UK Corporate Governance—under review

Corporate analysis: With the government adopting a stern tone on the importance of good behaviour in the corporate world, the Financial Reporting Council (FRC) has begun a review that will help inform responses to a recent green paper that seeks to address the issue. Stressing an increasing emphasis on transparency and reporting, and the spectre of shareholder concerns over executive pay, Eleanor Davison, of Fountain Court Chambers, presents an overview of what lies in store for companies and their lawyers.

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Original news

FRC response to Green Paper on corporate governance reforms, LNB News 22/02/2017 95

The FRC highlights the interests of stakeholders, executive remuneration, the accountability of large private companies and effective enforcement as key themes in its response to the government’s Green Paper on Corporate Governance reforms. The FRC’s response proposes reforms regarding the interests of major stakeholders, executive remuneration, large private companies and effective enforcement of the law.

What is the factual background that led to this review?

In her conference speech in October 2016 the Prime Minister stated that her vision was ‘a country that works for everyone.’ In relation to businesses, she observed ‘too often the people who are supposed to hold big business accountable are drawn from the same, narrow social and professional circles as the executive team. And too often the scrutiny they provide is not good enough.’ Since that speech, a green paper on Corporate Governance Reform has been published by the Department for Business, Energy and Industrial Strategy (BEIS), a consultation on the implementation of the Non-Financial Reporting Directive 2014/95/EU has been concluded and a call for evidence on reform of corporate liability is underway. 2017 is a year in which governance, corporate culture and the accountability of directors for the businesses they run is firmly on the government agenda.

On 16 February 2017, the Financial Reporting Council (FRC) joined the debate, announcing a fundamental review of the UK Corporate Governance Code (the Code) with its chairman, Sir Win Bischoff commenting ‘the Prime Minister has a vision of an economy that, in her words, “works for everyone”. This needs UK businesses to thrive so that all stakeholders including workers, customers, suppliers and society itself benefit through jobs growth and prosperity.’ The FRC will launch a consultation later in 2017 based on the outcome of its review and the government’s position on the BEIS green paper. The FRC is the UK’s independent regulator responsible for promoting confidence in corporate reporting and corporate governance and has guardianship of both the Code and the Stewardship Code, the latter of which applies to shareholders and aims to improve accountability to clients and beneficiaries.

This note seeks to draw out the likely position the FRC will take on amending the Code as the government forms its policy on corporate governance and any impact those potential changes may have on directors’ duties enshrined in the Companies Act 2006 (CA 2006), and on the implementation of the Non-Financial Reporting Directive in the UK.

First issued in 1992 and reissued in April 2016, the Code, which applies to all premium listed companies and places some further obligations on FTSE 350 companies, aims to disseminate best boardroom practice on issues such as:

  • board composition
  • effectiveness
  • risk management
  • remuneration, and
  • relations with shareholders

The Code is not prescriptive in that companies can choose how to comply with the principles and supporting principles set out within it. The aim is to support, rather than constrain, entrepreneurial leadership in the company while ensuring that risk is appropriately managed.

By requiring companies to report to shareholders rather than regulators the aim is to permit an assessment by those in whose interest the company is meant to act to whether the company’s governance is adequate. The FRC’s role in this regard, is to ensure investors have the information they need to make that assessment.

What are the blind spots of the current Code in the UK?

The essential features of the current Code are well established with its main principles, supporting principles and Code provisions. The five main areas covered by the Code are:

  • leadership
  • effectiveness
  • accountability,
  • remuneration, and
  • relationships with shareholders

In its January 2017 report, entitled Developments in Corporate Governance and Stewardship, the FRC noted that compliance with the Code remained at 90% among FTSE 350 companies. Full compliance in all FTSE companies rose from 57–62% in 2016. The weakest area among the FTSE 350 companies was compliance with Code provision B.1.2 which requires half the board to be independent. Investors were reportedly concerned about a lack of transparency regarding the link between executive pay and performance. Furthermore, there was a 24% increase in the number of resolutions with a significant minority vote against the recommendations of the board. The FRC’s view was that reporting by companies in these cases remains insufficient and is an area requiring improvement. These concerns about the links between executive pay and performance as well as full reporting of non-financial information are those where amendments to the Code or other measures may be required.

What are the proposed changes to the current code and what are the practical implications?

One point is clear from the FRC’s announcement of the Code review—that it will seek to protect the current approach of ‘comply or explain’ from any alteration. The principle of ‘comply or explain,’ first set out in the Cadbury Report following a series of corporate collapses in early 1990s, obliges all companies with a premium listing of equity shares, whether incorporated in the UK or elsewhere, to provide a statement of compliance with the Code in its annual reports, or explain to investors why the company has not done so in accordance with the Listing Rules of the Financial Conduct Authority (FCA).

Further insight into the FRC’s likely focus when it comes to reviewing the Code can be drawn from its response to the government green paper published on 21 February 2017. The FRC proposed four major reforms:

  • to the interests of major stakeholders requiring reinvigoration of the Companies Act 2006 duties
  • to executive remuneration
  • extending the applicability of the Code to larger private companies, and
  • effective enforcement of the law to all directors, regardless of professional affiliation

The first reform and its impact on the CA 2006 is considered below. In relation to executive pay, the proposals seek to expand the role of the remuneration committee and to give a harder edge to repeated votes against a remuneration package. An amendment to the Code to require shareholder consultation is suggested and legislation to permit escalation to the stage of binding vote in some circumstances, rather than the current advisory vote is proposed. In relation to large private companies, the FRC has stated that it stands ready to develop a governance framework if requested, and the minimum requirement in such a framework should be that already in place for companies with either a standard listing or which are quoted on the alternative investment market. In relation to enforcement, the FRC has stated that it would be willing to accept additional responsibility to investigate and prosecute all company directors, not just actuaries and auditors for financial reporting breaches and related integrity issues. How that proposal would dovetail with the current remit of the FCA remains to be seen.

How does this review affect CA 2006?

If the FRC’s response to green paper is adopted by the government, there will be an impact on the directors’ duty enshrined in CA 2006, s 172 to promote the success of the company. That duty, which is applicable to executive, non-executive, de jure and de facto directors alike, provides that a director must act in the way they consider, in good faith, would be likely to promote the success of the company. In so doing the director must have regard to a number of other factors such as long term consequences, the environment, employees, suppliers and customers. The FRC proposes that companies should be required to report on how they have discharged the CA 2006, s 172 duty. The FRC proposes amendment to the Strategic Report Regulations which will enable the FRC to monitor and enforce the requirement and to link CA 2006, s 172 duties to CA 2006, s 414 reporting requirements. FRC also proposes that CA 2006, s 172 reporting is included in the ambit of its monitoring powers so that the quality and integrity of reporting can be assessed.

How does this affect the compliance requirements of the Non-Financial Reporting Directive?

The Non-Financial Reporting Directive aims to improve the quality of non-financial reporting across Europe for those companies falling within its scope. The UK was required to transpose the Directive into UK law by 6 December 2016 and on 9 November 2016 the government published its response to the consultation on implementing the Directive. Prior to the Directive, non-financial reporting information was limited to a fair review of the company’s business and a description of its principal risks and uncertainties. The scope is wider under the Directive and requires information to the extent necessary for an understanding of the group’s development, performance, position and impact of its activity, including, as a minimum, reporting on environmental, social and employee matters, and matters concerning human rights, anti-corruption, and bribery.

These issues will continue to be reported in the strategic report and the director’s report in accordance with the CA 2006. The government determined not to require companies to have this information verified by an independent third party. Given the increasing focus of the FRC on the quality and integrity of reports made by companies, it is not difficult to envisage a time when the Code and related guidance on non-financial reporting will be amended to take account of the broadening in scope of reporting requirements and where directors are held to account for the accuracy of this information.

Interviewed by Julian Sayarer.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

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