21 Jan 2018

On 5 December 2017, the Financial Reporting Council (FRC) published a consultation document on its proposals for a revised UK Corporate Governance Code. The FRC has undertaken a comprehensive review to ensure that the Code remains fit for purpose and continues to promote improvement in the quality of corporate governance. The revised Code emphasises the value of good corporate governance to the sustainable growth of a company and encourages policies and practices that generate value for shareholders and aim to benefit society. There is a new focus on stakeholders, integrity and corporate culture, diversity and how the overall governance of the company contributes to its long-term success.

Many of the changes reflect the findings of the July 2016 report on Corporate Culture and the role of boards, which was led by the FRC.

Brexit is also a factor. Sir Win Bischoff, Chairman of the FRC said "At this critical time and as the country approaches Brexit, a revised Code will be essential to restoring trust in business, attracting investment and ensuring the long-term success of companies for members and wider society."

Application

The Code applies to all companies with a premium listing of equity shares. Unlisted publicly traded companies, such as AIM companies, apply the Code to varying degrees, depending on their size and circumstances. Compliance with the Code is regarded as best practice.

Structure

Key strengths of the existing approach have been retained – notably the flexibility of 'comply or explain'. Main Principles, Supporting Principles and Code Provisions have been replaced with updated Principles A-Q and Provisions 1-41, the existing Supporting Principles having been removed or either incorporated into the Code or moved to the FRC's revised Guidance on Board Effectiveness. The FRC describes the revised Code as 'shorter and sharper' so that it is clear and concise.

The existing Sections A-E and the two Schedules are replaced with Sections 1-5:

  1. Leadership and Purpose.
  2. Division of Responsibilities.
  3. Composition, Succession and Evaluation.
  4. Audit, Risk and Internal Control.
  5. Remuneration.

The majority of the amendments have been made in the first three sections of the revised Code, which broadly correlate with the existing Sections A (Leadership) and B (Effectiveness). Section 4, has largely the same content as the existing Section C (Accountability). The existing Section E (Relations with Shareholders) has been integrated within the revised Code.

The Code is supported by the FRC's Guidance on Board Effectiveness and boards should also take account of additional specific guidance, such as the Guidance on Audit Committees and the Guidance on Risk Management, Internal Control and Related Financial and Business Reporting.

Key changes include:

Smaller company exemptions removed

The FRC proposes the removal of all of the exemptions in the existing Code for those listed companies below FTSE 350 (B.1.2 – board composition; B.6.2 – board evaluation); B.7.1 – annual re-election and the composition of audit and remuneration committees (C.3.1 and D.2.1)). The FRC believes that even smaller companies should strive for the highest standards of corporate governance. Although a company might be outside the FTSE 350 it may be of a similar size and structure and such companies may also have significant impacts on their workforce and wider stakeholders and as such they should be subject to the same levels of corporate governance. Nevertheless, the FRC appreciates that recommending an independent board evaluation for smaller companies has the potential for disproportionate cost and other burdens and welcomes views about the proposal.

Section 1 – Leadership and Purpose

Principle A provides that a successful company is led by an effective and entrepreneurial board, whose function is to promote the long-term sustainable success of the company, generate value for shareholders and contribute to wider society. The board should establish the company's purpose, strategy and values and satisfy itself that these and its culture are aligned.

Views of the 'workforce' and whistleblowing

Provision 3 provides that the board should establish a method for gathering the views of the 'workforce'. This would normally be a director appointed from the workforce, a formal workforce advisory panel or a designated non-executive director. There should also be a means for the workforce to raise concerns in confidence and (if they wish) anonymously. This differs from C.3.5 in the existing Code, which provides that the audit committee should review arrangements by which staff may raise concerns about improprieties in relation to financial reporting 'or other matters' and subsequent investigations.

The term 'workforce' has been carefully chosen to capture the different types of contractual relationships between companies and individuals working for them. This could include, for example, workers, agency workers and those providing services as a contractor.

Significant votes against resolutions

The revised Code encourages boards to improve their engagement and communication with shareholders in situations where there is a significant vote against a resolution – that is, a vote of 20% or higher. Provision 6 provides that 'the company should explain, when announcing voting results, what actions it intends to take to consult shareholders in order to understand the reasons behind the result'. An update should be published within six months of the vote and the board should provide a final summary in the annual report, or in the explanatory notes to resolutions at the next shareholder meeting.

Section 2 – division of responsibilities

Chief Executive

Provision 10 clarifies the role of the chief executive for proposing and delivering strategy. The chief executive is responsible for the board receiving timely and balanced information to inform its decisions. This should be read alongside Principle H which provides that the board, supported by the company secretary, should ensure that it has the policies, processes, information, time and resources it needs in order to function effectively and efficiently.

Board composition

Composition of the board remains broadly the same in the revised Code. However, the requirement (in Provision 11) has changed from ' except for smaller companies [below the FTSE 350], at least half the board, excluding the chairman, should comprise non-executive directors determined by the board to be independent' (B.1.2 in the existing Code) to 'Independent non-executive directors, including the chair, should constitute the majority of the board'.

Independence of non-executive directors

The revised Code strengthens the Provisions on independence. B.1.1 in the existing Code lists specific criteria that should be taken into account by the board when considering whether non-executive directors and the chair (on appointment) are independent. The board should state its reasons if it determines that a director is independent notwithstanding the existence of relationships or circumstances included in its criteria. Whilst the criteria are the same (Provision 15), the revised Code changes the emphasis and states that where a non-executive director and/or the chair does not meet the stated criteria, they should not be considered to be independent.

Section 3 – Composition, Succession and Evaluation

Diversity

Following the Davies Report in 2011 on the gender balance of FTSE100 boards, the Hampton-Alexander Review in improving gender balance in FTSE leadership in 2016 and the Parker report on the ethnic diversity of UK boards, Principle J in the new Code requires appointments to the board to be subject to a formal, vigorous and transparent procedure and that an effective succession plan should be in place for board and senior management (executive committee or the first layer of management below board level, including the company secretary). Both appointments and succession plans should be based on merit and objective criteria and promote diversity of gender, social and ethnic backgrounds and cognitive and personal strengths.

The changes are intended to broaden the board's perceptions of diversity and encourage building diversity across the workforce and, in particular, in the executive pipeline. Provision 17 expands the remit of the nomination committee to include overseeing the development of a diverse pipeline for succession.

Reporting on diversity

Provision 23 provides that the annual report should describe the work of the nomination committee and should include:

  • the process used in relation to appointments, its approach to succession planning and how both support building a diverse pipeline with reference to Principle J
  • what other actions it has taken to oversee the development of a diverse pipeline for future succession to board and senior management appointments
  • an explanation of how diversity supports the company in meeting its strategic objectives
  • the gender balance of those in the senior management and their direct reports.

Section 5 – Remuneration

Government's response to Green Paper

The Government's response to the Green Paper Consultation on Corporate Governance Reform invited the FRC to 'consult on a revision to the UK Corporate Governance Code and its supporting guidance to give remuneration committees 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 FRC was also asked to consult on 'extending the recommended minimum vesting and post-vesting holding periods for executive share awards from three to five years to encourage companies to focus on longer-term outcomes in setting pay.'

Remuneration policies to be aligned to the strategy

The FRC has sought to address concerns over rising levels of executive pay and that incentives do not always support the success of the company over the longer term. Principle O provides that the board should satisfy itself not only that company remuneration and workforce policies and practices promote its long-term success but also that they are aligned with its strategy and values. Principle F provides that performance-related elements of remuneration should be aligned to the successful delivery of the strategy.

Remuneration schemes and outcomes

Principle Q emphasises the role of the board in exercising independent judgement and discretion when approving remuneration outcomes, taking account of company and individual performance and wider circumstances.

The current Code's Schedule A, which covers the design of performance-related remuneration for executive directors, has, where appropriate, been integrated into Section 5, which includes a range of matters the remuneration committee will need to consider (Provision 40).

Provision 36 provides that (as mentioned above) share and other forms of long-term incentives should be subject to a vesting and holding period of at least five years.

Provision 37 requires remuneration schemes to make provision for boards to be able to override formulaic outcomes; for example, where the measurement of any performance condition does not reflect the actual performance of the company or the performance of the individual director. The company should be able to recover and/or withhold sums or share awards in specified circumstances.

Remuneration committee and the chair

Provision 32 includes a requirement that the remuneration committee chair should have served for at least twelve months on a remuneration committee before taking on this role.

Provision 33 proposes an expanded remit for remuneration committees to include overseeing remuneration and workforce policies and practices, taking these into account when setting the policy for director remuneration. This section will be supported by the Guidance on Board Effectiveness on the role of the committee and its new responsibility for wider workforce pay and policies. Further changes may be made as a result of planned secondary legislation on pay ratios and for clearer reporting on the range of remuneration outcomes from complex share-based incentive schemes.

Reporting on the work of the remuneration committee and engaging with the workforce

Provision 44 provides that there should be a description of the work of the remuneration committee in the annual report which should include an explanation of the company's approach to investing in, developing and rewarding the workforce and what engagement with the workforce has taken place to explain how executive remuneration aligns with wider company policy.

Reporting on the Code

Code compliance has focused on the 'comply or explain' aspects of the Provisions rather than the application of the Principles. The revised Code emphasises the importance of applying the Principles.

The Listing Rules (LR 9.8.6(5)) require companies to make a statement of how they have applied the Principles 'in a manner that would enable shareholders to evaluate how the principles have been applied'. The statement should cover the application of the Principles in the context of the particular circumstances of the company and how the board has set the company's purpose and strategy, met objectives and achieved outcomes through the decisions it has taken.

When reporting on these, the company should justify to shareholders why the board has implemented certain structures, policies and practices. The Principles should then be linked to the company's strategy and business model and related to outcomes achieved. The Provisions should be complied with or an explanation given, in line with current practice (i.e. comply or explain). Good practice examples of reporting will include signposting and cross-referencing to those parts of the annual report that describe how the Principles have been applied; this will help investors with their evaluation.

The Corporate Governance Statement should relate particularly to the strategic report, so that shareholders can assess effectively how the quality of a company's governance arrangements and the board's activities help it to deliver its purpose and strategy and mitigate risks.

Section 172 Companies Act 2006 (Directors' duties)

The board should 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 of the Companies Act 2006 influenced the board's decision-making (Provision 4). This Provision will be kept under review pending planned secondary legislation to require all companies of a significant size to explain how their directors comply with section 172.

UK Stewardship Code

As part of the consultation, the FCA also asks some high-level questions about the future direction of the UK Stewardship Code and plans to consult on specific changes later in the year.

Timing

The FRC requests that comments on the consultation questions are received by 28 February 2018 by email to codereview@frc.org.uk. The FRC's aim is to publish a final version of the Code by summer 2018. The revised Code will apply to accounting periods beginning on or after 1 January 2019.