Corporate Governance

1. The Combined Code on Corporate Governance
This Corporate Governance Report explains key features of the Company’s governance structure, how it applies the principles in the revised Combined Code or Corporate Governance (the ‘Code’), and the extent to which the Company has complied with the “provisions” – or requirements – of the Code.

The guiding principle of “comply or explain” that was stressed in Sir Derek Higgs’ report is now enshrined in the Preamble to the Code. Each of the provisions set out in the Code has been reviewed. Where appropriate, steps have been taken to ensure that the Company is in compliance with all of those provisions. As at the date of this Report the Company complies with all of the provisions of the Code, save the requirement in Code Provision D.1.1 that the Senior Independent Director should attend meetings with a range of shareholders. Whilst the Senior Independent Director has attended various briefings and other meetings with analysts and other representatives of institutional investors in 2004, he has not undertaken a programme of meetings with individual shareholders, as this has not been considered necessary.

The Company has a comprehensive programme of meetings and dialogue with institutional investors. The views of investors expressed through this dialogue, and through the Annual Audit of Investor Opinion (referred to in more detail on page 58), are communicated to the Board as a whole, so that all Directors can develop a balanced understanding of the issues and concerns of major shareholders. Feedback from a number of shareholders suggests that these arrangements for communication between the Company and its shareholders are considered to be satisfactory and effective, and that regular or routine meetings between shareholders and the Senior Independent Director are not considered necessary.

The Senior Independent Director is, of course, always available to meet shareholders on request, to ensure that the Board is aware of any shareholder concerns that cannot be resolved through the routine mechanisms for investor communication.

2. Directors
Brief biographical details of current Directors are set out on pages 52 and 53. Kate Nealon and David Shearer were appointed Directors of the Company with effect from 23 March 2004 and, in accordance with the Company’s Articles of Association, were re-elected by shareholders at the 2004 AGM. Sir Bob Reid and Louis Sherwood retired at the conclusion of the Company’s Annual General Meeting on 27 April 2004. Philip Yea resigned from the Company with effect from 30 June 2004, following his appointment as Chief Executive of 3i plc. Mike Ellis retired as a Director on 31 December 2004. Mark Tucker was appointed as a Director on 30 April 2004.

Having served since November 1995 on the Boards of Bank of Scotland and subsequently the Company, John Maclean will retire at the conclusion of the Company’s Annual General Meeting on 27 April 2005 and will not seek re-election by shareholders. John has been and continues to be a fully effective member of the Board, but his ‘retirement’ from the Board is in line with the Company’s policy in relation to the tenure of Non-executive Directors. That policy, informed by the provisions of the Code that deal with the ‘independence’ of Non-executive Directors, recognises that, in almost all cases, Non-executive Directors will stand down from the Board no later than the ninth anniversary of their first election by shareholders.

The roles of Chairman and Chief Executive are separate and there is a clear, written division of responsibilities between those roles. There is also a Non-executive Deputy Chairman (Sir Ron Garrick) whose role is also separately defined. In addition to the Chairman, the Board comprised, as at 31 December 2004, seven Executive Directors and eight Non-executive Directors. All of the Non-executive Directors are considered by the Board to be independent. Following the retirement from the Board of Sir Bob Reid at the 2004 AGM, Sir Ron Garrick, the Company’s Non-executive Deputy Chairman, was also appointed to the role of Senior Independent Director. As Senior Independent Director, Sir Ron will, as necessary, lead meetings of the independent Non-executive Directors (without the Executive Directors and/or the Chairman being present); be available to meet with shareholders, to understand their concerns and (in the event that contacts with the Chairman and/or Chief Executive are inappropriate or have failed) to present these views to the Board as a whole; and to lead the performance evaluation of the Chairman.

In accordance with the Company’s Articles of Association, which provide for all Directors to stand for re-election at intervals of no more than three years, Colin Matthew, Charles Dunstone, Tony Hobson and Dennis Stevenson, will retire by rotation, and will each seek re-election by shareholders, at the 2005 AGM. The Chairman is pleased to confirm, following formal performance evaluations, that the performance of both Charles and Tony continues to be effective, and they continue to demonstrate commitment in their respective roles as Non-executive Directors. The Deputy Chairman confirms, following formal performance evaluation, that the performance of the Chairman continues to be effective, and that the Chairman continues to demonstrate commitment to his role. As announced by the Company on 28 February, the Company has invited Dennis Stevenson, to serve a further term as Chairman following expiry of his current appointment, on 30 June 2005. Dennis has accepted that invitation and, subject to his re-election being approved by shareholders at the 2005 AGM, will therefore serve as Chairman for a further three years, commencing on 1 July 2005.

Mark Tucker, having been appointed a Director on 30 April 2004 will also present himself for election in accordance with the Articles of Association.

In accordance with Principle A5 of the Code, Kate Nealon and David Shearer, as newly appointed Directors were provided during 2004 with a full, formal and tailored programme of induction, to familiarise them with the Group’s businesses; the risks and strategic challenges those businesses face; and the economic, competition, legal and regulatory environments in which they operate. In addition, a programme of strategic and other business reviews, together with other training provided during the year, ensures that all Directors continually update their skills; their knowledge and familiarity with the Group’s businesses; and their awareness of sector, risk, regulatory, legal, financial and other developments.

Particulars of Directors’ remuneration and interests in shares of the Company are given in the Report of the Board in relation to remuneration policy and practice in relation to Remuneration Policy and Practice (the “Directors’ Remuneration Report”) on pages 60 to 79.

The Company Secretary is an employee, but not a Director, of the Company.

3. The Board
The Board meets regularly to determine the strategic direction of the Group and to review operating, financial and risk performance. There is a formal schedule of matters reserved to the Board which includes approval of the Group’s annual Business Plan (that defines the operating and strategic objectives of the Group and the risk framework within which the Group will operate); Group policies and standards on financial and non-financial risks; significant transactions, above defined limits; the commencement of significant new business activities; and the scope of delegations to Board Committees, subsidiary boards and executive management of the Group. The executive management of the Group is responsible to the Board for developing strategy; for the profitability and overall performance of the Group; and for managing the Group’s businesses in accordance with the Group Business Plan, and the policies, standards and risk appetite defined by the Board. Details of the full list of matters reserved to the Board can be found on the Company’s website.

The Board has overall responsibility for the Group’s system of internal control and annually reviews its effectiveness, including a review of financial, operational, compliance and risk management controls. The implementation and maintenance of the risk management and internal control systems are the responsibility of the Executive Directors and other senior management. The system is designed to manage the risk of failure to achieve business objectives, and provide reasonable assurance against material misstatement or loss.

Until 31 December 2004, the Group Management Board was the senior executive committee of the Group. Its role primarily consisted of providing advice and support to the Chief Executive in relation to the discharge of his delegated responsibilities concerning the development of strategy and management of the Group, with particular reference to cross-Divisional or Groupwide issues, including monitoring the risk management practices approved and adopted by individual business areas. Information about these mechanisms and the Group’s compliance with “Internal Control: Guidance for Directors on the Combined Code” (the “Turnbull Guidance”) is set out in the Financial Review and Risk Management Report on pages 36 to 46.

With effect from 1 January 2005, the Group Management Board was superseded by the HBOS Executive Committee, whose membership reflects internal organisational changes that took place with effect from the end of 2004, including the appointment of the new Group Risk Director.

In addition to two formal meetings of the Board held solely to authorise release of the Company’s preliminary and interim results, following consideration of those results by the Audit Committee and the full Board (which are discounted for this purpose) there were ten Board meetings during 2004 at which all Directors were present, except for apologies from Charles Dunstone, James Crosby, Brian Ivory and John Maclean, on one occasion each.

The Company has established a two year evaluation programme in respect of the performance of the Board and its principal committees. This programme includes in-depth one-to-one discussions between the Chairman and individual Directors, together with collective discussion at a meeting of the full Board - supplemented, in alternate years, by detailed questionnaires, completed by all Directors. Actions are agreed to deal with issues raised as a result of this evaluation process. In 2004, for example, actions were implemented to facilitate greater challenge by Non-executive Directors, particularly in respect of strategic issues, and to give additional emphasis to succession planning in relation to the most senior management roles.

The performance of individual executive Directors is appraised annually by the Chief Executive, to whom they report. The performance of the Chairman is reviewed by the Non-executive Directors, led by the Deputy Chairman, taking into account the views of the executive Directors. A meeting was held in November 2004 under the Chairmanship of Sir Ron Garrick to carry out this review. The outcome of this meeting was confirmed to the Chairman by the Deputy Chairman. Individual Non-executive performance is kept under continuous review by the Chairman and by the Nomination Committee. The performance review of the Chief Executive is conducted by the Chairman, taking into account the views of other Directors.

4. Committees of the Board
The terms of reference of the principal Committees of the Board – Audit, Remuneration and Nomination – are available on the Company’s website. Those terms of reference are reviewed at least annually. Membership of the Committees of the Board is intended to make best use of the skills and experience of Non-executive Directors, in particular, and to minimise (to the extent practicable) unnecessary overlap and duplication of membership. Given their respective roles and responsibilities, however, at least some overlap between the Memberships of the Remuneration and Nomination Committees is considered desirable. The work carried out by the Audit and Nomination Committees in discharging their responsibilities is summarised opposite. The work carried out by the Remuneration Committee is described within the Directors’ Remuneration Report on pages 60 to 79.

Audit Committee
Tony Hobson (Chairman)
John Maclean
Coline McConville (appointed 27 April 2004)
Kate Nealon (appointed 27 April 2004)
Sir Bob Reid (retired 27 April 2004)
Louis Sherwood (retired 27 April 2004)

This Committee consists entirely of Non-executive Directors, and is chaired by Tony Hobson, who has significant recent and relevant financial experience. It is supported by Risk Control Committees for each Division which generally comprise at least two independent Non-executive Directors and an Executive Director independent of that Division. The Terms of Reference of the Audit Committee include all matters indicated by the Code. The Company Secretary or his nominated Deputy acts as Secretary to the Committee.

During 2004 the Committee met eight times with all members present with the exception of Sir Bob Reid (apologies for one meeting). In those meetings, as well as in seperate meetings with Executive Directors and management, and privately with both the external and internal auditors, the Committee reviewed:

• and advised the Board on the Group’s interim and annual financial statements, its accounting policies and on the control of its financial and business risks, the nature and scope of the work to be performed by the external and internal auditors, and the results of this audit work and of the response of management;
• the activities, resources, organisational structure and operational effectiveness of the internal audit function;
• the effectiveness of the Group’s system of internal control (including financial, operational, compliance and risk management), as well as the appropriateness and effectiveness of “whistleblowing” procedures;
• and made recommendations on the appointment and remuneration of the external auditors and monitored the performance of the auditors; and
• the non-audit services provided to the Group by the external auditors and monitored the independence of the auditors.

Both the Board and the external auditors have safeguards in place to prevent the auditors’ independence and objectivity being compromised. The Audit Committee maintains a comprehensive policy to regulate the use of auditors for non-audit services. This policy sets out the nature of work the external auditors may not undertake. For those services that are deemed appropriate for the auditors to carry out, the policy sets out the approval process that must be followed for each type of assignment which, above defined limits, requires that potential instructions in respect of defined non-audit services be subject to a competitive tendering process. Each year the Audit Committee establishes a limit on the fees that can be paid to the external auditors in respect of non-audit services and monitors quarterly the amounts paid to the auditors in this regard. For the purposes of this monitoring, the ICAEW classifications have been adopted in this year’s accounts on page 91. The external auditors also report regularly to the Committee on the actions that they have taken to comply with professional and regulatory requirements and current best practice in order to maintain their independence. This includes the rotation of key members of the audit team.

Since its formation in 2001, the Company has stated that an audit tender process would be undertaken every five years, commencing in 2005. This policy was adopted because the Board believed, and continues to believe, that the interests of shareholders are best served by reselecting auditors by means of a tender process undertaken at intervals of around five years, giving an opportunity for objective reassessment of the incumbent auditors as well as alternative audit firms.

However, following the appointment of Mark Tucker as Group Finance Director in October 2004, the Committee believes that it would, in fact, be more appropriate for any tender process to take place after the new Group Finance Director has had the opportunity to observe and experience the present auditor relationship at work over a complete annual cycle, rather than in 2005, immediately after his appointment.

The Audit Committee has therefore decided to defer the tender until 2006, with any change to be effective for the 2007 audit; but also to continue with the annual in-depth reviews of the external auditors’ performance in all years where there is no tender. These in-depth reviews are themselves in excess of the best practice recommendations of the Code and The Smith Guidance appended to the Code.

Nomination Committee
Sir Ron Garrick (Chairman)
Dennis Stevenson
James Crosby
Brian Ivory
Coline McConville
Sir Bob Reid (retired 27 April 2004)
Philip Yea (resigned 30 June 2004)

The Company Secretary acts as Secretary to the Committee.

The Committee has met on three occasions during the past twelve months with all members present, except for apologies from Dennis Stevenson and Brian Ivory on one occasion each. The Committee leads the process for making appointments to the Board; ensures that there is a formal, rigorous and transparent procedure for the appointment of new Directors to the Board; reviews the composition of the Board through a full evaluation of the skills, knowledge and experience of Directors; and ensures plans are in place for orderly succession for appointments to the Board, and to other senior executive management positions. Responsibility for making senior executive appointments (below Board level) is, however, vested in the Chief Executive. With assistance from external search and recruitment consultants, the Committee considers and lists potential candidates for appointment as Non-executive Directors of the Company, and ensures that list is updated and refreshed.

During 2004, the Committee instructed external search consultants to provide advice and support in relation to the appointment of appropriate Non-executive Directors, to fill the vacancies created on the retirements of Sir Bob Reid and Louis Sherwood. Detailed role specifications were drawn up, informed by the Chairman’s and the Committee’s assessment of the mix of skills, knowledge and experience of the continuing Directors, and the requirements of the Board. Interviews were conducted with a range of potential candidates, by the external search consultants, members of the Committee, and other Directors. As a result of this process, the Committee recommended to the Board, and the Board agreed, that Kate Nealon and David Shearer be appointed to the Board as Non-executive Directors with effect from March 2004. The anticipated time commitments for their roles have been discussed and agreed with Kate and David, and both have confirmed that they can and will make sufficient time available to carry out their responsibilities.

5. Relations with Shareholders
The Company directs its communications with shareholders through two principal channels. Firstly, the Investor Relations team has effective day-to-day primary responsibility for managing communications with institutional shareholders through a combination of briefings to analysts and institutional shareholders, both at the interim and year end results; site visits; and individual discussions with Board Members and key members of the management team. Briefings on topics of specific interest have also been arranged, for example, an IID seminar in April 2004, and a briefing in respect of the implications for the Company of the adoption of IFRS, carried out in December 2004. Regular dialogue with shareholders helps to ensure that the Company’s strategy is understood and that any issues are addressed in a constructive way.

There is also an Annual Audit of Investor Opinion, undertaken on behalf of the Board, which takes the form of structured interviews with individual investors through an independent external adviser. The 2004 report gathered opinion on strategy, operational performance, corporate governance and management capability from investors in the UK, Europe and North America. The non-attributable opinions, which were subsequently reported to the Board, give the Board direct access to investor feedback. The Annual Audit complements monthly reports to the Board in relation to market and investor sentiment and opinion.

The Company Secretary, primarily through the Shareholder Services team, oversees communications with private shareholders. Each year shareholders receive the Annual Review and Summary Financial Statement or, at their choice, the Annual Report and Accounts. The Company’s Annual General Meeting takes place at different UK locations each year, to give more shareholders the opportunity to attend, hear about and question the Group’s performance and the Directors’ stewardship of their Company. The Chairmen of the Audit, Remuneration and Nomination Committees attend the meeting, along with other Directors, and are available to answer shareholders’ questions on the activities of their own Committees.

During the year shareholders can receive up-to-date information through the Company’s website, www.HBOSplc.com. This provides share price information, financial results, copies of presentations to analysts and answers to frequently asked questions. A telephone helpline is available on 0870 702 0102 providing a contact point for shareholders on issues such as dividends and announcements.