The Financial Reporting Council ("FRC") has published the final 2018 edition of the Corporate Governance Code (the "2018 Code") and the associated Guidance on Board Effectiveness (the "Guidance"), along with a feedback statement which includes a detailed comparison between the previous 2016 Code, and the 2018 Code1 and a redline showing all of the changes between the consultation version of the Code, and the 2018 Code.
The 2018 Code will apply to financial years beginning on or after 1 January 2019, with the first compliant Annual Reports due to be published in 2020. That said, the FRC has indicated that, during 2019, companies should comply with the new Provision 4 (i.e. the transparency requirements that will apply following a 20% or more vote against a board recommended shareholder resolution) and consider the impact of the 2018 Code and the Guidance on future remuneration policies.
Although much has remained the same as in the drafts published in December 2017 (for a copy of our client alert discussing these drafts, click here), the final versions of the 2018 Code and the Guidance do include some significant adjustments inspired by the 275 responses the FRC received to the consultation. The key changes are summarised below ( see, "The Final 2018 Code - The Key Changes").
Action for companies to take now
Although the draft Code and Guidance published in December will have given companies significant food for thought, the real activity will start now in preparing companies to comply with the 2018 Code.
Action to take now:
- The Company Secretary and their team to familiarise themselves with the 2018 Code and the Guidance.2 Despite the FRC's claims that it has "shortened and sharpened the Code", companies will now need to refer to both the 2018 Code and the Guidance as a matter of course when looking at compliance so, overall, there is a lot more to be reading and thinking about. That said, the documents contain some thought provoking and useful information and questions for the board to be asking themselves, particularly in the Guidance.
- Consider current succession plans and whether they need updating, particularly in light of the new provisions on length of tenure of the chair, and the greater focus on an expanded definition of diversity.
- Make a final decision on which of the three methods of workforce engagement, or a combination, to employ, how that is going to operate in practice, and the roadmap to getting it in place. In particular, consider how the individual and/or advisory panel appointed will be supported with appropriate infrastructure and processes to enable effective engagement. Compile a central list of all of the workforce engagement activities the company already undertakes and what the outcome of that engagement is. Consider whether, and how, this might be adapted and supplemented in light of the new requirements. Also, consider what the internal and external communications about this will look like, and strategies to engage if this has unexpected outcomes, for example, certain members of the workforce taking this as an opportunity to publicise personal grievances not relevant to the wider workforce.
- Consider what the company's definition of "workforce" will be, and how that is justifiable.
- Identify the company's key stakeholders (other than the workforce) and develop or consider supplementing the company's engagement strategy with those stakeholders.
- Ensure the nomination committee and remuneration committee are familiar with their expanded roles, and provide any additional training or support they request, or may reasonably require. Consider what role HR, or other teams may play in assisting them with their expanded roles.
- Factor the amendments to the remuneration provisions into any new board appointment process and draft service agreements, and consider whether any changes should be made to the company's remuneration policy. Consider whether any amendments justify renewing the policy earlier than the triennial requirement. In particular, given the FRC's focus on this, do the remuneration policy and existing service agreements enable the use of discretion to override formulaic outcomes?
- Consider what explanation the remuneration committee will be in a position to give in the 2019 Annual Report about how they have addressed the following factors in the company's executive director remuneration policy and practices: (i) clarity; (ii) simplicity; (iii) risk; (iv) predictability; (v) proportionality; and (vi) alignment to culture. This new disclosure requirement is likely to require some considered drafting and may influence the decision about whether the remuneration policy needs amending.
- Think about the company culture. For those companies who have not yet articulated clearly, and embedded throughout the business, their set of values and culture, think about the steps the company needs to take to do this.
- Consider whether the company should disclose early against any of the 2018 Code provisions, or at least set out thoughts on how the company intends to come into compliance. What is the investor / stakeholder expectation?
- For smaller companies, prepare for annual re-election of directors and consider how to comply (or explain non-compliance) with requirement for at least half the board (excluding the chair) to be independent.
The FRC intends to publish consequential amendments to the Guidance on Audit Committees and the Guidance on Risk Management, Internal Controls and Related Financial Business Reporting (including possible amendments to the guidance on internal controls and viability statements in light of the collapse of Carillion). The FRC will also publish a consultation on revising the Stewardship Code before the end of the year.
Other things in the corporate governance pipeline which are yet to be published include: (i) new advice and guidance on the practical interpretation of the directors' duties in S172 of CA 2006 to be published by the GC100; (ii) a revised version of the 2014 FRC Guidance on the Strategic Report, including amendments to reflect the new requirement to include a separately identifiable statement in the Strategic Report describing how directors have had regard to the matters set out in S172(1) when performing their duties under S172, CA 2006. (for further on these developments and the new requirement to disclose the CEO pay ratio, click here); and (iii) the outcome of the consultation on strengthening corporate governance in pre-insolvency situations (for our client alert on this, click here).
The Final 2018 Code - The Key Changes
Section 1 - Leadership and Purpose
Is there a real choice beyond one of the three listed methods for workforce engagement?
There was a mixed response from respondents to the new Provision 3 (now Provision 5), which set out the new requirements for companies to engage with the workforce, "normally" using one of the following three methods: (i) appointing a director from the workforce; (ii) establishing a formal workforce advisory panel; or (iii) designating a NED to do this. Although, in the feedback statement, the FRC acknowledges that many respondents were concerned that the proposed Code drafting (stating that engagement would "normally" be done by one of the listed methods) could have been interpreted as a requirement to use one of the listed methods, and states it recognises that "there may be other effective methods …which achieve such engagement", in the 2018 Code the amended wording seems more restrictive, not less. It now states that "one of a combination of the following methods should be used…", and that "if the board has not chosen one or more of those methods, it should explain what alternative arrangements are in place and why they are effective". Paragraph 55 of the Guidance does confirm that, provided the board's approach delivers meaningful, regular dialogue with the workforce and is explained effectively, the 2018 Code provision will be met. However, the initial reaction of respondents to the consultation draft, coupled with the tightened language in the Code, means that few companies, if any, companies are likely to be willing to propose an engagement mechanism that does not involve one or more of the listed methods.
The meaning of "workforce"?
Respondents were also concerned about the use of the broader term "workforce" in this context, and that it could lead to misinterpretation as it is not a defined term. The FRC has responded by including some commentary in the Guidance which confirms that the term "workforce" is used for Code purposes only and is not meant to align with legal definitions of workforce, employee, worker or similar. Paragraph 50 clarifies that it is for the company to decide who is included in the definition, and that they must explain who they have included, and why. Companies should include those with formal contracts of employment (permanent, fixed-term and zero-hours). Companies should also consider including other members of the workforce who are affected by the decisions of the board, for example those engaged under contracts of service, agency workers, and remote workers, regardless of their geographical location.
A reinterpretation of S172?
Principle A received robust criticism from respondents to the consultation on the basis that it reinterprets S172, CA 2006, because it, among other things, stated that the "function" of the company's board is to" promote the long term success of the company" and to "contribute to wider society", whereas S172 makes no reference to contributing to wider society and is broad enough to allow a director legitimately to take action based on short-term considerations if this is for the benefit of the company's members. Despite this criticism, Principle A remains in similar form, though the term "function" has been replaced with "role" and the FRC confirms in the feedback statement that "Nothing in this new Code overrides or is intended as an interpretation of the statutory statement of directors' duties in the Act."
Clarity on the meaning of significant votes against shareholder resolutions
In a welcome move, the FRC has clarified that the new reporting requirements associated with a significant vote against a shareholder resolution will apply when there is a vote of 20% or more (not "more than 20%" as per the previous draft) against a resolution that has been recommended by the board (the previous draft did not make a reference to a board recommendation).
The FRC has separated Principle D into two Principles (D and E), so that a new Principle E (in conjunction with Provision 6) deals with whistleblowing. It now states that, "the workforce should be able to raise any matters of concern", rather than the previous, narrower language which referred to "concerns relating to management and colleagues."
Section 2 - Division of Responsibilities
Board composition, independence and the nine year tenure rule
There was very little support among respondents for the proposed changes to the independence provisions, namely to: (i) remove the current discretion of the board to determine whether a board member is in fact independent, despite meeting one of the non-independence criteria; (ii) replace the current requirement for the chair to be independent on appointment only, to a requirement that the chair meet the independence criteria throughout his or her tenure; and (iii) by proposing that the chair would no longer be "independent on appointment" only, subject the chair to the "independence criteria" on a continuing basis, which would restrict tenure to nine years, on a "comply or explain" basis. These changes had a knock on impact, being an amended requirement for the majority of the board including the chair to be independent NEDs (rather than half the board excluding the chair).
The FRC has responded by making some concessions. It has reverted to a position that: (i) the board has a discretion to determine whether a director is in fact independent despite meeting one of the non-independence criteria, though it will expect to see greater detail when companies report on the exercise of that discretion; (ii) the chair must meet the independence criteria on appointment only; and (iii) at least half the board (excluding the chair) should be independent NEDs.
However, in a classic case of giving with one hand while taking away with the other, the FRC has clearly not given up its position on maximum tenure of the chair. It has now included a new Provision 193, which provides that the chair should not remain in post beyond nine years from the date of their first appointment to the board, though that period can be extended for a limited time to facilitate effective succession planning and the development of a diverse board, particularly where the chair was an existing NED on appointment. In such cases, a clear explanation must be given. This is a really significant additional Provision. Companies would usually prefer to comply with the Code rather than explain why they are not doing so, and media reports published after the December consultation speculated that this nine year tenure rule could impact over 60 FTSE 350 chairs, 19 of whom are chairs of FTSE 100 companies. It will be interesting to see whether market practice develops so that this becomes one of the least complied with provisions in the 2018 Code, or whether companies have to scramble to amend their succession plans for the chair.
The FRC has included new language in Provision 15 to deal with concerns regarding overboarding. The new language provides that the board should take account of other demands on the director's time when making board appointments and "significant commitments" should be disclosed, with an indication of the time involved, prior to appointment. The board should explain in the Annual Report why permission has been given for a director to take on a significant appointment (this term is left undefined and the FRC states that it will vary depending on the companies and roles involved).
Section 3 - Composition, succession and evaluation
Diversity in the boardroom and beyond
The FRC states that respondents were positive about the approach taken to diversity in Section 3 and therefore few changes have been made (other than one significant amendment already discussed, namely the inclusion of a new Provision 19 on the maximum tenure of a chair). The defined term "senior management"4 has been retained in its original form, despite some respondents calling for it to be expanded to match the Hampton Alexander report equivalent definition, which includes the first layer of management below the board and their direct reports. Notably, the 2018 Code does not refer to the recent gender pay gap reporting requirements (unlike the newly published consultation draft of the Wates Principles for Large Private Companies, which requires director and senior management remuneration to be set having regard to a considered assessment of the company's response to matters such as gender pay gap reporting). Instead, the FRC has dealt with this by including, in the Guidance, a recommended question for the board ("What are we doing to address gender pay gaps?") and recommended questions for the remuneration committee ("How do the company's pay policies address pay gaps and pay ratios between the different quartiles of the workforce?" and "What interaction have we had with the nomination committee regarding the structure of the workforce and the company's plans for reducing its gender pay gap?").
With respect to the two issues on which the FRC was specifically seeking respondents' views, the FRC has come to the view that: (i) the requirement for reporting on the gender balance of those in senior management and their direct reports should be extended beyond the FTSE 350; and (ii) a requirement to report on ethnicity levels in executive pipelines should not be included in the 2018 Code, but companies should be encouraged to think about providing more information about different aspects of diversity in their workforce, in addition to gender. This "encouragement" language has been included in paragraph 89 of the Guidance, which suggests that greater transparency might cover a range of aspects of diversity, including age, disability, ethnicity, education and social backgrounds, as well as gender.
For all companies that conduct external board evaluations, there is a new requirement (in Provision 23) to report on "the nature and extent of an external evaluator's contact with the board and individual directors". This is because external evaluations can be limited to questionnaires only, and do not necessarily involve interviews with individual directors or attendance at board meetings. In the Guidance, there is a clear steer away from" questionnaire only" external evaluations. In paragraph 112, the FRC states, "Questionnaire-based external evaluations are unlikely to get underneath the dynamics in the boardroom".
Section 4 - Audit, risk and internal control
There was very little change to section 4 in the December version of the 2018 Code so, unsurprisingly, there has been little in the way of further amendment now. The FRC has decided to retain the duplication that exists with requirements of the Listing Rules and the Disclosure and Transparency Rules. It has also decided to stick with the decision to move the requirement for a company to disclose its audit committee's terms of reference from the 2018 Code to the Guidance. On the viability statement, no changes have been made now, but there are warning signs of possible changes on the horizon. Should the investigations into the collapse of Carillion warrant further amendments, the FRC has confirmed a further consultation will be undertaken.
Section 5 - Remuneration
Some concessions on the expanded role of the remuneration committee
Respondents to the consultation were particularly concerned about the significant expansion of the role of the remuneration committee, as provided for in the December version of the Code. That version stated that the remuneration committee should, "oversee remuneration and workforce policies and practices…" (Provision 33) and many respondents sought clarification as to what the expanded role would entail. The 2018 Code clarifies the position by amending Provision 33 so that the remuneration committee only has responsibility for reviewing the "workforce remuneration and related policies", and the Guidance then discusses this further. Two responsibilities that were assigned to the remuneration committee in the previous draft have been moved to the remit of the full board, namely the overarching responsibility for the "oversight of workforce policies and practices" (which now appears in Principle E), and monitoring the implementation of workforce policies and practices (which is now provided for in Provision 2, which includes requirement for the board to assess and monitor culture).
Despite criticism, the 2018 Code retains the requirement for the remuneration committee to set senior management pay, as well as board pay, on the basis that many remuneration committees are already doing this and the FRC considers it an appropriate part of the role.
Supporting executive remuneration that drives long-term sustainable performance
Having taken account of responses received on this topic, the FRC has:
- removed the language in section 5 that could be perceived as encouraging LTIPs as it does not want to encourage one form of remuneration scheme over others;
- included a requirement for the remuneration committee to develop a formal policy for post employment shareholding requirements, encompassing both unvested and vested shares (Provision 36);
- clarified the expectation that executive pension schemes should be in line with those available to the rest of the workforce on the basis that there is no obvious rationale for executives to have more generous arrangements (Provision 38);
- included requirements for the remuneration committee to: (i) ensure that a director's terms of appointment do not reward poor performance; and (ii) be robust in reducing compensation to reflect a departing director's obligation to mitigate loss;
- added risk (including reputational risk from excessive rewards and behavioural risks from target-based awards) as a factor to be addressed in executive director remuneration policy and practices;
- included a new Annual Report requirement for remuneration committees to explain how they have addressed the following factors in their executive director remuneration policy and practices: (i) clarity; (ii) simplicity; (iii) risk; (iv) predictability; (v) proportionality; and (vi) alignment to culture (Provision 41).
The FRC has chosen not to amend Provision 37, which provides that remuneration schemes and policies should enable the use of discretion to override formulaic outcomes. This is despite respondents highlighting that employment contracts and scheme rules may prevent the exercise of discretion in practice, even where the remuneration policy provides for it. The FRC states in the feedback statement that remuneration committees have a responsibility to ensure that different elements of the framework interact in such a way that the intent of the remuneration policy is not undermined and remuneration committees should pay attention to this. A modified disclosure requirement in Provision 41 requires remuneration committees to disclose in the Annual Report the extent to which discretion has been applied to remuneration outcomes and the reasons why. The FRC states that it would expect this disclosure to include a description of anything which prevents the use of discretion where remuneration outcomes would otherwise have been adjusted.
Reinstatement of some of the current exemptions for smaller companies
In the consultation version of the 2018 Code, the FRC had removed all of the exemptions which applied to companies that fell below the FTSE 350, which included the following 2016 Code provisions: B.1.2 (board independence provisions); B.6.2 (board evaluation); B.7.1 (annual re-election of directors); and C.3.1 and D.2.1 (composition of the audit and remuneration committees).
In response to concern expressed by respondents that removal of all of the exemptions would mean that smaller companies may feel increasingly obliged to meet criteria which could prove unduly onerous for them, the FRC has:
- reinstated the exemption for FTSE 350 companies in respect of the requirement to have an externally facilitated board evaluation at least every three years, but included language which encourages all chairs to consider the use of externally facilitated board evaluations (Provision 21 and paragraph 111 of the Guidance);
- reverted to the current position which allows FTSE 350 companies' audit and remuneration committees to each have a minimum membership of at least two independent NEDs (Provisions 24 and 32, respectively). However, the FRC has maintained the position (set out in the December consultation) that, even for smaller firms, the chair of the board should not also be a member of the audit committee; and
- removed the requirement for a nomination committee to have a minimum membership of three (Provision 17).
Smaller firms exemptions in respect of the requirements for: (i) the annual re-election of directors (Provision 18); and (ii) at least half the board, excluding the chair, to be independent NEDs (Provision 11), have not been retained in the 2018 Code so these rules will apply to all companies, including smaller firms.