19 March 2018
The Financial Reporting Council has proposed changes to the UK Corporate Governance Code (the Code) which are wide-ranging and aim to adapt the Code to reflect the changing economic and political climate.
Main Market companies will need to take action to comply with the new requirements and update internal procedures and documents.
The final version of the Code should be published by early summer 2018, applying to accounting periods beginning on or after 1 January 2019.
This timing may be challenging for some companies, especially those who will need to appoint additional directors due to the changes to board independence and board composition. Early preparation will be needed.
On the plus side, the proposed new Code is shorter and with a simpler format. The draft Code comprises Principles, which set out high-level requirements, and more detailed Provisions that continue to be 'comply or explain' in nature.
There is, however, a new emphasis on reporting on the application of Principles, rather than explaining non-compliance with Code Provisions. This is intended to address a perceived over-emphasis in existing reporting on the 'comply or explain' aspects of the Provisions under the current Code. Companies will need to be alert to this increased emphasis.
Key areas of change in the proposals include stakeholder engagement, independence, board composition (and withdrawal of exemptions for small companies), diversity, whistleblowing, significant votes against resolutions and remuneration.
The proposed Code has a new emphasis on board responsibility to consider the needs and views of a wide range of stakeholders in addition to shareholders. The board's function is stated to be not only promoting the long-term sustainable success of the company, but also generating value for shareholders and contributing to wider society.
This follows the UK government request for the FRC to consult on changing the Code to require companies to take wider stakeholder views into account and to adopt on a 'comply or explain' basis of one of three employee engagement mechanisms.
The board should establish a method for gathering the views of the workforce, which might be one or more of the following options:
Whilst there is flexibility for companies to select the right mechanism for them, we anticipate that many will choose the third option; at least at the outset while market practice develops.
The FRC comments that the term 'workforce' has been carefully chosen in this context to encompass not only those with formal contracts of employment, but also workers, agency workers and self-employed contractors. However, the term 'workforce' does have more ambiguity than 'employee' and differs from the government consultation document and the relevant statutory duty of directors, which both refer to employees.
The area of most frequent non-compliance with the Code amongst FTSE 350 companies is the minimum number of independent non-executive directors requirement; it is not a surprise then that independence is to be strengthened in the revised Code.
Currently, the chair of the board must simply be independent on appointment. The revised Code will require the chair to satisfy the independence criteria at all times. The Code also makes it clear that exceeding nine years on the board will cause independence to be lost. Given that some chairmen or chairwomen are often appointed after first serving as non-executives, the change requiring ongoing independence may deter such internal chair appointments due to the related limit of nine years' tenure.
There is also a change in emphasis in the independence criteria. Rather than a list of criteria which should be taken into account when assessing independence, a director will automatically be regarded as not independent where he or she does not meet the criteria. The FRC also wishes to strengthen the message that a director will not be considered independent if he or she has a current or previous relationship with the company.
Linking in with the chair's continuing independence, the draft Code reframes the board composition requirement so that independent directors, including the chair, must constitute the majority of the board.
Board composition remains broadly the same, save for the exemptions which currently apply to companies outside the FTSE 350 about:
The FRC proposes removing all of these exemptions on the basis that all companies should strive for the highest standards of corporate governance. Also, companies outside the FTSE 350 may still be of a similar size and structure to larger companies, and their workforce and wider stakeholders should have the benefit of the same levels of corporate governance.
Companies which currently rely on these exemptions will need to consider whether they appoint additional directors or explain their non-compliance.
The FRC is still considering the issue of independent board evaluations, given their cost for smaller companies, and may decide not to withdraw that exemption.
The revised Code aims to widen boards' perception of diversity and ensure appointment and succession planning practices are designed to promote diversity, not only of gender, but also of social and ethnic backgrounds. The focus of the Code is widened, encouraging diversity across the workforce and, in particular, the executive pipeline. The remit of the nomination committee is expanded to provide oversight of the development of a diverse pipeline.
New reporting on progress in relation to diversity is also introduced, addressing the Hampton-Alexander Review recommendation that all FTSE 350 companies should report in their annual reports on gender balance on the executive committee and those who are direct reports to members of the executive committee.
There is an increased emphasis on whistleblowing. At present, the Code requires the audit committee to review the arrangements by which staff are able to raise concerns about improprieties in matters of financial reporting. The FRC proposes widening this to allow the workforce to raise wider concerns, not merely matters of financial reporting.
In a climate of increasing shareholder votes against resolutions and government interest, a company will be required to explain, where more than 20 per cent. of votes have been cast against a resolution, what actions it intends to take to consult with shareholders to understand the reasons behind that result. This is supplemented by an interim action that an update should be published no later than six months after the vote in question, and before the final summary is published in the annual report.
This dovetails with the new public register of shareholder dissent maintained by the Investment Association, which will be available for reviewing these updates.
Where resolutions have attracted significant minority voting in the last couple of years, these have been most often about remuneration, election of directors and the issue of shares and pre-emption rights.
The proposed Code widens the remit of the remuneration committee to include setting the remuneration of senior management and overseeing pay and incentives across the workforce. It is also expected to have oversight of workforce policies and practices.
This will have clear implications for the time that the committee members need to devote to their role, which may require changes to terms of appointment.
The FRC has undertaken a comprehensive review of the Code. If the FRC confirms all the proposed changes, there will be a lot for companies to absorb and adapt to. Internal policies will need changing; remuneration committee members may need to devote more time to the role; and some companies may need to appoint additional directors.
Companies will need to start preparing early for these changes, which are due to take effect for accounting periods beginning on or after 1 January 2019.
At the same time, companies will need to prepare for new statutory reporting obligations under the government's measures to strengthen corporate governance. Draft legislation is expected shortly.
Changes are coming for AIM companies too. From 28 September 2018 AIM companies must state which recognised corporate governance code they apply. New applicants will need to state in advance which code they intend to apply. AIM companies will need to comply or explain (from 28 September 2018) against their chosen code.
All in all, corporate governance is a busy area of reform.
Please speak to your usual Taylor Wessing contact in Corporate about how we can help you prepare for these changes.
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