What are non-executive directors for?

In the wake of this year’s various corporate blow-ups, scandals and nasty surprises, shareholders could be forgiven for wondering if non-executives are doing their job. Stephen Connolly asks if that’s fair.

Patisserie Valerie chairman Luke Johnson had to lend the company £20m to stay afloat

The UK's corporate governance structure intended to safeguard investors has been called into question again after caf chain Patisserie Valerie dropped the bombshell that shareholders' money was missing, its accounts were misleading and that far from being cash-rich, profitable and growing, it was in fact £10m in debt and facing insolvency. The company has cited "significant and potentially fraudulent" accounting irregularities, the finance director has been arrested and bailed (and has since resigned), and the Serious Fraud Office is investigating.

Executive chairman Luke Johnson, who owns 37% of the company, has lent it £20m, and £15m of new shares have been sold to investors to raise capital at the heavily discounted price of 50p (compared with 429.5p before the news broke). While the immediate funding crisis appears to have been averted giving some hope to staff, landlords and suppliers investors have been let down and are nursing heavy losses. They can be forgiven for wondering why the company's auditors seem to have failed them, and what the directors have been doing with themselves.

In asking these questions, shareholders in Patisserie Valerie aren't alone. This year we've seen several headlines about corporate collapse, boardroom bust-ups and runaway pay, with investors generally left counting both the immediate and longer-term cost, financial as well as reputational. Investment is all about accepting risk, of course. Even business strategies that are well-executed in good faith can, and do, turn sour as markets decline, tastes change or innovation opens the door to rivals. But this is a long way from losing out because a firm took its eye off the ball, misled shareholders or left itself open to fraud.

Who's looking out for shareholders?

This is where the corporate governance framework is meant to step in. This broad system of oversight mainly boils down to two primary safeguards ensuring that boards are supervised and accountable; and that the accounts and financial statements are reliable. Much of the responsibility for this rests on the auditors, who report directly to shareholders to say the accounts are a true and fair representation (or not) of a business; and on the non-executive directors (see below) who are paid to supervise the executive directors and look after the interests of the owners the shareholders.

Both of these groups are under pressure right now. The multi-billion pound collapse of government contractor Carillion earlier this year led the Competition and Markets Authority to announce a probe into whether the "Big Four" accountants have created an environment of very little competition, driving down audit quality. One key question to address is the concern that auditors avoid challenging firms for fear of losing fees.

Meanwhile the non-executives who are meant to keep an eye on the executives in Britain's boardrooms are under scrutiny, too. The number of sizeable shareholder revolts against individual non-executives, and FTSE 100 pay deals, has doubled, and the corporate governance code has been rewritten, partly in response to perceived flaws in the non-executive role. There's also a slow-growing recognition that the system of supervision is struggling to keep up as businesses become more complicated and the demands on non-executives who can only devote so much time to a business expand. This matters. Whether it's challenging executive directors on strategy, ensuring the books are reliable, or advising on fair pay, non-executives are there to protect shareholders. If they don't get it right, it's investors who pay the price.

The evolution of the non-executive director role

This is hardly the first time the issue has come up. The supervisory nature of the non-executive role began evolving in the early 1990s, after a high-profile inquiry into boardroom accountability by Adrian Cadbury. Since then the size, geographic reach and all-round complexity of the average business has increased exponentially, with accounting, legal and regulatory responsibilities growing. Yet it's questionable whether corporate governance in general, and the non-executive role specifically, has kept pace. If you consider that Cadbury's inquiry was triggered by low trust in financial reporting, weak auditing and unjustified boardroom pay, it's reasonable to ask: "what's changed?" Here we are a quarter of a century later, stuck on the same page.

Given all this, investors could be forgiven for wondering if non-executives offer much, if any, value for money. So I asked some at companies as diverse as grocery chain Tesco, housebuilder Barratt and water utility Severn Trent for their views on whether non-executives really are effective stewards of shareholders' interests. Perhaps unsurprisingly they were emphatically positive, and to be fair, they did come across as earnest when talking of being accountable to shareholders and of sharing aligned interests. It's also reasonable to note that while we face some stubborn corporate governance issues, boards these days do seem to operate much more transparently and are more comprehensive in their financial reporting, with non-executives increasingly challenging, exercising greater oversight, and bringing independence to board discussions and decisions.

Yet it remains the case that investors are still losing out to poor boards and when they do so, the cost can be high. There's a long list of examples that can be drawn from this year alone. There's cheap booze distributor Conviviality, whose executives embarked, seemingly unfettered, on a fast and furious expansion that drove it straight into a ditch. Or global advertising group WPP after its founding chief executive Martin Sorrell quit, the company didn't finesse the fall-out with shareholders especially well. Then there's the board of consumer products giant Unilever, who tried to ride rough-shod over shareholder interests with a plan to relocate from London to Rotterdam, only to cancel at the last minute after investors stepped in and did the non-executives' job for them, delivering a humiliatingly public reminder that directors answer to them, and not the other way round.

Investors, politicians and commentators have all been up in arms after housebuilder Persimmon, which has gained from the taxpayer-funded Help to Buy housing scheme, saw fit to approve huge uncapped bonuses. Meanwhile, roughly a third of voters rejected directors' total pay at companies including publisher Informa and the aforementioned Unilever. More than 20% have objected to individual directors at companies including AstraZeneca, Costain and British American Tobacco.

Why non-executive directors slip up

The corporate governance code, which sets out best practice for boards of directors, seems straightforward. And those non-executives who are competent, dutiful and experienced, are very capable of working constructively with businesses. So what keeps tripping boards up? First, lack of time is a problem. Commitment varies between industries, but a non-executive and chair of the audit committee of a FTSE 100 company told me that even working on just one quoted company, there isn't a week without some work and it can be every day the required input has grown hugely over the past ten to 15 years. Yet the corporate governance code doesn't set limits on the number of non-executive directorships one can hold.

Secondly, and relatedly, boards of serious companies should be meeting monthly, but many don't. Supervision is key, and boards need to ask themselves continuously if they're giving enough time to achieve it meaningfully. More meetings make a huge difference as to how closely non-executives are involved, and what they learn and know. Monthly meetings make it easier to hold executives to account. Infrequent meetings can result in non-executives slipping into the more superficial role of appraising executive directors, but that's not their job they're there to challenge and, if necessary, take charge. Board meetings are not for cheerleading the chief executive, and while there shouldn't be constant conflict, discussion should be robust. Regular involvement can only strengthen this.

Third, independence is essential. Non-executives should owe nothing to a chief executive, and must be free to give their views. Without independent input, a board's purpose is diminished. The independent non-executive chairman is essential to attracting independent directors to the board a nominations committee, which many smaller companies do not currently have, is important. Candidates should be sought via headhunters and external recommendation only. Changes are on the way to reinforce this. There's sometimes a suspicion that confident executives can game the system to recruit "comrades" who are more likely to be supportive, and to manipulate boards to isolate "problem" non-executives. With genuinely independent directors, healthy debate should grow at the expense of "groupthink". A good independent director will have the confidence to sit on a board of eight or ten people and dissent, or be prepared to resign if necessary.

It's not always easy to ask the right questions

Finally, the corporate system and infrastructure is not designed to allow a non-executive to do their job properly. A non-executive with concerns about a firm's finances would never make for the finance department and ask for all the last quarter's debtors (for example) to be pulled out for review. Instead, they rely on "board packs" of information to analyse and base their decisions on, which highlights another crucial problem information management and control are potentially powerful tools for executive directors. If the information is considered lacking, then changes to what's provided can certainly be requested and it's up to the chairman to ensure the board is getting all it needs. But this relies on the non-executives knowing what to ask for, and it seems unlikely this will ever be 100% comprehensive.

Improvements in any of these areas (and more), as well as regular high-level reviews into corporate governance, can undoubtedly bring incremental benefits, and non-executives as a group do provide protections. However, their effectiveness as individuals varies from one company to the next and the unfortunate reality is that it's not easy from the outside to sort the wheat from the chaff. The most you can hope for is good people doing their best. And, to avoid a hit like a Patisserie Valerie or Carillion, a big stroke of luck, too.

What is a non-exec director?

Non-executive directors (non-execs or NEDs) are an integral part of the corporate governance system which oversees the running of businesses at board level. Non-execs are full, legal directors who attend and vote at board meetings, but aren't involved in the day-to-day management of a business.

They are appointed for their independence, which means they are well-placed to ensure boards take their responsibilities seriously, act with integrity and safeguard the interests of shareholders and other stakeholders. In the broadest sense they supervise and hold to account the executive directors (such as the chief executive and finance director), and offer advice. In particular they're involved in corporate strategy and policy debates, overseeing checks and audits of the books to ensure financial reliability, setting executive pay and incentives, business risk management, appointing and removing directors, and shareholder relations.

Today's non-exec role owes its existence to several investigations over the past 25 years prompted by concerns over boardroom accountability and weak financial reporting, starting with the Cadbury inquiry in 1992. The scope of the role is formally set out in the UK Corporate Governance Code produced by the Financial Reporting Council, the body that regulates auditors and accountants in the UK. Non-execs are paid a flat fee (anything from £40,000 to £100,000 a year) and don't participate in any incentive plans, in order to maintain their independence. The best bring experience and wisdom from often long and successful careers to the deliberations and actions of a company's board, while acting as a check and balance. As such, they're viewed by many shareholders as the primary stewards of their interests.


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