The new shorter and sharper 2018 UK Corporate Governance Code

The Financial Reporting Council (FRC) published its new 2018 UK Corporate Governance Code (2018 Code) on July 16, 2018, together with revised Guidance on Board Effectiveness (Guidance) which supplements the 2018 Code by suggesting good practice to assist companies in applying the 2018 Code's Principles and reporting on that application.

The 2018 Code has been designed to set higher standards of corporate governance in the UK so as to promote transparency and integrity in business and, at the same time, attract investment in the UK in the long-term, benefitting the economy and wider society. As a result, the definition of governance has been broadened in the 2018 Code. It emphasises the importance of positive relationships between companies, shareholders and stakeholders, a clear purpose and strategy aligned with healthy corporate culture, high quality board composition and a focus on diversity, and remuneration which is proportionate and supports long-term success.

In light of feedback received during the consultation process on the 2018 Code, the FRC has revised some of the Principles and Provisions in it and the 2018 Code will apply to accounting periods beginning on or after January 1, 2019. This briefing considers both the 2018 Code and the Guidance, and the steps that companies now need to start taking prior to its implementation.

Introduction to the 2018 Code

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 Principles in the 2018 Code since they emphasise the value of good corporate governance to long-term sustainable success.

The 2018 Code retains the "comply or explain" approach but provides guidance on discussions about how the Principles have been applied – action taken and resulting outcomes should be articulated, and signposting and cross-references to those parts of the annual report that describe how the Principles have been applied will help investors evaluate the company's practices.

While the Introduction states that corporate governance reporting should relate coherently to other parts of the annual report, particularly the strategic report which will include information enabling shareholders to assess how the directors have performed their duty under section 172 Companies Act 2006 (CA 2006), it makes it clear that nothing in the 2018 Code overrides or is intended as an interpretation of the statutory statement of directors’ duties in the CA 2006.

The Introduction also includes a new requirement on the boards of parent companies with a premium listing, whether incorporated in the UK or elsewhere. They should ensure that there is adequate co-operation within the group to enable the parent company board to discharge its governance responsibilities under the 2018 Code effectively, and this includes communicating the parent company's purpose, values and strategies.

Section 1 – Leadership and purpose

Section 1 comprises five Principles and eight Provisions and it emphasises the need for boards to determine and promote the culture of their company and to engage with shareholders and their wider stakeholders.

In terms of changes to the consultation draft, the following should be noted

• Principle E now requires boards to ensure that workforce policies and practices are consistent with the company's values and support its long-term sustainable success, and that the workforce can raise any matters of concern that they may have. In the December 2017 consultation on the new draft Code (the 2017 Draft Code), the FRC had suggested that this overarching responsibility should rest with the remuneration committee.
• Provision 2 requires the board to assess and monitor the company's culture and if it has concerns, it should seek assurance that management has taken corrective action. The board's activities and action taken should be explained in the annual report, together with an explanation of the company's approach to investing in and rewarding its workforce. This latter point was, in the 2017 Draft Code, a responsibility of the remuneration committee but has been moved to Provision 2 since the FRC considers it a responsibility of the board as a whole, as part of its monitoring of the company’s culture.
• Provision 4 continues to require a company to explain when 20 per cent or more votes are cast against a resolution recommended by the board, as well as provide an update on shareholders’ views and actions taken no more than six months after the shareholder meeting. Some had argued, in their response to the consultation, that six months was too long, while others thought there could be little to report at that point. However, the FRC states that the purpose of the report is to ensure that companies demonstrate that dialogue is ongoing and note any actions and outcomes, even where these are ongoing.
• Provision 5 clarifies that the board should explain how the interests of stakeholders have influenced the board and it requires the board, in the annual report, to describe how the interests of other key stakeholders and the matters in section 172 CA 2006 have been considered in board discussions and decision-making. The FRC notes that this requirement supports the new reporting requirements in the draft Companies (Miscellaneous Reporting) Regulations 2018 published recently, and Provision 5 requires boards to keep engagement mechanisms under review so that they remain effective.
  
  Provision 5 also sets out methods for engagement with the workforce. In light of feedback that the 2017 Draft Code was too restrictive in this area, the FRC has introduced flexibility by permitting one or more of a combination of the following methods to be used
  
  
  • A director appointed from the workforce.
  • A formal workforce advisory panel.
  • A designated non-executive director.
  In addition it states that if the board has not chosen one or more of these methods, it must explain the alternative arrangements it has in place and why these are effective. The FRC notes in the Feedback Statement on the 2017 Draft Code that these methods should be kept under review to make sure they remain effective although this is not explicitly stated in the 2018 Code as it is in relation to engagement mechanisms with other key stakeholders.
  
  The Provision is not limited to the UK workforce as some had suggested and the Guidance describes "workforce" in this context, making it clear that it is not meant to align with legal definitions of workforce, employee, worker or similar. It states that communications and engagement will involve those with formal contracts of employment and other members of the workforce affected by board decisions, so could include individuals engaged under contracts of service, agency workers and remote workers, regardless of their geographical location. Companies should be able to explain who they have included and why.

Section 2 – Division of responsibilities

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, and it provides guidance on determining the independence of directors. Changes from the 2017 Draft Code include the following

• Principle F, which sets out the role of the chair, requires the chair to demonstrate objective judgement throughout his/her tenure and an added responsibility for the chair is to ensure that directors receive accurate, timely and clear information.
• Principle H requires non-executive directors to have sufficient time to meet their board responsibilities.
• Provision 9 reflects feedback on whether the chair should be considered independent throughout their tenure, rather than "on appointment". The FRC states that it recognises the "special" role of the chair, their close involvement with the company and close relationship with the executives throughout their tenure, and as a result, has reverted in Provision 9 to the approach in the 2016 version of the UK Corporate Governance Code (2016 Code) for the chair to be "independent on appointment" rather than throughout their tenure, as was suggested in the 2017 Draft Code. Further requirements in relation to the chair’s tenure are set out in Provision 19 in Section 3 (see further below).
• Provision 10, which is concerned with the determination of the independence of the non-executive directors, has been amended in light of feedback in the consultation process. In the 2017 Draft Code, it had been proposed that the chair should be included in the Provision and that the current discretion permitting the board to determine a non-executive director (or the chair) to be independent, notwithstanding the list of independence criteria, be removed, with non-executive directors (and the chair) not being considered independent if any of the criteria apply to them. A number of concerns about this change of approach were raised with the FRC, and as a result, Provision 10 relates only to non-executive directors and not the chair and it sets out a list of criteria against which independence is to be determined. However, the board retains the discretion to consider a non-executive director to be independent, even if any of those or other relevant circumstances apply, provided that a clear explanation is given. In determining whether a non-executive director has been on the board for more than nine years (a factor that might impair independence), it is made clear that this should be calculated from their date of appointment, not election.
• The FRC had proposed in Provision 11 that the 2018 Code should require independent non-executive directors, including the chair, to constitute the majority of the board. However, feedback suggested this could add to the costs for smaller companies as they might have had to appoint additional non-executive directors. As a result, Provision 11 includes the 2016 Code wording requiring “at least half” (excluding the chair), rather than “the majority” of the board to be independent non-executive directors.
• Provision 15 has been amended to take into account concerns regarding over-boarding, whereby non-executive directors hold multiple directorships. The FRC wants both boards and directors to think carefully about the commitments they make when taking on new appointments. As a result, Provision 15 requires boards, on making new appointments, to take into account other demands on directors' time, and it also now requires prior board approval before a director takes on any additional external appointment. The reasons for permitting significant appointments should, in addition, be explained in the annual report.

Section 3 – Composition, succession and evaluation

Section 3 comprises three Principles and seven Provisions, with new emphasis on diversity in the 2018 Code. The FRC had asked for views on encouraging companies to report on levels of ethnicity in their executive pipelines. In light of feedback, the FRC has not added a new reporting requirement to the 2018 Code in relation to this but the Guidance encourages companies to think about providing more information about different aspects of diversity in their workforce, other than gender.

Other points to note in relation to Section 3 include the following

• As well as requiring boards and their committees to have a combination of skills, experience and knowledge, Principle K now requires consideration of the length of service of the board as a whole, so as to link with the requirement in Principle L to consider each director’s contribution as part of the board evaluation.
• Provision 19 is a new Provision concerning the chair’s tenure. It states that the chair should not remain in office for more than nine years from their first appointment to the board, and where a non-executive director is appointed as chair, time served in that capacity will count towards the nine year period. Provision 19 does permit a limited extension if the chair was previously a board member, the appointment supports the company’s succession plan and its diversity policy, and a clear explanation is provided. However, the FRC does state in the feedback statement that it would not, in normal circumstances, expect either an independent non-executive director or chair to be on a board for more than nine years in total, including in those circumstances where an independent non-executive goes on to be the chair.
• Provision 21 includes requirements in relation to external board evaluations. Wording has been added to encourage all chairs, including those of smaller companies, to consider using externally facilitated board evaluations (and, as now FTSE 350 companies should have one at least every three years), but it is still not an absolute requirement for smaller companies (those below the FTSE 350) to have an external board evaluation.
• Provision 23 sets out some of the matters to be reported on by the nomination committee. If the company has undertaken an external board evaluation, the nomination committee will in future have to report on “the nature and extent of an external evaluator’s contact with the board and individual directors” to address the concern that contact may be limited to questionnaires and not interviews with directors or attendance at board meetings.
• The requirement in Provision 23 for the nomination committee to report on diversity matters now more closely mirrors the diversity reporting requirements in the FCA’s Disclosure Guidance and Transparency Rules (DTRs), and the gender balance of those in the company’s senior management and their direct reports should also be included in the nomination committee’s report. The FRC defines “senior managers” as the executive committee or first layer of management below board level, including the company secretary. It notes in the Feedback Statement that, given the requirement in the CA 2006 for quoted companies to include the gender breakdown of senior managers in their strategic report, there could be duplication of information in annual reports, but the FRC encourages companies to think about how they can avoid duplication, possibly using signposting or aligning definitions.

Section 4 – Audit, risk and internal control

This section comprises three Principles and eight Provisions and largely replicates the requirements in Section C of the 2016 Code. The section duplicates requirements in the Listing Rules, the DTRs and the CA 2006 but a majority of respondents to the consultation confirmed that this is the right approach and the FRC has reintroduced some elements missing from the 2016 Code. As a result, there are some additional references to risk and emerging risks in the 2018 Code and the Guidance discusses risk in some detail.

The FRC has also reverted to the membership of the audit committee comprising two independent non-executive directors in the case of smaller companies, rather than its original proposal that it should comprise three independent non-executive directors in all companies, regardless of their size. However, the board chair of a smaller company can no longer be a member of the audit committee.

Section 5 – Remuneration

This section comprises three Principles and 10 Provisions. These cover both the remit of the remuneration committee and the structure of remuneration schemes. The FRC believes that the 2018 Code should be non-prescriptive on the structure of remuneration schemes and should avoid encouraging companies, explicitly or through implication, to adopt one form of scheme over another. As a result, it has removed language which could be perceived to encourage long-term incentive plans.

Key points to note are as follows

• Principle P now focuses on the need to link strategy, long-term sustainable success and executive remuneration, with the board’s responsibilities for workforce policies and practices now included in Principle E in Section 1 of the 2018 Code rather than in Principle P.
• Principle R has been amended to make it clear that it is the responsibility of the remuneration committee rather than the board for exercising discretion over remuneration outcomes. Provision 37 has been amended in a similar manner and the FRC states in its Feedback Statement that it expects remuneration committees to consider annually, as a normal part of the process to determine remuneration outcomes, whether there are circumstances which warrant the exercise of discretion.
• As with the membership of the audit committee, Provision 32 has reverted to the formulation in the 2016 Code so that remuneration committees of smaller companies can have a minimum of two, rather than three, members. In addition, the board chair can only be a member of the remuneration committee if they were independent on appointment, and the remuneration committee chair should have served on a remuneration committee for at least 12 months before being appointed.
• Provision 33 clarifies that the remuneration committee only has responsibility for reviewing workforce remuneration and related policies, rather than having oversight of these matters as the FRC originally proposed in the 2017 Draft Code. The Guidance makes it clear that the remuneration committee’s view is limited to workforce remuneration and related policies in respect of persons engaged under an employment contract, or a contract or other arrangement to do work or provide services personally, i.e. to the sections of the workforce whose pay and conditions are under the company’s control.
• Provision 36 states that total vesting and holding periods of five years or more (increased from three years in the 2016 Code) should apply to share awards granted to executives, and remuneration committees should have a formal policy in place relating to post-employment shareholding requirements covering both unvested and vested shares.
• Provision 38 makes it clear that executive pension contributions should be in line with those available to the rest of the workforce.
• Provision 40, which sets out factors to be addressed in determining executive director remuneration policy and practices, now includes risk as a factor to be addressed in scheme design and it asks remuneration committees to think about limits and discretions when addressing predictability.
• Provision 41, which sets out what remuneration committees should report on in the annual report, specifies that they should describe how they have addressed the factors in Provision 40. In addition, Provision 41 has been amended to require disclosure of the reasons for applying discretion to remuneration outcomes, and the FRC states in its Feedback Statement that it would expect this to include disclosure of anything that prevents its use where outcomes would otherwise have been adjusted.

In its Feedback Statement, the FRC summarises the key changes that have been made to the Guidance in light of responses received. These include the following

• The language has been changed so that its tone is less prescriptive.
• Changes have been made to the introduction to emphasise the importance of the Guidance in promoting high standards and to encourage its use alongside the 2018 Code.
• The FRC has made it clear that it intends to update the Guidance more frequently as practice develops.
• It has changed Section 1 of the Guidance to adjust its focus and embed the themes that it focuses on more effectively.
• A new section on externally facilitated board evaluations has been included in Section 3 of the Guidance.

When the FRC consulted on the 2017 Draft Code, the FRC also included some initial questions about the future of the UK Stewardship Code. The FRC’s feedback statement summarises responses to the questions raised. The feedback to those questions will inform the development of a revised Stewardship Code that the FRC will put out for public consultation later this year.

• As noted above, the 2018 Code will apply to accounting periods beginning on or after January 1, 2019. As a result, unless companies decide to adopt all or part of the 2018 Code early, the first reporting against the 2018 Code will be in 2020. However, the FRC makes it clear in its Feedback Statement on the 2017 Draft Code that it will expect companies to report on votes of 20 per cent or more against board recommended resolutions at shareholder meetings in 2019 in accordance with Provision 4, and it also points out that future remuneration policies and amendments to existing policies should be developed with reference to the 2018 Code and Guidance.
• Companies will need to consider whether they are to be early adopters of some or all of the 2018 Code’s provisions. In light of the greater disclosure requirements they will impose, and in view of the additional new corporate reporting requirements in the draft Companies (Miscellaneous Reporting) Regulations 2018, companies need to identify their workforce and key stakeholders for reporting purposes and start recording their engagement with them, and how the matters in section 172 CA 2006 have influenced the board’s decision-making, so that they can meet the new requirements.
• Companies will also need to consider how they are going to gather the views of their workforce. Should they adopt one or a combination of the suggested options in Provision 5 or does the company consider some other method or methods will be more effective?
• The FRC intends to make necessary consequential amendments to the following guidance in due course
  • Guidance on Audit Committees.
  • Guidance on Risk Management, Internal Controls and Related and Financial Business Reporting.
• As mentioned above, the FRC will also consult on a revised UK Stewardship Code later this year and it will publish, following consultation, the final version of the Wates Corporate Governance Principles for Large Private Companies. In addition, the FCA is to review its Handbook and consider any consequential amendments that are necessary in light of the changes being brought about by the 2018 Code.

In drafting the 2018 Code, the FRC’s aim has been to improve corporate governance practice, stimulate constructive challenge in the boardroom and improve governance reporting. The 2018 Code’s emphasis on the importance of corporate culture and diversity, the need for companies to engage with all their key stakeholders, including their workforce, and the requirement for executive remuneration and workforce policies to be aligned with the company’s strategy and values have been welcomed by investors.

Companies, particularly those below the FTSE 350, will be relieved that the FRC has amended the 2018 Code in certain respects in light of feedback in the consultation process but with no transitional implementation process, smaller companies with less than half the board (excluding the chair) comprising non-executive directors will need to review their board composition imminently, as will companies whose chair has been on the board for a period approaching nine years or more since it is not yet clear what investors and others will consider an acceptable “limited time” beyond nine years to be. However, smaller companies will also be pleased that they will not be required to make changes to the composition of their audit or remuneration committees (unless the board chair sits on the audit committee), and that external board evaluations are something that they should consider rather than be obliged to undertake going forward.