FRC Unveils Overhaul of the Corporate Governance Code
The FRC has published its long awaited consultation on amendments to the UK Corporate Governance Code (click here). As well as incorporating the specific amendments to the UK Corporate Governance Code (the Code) suggested by the Government in its response to the Green Paper Consultation on Corporate Governance Reform published in November 2016 (for further on which, click here), the FRC has conducted a thorough review of the structure, content and balance of Principles and Provisions in the Code and made sweeping changes to shorten and sharpen it. Particular areas of focus include: (a) a requirement for boards to consider the way that their companies interact with the workforce, customers, suppliers and wider stakeholders and how they have complied with section 172 of the Companies Act 2006 (section 172); (b) an increased focus on the importance of culture and diversity throughout the company; and (c) the expansion of the remit of the remuneration and nomination committees to cover wider company remuneration and succession planning issues. For a snapshot of the reforms, click here.
Responses to the consultation are due by 28 February 2018. The FRC currently anticipates that the final version of the new Code will be published in the Summer of 2018, and that it will apply to accounting periods beginning on or after 1 January 2019.
The FRC is also using this opportunity to start the process of a formal external consultation on the Stewardship Code. The FRC has not published a marked up version at this stage, but they have asked some important questions, including whether: (a) splitting the Stewardship Code into separate codes for fund managers, asset owners and advisors (it currently seeks to cover them all) would help drive best practice; and (b) investors should be encouraged to monitor and engage on issues relevant to the long term success of companies, including considerations relevant to section 172. The FRC expects to publish a detailed consultation on specific changes in mid-2018.
Summary of the proposed changes to the Code
"Comply or explain" principle
The concept of compliance on a "comply or explain" basis, as required by the Listing Rules, remains, but the revised Code emphasises that companies should avoid a "tick-box" approach, should report meaningfully on how the Principles have been applied and avoid boilerplate reporting.
Removal of exemptions for smaller companies
The FRC has decided to remove all of the exemptions in the current Code which apply to companies that fall below the FTSE 350, which includes the following current Code provisions: B.1.2 (board independence provisions); B.6.2 (board evaluation); B.7.1 (annual re-election of directors); and C.3.1 and D.2.1 (composition of the audit and remuneration committees). Compliance with the requirement to have an externally facilitated board evaluation at least every three years (currently in Code provision B.6.2), in particular, is likely to be onerous for smaller companies.
Section 1 - Leadership and Purpose
The revised Code includes references to the board's responsibility to consider the needs and views of a wider range of stakeholders. In particular, Principle C requires boards to, "ensure effective engagement with, and encourage participation from, shareholders and stakeholders." On the basis that no single approach would be suitable for all, Provision 3 includes the Government's three methods for gathering the views of the workforce, stating that this would "normally" be done by: (a) appointing a director from the workforce; (b) establishing a formal workforce advisory panel; or (c) designating a NED to do this. However, the revised "Guidance on Board Effectiveness" (the Guidance) makes it clear that this is not prescriptive and boards may opt for innovative alternatives (including adopting a combination of methods, or multiple channels for engagement at different levels) if they believe they would be as, or more, effective. The Code requirement will be satisfied as long as the method chosen provides regular two-way dialogue and a means for the board to listen to the workforce. Examples of workforce engagement activities may include:
- director breakfasts;
- listening groups;
- focus or consultative groups;
- groups of elected workforce representatives;
- social media updates;
- employee AGMs;
- town halls and open door days;
- surveys; and
- digital sharing platforms.
However, the Guidance confirms that, although surveys can be a powerful tool to engage with people, they will not be sufficient on their own. To be effective, there would need to be a forum for feedback after the results of the survey are made available and transparency around action to be taken in respect of any issues identified.
The FRC has purposely chosen the term "workforce", rather than "employees" as they want companies to consider how their actions impact on all, and not just those with formal employment contracts.
The new Provision 4 requires companies to report on how they have engaged with their workforce and other stakeholders, and how their interests and the matters set out in section 172 have influenced the board's decision-making. The FRC is consulting on whether they should include more specific references to the UN Sustainability Development Goals, or other NGO principles in the Code or the Guidance.
Significant votes against resolutions
Going further than the Government's recommendations (which only related to executive pay proposals), a new Provision 6 provides that when more than 20%1 of the votes have been cast against a resolution:
- the company should explain, when announcing the voting results, what actions it intends to take to consult shareholders in order to understand the reason behind the result;
- an update should be published no later than six months after the vote; and
- the board should provide a final summary in the annual report, or in the notes to the resolutions at the next AGM, on what impact the feedback has had on board decisions and any actions / resolutions then proposed.
The FRC led a coalition of parties that produced a report (click here) in 2016 on "Corporate culture and the role of boards" (the Report). It has included concepts that featured in that Report throughout the revised Code on the basis that a healthy culture ensures that the systems, procedures and overall functioning and mutual support of an organisation work effectively together. In particular, new Principles A (requiring a company's purpose, strategy and values to be aligned with its culture) and D (requiring the workforce to be able to raise concerns in relation to management and colleagues where they consider that conduct is not consistent with the company's value and responsibilities), and Principles 2 (requiring directors to embody and promote the desired culture of the company) and 3 (regarding whistleblowing) link directly to culture.
The FRC has added (in Provision 3) a requirement for there to be a means for the workforce to raise concerns in confidence and (if they wish) anonymously. This goes further than the current Code Provision C.3.5, which requires the audit committee to review the means by which staff are able to raise concerns about "improprieties in matters of financial reporting or other issues". They have also made this a full board responsibility, though this could be delegated to another committee which then reports back to the board.
Section 2 - Division of Responsibilities
The provisions regarding composition of the board remain broadly the same as under the current Code, save that:
- current Code Provision A.3.1 (which provides that the Chairperson should meet the independence criteria on appointment) has not been included and, according to the new Provision 15, the Chairperson is now considered independent at all times. As a result, the wording in the new Provision 11 has changed so that independent non-executive directors, including the Chair, should constitute the majority of the board; and
- Provision 11 does not provide an exemption for companies outside the FTSE 350.
Independence and tenure
The revised Code strengthens the Provisions on independence. The relevant criteria has not been amended, but, rather than the current approach of listing the criteria that should be taken into account when considering whether NEDs and the Chair are independent, the revised Code states that where they meet the stated criteria, they should not be considered to be independent. This is a change of emphasis, but the FRC has confirmed that it will still be open to companies to offer an explanation if they believe that an individual is still independent. They also recognise that, in some circumstances, companies can explain if they wish to retain a NED and/or Chair beyond nine years. They are consulting on whether this is an appropriate time period to be considered independent. Commentary in the consultation also clarifies that the nine year time period does not get re-set when an independent NED becomes Chair of the board, but applies from the date of first appointment to the board.
Section 3 - Composition, succession and evaluation
Diversity in the boardroom and beyond
Drawing on a range of reports, including, in particular, the Hampton-Alexander Review and the Parker Report, the revised Code seeks to ensure that companies intensify their efforts to build greater diversity among business leaders. New Principle J broadens the focus of the Code by encouraging the building of diversity across the workforce, in particular, in the senior management team (which, for these purposes, means the executive committee, or the first layer of management below board level, including the company secretary). It also extends the concept of diversity to promote diversity of social and ethnic backgrounds, cognitive and personal strengths, as well as gender.
The Hampton-Alexander Review recommended that, in order to address inconsistencies in reporting on the gender of senior managers under section 414C of the Companies Act 2006 which has made comparisons between companies difficult, the FRC should require all FTSE 350 companies to disclose the gender balance on the Executive Committee and Direct Reports to the Executive Committee. The FRC is proposing a new Provision 23 that requires all companies (not just FTSE 350) to include a description of the gender balance of those in senior management and their direct reports in their annual report, as well as what actions the nomination committee has taken to oversee the development of a diverse pipeline for future succession to the board and senior management appointments. The FRC is consulting on whether:
- reporting on gender balance should be extended beyond the FTSE 350, as proposed; and
- the Code should encourage companies to provide data on levels of ethnic diversity in their pipelines.
Section 4 - Audit, risk and internal control
Despite the continued feedback that investors want company viability statements to explain more adequately the long-term prospects of the company and to communicate messages about its long-term future, most recently in the Financial Reporting Lab's report on Risk and Viability Reporting (published in November 2017, click here), the FRC has chosen not to amend the requirements relating to viability statements set out in current Code Provision C.2.2 (new Provision 31).
Similarly, despite being aware that there is duplication between certain requirements of the Listing Rules, the Disclosure Guidance and Transparency Rules and the current Code, the FRC has decided to retain the current Code requirements, but is consulting on that decision.
Current Code Provision C.3.3 (requiring the terms of reference of the audit committee to be made available) has been removed, but is referred to in the Guidance (which states that terms of reference for all board committees should be set out clearly and made publicly available). The FRC is consulting on this amendment.
Section 5 - Remuneration
In light of the Government's recommendations in its response to the Green Paper Consultation on Corporate Governance Reform, the FRC proposes to include new Provisions requiring that:
- the remuneration committee chair should have served on any remuneration committee for at least 12 months on appointment (new Provision 32);
- in normal circumstances, shares granted (or other long term incentives) should be subject to a minimum vesting and holding period of at least five years (new Provision 36);
- remuneration schemes make provision for boards to be able to override remuneration formulaic outcomes, if appropriate, (the FRC gives, as an example of when such power should be available, circumstances where the measurement of any performance condition does not reflect the actual performance of the company over the period, or the performance of an individual director) (new Provision 37);
- the remuneration committee should have an expanded remit, which covers overseeing company remuneration and wider workforce policies and practices, and taking these into account when setting the policy for director remuneration (new Provision 33). The FRC has recognised that this will involve a greater time commitment and that, therefore, some companies may decide that it would be more appropriate to delegate some of this oversight to other committees, eg sustainability, corporate responsibility or people committees; and
- the annual report should include improved reporting on how the Principles and Provisions in Section 5 have been applied, including what engagement has taken place with the workforce to explain how executive remuneration aligns with the wider company pay policy (new Provision 41).
The FRC is seeking views on the proposals in this section. It also indicates that, once the Government's legislative proposals regarding pay ratios and clearer reporting on the remuneration outcomes from complex, share based incentive schemes have been published, they may make consequential changes to this section of the revised Code.
The revised Code is split into five sections: (1) Leadership and purpose; (2) Division of responsibilities; (3) Composition, succession and evaluation; (4) Audit, risk and internal control; and (5) Remuneration. The majority of the changes have been made to Sections A (Leadership) and B (Effectiveness) of the current Code. Section E (Relations with shareholders) has been largely integrated into the revised Code and the revised "Guidance on Board Effectiveness" (set out in Appendix B - click here). The Guidance is not statutory, but should be read alongside the revised Code to add clarity and explanation. Section C (Accountability) of the current Code has few changes and retains many of the current Code concepts and is included in Section 4 (Audit, risk and internal control). The current Schedule A (The design of performance-related remuneration for executive directors) has been removed and, where appropriate, incorporated into the new section 5 (Remuneration).
In an effort to "shorten and sharpen" the Code, the FRC has removed entirely the concept of "Supporting Principles" (currently the Code is set out as: (a) 18 Main Principles; (b) 27 Supporting Principles; and (c) 55 Provisions) and now includes just 17 Principles and 41 Provisions. Appendix C to the consultation (click here) goes through each part of the existing Code and indicates whether it has:
- become a Principle in its own right,
- been built into the Provisions;
- been moved into the amended Guidance;2 or
- been deleted.
Notable deletions include:
- Supporting Principle B.1 (which provides that the board should be of sufficient size to meet the requirements of the business);
- Provision B.2.3 (which provides that NEDs should be appointed for specified terms and any term beyond six years should be subject to particularly rigorous review);
- Provision D.1.2 (which provides that where an executive director serves as a NED elsewhere, the Remuneration Report should state whether the director will retain such earnings and, if so, the amount); and
- Provision E.2.4 (which provides that notice of an AGM should be sent to shareholders at least 20 working days before the meeting, and notice of a general meeting should be sent 14 working days in advance).
On 4 December, the FRC published a set of FAQs (click here) on non-financial reporting in order to assist companies that are required to comply with the Companies, Partnerships and Groups (Accounts and Non-Financial Reporting) Regulations 2016 (which insert section 414CA and 414CB into the Companies Act 2006) before the FRC's revised Guidance on the Strategic Report is published. The FRC confirmed that it intends to finalise its amendments to the Guidance on the Strategic Report when the Government has published its legislative changes in respect of reporting on section 172, which are currently expected to be published in March 2018.
In a move that is likely to be welcomed by companies and investors alike, the FRC has taken some of its own advice and "cut the clutter" in the current Code, significantly shortening it from 32 pages, to just 13. As well as deleting some items, and moving others to the revised Guidance, it has also added some significant new provisions for boards to grapple with.
Although the revised Guidance provides some useful indicators as to how boards might go about satisfying the new requirements, it will be interesting to see what actions companies start to take in practice. Some of the issues companies will need to think about include:
- which one of the three methods of gathering the views of their workforce should they opt for, or should they opt for a combination? What is the roadmap for putting this into practice?
- given the significant expansion of the roles and responsibilities of the remuneration and nomination committees, what additional training and support will they need? Presumably, at the very least, they will need to have greater interaction with the HR team;
- for those companies who have not yet articulated clearly, and embedded throughout the business, their set of values and culture, they will need to think about the steps they need to take to do this;
- examine what powers the remuneration committee currently has to override formulaic outcomes under existing remuneration schemes, and how these may be introduced if they do not currently have these powers; and
- although the revised Code will only apply to accounting periods starting on or after 1 January 2019, the extent to which they should (and investors will expect them to) include disclosure in earlier reporting periods regarding how they intend to comply with the revised Code.
With regard to items moved from the Code to the Guidance (which is not statutory, but should be read alongside the revised Code to add clarity and explanation), the FRC explained that these represent practices that are well embedded in company behaviour and the revised Code is focused on improving standards. In years to come, though, it will be interesting to see whether there is any slippage in compliance with these requirements as a matter of market practice (consciously or unconsciously) due to losing their "comply or explain" status.
1 The FRC is consulting on whether 20% is the right figure. Currently, Supporting Provision E.2.2 leaves it to the board to decide what is meant by a significant vote against.
2 The FRC has confirmed that this movement from the Code to the Guidance does not mean that the provision is now less important, but rather that the practices are well embedded in company behaviour, whilst the aim of the revised Code is to encourage companies to go further and raise standards.