What does it mean to be an independent director?

A key principle of good corporate governance is that there should be a sufficient number of independent NEDs on the board to create a suitable balance of power and prevent the dominance of the board by one individual or a small number of individuals.

 

Non-executive directors (NEDs) are members of the board of directors without executive responsibilities in the company who are appointed from outside the organisation for their independence, expertise and contacts to bring judgement and experience to the deliberations of the board that the executive directors on their own would lack.

 

Independent thinking is an essential requirement, but to be formally independent requires meeting certain criteria.

No director qualifies as 'independent' unless the board of directors affirmatively determines that the director has 'no material relationship' with the listed company, either directly or as a partner, shareholder or officer of an organization that has a relationship with the company

 

A common problem in many organisational situations is ensuring independence where it could represent an ethical threat if absent. In real-life situations, friendships and networks build up over many years in which relationships exist at a number of different levels of intensity.

 

Further, the longer a director serves on a board and becomes involved with a company, the more difficult it becomes to maintain a sufficient level of independence.

 

The independence of a non-executive director could be challenged, for example, if the individual concerned:

  • has a family connection with the CEO – a problem in some family-controlled public companies;
  • until recently used to be an executive director in the company;
  • until recently used to work for the company in a professional capacity (e.g. as its auditor or corporate lawyer);
  • has been a member of the board for more than nine years

In addition, a person cannot be independent if he or she personally stands to gain or otherwise benefit substantially from:

  • income from the company, in addition to his or her fee as a NED;
  • the company's reported profitability and movements in the company's share price.

These criteria of independence should be applied to a chairman as well as other non-executive directors.

 

FRC consultation on the UK Corporate Governance Code

The Financial Reporting Council is currently (2018) undertaking a consultation on the UK Corporate Governance Code, including a review of when non-executive directors should not be considered independent.

 

A significant change to the revised Code is that there will no longer be a reference to the board deciding that a non-executive director is independent notwithstanding the existence of one of the listed relationships or circumstances existing (eg having served on the board for more than nine years). Updated Provision 15 instead provides that non-executive directors should not be considered independent for the purposes of board and committee composition if any of the listed relationships or circumstances exist.

 

For existing listed companies that have one or more non-executive directors that they list as independent notwithstanding one of the relationships or circumstances being in place, although they are free to continue to do this and explain their non-compliance with the Code, they will need to bear in mind this greater focus on independence (along with the elevating of the importance of succession planning) and whether their shareholders may perhaps in the future be less accommodating of non-compliance here.

 

Independence of the chairman

The current Code takes the position that the chairman needs to be independent on appointment and thereafter the test of independence is not appropriate (A.3.1 and footnote 5). Following on from that assumption, in terms of composition of the board, the current Provision is that (other than for smaller companies) at least half the board, excluding the chairman, should comprise independent non-executive directors (B.1.2).

 

In the revised Code the chairman is to be included in proposed Provision 15 and will not be regarded as independent should one of those relationships or circumstances exist or come to exist (eg serving for more than nine years). The footnote mentioned above is to be removed and updated Provision 11 will provide that "Independent non-executive directors, including the chair, should constitute the majority of the board". In its consultation paper, the FRC notes that in normal circumstances it would not expect an independent non-executive director or a chairman to be on the board for more than nine years and this includes an independent non-executive director who goes on to be the chairman.

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