The Financial Reporting Council (FRC) has published a consultation on proposed targeted revisions to the UK Corporate Governance Code (UKCGC). The consultation follows the UK government’s response to the White Paper, Restoring Trust in Audit and Corporate Governance, published in May 2021 and the FRC Position Paper published in July 2022.
The review focusses primarily on Section 4 of the UKCGC (Audit, Risk and Internal Control), as well as adding in some supplemental provisions aimed at improving reporting in areas such as directors’ remuneration, diversity and environmental, social and governance (ESG) issues.
We consider some of the key changes proposed by the FRC below.
Section 1 – Board leadership and purpose
The FRC intends to add a new Principle D to Section 1 stating that companies should, when reporting on their governance activity, focus on activities and outcomes to demonstrate the impact of governance practices. The FRC feels that reporting in this area has been lacking and that the new Principle will better meet the needs and expectations of companies’ stakeholders.
Other amendments to section one aim to give more focus to ESG issues, including climate ambitions and transition planning.
Section 2 – Division of responsibilities
To address investor concerns about multiple board positions held by directors of listed companies, the consultation seeks views on proposals to strengthen the Code's disclosure requirements in this area.
The FRC invites feedback on two proposals:
- Amending current Principle L (Principle K in the revised Code), to specify that the annual board performance review should consider each director’s commitments to other organisations, and how directors are able to make sufficient time available to discharge their role effectively.
- Amending Provision 15 to recommend that annual reports include more information on directors’ other commitments and how they manage these.
Section 3—Composition, succession and evaluation
The proposed changes emphasise the importance of diversity and inclusion in a board’s composition and support the FCA’s policy in this area, although the FRC does not want to introduce duplicative requirements. These include:
- Amending current Principle J to specifically refer to inclusion and to give equal weight to all protected characteristics (under the Equality Act 2010) and non-protected characteristics (educational attainment, for example), to encourage companies to consider diversity beyond gender and ethnicity.
- Providing improved clarity on approach to succession planning and board and senior management appointments, again to promote equal opportunity, diversity and inclusion beyond gender, social and ethnic backgrounds. Diversity and inclusion initiatives, along with any targets, should contribute to the succession plan. The work of the nomination committee to feature in the annual report should include the search and nomination procedures and promotion of diversity for board and senior management appointments.
- Adopting the recommendations of the Chartered Governance Institute from its review of effectiveness of independent board evaluation.
Assuming these changes are made, companies will need to tread carefully in managing the increased emphasis on diversity and inclusion both at board level and senior management, as well as succession planning. “Positive discrimination” (e.g. promoting a woman instead of a man simply due to her sex – a protected characteristic) is unlawful under the Equality Act 2010. There are provisions for lawful “positive action” and the Government has recently produced guidance on this. However it is an area of law fraught with nuances, and those involved in overseeing appointments and succession planning, as well as those setting remuneration metrics (see further below), should be trained to understand which actions may be lawful and those which are not.
Section 4 – Audit, risk and internal control
Audit and assurance policy
In its response to the White Paper, the government confirmed its intention to introduce a statutory requirement for Public Interest Entities (PIEs) to produce an Audit and Assurance Policy (AAP), describing the directors' approach to seeking internal and external assurance of the information they report to shareholders. ‘PIEs’ will be defined as those companies which have 750 or more employees and an annual turnover of £750 million or more. However, the FRC believes all companies reporting against the UKCGC should consider producing an AAP on a comply or explain basis (irrespective of whether they are within the scope of the relevant legislation), using the (as yet unpublished) legislation as a guide to what should be included.
Audit committees and the external audit-minimum standard
Following its consultation in November 2022, the FRC has published a final version of a new minimum standard for audit committees (Standard), which will apply initially to FTSE 350 companies. Assuming primary legislation is passed to bring the Audit, Reporting and Governance Authority (ARGA) (ie the successor body to the FRC) into being, the Standard would, subject to the appropriate powers being provided in the legislation, become mandatory. Companies within scope are encouraged to begin to apply the Standard as soon as they are able. The Standard focuses on certain audit committee responsibilities, including:
- Requiring that the company manages its non-audit relationships with audit firms to ensure that it has a fair choice of suitable external auditors at the next tender and in light of the need for greater market diversity.
- Conducting the tender process and making recommendations to the board about the appointment, reappointment and removal of the external auditor, and approving the remuneration and terms of engagement of the external auditor.
- Engaging with shareholders on the scope of the external audit, where appropriate.
- Ensuring that the external auditor has full access to company staff and records.
- Inviting challenge by the external auditor, giving due consideration to points raised and making changes to financial statements in response, where appropriate.
- Reviewing and monitoring the external auditor’s independence and objectivity.
- Reviewing the effectiveness of the external audit process, taking into consideration relevant UK professional and regulatory requirements.
- Developing and implementing policy on the engagement of the external auditor to supply non-audit services, ensuring there is prior approval of non-audit services, considering the impact this may have on independence, and reporting to the board on any improvement or action required.
- Reporting to the board and shareholders on how it has discharged its responsibilities with respect to the external audit.
The Standard covers a number of matters which are identical to certain aspects of Provisions 25 and 26 of the UKCGC (26 and 27 of the revised Code). Specifically, these Provisions cover the work of the audit committee in relation to external audit, and the requirement for the audit committee to report on this. To avoid duplication, the FRC proposes that the relevant provisions be amended and that the revised UKCGC instead refer to the Standard. The FRC recognises that this will result in some non-FTSE 350 companies being indirectly brought into the scope of the Standard. However, it notes that many companies are already following the requirements of the Standard and if necessary, companies can explain their reasons for departing from the new UKCGC recommendation.
Sustainability and ESG reporting
The FRC considered including a recommendation that companies following the UKCGC have a sustainability committee but decided against this in view of the different approaches that companies are taking in this area. Instead, the audit committee would be given responsibility for monitoring the integrity of narrative reporting, including sustainability reporting, and for describing its work in this area in the annual report (where these matters have not been reserved for the board). Where the board has commissioned the assurance of ESG metrics and other sustainability matters, this should be described in the annual report.
Risk management and internal controls
The government’s White Paper response invited the FRC to strengthen the UKCGC provisions dealing with board accountability and reporting on internal controls. The FRC proposes strengthening board accountability for a company's risk management and internal control framework through a revised Principle O that would make the board responsible for not only establishing but also for maintaining the effectiveness of this framework. Boards will therefore have to report to shareholders on their work in this area during the relevant reporting period.
The FRC is also proposing to amend existing Provision 29 (new Provision 30), to require the annual report to include:
- A declaration of whether the board can reasonably conclude that the company’s risk management and internal control systems have been effective throughout the reporting period and up to the date of the annual report.
- An explanation of the basis for its declaration, including how it has monitored and reviewed the effectiveness of these systems.
- A description of any material weaknesses or failures identified and the remedial action being taken, and over what timeframe.
The revised UKCGC will not ask for reporting on whether the board intends to obtain external assurance over the effectiveness of the company’s risk management and internal control framework. That will be a matter for companies to determine when setting their Audit and Assurance Policy (commented on above). However, revised Guidance to be published in due course may set out circumstances in which external assurance might be considered appropriate, to aid the development of that policy.
The resilience statement is another component of the government’s package of audit and corporate governance reforms. The FRC notes that there is overlap with the current viability statement (Provision 31, which will become Provision 32).
The FRC proposes to amend this provision to ask the board to explain in the annual report how it has assessed the future prospects of the company, taking account of the company’s current position and principal risks. However, this provision will no longer apply to PIEs (who will be required to produce a resilience statement).
Section 5 – Remuneration
The FRC proposes amending the Principles in Section 5 to strengthen the links between a company's remuneration policy, its overall corporate performance and delivery of its long-term strategy, including ESG objectives. ESG usually includes diversity and inclusion, so as noted above, any performance metrics related to D&I should be carefully considered in the light of unlawful positive discrimination.
The remuneration committee should specifically take account of workforce pay and conditions when authorising executive pay.
Greater transparency will also be required on malus and clawback arrangements, specifically recommending their use in director contracts and/or other agreements or documents which cover director remuneration, as well as specifying the minimum circumstances in which they could be used, over what period (with an explanation), whether and why they have been used in the last reporting period, and their use in the last five years.
The FRC is also proposing removing the reference to pay ratios and pay gaps, on the basis that it leads to duplication where there is already gender pay gap reporting and disclosures on company websites. However it is seeking views on this, and whether this should be replaced with, for example, asking companies to report on what steps have been taken to reduce and eliminate pay gaps.
The revised UKCGCC will be supported by updated guidance, including the Guidance on Audit Committees, Guidance on Board Effectiveness and Guidance on Risk Management. The guidance will be available in final form when the new Code becomes applicable.
Responses to the consultation should be submitted by 13 September 2023. The FRC intends that the revised UKCGC will apply to accounting periods commencing on or after 1 January 2025.
As noted, this is a targeted consultation on the UKCGC, that deals primarily with the areas that the FRC were tasked with taking forward in the government response statement to the White Paper on restoring trust in audit and corporate governance. The government is still to bring forward the long-awaited draft legislation that is needed to address many of the proposals for reform which will enable the proposed new corporate reporting requirements, requirements for auditors and the transformation of the FRC into ARGA to be implemented.