08 December 2017 by David Styles
The FRC on how the code review will ensure relevance for modern business
In his original report, Sir Adrian Cadbury defined corporate governance as ‘the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies.
The shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place.’ All this remains true today, but the market environment in which companies operate has changed and continues to develop rapidly.
The principle of collective responsibility within a unitary board has been a success and – alongside the stewardship activities of investors – played a vital role in delivering high standards of governance and encouraging long-term investment.
But if the code is to remain relevant, respond to the new and changing environment, and lead good governance practice, then it has to evolve.
The current consultation is not a question of ‘throwing the baby out with the bathwater’, but stems from need to examine closely what we mean by governance in today’s business environment. This involves considering how companies build trust in order to achieve sustainable success.
We are told that UK public trust in business remains low – but not only in business, in the politicians and regulators, who oversee the business environment. This is of concern, since by setting and adhering to high standards in the code, we aim to foster trust that encourages investment in UK business.
And, over the life of the code, this has been an area of success; despite the current lack of public trust, the UK is highly regarded internationally and seen as a market with excellent standards of governance, where equity capital investments are looked after and provide a good return.
If we consider that good governance will lead to improved public trust, companies should be considering the quality of their relationships, not only with their shareholders, but with a wider range of stakeholders – employees, customers and suppliers, among others.
“Despite the current lack of public trust, the UK is highly regarded internationally and seen as a market with excellent standards of governance”
These relationships must be built on respect, trust and mutual benefit. Sustainable businesses underpin our economy and society by providing employment and creating prosperity, and these relationships are key to that long-term success.
This is where the strength of a company’s culture becomes important. Corporate culture should promote integrity and openness, and be responsive to the views of stakeholders. A healthy culture both protects and generates value.
It is therefore important to have a continuous focus on culture, rather than wait for a crisis. Poor behaviour can be exacerbated when companies come under pressure, whereas a strong culture will endure in times of stress and mitigate the impact. This is essential in dealing effectively with risk and maintaining resilient performance.
This is the first comprehensive review of the code the FRC has been undertaken ‘in-house’ – though other changes have been made to address specific issues. In doing so, we have taken care to engage with a broad range of stakeholders prior to public consultation. In particular, I would like to thank the ICSA for their support and valuable advice.
As a result, we are proposing a code that retains the essential focus on the effectiveness of the board and broadens the definition and responsibility for good governance.
The revised code is based upon an understanding of governance that recognises it is both the internal and external conduct of the company that are important for its long-term success, and that the ‘direction and control’ of a company is subject to wider influence.
This is already reflected in UK company law. Directors are subject to a number of duties, chiefly in section 170–177 of the Companies Act 2006.
Section 172 says that a duty of the directors is to ‘to promote the success of the company for the benefit of its members as a whole’ – in shorthand, ‘shareholder primacy’. However, it goes on to say that in doing so, directors should ‘have regard (amongst other matters)’ to a wider range of factors and stakeholders.
The challenge for companies and their investors is working out what this means in practice, in terms of their approach to governance and engagement. The first principle in the revised code establishes the board’s role in generating value for shareholders and contributing to wider society.
It is complemented by a provision that requires boards to explain how it has engaged with stakeholders and how their interests and the matters set out in section 172 influenced the board’s decision-making.
There is particular focus on the role of the workforce. As requested by the government’s response to its green paper on corporate governance reform, the FRC is also consulting on three methods for gathering the views of the workforce: a director appointed from the workforce, a formal workforce advisory panel, or a designated non-executive director.
We are also recommending that the role of the remuneration committee be extended to allow it to oversee remuneration and workforce policies and practices, and take these into account when setting the policy for director remuneration.
This is accompanied by a provision that requires the remuneration committee report to explain the company’s approach to investing in, developing and rewarding the workforce and what engagement has taken place to explain how executive remuneration aligns with wider company policy.
Evolution of the code
Over the years, the code has been revised and expanded to take account of the increasing demands on the UK’s corporate governance framework and to lead good governance practice – these are some of the key developments
In 1994, the Greenbury Committee was established in response to growing concern at the level of executive remuneration.
Its main findings were that remuneration committees made up of non-executive directors should be responsible for determining the level of executive directors’ compensation, that there should be full disclosure of each executive’s pay package and that shareholders be required to approve them
In 1998, the Hampel Committee was established to review the extent to which the objectives of the Cadbury and Greenbury Reports were being achieved. The resulting Hampel Report led to the publication, in June, of ‘The Combined Code on Corporate Governance’
Sir Derek Higgs’ review in 2003, addressed the role of independent directors, proposing that at least half of a board (excluding the chair) be comprised of non-executives; that potential non-executives should satisfy themselves that they possess the knowledge, experience, skills and time to carry out their duties; and that a senior independent director be nominated and be available for shareholder engagement
In June 2010, the code was revised to give clearer advice on board composition. It also recommended that all FTSE 350 directors be put forward for re-election every year and included improved risk management reporting provisions
The 2012 changes introduced the supporting principle for boards to confirm that the annual report and accounts taken as whole are fair, balanced and understandable.
Companies should also explain and report on progress with their policies on boardroom diversity, in line with the work undertaken by Lord Davies and continued by the Hampton-Alexander review
In 2016, the code was updated to take account of the implementation of the EU Audit Directive
To complement this wider governance focus, the updated principles emphasise the value of good corporate governance to sustainable success.
By applying the principles, following the more detailed provisions and using the associated guidance, companies can demonstrate throughout their reporting how governance contributes to their long-term success and achieves wider objectives.
The Listing Rules require companies to make a statement about how they have applied the principles, which shareholders can evaluate. Although there is some good reporting here, it is an area with room for improvement.
The ability of investors to evaluate the approach to governance is important. The statement should cover the application of the principles in the particular circumstances of the company, and how the board has set the company purpose and strategy, met objectives, and achieved outcomes through the decisions it has taken.
“Companies can demonstrate throughout their reporting how governance contributes to their long-term success and achieves wider objectives”
The governance statement as a whole should also relate coherently to other parts of the annual report – particularly the strategic report and other complementary information – so that shareholders can effectively assess the quality of the company’s governance arrangements and the board’s activities and contributions.
Additionally, it should include information that would allow shareholders to assess how directors have performed their section 172 duty to promote the success of the company.
The effective application of the principles should be supported by high-quality reporting on the provisions. An alternative to complying with a provision may be justified in particular circumstances based on a range of factors. These can include the size, complexity, history and ownership structure of a given company.
Explanations should set out the background, provide a clear rationale for the action the company is taking, and explain the impact that action has had, and this should be seen as a positive opportunity, not an onerous obligation.
Of course, investors have their responsibilities too. In line with the UK Stewardship Code’s principles, shareholders should engage constructively and discuss departures from recommended practice with the company.
In their consideration of explanations, shareholders and their advisors should pay attention to companies’ individual circumstances. Although they have every right to challenge explanations if they are unconvincing, they must not be evaluated in a mechanistic way. Shareholders and their advisors should also give companies sufficient time to respond to enquiries about corporate governance reporting.
The code is also supported by revised ‘Guidance on Board Effectiveness’, which assists boards when applying the principles. It does not set out the ‘right way’ to apply the code, but is intended to stimulate thinking on how boards can carry out their role most effectively.
When reporting on the application of the principles the board should consider how the guidance supports their actions and the decisions they have taken in response to the questions posed by it.
We look forward to engaging widely on the revised code.