BEIS Committee Report Recommendations for Corporate Governance Reform
Possible Implications for Large Private Companies and Directors
On 16 September 2016, the Business, Innovation and Skills Parliamentary Select Committee (now the Business Energy and Industrial Strategy Parliamentary Select Committee (the Committee)) launched an inquiry on corporate governance, focusing on executive pay, directors' duties, and the composition of boardrooms, including worker representation and gender balance in executive positions. This inquiry was prompted by the Committee's concerns about what they judged to be serious failings in corporate governance at two major UK businesses, BHS and Sports Direct. Separately, on 29 November 2016, the Department for Business, Energy & Industrial Strategy (BEIS) published a Green Paper intended to encourage debate and discussion on corporate governance reform in order that the Government can move quickly to consider what changes, if any, are necessary. In particular, it focused on executive pay, private companies and workers on boards. This is all part of a wider focus by the Government on strengthening public trust in UK businesses.
Responses to the BEIS Green Paper were due by 17 February 2017 and we are still waiting for the Government to indicate what its next steps will be. In the meantime, in connection with its separate inquiry on corporate governance, the Committee has collected oral evidence from over 170 organisations, and had discussions with a range of chairmen and CEOs of major companies, which have fed into its Report, which was published on 5 April 2017 and contains a number of recommendations for reform. Although the Government is likely to be interested in the Committee's recommendations, it remains to be seen whether or not the Government will adopt any of them.
The Committee concludes that its proposed reforms:
….are not intended to create onerous new requirements, but to establish arrangements to ensure that the better enforcement of the Companies Act 2006, to improve the voice of other stakeholders, including employees, and to require companies to engage in a more open and transparent manner with the public. Their aim is to ingrain permanently the values and behaviours of excellent corporate governance into the culture of British business.
In this note, we look at the Committee's recommendations to enhance corporate governance measures for large, privately-held companies and the directors' duties. We do not look at the recommendations regarding director remuneration, nor some of the more detailed revisions proposed for the UK Corporate Governance Code applicable to premium listed companies (the Code), except to the extent they would be likely to be extended to large, privately- held companies.
Large Private Companies
A particularly high standard of corporate governance and transparency is imposed upon UK public companies through the Code. In contrast, UK private companies have no comparable set of corporate governance standards to meet. Given the increasing number of significant private companies which are subject to weaker reporting requirements than their listed counterparts, the Committee's key recommendation is the development of a new voluntary governance code for the largest private companies (the New Code). The Committee recommends that the FRC, Institute of Directors and Institute for Family Business develop, with private equity and venture capital interests, the New Code. It is envisaged (although there is some inconsistency in the report) that the FRC would oversee and report on compliance with the New Code. Companies would report on compliance with the New Code on a comply or explain basis, like the existing Code for premium listed companies. The scheme could be funded by a small levy on business; if this voluntary scheme fails to raise standards after a three-year period, or reveals high rates of unacceptable non-compliance, then a mandatory regime could be introduced.
The first issue to clarify is what does the Committee mean by "large private company"? A number of recently introduced reporting standards apply to all companies or businesses above a certain size, regardless of their form or status. For example: (i) large businesses operating in the UK and with a turnover of £36 million, or more, are required to disclose the steps they have taken to prevent modern slavery in both their own business and their supply chains; (ii) employers with at least 250 employees need to report by April 2018 on gender pay issues; and (iii) large companies and large LLPs (i.e. that meet two of the following criteria: (a) an annual turnover of more than £36 million; (b) a balance sheet of more than £18 million; or (c) more than 250 employees) must report on their payment practices for financial years starting from April 2017. For these purposes, the Committee recommends starting with the largest employers, that is businesses that employ more than 2,000 employees - it estimates that there are currently up to 100 such companies operating in the UK. The Committee suggests that this threshold could be lowered over time as the New Code gains credibility and becomes something that private companies want to adhere to from a public relations perspective. It is important to note that, should the Government follow the Committee's recommendations (and depending upon how any implementing legislation is drafted), neither subsidiaries of UK listed entities, nor subsidiaries of non-UK companies that are listed outside of the UK and already complying with corporate governance standards similar to the Code, have been excluded from the Committee's concept of large private company. Conceivably, the former may not be intended to be caught, but for the latter, it is unclear. The Committee is, however, clear in its view that large, privately-owned companies with a significant footprint in society should be required to demonstrate that they adhere to certain minimum standards of good corporate governance.
As to what areas the New Code would cover, the Committee recommends a light touch approach based on requiring the provision of specified information, potentially covering revenues, compliance with section 172 of the Companies Act 2006 (for further on this, see "Directors' Duties" below), company structure, executive pay, numbers of employees and pension scheme contributions. The Committee suggests this information would be best provided on company websites, rather than in published annual reports. If it is to be modelled on the current Corporate Governance Guidance and Principles for Unlisted Companies published by the Institute of Directors, it could include provisions such as Principles 10 to 14 (specifically aimed at larger companies), which recommend splitting responsibilities between running the board and running the business (namely, having both a CEO and a Chairman); having a diverse board (competencies and experiences) which would include a number of NEDs; the establishment of appropriate board committees for an effective discharge of duties; periodic board evaluations; the publication of a balanced and understandable assessment of the company's position and prospects for external stakeholders; and a requirement to establish a suitable programme of stakeholder engagement.
With regard to the monitoring of compliance with the New Code, the Committee suggests that, depending on the number of companies subject to the New Code, compliance might be monitored by way of a risk-assessed sample. In any event, reporting on compliance by the new regulatory body should include the naming of companies for particularly poor behavior.
With regard to directors, the reforms recommended by the Committee are aimed at directors taking their duties to comply with the law more seriously - this is to be achieved by requiring more specific and accurate reporting, better engagement with boards and shareholders, and more accountable non-executive directors (NEDs).
The Committee states that the key requirements on company directors relating to corporate governance are set out in section 172 of the Companies Act 2006 (section 172). Section 172 provides that a director is required to act "in a way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole" (so-called shareholder primacy). In doing so, directors are required to "have regard to" a number of considerations, namely, the likely consequences of any decision in the long term, the interests of employees, the need to foster relationships with suppliers, customers and others, the impact of the company's operations on the community and the environment, the desirability of the company maintaining a reputation for high standards of business conduct and the need to act fairly as between shareholders (so-called "enlightened shareholder value").
The Committee concludes that, with Brexit negotiations about to begin, this is not the time to introduce further uncertainty to UK markets by seeking to reframe the law. They recognise, though, that the requirement for directors to "have regard to" other stakeholders and considerations is lacking in clarity and strength and is difficult to enforce by shareholders by court action. They conclude that directors have not paid sufficient attention to the interests of wider stakeholders, whether it be those working for them, the local community or suppliers, and that more effective measures are required to ensure that directors demonstrably take seriously their duties to have regard to other stakeholders and the long-term consequences of decisions. The effective measures suggested are requiring more specific and accurate reporting by companies, supported by robust enforcement. Although the reporting requirements suggested are discussed in the context of the Code, given the Committee's suggestion that a New Code for private companies should provide information on compliance with section 172 (see "Large Private Companies" above), we believe that the following recommendations would also be relevant for private companies.
The Committee recommends that directors should be required to report in an accessible, narrative and bespoke form on how they have complied with their duties under section 172. Companies should be required to provide better information on how they have looked after the interests of employees, fostered relations with suppliers and mitigated any environmental impacts. They should also provide an explanation as to the time horizon of decision making and how they have had regard to consequences of their decisions for the long term. The Committee does not believe that this kind of reporting needs to be included in the Annual Report as this invariably leads to boilerplate reporting, rather they would recommend the FRC encourages companies to be more imaginative and agile in communicating with stakeholders on these issues during the course of the year.
In terms of enforcing the section 172 duties, the Committee concludes that further regulation is not the solution to influence individual behaviours and prefer to use the tried and tested comply or explain approach with regards to directors' duties (backed up, of course, by the current legal framework that includes punishments for directors in cases of, among other things, fraud, misconduct and conduct unfairly prejudicial to shareholders).
Rather than create a new regulatory body to enforce cases where minimum standards have been breached by individual companies, the Committee recommends that Government brings forward legislation to give the FRC the additional powers it needs to secure information in order to take action directly with companies and to engage and hold to account company directors in respect of the full range of their duties (and to extend this to any directors, not just auditors, accountants or actuaries which are currently the only professions under the jurisdiction of the FRC). Where engagement is unsuccessful, it is suggested the FRC should report publicly to shareholders on any failings of the board collectively, or individual members of it. If companies were not to respond satisfactorily to engagement with the FRC, the FRC should be given authority to initiate legal action for breach of section 172 duties.
In the case of potentially serious bad practice or corruption, the Committee notes that the Secretary of State already has a range of powers to send in inspectors to investigate the affairs of a company. Inspectors may be sent in where, for example, the circumstances suggest grounds for suspicion of fraud, misconduct, conduct unfairly prejudicial to shareholders or of failure to supply shareholders with information they may reasonably expect. The Committee urges the Secretary of State to be more prepared than is presently the case to use its existing powers where there is any suspicion of serious wrongdoing that may be in breach of the law.
A brief comment on the recommendations for NEDs as these recommendations may also be relevant for the New Code - it is recognised that legal duties of NEDs are the same as those for executive directors, although statute law has not kept pace with the evolution of this role. The Committee recommends that the FRC includes best practice guidance on professional support for NEDs when it updates the Code, as well as providing guidance on how companies should identify clearly and transparently the roles of NEDs where they have particular responsibilities and how they should be held to account for their performance. When reporting on their people or human resources policy, companies should include details of training provided to board members. The Committee also recommends that NEDs should be required to demonstrate more convincingly their ability to devote sufficient time to each company when they serve on multiple boards.
It will be interesting to see how the Government responds to the many and varied responses it has received to its Green Paper. In light of the numerous issues raised during the inquiries into the demise of BHS and employment practices at Sports Direct, and the level of media attention these inquiries received, it seems likely that the Government will take some action in respect of large, privately- held companies.
Given the nature of the Committee, its recommendations from its separate corporate governance inquiry will certainly be of interest to the Government, and may be persuasive. If the Government does take forward the type of changes recommended by the Committee for private companies, this may herald a new era for the corporate governance of private companies in the UK.