The FRC has launched a consultation on a comprehensive shake-up of the UK Corporate Governance Code, the touchstone of corporate governance for listed companies that is celebrating its quarter-century this year. Off the back of the consultation, the FRC intends to publish a new Code in mid-2018, with the revised code applying to financial years commencing on or after 1 January 2019. The new Code is intended to be “shorter and sharper” to ensure it remains fit for purpose.

Whilst there are some significant changes in the new Code (in particular the welcome move towards a more principles-based rulebook), the broad foundations of current corporate governance practice established by the existing Code remain largely unchanged. As the FRC notes: “We are not starting from scratch. We are retaining those elements of the current Code that are still relevant today, and adapting others to reflect the changing economic and social climate to ensure that UK-listed companies achieve the highest standards of governance.”

Backdrop: the government’s reform agenda – encouraging executive pay restraint, enhancing the stakeholder voice and promoting the role of effective governance in privately-held businesses

Whilst the wider review of the effectiveness of the current Code was well underway prior its publication, the proposed Code reflects the recommendations for amendments to the Code set out in the government’s response to the Green Paper published in September 2017, which we summarise here.

Policy drivers in the Green Paper

The government response to the Green Paper focused on three main areas of concern:

  • Executive pay: The Green Paper highlighted “persisting concerns in the investment community and wider society over very high levels of executive remuneration at UK quoted companies.”
  • Enhancing the stakeholder voice: The government has identified the need for the existing duty on directors to “have regard” to stakeholder interests in in promoting the success of the company to work more effectively in practice, focusing in particular on the need to take into account the interests of employees.
  • Governance in large private companies: The government notes the somewhat arbitrary distinction between the current governance disclosure requirements for quoted companies and the lack of any transparency in relation to the governance arrangements largest unlisted companies (whose broader societal impact may be equal or greater than many quoted companies).

The new Code: refocusing on Principles

In the consultation paper, the FRC emphasises the need for companies to provide meaningful disclosure on how they have applied an expanded set of Principles. This represents a change in emphasis away from a large number of detailed supporting Provisions in the current Code which are subject to the “comply or explain” regime. The bias towards detailed Provisions in the current Code may perhaps have inadvertently led to a “tick-box” mentality to Code compliance, rather than a more holistic approach to governance and a more conscious application and consideration of the Principles.

Principles and Provisions: the structure of the Code

Principles – high-level requirements for best governance practice. Companies subject to the Code are, under the Listing Rules, required to report on how these have been applied. Adoption of the Principles is effectively a “given” for companies subject to the Code.

Provisions – more granular guidance on governance practice supporting the Principles. Companies must either comply with the Provisions or explain why they have departed from them in their annual report.

Section by section: principal changes under consultation

The revised version of the Code under consultation has been largely re-written, and now contains 17 Principles and 41 Provisions divided into five sections.

The FRC’s summary of the principal changes under the revised Code

The revised Code sets out good practice so that the boards of companies can:

  • Establish a company’s purpose, strategy and values and satisfy themselves that these and their culture are aligned;
  • Undertake effective engagement with wider stakeholders, to improve trust and achieve mutual benefit, and to have regard to wider society;
  • Gather views of the workforce;
  • Ensure appointments to boards and succession plans are based on merit and objective criteria to avoid group think, and promote diversity of gender, social and ethnic backgrounds, cognitive and personal strengths;
  • Be more specific about actions when they encounter significant shareholder opposition on any resolution, including those on executive pay policies and awards; and
  • Give remuneration committees broader responsibility and discretion for overseeing how remuneration and workforce policies align with strategic objectives.

Section 1: Leadership and purpose

This section brings together a number of key themes arising from the Green Paper:

  • New Principles in relation to stakeholders: New Principles provide that the board’s function includes contributing to wider society, and that the board should ensure effective engagement with, and encourage participation from, shareholders and stakeholders. These new Principles reflect the concern expressed in the Green Paper that the existing duty to have regard to wider stakeholder interests under section 172 Companies Act 2006 in promoting the success of the company is not clearly understood and inconsistently applied in practice.
  • Workforce representation: A specific mechanism to enhance the voice of the workforce – a key recommendation of the response to the Green Paper – was for companies to adopt, on a comply or explain basis, a employee consultation mechanism. All three government proposals have been reflected in the revised Code to give companies the flexibility to choose the mechanism most suitable for them. These are:
    • a director appointed from the workforce;
    • a formal workforce advisory panel; or
    • a designated non-executive director.

The FRC is deliberate in its use of the term “workforce” rather than “employees” as used in the Green Paper. This is intended to capture developments in the gig economy and includes contractors and agency workers.

  • Enhanced disclosure on section 172 compliance: The revised Code requires companies to explain in their annual report how they have engaged with the workforce and other stakeholders, and how their interests and the matters set out in section 172 of the Companies Act 2006 influenced the board’s decision-making. Section 172 requires company directors to “have regard” to wider matters (such as the interests of the employees) in carrying out their statutory duties to promote the success of the company for the benefit of its members. There was strong support in the Green Paper consultation responses for making this duty work more effectively. The FRC is mindful that the government is planning to introduce secondary legislation during 2018 to require “large companies” to report on section 172 compliance, and will keep the proposed drafting of this requirement under review.
  • Shareholder engagement: New Provisions provide that the chair should seek regular engagement with major shareholders to understand their views on governance and performance against strategy, and committee chairs should engage with shareholders on significant matters related to their areas of responsibility.
  • Addressing adverse shareholder votes: New provisions provide that where more than 20% of votes have been cast against a resolution:
    • the company should explain, when announcing voting results, the actions it intends to take to consult shareholders in order to understand the reasons behind the result;
    • no later than six months after the vote, an update should be published; and
    • a final summary should be provided in the annual report, or in the explanatory notes to resolutions at the next meeting, on the impact the feedback has had on the decisions of the board and any actions or resolutions now proposed.

Whilst the Green Paper focused on shareholder votes against director remuneration resolutions, the Code proposals (and the related public register maintained by the Investment Association, going live before the end of 2017) relates to votes against any resolution proposed at a general meeting. The FRC seeks views on whether 20% is significant, and whether an update should be published no later than six months after the vote.

Section 2: division of responsibilities

This section deals with the division of responsibilities between the executive and the board, as well as the role of the committees. Key changes include the following:

  • Non-executive and chairman independence. The revised Code introduces mandatory independence criteria, and where these are not met the director should not be considered independent. This is in contrast to the existing Code provision which sets out criteria against which the board should assess independence of non-executive directors and the chair. A new Principle provides that the chair should demonstrate independent and objective judgement throughout their tenure (and not just be independent on appointment, as provided in the current version of the Code).
  • Changes to required proportion of independent directors for all Code companies: A new Provision provides that independent non-executive directors, including the chair, should constitute the majority of the board (rather than the current requirement that at least half the board, excluding the chairman, should comprise independent non-executive directors). The exemption for this requirement for companies outside the FTSE 350 has been removed.
  • Annual re-election of directors for all Code companies: the revised Code preserves the requirement for all directors be subject to annual re-election, with the removal of the current exemption for companies outside the FTSE 350.

Section 3: Composition, success and evaluation

This section addresses the composition of the board, appointments and succession planning, to ensure that board membership is diverse and relevant to the company’s business, that boards operate effectively as a unit and that companies develop strong executive pipelines. Key changes include the following:

  • Diversity: A new Principle has been introduced that appointments and succession plans should, among other things, promote diversity of social and ethnic backgrounds, as well as gender. New Provisions require that the annual report should:
    • describe the nomination committee’s work and include reporting on actions taken to increase diversity and inclusion, and the outcomes in terms of progress on diversity; and
    • include the gender balance of those in senior management and their direct reports.
  • Expanded role of nomination committee in developing an executive pipeline: A new Provision has been included requiring the nomination committee to provide oversight of the development of a diverse pipeline for succession.

Section 4: Audit, risk and internal control

This section substantially replicates the provisions of the existing Code relating to these issues, with the removal of the exemption for companies outside the FTSE350 to have an audit committee with least three members.

Section 5: Remuneration

Proposed changes in relation to remuneration include the following:

  • Prior experience of committee chair: A new Provision has been included requiring that the chair of the remuneration committee should have served on a remuneration committee for at least 12 months.
  • Minimum membership of remuneration committee: Under a new Provision all Code companies should have a remuneration committee of at least three independent non-executive directors (the current exemption for companies outside the FTSE350 is deleted).
  • Expanded role of remuneration committee in workforce pay: The revised Code includes a Provision that remuneration committee should take include responsibility for oversight of company remuneration and workforce policies and practices. Remuneration committees should demonstrate how company policies and practices incorporate Code recommendations, including a requirement for companies to explain what workforce engagement has taken place, and how executive remuneration aligns with wider company pay policy.
  • Extension of LTIP vesting periods: A new Provision has been included extending the vesting and holding period for shares granted or other forms of long-term incentives, in normal periods, from at least three years to at least five years.
  • Mandatory formula override: A new Provision has been included requiring that remuneration schemes and policies should provide boards with discretion to override formulaic outcomes.

Consultations on related guidance

The FRC’s Guidance on Board Effectiveness has been amended to support the proposed changes to the revised Corporate Governance Code and to follow its structure. The FRC has also proposed some wide questions to seek views on the future of the Stewardship Code as well as other ways the FRC might be able to drive best practice reporting and stewardship activity. The FRC expects to publish a detailed consultation on specific changes to the Stewardship Code in mid-2018, once the review of the UK Corporate Governance Code has been finalised.

Consultation deadline and expected implementation dates

Responses to the consultation are requested by 28 February 2018. The FRC aims to publish the final version of the Code by early summer 2018, to apply to accounting periods beginning on or after 1 January 2019.