Consultation on “shorter and sharper” UK Corporate Governance Code

The Financial Reporting Council (FRC) published proposed revisions to the UK Corporate Governance Code (Code) on December 5, 2017. In reducing the Code from 32 to 13 pages, the FRC describes it as “shorter and sharper”, comprising 17 Principles and 41 Provisions. Some supporting principles from the current 2016 Code have been removed or incorporated into the new Principles or Provisions and others have been moved to the FRC’s proposed revised Guidance on Board Effectiveness (Guidance) or deleted.  It is anticipated that the new Code will apply to accounting periods beginning on or after January 1, 2019.

This briefing looks at the key revisions to both the Code and Guidance, as well as at the FRC’s initial consultation on the future direction of the UK Stewardship Code.

In conducting its review of the current Code, the FRC considered, among other things, the balance between the Principles and Provisions and the results of its 2016 report on “Corporate culture and the role of boards”. Many of that report’s findings have been included in the revised Code. The FRC was also mindful of the Government’s plans to require companies to explain in their annual report how their directors comply with their duties under section 172 Companies Act 2016 (section 172), as well as certain recommendations in the Government’s August 2017 response to its Green Paper on corporate governance reform, and issues raised in the April 2017 report on corporate governance published by the House of Commons Business, Energy and Industrial Strategy Committee.

As a result, the revised Code comprises five sections, with no schedules and Section E in the current Code (Relations with shareholders) has been integrated within the revised Code as the FRC considers shareholder engagement to be a key aspect of good governance.

The Introduction stresses the importance of culture and dialogue with a wide range of stakeholders in promoting the success of companies in the long-term, as well as the importance of applying the Code’s Principles since they emphasise the value of good corporate governance to long-term success.

The revised Code retains the “comply or explain” approach, but provides more guidance on discussions about how its Provisions have been applied – action taken and resulting outcomes should be described, and signposting and cross–references to those parts of the annual report that describe how the Principles have been applied is encouraged to help investors with their evaluation.

It is also made clear in the Introduction that the corporate governance statement should relate coherently to other parts of the annual report, particularly the strategic report and other complementary information, so that shareholders can effectively assess the quality of the company’s governance arrangements and the board’s activities and contributions.

Section 1 comprises four Principles and eight Provisions and it emphasises the need for boards to consider the culture of their company and wider stakeholder interests in achieving long-term sustainability, as well as the importance of shareholder engagement.

• Principle A states that one of the functions of a successful company is to contribute to a wider society.
• Principle C requires boards to conduct effective engagement with, and encourage participation from, shareholders and stakeholders in line with one of the Government’s recommendations to the FRC in its Green Paper response.
• Principle D requires the board to ensure that whistleblowing arrangements are in place where members of the workforce are concerned that conduct inconsistent with the company’s values and responsibilities has taken place. Noticeably this is not limited to concerns about improprieties in financial reporting as in the current Code, so the workforce should be able to raise wider concerns.
• Provision 3 reflects another of the Government’s recommendations to the FRC in its Green Paper response, since it requires boards to establish a method for gathering the workforce’s views – the Provision suggests three different approaches: This could normally be done by a director appointed from the workforce, by a formal workforce advisory council or by a designated non-executive director. In referring to the “workforce”, the FRC notes that it is encouraging companies to consider how their actions impact on all, not just employees, so this could include, for example, agency workers and self-employed contractors.
• Provision 4 refers to section 172 in that it requires 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 in section 172 have influenced the board’s decision-making. The FRC notes that it is keeping the exact wording of this Provision under review, pending the outcome of the Government’s legislation in this area and any subsequent changes to the FRC’s Guidance on the Strategic Report.
• Provision 6 sets out more detail of the expectations on companies where they have received a vote of more than 20 per cent against a resolution. As well as having to continue to explain, when announcing voting results, the actions the company plans to take to consult shareholders so as to understand the reasons behind the result, no later than six months after the vote companies will now be required to publish an update before the full summary is provided in their next annual report. The FRC notes that this is aimed at ensuring the company fully understands the reasons for the vote and enters into dialogue with shareholders to further discuss the relevant matters. The FRC will also add a footnote to the revised Code to highlight that these interim updates will be available to view on the public register the Investment Association will shortly be launching.

Section 2 comprises four Principles and eight Provisions. It considers the separation of duties within the board and the role of the non-executive directors, as well as defining the independence of non-executive directors.

• Principle E sets out the role of the chair and it requires the chair to demonstrate independent and objective judgement.
• Principle H requires the board to ensure it has the policies, processes, information, time and resources it needs to function effectively and efficiently.
• Provision 10 clarifies the role of the chief executive in proposing and delivering the agreed strategy, and also ensuring that the board receives timely and balanced information so that it can make decisions effectively.
• Provision 11 requires independent non-executive directors, including the chair, to constitute a majority of the board and there is no longer an exemption for companies outside the FTSE 350. The FRC comments that it proposes removing all exemptions in the current Code for companies below the FTSE 350 since it believes that even smaller companies should strive for the higher standards of corporate governance. However, it accepts that recommending an independent board evaluation every three years for such companies could be too burdensome so it specifically requests views on this point.
• While the criteria for determining whether or not a non-executive director is independent have not changed, Provision 15 has strengthened the independence requirements since it states that where a non-executive director or chair does not meet the stated criteria, they should not be considered independent. However, the FRC notes that companies still retain the option of explaining why they consider an individual to be independent.

This section comprises three Principles and seven Provisions and it takes account of the Hampton-Alexander Review and Parker Review reports on diversity to ensure that the revised Code challenges directors to consider the composition of both the board and the management pipeline:

• Principle J states that appointments and succession planning should promote not just gender diversity, but also social and ethnic diversity, cognitive and personal strengths.
• Provision 17 places responsibility on the nomination committee to oversee the development of a diverse pipeline for succession.
• Provision 23, which sets out the areas the nomination committee should report on in the annual report, includes reporting on actions taken to oversee the development of a diverse pipeline and an explanation of how diversity supports the company in meeting its strategic objectives. In addition, as recommended by the Hampton-Alexander Review, Provision 23 requires companies to disclose in the annual report the gender balance of those in the senior management and their direct reports, “senior management” being defined as the company’s executive committee or the first layer of management below board level, including the company secretary. The FRC notes that, as currently drafted, Provision 23 does not ask for data on levels of diversity other than for gender, and it asks for views as to whether the Code should also encourage companies to provide data on levels of ethnic diversity in their pipelines.

This Section comprises three Principles and eight Provisions and largely replicates the requirements in Section C of the current 2016 Code. The FRC notes that while a number of the requirements duplicate those in the Listing Rules, Disclosure Guidance and Transparency Rules and the Companies Act 2006, it believes retaining rather than deleting those requirements is a better course of action, but it seeks views on this. In addition, Provision 24 requires all companies to have an audit committee of at least three independent non-executive directors, even companies outside the FTSE 350.

This section comprises three Principles and 10 Provisions. It reflects not only the findings of the FRC’s Culture Report, notably the important role that incentives and rewards play in driving behaviours that support the desired culture, but also a number of matters concerning remuneration that the Government, in its Green Paper response, invited the FRC to consider. The FRC notes that the Government is planning to introduce secondary legislation on pay ratios and for clearer reporting on the range of remuneration outcomes from complex, share-based incentive schemes. It states that it will keep abreast of these changes and may make consequential changes to Section 5 of the Code, pending the outcome of that legislation.

• Principle O requires the board to be satisfied that the company’s remuneration and workforce policies and practices promote its long-term success and are aligned with its strategy and values.
• Principle Q emphasises the board’s role in exercising independent judgement and discretion when approving remuneration outcomes.
• Provision 32 requires all remuneration committees, including those below the FTSE 350, to be made up of at least three independent non-executive directors and it requires remuneration chairs to have served for at least 12 months on any remuneration committee before taking on this role, as suggested by the Government in its Green Paper response.
• Provision 33 proposes that the remuneration committee should have an expanded remit, taking on responsibility for oversight of company remuneration and wider workforce policies.
• Provision 36 extends the minimum vesting and post-vesting holding period for executive share awards from 3-5 years, although the Provision notes that longer periods, including post-employment periods, may be appropriate. This accords with the views of institutional investors on vesting and holding periods.
• Provision 37 requires remuneration schemes and policies to enable boards to override remuneration outcomes.
• Provision 40 sets out a range of matters the remuneration committee should address when determining executive director remuneration policy and practices. This section is supported by information in the revised Guidance on the role of the remuneration committee and its new responsibility for wider workforce pay and policies.
• Provision 41 sets out some of the matters that should be included in the description of the work of the remuneration committee in the annual report. This includes describing what engagement has taken place with shareholders and the impact this has had on remuneration policy and outcomes, as well as an explanation of the engagement with the workforce to explain how executive remuneration aligns with wider company policy.

The Guidance was last published in 2011 and the FRC has now amended it to support its proposed changes to the revised Code.  The structure of the Guidance follows the structure of the revised Code, with some elements of the current Code having been moved to the Guidance.  The FRC points out that this does not mean that those elements are no longer important, but that the practices are well embedded in company behaviour, and it states that the aim of the revised Code is to encourage companies to go further.

The Guidance includes questions for boards and questions for boards to raise with management which boards can use to consider how they report on their application of the Code’s Principles.

The FRC notes that further changes and refinements will be needed to the Guidance once the consultation on the revised Code is completed.

The UK Stewardship Code was last reviewed in 2012 and since it sets a framework for responsible engaged investors to work alongside company executives to achieve the long-term success of companies, the FRC is taking the opportunity, as part of the consultation on the revised Code, to ask some high-level questions about the future direction of the Stewardship Code. It plans to consult on specific changes to that in 2018.

It raises questions on both the format and content of the Stewardship Code, including the following:

Format

• Should the Stewardship Code should be more explicit about the expectations of those investing directly or indirectly and those advising them, and would separate codes or enhanced separate guidance for different categories of the investment chain help drive best practice?
• Should the Stewardship Code focus on best practice expectations using a more traditional “comply or explain” format and how could best practice be determined? In addition, how should the measures introduced in the 2017 amended Shareholder Rights Directive best be transposed and are there alternative ways in which the FRC could highlight best practice reporting other than the tiering exercise that it undertook in 2016?

Content

• Are there elements of the revised Code that should be mirrored in the Stewardship Code?
• How can an investor’s role in building a company’s long-term success be further encouraged through the Stewardship Code and would it be appropriate to incorporate “wider stakeholders” into the areas of suggested focus for monitoring an engagement by investors?
• How could the Stewardship Code encourage reporting on the way in which stewardship activities have been carried out and are there ways in which the FRC or others could encourage this reporting, even if the encouragement falls outside of the Stewardship Code?
• How could the Stewardship Code take account of some investors’ wider view of responsible investment?
• Are there elements of international stewardship codes that should be included in the Stewardship Code?
• Should board and executive pipeline diversity be included as an explicit expectation of investor engagement?
• Should the Stewardship Code explicitly request that investors give consideration to company performance and reporting on adapting to climate change?

The FRC has asked for questions on the consultation document by February 28, 2018. The FRC aims to publish the final version of the revised Code by early summer 2018, to apply to accounting periods beginning on or after January 1, 2019.

A detailed consultation on specific changes to the UK Stewardship Code will be published in mid-2018, once the review of the Code has been finalised.

The revised Code has been welcomed by investor bodies and other interested organisations as a step in the right direction, given its emphasis on the importance of corporate culture and diversity, the need for companies to engage with all their stakeholders, including their workforce, and the requirements for executive remuneration and workforce policies to be aligned with the company’s strategy and value. In its shorter and sharper format, the revised Code will require boards to think more holistically about how they apply its Principles and it should force companies to move further away from undertaking a box-ticking exercise when reviewing their compliance with the Code.

Smaller companies below the FTSE 350 may find removal of the exemptions in the current Code tricky to deal with initially but, given the proposed implementation date of the revised Code, those companies should have time to put in place arrangements to ensure that they can meet the new requirements when they are implemented.

Companies will have to consider in good time how they propose to gather the views of their workforce. The revised Code sets out the three options proposed in the Government’s response to its Green Paper but the revised Guidance makes it clear that these are not the only possible methods and that boards should be open to innovative alternatives if they believe these would be as or more effective. The Guidance comments that provided the method chosen delivers meaningful, regular two-way dialogue and a means of listening to the workforce, then the Code requirement will be met.

The proposals generally require greater disclosure by boards around decisions they are required to take. This includes more information in the annual report about the remuneration committee’s activities and its decision making-process, as well as explanations of how the board has engaged with its workforce and other stakeholders and how their interests and the matters in section 172 have influenced the board’s decision-making.  Boards need to start thinking about how they record that engagement and influence throughout the year to enable them to meet the new requirements.