27 June 2018 by Bernadette Barber
Dropping governance exemptions for smaller companies could be a backwards step
Corporate governance is a journey for any organisation but this is particularly the case for smaller entities. Their needs change as their business grows and evolves, therefore a key strength of the ‘comply or explain’ regime has always, at least in theory, been the flexibility it allows boards to shape the arrangements that will best serve their particular needs.
For smaller companies, there has always been some leeway provided. There has been no defined code requirement for AIM-listed companies and, within the UK Corporate Governance Code, there are three important carve-outs for smaller companies.
First, the boards of such companies are allowed to operate with only two independent non-executive directors, rather than the more onerous obligation of at least half the board (excluding the chairman). Second, such companies have not been obliged to conduct periodic externally facilitated board evaluations.
And finally, directors of companies outside the FTSE 350 have not been required to stand for annual re-election. However, in the new version of the UK Corporate Governance Code, which was the subject of consultation earlier this year, it was proposed these exemptions be removed.
The first of the current exemptions, which directly impact the size and composition of the board, is not even complied with by a significant number of FTSE 350 companies, let alone their smaller cousins.
The relevant provision, B.1.2, sees the highest number of non-compliance across the FTSE 350 (26 instances, according to the last FRC Developments in Corporate Governance and Stewardship report published in 2017). Similar issues of non-compliance also exist in relation to the external board evaluation requirement, with 10 of the FTSE 350 ignoring this best practice rule.
To be clear, this is not non-compliance during a period of transition. Boards of FTSE 350 companies, including some in the FTSE 100, are actively choosing to reject the long-established board independence code provision introduced after the 2003 Higgs report. This is despite the fact it may frequently have a knock-on effect in terms of compliance with the relevant committee membership requirements.
“There is often good reason why the governance businesses may take a different shape to the traditional model”
It is noticeable that these areas of non-compliance relate to issues that would cost boards money to resolve. Could it be that boards are simply making a value judgement about these provisions and are not prepared to spend company money on ‘ticking the box?’ Whatever the real reasons for resisting compliance with these provisions, one wonders how realistic it is to expect smaller companies to recruit additional independent non-executive directors and engage external evaluation consultants. It is unclear why they would see these standards as being relevant when even some of our largest corporates do not adhere to them.
Contrast this to the new requirement for AIM-listed companies to follow a recognised corporate governance code. Such companies, while encouraged to comply with a code, have hitherto not been obliged to. Although AIM is intentionally a lighter-touch regime, this has surely been a gap long overlooked. From September, though, under AIM rule 26, they will be required to state which code they have adopted and provide disclosures on their compliance.
Many will no doubt opt for the QCA Corporate Governance Code for Small and Mid-Size Quoted Companies, which provides a much more flexible regime and one arguably better suited to smaller entities.
Such businesses are frequently highly entrepreneurial. Some still have owner-managers who have retained a significant proportion of the shares and long histories with, and great passion for, the company they perhaps founded and have grown.
There is often good reason why the governance of those businesses may take a different shape to the traditional model. A system such as that embodied within the QCA code provides much greater
scope to mould arrangements within the accepted principles of good governance.
In particular, the QCA code avoids the use of detailed provisions, which history tells us will generally be interpreted by many investors and proxy voting advisors as edicts on practical application.
The application of corporate governance codes has undoubtedly raised boardroom standards over the last quarter of a century. Perhaps more than ever before, the new UK Corporate Governance Code emphasises the importance of applying good principles over complying with precise provisions, but the removal of the smaller company exemptions could be seen as a retrograde step.
It will make the code even more prescriptive for those businesses where more flexible arrangements may be more appropriate, in contrast to the QCA code, which allows boards to retain freedom to make decisions on governance they think will best serve their business.