Business, Innovation and Skills CommitteeShort statement provided (in personal capacity) by Harlan Zimmerman of Cevian Capital (Providing oral evidence 26 February, 2013)

Non-executive Directors and Failures in the Principal-Agent Relationship1

Over the last years equity markets have done a poor job of providing capital for British business. They have also done a poor job of acting as a control mechanism to steer British listed companies towards the sort of behaviour that society requires and, increasingly, demands.

The Kay Review comprehensively discusses the problems associated with principal-agent relationships throughout the investment chain, but has virtually ignored the all-important relationship between the shareholders (the principals) and non-executive directors (or NEDs, who are agents). While NEDs have obligations to their companies as a whole, shareholders alone vote on NED appointments so that they may select NEDs who they can entrust with the stewardship of the companies that they own.

However, this is not how things have been working in practice, and this is the root of many problems.

Shareholders have largely abdicated their right to appoint NEDs, as voting for NEDs has become a largely farcical rubber-stamping exercise that (to borrow from Lord Myners) would embarrass even the North Koreans. As evidence, note data from PIRC on FTSE 100 director elections for 2009–2012: There were 3,042 votes on director nominees during this period. In 3,040 cases (99.34%), the nominees were voted onto the board. (two nominees were voted down by controlling Kazakh owners). Average “yes” votes were c. 97.5%. Even in 2012 (the so-called “shareholder spring”), 100% of FTSE 100 nominees were voted through, with an average “yes” vote of 97.4%. 2

(This behavior is especially disappointing as appointing directors is the shareholders’ single most powerful tool of ownership, and by failing to exercise it, they are failing to fulfill their “primary role in promoting the accountability of management and boards for the performance of their businesses.”3)

It is the boards themselves (normally really the chairmen) that control the NED nomination process. Thus, with 99.34% success rates, the boards (chairmen) effectively control the entire appointment process. In other words, the chairmen are selecting their own board members. This is a very bad outcome that is the root cause of much sub-optimal behaviour.

Human nature means most chairmen will avoid selecting “natural challengers,” and most NEDs—having been given their job by the chairmen—will not be comfortable rocking the boat. (They also understand that appointments to other boards will be difficult without a good reference from their chairman).

When chairmen select NEDs who are not natural challengers, and when NEDs are uncomfortable rocking the boat, the result is a lack of challenge in the boardroom. This leads to poor decision-making, limited accountability and improper alignment of interests. (The Walker Review of BOFIs pointed to lack of boardroom challenge as a major cause of the sort of behaviour that led to the financial crisis).

Furthermore, NEDs virtually never even meet shareholders (other than the chairmen and occasionally senior independent directors). They rely on CEOs and CFOs (who do meet shareholders) and corporate banking advisors to inform the board about shareholder views. As the interests of management and bankers often diverge from the interests of shareholders and society at large, this is clearly sub-optimal.

Lastly, in an election system with candidates chosen by a single party and 99.34% of candidates winning their races, it is doubtful that the winners would feel empowered by a true mandate from the voters. It is likewise difficult to believe that NEDs feel any sort of true mandate or backing from shareholders.

Consequences of Poor Board Behaviour

Poorly functioning, out-of-touch, non-accountable boards display many symptoms that are damaging for stakeholders and society. These include:

Inappropriate risk-taking, strategic errors, poor acquisitions and capital management—arising from insufficient control over ambitious management teams, who often have asymmetric incentives and a desire to expand their domains.

Weak governance—chairmen, NEDs and executives who perform “well enough” to keep their seats, but are not compelled to drive a company to its potential; poorly managed succession processes.

Executive remuneration—Plans with targets that are too low, purely financial, and poorly aligned with the interests of shareholders and wider stakeholders; inappropriate benchmarks and structures; and unreasonably high levels of compensation.

Corporate underperformance—arising from un-ambitious, unchallenging and inappropriate target setting.

Short-term focused decision making—resulting from a lack of a mandate from shareholders, and thus a constant fear of missing quarterly estimates and disappointing “the market.”

Lack of diversity—A lack of diversity within the board, resulting from managed nomination processes that lack transparency and objectivity, and that favour the “old boys’ network.”

Shareholders, other stakeholders and policy makers have limited time and resources. Much effort is expended on trying to address individual issues such as the ones listed above. However, it would be more efficient, and more effective, if attention were focused primarily on comprehensively improving board behavior, which would address many symptoms at one time.

Shareholder Involvement in Board Nominations

We believe that the most tangible and realistic way to comprehensively address poor board performance is to directly involve shareholders in the company’s NED nomination process.

This system operates well in Sweden (as well as in Norway and at most large companies in Finland) and benefits all—shareholders, companies, directors and society at large. While it would be inappropriate to simply take the Swedish system and apply it to the UK, there are important lessons that can be drawn from the Swedish experience. (An idea would be to involve shareholders in nominating only chairmen).

Like there was initially in Sweden, there is much resistance to this approach in the UK. The status quo suits current chairmen and NEDs, who can say they are in fact very responsive to non-public dialogue with shareholders (while keeping their ability to self-determine and perpetuate). Most institutional asset managers, meanwhile, will say they are very active behind the scenes (when this is true in very limited cases), and thus the current (low-cost, low responsibility) works reasonably well.

The Kay Review briefly mentions, but does not consider seriously, the possibility of involving shareholders in NED nominations (and the issues it would address). This is a missed opportunity. It is possible that Professor Kay felt, as with some other ideas paid scant attention (eg differential voting and dividends), that resistance would be so great, there would be little point in advancing such approaches. That would be a disappointing stance from such a respected thinker, chosen from out of the box, presumably to suggest some out-of-the-box solutions to the difficult problems we face.

Harlan Zimmerman
Senior Partner
Cevian Capital (UK) LLP
22 February 2013

1 Many of the points in this document are discussed in greater detail in Cevian’s submission to the Kay Review.

2 During these four years there were also a total of 10 director proposals that were withdrawn prior to the vote. Comparable figures for FTSE 250 companies were 5,134 director votes, all but two were appointed. 26 withdrawn.

3 Text in italics taken from the background information and call for evidence of the Kay Review.

Prepared 24th July 2013