Sustainability and stakeholders: the proposed revision to the UK Corporate Governance Code

In its consultation published on 05 December 2017, the Financial Reporting Council (FRC) proposed substantially to rewrite the UK Corporate Governance Code (Code). The suggested new Code places greater emphasis on shareholder engagement and more focus on stakeholders, integrity and corporate culture, diversity and how overall governance contributes to a company’s long-term success.  The revisions also include the Government’s proposals for employee representation at board level. Finally with a specific focus on executive reward and pay, it suggests placing more positive obligations on a company when more than 20% of votes are cast against a resolution and giving the remuneration committee greater responsibilities.

The FRC is also consulting on changes to the Guidance on Board Effectiveness which should be read together with the Code.

The consultation closes on 28 February 2018 and the FRC expect to publish a final version by early summer 2018. The revised Code will apply to financial years beginning on or after 01 January 2019.

The Code consultation also raises some high-level questions on the UK Stewardship Code which the FRC will consult on in 2018.

Our view

This is a fundamental development in corporate governance. While the broad application of the revised Code seems familiar it:

• draws together much of the guidance from the FRC and others on culture, succession planning, stakeholder engagement and other matters, and
• is full of small changes and nuances which are important.

The revised Code is significant in its suggested new provisions because:

• it elevates various matters into Principles (remembering that the Listing Rules require companies to report on how they have applied the Principles (and comply or explain with the Provisions); the more meaningful the Principles, the more impactful becomes compliance with this aspect of the Listing Rules
• it focuses on sustainable long term success and the express recognition of responsibilities to stakeholders, and
• when read in conjunction with the regulations the Government intends to introduce to reinforce reporting about how directors have fulfilled their duties under section 172 Companies Act 2006, we think it impacts directors’ duties.

Our view is that if directors have to report how they have fulfilled their duties at the end of the year, this will influence their conduct during the year. The result is to raise the standards of conduct expected of directors.

Key changes

Below, we have provided a broad overview of some of the main changes in the revised Code and will comment further on the revised Code’s impact.

Structure

The Code has been reorganised and shortened into five sections: Leadership and purpose; Division of responsibilities; Composition, succession and evaluation; Audit, risk and internal; and Remuneration.

Main Principles (now called Principles) and Provisions have been retained but there are no longer any "Supporting Principles".

The revised Code re-emphasises the importance of applying the Principles. Companies will be expected to justify to shareholders why the board has implemented certain structures, policies and practices. And, the application of the Principles will have to be linked to the company’s strategy and business model, and related to outcomes achieved.

Generally, companies can continue to "comply or explain" against the Provisions.

Companies below FTSE 350

The current exemptions for companies below the FTSE 350 have been removed. The FRC state that they “believe that the Code sets good practice and that even smaller companies should strive for the highest standards of corporate governance”.

Currently exemptions apply to the following requirements:

• at least half the board to comprise independent non-executives
• external board evaluation at least every three years
• annual re-election of all directors, and
• at least three independent non-executive directors on the audit and remuneration committees.

The FRC recognises that independent board evaluations every three years may be disproportionate for smaller companies and is seeking views on this exemption but not on the others.

Leadership and purpose (Section 1)

The Principles in this section place greater emphasis on the long-term sustainable success of a company and require a board to consider the culture of the company and satisfy itself that its purpose, strategy and values are aligned with its culture. The directors must act with integrity.

The board also needs to consider its responsibilities to, and to engage with, shareholders and the wider stakeholder group. Companies are expected to explain, in their annual reports, how they have engaged with the workforce and other stakeholders and how their interests influenced board decision-making.

Workforce representation in the board room - as requested by the Government, the Code will require boards to establish a method for gathering the views of the workforce and proposes the Government’s three options as the "normal" way of doing so: a director appointed from the workforce; a formal workforce advisory panel or a designated non-executive director whose remit includes the impact on and views of the workforce. This provision explicitly requires consideration not just of employees but also other workers however engaged for example, via agencies.

Section 172 Companies Act 2006 duties - new provisions will require the board to explain how the matters in section 172 influenced board decision-making but the FRC notes that the exact wording of this provision is dependent on the Government’s proposed new legislation on section 172 and any subsequent changes to the revised Guidance on the Strategic Report.

Shareholder engagement - greater emphasis is placed on shareholder engagement and a number of the provisions from Section E of the current Code have been moved into this section to underline its importance.

Shareholder votes - the Government has already asked the Investment Association to maintain a public register of those companies that experience shareholder dissent of more than 20% of votes cast against executive remuneration resolutions and to keep a record of what those companies say they are doing to address shareholder concerns. This public register will apply to companies in the FTSE All-Share Index but not to AIM companies and is expected to go live before the year end. The Investment Association (IA) have said that the register will include a description of the resolution, the result of the shareholder vote, a link to the AGM results announcement (including any statement the company has made under E.2.2 of the current Code) and a link to any further statement the company has made on the actions they have taken since the vote.

A new Code provision will introduce the Government’s other proposal for greater explanations when more than 20% of votes cast against any resolution. A company will have to explain, when announcing voting results, what actions it intends to take to consult shareholders to understand the reasons behind the result. The board will then be expected to provide (i) an update no later than six months after the vote; and (ii) a final summary in the annual report (or in the explanatory notes to resolutions at the next meeting) on what impact the feedback has had on the decisions the board has taken and any actions or resolutions now proposed.

Whistleblowing - the current requirement for a company to have arrangements which allow staff to raise concerns relating to financial reporting matters has been expanded to allow the workforce (a wider group than employed staff) to raise any concerns and this is now the board’s responsibility rather than that of the audit committee.

Division of responsibilities (Section 2)

The division of responsibilities remains broadly the same. The main changes are around "independence":

• the chair will be considered independent at all times and therefore can count towards the majority of independent non-executives on the board (subject, presumably, to the chair meeting the independence criteria). There should be no impact for companies which retain their current board structure of having a majority of independent non-executives excluding the chairman. Smaller companies may, however, want to count the chair as one of the independent non-executives, in which case they will need to ensure that the chair meets the independence criteria, and
• the emphasis has changed so that a non-executive will not be considered independent if the person does not meet the listed criteria (which have not changed). The FRC state that this “is in line with the importance placed on the role of independent non-executive directors and the need for boards to be exposed to challenges, new ideas and expertise from individuals without links to the company.” Companies still retain the option of offering an explanation if they believe that an individual is independent.

One of those criteria is that where individuals have served on the board for more than nine years they are no longer considered independent. The FRC view this as a "de facto" tenure period and state that in normal circumstances it would not expect either an independent 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.

Composition; succession and evaluation (Section 3)

Greater emphasis is placed on succession planning and the need for a company to develop a diverse executive pipeline and the nomination committee’s remit has been expanded so that it will oversee the development of this pipeline.

Companies are expected to increase their efforts around diversity (gender, social and ethnic candidates and composition) and the FRC expect board recruitment and succession planning processes and practices to ensure that companies identify and consider a diverse pool of candidates and appointments increase diversity over time.

Companies will also have to report:

• specifically on the gender balance in the first layer of management below board level and their direct reports, and
• on actions taken to increase diversity and inclusion and the progress that has been made.

For large employers these provisions will also have to dovetail with the new annual gender pay reporting requirements which have been introduced for 2016/17 and wider actions and corporate explanation(s).

Audit, risk and internal control (Section 4)

This section remains mainly unchanged.

The FRC is looking for greater consistency in company’s viability statements. It encourages “companies to develop their viability statements in two stages - first by considering the prospects of the company over a period reflecting its business and investment cycles, and, second, by stating whether they have a reasonable expectation that the company will be able to continue to meet its liabilities as they fall due over the assessment period, drawing attention to any qualifications or assumptions.”

Remuneration (Section 5)

Vesting periods - as requested by the Government, the Code will provide that shares granted or other forms of long-term incentives should be subject to a vesting and holding period of at least five years (instead of the current three years).

Remuneration committee - the committee will be given a wider remit, taking on responsibility for oversight of company remuneration and wider workforce policies. The FRC notes that some companies may feel that it would be more appropriate to delegate some of the oversight for workforce policies to other committees where these exist as they might be better placed to deal with such matters. Examples include sustainability committees, corporate responsibility committees or people committees.

Remuneration committees will also have to report on how company policies and practices incorporate the Principles and Provisions of this section. This includes a requirement for companies to explain what workforce engagement has taken place to explain how executive remuneration aligns with wider company pay policy. This provision from the new Code would sit alongside new legislative changes which will also require companies to report on the ratio of the chief executive’s pay to the average pay of the UK workforce as a whole, along with an explanation of changes to the ratio from year to year and how the ratio relates to pay and conditions across the wider workforce.

As requested by the Government, the remuneration committee chair will have to have served at least 12 months on a remuneration committee before becoming chair.

Schedule A - the current Code’s Schedule A has been integrated into the remuneration section which now includes a range of matters the committee will need to address.

Pay ratios - the FRC notes that the Government plans to introduce secondary legislation on pay ratios and for clearer reporting on the range of remuneration outcomes from complex, share-based incentive schemes. The FRC may make consequential changes to this section of the Code, pending the outcome of the Government’s legislation.