As UK corporate governance comes under the spotlight again - are you ready for reform?

07 March 2018

In recent years the actions of those individuals charged with governance of some of the UK’s largest companies has come under increased scrutiny. High profile governance examples that have come under the media spotlight and parliamentary scrutiny include the demise of BHS and Carillion.

Areas such as executive pay have come under the spotlight also, often being perceived by many as excessive, and even leading to shareholder rebellions against some pay awards e.g. AstraZeneca, Morrisons, Pearson Plc being given substantial publicity.  

The UK Government’s response to this has been to consult on change with a white paper being produced.  The message is very clear - reform of corporate governance is required.

“In some companies, executive pay has become disconnected from the performance of the company itself. In others, some directors seem to have lost sight of their broader legal and ethical responsibilities. There is a worrying lack of transparency around how some large privately-held companies behave. A responsible government must recognise these problems and show leadership how to tackle them.” - Prime Minister RT Hon Theresa May MP August 2017

The key areas for reform highlighted in the white paper are as follows:

  • Executive pay
  • Large privately held businesses
  • Strengthening the employee, customer and wider stakeholder voice.

The reforms are to be introduced through a revision of the UK Corporate Governance Code (“the Code”) by the Financial Reporting Council (“FRC”), voluntary support from industry bodies such as the Investment Association and secondary legislation, which will be enacted during 2018.  The FRC issued its consultation paper on revisions to the Code in December 2017 with a final version expected by Summer 2018.  The provisions of the final revised Code will apply to all listed companies for accounting periods beginning, on or after 1 January 2019. Exemptions for companies outside the FTSE 350 have now been removed. As before the principle of “comply or explain” will apply with companies required to explain their reasons for not following the Code. The secondary legislation is expected to apply to all listed companies and some aspects will also apply to all companies of a significant size (private as well as public).

The key areas where companies will need to update their governance arrangements if they wish to comply with the new Code are set out below.

What do companies need to do?

Companies need to review the work of their remuneration committees. The Code proposes that remuneration committees take on a new responsibility for oversight of company remuneration and wider workforce policies. This may increase the amount of time committee members need to devote to this role.  Alternatively, it is suggested that other committees such as corporate responsibility, sustainability or people committees may be used to meet this expanded remit.  Specifically, there is an additional reporting requirement for companies to explain what workforce engagement has taken place to demonstrate how executive remuneration aligns with wider company pay policy.  The Chair of the remuneration committee also needs to have at least 12 month’s experience on a remuneration committee before taking on this role.

Arrangements for pay awards also need to be reviewed. Where executive pay awards are made in the form of shares, the Code proposes that the minimum vesting and post-vesting holding period for such share awards is extended from 3 to 5 years to encourage companies to focus on longer-term outcomes in setting pay.  Non-executive directors cannot participate in the company’s share option scheme or performance-related pay scheme if they wish to be considered independent.

Secondary legislation will also be enacted by the Government during 2018 that will require listed companies to report annually the ratio of CEO pay to the average pay of their UK workforce, along with a narrative explaining changes to that ratio from year to year, and setting the ratio in the context of pay and conditions across the wider workforce.  

In the event that executive pay awards are challenged, measures have been proposed to increase transparency over the steps taken by the company to respond to an adverse vote by shareholders.  This covers all votes (not just pay related) where there is a result of more than 20% against a resolution.  In this case, the Code proposes that a company should record the actions it intends to take to understand the reasons behind the vote. The Code also proposes that no later than six months after the vote, companies should publish an update on actions taken before a final summary is provided in the next annual report or in the explanatory notes to the resolutions at the next AGM.

In support of this, the Investment Association has agreed to maintain a public register of listed companies encountering shareholder opposition of 20% or more, along with a record of what these companies say they are doing to address shareholder concerns.  This register is already in operation.

Companies need to establish new arrangements to demonstrate more clearly that directors are meeting their responsibilities under the Companies Act 2006.  Section 172 (1) of the Act already requires directors to act in the way most likely to promote the success of the company with regard to the likely consequences of decisions in the long term, employee interests and the fostering of relationships with suppliers, customers and others. The Government is of the view that this primary legislation does not require amendment at this stage.  However, secondary legislation is to be introduced that requires all companies of a significant size (private as well as public) to explain in their annual report how directors comply with these requirements and how the Board has engaged with the workforce and other stakeholders.

The FRC also addresses this matter with a new provision in the Code requiring listed companies to adopt, on a 'comply or explain' basis, a method for gathering employee views.  This is expected to be through a director appointed from the workforce, a formal workforce advisory panel or a designated non-executive director.

The independence of non-executive directors and Board composition also needs to be reconsidered. Current exemptions in the Code for listed companies outside the FTSE 350 are now to be removed and in particular independent non-executive directors, including the Chair, should now constitute the majority of the Board for all listed companies.

The Code includes proposals to strengthen director independence provisions. This means that a non-executive director will not be considered to be independent unless they meet specified criteria. In particular, a non-executive director who has served more than nine years will no longer be considered independent. All directors are now required to be re-submitted for election annually. The role of the chief executive is also clarified as proposing and delivering strategy and reinforces the link between strategy and culture.

Finally, companies need to look at the arrangements that they have in place for promoting diversity at Board level. The recommendations of recent reviews, particularly the Hampton-Alexander Review (on gender balance) and the Parker Review (on ethnic diversity) have also been included in the proposed Code. The aim is to ensure that appointment and succession planning arrangements are designed to promote diversity of gender, social and ethnic backgrounds. Proposals also look to encourage diversity across the workforce, particularly in the executive pipeline with additional oversight and progress reporting from the nomination committee. The Code proposes that listed companies should also disclose in their annual reports the gender balance of those in senior management and their direct reports.

What should Heads of Internal Audit be considering?

The main changes proposed in the Code are to increase the responsibilities of the remuneration committee and nominations committee with additional reporting requirements so that listed companies can demonstrate that these responsibilities have been met. Arrangements for gathering employee views and collecting data on executive pay and diversity may also need to be enhanced to meet the requirements of the Code and secondary legislation. Additional emphasis has also been placed upon the configuration of the Board and the independence of non-executive directors. These should be the key new areas of focus for governance within the business during 2018.

Established Heads of Internal Audit will already have reviewed the governance arrangements of their companies and will also have a good understanding of how these operate in practice. If the company is listed or a large private entity, they now need to consider the impact of the proposed changes carefully and provide advice on how these can be applied appropriately by the Board and its committees.

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