Corporate governance – directors and the board

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1 Introduction

You should remember from the last chapter that corporate governance is the system by which companies are directed and controlled. Once a company grows, and certainly for a listed company, it is the directors who are in day-to-day control. It should not be surprising, then, that governance codes pay great attention to the composition and activities of a company's board of directors.

This chapter takes the board in four steps: how it can be structured (section 2), what it is for (section 3), what its members legally owe the company (section 4), and what a governance code requires of it in practice (sections 5 and 6).

2 Unitary and two-tier boards

Most corporate governance problems arose because of the way boards were structured and run. There were particular dangers where a company was headed by a charismatic chief executive. The word ‘charismatic’ was often used instead of more accurate descriptions such as ‘domineering’ or ‘bullying’. Often the chief executive would ensure that the board was filled with directors who would offer little resistance, and was then able to get away with outrageous decisions and, occasionally, robbery.

Two approaches have been taken to introduce some supervision into the board's own activities: unitary boards and two-tier boards. Within the European Union, the governance codes of eight countries recommend a unitary board, ten recommend a two-tier board, and in the remaining nine a hybrid applies and companies may choose.

2.1 Two-tier boards

There are two separate boards, and a director sits on one or the other, never both:

• A supervisory board. Elected by the shareholders and usually composed of more experienced senior figures, often including employee representatives. It is led by a chairman. It supervises and advises the management board, is involved in long-term decision making and strategic planning, and is in charge of hiring and dismissing the members of the management board.

• A management board. It meets regularly and is in charge of the day-to-day management of the business. It is led by a chief executive officer. Its concerns are tactical: short-term decisions and the everyday running of the business's transactions.

2.2 Unitary boards

There is only one board, and it contains a mix of executive and non-executive directors. The executive directors look after the day-to-day management of the company (the job the management board does in a two-tier system); the non-executive directors monitor, advise and warn (the job the supervisory board does). The difference is that all votes are taken by the single board, with each executive and non-executive director having one vote.

Neither structure is the right answer, and the exam will not ask you to pick one. What it will ask you to see is that both are attempts to solve the same problem — how to get somebody independent close enough to the executives to understand what they are doing, and far enough away to be willing to stop them.

3 What the board is for

Whichever structure is used, the board's own job is the same, and it has two halves that pull in different directions:

• Direction — setting the company's purpose, values and strategy, agreeing the plans and the budgets that follow from them, and appointing the senior management who will deliver them.

• Control — monitoring what management then does, deciding how much risk the company is willing to run, satisfying itself that the risk management and internal control systems are working, and reporting honestly to the shareholders.

The board is also where a company's governance standards are actually set. A code can require an audit committee; it cannot make a board take it seriously. The tone that decides whether controls are respected or worked around comes from the top, and that is a board output, not a policy document.

The syllabus asks for the board to be described as independent, objective, sceptical and resourceful. Those four words are worth taking one at a time, because each is a different failure when it is missing:

4 Directors' powers and duties

A director's powers come from the company's constitution: the shareholders own the company, but they delegate the running of it to the board, and the board delegates most of that to the executives. Those powers are not unlimited, and they are limited in two quite different ways — by law, which applies to every company, and by a governance code, which applies to listed companies through the exchange.

4.1 The general duties a director owes

The duties below are the English illustration, taken from the Companies Act 2006. Other jurisdictions express them differently and some leave them to case law, but the substance — act within your powers, in the company's interests, using your own judgement and reasonable care, and do not profit privately from the position — is common to company law generally. The duties are owed to the company, not to individual shareholders.

4.2 Section 172: what the duty actually says

Read that carefully, because a very common exam answer gets it wrong. The duty is not ‘maximise shareholder wealth’. Three things follow from the actual wording, and each of them is examinable:

• The test is the director's own good-faith judgement, not the outcome. A decision that turns out badly is not automatically a breach.

• The beneficiaries are the members as a whole — the body of shareholders, present and future, not the largest one and not this year's share price.

• The six listed matters must be had regard to. Employees, suppliers, customers, the community and the environment are inside the duty, not competing with it. That is why the model is called enlightened shareholder value: the wider interests are considered because doing so is how a company succeeds over time.

This matters far beyond company law. It is the answer to the argument, examined in Chapter 7, Corporate social responsibility, that spending money on social or environmental objectives is a breach of the directors' duty to the shareholders. It is not. Considering those matters is part of the duty.

4.3 How a governance code narrows what a board may do

The law says what a director must do. A governance code goes further and restricts how the board is allowed to organise itself. For a listed company the practical effects are:

• No one person may hold unfettered power. The roles of chair and chief executive are held by different people, and the chair should be independent on appointment.

• Some decisions must be taken by people with no stake in them. Directors' pay is set by a committee of independent non-executive directors; board appointments are led by a nomination committee; no director is involved in deciding his or her own remuneration.

• Independent challenge must be present in sufficient strength. At least half the board, excluding the chair, should be independent non-executive directors.

• The board must account publicly. It reports on its risk management and internal controls, explains any departure from the code, and stands for re-election by the shareholders each year.

• Pay can be taken back. Variable pay is subject to malus and clawback arrangements, so an award can be reduced or recovered if the performance it rewarded turns out not to have been real.

5 The UK Corporate Governance Code as an illustration

The OECD principles from Chapter 3 are put into effect in different ways in different countries. The UK Corporate Governance Code is used here as one worked illustration of best practice under a unitary board, because it is the code most CIMA material quotes. The principles it expresses are found, in different words, in codes all over the world — so learn the substance, and treat the UK labels as an example.

The Code is issued by the Financial Reporting Council. The current edition is the 2024 edition, published in January 2024 and applying to financial years beginning on or after 1 January 2025 — with one provision, the new internal-controls declaration, applying a year later. The Code states that its purpose is to facilitate “effective, entrepreneurial and prudent management that can deliver the long-term sustainable success of the company”.

The full Code is published on the FRC's website: Financial Reporting Council — UK Corporate Governance Code.

5.1 The five sections of the Code

Each section contains Principles, which a company must apply, and Provisions, which it must either comply with or explain. It is worth learning the five sections against the risk each one exists to deal with, because that is how they are examined.

5.2 Comply or explain

The Code has no force in law. It is enforced on listed companies through the Stock Exchange's listing rules, whose ultimate sanction is to suspend or cancel a listing. A listed company must state in its annual report either that it has complied with each provision, or which provisions it has departed from and why. This is the ‘comply or explain’ approach, and it is the trademark of UK corporate governance.

An explanation is not a confession. A departure that genuinely suits the business is permitted — but the explanation must say which provision, for what period, why the board considered the departure to be in the company's interests, what was put in place instead, and, where the departure is temporary, when and how compliance will be restored. A one-line admission with no reason is a governance failure; a properly reasoned departure is not. The contrast between this and a rules-based regime such as the United States' Sarbanes-Oxley Act is in Chapter 3, Corporate governance.

5.3 What the 2024 edition added

One change matters at this level. Under Provision 29 of the 2024 edition the board must declare in the annual report whether the company's material internal controls were effective, describe how it monitored and reviewed the risk management and internal control framework, and describe any material controls that did not operate effectively and what is being done about them. This applies to financial years beginning on or after 1 January 2026, a year after the rest of the edition.

That is a real tightening. Saying that the board has reviewed the effectiveness of its controls says only that a review happened. Declaring that the material controls were effective puts the board's name to the outcome — which makes the quality of the underlying control work, the subject of Chapter 6, Error and fraud, a board-level exposure rather than an internal matter.

6 The board's committees

A committee is how a board gives a job to people who can do it independently of the executives it concerns. The Code specifies three, and all three are made up of non-executive directors the board considers independent. Membership is a different question from attendance: the finance director, the auditors, the human resources director and outside advisers all routinely attend and advise. It is membership — who is in the room when the committee decides — that carries the independence.

6.1 Non-executive directors

A non-executive director (NED) is a full member of the board with full voting rights, but takes no part in day-to-day management. Executive directors run functions — finance, operations, sales. Non-executives sit on the board to monitor, advise, warn and, where necessary, vote against.

• They should be of sufficient standing and experience to constructively challenge the executives and to help develop proposals on strategy. A token appointment defeats the object.

• At least half the board, excluding the chair, should be non-executive directors whom the board considers independent.

• Independence is judged on substance, not on the job title: length of service, former employment with the company, material business relationships, cross-directorships and close family ties all threaten it.

• Their fees should not be performance-related. A non-executive whose income rises with reported profit has been given exactly the incentive they were appointed to police.

• They are appointed for a fixed term, and — like every director of a listed company — stand for re-election by the shareholders each year.

6.2 The nomination committee

Sometimes called the appointments committee. It leads the process for board appointments and makes recommendations to the board. It exists to answer a specific abuse: directors appointing their friends and colleagues, who then feel obliged to the person who appointed them and are reluctant to vote against him.

• It identifies the balance of skills, experience, independence and knowledge the board needs, and recruits against that specification through a formal, rigorous and transparent process.

• It plans succession for the board and for senior management, so that an unexpected departure does not force an improvised arrangement.

• It oversees induction for new directors and the continuing development of existing ones.

• It is chaired by an independent non-executive director or by the chair of the board — though not when the committee is choosing the chair's own successor.

6.3 The audit committee

The audit committee is composed of independent non-executive directors, at least one of whom has recent and relevant financial experience. It is the most important of the three, because it is the point at which an auditor with bad news can reach the board without going through the person the bad news is about.

Before audit committees existed, the auditors dealt principally with the finance director — who was very often the person responsible for the accounting and control problems they were reporting. Auditors were reporting problems to the person who had caused them, and, in the case of the internal auditors, to the person who controlled their pay and promotion.

The audit itself — what external and internal auditors do, and how they differ — is Chapter 5, Internal and external audit.

6.4 The remuneration committee

The remuneration committee is composed of independent non-executive directors. It sets the remuneration of the executive directors and of the chair, so that no director is involved in deciding his or her own pay. It does not set the fees of the non-executive directors, which are a matter for the board or the shareholders.

• Remuneration should be sufficient to attract, retain and motivate directors of the quality required — but no more than is necessary. The cheapest available director is not a saving.

• A significant proportion of executive pay should be linked to corporate and individual performance, so that what is good for the shareholders is good for the director. Directors should not receive high pay irrespective of how the company has performed.

• There must be a formal and transparent procedure for developing remuneration policy and for fixing individual packages.

• Variable pay should be deferred, held for a period, and subject to malus and clawback, so that an award can be reduced or recovered if the performance it rewarded proves not to have been real.

7 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.