ACCA P1 Governance, Risk and Ethics - 2010 - Study text

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Chapter 4: Board committees

 The audit committee reports to the board, and the board reaches decisions based

on the recommendations of the audit committee. However, if the board and the

audit committee disagree about a particular matter, the audit committee should

have the right to report the disagreement to the shareholders.

Example

The Smith Guidance went into some detail about the role of the audit committee in

the annual audit cycle. It is useful to look at some of the suggestions in the Guidance,

to get an idea of what the audit committee might actually do.

 At the beginning of the annual audit, the audit committee should check that

appropriate plans for the audit are in place. It should check that the work plan

for the audit is consistent with the size and scope of the audit engagement. It

should also check that the audit team will be of the right size and will have a

suitable range of skills and experience for the work.

 At some stage in the audit cycle, the audit committee should meet with the

external auditors to discuss the results of the audit and the findings of the

auditors. As a part of this review, the committee should discuss any particular

problems or disagreements that occurred during the audit (and whether these

have been resolved). The committee should also ask about any important

accounting judgements that have been made in preparing the financial

statements. They should also ask the auditors about the errors that they found

during the audit.

 There should be a review of the audit after it has been completed. The audit

committee should consider the audit plan and whether the auditors met the

requirements of the plan. The committee should also consider whether the

auditors were strong-minded in their dealings with the company’s management.

It should also obtain the views of the finance director about the conduct of the

audit by the auditors.

2.5 Composition of the audit committee

An audit committee should make its judgements and recommendations

independent of influence from executive management. However, the opinion about

the composition of the audit committee varies between countries.

 The UK Combined Code states that the audit committee should consist entirely

of independent non-executive directors. In large listed companies there should

be at least three members of the committee (and in smaller listed companies at

least two).

 The Singapore Code of Corporate Governance states that the audit committee

should consist of at least three members, all of them non-executive directors.

However, only a majority of the committee, including the committee chairman,

needs to be independent.

In order to perform their functions properly, the members of the audit committee

should have some understanding of finance and accounting. However, it would be

unreasonable to expect that all the audit committee members should be qualified

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accountants. There are differences of opinion about how much experience or

understanding of finance and accounting the audit committee members should

have.

 The UK Combined Code states that the board of directors should satisfy itself

that ‘at least one member of the audit committee has recent and relevant

financial experience.’ The Smith Guidance states that it is desirable that this

person (who is likely to be the audit committee chairman) should have a

professional accountancy qualification from one of the professional bodies. The

amount of financial understanding required from the other audit committee

members will depend on the nature of the company and its business.

 The guidelines in the Singapore Code of Corporate Governance state that the

members of the audit committee should be ‘appropriately qualified’ to carry out

their responsibilities, but at least two of the committee members should have

‘accounting or related financial management expertise or experience’.

Chapter 4: Board committees

The remuneration committee

 Remuneration as a corporate governance issue

 The need for a remuneration committee

 Main duties of a remuneration committee

 Composition of the remuneration committee

 Continuing problems with the remuneration of executive directors

3 The remuneration committee

3.1 Remuneration as a corporate governance issue

The remuneration of executive directors and senior managers is an important issue

in corporate governance. It is at the heart of the conflict of interest between

management and shareholders.

 It might be argued that executive directors and other senior managers, as full-

time employees of their company, are primarily concerned about their personal

remuneration. They will put concern for their personal remuneration ahead of

concern for the wealth of the company’s shareholders.

 Directors might attempt to increase their remuneration, without necessarily

doing anything to justify the increase.

 Higher rewards for managers, without any improvements in the company’s

performance, mean lower profits for the company.

 However, the conflict of interest between management and shareholders might

be resolved if the remuneration of directors could include incentives. If directors

are rewarded for achieving performance targets that are consistent with the best

interests of the company’s shareholders, the conflict of interests could be

reduced. Directors and shareholders would both benefit.

The issues involved in using incentives to reduce the conflict of interest, and link the

remuneration of directors to performance targets that are in the best interests of

shareholders, will be considered in more detail in a later chapter.

Origins of the controversy about directors’ remuneration

The remuneration of executive directors is seen as a major corporate governance

problem in some countries but not in others. The controversy began in the UK

during the 1990s, when the government privatised state-owned businesses and a

number of utility companies were created in energy production, and electricity,

water and gas supply.

The senior directors appointed to the new companies were the same individuals

who had managed the businesses when they were state-owned. For doing much the

same job as before, these individuals were given a very large increase in

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remuneration. They were criticised by the press as ‘fat cats’, who were being paid

far more than they were worth.

Directors’ remuneration became a cause of anger in the press some years later when

several high-profile directors of major companies were dismissed, or threatened

with dismissal. Because of the terms of their employment contract, these directors

were entitled on dismissal to very large termination payments. These termination

payments were described in the press as ‘rewards for failure’.

Criticisms of excessive directors’ remuneration have also been expressed by

institutional investors, who consider that the remuneration of directors should be

linked much more closely to company performance. There has been an increasing

willingness by institutional shareholders to express their displeasure with

remuneration for directors by voting against the board at general meetings of the

company. In the UK, shareholders are able to use their votes by:

 voting against the re-election of directors, or

 voting against the directors remuneration report: quoted companies in the UK

are required to include a directors remuneration report in their annual report

and accounts, and shareholders are able to vote on the report, indicating their

approval or disapproval.

Institutional investors have been concerned about the apparent lack of concern

about directors’ remuneration. There have been some reported cases where

shareholder action appears to have had some effect.

Example: United Business Media

At the annual general meeting of the media group United Business Media in 2005,

the shareholders voted against the directors remuneration report. 76% of

shareholders voted against the directors’ remuneration report at the AGM and

another 11% abstained. This was a remarkable majority.

The shareholders were objecting to the ‘ex gratia’ payment of a £250,000 bonus to

Lord Hollick, the departing chief executive. There was some uncertainty about

whether the payment was for helping to ensure a successful handover to the

incoming chief executive, or for the role Lord Hollick had played in the sale of NOP

World, a polling subsidiary. Shareholders felt that whatever the payment was for, it

was not justified.

Following the vote, Lord Hollick agreed to waive the bonus. UBM announced that it

would not make similar ex gratia payments to directors in the future.

Chapter 4: Board committees

Example: Misys

In 2005, UK company Misys proposed to make a payment of shares to each of two

senior executive directors. The reason for the payment was to persuade the two

executives not to leave the company. The board considered that without the

payment, they might otherwise leave the company unless they were appointed to

the vacant role of chief executive. The board decided to hold a binding vote on the

share award at the annual general meeting (AGM) of the company, to be held in

September.

The proposed award met strong resistance from institutional investors, who argued

that ‘retention rewards’ should have no part in succession planning.

The company, faced with the prospect of possible defeat at the AGM, withdrew the

proposed share award in the week before the AGM.

3.2 The need for a remuneration committee

The remuneration of executive directors and senior management is such a

contentious issue that it should be dealt with carefully.

The need for a remuneration committee was first recommended in the UK by the

Greenbury Committee in 1995, which published a report into directors’

remuneration. The Greenbury Report reached the following conclusions.

 Putting together a remuneration package for senior executives is a key issue in

corporate governance.

 The system for negotiating and agreeing a remuneration package is open to

abuse if executive directors can decide or influence their own remuneration

arrangements.

 It is not practicable for shareholders to be involved in the negotiation of

remuneration packages, and shareholders should not be able to make decisions

about the remuneration of individual directors. However, they are entitled to

extensive information about directors’ remuneration.

 Remuneration for executive directors and other senior executives should

therefore be decided by a remuneration committee of the board.

These recommendations were accepted. The UK Combined Code includes the

following principles about remuneration.

 Levels of remuneration should be sufficient to attract, retain and motivate

directors of the quality required to run the company successfully, but a company

should not pay more than is necessary for this purpose.

 There should be a formal and transparent procedure for developing policy on

executive remuneration and for fixing the remuneration packages of individual

directors.

 No director should be involved in deciding his or her own remuneration.

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The UK Code therefore states that a company should establish a remuneration

committee. The committee should:

 be given delegated responsibility by the board to set the remuneration levels for

all executive directors and the chairman, and

 recommend and monitor the level and structure of remuneration for senior

management. (The board should decide the definition of ‘senior management’

but it will normally include the first layer of management below board level.)

3.3 Main duties of a remuneration committee

The duties of a remuneration committee should be decided by the board of

directors. However, the Higgs Guidance suggested that the following duties should

be included:

 The committee should agree with the main board a policy for the remuneration

of the chairman, CEO, other executive directors and any other designated senior

management.

 Where there is a performance-related pay scheme, the committee should decide

the targets for performance.

 The committee should decide the pension arrangements for each executive

director.

 The committee should approve the design of any new share incentive plan.

 In negotiating service contracts with directors, the committee should ensure that

severance payments in the event of dismissal are fair, but that ‘failure’ is not

rewarded.

 Within the framework of the agreed remuneration policy, the committee should

negotiate and agree the remuneration of each individual executive director.

To provide advice and assistance, the remuneration committee should be able to

hire the services of remuneration consultants. The committee should also make a

report to the shareholders each year, for inclusion in the annual report and accounts.

Advice from executive colleagues

Although no one should be able to decide or influence their own remuneration, this

does not prevent a remuneration committee from taking advice from executive

colleagues on the board and other senior executives. Executives may be able to

provide helpful information about what managers might expect to earn, and what

specific performance targets might be appropriate for incentive schemes.

However, when it takes advice from executive colleagues, the remuneration

committee should take care to recognise and avoid conflicts of interest (UK

Combined Code).

The remuneration committee should also talk to the finance director about the

potential impact of a proposed remuneration scheme on the company’s reported

profits. The committee needs to be aware that the company should not pay more in

remuneration than it can sensibly afford, given its financial situation.

Chapter 4: Board committees

3.4 Composition of the remuneration committee

As with the composition of the audit committee, views about the composition of the

remuneration committee vary between countries. However, the general view is

accepted that individuals should not be allowed to decide or influence their own

remuneration.

 In the UK, the Combined Code states that in large companies, the remuneration

committee should consist of at least three members, and all members should be

independent non-executive directors. (In smaller listed companies, the

remuneration committee should consist of at least two independent NEDs.)

 The Singapore Code of Corporate Governance does not specify the size of the

remuneration committee. However, the committee should consist entirely of

non-executive directors, the majority of whom should be independent. ‘This is to

minimise the risk of any potential conflict of interest.’

3.5 Continuing problems with the remuneration of executive directors

In the UK, since remuneration became a significant issue for corporate governance,

the remuneration of executive directors in public companies has risen at a much

faster rate than pay rises generally for the working population.

Remuneration committees have been criticised for making wrong judgements, or

overlooking aspects of remuneration, and as a result remuneration has been higher

than it should be.

The main reason for the problem appears to be ‘benchmarking’. This is a method of

deciding the level of remuneration by making comparisons with remuneration

levels in other public companies.

Problems with using benchmarks

A problem with looking at what other companies are paying their directors is that

when most companies do this, there is a tendency for remuneration levels to rise.

Other companies are typically divided into four quarters (quartiles): companies

paying the highest remuneration are placed in the upper quartile and companies

paying the least are put in the lowest quartile.

The remuneration committee of a company in the FTSE 250 index might decide that

its executive directors should be paid on a similar level to executives in companies

in the second quartile, and negotiate remuneration on that basis. However, since

very few companies will set a policy of being in the lowest quartile of companies in

the benchmark group, there will be a tendency for remuneration levels to rise

continuously as each company re-sets remuneration levels that put it in the middle

level or in the upper quartile.

The UK Combined Code recognises that benchmarking is likely to result in higher

remuneration. It therefore states that comparisons should be used with caution ‘in

view of the risk of an upward ratchet of remuneration levels with no corresponding

improvement in performance.’

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International benchmarks

For large companies, there is the additional problem of international comparisons. It

may be argued in order to attract the best executive talent it is necessary to offer

remuneration packages comparable to those paid to executives in global

competitors. Global competitors will often include US corporations, where executive

remuneration is high. For global companies in other countries, this could be an

‘excuse’ for increasing executive pay to very high levels.

Example

Occasionally, a remuneration committee might overlook entirely an aspect of

executive remuneration, and as a result executive rewards might be higher than they

should be.

In August 2006, the Association of British Insurers (ABI) in the UK sent a letter to

each of the FTSE 350 companies asking remuneration committees to look at the

pension arrangements in the service contracts of senior executives.

The letter was prompted by the publication of details of the pension arrangements

for four senior executives at the energy company Scottish Power, which the ABI

criticised because it considered them excessive and they were not performance-

based.

The four Scottish Power executives all retired (before their ‘normal’ retirement age)

with very large increases in their pension funds. For example, the pension of the

CEO doubled on termination of his contract, from £3.4 million to £6.8 million. In

addition, his contract allowed him to retire early on exactly the same pension he

would have received if he had stayed in his job until normal retirement age. The

company argued in its own defence that it was contractually obliged to make the

payments.

Chapter 4: Board committees

The nominations committee

 Appointments to the board as a corporate governance issue

 The need for a nominations committee

 Main duties of a nominations committee

 Composition of the nominations committee

 The nominations committee and appointment of a new chairman

4 The nominations committee

4.1 Appointments to the board as a corporate governance issue

When new appointments are made to the board of directors, it is obviously

important that the individual selected should be someone with suitable skills and

experience. The board as a whole should also consist of individuals who collectively

have an appropriate breadth of skills and experience to bring to the discussions and

decision-making of the board.

To ensure that there is a suitable balance of power on the board, the system for

nominating and selecting new directors should not put the choice into the hands of

one individual or a small group of individuals.

However, executive directors should have a voice in new appointments to the

board.

 When the appointment of a new executive director is considered, the executive

directors are probably in a better position than NEDs to assess the qualities of

internal and external candidates for the position.

 The executive directors should be aware of the skills and experience that they

lack, and so can offer suggestions about the type of non-executive that they

would like to add to the board.

Decisions about nominations to the board might occur quite frequently with non-

executive directors. Whereas executive directors are normally expected to retain

their position on the board as long as they have their job with the company, non-

executives might be expected to retire when their current fixed term of appointment

reaches an end. When a current NED retires, he or she will probably be replaced

with someone else.

Succession planning

In addition to selecting new directors for the board, the process of nomination also

involves succession planning. Succession planning means planning in advance for

the eventual replacement of key members of the board when they eventually retire

(or in the event that they are dismissed).

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Succession planning applies in particular to:

 the board chairman

 the CEO, and

 possibly, the finance director.

Institutional investors want reassurance that a company has plans for the eventual

replacement of a successful chairman or CEO, so that the financial performance of

the company will not be damaged when that individual retires or resigns.

4.2 The need for a nominations committee

There are two main reasons for having a nominations committee:

 When a vacancy on the board has to be filled, or when succession planning is

considered, the process of identifying and evaluating suitable candidates takes

time. The board should delegate the task to a committee to save time and

resources. The committee should then make recommendations to the board, so

that the full board takes the final decision about any appointment.

 The appointment of directors to the board, and the succession for top positions

on the board, should be a carefully organised process. The UK Combined Code

states that ‘there should be a formal, rigorous and transparent procedure for the

appointment of new directors to the board’. Such a formal procedure can be

established by setting up a nominations committee. Transparency can be

achieved by requiring the nominations committee to present an annual report on

its activities to the shareholders.

4.3 Main duties of a nominations committee

The UK Combined Code states that the nominations committee should ‘lead the

process for board appointments and make recommendations to the board’. The

board should decide what the exact duties of the nominations committee should be.

The Higgs Guidance suggests that the committee’s duties should include the

following.

 To identify candidates to fill vacancies on the board, when these arise.

 To select a preferred candidate for nomination, and recommend this individual

to the board for appointment.

 Before recommending any person for appointment to the board, the committee

should evaluate the balance of skills, knowledge and experience of board

members, and on the basis of this evaluation identify the skills, knowledge and

experience that the new director should have.

 To consider succession planning.

 To review regularly the size and composition of the board, and make

recommendations for change if this is considered appropriate.

The Singapore Code of Corporate Governance suggests that the nominations

committee should be responsible for the annual performance review of the board

and its individual directors.

ACCA P1 Governance, Risk and Ethics - 2010 - Study text - Emile Woolf Publishing

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