04 September 2018 by Peter Swabey
A leaner UK Corporate Governance Code seeks to refocus attention on the objective of governance, rather than merely ticking boxes
On 16 July, the Financial Reporting Council (FRC) published the 2018 revision of the UK Corporate Governance Code, which will come into effect from 1 January 2019.
Companies should note that although reporting will not be required against the new code until 2020, they will be expected to apply the new provision requiring an explanation of proposed actions in the event that a resolution receives less than 20% support at the 2019 annual general meeting.
The new code is shorter and sharper than the existing one, with a greater focus on the application of its principles rather than on compliance (or the explanation of non-compliance) with its provisions.
This was one of the objectives that the FRC announced when it commenced the consultation process and reflected its concern that, in the minds of some companies, not to mention investors and their advisers, compliance had become a question of ‘ticking the box’ – rather than questioning whether the approach was right for an individual organisation.
“The new code has a greater focus on the application of its principles rather than on compliance with its provisions”
A feature of ICSA’s review of corporate reporting for our annual awards is that explanations of non-compliance with provisions are improving and in many cases demonstrate considerable thought about the best approach to a specific issue. Often a good explanation is better that rote compliance.
Although much of the new code is the same as the consultation draft published in December 2017, and ICSA’s response was discussed in the March 2018 edition of Governance and Compliance, there are some significant differences as a result of the FRC’s consideration of the 275 responses that it received to the consultation.
The new code is helpfully accompanied by a feedback statement and updated detailed guidance on board effectiveness.
There is an increased focus on the board’s relationship with the workforce in the new code. Principle E has been extended to state that ‘The board should ensure that workforce policies and practices are consistent with the company’s values and support its long-term sustainable success,’ while provision 2 requires that the annual report ‘should include an explanation of the company’s approach to investing in and rewarding its workforce’.
This is defined in paragraph 50 of the guidance as including ‘those with formal contracts of employment (permanent, fixed-term and zero-hours) and other members of the workforce who are affected by the decisions of the board.’
Provision 5 has extended the requirements for workforce engagement so that the board must describe in the annual report how it has engaged with the workforce and other stakeholders, and how their interests and the matters set out in section 172 of the Companies Act 2006 have been considered in board discussions and influenced decision-making.
Provision 5 goes on to specify the mechanism for workforce engagement and does so with more prescription than the consultation draft, proposing one or a combination of the following methods: a director appointed from the workforce; a formal workforce advisory panel; or a designated non-executive director. If the board has not chosen one or more of these methods, it should explain what alternative arrangements are in place and why it considers that they are a better option than the three proposed mechanisms.
“The company secretary is well placed to take responsibility for concerns raised by the workforce about conduct, financial improprieties or other matters”
The guidance on board effectiveness (paragraph 55) is helpful here, explaining that ‘provided the board’s approach delivers meaningful, regular dialogue with the workforce and is explained effectively; the code provision will be met.’ In the FT–ICSA Boardroom Bellwether survey, published on 6 August, we established that the most popular option amongst FTSE 350 companies is currently the designated non-executive director.
Finally in this section, the new principle E also addresses whistleblowing, with the workforce able ‘to raise any matters of concern’, and the guidance (paragraph 85) proposing the company secretary as a point of contact, as they are ‘well placed to take responsibility for concerns raised by the workforce about conduct, financial improprieties or other matters.’
The major – and very welcome – change from the consultation is around independence, and specifically the independence of the chair (and note the terminology in the new code is now ‘chair’ rather than ‘chairman’).
The consultation draft required that the chair be independent throughout their term, rather than only ‘on appointment’ and stipulated criteria that would preclude independence, including a nine-year tenure, thereby removing the board’s discretion to assess whether or not a director is independent, except on a ‘comply or explain’ basis.
ICSA was one of a number of respondents to the consultation who felt that this misunderstood the role of the chair and conflated the concepts of independence and objectivity.
The FRC has accepted these representations and has reverted to the position that it is for the board to determine whether a director is independent and that the chair only need meet the independence criteria on appointment. However, the FRC remains focused on board refreshment and has introduced a term limit for the chair in the next section of the code.
Provision 15 addresses the issue of ‘overboarding’. Boards will now be required to ‘take into account other demands on directors’ time’ and ‘prior to appointment, significant commitments should be disclosed with an indication of the time involved.
Additional external appointments should not be undertaken without prior approval of the board, with the reasons for permitting significant appointments explained in the annual report.’ This latter point is important, particularly in the case of portfolio non-executive directors who will now have to seek approval from their existing board(s) before taking on a new role. This is not always currently the case and company secretaries will need to ensure that all board members understand the new requirement.
Finally in this section, it should be noted that some exemptions for smaller companies have been removed and they will now be expected to have at least half the board, excluding the chair, as independent NEDs with all directors facing annual re-election.
Two issues that the FRC clearly wanted to address were those of board refreshment and diversity. Principle K in the new code refers to the board having a ‘combination’ rather than ‘balance’ of skills and goes on to say that ‘consideration should be given to the length of service of the board as a whole and membership’.
As noted above, the new provision 19 on the tenure of the chair is very important, sufficiently so to quote it in full: ‘The chair should not remain in post beyond nine years from the date of their first appointment to the board. To facilitate effective succession planning and the development of a diverse board, this period can be extended for a limited time, particularly in those cases where the chair was an existing non-executive director on appointment. A clear explanation should be provided.’
“There is a vast difference between a board evaluation conducted by questionnaire and one conducted through interviews with the individual directors”
There was widespread commentary when the consultation draft was published that restricting the chair to nine years tenure would affect 19 chairs of FTSE 100 companies and would also particularly affect chairs who were internal appointments. Some claimed that this would also adversely affect board diversity.
On diversity, provision 23 requires that the annual report include an explanation of how the nomination committee’s process for appointments and approach to succession planning support developing a diverse pipeline.
It should also explain the organisation’s policy on diversity and inclusion, its objectives and linkage to company strategy, how it has been implemented and progress made. It should also explain the gender balance of those in the senior management and their direct reports.
The requirement on board evaluation has been retained and strengthened by the inclusion of a requirement (provision 23) that the annual report describe how the board evaluation has been conducted, the nature and extent of an external evaluator’s contact with the board and individual directors, the outcomes and actions taken, and how it has or will influence board composition. This greater focus is welcome and the point on how the board evaluation has been conducted is important as there is a vast difference between an evaluation conducted by questionnaire and one conducted through interviews with the individual directors.
In response to feedback received, the code has reverted to only requiring FTSE 350 companies to undertake an externally facilitated evaluation at least every three years.
This section of the new code is largely unchanged from the consultation draft or, indeed, from the 2016 code.
Provision 24 reinstates the carve out for smaller companies to have a minimum of two audit committee members and provision 25 includes a specific new responsibility for the audit committee to provide advice – where requested by the board – on whether the annual report and accounts, taken as a whole, is ‘fair, balanced and understandable, and provides the information necessary for shareholders to assess the company’s position and performance, business model and strategy.’
The same provision also clarifies that the audit committee is responsible for conducting the tender process for the external auditor and ensuring prior approval of non-audit services is sought, considering the impact this may have on independence.
The major change in this section is around the degree to which the role of the remuneration committee is being refocused.
In the new code, the committee is to ‘review workforce remuneration and related policies and the alignment of incentives and rewards with culture, taking these into account when setting the policy for executive director remuneration.’
This is less challenging than the consultation draft requirement that it should ‘oversee remuneration and workforce policies and practices’, which many felt trespassed too far into management responsibilities.
ICSA lobbied for the pay of the company secretary to be a matter for the remuneration committee and we are pleased to see that this requirement has been retained both in provision 33 and in paragraph 80 of the guidance. This is an important safeguard of the independence of the role.
There are also some small but important enhancements to this section of the code – these are covered in Charlotte Fleck article on remuneration and so I will not go into more detail here, save to say that there is a focus on avoiding ‘rewards for failure’ and on post-employment shareholding requirements. There is also an expectation that ‘pension contribution rates for executive directors, or payments in lieu, should be aligned those available to the workforce.’
The new code creates an excellent opportunity for company secretaries to think about how its requirements will work best for their company and to demonstrate mastery of the new market expectations. There is a lot in the guidance, which is well worth close reading, and the chair and the board will need the active support of the secretariat if the company is to get the best value from its application of the code.