RREV report on board composition, shareholder engagement and the new Combined Code

Last month Research Recommendations Electronic Voting (RREV) published a Report on Board Composition, Shareholder Engagement and the New Combined Code, which describes the extent to which FTSE 100 and 350 companies are in compliance with the new Combined Code (new Code) and sets out RREV's approach to many of the controversial issues in the new Code.

RREV is a joint venture set up in January 2004 between the NAPF and Institutional Shareholder Services (ISS) which provides voting recommendations, based on the NAPF's governance policy, on resolutions proposed by FTSE All-Share and AIM companies. The report effectively supplements the NAPF's 2004 Corporate Governance Policy, which will be revised early next year.

In particular, the report contains RREV's views on three of the most significant and controversial changes to corporate governance introduced by the new Code:

1. The board chairman, once appointed, is no longer considered independent.
2. More stringent criteria for the classification of independence – especially the 'rule' that an NED who has served on the board for more than nine years is no longer independent – and the more limited boardroom roles that can be played by NEDs who are not independent.
3. An increase in the proportion of the board that should comprise independent NEDs.

RREV states that it has treated the 2004 reporting season as one of transition. However, it will expect companies to report fully within the framework of the new Code in 2005.

Independence of NEDs

The criteria in the new Code for assessing NEDs' independence are approached by RREV as follows:

Material business relationship: a business relationship is likely to be material if, in any one of the last three years, the transaction value has been, or was equivalent to, either one percent of the company's turnover, or one percent of the turnover of the company or organisation with which the director is associated.

Remuneration: NEDs should not receive performance-related pay. Where a company provides performance-related incentives, such as share options, the NED will not normally be considered independent.

Representative of a significant shareholder: a company's explanation that a NED does not represent a significant shareholder and remains independent will normally be accepted if the shareholder concerned "is an institutional investor acting on behalf of third party clients, and a long-term investor by nature."

Nine year rule: despite criticism of the rule by various companies, RREV supports it and generally will characterise NEDs who have served longer than nine years as no longer being independent. If the company can provide compelling reasons, RREV may be prepared to support the re-election of a director as a (non-independent) NED, but only on a temporary basis. The director will be subject to annual re-election, RREV will re-assess his independence the following year and, during the intervening period, RREV will expect the board to remedy the circumstances that necessitated his re-election as an NED - such as by carrying through succession planning on the departure of the Chairman or other NEDs.

Multiple directorships

Extending the provision in the new Code that full-time executive directors should not take on more than one non-executive directorship in a FTSE 100 company, NAPF policy applies this rule to "all significant commitments to major organisations". Where a director does have multiple commitments, a timetable should be agreed with the board for their reduction. The board should communicate to shareholders its policy on multiple commitments for all directors.

Disclosure of board evaluation processes

The new Code requires boards to carry out a formal and rigorous annual evaluation of the performance of the board as a whole, its committees and individual directors, and to disclose details in the annual report. Cable & Wireless, Tomkins and Marks and Spencer are cited as examples of companies that provided detailed descriptions of their practice in this area.

For example, Cable & Wireless' 2004 annual report contains the following statement:

"Under the direction and control of the Chairman, the Board considers its performance both as a group and as individual members. This involves regular discussions between the individual Board members. The Board will also consider the need for external support in conducting an annual evaluation of its performance. As part of the evaluation process, the independent Non-executive Directors meet privately without the Chairman, and as a group with the Chairman as necessary, at least once a year, and similarly both with the Chairman and the Chief Executive Officer, to consider management performance and succession issues. The independent Non-executive Directors also review annually the relationship between the Chairman and Chief Executive Officer to ensure that the relationship is working to promote the creation of shareholder value."

Second chairmanships

The new Code states that no individual should be appointed to a second chairmanship of a FTSE 100 company. NAPF policy goes further in interpreting this rule as applying to "all large complex companies - i.e. companies that are organisationally complex, operate in a number of commercial and geographic markets, operate in rapidly changing markets, and are subject to particular competitive or regulatory pressures or constraints."

Chairman's remuneration

RREV is generally averse to companies providing chairmen with any performance-related remuneration, although it will "carefully review developments in this area going forward".

Senior Independent Director (SID)

All companies, regardless of size, should appoint a senior independent director to act as an important contact for shareholders when contact through the normal channels of chairman, CEO or finance director has failed to resolve issues or where such contact is inappropriate. This is especially important when the roles of chairman and CEO are combined.

Importance of independent NEDs where company has a major or majority shareholder

In these circumstances "there is an ever-present possibility that the majority holder will make a bid for the company and de-list. The dominant shareholder may be in a position to pay a lower price, as the position of the minority shareholders is relatively weak. The independent NEDs are required to consider such offers to obtain the best outcome for the minority shareholders, which is stark reinforcement of the NAPF's view that independent NEDs are a bastion of security for shareholders in all companies."

For example, when the Executive Chairman of DFS Furniture Group plc (who founded the Company and remained a significant shareholder) made an offer to take the company private earlier this year, RREV refused to recommend a vote in favour of the proposal on the grounds that the NEDs who sat on the committee which negotiated the offer were not fully independent under the new Code, and therefore could not be seen to be acting in the best interest of shareholders.

Similarly, RREV will scrutinise the independence of NEDs where a company proposes a buy-back of its own shares which, if implemented, could take the holding of a major shareholder over 30%, and the shareholder seeks a waiver of the obligation under Rule 9 of the Takeover Code to make an offer for all the remaining shares in the company.

Board composition

The report also includes details of the percentages of FTSE 100 and 350 companies which were in compliance with the old Code, and are in compliance with various provisions of the new Code, particularly those dealing with the membership of the Audit, Remuneration and Nomination Committees, and the role of the Chairman and SID.

RREV implementation of NAPF policy in 2005

The report states that RREV may "divert a vote to oppose a corporate governance issue if, for example, it is not possible to vote directly against the re-election of the director considered directly responsible for the unacceptable situation. This will be achieved by escalating the opposition to another director who has a responsibility for that aspect of corporate governance at a higher level within the accountability pyramid, e.g. the chairman of a committee, the senior independent director or the chairman of the board."

For example, "if, at the time of the 2005 AGM, the chairman of the nomination committee is neither the chairman of the board nor one of the NEDs, this may lead RREV to recommend a vote against the chairman of the nomination committee, or, depending on circumstances, the chairman of the board or the senior independent director."

On a similar note, at the 2004 AGM of Beazley Group, RREV recommended a vote against the approval of the company's report and accounts on the grounds that one of the members of the Group audit committee was an NED of a subsidiary (and a former member of the main board) who, in RREV's view, could not therefore be held directly accountable to shareholders.

Relations between companies and RREV

RREV emphasises that its research team "engages with companies to supply considered vote recommendations on all resolutions", and that it "actively engages with a company in order to fully understand the thinking of a board when it diverges from guidelines or offers an explanation in lieu of compliance".

The various 'case study' examples contained in the report illustrate that disagreements between companies and RREV over non-compliance with the new Code can often be resolved through:

• Discussion in advance of the annual report being printed and published. For this purpose, RREV requests that companies ensure that the Company Secretary (or, if he is unavailable, the Chairman or SID) is available to deal with questions from RREV in the period leading up to publication.
• The provision by companies of detailed and well-reasoned explanations for non-compliance.
• Undertakings being given by companies to take steps over the next year or so to remedy any non-compliance. Often RREV will support a proposal if such undertakings are given.
• Commitment by RREV to review the situation in a year's time or at the next AGM.

The report is available from RREV on request.