The UK Financial Reporting Council (FRC) has published the new edition of the UK Corporate Governance Code following the completion of its consultation process earlier this year. The new Code is substantially different in layout from the current Code and includes significant amendments in the areas of stakeholder engagement, board composition, diversity and executive remuneration. There have also been some important changes to the consultation draft of the new Code. Most notably, these include the re-instatement of some, but not all, of the concessions for companies below the FTSE 350 in the current Code. This article summarises the key changes the FRC has made to the current Code and highlights where the FRC has changed its position as a result of the consultation. It also summarises the changes to company reporting obligations as a result of the Companies (Miscellaneous Reporting) Regulations 2018.
The new Code follows from the renewed focus on corporate governance reform by the UK government, which began with a Green Paper consultation published by the Department for Business, Energy & Industrial Strategy (BEIS) in November 2016. The outcome of this consultation, and work of the House of Commons BEIS Committee, has driven many of the FRC’s changes to the Code, as well as the content of the new Companies (Miscellaneous Reporting) Regulations 2018 (the Regulations).
Leadership and purpose
In line with recent trends in corporate governance, the new Code includes social purpose, culture and shareholder engagement as key areas of board responsibility. It also states that the board’s role is to contribute to the wider society, as well as to promote the long-term sustainable success of the company and to generate shareholder value – although the FRC emphasises that it intends this broader principle to promote good governance, rather than to override or interpret directors’ statutory duties. The new Code also places increased emphasis on other stakeholders in a company and not just the company’s shareholders, and highlights the board’s role in ensuring effective engagement with all stakeholders.
At the same time, the 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. Where shareholders formally express their discontent, the FRC requires boards to go further and take remedial action. As a result, where 20 per cent or more of shareholder votes are cast against a resolution, the board will need to explain the action it intends to take to consult shareholders on the reasons behind the result, provide an update in the following six months on shareholder views and the action taken, and set out in the annual report and AGM notice how this has impacted on the board’s decision-making and any actions or resolutions it now proposes.
In line with the Regulations, the new Code requires the board to understand the views of the company’s other key stakeholders and to describe in its annual report how their interests and the matters set out in section 172 of the Companies Act 2006 (the duty to promote the company’s success) have been considered in board discussions and decision-making. These include factors such as the long-term consequences of decisions, employee interests, the need to foster relationships with suppliers, customers and others, the impact on the environment and community, the company’s reputation and fair treatment of shareholders. The Regulations impose similar annual reporting obligations on large companies, specifically in relation to their business relationships with suppliers, customers and others, and more detailed reporting rules for companies with 250 UK employees or more in relation to employee engagement and employee interests. The FRC’s revised strategic report guidance issued in July 2018 also has a greater emphasis on the section 172 duty, and addresses some of the practical issues associated with the new section 172 reporting obligations. In addition, there are draft Q&As accompanying the Regulations which provide guidance on the detail a company should include in its section 172 statement.
The new Code expects boards to keep engagement methods under review so that they remain effective. To engage with the workforce, the board should use one or a combination of the following methods: a director appointed from the workforce, a formal workforce advisory panel or a designated non-executive director. This is a change from the consultation version, in that companies must use one or more of these specific methods, or explain the alternative arrangements in place and why these are effective. Companies must also have appropriate whistleblowing procedures in place for the workforce. The reference in the new Code to ‘workforce’, rather than ‘employees’, is deliberate – the FRC expects a company to consider its impact on not only formal employees but also other personnel affected by board decisions.
Division of responsibilities
As a result of feedback during the consultation process, the FRC has reinstated the board’s discretion to determine the independence of non-executive directors (rather than, as originally proposed, providing that a non-executive director would not be considered independent if any of the criteria listed in the Code apply). However, if the board nevertheless considers a director to be independent despite the existence of an existing or past relationship with the company of the kind listed in the Code, it must now provide a clear explanation as to why it considers this to be the case.
The new Code clarifies that chairs only have to meet the Code’s independence criteria on appointment (restating the position in the current Code), although they should demonstrate objective judgment throughout their tenure.
The final version reverts to the position in the current Code in its expectation that at least half the board, excluding the chair, will be independent non-executive directors. However, it expects all companies to comply with this provision, including companies below the FTSE 350 (as proposed in the consultation version).
The consultation version suggested that the board would have to give its reasons for permitting a director to have any external appointment; however, the final version confirms that this is only needed where the appointment is significant.
Board composition, succession and evaluation
The proposed changes in this section of the new Code focus on diversity, with the growing recognition that a diverse leadership can significantly influence the success of a business and its ability to adapt to the changing environment in which it operates. While the current Code identifies the need for gender diversity, the new Code specifically references diversity of social and ethnic background, as well as gender. It also gives a key role to the nomination committee in promoting diversity, by expanding its remit to include oversight of the development of a diverse succession pipeline, and reporting back in the annual report on this and related matters (including the gender balance of those in senior management and their direct reports).
As revised following the consultation process, the new Code also clarifies that the FRC expects chairs to be in post for no more than nine years after their first appointment as a director (whether as chair or any other board member). Provided the company gives a clear explanation, the Code permits a limited extension for succession planning purposes and in order to develop a diverse board, particularly where the chair was an existing non-executive director on appointment.
Chairs should consider having a regular externally facilitated board evaluation, but (in a change to the consultation version) the new Code only expects FTSE 350 companies to have one at least every three years. The annual report should describe the nature of the external evaluator’s contact with the board and individual directors.
The new Code expects all companies to submit their directors for re-election annually, including companies below the FTSE 350.
The final version of the new Code also requires companies to consider the length of service of the board as a whole when succession planning.
Audit, risk and internal control
As proposed in the consultation version, FRC has left most of the content of this part of the new Code unchanged. It has also reverted in part to the current Code position on audit committee composition, which should comprise independent non-executive directors, with a minimum membership of three or, in the case of companies below the FTSE 350, two. However, the final version of the new Code confirms that it is no longer acceptable for chairs to be on the audit committees of smaller companies, even if they are considered independent on appointment.
As proposed in the consultation version, the FRC has largely re-written this area of the Code, with the government’s renewed focus on senior executive pay driving many of the amendments.
Following the consultation process, as with the audit committee, the FRC has returned to the current Code position on remuneration committee composition. This should comprise independent non-executive directors, with a minimum membership of three or, in the case of companies below the FTSE 350, two. However, as proposed in the consultation version, the new Code will expect the chair to have served on a remuneration committee for at least 12 months before appointment.
In addition to determining the executive director pay policy and remuneration for the chair, executive directors and senior management, the remuneration committee will also have a new responsibility for reviewing workforce pay and related policies, and the alignment of incentives and rewards with culture – and must take these into account when setting the executive director pay policy.
In normal circumstances, the new Code expects companies to release executive director share awards for sale on a phased basis and for total vesting and hold periods to be five years or more – a widely publicised change derived from the increasing focus on improving the alignment between executive pay and long-term company performance. In its feedback statement following the consultation, the FRC says that this would not include the deferred elements of annual bonuses, which typically vest over a shorter period. The committee should develop a formal policy for post-employment shareholding requirements, covering both unvested and vested shares.
Companies should also align pension contribution rates for executive directors, or payments in lieu, with those of the workforce – a new provision added by the FRC following the consultation process.
The new Code sets out a list of matters the remuneration committee will need to address when designing executive director pay policy and practices. These include avoiding complexity, and providing clarity, predictability, proportionality and alignment to culture. Following the consultation process, the list also includes identifying and mitigating reputational and other risks from excessive rewards and behavioural risks arising from target-based incentive plans. There should also be discretion to override formulaic outcomes.
The description of the committee’s work in the annual report must also explain why remuneration is appropriate, using internal and external measures, including pay ratios and pay gaps; and what engagement with the workforce has taken place to explain how executive pay aligns with wider company pay policy. It must also outline how the committee has addressed the above list of matters, and the extent to which any discretion has been applied in awarding pay and the reasons why.
These new reporting obligations tie in with those imposed on quoted companies by the Regulations. In addition, the Regulations require the remuneration report to disclose the amount of executive director pay attributable to share price appreciation, and the exercise of any discretion as a result of share price changes. Companies with more than 250 UK employees will also have to report on the ratio of CEO pay to the median (fiftieth), twenty-fifth and seventy-fifth percentile remuneration of the company’s UK employees, and provide supporting information, including the reason for year-on-year changes and whether (and, if so, why) the company believes the median pay ratio is consistent with its employee pay and progression policies. Pay policies of quoted companies must also disclose, for multi-year performance measures, the maximum pay receivable by executive directors, assuming a 50 per cent share price appreciation during the performance period.
Guidance on board effectiveness
In general, the revised Code is much more concise than the current version. However, the FRC has also made significant changes to its Guidance on Board Effectiveness, which now includes many of the provisions that were originally in the Code. It also expands on the FRC’s focus on diversity, and workforce and wider stakeholder engagement.
The new Code and the changes made by the Regulations apply to financial years beginning on or after 1 January 2019, which means the first reporting on the new requirements will not be until 2020. However, the FRC expects companies to begin reporting on significant votes at shareholder meetings in 2019, and to develop future remuneration policies and make changes to existing ones with reference to the new Code. Companies should in any case start to think about the impact of the changes on their business. In particular, they should review their policies and practices on stakeholder engagement, board composition, diversity and executive remuneration. Companies should also be alert to the possibility of further changes in these areas in the future. In its recent report on gender pay gap reporting, the House of Commons BEIS Committee expressed the view that the Code changes on diversity do not go far enough, and companies should report further on the measures they are taking to address gender pay gaps. Executive remuneration is also likely to remain an area of government and media focus, with reports on the rate at which senior executive pay is increasing in comparison to workforce pay continuing to attract headlines.
Client Alert 2018-170