NEDs must walk a difficult line between risk and reward

Elinor Ostrom was a co-winner of the 2009 Nobel Memorial Prize in Economic Sciences for her analysis of economic governance, especially the commons (cultural and natural resources that are held in common, available to all and not privately owned). In her acceptance speech she referenced a comment made by Henry Savile, Vice Chamberlain to Charles II and James II, and Envoy in Paris. Savile said that if bankruptcy resulted in being hanged, it would prevent others from going down this route.

Professor Ostrom said: ‘Extensive empirical research leads me to argue that instead [of such punishment], a core goal of public policy should be to facilitate the development of institutions that bring out the best in humans. We need to ask how diverse polycentric institutions help or hinder the innovativeness, learning, adapting, trustworthiness, levels of cooperation of participants and the achievement of more effective, equitable and sustainable outcomes at multiple scales.’

It is worth reflecting on her thoughts because the general consensus is that some companies – particularly those in the financial sector – could do with the noose. Certainly after the financial crisis of 2008, there are concerns regarding the way that financial markets function, how companies behave, the actions of regulators and the regulations within which they and regulated firms act.

Regulating governance

Historic regulations and governance codes have brought some change to the way organisations conduct their business – they have definitely changed the way executives approach corporate governance, with non-executive directors facing increasingly onerous legal responsibilities. Yet there are big differences between organisations in heavily regulated industries (such as banking) and those in non-regulated industries.

Regulations were not able to prevent cases like the recent LIBOR scandal and the $6.2 billion loss at JPMorgan Chase in 2012. The latter case is an interesting one, not just because of the enormity of the loss.

In October 2014, the U.S. Federal Reserve’s Inspector General issued a report saying that regulators had botched oversight of the JPMorgan unit where the losses took place. The report claimed that examiners in the Federal Reserve Bank of New York had spotted risks in the unit’s trading as early as 2008 but never followed up. Additionally, there was poor coordination with other regulatory agencies.

The responsibility of NEDs

Risk is an essential part of every business and regulation may be limited in its ability to effectively control it. However, regulation – and good practice – does make non-executive directors responsible for satisfying themselves on the integrity of financial information provided by the executive team. In addition, it ensures that financial controls and systems of risk management are robust and defensible. There is however a limit to the depth into which regulations can go, especially in a business as complex as a bank, without appearing to doubt the integrity of the senior management. NEDs have to trust the senior management or, if they have any doubt, they should remove them.

Whether the NEDs could have prevented the excessive risk taking at JPMorgan is a different matter. What happened at the bank was, according the US prosecutors, a securities fraud because the perpetrators hid the true extent of losses from the bank’s management. After the trades collapsed, regulators found that employees at the centre of the loss had been keeping two sets of books to minimise the projected size of the losses. The NEDs could not have been expected to have discovered that.

Back in February this year however, an attorney for a Maryland-based fund that owns shares in the bank told a Delaware Chancery Court that the JPMorgan board showed ‘blatant disregard’ for its oversight responsibilities and should, therefore, be liable for investors’ losses. JPMorgan’s lawyers countered that only a handful of directors who served on some board committees had information that could have warned of the trading losses. They contended that there was no ‘sustained or systematic failure of oversight’ by the entire board.

In May, the judge dismissed the claim, citing rulings by two previous New York courts that rejected shareholders’ allegations that executives disregarded red flags about the bank’s trading operations.Nevertheless, this case raised two issues: to what extent did the NEDs satisfy themselves of the integrity of the financial information that was provided by the executive team? Did they do enough to ensure that financial controls and systems of risk management were robust and defensible?

Particularly for the banking and finance sector, there are many who are calling for additional regulation and supervision. Some commentators are suggesting that banks and other financial institutions will face considerable new and more onerous regulations under Basel III and a plethora of national and supranational legislation.

A changing role

This highlights the increasing demands being placed on non-executive directors. Few will doubt that the role of the non-executive director has changed significantly over the past decade. Although they are still expected to have substantial industry expertise and be able to contribute directly and effectively to the company strategy and operational excellence, NEDs are having to spend more time on their significantly expanded boardroom duties. Furthermore, the regulatory pressures they now face have resulted in increased responsibilities and personal risk.

Outside of board meetings, NEDs are encouraged to make company site visits, talk to customers, mentor and encourage executives within the business and to put time aside to attend appropriate non-executive training and development programmes. All this while maintaining independence and, in some cases, holding down a full-time job.

Since the role of the NED is to ensure that the needs and interests of all stakeholders are taken into account in a balanced and transparent manner, it could be argued that they need to do whatever it takes to achieve that. However, we may be expecting too much from NEDs.

Increased pressure

To address this issue, Tyzack Partners, with support from Advanced Boardroom Excellence, surveyed our extensive network of board chairmen and non-executive directors. The survey looked at the demands and pressures on non-executive directors to identify whether the conventional understanding of the NED role needed radical rethinking – or whether the role had become untenable. Either way, a better system may need to be developed.

The study found a wide divergence of views about whether the levels of knowledge and responsibility expected of NED’s is reasonable – if this was the case, a NED would have become involved in the business to an unreasonable extent. In many cases, differing views came down to whether the business was in a regulated or non-regulated environment.

NEDs in heavily regulated sectors are concerned not only about the level of regulation, but also their personal liability, the ‘senior manager’ rule and the impact of the current views on knowledge and responsibility held by the FCA and PRA. This compares starkly with those in less regulated environments who are more sanguine about their prospects, although many commented on a fear of ‘regulation creep’.

It is universally accepted that the level of  expectation is a concern. One might cynically say that NEDs would claim that, but the reality is that not only do they need to be financially astute, they must also have a deep understanding of corporate governance, risk management and business strategy. Furthermore, they must grasp compliance obligations, possess effective communication skills coupled with the ability to build good working relationships with the executive management team, taking a supportive rather than a lead role.

The non-executive oversight role also demands that the holder evaluate and synthesise large volumes of information so that they can constructively challenge the executive team and provide evidence of independent thinking, curiosity and ability to question diligently but unthreateningly.

As the demands placed on NEDs have risen significantly in recent years, the legal duties, responsibilities and accountabilities should not be underestimated by those considering a NED position. Many NEDs said that significantly more time is needed to be spent on training executives for their first NED appointment. There was a concern that new NEDs simply did not appreciate the levels of responsibility and the extent to which they would be liable if things went wrong.

Appropriately-qualified NEDs

It is critically important that non-executives are chosen for what they can contribute in terms of their skill set, business experience, independent perspective and commercial acumen.

With shareholders and regulatory authorities demanding more accountability and transparency from NEDs, this could potentially lead to a shortage of qualified and experienced people capable of taking up positions in the boardroom. However, our research suggests it will not. The risk/reward equation is increasingly uppermost in the minds of good candidates – although there was a recognition that in the highly regulated financial services sector it is more difficult to find experienced candidates willing to take on the challenge.

As for changing to a better system of corporate governance, David Becher and Melissa Frye point out in their paper ‘Does regulation substitute or complement governance?’ the relation between regulation and corporate governance remains an open debate. The majority of respondents to this study believe that under current regulations, Higgs’ non-prescriptive approach of ‘comply or explain’ works well and means that there is a measured approach to corporate governance.

With the introduction of professional development programmes provided by some universities and organisations such as the Non-Executive Directors Association, NEDs can increase their knowledge of what is required in an evolving environment. This will enable them to develop the skills that contribute to the creation of an effective board culture and performance.

Coupled with a more effective approach to recruitment, it is possible that the demands currently placed on NEDs will become less onerous and more rewarding. As Professor Ostrom said, a core goal of public policy should be to facilitate the development of institutions that bring out the best in humans.