A substantial reworking of the UK corporate governance code is on the way
The UK has commenced consultations on the promised ‘fundamental review’ of its Corporate Governance Code – the equivalent of our ASX Corporate Governance Principles & Recommendations. Consultations close on 28 February with the new Code proposed to apply to listed UK firms from 1 January 2019.
In launching the consultation the UK Financial Reporting Council (FRC) noted:
Over the last few years, governance within the largest companies has been subject to heightened public scrutiny due to their impact on a wide range of stakeholders globally, nationally and locally. In some high-profile cases the quality of governance has been poor. Now is the right time to undertake a comprehensive review to ensure that the Code remains fit for purpose and continue to promote improvement in the quality of governance. We are not starting from scratch.”
The key changes proposed for the revised UK Code are summarised below:
- New structure to make the Code ‘shorter and sharper’, with obligations set out in five distinct sections (see below).
- Stronger focus on culture and aligning company strategy and values with culture
- Workforce engagement, requiring firms to adopt one of three methods for employee engagement in governance (or alternate options, if they achieve the same aims)
- Whistleblowing policies approved and monitored by the Board are now required
- Stricter independence definitions, including requiring that the Chair of the Board must be independent on an ongoing basis (not just on appointment)
- Greater diversity focus with new reporting requirements and a focus on gender, social and ethnic diversity in succession planning for boards
- New requirements for significant shareholder votes ‘against’, defining significant votes at 20% and requiring companies to report on what actions it intends to take to consult with shareholders on the issues (along with six monthly updates).
- Extensive executive remuneration changes, including vesting and holding periods for LTIs to be set at five years
- Broader Stakeholder interest requirements, and new reporting obligations in this area
- Removal of concessions for smaller companies (i.e. those under FTSE 350).
The FRC has noted that the proposed changes are informed by a number of recent reports and initiatives including the government’s Green Paper Consultation on Corporate Governance Reform released in August; the House of Commons’ Business, Energy and Industrial Strategy Committee’s Report on Corporate Governance released in April; the FRC’s own 2016 report on Corporate culture and the role of boards; and the Hampton-Alexander Review and Parker Review reports on diversity. In addition, the FRC was asked by government to consider making changes to the code in response to recommendations emerging from its corporate governance report. These inform the changes proposed to remuneration.
Proposed new structure of the Governance Code
The FRC proposes to restructure and rewrite the code to make it ‘shorter and sharper’ than the existing code. The proposed code is divided into five sections:
- Section 1 – Leadership and purpose
- Section 2 – Division of responsibilities
- Section 3 – Composition, succession and evaluation
- Section 4 – Audit, risk and internal control
- Section 5 – Remuneration
Although the structure of the Code changes significantly, many of the existing provisions have been retained or moved into the Guidance on Board Effectiveness. This reflects the FRC’s view that many of these provisions, while remaining important, have become common and expected business practice. The principles and provisions in the Code itself aim instead to raise standards.
The FRC is also seeking to change the focus of UK governance reporting from the current ‘comply or explain’ model of dealing with specific provisions, to reporting on the application of the Principles. The FRC is seeking to promote adopting of all of the Code Principles as mandatory expectations, with reporting to focus on how the Principles have been implemented and linking these to the organisation’s strategy and business model.
Strong focus to culture
The revised Code focuses heavily on culture, drawing on the FRC’s “Corporate Culture and the Role of Boards” report from 2016.
The consultation paper explains:
“The Culture Report found that culture in business is an important ingredient in delivering long-term sustainable performance. Where there is a healthy culture, the systems, procedures and overall functioning and mutual support of an organisation work effectively together. This brings integrity, confidence, long-term success and ultimately trust. A poor culture is a significant business risk in itself. Principles A and D, along with Provisions 2 and 3, link directly to culture. The concepts outlined in our report feature throughout the revised Code.”
“We found that in order to establish an appropriate culture, a board must define the purpose, strategy and values of the company, and consider the type of behaviours it wishes to promote in order to deliver its business strategy. This involves creating the right corporate culture, working with the wider workforce, and aligning the company values and purpose to the strategy. Paying due attention to the company culture helps to achieve long-term success and build trust. Grant Thornton’s review of FTSE 350 companies found that, although there has been year-on-year improvement, there is more to be done to explain how culture is integrated within a company. For instance, only 39 per cent provided a strong disclosure on company culture and only 29 per cent of chief executives referred to it in their annual report statement.”
Culture informs several aspects of the revised Code (as summarised by Herbert Smith Freehils in a December 2017 Corporate Governance Update):
The Introduction to the Code states that a company’s culture should ‘promote integrity and openness, value diversity and be responsive to the views of shareholders and wider stakeholders’.
The first Principle of the Code states that the function of a successful company includes contributing to wider society (as well as promoting the long-term success of the company and generating value for shareholders) and provides that the board should establish the company’s purpose, strategy and values, and align those with its culture (Principle A).
The Code includes a Provision stating that the directors should embody and promote the desired culture of the company and states that the board should monitor and assess the culture to satisfy itself that behaviour throughout the business is aligned with the company’s values. Where there is misalignment, the board should take corrective action, and the annual report should explain the board’s activities (Provision 2).
The Code also requires boards to establish and monitor whistleblower policies and procedures, and brings in changes to executive remuneration (as foreshadowed by the UK).
Other notable changes include:
- Directors Duties (s 172 obligations): The board should explain in the annual report how it has engaged with the workforce and other stakeholders, and how their interests and the matters set out in s172 of the Companies Act 2006 have influenced the board’s decision making. The government has announced its intention to introduce regulation to require directors of large firms to report on their compliance with their s172 duties, and the consultation paper notes that finalisation of this provision will await the law reform process.
- Board composition — the role of the chair: The new code requires that the Chair of the Board must be independent at all times, and new provisions require that the majority of the board must be independent (increased from the current Code’s requirement for 50% of the Board to be independent). Importantly, the new Code will remove exemptions for smaller companies from these and other requirements.
- Diversity: The new code will require Boards to increase their efforts’ to improve diversity. New diversity reporting obligations (including ethnicity and race, along with gender) will require firms to report on the actions they are taking to boost diversity, amongst other items.
- Executive remuneration: The Code would require new and expanded disclosure of remuneration, establish new obligations on remuneration committees to ensure executive pay is aligned with pay in the wider workforce, lengthen vesting periods for long-term incentives and prohibit variable remuneration for NEDs.
Download the UK Corporate Governance Code Consultation paper here.