The FRC's consultation followed on from a renewed focus on corporate governance reform by the UK government, beginning with a Green Paper consultation published by the Department for Business, Energy & Industrial Strategy in November 2016. The outcome of this consultation has driven many of the FRC's proposed changes to the Code.
Leadership and purpose
In line with recent trends in corporate governance, this section of the draft new Code now includes social purpose, culture and shareholder engagement as key areas of board responsibility. In a significant departure from the board's traditional role, it also states that the board's function is to contribute to wider society, as well as to promote the long-term success of the company and to generate shareholder value. The draft Code also places increased emphasis on other stakeholders in a company, as well as its shareholders – and highlights the board's role in ensuring effective engagement with all stakeholders. As part of this engagement process, the board would be expected to establish a way of gathering the views of the workforce. This could be a director appointed from the workforce, a workforce advisory panel or a non-executive director designated with this role. Companies must also have appropriate whistleblowing procedures in place for the workforce. The reference to 'workforce', rather than employees, is deliberate – in an acknowledgement of the growing 'gig economy', the FRC will expect a company to consider its impact on other personnel, as well as formal employees.
These themes are continued into the board's reporting responsibilities. In line with proposed changes to UK company law, the Code will require the board to explain in its annual report how it has engaged with its workforce and other stakeholders, and how their interests and the matters set out in section 172 of the Companies Act 2006 (the duty to promote the company's success) influenced the board's decision-making. (These include factors such as the long term consequences of decisions, employee interests, relationships with suppliers, customers and others, the impact on the environment and community, the company's reputation and fair treatment of shareholders.)
At the same time, the proposed new Code continues to recognise the importance of a company's relationship with its shareholders, requiring board chairs to engage with major shareholders to understand their views, and committee chairs to do the same in relation to their areas of responsibility. However, where shareholders formally express their discontent, the FRC will expect boards to go further and take remedial action. Accordingly, where a significant percentage of shareholder votes (the FRC suggests 20 per cent) are cast against a resolution, the Code will require the board to explain the action it intends to take to consult shareholders on the reasons behind the result, and to report back periodically on how this has impacted on the board's decision-making.
Division of responsibilities
The Code places a high degree of importance on the independence of non-executive directors, but this remains an area where there are significant levels of non-compliance. Currently, there is a list of matters that boards should take into account when determining the independence of the chair or a non-executive director. To improve standards of independence, the FRC proposes to make this list mandatory, so it is clear that where a director has a relationship with the company, either present or historical, they will not be considered to be independent. The chair will also need to demonstrate independent and objective judgement. The FRC has sought views on whether a tenure of less than nine years is an appropriate period to be regarded as independent (and whether a maximum period of tenure is unnecessary).
The revised Code is expected to mandate the annual election of directors for all companies, including companies below the FTSE 350.
Board composition, success and evaluation
The proposed changes in this part of the revised Code focus on diversity, with the growing recognition that a diverse leadership can significantly impact upon the success of a business and its ability to adapt to the changing environment in which it operates. While the existing Code identifies the need for gender diversity, the revised Code would specifically reference diversity of social and ethnic background, as well as gender. It would also give a key role to the nomination committee in promoting diversity, by expanding its remit to include oversight of developing a diverse succession pipeline. The committee will have to report back in the annual report on the action it has taken to increase diversity, how this supports the company in meeting its strategic objectives and the progress made. The report must also include the gender balance of those in senior management and their direct reports.
The revised Code will expect all companies, including companies below the FTSE 350, to have an externally facilitated board evaluation at least every three years.
Audit, risk and internal control
The FRC has proposed leaving most of this part of the Code unchanged, but has sought views on whether it should remove areas of overlap with other regulatory provisions.
The revised Code would require all companies, including companies below the FTSE 350, to have an audit committee made up of three independent non-executive directors.
This area of the Code has seen a significant re-write, with the government's renewed focus on senior executive pay driving many of the amendments.
There are some important changes proposed to the composition and remit of the remuneration committee. For all companies, including those below the FTSE 350, the committee would need to consist of at least three independent non-executive directors. Before appointment, the chair should have served on a remuneration committee for at least 12 months. In addition to determining the pay policy and remuneration for the board and senior management, the committee will also have a new responsibility for overseeing remuneration in the wider group, as well as workplace policies and practices, and taking these into account when setting the policy on board pay.
Vesting and holding periods for share-based pay or other long-term incentive plans will be expected to be, in normal circumstances, at least five years – a widely publicised change derived from the increasing focus on improving the alignment between executive pay and long-term company performance. The Code also includes a list of matters the remuneration committee will need to address when designing executive director policy and practices. These include avoiding complexity, and providing clarity, predictability, proportionality and alignment to culture. At the same time, boards should have discretion to override formulaic outcomes. The description of the committee's work in the annual report must also explain how it has engaged with the workforce and how executive pay aligns with wider company pay policy.
Guidance on Board Effectiveness
In general, the revised Code is much more concise than the current version. However, the FRC also proposes to make significant changes to its Guidance on Board Effectiveness, which will now include many of the provisions that were originally in the Code. It will also expand on the FRC's focus on diversity, and workforce and wider stakeholder engagement.
The FRC also took the opportunity, as part of its consultation on the revised UK Corporate Governance Code, to ask for feedback on a series of high-level questions about the future direction of the Stewardship Code. It plans to consult on specific changes later this year.
Although the final form of the new Code is not expected to be available until early summer and will not apply until financial years beginning on or after 1 January 2019, companies should start to think about the impact of the changes on their business. In particular, companies should consider reviewing their policies and practices on stakeholder engagement, board composition, diversity and executive remuneration. Companies below the FTSE 350 should also consider whether their existing board structures will remain suitable once the concessions for smaller companies have been removed from the Code.
Client Alert 2018-063