On 29 August 2017, the Government issued its response (the "Response") to the Green Paper published on 29 November 2016, in which it canvassed the business sector on a number of proposals for reform in specific areas of corporate governance. In an introduction by the Prime Minister, the Response declares the Government's intention to tackle issues arising in a minority of companies, where "executive pay has become disconnected from the performance of the company", or "directors have lost sight of their broader legal and ethical responsibilities". The Government's view is that improving transparency around how companies behave, and giving a stronger voice to those outside the boardroom, will restore public trust, and allow the UK to retain a competitive edge. The Response summarises the feedback received and sets out the proposals which the Government now intends to take forward in relation to executive pay, strengthening stakeholder voices, and governance in private companies.
The UK is often recognised as having a world-leading corporate governance framework, combining high standards with low burdens and flexibility. However, in light of damage to public trust in business caused by a small minority of companies (most notably BHS and Sports Direct), last Autumn the Government expressed interest in trying to tackle perceived problems to help restore the public’s faith.
In April 2017, the House of Commons Select Committee for the Department of Business, Energy & Industrial Strategy ("BEIS") issued its own (but separate) report (the "BEIS Report") making recommendations to the Financial Reporting Council ("FRC"), and the Government, on how corporate governance could be strengthened. This BEIS Report also focussed on a range of issues including those covered by the Green Paper. Our earlier article The Quiet Revolution of Corporate Governance in the UK discussed the recommendations made in the BEIS Report, some of which were fairly radical.
The FRC is due to consult on the recommendations made in the BEIS Report and to consider improvements to the UK Corporate Governance Code (the "Code") for which it is responsible, later this Autumn. The Response will also now need to be factored into the FRC's consultation process.
We discuss the Response more fully below, which sets out a range of legislative and business measures designed to improve corporate governance.
Section 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 subject to an annual binding vote, nor to introduce an upper threshold on total annual remuneration.
The Response focusses on the following areas:
• Shareholder dissent on executive pay
Although it is accepted that many companies have responded positively to the reforms introduced in 2013 (which gave shareholders greater powers and oversight over executive pay), the Response concludes that a small minority of companies continue to disregard the views of shareholders on pay, requiring enhanced ability to hold companies to account. It is intended that this will be provided by inviting:
- The FRC to revise the Code to identify specific steps that listed companies should take when they encounter significant shareholder opposition (a dissenting vote of 20% or more); and
- The Investment Association (IA) to maintain a public register of listed companies encountering shareholder opposition to pay awards of 20% or more, together with a record of what these companies say they are doing to address concerns.
Limited commentary is provided in terms of the specific steps that companies might be expected to take. The Response comments on the possible introduction of new Code provisions to require companies to address shareholder dissent by putting the revised remuneration policy to a vote at the next annual general meeting.
The FRC will now need to consider the steps further, as well as the scope of their application (i.e. whether they should apply to all listed companies or only those in the FTSE350).
The proposal to maintain a public register has attracted considerable media attention and has been described as "the world’s first public register of this kind". Whether this will have a significant impact in practice remains to be seen. Most material shareholder disputes over pay are well publicised in the media in any event.
Nevertheless, the threat of being "named and shamed" on a public register, coupled with stronger provisions in the Code, may well provide confidence that companies facing dissent will take visible and effective remedial action.
• Introduction of pay ratios for quoted companies
Probably the most significant and controversial proposal is the Government's intention to introduce secondary legislation to require listed companies to report annually the ratio of CEO pay to the pay of their average UK worker, together with a narrative explaining changes to that ratio from year to year. This will only cover UK employees in the first instance.
Only a small majority of respondents to the Green Paper favoured this idea, borne out of concerns that such ratios may be misleading in certain industries: the so-called “Goldman Sachs/Waitrose supermarket” issue where the pay ratio of a company like Goldman Sachs is likely to appear less diverse than that of a supermarket, where the disparity between the CEO and the average pay of a shop floor worker will be greater.
Limited detail is given as to the necessary calculations at this stage. It is, however, likely that ratios will be calculated based on the CEO’s total annual remuneration as a "single figure", and compared against the average total remuneration of a company’s UK workforce.
In practice, this may not prove to be an onerous requirement as, in most cases, this data can be taken from existing payroll records.
• Long-term incentive plans (“LTIPs”)
The Government advocates a more flexible, tailored and transparent approach to LTIPs, in view of their complexity (rather than abolition) and there are two proposals in this regard:
- Invite the FRC to consult on a proposal to extend the recommended minimum vesting and post-vesting holding period for executive share awards from 3 to 5 years; and
- Introduce secondary legislation to require a “clearer” explanation in remuneration policies of the range of potential outcomes for LTIPs.
In practice, extending the vesting period may have limited impact for large 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.
• The responsibilities of remuneration committees
The Government will also invite the FRC to revise the Code to give remuneration committees more responsibility for overseeing pay and requiring them to engage with the wider workforce to explain how executive pay aligns with the wider company pay policy (using pay ratios where appropriate). The FRC is also directed to consider the recommendation that the chair of the remuneration committee should usually have served for a minimum of 12 months on such a committee.
There are still a number of other recommendations made in the BEIS Report, regarding executive pay, which have not been addressed by the Government, such as the consequences for a company losing its annual advisory remuneration report vote, and installing an employee representative on the remuneration committee, that the FRC will still need to consider further.
Section 2 - Strengthening the employee, customer and wider stakeholder voice
The Response confirms that the public still requires reassurance that companies are not being run solely in the interests of the board and the shareholders.
Section 172 of the Companies Act 2006 (the “Act”) already requires the directors of a company to have regard to wider interests (such as its employees, suppliers, customers and wider society) in pursuing the success of the company. Nevertheless, the Report accepts that there are a few recent examples of poor corporate practice in this area. The government, therefore, intends to introduce secondary legislation to require all companies of significant size (private as well as public) to explain how their directors have complied with the requirements of s172.
The operation of the new reporting requirement will be subject to further consideration in due course, in particular, for example, its scope (it is likely to apply to companies with 1,000 employees or more).
It is envisaged that the disclosure will involve a narrative as to how key stakeholders have been identified, how their views have been sought, why the company’s engagement mechanisms were considered appropriate and how the information obtained from them influenced the board’s decision-making.
At present it is not possible to comment further on how easy it will be for companies to meet this new disclosure obligation in practice.
In conjunction with this new statutory requirement, the Government also intends to:
- Invite the FRC to consult on a new Code provision establishing the importance of strengthening the voice of employees, and other non-shareholder interests at board level. The Government will also invite the FRC to consider developing a specific Code provision requiring listed companies to adopt, on a “comply or explain” basis, one of the following three employee engagement mechanisms: (a) assign a designated non-executive director to represent employees; (b) create a formal employee advisory council; or (c) nominate a director from the workforce; and
- Encourage industry-led solutions by asking the Institute of Chartered Secretaries and Administrators: The Governance Institute (ICSA) and the IA to complete their joint guidance on practical ways in which companies can engage with their employees and other stakeholders. It will also invite the GC100 group of the largest listed companies (FTSE100 General Counsels) to complete and publish new advice and guidance as to how directors should, in practice, go about discharging this duty and satisfying themselves that they have done so.
It is hoped that these proposals will impel directors to think carefully about how they are taking into account wider matters.
Section 3 - Corporate governance in large privately-held businesses
The Government confirms that the consultation revealed broad support for action to encourage high standards of corporate governance in the UK’s largest private companies to reflect the fact that they have just as significant an impact on employees, suppliers, customers and others, as listed companies and do, therefore, impose similar risks. Currently private companies are not subject to the Code in the same way as listed companies.
Most respondents expressed support for a bespoke governance framework for private companies, which could be applied to a lesser or fuller extent, depending on the size and nature of the company in question.
Accordingly, the Government intends to:
- Invite the FRC to work with the Institute of Directors (IoD) and others to develop a voluntary set of corporate governance principles for large private companies; and
- Introduce secondary legislation to require companies of a significant size to disclose their corporate governance arrangements in their Directors’ Report and on their website, including whether they follow any formal code. This requirement will apply to all companies of a significant size (probably those with 2,000 employees or more), unless they are subject to an existing corporate governance reporting requirement. The government will also consider extending a similar requirement to Limited Liability Partnerships (LLPs) of equivalent scale.
The Response is silent as to the content of the proposed new Code, and how compliance with this Code will be monitored. It also remains unclear how this scheme will be funded. We shall need to wait and see if the proposal to impose a small levy on members (made in the BEIS Report) will be adopted.
FRC’s remit and powers
Recognising that corporate governance is such a broad topic, the Green Paper consultation provided respondents with an opportunity to provide observations on the governance framework as a whole. A key issue raised concerned whether the FRC has the appropriate powers, resources and status to undertake its functions effectively. To address this issue, the Government intends to:
- Ask the FRC, the Financial Conduct Authority and the Insolvency Service to conclude new or, in some cases, revised letters of understanding with each other before the end of this year to ensure the most effective use of their existing powers to sanction directors and ensure the integrity of corporate governance reporting. The government will then consider, in light of this work, whether further action is required.
A number of respondents also echoed the comments made in the BEIS Report regarding the lack of effective mechanisms currently available for the FRC to sanction directors (outside of those working for accountancy and actuarial bodies) when their conduct falls short or where they failed to comply with their duties. It was suggested that the FRC should be appointed powers to intervene and sanction all directors.
There was also a suggestion that: (i) The Company Directors Disqualification Act and (ii) the investigative powers conferred on the Secretary of State under the Companies Act 1985 could be put to better use.
The Government has noted these comments and has actively encouraged the FRC to respond on this issue after its consultation.
Whilst the Green Paper did not expressly seek views on this issue (which is being actioned separately), many respondents highlighted the continuing need for greater board diversity.
The Government accepts that this is an important issue and the Response refers to a number of reviews underway in the area of gender, ethnic and social diversity.
We shall need to wait and see which of recommendations made in the BEIS Report, are accepted by the FRC later this year. However, the Government has confirmed that it will not currently be acting on two key recommendations in the BEIS Report, that:
- From May 2020 at least half of all new appointments to senior and executive management positions in FTSE350 and all listed companies should be women, and
- All FTSE100 companies should be required, by legislation, to publish their workforce data, broken down by ethnicity and pay band.
Several of the Government's proposals mirror key recommendations made in the BEIS Report. In particular, the Government agrees with the recommendations for: (i) more narrative reporting on how companies are engaging with stakeholders and how directors are meeting the s172 duty; (ii) the development of a Code for large privately-held businesses; and (iii) the introduction of a CEO pay ratio report.
Although the Response confirms that some of the recommendations made in the BEIS Report will not be considered further (such as the abolition of LTIPs) and others may now be superseded, it accepts that a large number of recommendations made in the BEIS Report are concerned with potential amendments and enhancements to the Code and guidance.
This means that a number of the recommendations made are still in play and we shall need to wait and see what further proposals are made by the FRC, and the Government, on corporate governance generally after the consultation period closes later this year.
The interesting suggestion that a wider role and new powers be given to the FRC, to act as a regulator and enforcer of directors’ duties has not been dismissed in the Response. Currently, there is still limited detail on how the FRC’s wider powers might operate in practice. However, presuming this recommendation is accepted by the FRC (which has already sought additional powers), further details should shortly follow.
Implementing these reform proposals will require a combination of changes to the Code, voluntary industry action, secondary legislation and action by relevant regulators to improve co-ordination and the use of existing powers.
The Government intends to lay before Parliament draft secondary legislation, where required, before March 2018, to be brought into effect by June 2018. The work on developing voluntary corporate governance principles for large private companies will also commence later in the Autumn.
Any changes proposed to the Code (after the FRC’s consultation has ended) are more likely to come into force in 2019.
While these new proposals have been welcomed by most business groups, unions and opposition parties have been quick to dismiss this package. The Government has been criticised for dropping some of the more radical proposals contained in the Conservative Party’s 2017 manifesto to put workers on boards and annual binding pay votes. The policy package has been described in some quarters as “strong on rhetoric, weak on action”, providing little more than superficial changes.