12 September 2018 by Henry Ker
The FRC’s executive director of corporate governance and reporting discusses the new UK Corporate Governance Code, principles versus provisions, and warns that governance cannot fix society on its own
There are a number of factors that led us to take the decision to revise the UK Corporate Governance Code. Firstly, Theresa May put corporate governance firmly on the agenda as part of her campaign to be leader of the Conservative party and prime minister. Rather than just add more into the code as a result of this and other requests to the FRC, it was better to look at it afresh.
Secondly, we were increasingly concerned that the code was being treated as a tick-box exercise. We wanted to reinforce the message that boards need to apply the principles rather than merely tick off the provisions.
Thirdly, there is the whole issue around trust in big business and the role for the code to play in restoring that trust. Fourthly, it was an opportunity to reinforce the director’s duties to broader stakeholders under section 172 of the Companies Act 2006.
“We decided to take the opportunity to shorten and sharpen the code”
Therefore, we decided to take the opportunity to shorten and sharpen the code, rather than just keep adding to it in a piecemeal way and ending up with a slightly unwieldy document.
We also followed up on our work on corporate culture – and the report from June 2016, ‘Corporate Culture and the Role of Boards’ – with a greater focus on this in the code, as well as highlighting the importance of succession planning and board diversity.
In addition, public concerns over executive remuneration meant we looked at broadening the responsibility of the remuneration committee.
We have also strengthened the provisions around board effectiveness and both the independence and tenure of the chair.
As mentioned, there was the tick-box aspect that we wanted to address. But it was also because we felt that companies were ignoring an important aspect of the listing rules, which give the code effect.
There are two relevant parts to the listing rules: one that directors have to explain how they have applied the principles in a manner that enables shareholders to assess this; and secondly, the extent to which they have met the provisions on a comply or explain basis. We felt that there was insufficient reporting on the application of the principles and less consideration of the flexibility afforded by the comply or explain basis.
The UK Corporate Governance Code is seen as a world leader and most international jurisdictions look to our framework of governance as the standard. And yet domestically we feel that more could be achieved.
We wanted to make sure that we maintain two of the very important features of the corporate governance framework in the UK: one, the unitary board and two, the comply or explain model.
I am not sure that any one part of the code or piece of legislation on its own is going to tackle all of the different features of stakeholder concern around the level of executive remuneration.
But getting the board and the remuneration committee in particular to focus on any potential inappropriate divergence between the policies that have been applied to the executives compared to the workforce more generally will be an important contribution, particularly around trust in business.
“Remuneration is symbolic and the lightning rod for other concerns around the role that corporate governance plays”
The question being asked is, is business in it for itself, or is business in it for wider society?
A governance code cannot solve all society’s ills. It is not going to address issues around social mobility or issues around relative fairness. What it can do is get those that are responsible for decisions within organisations to take more responsibility for, and more account of, the impact of decisions they take.
It is not just about the actual remuneration itself. It is also about other aspects of how boards take decisions on how the value the business creates is allocated. Whether that be in terms of pay and conditions of the workforce, executive remuneration, the level of dividends, share buy-backs, or reinvestment in R&D or products.
The focus on remuneration is very important, but it is also a key part of a bigger conversation. It is symbolic and the lightning rod for other concerns around the role that corporate governance plays and the role of big business in society.
We made a particular emphasis in the code on engagement with the workforce. That was one of the points that the government wanted us to consider. The government suggested three options, which are in the new code. We have provided flexibility on how this is delivered. It could be one of those options, a combination of options or possibly an unspecified ‘fourth’ option.
If you chose a fourth option, you will have to explain why you consider as a board that this a more effective approach.
There is also a lot more content in the code around stakeholder and shareholder engagement, to make sure that the board understands the views of those they serve.
This should be considered in conjunction with the guidance on the strategic report we have just published. We are particularly emphasising the board’s responsibility for making sure the culture that they believe is right to deliver the vision and strategy is implemented throughout the organisation and they have appropriate mechanisms for understanding the extent to which that is the case.
There has been a hugely positive response to our work around culture, not only from companies but from stakeholders more generally. However, there is a lot more work to be done in order to convert this enthusiasm into positive action.
Most chief executives and chairs will agree on the importance of culture and can talk about the various things that they are doing in their organisation to instil an appropriate culture throughout.
Too often we see problems in culture leading to issues around the way companies are run, how they are reporting, alongside more general business issues.
Boards need to work harder to assess the extent to which the right culture is embedded. It is comparatively easy for boards to point to one or two positive initiatives. But are those initiatives really getting to the heart of the matter?
The telling factor is whether, when there is pressure on the organisation, the culture shines through – or have shortcuts been taken that are then exposed. Having a positive culture is comparatively easy when business is growing and enjoying success. It is when challenges arise that the culture becomes so important and can be such a positive asset to an organisation.
There is no point consulting if you do not listen to that consultation. That does not mean that you do not on occasion still have to take tough decisions, and override consultation feedback, but of course we listen to the responses.
For example, in terms of the chair, we listened to feedback around the extent to which a chair could ever be considered to be independent because of the unique nature of that role and we have given slightly greater flexibility than when we originally consulted, particularly for certain circumstances around succession planning and diversity.
It is hard because everybody talks a positive game around a preference towards principles. Yet there is also a human desire not to breach something fixed. Therefore, it is much easier to ensure you are compliant with a rule than with the spirit of a principle. Because of this, there is a tendency within the system to push for more rules, as opposed to principles. There is a balance to strike.
Overall, I should emphasise that we have made significant changes and, by and large, the changes have been welcomed.
To those who feel the code does not go far enough, we want to hear from you. We have not got all of the answers and consultation is an important way to improve things.
I should also not let this opportunity go without mentioning our consultation on the Wates Corporate Governance Principles for Large Private Companies. This closes on 7 September and we really do want to hear from people about the principles. It is the first real concerted effort at developing governance principles for large private companies and feedback is important to ensure we get it right.
Engagement has got to be a two-way process. We cannot expect directors and companies to engage more with shareholders unless there is appropriate expectation on shareholders to engage with companies as well.
This should be looked at together with the work we are planning to do on the stewardship code – there is more to be done there and we will be consulting on that code later this year.
We have received some high-level feedback already and are engaging with a variety of different stakeholders on the issues. But I think it is premature to be forecasting exactly where we are going to go with that.
We welcome it and its aim to ensure the FRC is ‘fit for the future’. As an organisation, the FRC is increasingly in the spotlight and there are some particular criticisms that have been directed towards us, but we think the Kingman review provides a good opportunity to address some of those concerns.
Some of those concerns or criticisms maybe result from a misunderstanding of what our powers are and how the government has set us up to play our part within the regulatory environment.
We have a very complex legal framework underpinning regulation in the UK. There are lots of different players who have various different responsibilities in that. It has evolved over a number of years and it reflects different governments attitudes towards the degree of regulation.
“The FRC should be put on a statutory footing with statutory powers and we should be given statutory objectives”
For example, when the government implemented the EU directive on audit, there was a ministerial statement saying the FRC should be required to delegate everything they can under European law to the professional bodies. Roll forward a short period and there is stakeholder concern that the UK did not take the opportunity to put in place a more robust independent regulatory framework for audit.
It is a challenge, especially during the good times, to explain the UK’s regulatory framework and our role in it. Once something happens, attention increases on our role and it becomes harder to explain without appearing defensive. We are not the prudential regulator of businesses; government decided we did not need a prudential regulation for companies.
We do not have the powers to stop a failure like Carillion. However, because of the significant role businesses play in society and the risks that happen if they go bust, society is starting to take a different view, as previously has been the case for banks.
There are plenty of areas where we could be more effective if we were given more powers.
I think the FRC should be put on a statutory footing with statutory powers.
We should be given statutory objectives, with the powers to deliver those objectives effectively, with our funding on a similar basis. If the objectives and powers are right, then everything flows from that.
A lot of what we did in the past used our influence and a lot of goodwill with corporates, auditors and others to make things happen.
Market-led initiatives work really well when there are a benign set of conditions. They does not work so well during periods of stress.
I think the powers that we have to monitor annual reports – or at least the annual accounts, the director’s report and the strategic report – should be strengthened and replicated across the whole of the annual report, including corporate governance. Not with a view to diminishing the responsibility and role of shareholders, but to provide better regulatory support for shareholders.