Corporate Governance – Principles, Policies and Practices 3e

1. Corporate Governance – Principles, Policies and Practices 3e Chapter 12 Board Membership - directors’ appointment, roles and remuneration

2. Board Membership - directors’ appointment, roles and remuneration • In which we review: - the appointment of directors -desirable attributes in a director -core competencies of a director -roles directors play -director s’ duties, rights and powers -directors' disclosures, service contracts and agreements -directors’ remuneration.

3. The appointment of directors Director appointments arise: • on the initial incorporation of a company • on re-appointment at the expiry of a director's term of office • to fill a vacancy • on the creation of an additional directorship.

4. The appointment of directors The rotation of directors • articles typically provide terms of service for directors • traditionally a fixed proportion retired and could be elected each year, often a third (a staggered board) • preserves experience • provides stability • produces a longer term strategic horizon • BUT staggered boards inhibit change • directors of poorly performing companies entrenched • wholesale change difficult • pressures of market for control circumvented • Calls for annual re-election of entire board.

5. The appointment of directors The size of boards • articles typically provide for upper and lower limits • some company law provides limits • Eg. prohibiting boards with a sole director • requiring directors to be real persons not other companies • case often made for additional directors • seldom argued that a board is too large • lack of cohesion • more difficult to reach consensus • formation of cliques or cabals • reduced opportunity for each director to contribute.

6. The appointment of directors Retirement, disqualification and removal • some company law provides age limit • Often 70 unless shareholders agree • Some company law provides lower limit • frequently 18 • Company law has provisions for director disqualification • bankruptcy • mental illness • disqualification by courts • offences against companies law • failure to file official returns • corrupt business behaviour.

7. The appointment of directors How are directors appointed? • in private companies: decisions taken by dominant shareholders • In public listed companies: • nomination committee of board makes recommendation • board agrees • proposal put to shareholders • shareholders vote • Criticism that boards become self-perpetuating • shareholders have little opportunity to make nominations • proposals to make shareholder nominations easier.

8. Desirable attributes in a director Behind the corporate constitutions, board structures and corporate governance codes are people People bring personal prejudices, political behaviours and power plays to board affairs What personal attributes are needed in a successful and professional director?

9. Desirable attributes in a director • Desirable attributes in a director • Integrity • Independence • Intellect • Character • Personality

10. Desirable attributes in a director • Integrity • Means being able to: • Distinguish right from wrong and judge corporate behaviour accordingly • Recognise and declare a conflict of interest • Act in the company interest, not self interest or personal gain • Essentially integrity means acting honestly. • A director with integrity is trusted. • The concept of the company is based on trust.

11. Desirable attributes in a director • Independence • For Independent Non-executive Directors (INEDs) - having no interest in the company that can affect or be seen to affect the exercise of independent, objective judgement • For Connected Non-executive directors (CNEDs) and Executive Directors (EDs) • being able to recognise the nature and extent of interests in the company • being able to exercise independent judgement, doing what is right for the company despite personal or other interests.

12. Desirable attributes in a director • Intellect • What is sometimes called having • ‘a good mind’. • Intellect combines: • an appropriate level of intelligence • the ability to think at different levels of abstraction • the imagination to see situations from different perspectives, not along a single track.

13. Desirable attributes in a director • Character (Some say ‘strength of character’) • Desirable character traits include being: • independently minded, objective and impartial • tough-minded, tenacious and resilient, with the courage to make a stand, yet capable of moving towards consensus • balanced in approaching risk, results orientated but neither risk-averse nor rash • wise or just having common sense.

14. Desirable attributes in a director Personality the ability to interact positively with others - flexibility - sensitivity - diplomacy - persuasiveness - and the ability to motivate Other desirable personality traits include being: - a sound listener - a good communicator - and being politically sensitive.

15. Desirable attributes in a director • A company – as a ‘legal entity’, has a legal persona, but it does not have a conscience. • The board has to act as the corporate conscience. • Obey the laws of all the jurisdictions in which it operates • Create a corporate character which establishes the way the company operates over and above merely staying within the law • Formal statement of the corporate mission and core values - can be little more than pious aspirations - can produce rigorous policies, approved and monitored by the board.

16. Desirable attributes in a director • Microsoft corporate mission and values • Our Mission • At Microsoft, we work to help people and businesses throughout the world realize their full potential. This is our mission. Everything we do reflects this mission and the values that make it possible. • Our Values • As a company, and as individuals, we value: • Integrity and honesty • Passion for customers, for our partners, and for technology • Openness and respectfulness • Taking on big challenges and seeing them through • Constructive self-criticism, self-improvement, and personal excellence • Accountability to customers, shareholders, partners, and employees for commitments, results, and quality.

17. Lord Nolan’s seven principles of public life • selflessness - holders of public office should serve the public interest, not seek gains for their friends 2. integrity – they should not place themselves under financial obligation to outsiders who might influence their duties 3 objectivity – they should award public appointments and contracts on merit 4. accountability –they should submit themselves to the appropriate scrutiny 5. openness – they should give reasons for their decisions 6. honesty – they should declare conflicts of interest 7. leadership – they should support these principles by personal example.

18. The core competencies a director needs • Every governing body is different • Each director brings a different set of experience, skills and knowledge to the board • Overall every board needs to have a mix of capabilities for a balanced and well qualified team • So directors need some basic core competencies -experience, skills, and knowledge - appropriate to the corporate entity. What might they be?

19. Core competencies for a director • Experience • Essential director-level experience supplements the knowledge available to the board • for example, additional experience about financial reporting standards, corporate governance, board procedures, strategy formulation, and policy making • or experience of overseas markets, frontier technologies, international finance or other areas that supplement the experience of the existing board.

20. Core competencies for a director Skills Essential director-level skills include: • strategic reasoning • perception and vision • a critical faculty capable of quantitative and qualitative analysis and financial interpretation • planning and decision-making capabilities • communication and inter-personal skills • networking and political abilities.

21. Core competencies for a director Knowledge Directors need appropriate knowledge of the enterprise, its business and board-level activities, as well as relevant information about the company’s political, economic, social, and technological context If directors are to make sense of board information and contribute meaningfully to board discussion, they must have basic knowledge about the company, its business and the financials.

22. Core competencies for a director Knowledge of the company involves a clear understanding of: • The basis of power over the company (who are shareholders, where does power lie to appoint directors) • The basis of law under which the body operates • The governance rules and regulations • The board structure, membership and personalities • The board processes, such as the use of board committees and the basis of board information • An awareness of the history of the entity is also vital in interpreting the current situation and understanding board culture and the perspectives of the chairman and other board members.

23. Core competencies for a director Knowledge of the business involves an understanding of: • The basic business activities and processes • Its purpose and aims • Its strengths and weaknesses • How it measures success • The field of its operations (including markets and competitors) • The strategies being pursued • The structure of the organisation, its culture, management, and people, • Management control and risk management systems.

24. Core competencies for a director Knowledge of the financials involves an understanding of: • How the company is financed • The essence of its annual accounts and directors’ reports • Developing trends in key financial ratios • Criteria used in investment appraisals • Calibre of financial controls • Who the auditors are • It is not necessary to be an accountant to be a good director but financial literacy is important.

25. Roles directors play Directors make different contributions to the board and play a number of roles Some of these roles contribute to performance - strategy formulation and policy making others contribute to conformance - executive supervision and accountability.

26. Roles directors play Performance related roles • Bringing wider business and board experience to the identification, discussion, and decision of board-level issues. Identifying issues that the board, not management, should be handling • Adding specialist knowledge, skills and know-how to board deliberations • Being the source of external information for board discussions - a window on the world for other directors • Being a figurehead or an ambassador for the company, being able to represent the company in the outside world • Connecting the board to networks of useful people • Providing status to the board and the company.

27. Roles directors play Conformance related roles • Providing independent and objective judgement • Providing a catalyst for change, questioning existing assumptions, introducing new ideas • Being a monitor of executive activities, offering objective criticism and comment on management performance • Playing the role of watchdog, able to provide an independent voice and protect the interests of minorities • Being a sounding board for the chairman, the chief executive or other directors • Acting as a safety valve able to act in a crisis.

28. The legal duties of a director Directors’ responsibilities derive from the nature of the joint stock limited liability company and are enshrined in statute law, case law and regulation Details vary by jurisdiction, but the essential duties are: • a duty of trust - to exercise a fiduciary responsibility to the shareholders • a duty of care - to exercise reasonable care, diligence and skill.

29. The legal duties of a director The duty of trust • Act honestly - for the benefit of members • Show independence of judgement • Avoid conflict of interest • Act fairly

30. The legal duties of a director Act honestly - for the benefit of members Exercise powers honestly in line with the company’s constitution Exercise powers in good faith, for the benefit of the members in the short and long term Recognise the need to foster business, to see the impact of operations on communities and environment, and maintain a reputation for good business conduct.

31. The legal duties of a director Show independence of judgement A director has a duty to exercise independence of judgement and not restrict his thinking or action.

32. The legal duties of a director Avoid conflict of interest A director must disclose a personal interest in any company transaction and abide by the board’s decision on that interest A director must not make a secret profit out of the company A director must not use any property, information or opportunity from the company for his own benefit unless allowed by the company’s constitution and disclosed.

33. The legal duties of a director Act fairly A director’s duty is to act fairly between all the members of the company A director must recognise the interests of minority shareholders

34. The legal duties of a director The duty of care Exercise care, skill and diligence A director must exercise the care, skill and diligence which would be exercised by a reasonably diligent person - with the knowledge, skill and experience expected of a director - and the knowledge, skill and experience which that director has.

35. The legal duties of a director Codification of Directors’ Duties UK Company Act 2006 • Duty to act within powers • Duty to promote the success of the company • Duty to exercise independent judgement • Duty to exercise reasonable care, skill, and diligence • Duty to avoid conflicts of interest • Duty not to accept benefits from third parties • Duty to declare interest in proposed transaction or arrangement

36. The legal duties of a director A related party transaction is one between a company and a party closely related to it, such as a director or a major shareholder • for example, the purchase by the company of a property from one of its directors Related party transactions provide good examples of the requirement to disclose personal interests The listing rules of most stock exchanges and securities regulators require related party transactions to be disclosed and, often, approved by the other shareholders.

37. The legal duties of a director Insider trading, that is trading in a listed company’s shares on the basis of privileged, share-price sensitive insider information is a breach of a director’s fiduciary duty It is also illegal in almost all countries Japan, Hong Kong and Germany were among the last countries to make insider trading a criminal offence The United States has the most severe penalties for insider dealing.

38. The legal duties of a director • Directors have to be careful not to trade in their company’s shares when they are in possession of inside or privileged information such as the company results just prior to publication and before the stock market has that information • The company secretary will often inform directors when the window of opportunity for trading in the company’s shares is open and, more importantly, when it is closed.

39. The legal duties of a director s.9(1) Securities (Insider Dealing) Ordinance Insider Dealing Tribunal (Hong Kong) Insider trading takes place: When a person concerned with a corporation who is in possession of information which he knows is relevant information in relation to that corporation deals in any listed securities of that corporation or their derivatives (or listed securities of related corporation) or counsels or procures another person to deal in such listed securities knowing or having reasonable cause to believe that such persons would deal in them.”

40. The legal duties of a director The US Sarbanes-Oxley Act 2002 (SOX) • To strengthen corporate governance and restore investor confidence following Enron, WorldCom and others • SOX imposed new accountability standards, with criminal penalties, on directors. • CEOs and CFOs must certify under oath that their financial statements neither contain an ‘untrue statement’ nor omit any ‘material fact’. • Audit committees must be comprised totally of independent outside directors.

41. The legal duties of a director The US Sarbanes-Oxley Act 2002 (SOX) • SOX also established new independence standards for external auditors • Areas of lucrative non-audit work by audit firms prohibited • A Public Company Accounting Oversight Board (PCAOB) created to oversee public accounting (auditing) firms and to issue accounting standards • Rules regulated by the SEC and apply to all companies quoted in the United States, including overseas companies listed there • Sarbanes Oxley Act differentiated the United States from many other countries by enshrining corporate governance practice in law rather than voluntary codes.

42. The legal duties of a director The US Sarbanes-Oxley Act 2002 (SOX) • SOX has proved expensive to operate, particularly section 404 • Some overseas companies have complained about the potential extra-territorial legislation • Others have withdrawn from listing in the United States.

43. The legal duties of a director S404 SOX Management must: • Accept responsibility for the effectiveness of the company’s internal control over financial reporting • Evaluate the effectiveness of the company’s internal control • Support its evaluation with sufficient evidence • Present a written assessment • If the auditor concludes that management has not fulfilled these responsibilities, the auditor should report to management and the audit committee and disclaim an opinion.

44. The legal duties of a director UK Companies Act 2006 • Clarified directors' duties for the first time in statute law • Made clear that directors have to act in the interests of shareholders • But added that in acting in the shareholders' interests, they must pay regard to the longer term interests of employees, suppliers, consumers, and the environment.

45. The legal duties of a director UK Companies Act 2006 • Encouraged narrative reporting by companies calling for them to be forward-looking, identifying risks as well as opportunities • Quoted companies have to provide information on environmental matters, employees and social and community issues • This business review must include information on any policies relating to these matters and their effectiveness, plus contractual and other relationships essential to the business.

46. The legal duties of a director UK Companies Act 2006 • Promotes shareholder involvement in governance by enhancing the powers of proxies • Makes it easier for outside investors to be informed and exercise governance rights in the company • Allows shareholders to limit the auditors' liability to the company to what is fair and reasonable • Requires institutional investors to disclose how they used their votes • Introduces a new offence for recklessly or knowingly including misleading, false or deceptive matters in an audit report.

47. Directors’ remuneration The remuneration committee • Sub committee of main board • Recommends remuneration packages of directors (and sometimes other senior management) • Greenbury report (UK 1995) • most CG codes require remuneration committee Need to balance incentive to attract and retain top management in a competitive market for talent, rewarding success, whilst avoiding excesses and apparently rewarding failure.

48. Directors’ remuneration Determining directors’ remuneration • no one should determine their own reward • top management pay escalation • 1979 top earned 20 times lowest paid employees • today many hundred times more • John Lewis partnership (retail chain) highest pay is ratio of lowest paid • (FSA) in the UK required financial institutions to apply ‘remuneration policies, practices and procedures that are consistent with and promote effective risk management • use of remuneration consultants • share options

49. Directors’ remuneration Reporting and voting on director remuneration • SEC rules since 2007 require full disclosure of pay packages of top management • US Corporate and Financial Institution Compensation Fairness Act (20090 • response to perceived excessive rewards in financial institutions • did not impose pay limits • passed responsibility to shareholders • UK legislation (2003) required quoted companies to • publish a directors’ remuneration report • put itto shareholder vote at the AGM • But advisory only • 2012 suggestion by government that vote becomes binding.

50. Board Membership - directors’ appointment, roles and remuneration • we have reviewed: - the appointment of directors -desirable attributes in a director -core competencies of a director -roles directors play -director s’ duties, rights and powers -directors' disclosures, service contracts and agreements -directors’ remuneration.