27 July 2018 by Peter Swabey
As the regulatory gaze turns onto the country’s large private companies, the new Wates governance principles offer a framework for reporting
On 13 June, the Financial Reporting Council (FRC) published a consultation paper seeking comments on the Wates Corporate Governance Principles for Large Private Companies (Wates Principles).
The proposed principles and consultation are the next step in a programme of work to address the perceived issue of corporate governance standards in large private companies, which was one of the issues on which the government focused in its green paper on corporate governance in April last year.
We were delighted that ICSA was invited to be one of the bodies included in the coalition which helped James Wates CBE develop the principles.
Of course, the background to the government’s concern is the public, press and parliamentary furore over the failure of BHS, where thousands of people lost their jobs and the pension scheme was found to be significantly underfunded.
“The code creates an obligation to report to society as a whole as the price they pay for the use of societal capital and the privilege of limited liability”
The green paper recognised that the focus of the UK’s highly-regarded corporate governance regime is on public companies, where the owners and/or shareholders can have little direct relationship with management and the agency principle therefore needs to be protected.
In private companies this can also be the case, but it is far more likely that the owners will be directly involved in the running of the company, often with one or more family members on the board.
Although some private companies are managed by the shareholders, some are managed by others. In these cases, however, the shareholders are generally much more ‘hands on’ and often have daily interaction with the managers.
There are some very large private companies in the UK, the activities of which can have a significant impact on our society.
As the government’s response to the green paper noted, ‘good governance can go beyond the relationship between the owners and the managers of a company, and … there are other stakeholders, including employees, suppliers and customers with a strong and legitimate interest in the way a company is run.’
The Wates principles
Principle one: Purpose
An effective board promotes the purpose of a company and ensures that its values, strategy and culture align with that purpose.
Principle two: 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.
Principle three: 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.
Principle four: Opportunity and risk
A board should promote the long-term success of the company by identifying opportunities to create and preserve value and establishing oversight for the identification and mitigation of risks.
Principle five: Remuneration
A board should promote executive remuneration structures aligned to the sustainable long-term success of a company, taking into account pay and conditions elsewhere in the company.
Principle six: 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 stakeholder relationships based on the company’s purpose.
James Wates CBE, the chairman of the coalition group which developed the principles, has said that ‘Good business well done is good for society. Private companies are a significant contributor to the UK economy, providing tax revenue and employing millions of people. They have a significant impact on people’s lives, and it is important they are well-governed and transparent about how they operate.’
ICSA agrees. As we said in our letter to prime minister Theresa May in August 2016: ‘the fact that a large company may be privately owned does not reduce the public impact when it fails. Arguing that there should be different expectations on the board of directors simply because there is a different ownership structure is a red herring.
‘The Companies Act 2006 already recognises this to be the case, which is why the duties of directors set out in Part 10 of the Act – which include a requirement to consider the long-term consequences of their decisions and the impact on their employees and the community – apply to directors of all companies, not only publicly quoted ones.
‘… the boards of larger private companies should be expected to aspire to the same standards of governance as those in the listed sector.’
Responses to the green paper agreed, with more than 80% supporting the strengthening of corporate governance arrangements of large private companies.
The government identified two actions to address this issue. It undertook to introduce secondary legislation to require all companies of a significant size to disclose their governance arrangements in their directors’ report and on their website. This disclosure should include whether they follow any formal code.
“Many private companies already comply with much of the code because it is simply good business to do so”
Alongside this, it also invited the FRC to work with a number of industry groups to develop a voluntary set of corporate governance principles for large private companies.
The first of those commitments was met on 11 June, when the Companies (Miscellaneous Reporting) Regulations 2018 (the Regulations) were published. These new regulations, which have now become law, were explored in an article in the June/July edition of Governance and Compliance and require qualifying companies to include in their directors’ report a statement covering which corporate governance code, if any, the company applied in the financial year and how it was applied. Alongside this, it must also state whether the company departed from such a code – and if so, how and why.
If the company has not applied any corporate governance code for the financial year, the statement must explain why not and what corporate governance arrangements were applied for that year.
Implementing this is not straightforward, despite the fact that many private companies already comply with much, if not all, of the code – because it is simply good business to do so and some larger private companies choose to report on their governance voluntarily.
In many cases this is because the firms used to be publicly quoted, have aspirations to quotation in the future, or want to demonstrate they are compliant with the code for other reasons – for example, those private equity owned entities that report as a result of the Walker review.
Although some provisions of the UK Corporate Governance Code are not applicable to private companies, many find it a useful document from which to take the parts relevant to them, in order to develop their own governance framework – in part, because of the greater variety of owner/manager relationships noted above. The Wates Principles – the outcome of the second of the government’s actions – are an attempt to help them to do so.
Each of the principles is supported by ‘guidance for consideration’, which explains the sort of issues that the coalition felt would fall to be addressed under each heading. These are helpful, although we would welcome the addition of a recommendation that large private companies have a company secretary or governance professional to support the board.
In themselves, the six principles are not onerous. Indeed, it could be argued that they are just common sense and that it is hard to see how any company could not comply with them. But that is not the point. The critical point is that these are principles which, like the principles in the code, must be applied and their application explained. These are not just; boxes to be ticked.
We often think of and describe the code as a ‘comply or explain’ model, but there is more to it than that. Listing Rule 9.8.6 requires that a UK listed company must include both a statement of how it has applied the main principles of the code, in a manner that would enable shareholders to evaluate this application, and a statement of whether it has complied with all the provisions of the code and, if not, with which provisions it did not comply and why. It is therefore a matter of ‘apply and explain’ the principles and ‘comply or explain’ with the provisions.
This distinction is important for two reasons. Firstly, it is often argued that it is more difficult to explain how you have applied the principles than it is to say that you have ‘ticked the boxes’ of the provisions and perhaps explained one or two. This is one of the reasons that the FRC have given for the restructure of the code they are planning to release shortly.
Secondly, there is the issue of reporting. Listed companies are reporting to shareholders. Because of the differing ownership structures of private companies, the new requirement is, in effect, that private companies report to society at large.
This is no bad thing. Companies of all kinds have the right to operate as they wish within the law, but compliance with the code is essentially voluntary. Companies can choose whether or not to list and, therefore, fall within its scope, and can choose whether to comply with or explain to shareholders against its specific requirements.
This provides an ‘enforcement mechanism’ ensuring compliance with the code or alternative governance arrangements that are sufficiently robust to satisfy shareholders. Reporting on compliance with the code is the price publicly quoted companies pay for raising capital from shareholders.
Effective governance requires this external ‘tension’ in reporting – specifically, someone to whom to report and a mandatory corporate governance code for private companies would have required a change in the law to provide the necessary ‘enforcement mechanism’.
The new requirement, based on the application of a code, gets around that problem and creates, for private companies of a significant size, an obligation to report to society as a whole as the price they pay for the use of societal capital and the privilege of limited liability. This is a significant benefit and it seems reasonable that such companies accept some public responsibility in return for it.
ICSA will be responding to the consultation and would welcome views at email@example.com.