Board Formation: The UK Experience

1. OECD Russia Corporate Governance Roundtable Moscow, 25–26 October 2012 Board Formation: The UK Experience Dr. Roger Barker Head of Corporate Governance at the Institute of Directors (UK) and Senior Advisor to the Board of the European Confederation of Directors Associations (ecoDa) roger.barker@iod.com Co-sponsored by Informational partner

2. Agenda The UK boardroom context – key features of UK corporate governance The board formation process in the UK Recent developments in board formation – proposed changes to UK listing rules for companies with controlling shareholders Key lessons from the UK experience

3. UK Boardroom Context (1) – Ownership Structure Large quoted companies in the UK are widely held, i.e. there is dispersed rather than concentrated ownership Institutional investors are the main category of shareholder, although there is more than 40% foreign ownership. Around 8% of UK equities are now held by Sovereign Wealth Funds Some examples (as of H1 2012): • Royal Dutch Shell (Blackrock: 6.6%; Legal & General: 4.2%). Market Cap - $228 bn • GlaxoSmithKline (Blackrock: 5.6%; Legal & General: 3.7%). Market cap - $98.6 bn • Vodafone (Blackrock: 6.0%; Legal & General: 3.6%). Market cap - $145.9 bn • BP (Blackrock: 5.9%; Legal & General: 4.2%). Market cap - $ 136.8 bn. • HSBC (Blackrock: 6.6%; Legal & General: 4.0%). Market cap - $181.9 bn. All other shareholders own less than 3%

4. UK Boardroom Context (2) – Directors’ Duties Company law defines fiduciary duties for directors. Directors are required to promote the success of the company for the benefit of all its shareholders (section 172, Companies Act 2006) However, there should not be a narrow focus on shareholders. Directors should take into account a range of other factors when pursuing the interests of shareholders, including: • the likely consequences of any decision in the long term • the interests of the company's employees • the need to foster the company's business relationships with suppliers, customers and others • the impact of the company's operations on the community and the environment • the desirability of the company maintaining a reputation for high standards of business conduct • the need to act fairly as between members (i.e. shareholders) of the company The ‘enlightened shareholder value’ concept

5. UK Boardroom Context (3) – Board Structure UK companies have a unitary board structure, containing a mixture of executive and non-executive directors There is a strong trend toward boards where the majority of directors are independent non-executive directors. In the FTSE 350, 80% of companies have boards where more than half the board is independent (excluding the chairman) There is also a strong bias in favour of an independent chairman and a split of the chairman/CEO roles. Only 11 companies in the FTSE 350 continue to combine the chairman and CEO roles Employees are not typically represented on UK boards

6. UK Boardroom Context (4) – Regulatory Approach Company law and listing rules define baseline requirements for corporate governance However, most corporate governance requirements are prescribed in the UK Corporate Governance Code – applied on the basis of ‘comply or explain’ by Premium Listed companies. Key Provisions include: • The roles of chairman and chief executive should not be exercised by the same individual. (A.2.1) • The chairman should on appointment meet the independence criteria set out in the Code. A chief executive should not go on to be chairman of the same company. (A.3.1) • Except for smaller companies (outside the FTSE 350), at least half the board, excluding the chairman, should comprise non-executive directors determined by the board to be independent. (B.1.2) • Evaluation of the board of FTSE 350 companies should be externally facilitated at least every three years. (B.6.2) • All directors of FTSE 350 companies should be subject to annual election by shareholders. (B.7.1) Around 50% of companies in the FTSE 350 fully comply with all the Provisions of the Code (up from 28% in 2005). Most of the remainder are non-compliant with only one or two Provisions of the Code

7. Anatomy of the UK Boardroom in 2012 The average FTSE 350 board has 3 executive directors, 5.3 non-executive directors and a non-executive chairman. (As recently as 2006, executive directors were still in the majority) Average number of board meetings per year: 8.7 Average age of a FTSE 350 director: 57.5 15% of FTSE 100 directors are female. This falls to 10% in the FTSE 350 as a whole. There are only 2 female chairmen 25% of FTSE 350 companies had an external board evaluation in 2011 70% of FTSE 350 companies annually elect their directors Average fee for a non-executive: £79,500 in the FTSE 100; £48,500 in the Mid 250 Source: Grant Thornton Corporate Governance Review 2011

8. Appointment of Directors – The Legal Process Company law defines a key role for shareholders – appointment or dismissal of any director is possible by an ordinary resolution (50%+1) of shareholders However, the Model Articles of Association for Public Companies (section 20) states: Any person who is willing to act as a director, and is permitted by law to do so, may be appointed to be a director— (a) by ordinary resolution, or (b) by a decision of the directors. In practice, almost all board members are initially appointed by a decision of the directors, i.e. by method (b). Only afterwards is the decision ratified by shareholders Section 21 of the Model Articles states: (1) At the first annual general meeting all the directors must retire from office. (2) At every subsequent annual general meeting any directors— • (a) who have been appointed by the directors since the last annual general meeting, or • (b) who were not appointed or reappointed at one of the preceding two annual general meetings, must retire from office and may offer themselves for reappointment by the members (i.e. shareholders).

9. The Role of the Nomination Committee The UK Corporate Governance Code states that there should be a “formal, rigorous and transparent procedure for the appointment of new directors to the board” It also recommends that there should be a nomination committee which should lead the process for board appointments and make recommendations to the board According to the Code: • The search for board candidates should be conducted, and appointments made, on merit, against objective criteria and with due regard for the benefits of diversity on the board, including gender • A majority of members of the nomination committee should be independent non-executive directors • The chairman or an independent non-executive director should chair the nomination committee - 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 balance of skills, experience, independence and knowledge on the board. In the light of this evaluation, it should prepare a description of the role and capabilities required for a particular appointment. The terms and conditions of non-executive director appointments should be available to shareholders • A separate section of the annual report should describe the work of the nomination committee, including the process it has used in relation to board appointments. Its terms of reference should be publicly available • An explanation should be given if neither an external search consultancy nor open advertising has been used in the appointment of a chairman or a non-executive director

10. Effectiveness of Nomination Committees in Practice Places the director appointment decisions in the hands of an ‘independent’ committee comprised mainly or wholly of independent non-executive directors Purpose – to avoid domination of director selection by CEO (the main concern in the UK) or a dominant shareholder (a common concern in many other countries) Seeks to prevent the board becoming a self-perpetuating ‘club’ or just a representative body for powerful interests (management, controlling shareholders, etc) But the experience of the UK shows that supposed independence can be illusory: • If so-called ‘independent’ non-executive directors are themselves part of the ‘club’ – in the UK, independent directors are still drawn from a relatively narrow pool of candidates (male, former CEO/CFOs) • Often a perceived need to support the CEO and the executive team – otherwise may be seen as ‘disruptive’ or not a team player • May perceive an allegiance to those who nominated them As a result, UK boards may lack diversity, be insufficiently challenging of management, susceptible to ‘groupthink’, inclined to consensus rather than rigorous debate, insufficiently sensitive to wider stakeholder concerns

11. Recent Developments – Dealing with Controlling Shareholders New proposed changes to UK listing rules – published in October 2012. Public consultation will conclude in January 2013 Re-introduces the concepts of the ‘controlling shareholder’ and ‘independent shareholders’ into the Listing Rules – response to increasing number of foreign companies with controlling shareholders listing in London Relationship Agreements must be created between the company and the controlling shareholder – must be published in the annual report or otherwise publicly accessible Companies with a controlling shareholder must have boards with a majority of independent directors. A binding requirement – no longer to be applied on the basis of ‘comply or explain’ Independent directors must be elected by a dual vote of both a) all shareholders and b) independent shareholders. If the result of the two votes conflicts, a further vote takes place on a simple majority basis after not less than 90 days – aims to give independent shareholders time to engage with the controlling shareholder and reach a compromise

12. Board Formation – Lessons from the UK Experience “The objective should be to facilitate the creation of competent boards that are capable of objective and independent judgement.” (OECD 2009: 9). But ‘independence’ and ‘objectivity’ in the board formation process are not easy to achieve A nomination committee that fulfils formal independence criteria avoids some obvious conflicts of interest – such criteria are worthwhile But formal processes will not guarantee a genuinely independent and objective board appointments process – it could just be box ticking In addition to formal rules, policy makers should focus on: • encouraging a high level of transparency with respect to the board appointments process • director education and the development of a cadre of highly credible independent directors • dissemination of best practices, including wider use of board evaluation processes

13. OECD Russia Corporate Governance Roundtable Moscow, 25–26 October 2012 Disclaimer: The views expressed in this presentation are those of the author and do not necessarily represent the opinion of the OECD Russia Corporate Governance Roundtable, the OECD or its Member countries, or of the Moscow Exchange. Co-sponsored by Informational partner