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UK governance reforms are balanced and comprehensive

05 October 2017 by Peter Swabey

UK governance reforms are balanced and comprehensive - Read more

The government has released a set of proposals to address issues with executive pay, stakeholder engagement and private companies.

For governance professionals, the UK government’s response to a consultation on its November 2016 green paper on corporate governance reform is among the key events of this year.

Under proposed reforms, the Department for Business, Energy and Industrial Strategy (BEIS) will join with regulators and industry to address issues of executive pay; strengthen employee, customer and supplier voices; and encourage corporate governance in large, privately-held businesses.

Not all the options discussed in the green paper made the final cut, prompting accusations in the press that the government had retreated from its original proposals.

ICSA: The Governance Institute supports sound governance principles and wishes to improve the standard of governance in the UK.

As we said to the prime minister on 24 January in our joint letter with the Institute of Directors, the International Corporate Governance Network (ICGN) and the Trades Union Congress (TUC):

‘There are certainly some areas where improvement should be actively sought; others where more time should be given to assess the effectiveness of legal and regulatory measures that have already been taken; and still others where we are not convinced that an adequate case has been made for change.’

We were among those who responded to the green paper and have since worked with officials at BEIS as they develop their thinking.

Our view is that the government proposals have fairly balanced the desire to see some issues addressed more quickly with awareness that legal, regulatory and industry initiatives over the last few years are starting to have an effect.

Executive pay

We believe that executive pay is sometimes excessive and that action needs to be taken to address it.

There is a good argument that high pay is not solely an issue in public companies, who may only account for a small proportion of the highly-paid in our society. But this is the issue that the government has chosen to address and – rightly – it has focused on some of the gaps in existing legislation.

“In 2016 there were relatively few companies that saw shareholder votes against their remuneration reports, and in 2017 even fewer saw votes against their remuneration policies”

We previously urged the government to remember that the changes to executive pay regulation brought in during 2013 are only just coming into effect and argued that shareholders do not need stronger powers over executive pay right now.

In 2016 there were relatively few companies that saw shareholder votes against their remuneration reports, and in 2017 even fewer saw votes against their remuneration policies.

This suggests that engagement between companies and stakeholders has been effective, justifying the government’s decision not to introduce annual binding votes on remuneration. 

In our view, this was unlikely to reduce levels of executive pay, and could have made it more difficult for companies to recruit talented individuals, and led to short-term thinking.

Shareholder dissent

On the other hand, the proposal that companies should state more clearly what they intend to do where they receive an adverse shareholder vote is a good one.

We believe there should be consequences after an adverse vote. However, shareholder dissent can have many causes, sometimes conflicting.

As such, the requirement should be complemented by a duty for investors to communicate their explicit reasons for a negative vote to the company.

There is a vital distinction between situations where investors no longer consider the policy to be appropriate and where they are concerned about the subjective elements of implementation, such as matters of judgment and discretion.

The proposal that the Investment Association maintain a register of companies receiving adverse shareholder votes and their proposed actions is also good, creating a central repository for information that is already mostly in the public domain.

Remuneration schemes

The requirement for greater clarity in executive remuneration schemes is also one that ICSA backs.

As discussed above, binding votes provide useful certainty on remuneration policy, but it is also important that shareholders fully understand the policy and its resulting pay structure. Similarly, an increase in the minimum holding period for share-based payments is sensible.

However, we are not convinced that holding periods are generally perceived to be a problem: the concern mostly seems to be about the size of awards, which in many cases is driven by a tendency to discount the value of potential future payments, sometimes referred to as ‘jam tomorrow’.

Ensuring executives have a long-term stake in the company is vital, but this can be achieved in other ways – for instance, by setting additional shareholding requirements.

We are also pleased to see that the green paper’s suggestion of a ‘senior shareholder committee’ has been shelved. Where this model has been successful, it has been so under completely different company law and market structures.

“Our view is that remuneration committees do take into account wider stakeholder interests and challenge pay policies”

However, the proposal to give the remuneration committee a broader responsibility for overseeing pay and incentives across their company is interesting, as is requiring them to engage with the wider workforce to explain how executive pay aligns with wider company pay policy.

Our view is that remuneration committees do take into account wider stakeholder interests and challenge pay policies. This is the experience of our members, who regularly attend remuneration committee meetings.

Even so, specific responsibility for reviewing pay across the company may be useful.

Pay ratio

Finally, there is the introduction of the pay ratio (this has been discussed in-depth on the Governance and Compliance website). This will be an interesting statistic, providing useful information for and about a company when judged over a period of time.

In our view, there are other metrics which would be more meaningful and effective if disclosed. However, the required narrative explaining year-to-year changes to that ratio and how it relates to pay and conditions across the wider workforce does somewhat mitigate our fears.

The ratio should not be used to compare between companies, and there is a risk the headline ratio figures will be reported by the media without context, leading to unfair public criticism for some companies.

Strengthening the employee, customer and supplier voice

Our members’ experience is that boards already take into account the interests of staff and other stakeholders.

In our response to the green paper, we argued that legislation in this area was unnecessary:

‘There will, undoubtedly, be companies for which [stakeholder advisory panels, a designated non-executive director or an employee director] would work well and they should be free to adopt them. However, we have concerns about these options being mandated for all companies.’

We are pleased to see that the government has heeded this advice. However, it has proposed that companies should have ‘one of three employee engagement mechanisms [those mentioned above]’ asking the FRC to consult on making this a UK Corporate Governance Code requirement on a ‘comply or explain’ basis.

It has also asked the Association of General Counsel and Company Secretaries working in FTSE 100 Companies (GC100) to publish new advice and guidance on the practical interpretation of the directors’ duties set out in section 172 of the Companies Act 2006.

Our preferred solution here was for enhanced reporting on stakeholder engagement, the option favoured by the government. It proposes to require that all public and private companies of a certain size explain how their directors comply with the requirements of s172 to consider employee and other interests.

This is important – so important, in fact, that we have been working on guidance with the Investment Association to help companies needing support in this area, and to share existing good practice.

The government recognised this work by directly asking in the green paper that this guidance be completed. It now has been and you can read more about it here.

Corporate governance in large, privately-held businesses

Many private companies already comply with much, if not all, of the UK governance code because it is simply good business to do so, and some larger private companies choose to report on their governance voluntarily.

However, the governance of private companies could be better, most notably in terms of transparency.

As we said in a letter to the prime minister 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.’

“The governance of private companies could be better, most notably in terms of transparency”

It should be no surprise that we back the government’s proposal that all public and private companies of a given size disclose their corporate governance arrangements in their directors’ report and on their website, including whether they follow any formal code.

Previously we argued that the responsibilities of companies should match their size and societal impact, whether measured through the number of people a firm employs, its position in the marketplace or whatever else except its ownership structure.

It is good to see this theme running through the government’s proposals. The thresholds will need careful consideration and we look forward to working on these as BEIS consults further.

FRC action

We also agree the FRC, working with other relevant bodies such as ourselves, should develop a voluntary set of corporate governance principles for large private companies.

Although there have been some notable failures in private companies – BHS being a case in point – there is little evidence that the existing governance model for private companies does not work for most firms.

It is important any enhanced rules governing private companies be proportionate to their benefits. We expect that the thresholds at which a company has sufficient societal impact to bring it within the scope of reporting requirements be set at a high level, in which case it is likely that companies will already largely be meeting such requirements.

The government has also taken the opportunity to indicate its intention to proceed in two further areas. It will ask the FRC, Financial Conduct Authority and the Insolvency Service to work together to ensure the most effective use of existing powers to sanction misbehaving directors, and ensure the integrity of corporate governance reporting.

Lastly, the government will further consider the need for additional powers for the FRC, and plans to commission an examination of the use of share buybacks to ensure that they cannot be used artificially to hit performance targets and inflate executive pay.

All in all, this is a comprehensive package of reforms and it will be interesting to see how they are implemented, as well as how effectively they address the issues identified in the original green paper.

Peter Swabey FCIS is policy and research director at ICSA: The Governance Institute

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