On 13 June, the FRC published a consultation on the long awaited Wates Corporate Governance Principles for Large Private Companies (the Wates Principles). This came two days after the Government released a draft statutory instrument (The Companies (Miscellaneous Reporting) Regulations 2018 (the Regulations)) and accompanying FAQs (the FAQs), which, subject only to Parliamentary approval, will require additional disclosures to be made in the Annual Reports of certain large private companies and unlisted PLCs for financial years beginning on or after 1 January 2019. In the main, these changes will be implemented via amendments to the Large & Medium-sized Companies and Groups (Accounts & Reports) Regulations 2008.

These new reporting requirements are part of the Government's wider package of corporate governance reforms announced in August 2017 (for further on the wider package of reforms, click here, and for further on the reforms affecting listed PLCs, click here).

Summary of the Additional Disclosures Required in the Annual Report

Subject to meeting the relevant thresholds described below, companies will be required to make additional disclosures regarding: (i) how the directors have had regard to the matters in section 172(1) of the Companies Act 2006 (S172(1)); (ii) how the directors have engaged with employees; (iii) how the directors have had regard to the need to foster the company's business relationships with suppliers, customers and others; and (iv) which corporate governance code (not necessarily the Wates Principles), if any, has been applied and how.

Comment

While it is unsurprising that the new Regulations and the qualifying thresholds that they include are complex, there are certain elements that could be clearer. While the current draft of the FAQs go some way to clarifying the uncertainties, there are still areas requiring further clarification. For example, with respect to the qualifying threshold of "number of UK employees", for the "employee engagement" disclosure (discussed below), the Regulations explicitly state that where the company is a parent company, the average number of persons employed by the company refers to the number of UK employees within the group, whereas for the "corporate governance statement" disclosure (discussed below), the Regulations are silent on this. The FAQs do make it clear that the corporate governance statement threshold refers to the number of "global" employees and that "the consolidation does not apply to this threshold" when answering a question about a parent company preparing consolidated group accounts where a subsidiary meets the qualifying conditions but the parent does not. This leads us to conclude that parent companies should look at company numbers, and not the number of employees within the group. However, neither the Regulations, nor the FAQs explicitly state this, or the rationale behind it. There are similar issues with the qualifying threshold for the requirement to summarise how the directors have had regard to fostering the company's business relationships. We hope that, once companies have had a chance to digest the Regulations, these areas of uncertainty will be addressed, presumably in further iterations of the FAQs.

Further Detail on the Additional Disclosure Requirements

Statement regarding how directors have complied with their duty to have regard to matters in S172(1)

All large1 companies (including subsidiaries, even where the parent is required to produce a consolidated group Strategic Report) will be required to include a separately identifiable statement in their Strategic Report describing how directors have had regard to the matters set out in S172(1) when performing their duties under S172.

The contents, level of detail and length of the statement will be different for every company, but should be consistent with the size and complexity of the business. The Government indicates in its FAQs that companies will probably want to include information on some, or all, of the following:

  • the issues, factors and stakeholders the directors consider relevant in complying with S172(1) and how they have formed that opinion;
  • the main methods the directors have used to engage with stakeholders and understand the issues to which they must have regard; and
  • the effect of the above on the company's decisions and strategies over the year.

The Government acknowledges that there may be overlap between the disclosure required in the Directors' Report on employee engagement and customer and supplier relationships (described below), and what the company intends to disclose in its S172(1) statement in the Strategic Report. They have confirmed that, in these cases, companies can solely make a disclosure in the Strategic Report (as long as they make it clear in the Directors' Report which information has been included in the Strategic Report). Although the rules may seem duplicative, the rationale for the additional requirements in the Directors' Report is twofold: (i) to ensure that there is disclosure in the Annual Report about engagement with employees, customers and suppliers even where directors do not consider the information to be of strategic importance to the business; and (ii) to allow companies to provide more information than may be warranted in the Strategic Report, in the Directors' Report, for example by providing more detail on their employee engagement mechanisms.

Updated FRC Guidance on the Strategic Report is due to be published in July 2018 and the FRC has agreed to include guidance on how companies should prepare a S172(1) statement.

Large private companies and unlisted PLCs will need to make their S172(1) statement available on a website as soon as reasonably practicable, though posting the whole Strategic Report, or the whole Annual Report will also satisfy this requirement. For a subsidiary company, the statement can be put on its parent's website, as long as it identifies the subsidiary company.

Employee engagement

All companies that have more than 250 UK employees (for parent companies, look at the number within the group) will be required to explain in the Directors' Report how the directors have engaged with employees and had regard to employees' interests, and the effect of that regard, including on the principal decisions taken during the financial year. The Government estimates that around 12,400 UK companies have more than 250 employees, but are not able to estimate how many of these have more than 250 UK employees and will therefore be impacted by this rule change. Notably, this amendment will be implemented via a wholesale replacement of the existing rules on employee involvement disclosure set out in Part 4 ("Employee Involvement") of Schedule 7 ("Matters to be dealt with in a Directors' Report") of the Large & Medium-sized Companies and Groups (Accounts & Reports) Regulations 2008. Any companies already complying with that Part 4 will need to look at the amended rules carefully and consider whether they need to comply in each financial year (see "Qualifying Thresholds" below).

Fostering the company's business relationships with suppliers, customers and others

All large1 companies will be required to summarise in the Directors' Report how the directors have had regard to the need to foster business relationships with suppliers, customers and others, and the effect of that regard, including on the principal decisions taken during the financial year.

Requirement to make a corporate governance statement

All very large2 private companies and unlisted PLCs will be required to disclose their corporate governance arrangements in their Directors' Report, including whether they follow any formal corporate governance code (not necessarily the Wates Principles discussed below), how they have applied any such code and the reasons for departing from any part of the code (if applicable). The FAQs make it clear that all subsidiaries meeting the qualifying thresholds will need to comply, even where they are a wholly owned subsidiary of a parent company that: (i) complies with the UK Corporate Governance Code for premium listed companies; and (ii) prepares a consolidated group Directors' Report. However, the Government does acknowledge that, in these circumstances, the subsidiary's corporate governance statement might be considerably shorter (for example, it may say that it does not apply a corporate governance code because its parent applies a corporate governance code and this is applied throughout the group, but the subsidiary would still need to explain how that code actually applies to governance arrangements in the subsidiary and its directors).

Large private companies and unlisted PLCs will need to make their corporate governance statement available on a website as soon as reasonably practicable. We assume (though this is not stated in the FAQs) that, in the same way as for the S172(1) statement, posting the whole Directors' Report, or the whole Annual Report will also satisfy this requirement and that, for a subsidiary company, the statement can be put on its parent's website, as long as it identifies the subsidiary company.

It is generally accepted that, at a basic level, corporate governance is concerned with the way in which companies are directed and controlled, and the systems that they have in place for ensuring proper accountability in the conduct of their businesses. Discussions about corporate governance, though, also commonly overlap with discussions around broader environmental, socio-economic and compliance issues. Helpfully, the Regulations define what is meant by corporate governance for these purposes being, in relation to a company:

  • the nature, constitution or functions of the organs of the company;
  • the manner in which organs of the company conduct themselves;
  • the requirements imposed on organs of the company;
  • the relationship between different organs of the company; and
  • the relationship between the organs of the company and the members of the company.

Although the FAQs confirm that the Government does not have a preferred corporate governance code for large private companies to apply, the Wates Principles (described below) were drafted specifically with these Regulations in mind. The Wates Principles are therefore likely to be the corporate governance code of choice for most companies subject to the Regulations not already complying, or part of a group that already complies, with a corporate governance code. The other obvious alternatives would be the UK Corporate Governance Code (the Code) for premium listed companies, or the QCA Corporate Governance Code aimed at smaller listed companies. Both of these are much more prescriptive in their approach and therefore likely to be less attractive to companies seeking to apply a code for the first time.

Qualifying thresholds

Each of the reforms set out in the Regulations has its own unique set of qualifying thresholds, in most cases referred to as the "qualifying conditions". Although the headline qualifying thresholds are described above, it will be necessary for companies to look at each of the Regulations in turn and work out whether or not they need to comply each year. In particular, for companies whose size may fluctuate from year to year above and below the relevant thresholds, it is worth noting that the Regulations contain "smoothing provisions" which provide for a two year time lag before a company drops out of, or is covered again, by the requirements.

The Wates Principles

As part of the Government's corporate governance reforms announced in August 2017, the Government commissioned James Wates CBE (Chairman of Wates Construction) to lead a coalition of industry and wider society bodies (including the FRC and ICSA) to develop a new set of corporate governance principles aimed as a code of practice for large private companies. The draft Wates Principles were published on 13 June and the Government hopes that they will be used by both very large private companies and unlisted PLCs subject to the Regulations, and also by other companies not subject to the Regulations.

A significant challenge the coalition faced in drafting the Principles was drafting something that was both meaningful and robust, but also flexible enough to be applied by a range of types of companies (from private equity owned firms to large family owned companies to large subsidiaries of publicly listed companies). The result is a high-level approach to good corporate governance, consisting of six short form principles, with associated Guidance.

While there are echoes of the proposed revised Code throughout (for example, the reference to the following diverse characteristics a board may consider in the discussion around board composition: gender, social and ethnic backgrounds, and cognitive and personal strengths, and the use of the broader term "workforce" rather than "employees"), they are not prescriptive like the Code. There are no set requirements as to establishing a certain number of committees, or having a certain number of independent directors on the board.

The key difference between the revised Code and the Wates Principles, though, is the disclosure that a company needs to make about compliance. While the Code works on the principle of "comply or explain", meaning that a company need only go into detail about a particular provision of the Code when that company has not complied with it in a particular year, the Wates Principles work on the basis of "apply and explain". Although compliance with the Wates Principles is entirely voluntary, if a company wants to benefit from stating such compliance, they cannot just say, "the company complies with each of the Wates Principles". The company will be expected to provide a supporting statement for each of the six Principles that gives an understanding of how their corporate governance processes operate and achieve the desired outcomes. This approach to compliance is one of the most interesting and innovative elements of the Wates Principles. It will also make drafting the corporate governance statement a real challenge in the next couple of years, as each company will have a unique perspective on how they seek to apply the Wates Principles.

Sanctions for Non-Compliance with the Disclosure Requirements

If either (or both) of the Strategic Report and the Directors' Report do not contain any of the required information discussed above, each director of the company may be criminally liable and subject to a fine where they either knew it did not contain the required information, or were reckless as to whether or not it contained the information, and failed to take reasonable steps to secure compliance.

Additionally, if a company fails to post a copy of its S172(1) statement and its corporate governance statement on a website and (subject to reasonable circumstances preventing it from doing so) maintain it on the website, every officer of the company who is in default will have committed a criminal offence and be liable to a fine.

Next Steps

  • The Regulations are subject only to approval by Parliament. The Government expects them to be passed before 1 January 2019 as they will apply to financial years beginning on or after that date. In the meantime, the FRC expects to publish its updated Guidance on the Strategic Report in July 2018.
  • The consultation on the Wates Principles is open until 7 September 2018 and the final version is expected to be published in December 2018.
  • The first Annual Reports required to comply with the new rules are expected to be published in 2020.
          

Action to Take Now

  • Review corporate structures to work out which companies will need to comply with each of the new obligations described above.
  • Consider the employee and wider stakeholder engagement mechanisms each relevant company has in place now, if any, and whether they should be introduced, improved or expanded.
  • Consider whether to provide any additional messaging both externally and internally at the time that these new disclosures are published. For example, many companies reporting on their gender pay gap in April took the opportunity separately to report the results to their employees and, in doing so, added additional disclosure not required by the rules.
  • If relevant companies do not already have corporate governance strategies, policies and procedures in place, consider drafting them. If relevant companies (or their group) already have corporate governance strategies, policies and procedures in place, review them in light of the new requirements and emerging best practice. Where companies already have group wide subsidiary governance policies, update these with an eye to the Wates Principles for the benefit of any UK subsidiaries which meet the relevant corporate governance statement disclosure thresholds now, or in the future.
  • Work out which members of the business need to be involved in drafting and / or reviewing the relevant engagement mechanisms, strategies, policies and procedures described above (HR, Legal, Compliance etc).
  • Consider more in-depth director training, especially as regards the requirements of S172(1).
  • Consider best board practices (composition, frequency of meetings, formality of board minutes etc) for all subsidiaries subject to the Regulations.
  • Where multiple members of the same group of companies need to comply with the new rules, consider how to ensure a co-ordinated approach to compliance and drafting of the required disclosures.

[1] A large company is a company that meets two or more of the following criteria:

  • turnover of > £36 million;
  • balance sheet total of > £18 million; and
  • Number of employees > 250.

The Government estimates that changes affecting large companies will impact around 16,000 companies.

[2] A very large company is a company which is not already subject to a corporate governance requirement and has either (or both):

  • > 2,000 global employees; and
  • turnover of > £200 million AND a balance sheet total of > £2 billion.
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