25 years after the Cadbury Report on corporate governance, the House of Common's Business, Energy and Industrial Strategy Committee (the "Committee") has recently published its latest corporate governance report (the "Report").[1]

The Report was commissioned to address the Committee's findings of serious corporate governance failings at BHS[2] and Sports Direct[3] and the increased public mistrust in business following a number of high profile corporate scandals and bankruptcies.

The Report describes its proposals as "evolutionary in spirit". However, if adopted, some of the recommendations are quietly revolutionary, including:

  • a wider role and new powers for the Financial Reporting Council ("FRC") to act as regulator and enforcer of directors' duties;
  • the development of a new corporate governance code for large, privately held companies with 2000 plus employees, together with a new body to oversee compliance with that code;
  • the phasing out of long term incentive plans ("LTIPs") with a renewed focus on simpler pay structures for senior executives;
  • the publication of pay ratios between the CEO and average UK employees; and
  • setting a target for FTSE 350 companies, that 50% of appointments to senior executive positions, by May 2020, should be women.

In response to the proposals, the FRC stated that the Report "recognises the important role of the [FRC] in policing corporate behaviour and supports [the FRC's] call for more powers to be able to hold directors to account for their responsibilities under Section 172 of the Companies Act."

The next stage will be for the FRC to consult on the proposals and for the Government to respond, indicating which, if any, of the proposals it wishes to adopt.

We examine the background to the Report and outline some of the key recommendations in further detail below.

Background

The Report was commissioned following a number of high profile corporate scandals and bankruptcies, and the Committee's findings of serious corporate governance failings at BHS and Sports Direct. According to the Report, such scandals, together with frequent press reports of executive pay appearing to be disproportionate to performance, have eroded public trust in business.

The Committee opened the inquiry in September 2016 and obtained evidence from over 170 organisations and individuals. Following its enquiry, the Committee considers that the UK's corporate governance regime is generally fit for purpose and that the underlying "comply or explain" principle of accountability should remain. However, the Report's proposals seek to:

  • address reduced board accountability as a result of the trend towards short term, institutional and international shareholding;
  • improve the voice of other business stakeholders, such as employees;
  • address the lack of enforcement of directors duties under the Companies Act 2006;
  • promote more open and transparent dialogue between companies and the public; and
  • encourage greater board diversity and gender equality.

The Committee are concerned to address these issues in a number of ways but without seeking to create new statutory obligations. Instead, the Report promotes better adherence to and enforcement of, the existing powers within the Companies Act and the UK Corporate Governance Code (the "Code").

Improving corporate governance appears to be a priority for the Government as this Report is concurrent with the Government's own Green Paper on Corporate Governance, which was published in November 2016[4]. Feedback on the Green Paper closed on 17 February 2017 and the Government is currently reviewing the feedback.

Directors' duties to shareholders and employees

Section 172 Companies Act 2006 (duty to promote the success of the company) will have been in force for ten years this year. The section has been the cause of long standing debate as it combined a director's fiduciary duty to act in good faith in the best interests of the company with the statutory duty to consider the interests of employees under section 309 Companies Act 1985.

The Report acknowledges the inherent difficulties with the phrasing of s172, "the requirement for directors to “have regard to” other stakeholders and considerations is lacking in clarity and strength and is not realistically enforceable by shareholders…". Despite the shortcomings of the existing wording, identifying suitable alternate wording is not straightforward. Further, amending the drafting would create uncertainty which the Committee is conscious to avoid when EU exit talks are beginning.

The Companies Act 2006 also enacted shareholders' power to bring derivative actions. However, due to the time, cost and difficulties of securing the court's permission to bring the action, only 22 derivative actions have been instituted under the Companies Act 2006.[5] Further, the Committee heard evidence that there have not been any reported cases of shareholder actions based on a breach of a s172. Instead, it appears that s172 has only been utilised in the insolvency context.[6] Clearly, by this point, the damage has been done and it is too late to save the business.

To address the lack of enforcement prior to insolvency, the Report proposes that:

  • the Code is amended to require companies to produce an "informative narrative reporting on the fulfilment of section 172 duties";
  • FTSE 350 companies should include a new corporate governance compliance rating, in their annual report, using an "easy to digest red, yellow and green assessment".The FRC is tasked with developing the metrics for this system; and
  • the FRC's existing powers of enforcement, against accountants and actuaries, are widened to cover breaches of s172 duties by all directors.The Committee acknowledges that this will require legislation, additional resourcing, additional investigatory powers and a rebranding for the FRC.

At this stage there is limited detail in the Report on how the FRC's wider powers might operate, save for anticipating that the FRC will have authority to initiate legal proceedings for breach of s172. Currently, the mechanism for how this will operate is unclear as a director owes his duty under s172 to the company.

New large company governance code

To reflect the increased number of large unlisted UK companies, the Report recommends that the FRC, Institute of Directors and Institute for Family Business develop a new governance code and a new body to oversee compliance with that code. Initially the new code will just be for large private companies with 2000 plus employees although the Committee hopes that smaller companies will also want to comply as a sign of their good corporate governance.

Pay

The Committee is concerned by the damage done by the apparent disconnect between poor or stagnant company performance and excessive pay to top executives. To address this, the Report makes a number of recommendations, including:

  • reducing incentive pay so that bonuses do not comprise an unjustifiably large proportion of a director's pay package;
  • phasing out LTIPs (with no new LTIPs from 2018) as they have been found to be too complex and largely ineffective. Instead the Report favours executive pay packages based on salary combined with stock options, deferred for five years, to promote longer term decision making;
  • amending the Code to recommend including an employee representative on remuneration committees; and
  • publishing pay ratios between the CEO and senior executives and the CEO and the average of all UK employees.

Board diversity

The Report acknowledges and promotes the benefits of a more diverse and gender balanced company board. It also cites evidence that setting targets works: the percentage of women holding directorships has doubled since 2010, clearly linked to the target of 25% set following Lord Davies' 2011 review[7].

However, this is not the whole story as, in the FTSE 100, there are still only six women CEOs and only nine chairs or CEOs are from black, Asian and minority ethnic ("BAME") backgrounds. More work is needed for women and people from BAME backgrounds to fill executive board positions. Therefore, the Report's recommendations include that:

  • the Government should set a target, for FTSE 350 companies, that 50% of appointments to senior executive positions by May 2020 should be women;
  • companies should outline what they are doing to engage and support women to reach executive roles throughout their careers;
  • the FRC should also oversee nomination committees and boards should advertise executive roles publically;
  • the revised Code should promote ethnic diversity of boards; and
  • the Government should legislate to require FTSE 100 companies to publish their workforce data broken down by ethnicity and pay.

NEDs

The Committee is keen to ensure that non-executive directors ("NEDs") are actively involved in the board and able to challenge the executive directors. To facilitate this, the Report recommends that the FRC should:

  • update the Code to provide guidance on how companies should identify clearly and transparently the roles and responsibilities of NEDs and how they should be held to account for their performance;
  • amend its best practice guidance to recommend that NEDs receive suitable training and professional development to enable them to fulfil their duties; and
  • require NEDs who serve on multiple boards to demonstrate "more convincingly" that they can devote sufficient time to each board.

Improving communications with stakeholders

The Report recommends that the FRC should:

  • actively push back on the increased overuse of legalistic boiler-plate statements in annual reports; and
  • encourage companies to utilise their websites and new technology platforms to communicate with stakeholders throughout the year.

Despite the recent high profile scandals, the Report generally paints a positive picture about the strength of the existing corporate governance framework in the UK. However, it is clear to the Committee that changes are needed to better protect shareholders and stakeholders and to improve public confidence.

Unsurprisingly, at this stage, the detail of many of the most interesting aspects, such as the FRC's new enforcement powers or the metrics for the new corporate governance compliance rating system, is lacking. However, presuming those recommendations are accepted then, that detail should follow.