Out-Law Analysis | 18 Dec 2017 | 4:57 pm | 7 min. read
All companies with a premium listing of equity shares in the UK are required under the Listing Rules to report in their annual report and accounts on how they have applied the Code. Listed companies are required to report on:
The emphasis of the revised Code has shifted from compliance to desired outcomes, as a concerted move against 'box ticking' by companies. It seeks to achieve this through a greater number of more specific principles, and a reduced number of more detailed provisions.
Corporate governance is topical, and the revised Code reflects themes that have been well-established over the past 12 months: the importance of culture; the necessity of wide stakeholder engagement, particularly with employees; the independence of non-executive directors (NEDs) and the chair; and the treatment and reporting of executive remuneration. Note that the revised Code removes all exemptions for companies below the FTSE 350 on the basis that all premium listed companies should aspire to the highest levels of governance. The extent and appropriateness of the burdens imposed forms part of the consultation.
Overall, the revised Code is more direct and its aims much more targeted. Express focus on diversity, succession and independence is likely to result in more attention from companies on the role of the board and its constituent directors on creating real impact within the company. Increased dialogue with stakeholders, particularly employees and investors, is also aimed at producing conversations about how the company influences its environment by requiring more regular and substantive dialogue with decision-makers.
The revised Code will apply for accounting periods beginning on 1 January 2019. This means that, for companies whose year end is 31 December or 31 March, there is some time before the revised Code bites. It is, of course, helpful to take note of these changes in advance, and any lead-in time will allow smaller premium-listed companies in particular to be informed by the approaches taken by early adopters.
The FRC is consulting on the proposed revisions until 28 February 2018, and envisages publishing a final version incorporating any amendments in the summer.
The revised Code is divided into five sections, with principles indicated by letter (A-Q) and provisions by number (1-41). Here, we examine each section in turn.
Section 1: leadership and purpose
Of immediate note is Principle C, which explicitly requires engagement with "stakeholders" in addition to shareholders – particularly engagement with and participation by employees. Ways of encouraging this engagement and participation are set out in Provisions 2 and 3.
Despite the push for greater stakeholder involvement, the consultation acknowledges the importance of stakeholder engagement and the FRC has very deliberately moved a number of provisions to the first section of the revised Code. In particular, companies will now be required to explain, when announcing voting results, what action they intend to take to consult with shareholders in order to understand the reasons behind any vote where more than 20% of votes have been cast against the resolution. The 20% figure is a change from the current reference to "a significant proportion" of votes.
The Investment Association (IA) will shortly launch a public register highlighting these votes, along with instances of companies withdrawing resolutions before a vote and links to the required announcement and any updates. This is intended to focus directors' minds on particular issues indicated by shareholders and to encourage dialogue and transparency. The consultation raises the question of whether the 20% threshold is the right one, but as this figure will be used for the IA's public register and was agreed with the government for that purpose it seems likely to remain.
The government plans to introduce secondary legislation requiring all companies, private as well as public, to explain how their directors comply with the requirements of section 172 of the 2006 Companies Act, which is the statutory codification of directors' duties. Provision 4 makes reference to reporting on the impact of section 172 on decision-making, but the FRC notes that the wording may change once the government provides further information on its proposal.
Section 2: division of responsibilities between board members
The revised Code strengthens the provisions on independence for NEDs and the chair. Specific criteria that should be taken into account by the board when considering independence remain unchanged, but the revised Code subtly changes the position so that unless a NED and/or the chair meets the stated criteria, they should not be considered independent. Companies still retain the option of offering an explanation if they believe that an individual is still independent.
Provision 11 maintains the position that independent NEDs should constitute the majority of the board. It now also explicitly incorporates the chair as part of the independent majority of the board - something that, although only now incorporated into the Code, largely reflects current practice.
As the consultation provisionally removes the current exemptions set out in the Code for companies below the FTSE 350, smaller premium listed companies will need to increase the independent NED representation on their boards to at least 50% with the accompanying administrative and costs burden than implies.
Section 3: composition, succession and evaluation of the board
Dovetailing with Section 2, Provision 18 states that all directors must be submitted for re-election annually. The FRC's view is that this, in conjunction with the maintained nine-year rule for independence (now contained in Provision 15) and the requirement for external board evaluation every three years, will lead boards and shareholders to carefully consider each director's contribution to the board and their effectiveness generally.
In many companies, it will be the case that the chair in particular will have served for over nine years - or a considerable portion of that time - when appointed. The Financial Times has identified 67 FTSE 100 chairs who would technically be affected by this change (registration required). However, the emphasis in the revised Code is on material explanation against the Principles and so, rather than ushering in an immediate change for chairs, it is intended to instil a culture of reflection: why is the chair still deemed to be independent and able to remain in post?
Although the revised Code is only at consultation stage, it is clear that the FRC sees diversity and an explicitly recorded culture as important in developing trust and ensuring integrity in the corporation. Two McKinsey studies are quoted approvingly: 'Women Matter', which found that greater female representation in the boardroom and senior management has a positive impact on performance; and 'Diversity Matters', which found a statistically significant relationship between ethnically and gender diverse leadership teams and better financial performance.
Provision 23 now requires reporting on actions taken to increase diversity and inclusion and progress made, together with an explanation of how diversity supports the company in meeting its strategic objectives. Note that this also incorporates the recommendations of the Hampton-Alexander review on gender balance.
Again as a result of the removal of the previous exemption for smaller premium listed companies, the requirement to commission an independent board evaluation every three years at Provision 21 now applies to all companies to which the Code applies. Appointing an external reviewer is likely to have relatively significant cost implications for those companies previously exempt.
Section 5: remuneration
The revised Code includes new provisions that, broadly, direct remuneration committees to engage with remuneration in a more strategic and principled manner, and to regularly and clearly explain certain aspects of their work.
Provision 31 contains an important new requirement for remuneration committees to have express power to adjust any formulaic remuneration outcomes to properly align with company and individual performance. This reflects current investor expectations about the use of remuneration committee discretion, which investors perceive companies wish to apply asymmetrically - that is, largely or exclusively to benefit directors rather than also to reduce rewards that seem excessive in a broader performance context.
Remuneration committee remits are expanded, with greater responsibility for remuneration of senior management below board level and new responsibility for oversight of broader company workforce and remuneration policies. Provision 41 also requires the committee to engage with the workforce to "explain how executive remuneration aligns with wider workforce pay policy". Remuneration committees could well find such engagement and explanation quite difficult, even if limited only to employees. If the "wider workforce" could also include workers at businesses providing outsourced services to the company, it is even harder to see how the remuneration committee could effectively engage with them.
As with the secondary legislation relating to section 172 of the Companies Act, the FRC is similarly waiting for legislation requiring CEO : average pay ration reporting and to strengthen reporting requirements in respect of the range of possible outcomes under complex, share-based incentive schemes. Section 5 is therefore something of a moving target, under review, and primed for further revision in light of the final amending legislation.
We will look at the likely impact of the revised Code on remuneration practice and policy in a future article on Out-Law.com.
Tom Garbett is a corporate governance expert and Graeme Standen a share plans and remuneration expert at Pinsent Masons, the law firm behind Out-Law.com.