Government addresses corporate governance concerns in private companies with new corporate reporting regulations

Last week the Government published the draft Corporate (Miscellaneous Reporting) Regulations 2018 which cover corporate governance, stakeholders' interests, employee engagement and CEO/employee pay ratios. These build on its strategy of addressing issues around corporate governance in the wake of recent corporate failures and issues at Sports Direct. The new regulations form a core part of the government’s modern Industrial Strategy which "aims to build on the UK’s strong reputation and make sure our largest companies are more transparent and accountable to their employees and shareholders".

The changes introduce a new compliance burden for large companies, as well as provoking many companies to take practical steps to assess their impact on brand and reputation.

Timing

The new reporting requirements for large companies will apply to financial years beginning on or after 1 January 2019 (previously this was to have been June 2018). This means that companies will start reporting their pay ratios in 2020.

Key points include:

New "section 172(1) statement" in strategic report

Large companies must include a 'section 172(1) statement' in their annual strategic report, describing how directors have had regard to the factors set out in section 172(1) Companies Act 2006 when performing their duty to promote the success of the company for the benefit of its members as a whole.

Those factors include (amongst others) the interests of employees, the need to foster relations with suppliers and customers and maintain a reputation for high standards of business conduct and impact on the environment and community.

Companies subject to this new requirement include PLCs and private companies which satisfy two or more of the following conditions:

• annual turnover over £36 million
• balance sheet total over £18 million
• more than 250 employees.

The statement must also be made available on a website (unless the company is listed on the Main Market of the London Stock Exchange).

Breach is a criminal offence by the company and its directors with fines up to £1,000.

Reporting on employee engagement

Companies with more than 250 average number of UK employees (in the group) during a financial year (other than their first financial year) or previous financial year must contain a statement on their UK employee engagement measures in the directors' report. This will include action to introduce, maintain or develop arrangements aimed at:

• providing employees with information on matters of concern to them as employees
• consulting employees or representatives so their views can be taken into account on decisions likely to affect their interests
• encouraging employee involvement in the company's performance through share schemes and
• achieving a common awareness on the part of employees of the financial and economic factors affecting the company's performance.

It will also need to cover how directors have engaged with employees and had regard to employee interests and the effect of this on principal decisions taken during the financial year.

Reporting on engagement with customers, suppliers and others

Large companies will also need to state in the directors' report how directors have considered the need to foster the company's business relationships with suppliers, customers and others and the effect of this on the principal decisions taken during the financial year.

This will apply to companies which satisfy two or more of the following in a financial year (other than their first financial year) or the previous year:

• annual turnover over £36 million
• balance sheet total over £18 million
• more than 250 employees.

Corporate governance statement

One of the key changes is the introduction of corporate governance reporting for those large public and private companies which meet either an employee or financial threshold.

The requirement will apply to companies which have either more than 2,000 employees or both turnover of more than £200 million and a balance sheet of more than £2 billion, either in their first financial year or in two consecutive financial years. Companies already subject to the UK Corporate Governance Code will be exempt.

A corporate governance statement must be included in the directors' report, identifying which corporate governance code the company applies (if any), how the company applied that code and any areas in which the company departed from that code (with reasons for doing so). Companies will also need to publish this statement on a website (unless a quoted company – which includes those on the Main Market of the London Stock Exchange but not AIM).

This is a significant change for large private companies who are not currently required by law to follow or report against any corporate governance code (although some may comply with specific industry-specific guidelines, such as the Guidelines for Disclosure and Transparency in Private Equity). To support this new reporting requirement, a coalition group chaired by James Wates CBE is preparing corporate governance principles, known as the "Wates Corporate Governance Principles for Large Private Companies" (see below).

Failure to comply with this new reporting requirement will be a criminal offence by the company and its directors with fines up to £1,000.

Reporting on pay ratio information (quoted companies only)

The directors' remuneration report of a quoted company (which includes a company on the Main Market of the London Stock Exchange but not AIM) with more than 250 employees (in its first financial year or two consecutive financial years) will need to report pay ratio information of the chief executive with the 25th, 50th and 75th percentiles of the full-time equivalent remuneration of the company’s UK employees, using one of three methods for calculating the ratio.

Affected companies would need to explain the reasons for the choice of methodology, and publish the reasons for changes to the ratios from year to year. For the median ratio this would include whether, and if so why, the company believed this ratio to be consistent with the company’s wider policies on employee pay, reward and progression. For a parent company, the information would need to relate to the group.

New corporate governance principles for large private companies

The Financial Reporting Council has published a draft form of the Wates Corporate Governance Principles for Large Private Companies to support the governance reporting requirement.

Companies will be able to adopt these principles as an appropriate framework when making their corporate governance statement under the 2018 Regulations, but it is hoped that these new principles will be a useful tool for a wide range of companies (not just those covered by the new reporting requirement) to understand and adopt good practice in corporate governance. The draft principles introduce a high-level approach, mindful that the variety of management and ownership structures in large private companies requires flexibility. Companies will be encouraged to follow six principles to inform and develop their corporate governance practices and adopt them on an ‘apply and explain’ basis.

The six principles (supported by guidance to help companies apply the principles in practice) cover the following areas:

• Purpose: An effective board promotes the purpose of a company, and ensures that its values, strategy and culture align with that purpose.
• Composition: Effective board composition requires an effective chair and a balance of skills, backgrounds, experience and knowledge, with individual directors having sufficient capacity to make a valuable contribution. The size of a board should be guided by the scale and complexity of the company.
• Responsibilities: A board should have a clear understanding of its accountability and terms of reference. Its policies and procedures should support effective decision-making and independent challenge.
• Opportunity and risk: A board should promote the long-term success of the company by identifying opportunities to create and preserve value and establish oversight for the identification and mitigation of risk.
• Remuneration: A board should promote executive remuneration structures aligned to sustainable long-term success of a company, taking into account pay and conditions elsewhere in the company.
• Stakeholders: A board has a responsibility to oversee meaningful engagement with material stakeholders, including the workforce, and have regard to that discussion when taking decisions. The board has a responsibility to foster good relationships based on the company’s purpose.

The draft principles are open for consultation until 7 September 2018 with the final version due to be published in December this year. The new reporting requirement will apply to financial years starting on or after 1 January 2019 and companies will need to report on their corporate governance arrangements annually. Failure to comply with the reporting obligation will be a criminal offence and punishable by fines for the company and directors.

The draft Regulations and new corporate governance principles are part of the government's commitment to probe and, where appropriate, address systemic weaknesses within the corporate governance regime. The new requirements reflect the fact that the conduct and governance of large companies can, in the view of the government, have a sizeable impact on the interests of employees, suppliers and customers.

Large companies will need to reassess their responsibilities and internal processes for corporate governance, stakeholders' interests, employee engagement and CEO/employee pay ratios to ensure that they are in a position to respond to the new regime in 2019.

Corporate governance is high on the business agenda this year for listed companies too, with new corporate governance reporting obligations for AIM companies from September 2018 and extensive changes to the UK Corporate Governance Code due to be published this summer, for financial years starting on or after 1 January 2019. A further corporate governance consultation is also underway. Corporate governance is very much in the spotlight.

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