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ICSA: Comply or explain is vital for UK governance

06 March 2018 by Peter Swabey

ICSA: Comply or explain is vital for UK governance - Read more

Retaining comply or explain in the proposed update to the UK Corporate Governance Code leaves important room for manoeuvre

We have now completed our response to the Financial Reporting Council consultation on the proposed revisions to the UK Corporate Governance Code and are grateful to all those who have contributed their thoughts and expertise.

The feedback we received concentrated on a few key areas, reinforcing our view that the work by the FRC has been well thought through.

We were pleased to see the focus by the FRC on the purpose of corporate governance, the application of the code’s principles and their use to underpin the long-term health of the company, rather than as a compliance exercise just ticking the box of the various provisions.

We were also delighted that there is such an emphasis on board composition and refreshment, and on culture.

Although we have some specific comments, these should not be seen to detract from the excellent work that the FRC has delivered in its proposed revisions. Above all else, we commend the FRC for retaining the focus on the ‘comply or explain’ model rather than seeking to impose rules.

‘Comply or explain’ is especially important in giving companies flexibility to make the arrangements that suit their circumstances, rather focing them to adopt a one-size-fits-all approach, and then to explain to shareholders why those arrangements are appropriate.

Shareholders and their advisors should then properly consider alternative governance arrangements, appreciating the ‘comply or explain’ nature of the code.

Directors’ duties

Principle A, as drafted, appears to extend directors’ duties beyond those set out in section 172 of the Companies Act 2006.

The statutory duties of a director are clearly defined in the act and we are concerned that the proposal that the function of the board is ‘to promote the long-term sustainable success of the company, generate value for shareholders and contribute to wider society’ does not accurately reflect those duties and might cause confusion.

“We do believe that the code should align with the statutory requirement on directors' duties”

That is not to say that we are opposed to further consideration of the balance of directors’ duties between shareholders and other stakeholders, but we do believe that the code should align with the statutory requirement.

Stakeholder engagement

The consultation complies with the government’s request that the code require companies to ‘establish a method for gathering the views of the workforce,’ and goes on to say, ‘this would normally be a director appointed from the workforce, a formal workforce advisory panel or a designated non-executive director.’

This is a ‘comply or explain’ obligation, which gives companies scope to do something else if that is more effective for them.

As we suggested in our joint guidance with the Investment Association, ‘The Stakeholder Voice in Board Decision Making’, it is likely that the best solution for any company will be a combination of some, all or none of these methods – and probably something else.

As drafted, the revised code focuses on the workforce. Although staff are important stakeholders, they are not the only ones and the code might be better if it refers to stakeholders.

Independence

The existing code treats the chair as a special category – neither independent nor non-independent, although they must be independent on appointment and are expected to continue to meet the independence criteria. The revised code explicitly includes the chair as an independent director.

We believe that this disregards the unique role of the chair and the importance of the role to both the company and the individual holding the position. The chair’s role is unlike that of other NEDs and is more akin to a part-time executive.

They spend much more time in the company, have a unique relationship with the chief executive and finance director, and receive substantially higher pay than any other NED. Although we would always expect the chair to behave independently, these factors all compromise the chair’s independence from a practical perspective.

The position is exacerbated by the greater certainty that the revised code brings to the independence criteria. Although the criteria are unchanged, they are no longer matters that ‘may appear relevant to [the company’s] determination’ as to whether a director is independent.

The proposed change to the wording is small but significant, as it is suggested that a director ‘should not be considered independent’ if they do not meet the criteria. This has particular implications for the chair as they will cease to be independent after nine years and therefore, subject to ‘comply or explain’, must cease to be chair.

We appreciate that this provision is subject to the ‘comply or explain’ rule, but some investors and particularly their advisors tend to be more black and white than that – and a provision of this sort then becomes a ‘box-ticker’s charter’.

“We believe that removing the board’s judgment over the independence of NEDs is unhelpful”

We do not believe it is appropriate that the chair’s time as a NED prior to appointment as chair be included when tenure is assessed. The role of chair is different from that of an NED and this could result in a chair being regarded as having served their time at a point when they become most effective.

We firmly believe in the need for regular board refreshment and for both increasing and diversifying the pipeline of board-ready candidates, as well as widening the pool from which potential directors are drawn.

But we believe that removing the board’s judgment over the independence of NEDs is unhelpful, as we think the board is best placed to assess the independence of individual NEDs and the circumstances of their appointment, and to explain this appropriately.

Some have suggested to us that there is a risk that NEDs will begin to see nine years as the normal length of appointment, but we do not believe this should be the case. As businesses change over time, we would expect the required competencies and skills of the directors to change too. It is striking that nine years is rather longer than most viability statements.

Smaller companies

The revised code proposes removing the exemptions for smaller companies from the requirement for annual election of directors, for a majority of independent NEDs on the board and for an independent board evaluation every three years.

Although we believe that all these requirements are important and valuable for companies of all sizes, we are concerned about the additional burden that these changes will create.

We remain unconvinced that there is an adequate pool of organisations providing good quality board evaluation services to support this widening of the market. We also think that the type and depth of evaluation required should be for the board to decide.

Remuneration committee role

The revised code widens the remit of the remuneration committee to ‘oversee remuneration and workforce policies and practices’.

We believe it is important for the remuneration committee to have oversight and understanding of pay policy across the company as a whole, to provide the broader context when considering executive pay.

It is also right that the board, through the remuneration committee, should have ‘oversight of workforce policies and practices’ insofar as they relate to pay.

That said, it is important that the terms of reference set clear boundaries between the oversight role of the board, delegated to the remuneration committee, and legitimate day-to-day management activities.

Workforce policies include many areas outside pay, such as disciplinary policies and policies on annual leave, which are management responsibilities.

Additionally, we are pleased to see recognition in the revised code of the importance of discretion in remuneration decisions.

Stewardship Code

The consultation also includes what is described as an ‘initial consultation on the future direction of the UK Stewardship Code’. This provides a helpful chance to consider investor responsibilities at the same time as we consider issuer responsibilities in the revised Corporate Governance Code.

The feedback that we have received from firms is that the Stewardship Code does not seem to be working. Although our research shows that there has been some increase in both the quality and quantity of stewardship activity, commitment to the Stewardship Code varies between investors.

Those who ‘did stewardship well’ before the introduction of the Stewardship Code now do it better; those who did not still do not. The tiering process, carried out by the FRC in 2016, emphasised this divide.

“We see merit in a code combining both the governance and stewardship codes”

The Stewardship Code focuses on processes. It does not include principle-based ideas, which play a major role in the Corporate Governance Code. A greater focus on company expectations of investors would make the Stewardship Code more effective, but we think the critical gap is the lack of effective enforcement mechanisms.

In our view the Financial Conduct Authority should take responsibility for this as part of their oversight of regulated businesses.

The consequences of a breach of the Corporate Governance Code are negative votes from investors. Currently there are no real consequences for a failure to comply with Stewardship Code obligations.

It is a more radical solution, but we see a lot of merit in a revised Corporate Governance Code combining both the existing code and the Stewardship Code.

Having separate codes for companies and shareholders is unhelpful and causes confusion. A combined code providing a joined-up approach to governance for all parties might be more effective.

Board effectiveness

The guidance on board effectiveness that accompanied the consultation is well-written and will be helpful, especially the ‘questions for boards’ and ‘examples’ set out in boxes.

We have made some suggestions around the text, but our only significant concern relates to the standing of the guidance, the status of which we believe needs clarification.

There are many areas where the guidance is more flexible than the code, but our members’ experience is that corporate governance bodies, proxy advisors and the media are unlikely to take account of the guidance or give it sufficient weight.

It is therefore important that the increased flexibility is reflected in the code’s wording and that the code emphasises that it is the responsibility of all investors and advisors to consider the guidance and the code together.

We look forward to reading the published responses to the consultation and engaging further with the FRC on the proposed changes.

Peter Swabey FCIS is policy and research director at ICSA: The Governance Institute. ICSA's full submission to the proposal consultation on the UK Corporate Governance Code can be found here

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