in one in five in the UK, and below half in the
2010. US.
The percentage of foreign directors in British Yet the underlying picture is less
companies puts the UK among the most straightforward—and suggests less corporate
internationally diverse countries when it comes enthusiasm for broadly diverse boards than may
to the boardroom. first appear.
First, some directors from emerging markets
“There are three trends behind these figures,” are appointed solely because they represent
says Edward Speed of Spencer Stuart. “Mid-cap investors. Annabel Parsons, partner at
companies are now getting a higher percentage international search firm Heidrick & Struggles,
of foreign directors; there is the influx of cites increasing levels of Chinese investment in
overseas companies with London listings; and Europe. “A high percentage of Chinese non-
very big traditional UK companies are taking on executives are on the board because they are
more directors with experience of emerging shareholders,” she says.
markets.” Recent examples of overseas directors
becoming part of UK companies include Fabio Second, while companies are keen to
Barbosa’s appointment as finance director of BG harness emerging markets experience, they
Group; and Phuthuma Nhleko’s joining the worry about how bringing in directors from
boards of oil major BP and miner Anglo very different backgrounds will affect board
American. balance and behaviour.

Two obvious issues are language and

The attraction of growth in emerging markets geography. Victor Prozesky, of Heidrick
is contributing to the rise in the proportion of & Struggles, puts it like this: “You have to
directors from beyond national boundaries at think, what strain does it put on the functioning
large quoted companies—to reach almost two of a board, if people cannot attend in person or
in five in Switzerland, for example, and more attend with an interpreter?” The desire for a
than one in four for companies in France, different perspective and yet a common
Sweden and the UK. language appears reflected in companies’ choice
of foreign board members. Among French
“When boards are looking for non-local companies, for example, many non-national
members to diversify their understanding of directors come from Belgium, while in the US,
international markets, there is a very strong Canada and the UK are the most popular sources
interest in Asia,” says Bertrand Richard, partner of foreign directors.
at Spencer Stuart.

Even in the US, where companies face Yet companies are getting used to dealing
less pressure to internationalise, with linguistic differences in the
194 DIRECTORS AND BOARD STRUCTURE

boardroom. Some groups, such as Nokia and gaining the experience in developed markets
Skandia, run the boards in English. Even which multinational companies also value. “In
companies in countries such as France and some countries, when it comes to having a good
Germany, where there is some expectation that network of government contacts,” he says, “that
non-nationals will understand the language, are can change every six weeks.” But while the
adapting. survey indicates that companies have embraced
“In France, what we are more and more used diversity in term of nationality, it suggests that
to is a company that runs the board in French, but companies will struggle to meet the
if non-French board members want to speak in recommendation by Lord Davies that FTSE100
English they can, and French board members will companies should aim for a minimum 25 per
all understand it,” Mr Richard says. As for cent female representation by 2015. The
German companies, “An interpreter in the proportion of women on executive committees
boardroom is not as good as everyone speaking among the 50 largest quoted companies is just
the same language, but if a board is not used to 11.5 per cent.
doing so, it very, very definitely limits its ability
to get non-Germans.” Beyond language lie
cultural differences. Non-executive directors in
many developed western economies are “This is not a large pool to help boards meet
increasingly expected to play a vigorous role in the 25 per cent target,” says Mr Speed. “Boards
the life of the company, ready to ask searching will have to trawl more widely to reach it.”
questions of executives and keep a close eye on Finance officers limit their directorships Spencer
the management of the group. Stuart’s annual board composition survey shows
that the proportion of chief financial officers
who are also non-executive directors at other
companies has dropped from 41 per cent in 2010
“In emerging markets, quite often the to 27 per cent this year, writes Alison Smith.
culture is consensus driven,” says Ms Parsons.
“That can pose quite a lot of challenges if you
are putting someone with that sort of Edward Speed of Spencer Stuart says that this
background into a board where the expectation fall is partly attributable to some finance
is that non-executive directors will challenge directors being new in their posts. But, he says,
the management.” While many companies some who would be comfortable with taking up
work successfully with very internationally an external role are facing other pressures not to
diverse boards, some groups question whether spread themselves too thinly.
this approach is necessarily the best way to
make the most of their prospects in emerging “Anecdotally, I think chief executives are
markets. saying to finance directors seeking to become
non-executive directors ‘Is this the right thing to
do? And if you do take the role, don’t even think
“Having a token person from an emerging about being chairman of the audit committee’”.
market will probably not make that much of an
impact,” says Ms Parsons, pointing to the Prominent UK finance directors that hold
research on gender diversity that suggests a shift non-executive roles include René Médori,
in attitude probably requires a minimum of three Anglo American’s CFO who sits on the board
women on a board. of Scottish and Southern Energy and chairs its
audit committee.
Mr Prozesky warns that people appointed Mr Speed believes the approach of
partly for emerging market credentials may find discouraging CFOs from becoming non-
that their local expertise and network of executives is short-sighted. “It is always a
contacts can become out of date while they have positive for boards if someone has broader
been experience,” he says.

© 2012 The Financial Times Ltd.

 DIRECTORS AND BOARD STRUCTURE 195

FT: Board make-up becomes a

governance issue
By Ruth Sullivan

March 4, 2012

Regulators, politicians and shareholders nationality, skills and gender leads to

are stepping up pressure on companies more transparency and improved
for greater board diversity as part of a governance practice, however painful the
drive to boost good governance and path.
efficiency, forcing boards to rethink their In the US, advisory council members
composition. of the National Association of Corporate
Among shareholders calling for Directors maintain “lack of apparent
change in the companies in which it diversity can be a sign that the board is
invests is Legal & General Investment not engaging in a rigorous search for the
Management, one of the UK’s largest most qualified people, since qualified
investors. directors are not concentrated in only
“LGIM is challenging the composition one race or gender but can be found in
of boards and bringing diversity into the every demographic group”.
broader discussion on board The council also suggests that a low
nominations and succession planning. level of demographic diversity could be
We intend to increase that pressure in the result of a high proportion of board
the future,” says Sacha Sadan, head of members being chief executives rather
corporate governance. than senior managers or professionals,
“We want dynamic people and care as the former tend to reflect a less
about skills, nationalities and gender,” diverse population.
he adds. A 2011 joint report by the New-York
On the other side of the Atlantic, based Conference Board, NYSE Euronext
pressure from Calpers, the California and Nasdaq on diversity shows little
Public Employees’ Retirement System, change over the past few years on
the largest US public pension fund, diversity of directors’ professional
recently forced Apple to give backgrounds, with half of the board
shareholders more influence over the members of public companies coming
election of directors, a move that other from other for-profit companies. In the
companies may have to follow. financial sector this rises to nearly three
In Japan last year, bringing in Michael quarters.
Woodford, a Briton, to head Olympus, the Little progress has been made on
camera maker, triggered more than just increasing the number of female chief
a departure from the culture of an executives in large quoted companies
all-Japanese executive, uncovering one with only 16 women CEOs in the entire
of the country’s biggest accounting S&P 500, according to S&P data for 2010.
scandals and shaking up the company. Matteo Tonello, head of corporate
Olympus still has a long way to go on leadership at the Conference Board, says
reforms. Foreign shareholders such as the board of directors of US public
F&C are voicing unhappiness over a new companies over the past decade “has
11-member board, which it says consists continued to draw its talent from the
of the company’s bankers, major same old pool of individuals with
investors and related parties. top-level experience as business
Shareholders will vote on the board at an strategists—individuals who often know
emergency general meeting next month. little about the new set of oversight
There is increasing agreement among responsibilities and, by the open
stakeholders that diversity at board and admission of many of them, loathe
top executive level in terms of having to deal with what they perceive as
196 DIRECTORS AND BOARD STRUCTURE

a distraction from business leadership However, it concludes this is due to

matters”. institutional investor bias against female
Some stakeholders believe best practice in appointments, as it finds that “female
diversity brings more benefit to a company than directors have negative effects on stock value
improving governance in that more diversified and no effects on profits”.
boards lead to better performance.
It adds that this is no surprise, given that other
“Getting the best people on boards is favoured corporate governance practices, such as
important to getting the best returns,” splitting the chairman and chief executive role,
according to L&G’s Mr Sadan. do not lead to “increases in profits, stock value,
Helena Morrissey, chief executive of Newton or institutional holdings”.
Investment Management and founder of the 30
per cent Club that aims to bring more women on Regardless of differing opinions, regulation
to UK boards, takes it further. “Board diversity and guidance on diversity is clear. The US
is aimed at improving business decisions, financial regulator introduced rules in 2009
reducing risk, sustaining profits growth and requiring public companies to define and
therefore higher long-term returns for disclose their diversity policy, while in the UK
shareholders,” she maintains. the Financial Reporting Council and the revised
UK Corporate Governance Code followed suit
Research on the extent to which board last year.
diversity contributes to performance is growing
but findings differ and it it is hard to determine So what else is needed? Seamus Gillen, policy
cause and effect. director at the Institute for Chartered Secretaries
In terms of gender diversity, a recent and Administrators, says an awareness of the
Thomson Reuters report, Women in the issue at board level is not enough. “Boards need
Workplace, indicates share prices at companies to have a real understanding of what diversity in
that open job opportunities to women may fare a company means, the challenges it brings, and
better in volatile or falling markets. act on it,” he says.

In contrast, a study published in the North

Carolina Law Review by Frank Dobbin, a To do this boards have to work out where the
Harvard sociologist, Corporate Board Gender gaps in skills and mindsets are within their own
Diversity and Stock Performance 2011, says companies, and recruit from a wider range of
studies suggest that over the long term board people, including academics, entrepreneurs and
gender diversity does not help companies and people from other social class backgrounds, as
may hurt them. well as women, he adds.

© 2012 The Financial Times Ltd.

 9 Directors’ Performance
and Remuneration

Learning Objectives
● To be aware of the main features of the directors’ remuneration debate
● To know the key elements of directors’ remuneration
● To assess the role of the remuneration committee in setting
directors’ remuneration
● To understand the different measures used to link directors’
remuneration with performance
● To know the disclosure requirements for directors’ remuneration
● To be aware of possible ways of evaluating directors

The directors’ remuneration debate

The last decade has seen considerable shareholder, media, and policy attention given to
the issue of directors’ remuneration. The debate has tended to focus on four areas: (i) the
overall level of directors’ remuneration and the role of share options; (ii) the suitability of
performance measures linking directors’ remuneration with performance; (iii) the role
played by the remuneration committee in the setting of directors’ remuneration; (iv) the
influence that shareholders are able to exercise on directors’ remuneration.
The debate about directors’ remuneration spans continents and is a topic that is as
hotly debated in the USA as it is in the UK. Indeed, the UK’s use of share options as long-
term incentive devices has been heavily influenced by US practice. Countries that are
developing their corporate governance codes are aware of the ongoing issues relating to
directors’ remuneration and try to address these issues in their own codes. In the UK the
debate was driven in the early years by the remuneration packages of the directors of the
newly priva-tized utilities. The perception that directors were receiving huge remuneration
packages— and often, it seemed, with little reward to the shareholders in terms of
company performance—further fuelled the interest in this area on both sides of the
Atlantic. The level of directors’ remuneration continues to be a worrying trend and as Lee
(2002) commented ‘the evidence in the US is of many companies having given away 10
per cent, and in some cases as much as 30 per cent, of their equity to executive directors
and other staff in just the last five years or so. That is clearly not sustainable into the
future: there wouldn’t be any companies left in public hands if it were’.
It is interesting to note that a comparison of remuneration pay and incentives of directors in
the USA and the UK gives a useful insight. Conyon and Murphy (2000) documented the
198 DIRECTORS AND BOARD STRUCTURE

differences in chief executive officer (CEO) pay and incentives in both countries for 1997.
They found that CEOs in the USA earned 45 per cent higher cash compensation and 190
per cent higher total compensation than their counterparts in the UK. The implication is
that, in the USA, the median CEO received 1.48 per cent of any increase in shareholder
wealth com-pared to 0.25 per cent in the UK. The difference being largely attributable to
the extent of the share option schemes in the USA.
The directors’ remuneration debate clearly highlights one important aspect of the
principal–agent problem discussed at length in Chapter 2. In this context, Conyon and
Mal-lin (1997) highlight that shareholders are viewed as the ‘principal’ and managers as
their ‘agents’, and that the economics literature, in particular, demonstrates that the
compensa-tion received by senior management should be linked to company performance
for incen-tive reasons. Well-designed compensation contracts will help to ensure that the
objectives of directors and shareholders are aligned, and so share options and other long-
term incen-tives are a key mechanism by which shareholders try to ensure congruence
between directors’ and shareholders’ objectives.
However, Bebchuk and Fried (2004) highlight that there are significant flaws in pay
arrangements, which ‘have hurt shareholders both by increasing pay levels and, even
more important, by leading to practices that dilute and distort managers’ incentives’.
More recently the global financial crisis has served to highlight the inequities that exist
between executive directors’ generous remuneration and the underperformance of
the companies that they direct, and the concomitant impact on shareholders who may
lose vast sums of money, sometimes their life savings, and employees who may find
themselves on shorter working weeks, lower incomes, or being made redundant. The
International Labour Organization (ILO) 2008 reported that,

the gap in income inequality is also widening—at an increasing pace—between top

executives and the average employee. For example, in the United States in 2007, the
chief executive officers (CEOs) of the 15 largest companies earned 520 times more
than the average worker. This is up from 360 times more in 2003. Similar patterns,
though from lower levels of executive pay, have been registered in Australia,
Germany, Hong Kong (China), the Netherlands and South Africa.

Furthermore the ILO state that,

developments in global corporate governance have also contributed to perceptions of

excessive income inequality. A key development has been the use of so-called
‘performance pay systems’ for chief executive managers and directors . . .
Importantly, empirical studies show only very moderate, if any, effects of these
systems on company performance. Moreover, large country variations exist, with
some countries displaying virtually no relation between performance-pay and
company profits. . . . Altogether, evidence suggests that developments in executive
pay may have been both inequality-enhancing and economically inefficient.

In the context of the global banking crisis, the UK’s Turner Review reported in March 2009, and
highlighted that executive compensation incentives encouraged ‘some executives and traders
to take excessive risks’. The Review emphasizes the distinction between ‘short-term
remuneration for banks which have received taxpayer support which is a legitimate issue of
public concern, and one where governments as significant shareholders have crucial roles to
 DIRECTORS’ PERFORMANCE AND REMUNERATION 199

play’ and ‘long-term concerns about the way in which the structure of remuneration
can create incentives for inappropriate risk taking’. The Review therefore
recommends that risk management considerations are embedded in remuneration
policy, which of course has implications for the remit of remuneration committees and
for the amount of time that non-executive directors may need to give.
The House of Commons Treasury Committee reporting in May 2009 on the Banking Crisis:
Reforming Corporate Governance and Pay in the City stated:
Whilst the causes of the present financial crisis are numerous and diverse, it is clear that bonus-
driven remuneration structures prevalent in the City of London as well as in other financial
centres, especially in investment banking, led to reckless and excessive risk-taking. In too many
cases the design of bonus schemes in the banking sector were flawed and not aligned with the
interests of shareholders and the long-term sustainability of the banks.

The Committee also refers to the complacency of the Financial Services Authority (FSA)
and states ‘The Turner Review downplays the role that remuneration structures played in
causing the banking crisis, and does not appear to us to accord a sufficiently high priority
to a fundamental reform of the bonus culture’. The Committee urges the FSA not to shy
away from using its powers to sanction firms whose activities fall short of good practice.
The Committee also encourages the use of deferral or clawback mechanisms to help
ensure that bonus payments align the interests of senior staff more closely with those of
shareholders. Moreover, the Committee believes that links should be strengthened
between the remuneration, risk, and audit committees, ‘given the cross-cutting nature of
many issues, including remuneration’ and also advocates

that remuneration committees would also benefit from having a wider range of inputs
from interested stakeholders—such as employees or their representatives and
shareholders. This would open up the decision-making process at an early stage to
scrutiny from outside the board, as well as provide greater transparency. It would,
additionally, reduce the dependence of committees on remuneration consultants.
Sir David Walker headed a review of corporate governance in the banking sector which reported in
2009. Of its thirty-nine recommendations, twelve related to remuneration (including the role of the
board remuneration committee, disclosure of executive remuneration, and the Code of Conduct for
executive remuneration consultants written by the Remuneration Consultants Group). Some of the
recommendations were to be taken forward by the FRC through amendments to the Combined Code,
whilst others were to be taken forward by the FSA. When the UK Corporate Governance Code 2010
(’the Code’) was introduced, it incorporated some of the Walker Report recommendations, including
that performance-related pay should be aligned to the long-term interests of the company and to its
risk policy and systems.
The Department for Business, Innovation & Skills (BIS) issued a discussion paper on
exec-utive remuneration in September 2011. The paper highlights the increasing disparity
between the pay of CEOs and employees in the largest companies, and cites evidence to
suggest that executive pay, particularly at CEO level in FTSE 100 companies, bears very
little relationship to company performance or shareholder returns.
The High Pay Commission is an independent inquiry into high pay and boardroom pay
across the public and private sectors in the UK. In 2010 they started their year-long inquiry
into pay at the top of UK companies and found ‘evidence that excessive high pay
200 DIRECTORS AND BOARD STRUCTURE

damages companies, is bad for our economy and has negative impacts on society as
a whole. At its worst, excessive high pay bears little relation to company success and
is re-warding failure.’ Their report More for Less: what has happened to pay at the top
and does it matter? issued in May 2011, stated: ‘Pay is about just rewards, social
cohesion and a functioning labour market, and it is the view of the High Pay
Commission that the expo-nential pay increases at the top of the labour market are
ultimately a form of market failure’. The report identifies four causes of the dramatic
growth in top pay: attempts to link pay to performance, company structures fail to
exert proper control over top earnings, the labour market contributes to increasing
pay at the top, and the rise in individualism.
Their report What are we paying for? Exploring executive pay and performance
(2011) finds that, in addition to an average rise in FTSE 350 salaries of 63.9 per cent
between 2002 and 2010, average bonuses increased from 48 per cent to 90 per cent
of salary in the same period. Comparing company performance to stock and balance
sheet performance, the report sug-gests that ‘salary growth bears no relation to either
market capitalisation, earnings per share (EPS) or pre-tax profit’ and that ‘there is no
or little relation between the total earnings trends and market capitalisation’.
The High Pay Commission’s final report Cheques with Balances: why tackling high pay
is in the national interest was issued in November 2011. The report recommends a twelve-
point plan based on the principles of accountability, transparency, and fairness aimed at
redressing the out-of-control executive pay spiral. The report highlights some of the
excesses, for example: ‘In BP, in 2011 the lead executive earned 63 times the amount of
the average employee. In 1979 the multiple was 16.5. In Barclays, top pay is now 75 times
that of the average worker. In 1979 it was 14.5. Over that period, the lead executive’s pay
in Barclays has risen by 4,899.4%—from £87,323 to a staggering £4,365,636’.
The High Pay Commission’s twelve recommendations, under three headings, are
as follows:

Transparency
1. Pay basic salaries to company executives (remuneration committees may elect to award
one additional performance-related element only where it is absolutely necessary).
2. Publish the top ten executive pay packages outside the boardroom.
3. Standardise remuneration reports.
4. Require fund managers and investors to disclose how they vote on remuneration.

Accountability

5. Include employee representation on remuneration committees.

6. All publicly listed companies should publish a distribution statement (to show
the distribution of income over a period of three years, importantly showing
percentage changes in: total staff costs; company reinvestment; shareholder
dividends; executive team total package; and tax paid.
 DIRECTORS’ PERFORMANCE AND REMUNERATION 201

7. Shareholders should cast forward-looking advisory votes on remuneration

reports (votes should be cast on remuneration arrangements for three years
following the date of the vote and these arrangements should include future
salary increases, bonus packages and all hidden benefits, giving shareholders a
genuine say in the remuneration of executives).
8. Improve investment in the talent pipeline.
9. Advertise non-executive positions publicly—(helping to make remuneration
committees open to a wider group, encouraging diversity and ending the closed
shop culture of appointments.
10. Reduce conflicts of interest of remuneration consultants.

Fairness

11. All publicly listed companies should produce fair pay reports.
12. Establish a permanent body to monitor high pay (on a social partnership basis, much
like the Low Pay Commission by government to: monitor pay trends at the top of the
income distribution; police pay codes in UK companies; ensure company legislation
is effective in ensuring transparency, accountability and fairness in pay at the top of
British companies; and report annually to government and the public on high pay.

Vince Cable, the Business Secretary, has taken forward ten of the twelve
recommendations from the High Pay Commission. Furthermore, in January 2012 he
announced the govern-ment’s next steps to address failings in the corporate
governance framework for executive remuneration. These included:
● greater transparency in directors’ remuneration reports;
● empowering shareholders and promoting shareholder engagement through
enhanced voting rights;
● increasing the diversity of boards and remuneration committees;
● encouraging employees to be more engaged by exercising their right to
Information and Consultation Arrangements;
● working with investors and business to promote best practice on pay-setting.
Following this, a consultation on Executive Pay and Enhanced Shareholder Rights
was launched, which provides more details on a new model for shareholder voting.
The BIS website lists the main components of this as:
● an annual binding vote on future remuneration policy;
● increasing the level of support required on votes on future remuneration policy;
● an annual advisory vote on how remuneration policy has been implemented
in the previous year;
● a binding vote on exit payments over one year’s salary.
The outcome of the consultation, which closed in April 2012, is awaited.
202 DIRECTORS AND BOARD STRUCTURE

As part of government reforms in this area, Deborah Hargreaves, who chaired the High
Pay Commission, will run a new High Pay Centre to monitor pay at the top of the income
distribution and set out a road map towards better business and economic success. In
May 2012 the High Pay Centre issued It’s How You Pay It, a report that looked at the
current situ-ation with regard to executive pay packages, the elements included in them,
and how they can be calculated. The report states that: ‘Levels of pay matter, and how we
pay people mat-ters too. While the corporate world has embraced wholeheartedly the idea
that you can incentivise those at the top to act in the interests of shareholders, at best we
can argue that evidence is unclear. At worst it is fair to say that the case against large
variable awards is increasingly compelling’. The report also points out that ‘providing a
single figure for the pay awarded in any one year is an essential step forward for
businesses’ although it recognizes that this may, in itself, be a complex exercise.
As can be seen, there has been much heated debate about flawed remuneration
packages which enable large bonuses to be paid even when the company has not met the
perfor-mance criteria associated with those bonuses; which also allow departing directors
to have golden goodbyes in the form of generous (some would say obscene) payments
into their pension pots, or other means of easing their departure from the company; and
bring about much distaste regarding the growing multipliers of executive remuneration
compared to that of the average employee. The debate is far from over, although one
thing is certain, which is that the remuneration committees and the shareholders will be
looking ever more carefully at the remuneration packages being proposed for executive
directors in the future, given the expectations of government and the public about what
remuneration packages should look like.
Finally, the issuance in December 2010 by the FSA of ‘PS10/20 Revising the Remuneration
Code’ should be mentioned. The revised framework for regulating financial services firms’
remuneration structures and extension of the scope of the FSA Remuneration Code, arose
primarily as a result of amendments to the Capital Requirements Directive (CRD3) which aimed
to align remuneration principles across the EU, but also took into account provisions relating to
remuneration within the Financial Services Act 2010, Sir David Walker’s review of corporate
governance, and also lessons learned from the FSA’s implementation of its Remu-neration
Code. The FSA states: ‘Our Remuneration Code sets out the standards that banks, building
societies and some investment firms have to meet when setting pay and bonus awards for their
staff. It aims to ensure that firms’ remuneration practices are consistent with effective risk
management’. The twelve Principles cover the three main areas of regulatory scope:
governance; performance measurement; and remuneration structures. The headings
encompass:

● risk management and risk tolerance;

● supporting business strategy, objectives, values and long-term interests of the firm;
● avoiding conflicts of interest;
● governance;
● control functions;
● remuneration and capital;
● exceptional government intervention;
 DIRECTORS’ PERFORMANCE AND REMUNERATION 203

● profit-based measurement and risk adjustment;

● pension policy;
● personal investment strategies;
● avoidance of the FSA Remuneration Code;
● remuneration structures;
● the effect of breach of the FSA Remuneration Principles.
It also introduced some new rules, for example on discretionary severance pay,
linking remuneration to a firm’s capital base, and discretionary pension payments.

Key elements of directors’ remuneration

Directors’ remuneration can encompass six elements:
● base salary;
● bonus;
● stock options;
● restricted share plans (stock grants);
● pension;
● benefits (car, healthcare, etc.).
However, most discussions of directors’ remuneration will tend to concentrate on the
first four elements listed earlier and this text will also take that approach.

Base salary
Base salary is received by a director in accordance with the terms of his/her contract.
This element is not related either to the performance of the company nor to the
performance of the individual director. The amount will be set with due regard to the
size of the company, the industry sector, the experience of the individual director, and
the level of base salary in similar companies.

Bonus
An annual bonus may be paid, which is linked to the accounting performance of the firm.

Stock options
Stock options give directors the right to purchase shares (stock) at a specified
exercise price over a specified time period. Directors may also participate in long-
term incentive plans (LTIPs). UK share options generally have performance criteria
attached, and much discussion is centred around these performance criteria,
especially as to whether they are appropriate and demanding enough.
204 DIRECTORS AND BOARD STRUCTURE

Restricted share plans (stock grants)

Shares may be awarded with limits on their transferability for a set time (usually a few
years), and various performance conditions should be met.

Role of the remuneration committee

The Code (2010) recommends that ‘there should be a formal and transparent
procedure for developing policy on executive remuneration and for fixing the
remuneration packages of individual directors’ (principle D.2). In practice, this
normally results in the appointment of a remuneration committee.
The remuneration committee’s role and composition was discussed in Chapter 8.
However, in this chapter we consider the effect of remuneration committees on direc-tors’
remuneration levels in recent years. Sykes (2002) points out that, although remu-neration
committees predominantly consist of a majority, or more usually entirely, of non-executive
directors, these non-executive directors ‘are effectively chosen by, or only with the full
agreement of, senior management’. Given that the non-executive directors of one
company may be executive directors of another (unrelated) company, they may not be
willing to stipulate demanding performance criteria because they may have a self-interest
in ensuring that they themselves can go on earning a high salary without unduly
demanding performance criteria being set by their own companies’ remunera-tion
committees. There is also another aspect, which is that remuneration committees will
generally not wish the executive directors to be earning less than their counterparts in
other companies, so they will be more inclined to make recommendations that will put the
directors into the top or second quartile of executive remuneration levels. It is certainly the
case that executive remuneration levels have increased fairly substantially since
remuneration committees were introduced which, of course, was not the intended effect.
Sykes (2002) makes the pertinent point that all the remuneration packages now so widely
criticized as flawed and inappropriate were once approved by an ‘independent’
remuneration committee.
The performance measures that the remuneration committee decides should be used
are therefore central to aligning directors’ performance and remuneration in the most
appro-priate way. Remuneration committees are offered some general guidance by the
Code (2010) recommendation that ‘levels of remuneration should be sufficient to attract,
retain and motivate directors of the quality required to run the company successfully, but a
company should avoid paying more than is necessary for this purpose’ (principle D.1).
In the UK both the National Association of Pension Funds (NAPF) and the
Association of British Insurers (ABI) have been involved in the debate about
executive remuneration and have issued guidance in this area. The ABI (2002)
Guidelines on Executive Remuneration included the recommendations that:
● remuneration packages should have a balance between fixed and
variable pay, and between long- and short-term incentives;
● performance-based remuneration arrangements should be demonstrably
clearly aligned with business strategy and objectives;
 DIRECTORS’ PERFORMANCE AND REMUNERATION 205

● the remuneration committee should have regard to pay and conditions generally
in the company, taking into account business size, complexity, and geographical
location and should also consider market forces generally;
● share option schemes should link remuneration to performance and align the long-
term interests of management with those of shareholders;
● performance targets should be disclosed in the remuneration report within the
bounds of commercial confidentiality considerations.
In December 2005 the ABI issued its Principles and Guidelines on Remuneration, which have a
two-fold aim of providing ‘a practical framework and reference point for both shareholders in
reaching voting decisions and for companies in deciding upon remuneration policy’. The
Principles and Guidelines emphasize that remuneration (committee) reports should provide a
clear and full explanation of remuneration policy, showing a clear link between reward and
performance and that ‘shareholders believe that the key determinant for assessing
remuneration is performance in the creation of shareholder value’.
In December 2007 the ABI made some minor amendments to its Executive Remuneration—
ABI Guidelines on Policies and Practices. In September 2008 the ABI wrote a letter to the
chairmen of the remuneration committees explaining that it did not plan to make any changes at
that time to the ABI (2007) guidelines. However, the letter highlighted a number of areas to
which the ABI wished to draw attention in the current economic climate. The points raised were:

(i) the remuneration policy should be fully explained and justified, particularly when changes are
proposed. Members will carefully scrutinise remuneration uplifts, particularly increases in
salaries or annual bonus levels; (ii) where a company has underperformed and seen a
significant fall in its share price, this should be taken into account when determining the level of
awards under share incentive schemes. In such circumstances, it is not appropriate for
executives to receive awards of such a size that they are perceived as rewards for failure;
(iii) shareholders are generally not in favour of additional remuneration being paid in relation to
succession or retention, particularly where no performance conditions are attached;
(iv) in the context of the consultation process for share incentive schemes,
Remuneration Committees should ensure that shareholders have adequate time to
consider the proposal and that their views are carefully considered. Relevant
information related to the consultation should be clearly and fully disclosed.

In September 2011 the ABI issued the ABI Principles of Executive Remuneration,
which are predominantly for companies with a main market listing but useful for
companies on other public markets and also for other entities. The Principles relate to
(in a remuneration context), the role of shareholders, the role of the board and
directors, the remuneration committee, remuneration policies, and remuneration
structures. There is detailed guidance for remuneration committees.

Role of remuneration consultants

Remuneration committees may draw on the advice of specialist remuneration consultants when
constructing executive remuneration packages. The role of remuneration (compensation)
consultants has started to receive more attention in the last few years in the academic
206 DIRECTORS AND BOARD STRUCTURE

literature. Voulgaris et al. (2010) in a study of 500 UK firms from the FTSE 100, FTSE
250, and the Small Cap indices, find that compensation consultants may have a
positive effect on the structure of CEO pay since they encourage incentive-based
compensation, and they also show that economic determinants, rather than CEO
power, explain the decision to hire compensation consultants.
Murphy and Sandino (2010) examine the potential conflicts of interest that remuneration
consultants face, which may lead to higher recommended levels of CEO pay. They find
‘evi-dence in both the US and Canada that CEO pay is higher in companies where the
consultant provides other services, and that pay is higher in Canadian firms when the fees
paid to con-sultants for other services are large relative to the fees for executive-
compensation services. Contrary to expectations, we find that pay is higher in US firms
where the consultant works for the board rather than for management.
Similarly, Conyon et al. (2011), in a study of compensation consultants used in 232
large UK companies, find that ‘consultant use is associated with firm size and the equity
pay mix. We also show that CEO pay is positively associated with peer firms that share
consultants, with higher board and consultant interlocks, and some evidence that where
firms supply other business services to the firm, CEO pay is greater’.
Bender (2011), drawing on interview data with a selection of FTSE 350 companies,
finds remuneration committees employ consultants for a number of reasons. First,
the consultant is to act as an expert, providing proprietary data against which companies
can benchmark pay, and giving insight and advice into the possibilities open for plan
design and implementation. In this role, consultants have a direct and immediate influence
on executive pay. That is, by influencing the choice of comparators, consultants both
identify and drive the market for executive pay. They also bring to bear their knowledge of
pay plans, and their views on what is currently acceptable to the market, thus spreading
current practice more widely and institutionalizing it as best practice.

Secondly, they act as liaisons and serve an important role in the communication with
certain institutional investors. Thirdly Bender finds that they legitimize the decisions of
the remuneration committee by providing an element of perceived independence but
she points out that ‘this route to legitimacy is under threat as various constituencies
question consultants‘ independence’.
Also questioning the independence of remuneration consultants, Kostiander and
Ikäheimo (2012), examine the remuneration consultant–client relationship in the non-
Anglo-American context of Finland, focusing on what consultants do under heavy political
remuneration guidance. Their findings show that ‘restrictive remuneration guidelines can
be ineffective and lead to standardized pay designs without providing competitive
advantage. Shareholders should request greater transparency concerning remuneration
design. The role of consul-tants should be considered proactively in the guidelines, even
by limiting the length of the consultant–client relationship or increasing their transparency’.
There does therefore seem to be a growing body of evidence highlighting the role
of remuneration consultants in the setting of executive remuneration, and raising
issues re-lating to their independence and the impact on CEO pay when the
remuneration consultants offer other services to the firm.
 DIRECTORS’ PERFORMANCE AND REMUNERATION 207

Performance measures
Performance criteria will clearly be a key aspect of ensuring that directors’ remuneration is
perceived as fair and appropriate for the job and in keeping with the results achieved by
the directors. Performance criteria may differentiate between three broadly conceived
types of measures: (i) market-based measures; (ii) accounts based measures; and (iii)
individual based measures. Some potential performance criteria are:

● shareholder return;
● share price (and other market based measures);
● profit-based measures;
● return on capital employed;
● earnings per share;
● individual director performance (in contrast to corporate performance measures).
Sykes (2002) highlights a number of problems with the way in which executive
remuneration is determined: (i) management is expected to perform over a short period of
time and this is a clear mismatch with the underlying investor time horizons; (ii)
management remuneration is not correlated to corporate performance; (iii) earnings
before interest, tax, and amortisation (EBITA) is widely used as a measure of earnings
and yet this can encourage companies to gear up (or have high leverage) because the
measure will reflect the flow of earnings from high leverage but not the service (interest)
charge for that debt. He suggests that the situation would be improved if there were:
longer term tenures for corporate management; more truly independent non-executive
directors; the cessation of stock options and, in their place, a generous basic salary and
five-year restricted shares (shares that could not be cashed for five years).
The ABI (2002, 2005) guidelines state that total shareholder return relative to an appro-priate
index or peer group is a generally acceptable performance criterion. The guidelines also favour
performance being measured over a period of at least three years to try to ensure sustained
improvements in financial performance rather than the emphasis being placed on short-term
performance. Share incentive schemes should be available to employees and executive
directors but not to non-executive directors (although non-executive directors are encouraged to
have shareholdings in the company, possibly by receiving shares in the com-pany, at full
market price, as payment of their non-executive director fees).
The ABI published its Disclosure Guidelines on Socially Responsible Investment in
2007. Interestingly, the guidelines said that the company should state in its remuneration
report ‘whether the remuneration committee is able to consider corporate performance on
ESG [environmental, social, and governance] issues when setting remuneration of
executive directors. If the report states that the committee has no such discretion, then a
reason should be provided for its absence’. Also ‘whether the remuneration committee has
ensured that the incentive structure for senior management does not raise ESG risks by
inadvertently moti-vating irresponsible behaviour’. These are significant recommendations
in the bid to have ESG issues recognized and more widely taken into consideration.
208 DIRECTORS AND BOARD STRUCTURE

Another area that has attracted attention, and which is addressed in joint ABI/NAPF guid-
ance, is the area of ‘golden goodbyes’. This is another dimension to the directors’ remunera-
tion debate because it is not only ongoing remuneration packages that have attracted adverse
comment, but also the often seemingly excessive amounts paid to directors who leave a
company after failing to meet their targets. Large pay-offs or ‘rewards for failure’ are seen as
inappropriate because such failure may reduce the value of the business and threaten the jobs
of employees. Often the departure of underperforming directors triggers a clause in their
contract that leads to a large undeserved pay-off, but now some companies are cutting the
notice period from one year to, for example, six months where directors fail to meet
performance targets over a period of time, so that a non-performing director whose contract is
terminated receives six months’ salary rather than one year’s salary.
The ABI/NAPF guidance emphasizes the importance of ensuring that the design of con-
tracts should not commit companies to payment for failure; the guidance also suggests
that phased payments are a useful innovation to include in directors’ contracts. A phased
pay-ment involves continuing payment to a departing director for the remaining term of the
contract but payments cease when the director finds fresh employment. An alternative
sug-gested by the Myners Report (2001) is that compensation for loss of office should be
fixed as a number of shares in the company (and hence the value of the compensation
would be linked to the share price performance of the company).
It does seem that the days of lucrative payments for underperforming directors are
drawing to a close. Furthermore, the UK’s Department of Trade and Industry (DTI)
issued a consultation document in summer 2003, ‘Rewards for Failure: Directors’
Remuneration— Contracts, Performance and Severance’, which invites comment on
ways in which severance pay might be limited by restricting notice periods to less
than one year, capping the level of liquidated damages, using phased payments, and
limiting severance pay where a company has performed poorly.
In February 2008 the ABI and the NAPF issued joint guidance entitled Best Practice on
Executive Contracts and Severance—A Joint Statement by the Association of British Insurers
and the National Association of Pension Funds. The guidance aims to assist boards and their
remu-neration committees ‘with the design and application of contractual obligations for senior
executives so that they are appropriately rewarded but are not rewarded for under-
performance’. The concluding statement to the guidance succinctly sums up the views of many:
‘It is unac-ceptable that poor performance by senior executives, which detracts from the value
of an enterprise and threatens the livelihood of employees, can result in excessive payments to
departing directors. Boards have a responsibility to ensure that this does not occur’.
In relation to bonuses, Fattorusso et al. (2007) point out that
the focus of most criticism has been on salary, severance payments and various long-term
incentives (particularly share options). However, executive bonuses have attracted little
attention and have been only lightly regulated. This raises important questions. Has lighter
regulation been associated with significant levels of rent extraction through bonuses, that
is, a weak relation between bonus pay and shareholder returns?

In March 2012 Hermes Equity Ownership Services (Hermes EOS) and the NAPF, for the first
time brought together remuneration committee members from forty-four of the FTSE 100
companies and forty-two occupational pension funds from across the globe. The dialogue
 DIRECTORS’ PERFORMANCE AND REMUNERATION 209

focused on executive pay structures and how long-term investors can best challenge,
and support companies in improving remuneration practices through engagement
and the considered use of their voting powers. The intention is to shift the current
political and societal debate with the view of creating greater alignment between
companies and their shareholders, and to promote a culture within companies that
rewards long-term success and alignment across the organization.

Remuneration of non-executive directors

The remuneration of non-executive directors is decided by the board, or where required by
the articles of association, or the shareholders in general meeting. Non-executive directors
should be paid a fee commensurate with the size of the company, and the amount of time
that they are expected to devote to their role. Large UK companies would tend to pay in
excess of £50,000 (often considerably more) to each non-executive director. The
remuneration is generally paid in cash although some advocate remunerating non-
executive directors with the company’s shares to align their interests with those of the
shareholders. However, it has generally been viewed as not being a good idea to
remunerate non-executive directors with share options (as opposed to shares) because
this may give them a rather unhealthy focus on the short-term share price of the company.
Nonetheless, in 2010 the International Corporate Governance Network (ICGN) published its
Non-executive Director Remuneration Guidelines and Policies. The recommendations include
that the retainer/annual fee should be the only form of cash compensation paid to non-
executive directors, and that there should not be a separate fee for attendance at board
meetings or at committee meetings. However, it is recognized that companies may want to
differentiate the fee amount to reflect the differing workloads of individual non-executive
directors, for example, where a non-executive director is also a committee chair. Interest-ingly,
the guidelines state that, in order to align non-executive director–shareowner interests, non-
executive directors may receive stock awards or similar. However, any such ‘equity-based
compensation to non-executive directors should be fully vested on the grant date . . .
a marked difference to the ICGN’s policy on executive compensation which calls for
performance-based vesting on equity-based awards’.
Importantly, the ICGN also states: ‘Separate from ownership requirements, the ICGN
believes companies should adopt holding requirements for a significant majority of equity-
based grants. These policies should require that non-executive directors retain a
significant portion of equity grants until at least two years after they are retired from the
board’. Such policies would help ensure that interests remain aligned.
There has been relatively little academic research into non-executive directors’
remuner-ation. Hahn and Lasfer (2011) referred to non-executive directors’ remuneration
as ‘an enigma’. A recent study by Gaia et al. (2012) compares the remuneration of
independent non-executive directors in Italy and the UK. The authors find that
‘independent non-executive directors do not receive performance-based remuneration
except in very limited instances. In line with equity and human capital theories, we find
that independent non-executive directors do receive higher remuneration when they exert
more effort, have more responsi-bilities, and have a higher human capital’.
210 DIRECTORS AND BOARD STRUCTURE

Disclosure of directors’ remuneration

There has been much discussion about how much disclosure there should be of directors’
remuneration and how useful detailed disclosures might be. The Greenbury Report, issued in
the UK in 1995, was established on the initiative of the Confederation of British Industry (CBI)
because of public concern about directors’ remuneration. Whilst the work of the Greenbury
Report focused on the directors of public limited companies, it hoped that both smaller listed
companies and unlisted companies would find its recommendations useful.
Central to the Greenbury Report recommendations were the strengthening of account-ability
and enhancing the performance of directors. These two aims were to be achieved by
(i) the establishment of remuneration committees comprised of independent non-executive
directors who would report fully to the shareholders each year about the company’s
execu-tive remuneration policy, including full disclosure of the elements in the
remuneration of individual directors; and (ii) the adoption of performance measures linking
rewards to the performance of both the company and individual directors, so that the
interests of directors and shareholders were more closely aligned.
One of the Turnbull Committee recommendations (1999, revised 2005) was that
boards should consider whether business objectives and the risk
management/control systems of a business are supported by the performance-
related reward system in operation in a company.
As part of the accountability/transparency process, the remuneration committee mem-
bership should be disclosed in the company’s annual report, and the chairman of the
remu-neration committee should attend the company’s annual general meeting to answer
any questions that shareholders may have about the directors’ remuneration.
The DTI published its Directors’ Remuneration Report Regulations 2002. These
regulations require, inter alia, that:
● quoted companies must publish a detailed report on directors’ pay as part of their
annual reporting cycle, and this report must be approved by the board of directors;
● a graph of the company’s total shareholder returns over five years, against a
comparator group, must be published in the remuneration committee report;
● names of any consultants to the remuneration committee must be disclosed,
including whether they were appointed independently, along with the cost of any
other services provided to the company;
● companies must hold a shareholder vote on the directors’ remuneration report at
each general meeting.
The stipulation that companies must hold a shareholder vote on the directors’ remuneration
report is an interesting one, and something that various shareholder representative groups have
campaigned for over a long period of time. However, the vote is an advisory shareholder vote,
but it will serve a useful purpose of ensuring that the shareholders can vote specifically on
directors’ remuneration, which has caused so much heated debate for so long. The other
provisions will help to strengthen the role of the remuneration committee and enhance both the
accountability and transparency of the directors’ remuneration-setting process. The disclosures
relating to the consultants used by the remuneration committee may also lead to
 DIRECTORS’ PERFORMANCE AND REMUNERATION 211

interesting questions relating to any other services they may provide to a company to
try to determine their independence.
The ILO (2008) reports:
Disclosure practices differ widely across countries. While some countries, including
France, the Netherlands, the United Kingdom and the United States require companies to
report detailed compensation data in a remuneration report, others like Greece, have no
specific requirements . . . companies in such countries as Brazil, Germany, Japan and
Mexico frequently report only aggregate data on executive compensation . . . In some
countries, executives seem to consider the disclosure of the precise amount of
remuneration to be a risk to their personal safety. (Leal and Carvalhal da Silva, 2005)

International guidance on executive remuneration

International Corporate Governance Network (ICGN)
The ICGN issued its recommendations on best practice for executive remuneration in
2003. It was hoped that the recommendations would create a consensus amongst both
companies and investors around the world about the structure of remuneration packages.
The ICGN recommendations stated that the ‘fundamental requirement for executive
remuneration reporting is transparency’. This was the starting point: that there should be
disclosure of the base salary, short-term and long-term incentives, and any other payments or
benefits to each main board director. The remuneration committee should publish state-ments
on the expected outcomes of the remuneration structures, in terms of ratios between base
salaries, short-term bonuses, and long-term rewards, making both ‘high’ and ‘low’ assumptions
as well as the ‘central’ case. Whilst recognizing that share options are probably here to stay, the
ICGN recommendations supported the International Accounting Standards Board (IASB)
proposal to expense share options through the profit and loss account.
The remuneration committee report should be presented as a separate voting item at
every annual meeting (this would depend on local practice). The ICGN also urged institu-
tional investors to devote more resources to the analysis of remuneration resolutions.
In 2004 the ICGN published statements about the compliance of each of the UK, USA, and
Australia with the ICGN’s Executive Remuneration Principles. Each of these countries generally
complied with the principles, although each had strengths and weaknesses on particular issues.
In 2006 the ICGN approved the updated ICGN Remuneration Guidelines. Three
principles underpin the new guidelines: transparency, accountability, and the
performance basis. The guidelines state that there should also be thought given to
the reputational aspects of remuneration.
At present the ICGN have circulated recommendations on non-executive director remu-
neration (discussed earlier) but no further guidelines on executive remuneration.

Organisation for Economic Co-operation and Development (OECD)

The OECD Corporate Governance Committee (2010) in Corporate Governance and
the Financial Crisis: Conclusions and Emerging Good Practices to Enhance
Implementation of the Principles (hereafter ‘the Conclusions’) noted that
212 DIRECTORS AND BOARD STRUCTURE

the ability of the board to effectively oversee executive remuneration appears to be a key
challenge in practice and remains one of the central elements of the corporate governance
debate in a number of jurisdictions. The nature of that challenge goes beyond looking
merely at the quantum of executive and director remuneration (which is often the focus of
the public and political debate), and instead more toward how remuneration and incentive
arrangements are aligned with the longer term interests of the company.

Furthermore, they highlight that policymakers have ‘focused more on measures that seek to
improve the capacity of firm governance structures to produce appropriate remuneration and
incentive outcomes. These can roughly be characterized in terms of internal firm governance
(and, in particular, fostering arms-length negotiation through mandating certain levels of
independence), and providing a mechanism to allow shareholders to have a means of
expressing their views on director and executive remuneration’. The OECD (2011) conclude
that ‘aligning incentives seems to be far more problematic in companies and jurisdictions with a
dispersed shareholding structure since, where dominant or controlling shareholders exist, they
seem to act as a moderating force on remuneration outcomes’.

The European Commission

In April 2009 the European Commission announced new guidelines for directors’ remuneration
which include, inter alia, performance criteria that ‘should promote the long-term sustainability
of the company and include non-financial criteria that are relevant to the company’s long-term
value creation’; clawback provisions where variable elements of remuneration were rewarded
on misleading data; and termination payments not to be paid where performance had been
poor. However, these guidelines are not intended to be binding on member states. In June
2010 the EU issued a Green Paper on ‘Corporate governance in financial institutions and
remuneration policies’; one of the issues it consulted on was the recommendation of a binding
or advisory shareholder vote on remuneration policy and greater independence for non-
executive directors involved in determining remuneration policy. The Commission also
consulted on this issue in the 2010 Green Paper on ’Corporate Governance in Financial
Institutions’. In April 2011 another Green Paper, ‘The EU corporate governance framework’,
was issued, with responses invited to various consultation questions. These included whether
disclosure of remuneration policy, the annual remuneration report (a report on how the
remuneration policy was implemented in the past year), and individual remuneration of
executive and non-executive directors should be mandatory; and also whether it should be
mandatory to put the remuneration policy and the remuneration report to a vote by
shareholders. The final outcome of the consultation is awaited.

The Conference Board

In the USA the Conference Board Commission on Public Trust and Private Enterprise
was established to address widespread abuses that led to corporate governance
scandals and a resulting lack of confidence in the markets.
One area that the Commission looked at was executive compensation. The Commission
reported in 2002 with principles, recommendations, and specific best practice suggestions. The
seven principles relate to: the compensation (remuneration) committee and its
 DIRECTORS’ PERFORMANCE AND REMUNERATION 213

responsibilities; the importance of performance-based compensation; the role of equity-based

incentives; creating a long-term focus; accounting neutrality; shareholders’ rights; and trans-
parency and disclosure. The principles serve to clarify several areas and identify that the com-
pensation committee—which should be comprised of directors who are free of any relationships
with the company and its management—should be primarily responsible for ensuring that there
is a fair and appropriate compensation scheme in place. In order to aid them in this role, the
compensation committee may appoint outside consultants who should report solely to the
committee. Performance-based remuneration incentives should ‘support and reinforce the
corporation’s long-term strategic goals set by the board (for example, cost of capital, return on
equity, economic value added, market share, quality goals, compliance goals, environment
goals, revenue and profit growth, cost containment, cash management, etc.)’. In relation to the
role of equity incentives, such as share options, the compensation committee should ensure
that disclosure is made of any costs to shareholders associated with equity-based compensa-
tion such as dilution (the earnings per share after dilution should be shown). Key executives
and directors should be encouraged to build up a reasonable shareholding in the corporation
and hold that shareholding for the longer term.
The Commission’s report is likely to influence policy in many countries, especially
those countries that have already followed the US-style remuneration package and
adopted share option schemes.
In spring 2009 the Conference Board announced the establishment of an Executive
Com-pensation Task Force. They state that:
The Task Force brings together corporations and investors, and governance, legal,
compensation and ethics experts to address one of the most important issues in
today’s business world. The Conference Board’s new Task Force is part of its
broader reexamination of the foundations of the current crisis and its impact on global
growth and stability as well as institutions, business organizations and markets.

In autumn 2009 the Conference Board Task Force on Executive Compensation

reported and provided guiding principles for setting executive compensation, which, if
appropriately implemented, are designed to restore credibility with shareholders and
other stakeholders. The five principles are as follows: payment for the right things and
payment for performance; the ’right’ total compensation; avoidance of controversial
pay practices; credible board oversight of executive compensation; and transparent
communications and increased dialogue with shareholders.

Dodd-Frank Wall Street Reform and Consumer Protection Act (2010)

In July 2010 the USA passed the Dodd-Frank Wall Street Reform and Consumer
Protection Act that amends US requirements relating to executive compensation practices
in a number of respects. From mid-2011 the Securities and Exchange Commission (SEC)
required listed companies compensation committee members to be independent directors.
There are new ‘say on pay’ provisions such that the Act requires that, at least once every
three years, there is a shareholder advisory vote to approve the company’s executive
compensation, as well as to approve ‘golden parachute’ compensation arrangements.
Whilst the ‘say on pay’ is at least once every three years, it may occur every year.
214 DIRECTORS AND BOARD STRUCTURE

‘Say on pay’
The ‘say on pay’ was introduced in the UK in 2002 by the Directors’ Remuneration Report
Regulations. It has come very much to the fore since the financial crisis as a tool of governance
activism in the context of expressing dissent on executive remuneration awards. Many
countries including the USA, Australia, and various countries in Europe have introduced the
‘say on pay’ as a mechanism for voting against executive remuneration. In some countries,
such as the UK, the ‘say on pay’ vote is an advisory one (at least for the time being), whilst in
other countries it is a binding vote on which the board must take action.
As mentioned earlier, in the USA, the Dodd-Frank Wall Street Reform and Consumer
Pro-tection Act (2010), under new ‘say on pay’ provisions, requires that at least once
every three years there is a shareholder advisory vote to approve the company’s
executive compensation as disclosed pursuant to SEC rules. The ‘say on frequency’
provision requires companies to put to a shareholder advisory vote every six years
whether the ‘say on pay’ resolution should occur every one, two, or three years.
Conyon and Sadler (2010), in a study of shareholder voting behaviour in the UK
from 2002–7, find that there is
little evidence of widespread and deep shareholder voting against CEO pay. Critics of
CEO pay may be surprised, as one frequently proposed remedy for excess pay has been
to give shareholders a voice. The UK experience suggests that owners have not seized
this opportunity to reign in high levels of executive pay . . . this noted, we do find that high
CEO pay is likely to trigger greater shareholder dissent. This suggests that boards and
compen-sation committees might try to communicate the intentions of CEO pay policies
better to the firm’s multiple stakeholders. Moreover, at present there is little evidence that
shareholder voting dissent leads to drastic cuts in subsequent CEO pay.

Conyon and Sadler do, however, recognize that their study was carried out on pre-financial
crisis data and that there may be a higher incidence of dissent post-financial crisis, especially in
companies that have received financial support from governments or where executive pay is
perceived to be excessively high. Recent evidence does indeed show that institutional investors
are voting with much higher levels of dissent, and more frequently, against executive
remuneration packages in the UK, the USA, and other countries.
Ferri and Maber (2011) examine the effect of ’say on pay’ regulation in the UK. They report that

consistent with the view that shareholders regard say on pay as a value-creating mechanism,
the regulation’s announcement triggered a positive stock price reaction at firms with weak
penalties for poor performance. UK firms responded to negative say on pay voting outcomes by
removing controversial CEO pay practices criticized as rewards for failure (e.g., generous
severance contracts) and increasing the sensitivity of pay to poor realizations of performance.

Conclusions
The debate on executive directors’ remuneration has rumbled on through the last decade, but
with the increase in institutional investor activism, and the scandals and subsequent collapses
associated with a number of large corporations in the UK, USA, and elsewhere, the
 DIRECTORS’ PERFORMANCE AND REMUNERATION 215

focus is well and truly on curtailing excessive and undeserved remuneration packages. The
global financial crisis and the collapse of various high profile banks and financial institutions has
left the market reeling. There is a lack of public confidence in the boards of banks, and disbelief
at some of the executive remuneration packages and ad hoc payments that have been made to
executive directors. There is now an emphasis on payment for performance in a way that
theoretically was present before the global financial crisis but, in practice, all too often was not.
The remuneration committees, comprised of independent non-executive directors, will come
under increased scrutiny as they try to ensure that executive directors’ remuneration packages
are fairly and appropriately constructed, taking into account long-term objectives. Central to this
aim is the use of performance indicators that will incentivize directors but at the same time align
their interests with those of shareholders, to the long-term benefit of the company.
Shareholders in many countries now have a ‘say on pay’, either in the form of an advisory or a
binding vote, and seem increasingly active in expressing their dissent on executive
remuneration.

Summary
● The debate on executive directors’ remuneration has been driven by the view that
some directors, and especially those directors in the banking sector, are being
overpaid to the detriment of the shareholders, the employees, and the company
as a whole. The perception that high rewards have been given without
corresponding performance has caused concern, and this area has increasingly
become the focus of investor activism and widespread media coverage.
● The components of executive directors’ remuneration are base salary,
bonuses, stock options, stock grants, pension, and other benefits.
● The remuneration committee, which should be comprised of independent
non-executive directors, has a key role to play in ensuring that a fair and
appropriate executive remuneration system is in place.
● The role of the remuneration consultant is a complex one and there may be
potential conflicts of interest.
● There are a number of potential performance criteria that may be used to
incentivize executive directors. These are market-based measures (such as
share price), accounts-based measures (such as earnings per share), and
individual director performance measures.
● It is important that there is full disclosure of directors’ remuneration and the
basis on which it is calculated.
● There seems to be a trend towards convergence internationally in terms
of the recommendations for the composition, calculation, and disclosure
of executive directors’ remuneration.
● The ‘say on pay’ is a mechanism for investors to express their approval or dissent
in relation to executive remuneration packages and has become widely adopted.
216 DIRECTORS AND BOARD STRUCTURE

Example: AstraZeneca Plc, UK

This is an example of a company that came under shareholder pressure over its executive
remuneration package, and its financial performance and strategy.
AstraZeneca is a global biopharmaceutical company operating in over one hundred
countries. Their primary focus is the discovery, development, and commercialization of
prescription medicines for six important areas of healthcare: cardiovascular, gastrointestinal,
infection, neuroscience, oncology, and respiratory/inflammation.
At 31 December 2011 AstraZeneca’s board comprised two executive directors (the CEO and
chief financial officer) and nine non-executive directors, of whom three are female, one of these
being the senior independent non-executive director. There are no female executive directors on
the board. In terms of international directors, two directors are French, three are from the USA,
five from the UK, and one from Sweden.
There are four principal board committees: audit; remuneration; nomination and governance; and
science committees. The remuneration committee is comprised of four independent non-executive
directors, one of whom, John Varley, is the Chair of the remuneration committee.
In the spring of 2012 AstraZeneca announced that it would be making around 12 per cent of
its staff redundant; yet just a few weeks later, it announced a substantial increase in the pay of
its CEO, David Brennan, to £9.27 million. A substantial part of this came from a long-term
incentive scheme but AstraZeneca nonetheless increased David Brennan’s basic pay and
bonus by some 11 per cent. This was at a time when AstraZeneca’s shares had fallen 13 per
cent over the past year, whereas its peer group had seen increases of more than 4 per cent
during the same time. However, John Varley pointed out that AstraZeneca’s core earnings per
share had risen during 2011. There was investor pressure over David Brennan’s remuneration
package at a time when AstraZeneca’s performance has, in their eyes, been disappointing, and
there has also been concern over the company’s strategy going forwards. In April 2012 David
Brennan stepped down as CEO of AstraZeneca after shareholder pressure to do so.

Example: American International Group (AIG), USA

This is an example of one of the largest American insurers that has received federal government
bail-out money but has continued to pay retention bonuses to its senior employees.
AIG has been kept afloat by more than US$170 billion in public money since September 2008.
A furore broke out after it was revealed that large bonuses were being paid to executives only a
few months after AIG received federal support. The American Federation of Labor and
Congress of Industrial Organizations (AFL-CIO), a voluntary federation of fifty-six national and
international labour unions and representing 11 million members, was one of the groups
astounded at the payouts at a time when thousands are losing their jobs. AFL-CIO were
particularly incensed about these payments, which ‘were in the form of “retention” bonuses to
employees of its financial products division, which sold the complex derivatives at the heart of
the company’s financial troubles . . . AIG’s poor pay practices expose the fallacy of “pay for
performance.” The potential windfalls for executives were so massive they had nothing to lose
by taking on huge risks to create the illusion of profits.’
The CEO, Edward Liddy, asked the senior employees to pay back the bonuses, totalling
US$165 million, urging them to ‘do the right thing’. Many of them have now done so.
 DIRECTORS’ PERFORMANCE AND REMUNERATION 217

In recent years, the US government has been looking into how the oversight of executive
compensation might be changed. One area where a significant change has occurred is the
introduction of the ‘say-on-pay’ legislation whereby shareholders have the right to vote on directors’
remuneration. In July 2010 new ‘say on pay’ provisions were introduced by the Dodd-Frank Wall Street
Reform and Consumer Protection Act 2010, whereby at least once every three years, there is a
shareholder advisory vote to approve the company’s executive compensation.
In 2011 using the ‘say on pay’, shareholders voted overwhelmingly in favour of AIG’s
executive remuneration. Subsequently, in February 2012 AIG reported a US$19.8 billion profit
for its fourth quarter but US$17.7 billion of that profit was a tax benefit from the US
government. The company made relatively little during the quarter from its actual operations.
Ironically, the tax benefit will also benefit employees who are paid based on the company’s
performance. However, the US Treasury Department has ordered that nearly seventy top
executives in AIG to take a 10 per cent pay-cut, and the pay for the CEO was frozen at 2011
levels. Nonetheless, AIG’s CEO is still expected to receive US$10.5 million.

Mini case study Aviva Plc, UK

This is an example of a company that is itself renowned for its corporate governance
activism in its investee companies but which suffered a defeat of its executive remuneration
proposals via the ‘say on pay’ and also saw the departure of its CEO soon afterwards.
Aviva is the UK’s largest insurer and one of Europe’s leading providers of life and general
insurance with over 36,000 employees and some 43 million customers worldwide.
Its board of directors consists of twelve directors of whom eight are independent non-
executive directors (three of these independent non-executive directors are female, there being
no female executive directors on the board), plus the chairman, the executive deputy chairman,
the chief financial officer, and the executive director for developed markets. There are five key
board committees: audit, remuneration, nomination, corporate responsibility, and risk. The
remuneration committee comprises three independent non-executive directors, one of whom
chairs it. The remuneration committee, like many, seeks the advice of remuneration consultants
when setting the pay packages for its executive directors, and the activities of the remuneration
committee note that during 2011 the remuneration committee approved the appointment of FIT
Remuneration Consultants in place of AON Hewitt New Bridge Street.
During the first part of 2012 Andrew Moss, the CEO of Aviva, announced restructuring plans
which included Aviva Investors shedding more than one-tenth of its workforce; subsequently, in
April 2012 he announced a simplification of the management structure, which saw some of its most
respected executives leaving the company. At around this time, ABI issued an ‘amber alert’ over
Aviva’s remuneration report. With investor concern about Aviva’s executive pay proposals
mounting, Aviva announced that it would review the executive pay proposals. Andrew Moss
declined a pay rise of £46,000 but, nonetheless, looking back at 2011, his pay (excluding a long-
term share incentive plan) rose by around 8.5 per cent, whilst Aviva’s shares lost around one-
quarter of their value, which raised shareholders’ concerns of reward for poor performance.
However, the unease from institutional investors was not just about the executive pay proposals but
also about the performance of Aviva in recent years, with share prices falling and Aviva
underperforming compared to its peers. In early May 2012 Aviva became one of the few com-
panies in the UK to suffer a shareholder defeat of its executive remuneration proposals since the
‘say on pay’ was introduced in the UK some ten years ago. Just over a week later, Andrew Moss
resigned from his post as CEO of Aviva.
(continued)
218 DIRECTORS AND BOARD STRUCTURE

Questions
The discussion questions to follow cover the key learning points of this chapter. Reading
of some of the additional reference material will enhance the depth of the students’
knowledge and under-standing of these areas.

1. What factors have influenced the executive directors’ remuneration debate?

2. Why is the area of executive directors’ remuneration of such interest to investors, and
particu-larly to institutional investors?
3. What are the main components of executive directors’ remuneration packages?
4. Critically discuss the roles of the remuneration committee and remuneration
consultants in setting executive directors’ remuneration.
5. Critically discuss the performance criteria that may be used in determining executive
directors’ remuneration.
6. Critically discuss the importance of executive director remuneration disclosure.

References
ABI (2002), Guidelines on Executive ——— (2009), The Conference Board Task Force on
Remuneration, ABI, London. Executive Compensation, Conference Board, New York.
——— (2005), Principles and Guidelines on Conyon, M.J. and Mallin, C.A. (1997), Directors’
Remuneration, ABI, London. Share Options, Performance Criteria and
——— (2007), Disclosure Guidelines on Socially Disclosure: Compliance with the Greenbury
Responsible Investment, ABI, London Report, ICAEW Research Monograph, London.

——— (2007), Executive Remuneration—ABI ——— and Murphy, K.J. (2000), ‘The Prince and the
Guidelines on Policies and Practices, ABI, London. Pauper? CEO Pay in the United States and United
Kingdom’, The Economic Journal, Vol. 110.
——— (2008), Best Practice on Executive Contracts and
Severance—A Joint Statement by the Association of ——— and Sadler, G.V. (2010), 'Shareholder Voting
British Insurers and National Association of Pension and Directors' Remuneration Report Legislation:
Funds, ABI/NAPF, London. Say on Pay in the UK', Corporate Governance: An
International Review, Vol. 18(4), pp. 296–312.
——— (2011), ABI Principles of Executive
Remuneration, ABI, London. ——— Peck S.I. and Sadler G.V. (2011), ‘New
Bebchuk, L. and Fried, J. (2004), Pay Without Perfor- Perspectives on the Governance of
mance: The Unfulfilled Promise of Executive Executive Compensation: an Examination
Compensation, Harvard University Press, Boston, MA.
of the Role and Effect of Compensation
Consultants’, Journal of Management and
Bender, R. (2011), ‘Paying for advice: The role of the
Governance, Vol. 15, No.1, pp. 29–58.
remuneration consultant in U.K. listed companies’,
Dodd-Frank Wall Street Reform and Consumer Protection
Vanderbilt Law Review, Vol. 64(2), pp. 361–96.
Act (2010), USA Congress, Washington DC.
BIS (2011), Executive Remuneration Discussion Paper,
DTI (2002), The Directors’ Remuneration Report
September 2011, BIS, London.
Regulations 2002 (SI No. 2002/1986), DTI, London.
Combined Code (2008), The Combined Code on
——— (2003), ‘Rewards for Failure: Directors’
Corporate Governance, Financial Reporting
Council, London. Remuneration—Contracts, Performance and
Severance’, DTI, London.
Conference Board (2002), Commission on Public
Trust and Private Enterprise Findings and European Commission (2009), Commission
Recommendations Part 1: Executive Recommendation on Directors’ Remuneration, April
Compensation, Conference Board, New York. 2009, Brussels.
 DIRECTORS’ PERFORMANCE AND REMUNERATION 219

——— (2010), Green Paper on Corporate Governance in ——— (2004b), UK Compliance 2004 with ICGN’s
Financial Institutions and Remuneration Policies, Executive Remuneration Principles, ICGN, London.
European Commission, June 2010, Brussels. ——— (2004c), US Compliance 2004 with ICGN’s
——— (2011), Green Paper on the EU Executive Remuneration Principles, ICGN, London.
Corporate Governance Framework, ——— (2006), Remuneration Guidelines, ICGN, London.
European Commission, April 2011, Brussels.
——— (2010), Non-executive Director Remuneration
Fattorusso, J., Skovoroda, R., and Bruce, A. Guidelines and Policies, ICGN, London.
(2007), ‘UK Executive Bonuses and
ILO (2008), World of Work Report 2008: Income
Transparency—A Research Note’, British
Inequalities in the Age of Financial
Journal of Industrial Relations, Vol. 45, No. 3.
Globalization, International Institute for Labour
Ferri, F. and Maber, D. A. (2011), ‘Say on Studies, Geneva, Switzerland.
Pay Votes and CEO Compensation:
Evidence from the UK’, Review of Kostiander, L. and Ikäheimo, S., (2012),
Finance, forthcoming. Available at SSRN: ‘“Independent” Consultants’ Role in the
http://ssrn.com/abstract =1420394 Executive Remuneration Design Process under
Restrictive Guidelines’, Corporate Governance:
FRC (2010), UK Corporate Governance Code, Financial
An International Review, 20(1) pp. 64–83.
Reporting Council, London.
Leal, R.P.C. and Carvalhal da Silva, A. (2005), Corporate
FSA (2010), PS10/20 Revising the Remuneration Code,
Governance and Value in Brazil (and in Chile), available
FSA, London.
at SSRN: http://ssrn.com/abstract=726261 or DOI:
Gaia S., Mallin C.A., and Melis A. (2012), 10.2139/ssrn.726261
‘Independent Non-Executive Directors’
Lee, P. (2002), ‘Not Badly Paid But Paid Badly’, Corporate
Remuneration: A Comparison of the UK and Italy’,
Governance: An International Review, Vol. 10, No. 2.
Working Paper, Birmingham Business School.
Murphy, K.J. and Sandino, T. (2010), ‘Executive pay and
Greenbury, Sir R. (1995), Directors’ Remuneration:
"independent" compensation consultants’ Journal of
Report of a Study Group Chaired by Sir Richard
Accounting and Economics, Vol. 49, Issue 3, pp.
Greenbury, Gee Publishing Ltd, London.
247–62.
Hahn, P. and Lasfer, M. (2011), ‘The compensation
Myners, P. (2001), Institutional Investment in the UK:
of non-executive directors: rationale, form, and
A Review, HM Treasury, London.
findings’, Journal of Management and
Governance, 15(4), pp. 589–601. OECD (2010), Corporate Governance and the Financial
Crisis: Conclusions and Emerging Good Practices to
High Pay Centre (2012), It’s How You Pay It,
Enhance Implementation of the Principles, OECD,
High pay Centre, London.
Paris.
High Pay Commission (2011), More for Less:
what has happened to pay at the top and ——— (2011), Board Practices: Incentives and
does it matter? Interim Report, May 2011, Governing Risks, OECD, Paris.
High Pay Commission, London. Sykes, A. (2002), ‘Overcoming Poor Value Executive
——— (2011), What are we paying for? Exploring Remuneration: Resolving the Manifest Conflicts of
executive pay and performance, September Interest’, Corporate Governance: An International
2011, High Pay Commission, London. Review, Vol. 10, No. 4.

——— (2011), Cheques with Balances: Why tackling Turnbull Committee (1999), Internal Control:
high pay is in the national interest, Final Report, Guidance for Directors on the Combined
November 2011, High Pay Commission, London. Code, ICAEW, London.
House of Commons Treasury Committee (2009), Turner Review (2009), A Regulatory Response
Banking Crisis: Reforming Corporate to the Global Banking Crisis, March 2009,
Governance and Pay in the City, Ninth Report of FSA, London.
Session 2008–09, House of Commons, The Voulgaris G., Stathopoulos K., and Walker M.
Stationery Office, London. (2010), ‘Compensation Consultants and CEO
ICGN (2003), Best Practices for Executive and Pay: UK Evidence’, Corporate Governance: An
Director Remuneration, ICGN, London. International Review, Vol. 18(6), pp. 511–26.
——— (2004a), Australian Compliance 2004 Walker, D. (2009), A Review of Corporate Governance in
with ICGN’s Executive Remuneration UK Banks and Other Financial Industry Entities, Final
Principles, ICGN, London. Recommendations, HM Treasury, London.
220 DIRECTORS AND BOARD STRUCTURE

Useful websites
www.abi.org.uk The website of the Association of British Insurers has guidelines on
executive remuneration issues.
http://blog.thecorporatelibrary.com/ The website of the Corporate Library, which has
comprehensive information about various aspects of corporate governance including
shareholders and stakeholders; and executive remuneration. (Renamed the GMI blog.)
www.conference-board.org/ The Conference Board website gives details of its
corporate governance activities and publications including those relating to
executive remuneration (compensation).
www.bis.gov.uk The Department for Business, Innovation & Skills website offers a
range of information including ministerial speeches and regulatory guidance.
www.highpaycentre.org The website of the High Pay Centre which contains a
range of documents and reports relating to executive remuneration.
www.highpaycommission.co.uk/facts-and-figures/ The website of the High Pay Commission,
which contains a range of documents and reports relating to executive remuneration.
www.icgn.org The website of the International Corporate Governance Network contains
various reports it has issued in relation to directors’ remuneration.
www.ivis.co.uk The website of Institutional Voting Information Service, providers of
corporate governance voting research. The service has developed from the low key,
proactive, but non-confrontational approach to corporate governance adopted by the
ABI. Includes ABI Guidelines such as those on executive remuneration.
www.napf.co.uk The website of the National Association of Pension Funds has
guidelines on various corporate governance issues.
www.parliament.uk/treascom This website has the publications of the Treasury Committee.

For further links to useful sources of information visit the Online

Resource Centre www.oxfordtextbooks.co.uk/orc/mallin4e/

Part Three case study Royal Bank of Scotland Plc, UK

This case study draws together a number of the issues covered in this section of the book
relating to a dominant CEO, the lack of appropriate questioning of strategy by the board,
and perceived overly generous executive remuneration packages.
The Royal Bank of Scotland (RBS) Plc hit the headlines when it had to be bailed out by the UK
government in 2008 to the tune of £20 billion with the government becoming a 70 per cent
shareholder. The government has also underwritten £325 billion of RBS assets in an effort to
stabilize the bank. In common with various other well-known financial institutions in the UK, USA,
and elsewhere, RBS had been badly affected by the global financial crisis which, ironically, the
financial institutions themselves had helped to cause. Following the initial shock that such a well-
known name needed to be rescued by public funding, came the angry outcry at the remuneration
packages being paid out to top executives, even after the bank had been bailed out.
 DIRECTORS’ PERFORMANCE AND REMUNERATION 221

In 2007 Sir Fred Goodwin, CEO of RBS at that time, received a salary of £1.29 million and a bonus of £2.86
million, a total of £4.15 million. This package was more than the CEO of any of Lloyds TSB, HBOS, or
Barclays received. Under Sir Fred’s time as CEO, RBS followed two strategic decisions that ultimately
contributed to it incurring massive losses of £24 billion in 2008. The first was that goodwill on past acquisitions
had to be written down, and the second was losses arising from its expansion into investment banking and
toxic assets. The board has been criticized for not standing up to Sir Fred who has been accused of not only
going on a seven-year acquisition spree but also paying generous prices for the acquisitions. Sir Fred
subsequently left RBS after being given early retirement at the age of fifty but with a pension of over £700,000
per annum, which caused even more anger. Despite requests from the government asking him not to take this
huge amount, Sir Fred initially remained unmoved and legal enquiries indicated that the terms of the
arrangement meant that he could not be forced to pay it back. However, the annual pension has now been
reduced substantially although anger at Sir Fred remains high.
Needless to say, at RBS’s annual general meeting the remuneration report received an 80
per cent vote against it, clearly displaying the institutional shareholders’ disapproval.
RBS’ corporate governance was criticized as it was perceived as having a dominant CEO combined
with a board comprised of directors who had either been on the board for some years and hence might
be seen as being rather too ‘cosy’ with the CEO, or directors who had limited banking experience. Lord
Paul Myners has viewed bank boards generally as inadequate: ‘The typical bank board resembles a
retirement home for the great and the good: there are retired titans of industry, ousted politicians and
the occasional member of the voluntary sector. If such a selection, more likely to be found in Debrett’s
Peerage than the City pages, was ever good enough, it is not now’.
Following on from the disastrous financial performance in 2008, and the criticism across the board
from angry investors, an angry government, and an angry public, RBS reduced its board size from
sixteen to twelve, the latter including three new non-executive directors who had received UK
government approval. Sir Sandy Crombie, CEO of Standard Life, the insurer, became the bank’s
senior independent director in June 2009, which should greatly have strengthened the RBS board.
The FSA Report (2011) into the failure of the RBS highlighted a number of factors that contributed
to the bank’s downfall and also stated that ‘the multiple poor decisions that RBS made suggest,
moreover, that there are likely to have been underlying deficiencies in RBS management, governance
and culture which made it prone to make poor decisions’. Sentiment against Sir Fred Goodwin
continued to run high and in early 2012 Sir Fred Goodwin was stripped of his knighthood, awarded in
2004 for his services to banking, as he was the dominant decision-maker in RBS in 2008 when
decisions were made that contributed significantly to RBS’s problems and to the financial crisis.
During 2012 RBS was once again caught up in the executive pay furore, and the wave of
shareholder activism and public sentiment were directed at RBS’s CEO, Stephen Hester, who
decided to waive £2.8 million in salary and long-term incentives.
222 DIRECTORS AND BOARD STRUCTURE

FT Clippings

FT: Trinity Mirror investors

rebel over pay
By Salamander Davoudi, Media Correspondent

May 10, 2012

Investors underlined their dissatisfaction with the Steve Bennett, shareholder, said: “What is
pay culture at Trinity Mirror on Thursday as 45 going on? When you read the Mirror it talks
per cent voted against its 2012 executive pay about fat cats and bonuses. Why don’t you look
plan in the latest example of shareholders taking in your own back yard? I have no confidence in
action against perceived corporate excess. the board. All I can say is that you are fired.” His
comments were met with a round of applause.
Sly Bailey, the chief executive who resigned
last week, saw 14.5 per cent of votes cast
against her re-election for the time she remains Sir Ian defended her package: “We have not
and 17 per cent voted against Jane Lighting, the been rewarding our people irresponsibly. Our
chair of the remuneration committee. payment structure is not out of line,” adding
that Ms Bailey would not be getting a pay-off.
Investors in Trinity have repeatedly He said that the board had delivered on the
demanded a substantial cut in Ms Bailey’s pay strategy required.
in the light of the group’s share price
performance. Trinity’s market capitalisation has Chris Morley, shareholder and
dwindled from £1.1bn when she joined in 2003 member of the National Union of
to about £84m today. Trinity has paid no Journalists, said: “It has been a
dividend since 2008. strategy of despair rather than
success and achievement.” The company
Fewer than half of all shareholders voted for announced that in the 17 weeks to
the remuneration report as 15 per cent of votes April net debt was reduced by £24m to £197m.
were withheld. Twenty-two per cent voted The pension deficit fell by £54m to £176m.
against executives’ long-term incentive plan.
Trinity Mirror has forecast that in May,
With the exception of the outgoing chairman, revenues would fall 5 per cent year-on-year, with
Sir Ian Gibson, all other directors were re- advertising income down 10 per cent and
elected with a majority of 98 per cent or more. circulation revenue down 4 per cent.

Ms Bailey is expected to leave Trinity, the Sir Ian said: “This is a secure business, it is in
publisher of the Mirror and the People, at the tough times but it is not in crisis. Many of our
end of the year. She resigned amid investor competitors, if they were not privately owned,
anger over her £1.7m pay package. would be in crisis.” “It is false to say that the
business in 2003/4 or 1989 or even now is as
At the company’s annual meeting efficient as it ought to be. It can be more
shareholders were critical of how Trinity had efficient and should be more efficient even
been run and expressed anger over Ms now.” The shares rose 3.5p to 33.75p.
Bailey’s remuneration.

© 2012 The Financial Times Ltd.

 DIRECTORS’ PERFORMANCE AND REMUNERATION 223

FT: Shareholders lose patience

on bankers’ pay
By Dan McCrum in New York and Kate Burgess in London

April 20, 2012

Vikram Pandit, Citigroup’s chief executive, “What Citi tells us is that shareholders don’t
turned around this week to find that the crowd of have short memories, they aren’t looking at what
supporters he thought he had at his back had happened in the last 18 months, they are looking
melted away. Without an overt campaign or at what happened since 2007,” said Anne
agitation from a leading activist, shareholders Simpson, head of corporate governance for
simply refused to approve his $15m pay package. Calpers, the largest US public pension fund,
which voted against the pay arrangements at the
He was not the only one to be shocked when bank.
over half of the votes cast on pay at the bank’s
annual meeting were against or withheld. The The head of governance at one large,
vote made Citi the first big, financial company in global fund manager, said the Citi vote
the US to have suffered such a defeat. Patrick would resonate across the corporate
McGurn, general counsel at shareholder voting world, and was a sign of things to come.
agency ISS, says the rebellion came out of the “This is the second year that US
blue. “We hadn’t heard any drum beat about shareholders have had a say on pay
pay.” Many companies thought they had filed the and they have found their feet. They feel
rough edges off controversial pay schemes, he more confident in expressing their
says, and pay had fallen down the agenda. But views—not just about US banks.” In
days later, on the other side of the Atlantic, part it reflects a broader debate about
Barclays bowed to investor protest at a package pay. In the US attention has begun to
for chief executive Bob Diamond that included a focus on the rewards going to the richest
“tax equalisation” payout of £5.75m. segment of society after more than two
decades where incomes for the majority
have been static, after adjusting for
Boards looking at their own pay scales are inflation.
now faced with the question of whether such The focus on pay also reflects regulatory
shareholder unrest is an aberration, confined to changes introduced last year as part of financial
the banks, or if it signifies a more assertive reform legislation. All US-listed companies
stance from investors that is here to stay. must now hold an advisory “say on pay” vote
at their annual meeting.
Investors’ tempers have been fraying for
some time. Poor returns are testing their Congressman Barney Frank, an architect of
patience, while politicians are increasing the the reforms, says the Citi vote “will encourage
pressure on shareholders to exercise their shareholders throughout the financial sector to
powers and hold directors to account after the take their responsibilities seriously. And the
failings of the financial crisis. result should be a reduction in the excessive
levels of compensation to financial company
At Citi, investors have suffered 90 per cent executives.” But anger over remuneration goes
decline in their shares over the past decade. A beyond financial services, focusing concerns
cash bonus of $5.3m and $8m in deferred stock about strategy, management and performance
and cash for Mr Pandit rubbed salt into their and galvanising investors in a way that no
wounds. Mr Diamond’s take home pay last year other issue does, say voting and pay
rose 25 per cent to about £25m, all in, when consultants.
shares in Barclays fell by about 3 per cent.
224 DIRECTORS AND BOARD STRUCTURE

Many companies have consulted investors and Investors say that in the UK, for instance, no-
changed plans again and again in recent months votes will rise. And abstentions and withheld
to avoid public confrontation. Two companies votes will no longer be used as a way of subtly
that failed to receive shareholder support last reprimanding boards. “People now see
year, Jacobs Engineering Group and Beazer abstentions as a wasted action,” says Robert
Homes, took pains to recraft their pay packages Talbut of Royal London Asset Management and
and both received more than 95 per cent support chairman of the Association of British Insurer’s
this year. investment committee. Votes against the re-
election of individual directors, especially those
Such votes, even when just advisory, are also serving on remuneration committees, are also
widely credited with forcing boards of companies expected to rise.
to talk to their owners, and it has given investors
a way to shape the companies they own more
directly by setting management incentives. Investors were already expecting a set-to at
Michael McCauley, head of corporate Barclays’ meeting in London next Friday. The
governance for Florida’s public pension fund, board has for months tried to justify to
says that investors are thinking about pay in the investors the £5.75m “tax equalisation”
context of three to five years. “It’s not just about payment and explain why Mr Diamond’s bonus
share price performance, it’s about the change in was so high.
pay relative to performance.” Even so, some Now Mr Diamond has promised investors a
boards have remained impervious to calls to link higher share of profits and said he will forgo half
payouts clearly to performance, warn of his bonus until performance improves. Is it
shareholders. These companies will come under enough? Standard Life Investments, previously a
fire at annual meetings this year in a way they vocal opponent, now says it will vote for the
have not seen before. plan. But several are still threatening to vote no.

Turnouts are already rising, particularly in

Europe. In part this is because US shareholder In the US there have been only four votes
groups, which are diversifying overseas, are against pay packages so far this year, but the
obliged by US law to cast their votes. annual meeting season has only just got under
Meanwhile European institutions are on notice way. Roughly three-quarters of companies will
from politicians, regulators and their clients to face investor votes in the next two months.
make every vote count. Unresponsive executives will pay a hefty price.

© 2012 The Financial Times Ltd.