Following on from the Department of Business, Energy and Industrial Strategy's response to its November 2016 Green Paper on corporate governance reform, the Financial Reporting Council (FRC) has published proposed revisions to the UK Corporate Governance Code (Code) stating an intention to 'simplify and shorten it and set it on its course for the next 25 years'.
Consultation and implementation timetable
The FRC has requested responses to its proposals by 28 February 2018 and aims to publish a final version of the Code by early summer 2018 intending that it applies to accounting periods beginning on or after 1 January 2019.
The FRC has also published revised Guidance on Board Effectiveness (Guidance) (which will be revisited once responses to the consultation on changes to the Code have been considered) and has started an initial high-level consultation on the future direction of the UK Stewardship Code, with an aim to formally consult on changes to that code in 2018.
The FRC's proposed revisions have focused on a number of specific areas, including:
Creating a Code for the future
The Code is now 25 years old. To ensure that it remains fit for purpose for the next 25 years, the FRC proposes simplifying and shortening it. In particular, the FRC has considered the appropriate balance between Principles, Provisions and guidance whilst preserving the Code's current strengths, including the 'comply or explain' approach. There is a particular refocus on the application of Principles to address an over-emphasis in reporting on compliance with Provisions under the current Code. It is proposed that Supporting Principles be removed (some being 'upgraded' to Principles, other becoming Provisions or being moved into associated guidance).
The proposed Code will be divided into 5 sections:
1.Leadership and purpose
2.Division of responsibilities
3.Composition, succession and evaluation
4.Audit, risk and internal control
The FRC's work on culture and, in particular, its publication 'Corporate Culture and the Role of Boards – Report of Observations' (July 2016) revealed that a healthy corporate culture, which derives from a clear understanding of the company's purpose and strategy, can enhance confidence and trust in the business and as such it is a vital ingredient in delivering long-term sustainable performance. The proposed revisions to the Code include many of the findings from that report, including the need to demonstrate openness and accountability throughout the entire organisation and the fact that the company's values should be evident in the manner in which it conducts its business and engages with stakeholders.
The revised Code includes references to the board's responsibility for considering the need and views of a wide range of stakeholders. This was a key issue highlighted by the FRC's findings in its report on culture. The new stakeholder focus also complements the government's proposed reforms to ensure greater transparency around reporting how directors have discharged their duty under section 172 of the Companies Act 2006 (2006 Act) by the insertion of a provision requiring the board to explain in the annual report how it has engaged with the workforce and other stakeholders, and how their interests and the matters set out in section 172 influenced the board's decision-making.
The revised Code also specifically addresses the government's request as set out in its response to the Green Paper that the FRC develops a new Principle to improve board level engagement with employees and other stakeholders and a new Provision requiring listed companies to adopt, on a 'comply or explain' basis, a method for gathering employee views which it is envisaged would normally be through a director appointed from the workforce, a formal workforce advisory panel or a designated non-executive director. The FRC specifically applies its proposals to the 'workforce' more generally to ensure a wider reach than just those with formal contracts of employment.
Succession and evaluation
The revised Code takes account of the recommendations of the recent diversity reviews, particularly The Hampton-Alexander Review (on gender balance in FTSE leadership) and The Parker Review (on ethnic diversity on UK boards). It aims to ensure that appointment and succession planning practices are designed to promote diversity of gender, social and ethnic backgrounds. Proposals also encourage the building of diversity across the workforce, particularly in the executive pipeline with oversight from the nomination committee and enhanced reporting from that committee on actions taken.
The FRC also proposes that listed companies should disclose in their Annual Reports the gender balance of those in senior management (i.e. in the first layer of management below the board) and their direct reports. This proposal aims to bring an end to inconsistent disclosure caused by the various interpretations of the term 'senior manager' as used in section 414C(8)(c)(ii) of 2006 Act as well as implementing one of the recommendations flowing from The Hampton-Alexander Review (although notably the FRC is seeking to apply it more widely and therefore beyond the FTSE 350).
The revised Code gives greater focus to the importance of non-executive director independence with proposals to strengthen the independence provisions which are consistently rated as the lowest in terms of compliance. Specifically, a proposed change of emphasis means that a non-executive director will not be considered to be independent where the director does not meet the 'independence' criteria (although companies will still have the option to 'explain' non-compliance). Currently, those criteria need only be taken into account when considering whether the non-executive director is independent. The revised Code also proposes clarifying the role of the chairman as an independent director at all times (not just on appointment), and allowing the chair to be counted for the purpose of meeting committee composition recommendations.
The FRC also proposes the removal of current exemptions in the Code for listed companies outside the FTSE 350. The proposal covers not only those exemptions that relate to independent director representation on boards and committees, but also those that relate to external board evaluation and annual director re-election.
The revised Code also seeks to clarify the role of the chief executive in proposing and delivering strategy and reinforces the link between strategy and culture.
The revised Code notes the importance of role of incentives and reward in driving behaviours that support a healthy corporate culture and, ultimately, long-term success. Incentives and workforce policies should be aligned with purpose, strategy and values.
The revised Code specifically addresses the government's requests as set out in response to the Green Paper that:
- the remuneration committee be given greater responsibility for demonstrating how pay and incentives align across the company and to explain to the workforce each year how decisions on executive pay reflect wider pay policy. The Code proposes an expanded remit for the remuneration committee to engage with employees and oversee pay and incentives across the wider workforce, together with an enhanced annual reporting requirement on engagement undertaken and the impact of such interaction. It is hoped that this will encourage greater focus on the strategic rationale for executive pay levels in a broader context;
- the recommended minimum vesting and post-vesting holding period for executive share awards be extended from three to five years to encourage a focus on longer-term outcomes in setting pay. This also mirrors developing market practice; and
- the chair of remuneration committees should have served for at least 12 months on any remuneration committee before becoming chair.
Significant votes against
To improve transparency, the revised Code proposes that a company should explain, when announcing voting results, what actions it intends to take to understand the reasons behind any vote of more than 20 per cent. against a resolution. The threshold is aligned with that which will also trigger inclusion on the Investment Association's public register of shareholder dissent. The Code also proposes an interim action that no later than six months after the vote, companies should publish an update on actions taken before a final summary is provided in the next Annual Report or in the explanatory notes to the resolutions at the next AGM. These proposals implement the government's request that the FRC addresses concerns that some companies are not responding adequately when they encounter significant shareholder opposition, particularly to levels of executive pay.
BEIS Select Committee Proposals
The FRC notes that its review of the Code also took account of issues raised by the BEIS House of Commons Select Committee in its April 2017 report on corporate governance. That report made a series of recommendations to help embed the behaviours of good governance. While there were areas of overlap with the government's own proposals for reform, there were a number of additional recommendations for the FRC's consideration. These included a recommendation that the FRC establishes a corporate governance ratings system under which companies would be required to disclose their ranking. This was a proposal about which the government expressed reservations and the FRC has not taken it forward as part of its consultation. Neither has the FRC taken up the recommendation that the Code should require a binding vote on executive pay if there is a significant minority of opposition to pay awards in the previous year. The government had already indicated that it does not intend to legislate to introduce a binding vote.
Guidance on Board Effectiveness and UK Stewardship Code
The consultation also covers revised Guidance on Board Effectiveness. The guidance proposes changes to support the new, streamlined Code and to stimulate board's thinking around how the directors can carry out their roles more effectively. The guidance proposes more information about how the views of a wider range of stakeholders might be heard in the boardroom, complementing the proposed legislative reform of section 172 and the FRC's own proposals for revision of the FRC Strategic Report Guidance. The guidance also incorporates a number of the Supporting Principles that FRC intends to remove from the Code.
Given the importance of the role of investors in shaping good governance, the FRC's paper also includes an initial high-level consultation on the future direction of the UK Stewardship Code. The FRC intends to consult formally on that Code during the course of 2018.
This post comes to us from Addleshaw Goddard LLP, and has been authored by Will Chalk and Richard Preston.