Proposed Revisions to the UK’s Corporate Governance Regime

On 5 December the Financial Reporting Council (FRC) published proposals for the latest revisions to the UK Corporate Governance Code (the Code), which are due to be published by “early summer” 2018 and will be effective for all accounting periods beginning on or after 1 January 2019.

The stated aim of the FRC in proposing the revisions was to make the Code “shorter and sharper” with supporting principles either removed and incorporated into new principles and provisions or supplementary guidance, such as the guidance on Board Effectiveness. The proposed revisions to the Code place particular emphasis on:

1. Director Independence;
2. Stakeholder Engagement;
3. Executive Remuneration;
4. Diversity;
5. Corporate Culture;
6. Shareholder Engagement; and,
7. Smaller Company Exemptions.

The proposed revisions to the Code follow a series of developments relating to corporate governance in the UK over the past 12 months, which commenced with a consultation paper from the UK Government in December 2016. Since then, the department for Business, Energy and Industrial Strategy (BEIS) published its final reforms requiring listed companies to disclose the pay ratio between bosses and workers; and, to explain how Directors take employees’ interests into account—reforms designed to increase the voice of wider stakeholders in decision-making at Board level. Certain of the BEIS reforms have been incorporated into the FRC’s proposed revisions, with the aim of extending Boardroom responsibility beyond shareholders to wider stakeholders in an effort to foster long-term considerations and sustainable performance. The UK Government reforms also formed the basis for the Investment Association’s creation of a new public register, which will be referenced in the revised Code and include all companies that received more than 20% votes against remuneration proposals.

In the Appendix to this post, we have included all the questions the FRC has raised as part of the consultation. The FRC has invited interested parties to respond to the Paper by 28 February, 2018 to the following email: [email protected].

Next Steps

The revisions to the Code will not be confirmed until the summer of 2018 and will only be effective from 1 January 2019; nonetheless, certain of the revisions—if adopted—would necessitate significant alterations to Board practices in the UK and Ireland, particularly around responsibilities to engage with the workforce—both through the Board and the Remuneration Committee. Consideration will need to be given to the implications of the revisions at the earliest opportunity in order to provide sufficient lead time to ensure compliance by 2019 and to foster stronger reporting in the first Annual Report after the revised Code is finalised.

For all companies:

• The Board as a whole should be advised on potential changes to the Code, the impact on independence considerations; and, new reporting requirements;
• The Board as a whole should be advised of their responsibility to put in place appropriate channels for employee engagement through one of the three options available under the revised Code as set out on page 3 of this memo;
• The Remuneration Committee should be advised of their increased responsibility under the new Code with respect to discretion and wider workforce pay practices; and, the expectation that all LTIPs include five-year time horizons; and,
• The Nomination Committee should be advised on changes to the Code relating to reporting on gender diversity and succession planning.

For companies outside the FTSE 350:

• The Board and each of the sub-Committees should be informed that, from 1 January 2019, its composition may be expected to meet the standards previously reserved for FTSE 350 companies; and, put in place plans for Board evaluations.

Director Independence

Of the proposed revisions, the one that may have the most immediate impact on Board practices and composition is the Code’s strengthening of provisions relating to Director independence. The current iteration of the Code (Provision B.1.1) lists specific criteria that should be taken into account by the Board when considering whether non-executive Directors and the Chair are independent, including whether a Director has previously been an employee of the company, has received performance-related remuneration, is a representative of a substantial shareholder, or has served on the Board for more than nine years. Under the new Code, instead of taking those criteria into account, the provision will state that “where a non-executive Director and/or the Chair do not meet the stated criteria, they should not be considered independent.”

While the criteria themselves have not been altered, the rewording of this section represents a significant change, particularly as it relates to Director tenure. It appears the revised Code’s guidance will state that a Director or Chair on a Board for more than nine years should no longer be considered independent, which the FRC considers consistent with the revised Code’s “approach to succession planning and the importance of Board refreshment.” Furthermore, the FRC states 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.” In doing so, the FRC appears to be linking longer-serving Directors to unsatisfactory progress on new appointments to Boards, including as an impediment to not just independence, but also diversity.

While certain of the criteria—such as being a former employee or receiving performance-related pay—have consistently resulted in investors considering a Director to be ‘non-independent’, companies were often afforded greater latitude against the ‘nine year’ rule, so long as the Board as a whole had been suitably refreshed. As with all the Code’s provisions, companies will still have the option of offering an explanation if they believe that an individual is still independent. However, the hardening of the Code’s wording on independence will raise the bar for companies when considering Directors to be independent; and, dictate that explanations from are extensive and detailed.

Stakeholder Engagement

The FRC’s proposals state that:

The primary duty of Directors is to promote the long-term success of the company. Companies can do more to recognise that other stakeholders, particularly their own workforces, play a significant part in that success. Therefore, the revised Code encourages corporate governance policies and practices that generate value for shareholders and aim to benefit society.

As part of their investigation into corporate governance, the UK Government requested that the FRC consult on a specific Code principle relating to companies placing greater emphasis on considering wider stakeholder views. Specifically, the UK Government had sought a Code provision requiring the adoption, on a ‘comply or explain’ basis, of one of three employee engagement mechanisms. A new provision (Provision 3) will include the UK Government’s three options for fostering employee engagement by Boards:

1. A Director is appointed to the Board from the workforce;
2. A formal workforce advisory council is set up to promote engagement with the workforce; or
3. A designated non-executive Director is made responsible for engagement with the workforce.

Based on feedback to the UK Government’s consultation, which failed to reach a consensus on how best to promote the voice of stakeholders, the FRC has proposed including all three options in the revised Code. Subject to the publication of the revised Code, companies may be expected to choose one option and explain why it is suitable for its business model and interaction with its employees. Given the strength of opposition to the idea of appointing an employee representative to the Board, if this provision is adopted, it seems likely that the majority of companies will elect to form a workforce advisory council or designate a Director as responsible for employee engagement and feedback.

Notably, the revised Code says that by using the term “workforce,” the FRC is encouraging companies to consider “how their actions impact on all, not only those with formal contracts of employment. For example, this could include workers, agency workers and those providing services as a contractor (self-employed).” Given the variance in how companies employ individuals in UK and Irish companies, this wide definition of the workforce has the potential to present challenges to listed companies and the manner in which employee engagement takes place.

Executive Remuneration

In terms of remuneration, the revised Code includes four material updates:

1. Long-term incentives should be held for five years;
2. An increased emphasis on the role of the Board in exercising discretion over formulaic outcomes under incentive plans;
3. Chairs of Remuneration Committee should have served at least 12 months on a Remuneration Committee previously; and,
4. The remit of Remuneration Committees will be expanded to take on responsibility for oversight of wider workforce pay policies.

The proposed update to performance and holding periods is aligned with the general movement in the market while the expectation that Remuneration Committee Chairs have previous experience does not appear contentious. However, the explicit mention of the expectation for Boards to exercise “independent judgement and discretion” over pay outcomes is likely to substantially increase scrutiny of variable pay outcomes, particularly in years of modest performance or negative shareholder returns. Moreover, the expectation that Remuneration Committees take more responsibility for pay policy of the wider workforce will present challenges for companies, with Committees potentially expected to engage not just with employees but also contractors on whether working practices include “fair rewards and recognition.”

Diversity

The proposed revisions to the Code enshrine the benefits of diversity to successful business performance. While the FRC notes the significant progress made in terms of gender diversity at Board-level, the revised Code “asks Boards to intensify their efforts.” While the emphasis on diversity remains in a general sense, a new principle aims to broaden Boards’ perceptions of diversity and “to ensure appointment and succession planning practices are designed to promote diversity, not only of gender, but also of social and ethnic backgrounds.”

The proposed revisions to the Code also note that progress in increasing the number of women on Executive Committees has been much slower that Board representation. A new principle will be added to the Code that seeks to ensure appointment and succession planning at company management level is designed to promote gender, social and ethnic diversity. Under the new Code, in line with the recommendations of the Hampton Alexander Review, FTSE 350 companies would be expected to disclose in their Annual Reports the gender balance on the Executive Committee and Direct Reports to the Executive Committee. As drafted, the new provision asks Nomination Committees to explain what action they have taken to increase diversity in the pipeline; however, there is no expectation that companies disclose data on levels of diversity other than for gender.

Corporate Culture

In 2016, the FRC led a coalition of parties that produced a report on corporate culture and the role of Boards. This report argued that culture in business is a key ingredient in delivering long-term sustainable performance. The Code has been revised to include many of the findings of that report, including that “openness and accountability are essential for a healthy culture.” Creating an appropriate culture, and reporting on its evolution to shareholders, is a central theme of the proposed revisions to the Code. The proposals state that “in order to establish an appropriate culture, a Board must define the purpose, strategy and values of the company, and consider the type of behaviours it wishes to promote in order to deliver its business strategy.” Two new principles, along with two new provisions, will link directly to culture while the concepts outlined in the FRC’s previous report feature throughout the proposed revisions to the Code.

Shareholder Engagement

Since 2014, the Code has provided that “When, in the opinion of the Board, a significant proportion of votes have been cast against a resolution at any general meeting, the company should explain when announcing the results of voting what actions it intends to take to understand the reasons behind the vote result.” Under the revised Code, “significant” is set to be clearly defined as 20% of votes.

In addition to this alteration, the revised Code includes an expectation that “no later than six months after the vote, an update should be published” on the underlying reasons for the significant vote against a resolution. Consequently, companies will need to ensure that the analysis of the voting outcome after an AGM has been carried out and initial consultations with shareholders have taken place within six months of the AGM.

Smaller Company Exemptions

Currently, the Code provides exemptions for companies outside of the FTSE 350 in the following areas:

• Majority Board Independence;
• Triennial External Board Evaluations;
• Annual Re-elections; and,
• The Composition of Audit and Remuneration Committees.

Under the revised Code, none of the exemptions outlined would apply; and, all premium listed companies would be expected to meet the same standards as set out in the Code. In the proposed revisions, the FRC notes that “the Code sets good practice and that even smaller companies should strive for the highest standards of corporate governance.” The removal of these exemptions will necessitate changes at a significant number of companies outside the FTSE 350, with there likely to be an increase in the recruitment and appointments of Directors.

Appendix

Q1. Do you have any concerns in relation to the proposed Code application date?

Q2. Do you have any comments on the revised Guidance?

Q3. Do you agree that the proposed methods in Provision 3 are sufficient to achieve meaningful engagement?

Q4. Do you consider that we should include more specific reference to the UN SDGs or other NGO principles, either in the Code or in the Guidance?

Q5. Do you agree that 20 per cent is ‘significant’ and that an update should be published no later than six months after the vote?

Q6. Do you agree with the removal of the exemption for companies below the FTSE 350 to have an independent board evaluation every three years? If not, please provide information relating to the potential costs and other burdens involved.

Q7. Do you agree that nine years, as applied to non-executive directors and chairs, is an appropriate time period to be considered independent?

Q8. Do you agree that it is not necessary to provide for a maximum period of tenure?

Q9. Do you agree that the overall changes proposed in Section 3 of revised Code will lead to more action to build diversity in the boardroom, in the executive pipeline and in the company as a whole?

Q10. Do you agree with extending the Hampton-Alexander recommendation beyond the FTSE 350? If not, please provide information relating to the potential costs and other burdens involved.

Q11. What are your views on encouraging companies to report on levels of ethnicity in executive pipelines? Please provide information relating to the practical implications, potential costs and other burdens involved, and to which companies it should apply.

Q12. Do you agree with retaining the requirements included in the current Code, even though there is some duplication with the Listing Rules, the Disclosure and Transparency Rules or Companies Act?

Q13. Do you support the removal to the Guidance of the requirement currently retained in C.3.3 of the current Code? If not, please give reasons.

Q14. Do you agree with the wider remit for the remuneration committee and what are your views on the most effective way to discharge this new responsibility, and how might this operate in practice?

Q15. Can you suggest other ways in which the Code could support executive remuneration that drives long-term sustainable performance?

Q16. Do you think the changes proposed will give meaningful impetus to boards in exercising discretion?