Last month, Board Intelligence hosted some round table meetings for directors to discuss issues raised by the Financial Reporting Council’s draft revised UK Corporate Governance Code. One recurring theme in those meetings was a concern about the FRC’s proposal to classify the chair as independent. Judging by the consultation responses published on the FRC’s website, this concern is widely shared by companies.
Many are concerned that, as a consequence, the so-called ‘nine-year rule’ will be extended to chairmen as well as non-executive directors. I don’t want to get into that issue here. You either think indicative time limits are a good idea or you don’t, and your view on that may be influenced by whether you believe ‘comply or explain’ works as intended. I would simply note that, according to the Investment Association’s ‘naughty step’ register, only five directors across the entire FTSE failed to be re-elected last year. This suggests that claims of mass culls of chairs because of this change may perhaps be overstated.
Defining ‘independence’
Having sat in on a lot of conversations on this topic, I think part of the problem is that the term ‘independence’ is being used to refer to different concepts at different times, and that people are talking at cross-purposes as a result.
For me, there are broadly three connotations to the term ‘independence’ which — handily for the purposes of a punchy article — can be summed up in three alliterative words: conflicts, closeness and character.
1. Conflicts
If you look at how the FRC defines independence, or rather the absence of independence, in the Code then — the ‘nine-year rule’ apart — it is really all about conflicts of interest: being a recent employee of the company, having a material business relationship with it, being the CEO’s auntie, that sort of thing. If this section of the Code was reworded to say “the chair should not be conflicted”, then I doubt anyone would find anything to object to.
2. Closeness
Which brings us to closeness — the need for the chair to have a close but not collusive relationship with the CEO, and to roll up their sleeves and get stuck in if needed. Some respondents seem to believe that, by proposing to classify the chair as independent, the FRC is saying that this level of involvement is not appropriate.
I don’t think that is what the FRC is actually saying. If it were, it would be going against the prevailing public and political mood, as well as established practice. The chair of Carillion wasn’t hauled in front of Parliament to be told off for being too hands on — quite the opposite.
In many ways, I think closeness is one of the defining characteristics of the chair’s role. As Sir Derek Higgs put it when developing an earlier version of the Code, “the particular nature of the chairman’s role will inevitably be shaped by the challenges facing the company, its scale and complexity and the nature of its business. The role differs significantly from that of other non-executive directors and executive directors”.
But while closeness is good, coziness is not, and it can be difficult for chairs to stay on the right side of the line. It is even more difficult to judge from outside the organisation if that line has been crossed.
Reducing potential conflicts of interest, as the Code and the Companies Act 2006 attempt to do, and putting in place checks and balances — such as a senior non-executive director — can provide some assurance. But ultimately it comes down to character. Can the chair be relied on to exercise independent judgement?
3. Character
Character is the key to it all: the single most important factor in the success or failure of any governance system. Without it, no processes and procedures are fool-proof. Unfortunately, it is also something that is impossible to codify in any meaningful way. “You know it when you see it” may work as a rule of thumb, but it is not the sort of thing you could write a rule around.
The debate about whether the chair is considered independent for the purposes of the Code is not a complete red herring, and perhaps some drafting changes to attempt to distinguish between the different interpretations of ‘independence’ might be helpful.
But ultimately what is needed to ensure that chairs are exercising independent judgement while maintaining the closeness their role and circumstances require is diligence — on the part of the board, the shareholders and other stakeholders, but most of all on the part of the chair themselves.
We host a number of roundtable dinners throughout the year for chairs, CEOs and Company Secretaries. If you would like to challenge the board status quo, and stimulate fresh thinking around good governance, get in touch and request a seat.