BEIS has published the Government’s response to the Green Paper on Corporate Governance Reform (the White Paper). Many of the more controversial proposals have been dropped. None of the remaining proposals will require primary legislation.
Annual binding votes, caps on pay and changes to directors’ duties are all off the agenda – at least for now. Instead, the Government has passed the baton to the Financial Reporting Council (the FRC) and other key bodies with a mandate to develop codes and guidance. But there are nevertheless a number of changes of which companies will need to be aware.
The current intention is to bring the reforms into effect by June 2018 to apply to company reporting years commencing on or after that time (although, as noted below, some of the proposals may be implemented earlier). This briefing gives an overview of what is being proposed. As a firm we are involved in a number of the follow on initiatives described below. We would of course be very happy to discuss the content of the White Paper and its implication for your business in more detail.
1. Executive pay
The Government has stepped back from many of the alternatives canvassed in the Green Paper. For example, it has decided not to make the executive pay package (or elements of it) subject to an annual binding vote, nor to introduce an upper threshold on total annual remuneration. It has decided not to introduce stronger consequences for a company losing its annual advisory remuneration report vote (although, as discussed below, it is possible this may be addressed in revisions to the UK Corporate Governance Code (the Code)). Nor will the Government require the directors’ remuneration policy vote to be held more frequently than every three years.
Addressing significant shareholder dissent on executive pay
The Government believes that shareholders need an enhanced ability to hold to account what it describes as the small majority of companies that experience significant investor dissent on executive pay. It suggests that this will be provided by:
- inviting the FRC to revise the Code to be more specific about the steps that listed companies should take when they encounter significant shareholder opposition to executive pay (it appears that a vote of 20% or more will be treated as constituting significant shareholder opposition for these purposes); and
- inviting the Investment Association to maintain a public register of listed companies encountering shareholder opposition of 20% or more to executive pay and other resolutions, along with a record of what these companies say they are doing to address concerns.
Limited guidance is given on what steps listed companies may be expected to take to address significant shareholder opposition, although this may include provisions for companies to respond publicly to dissent within a certain time period. More significantly, however, the White Paper raises the possibility that a revised Code could provide for companies to address dissent by putting the existing or a revised remuneration policy to a shareholder vote at the next annual general meeting. If introduced, this would be a potentially important development.
The FRC will need to consult on any proposed changes to the Code, including whether they should apply to all premium listed companies or only those in the FTSE350. The FRC had already announced its intention to undertake a fundamental review of the Code in the Autumn, taking into account its work on corporate culture and succession planning and the issues raised in the Green Paper. The outcome of this review is likely to be an important piece in the evolving corporate governance picture in the coming months.
It is not clear whether the proposal to maintain a public register, which echoes the approach adopted by the Government in other areas (including for example in relation to national minimum wage matters), is likely to have a significant impact. Most material shareholder opposition to executive pay already attracts press attention.
Introduction of pay ratios for quoted companies
This is likely to be the most significant change on executive pay for many quoted companies. In spite of concerns that pay ratios can operate crudely and notwithstanding the fact that only a small majority of respondents to the Green Paper were in favour of the introduction of a pay ratio, the Government has nevertheless decided to require quoted companies to report annually on the ratio of CEO pay to the average pay of their UK workforce. This will be implemented by secondary legislation.
Limited detail is given of how companies will be required to make the necessary calculations, including how average pay will be determined. A draft statutory instrument, providing further detail, will be published later this year. Experience in the US has raised concerns about the complexity of the methodology required. The Government appears to be mindful of this – it suggests that the reporting requirement can be based “in most cases” on existing payroll data and proposes that the ratio should be calculated based on the CEO’s total annual remuneration as set out in the single figure table in the directors’ remuneration report, and compared against the average total remuneration of a company’s UK workforce. How straightforward the methodology will be in practice remains to be seen.
It is worth noting that the Government is proposing that only the UK workforce needs to be taken into account in determining average pay. This may be partly because of the complexity of obtaining and measuring data across multiple jurisdictions and partly because of the potentially distortive impact of being required to take into account countries with different pay norms. Multinational companies will be free to publish a broader ratio alongside the UK pay ratio, covering all employees within the corporate group, but will not be required to do so.
Long-term incentive plans
Two changes are proposed in relation to long-term incentive plans.
First, the Government intends to invite the FRC to consult on a proposal to increase from three to five years the minimum holding period for share-based remuneration. In practice, this may have limited impact for many companies. The introduction of a two year holding period, applicable following a three year vesting period, has been a focus of institutional investors for some time, and many companies will already have adjusted their long-term incentive plans to cater for this.
Secondly, the Government intends to introduce secondary legislation (to be laid before Parliament before March 2018) to require a “clearer” explanation in remuneration policies of the range of potential outcomes for long-term incentive plans, including where there is significant share price growth. This is intended to boost transparency and understanding.
The Government will also ask the FRC to give (via the revised Code) remuneration committees broader responsibility for overseeing pay and incentives across companies. Remuneration committees will be required to engage with the wider workforce to explain the alignment of executive pay with wider company pay policy, using pay ratios to explain the approach where appropriate. Little detail is given on this proposal: the details will presumably be developed by the FRC in the course of consultation.
The Government will also ask the FRC to include in its consultation a proposed new Code provision that remuneration committee chairs should have served for at least 12 months on a remuneration committee unless there is a clear and valid explanation why this may not be appropriate or possible.
2. Strengthening the employee, customer and wider stakeholder voice
There will be no change to the duty in section 172 of the Companies Act 2006 to promote the success of the company for the benefit of its members, which requires directors to have regard to employees’ interests and the need to foster business relationships with suppliers, customers and others, amongst other things.
But the Government will ask the GC100 to develop guidance (building on its existing guidance) as to how directors should in practice go about discharging that duty and satisfying themselves that they have done so.
Companies will also have to explain in their strategic report (and possibly on their websites too) how the directors have complied with the duty. This new statutory requirement will apply to public and large privately owned companies - the Government’s initial view is that the threshold should be 1,000 employees.
Many companies will already have these structures and processes in place, but they will now need to disclose details. The Government envisages that companies will need to show how they identified and sought key stakeholders’ views, why the mechanisms they adopted were appropriate, and how this information influenced board decision-making.
The Government will also ask the FRC to consult on two Code changes for premium listed companies. First, there should be a new principle (backed by guidance to be completed by ICSA and the Investment Association) to establish the importance of strengthening the voices of employees and other non-shareholder interests at board level. Second, there should be a new provision for adoption by companies of one of three employee engagement mechanisms: a designated non-executive director, a formal employee advisory council, or the appointment of a director from the workforce. This provision would operate on a ‘comply or explain’ basis in the usual way.
The Government’s suggestions for strengthening the FRC’s ability to monitor and enforce governance reporting are sketchy. It has asked the FRC, FCA and Insolvency Service to conclude new letters of understanding by the end of 2017 to ensure the most effective use of existing sanction powers, and has said that it will consider further whether the FRC has appropriate powers, resources and status.
3. Corporate governance in large privately held businesses
The Government wants to see a voluntary set of corporate governance principles for large private companies and has passed the job of developing these to the CBI, BVCA, Institute for Family Business, Institute of Directors and FRC. Companies will be able to use other industry developed codes and guidance - such as that developed by the BVCA for private equity owned businesses - if they think they are more appropriate.
The Government is planning to legislate to require large privately owned and public companies (its initial view is that this means companies with more than 2,000 employees) to report on their corporate governance arrangements in the directors’ report and on their website. This will not apply to companies that are already required to publish a governance statement under FCA rules.
4. Boardroom diversity
Although the initial Green Paper did not cover board diversity expressly, the White Paper addresses some issues on gender and ethnic diversity that were raised during the consultation process. In summary, the Government is not proposing any further steps beyond those already in place (for example, the 2020 target for gender diversity set by the Davies Review and encouraging voluntary disclosure of workplace ethnic diversity data). It is possible that the FRC’s review of the Code will involve some form of diversity reporting requirement.