Introduction

On 20 April 2012 the Financial Reporting Council ("FRC") published consultation papers setting out a number of proposed changes to the UK Corporate Governance Code and the International Standards on Accounting (UK and Ireland) to give effect to its Effective Company Stewardship proposals and also published a consultation paper proposing updates to the UK Stewardship Code.

The Effective Company Stewardship proposals were issued in September 2011, largely in response to criticism of the way in which companies were seen as having failed to provide key information and explain key sensitivities in their annual reports in the run up to the financial crisis and a need to improve the role of auditors.

The FRC has described the proposed changes on which it is consulting as "deliberately limited" and said that it wants to "build on the proven track record of the UK Corporate Governance Code and the promising initial response to the Stewardship Code by reinforcing rather than fundamentally changing the codes". The FRC also stated that the proposed changes to the auditing standards are designed "to enhance the relevance and value of the audit for users and the public by stimulating greater transparency about the judgments made by boards and auditors".

The full text of the consultation documents and the amended codes and standards can be found here.

UK Corporate Governance Code

The FRC is proposing the following key changes to the Corporate Governance Code:

  • Requesting FTSE 350 companies to put the external audit contract out to tender at least every 10 years (on a comply or explain basis)

The FRC believes that this proposed change needs to be carefully managed so that the market does not struggle to cope with its introduction. Accordingly it is only planning for the requirement to apply to FTSE 350 companies in the first instance instead of the whole premium listed market.

In addition, transitional arrangements have been set out in the consultation paper which attempt to link timing of any tender to (i) when the current audit engagement partner is due to rotate and (ii) the length of time since the audit contract was previously put out to tender. Where a company has put the contract out to tender in or after 2000 the tender process could be deferred for another five years. The FRC believes that this would defer the date for tendering the audit contract of a significant number of FTSE 100 companies until 2018 or later.

The FRC is also proposing to add wording to its Guidance on Audit Committees to the effect that the audit committee section of the annual report should (i) announce a company's intention to carry out a tender the following year, rather than announcing it after the event and (ii) explain the approach taken to the appointment or reappointment of the external auditor, including the steps taken in deciding whether or not to recommend that the audit be put out to tender.

This is a considerably less aggressive approach than the European Commission ("EC") may end up taking. The EC is due to release planned reforms that will enforce mandatory rotation of auditors every six years whilst the Dutch government is considering requiring companies to rotate their auditors every eight years. The FRC acknowledges the threat of overlapping regulation given that its European counterparts are considering changes to the EU-wide rules but has said that making sure the UK was already applying best practice could help alleviate the pressure for more prescriptive action at EU level.

  • Asking boards to explain why they believe their annual reports are fair, balanced and understandable

The FRC proposes to require the audit committee to consider the whole annual report (including the narrative report) in order to determine and advise the board on whether the annual report is fair, balanced and understandable, and whether it provides the information necessary for users to assess a company's performance, business model and strategy.

It is also proposed that there should be a corresponding obligation on the directors to set out in the annual report the basis on which they consider that the report is fair, balanced and understandable and provides the information necessary for users to assess a company's performance, business model and strategy.

Companies will need to consider what disclosure will be required to enable users to assess the company's "performance, business model and strategy". This threshold should, however, be considerably easier to satisfy than the previous threshold that the FRC was proposing being "performance and prospects". This change was introduced due to the concerns that were raised that the word “prospects” might be construed as requiring companies to provide detailed forecasts of future financial performance in the report. This was not the FRC’s intention. The proposed addition to the Code is intended to encourage boards to pay more attention to the disclosures in the business review (which the Companies Act states should cover “the future development, performance and position of the company”) and on their business model and strategy.

  • Encouraging more meaningful reporting by audit committees

The FRC is also proposing a new requirement that a separate section of the annual report should describe the work of the audit committee in discharging its responsibilities, including:

  • the significant issues that it considered in relation to the financial statements, and how these issues were addressed;
  • an assessment of the effectiveness of the external auditor and the approach taken to the appointment or reappointment of the external auditor, including the length of tenure of the current audit firm and when a tender was last conducted; and
  • if the auditor provides non-audit services, an explanation of how auditor objectivity and independence is safeguarded.  
  • Providing more guidance on explanations given to shareholders when a company does not follow the Corporate GovernanceCode

As discussed in its paper titled "What Constitutes an Explanation under 'Comply or Explain'" dated February 2012, in order to address the issue of poor quality explanations, the FRC proposes to add wording to the introductory section of the Corporate Governance Code to help companies understand what is expected of them and to give shareholders a benchmark against which to assess explanations. Where a company is deviating from the Corporate Governance Code, a meaningful explanation should:

  • set out the background, provide a clear rationale for the action the company is taking, and describe any mitigating actions taken to address any additional risk and maintain conformity with the relevant principle; and
  • indicate whether a deviation from the Corporate Governance Code's provisions is limited in time and, if so, when the company intends to return to conformity with the Corporate Governance Code's provisions.  
  • Other changes

A number of other changes to the Corporate Governance Code have been proposed including the addition of a reference to the interests of debt holders and other providers of non-equity capital in the introductory section of the Corporate Governance Code, recognising that both debt and equity holders have a common interest in the long term stability of a company. The new Corporate Governance Code will also embody provisions previously announced in October 2011 requiring boards to report on their gender diversity policies

UK Stewardship Code

The UK Stewardship Code was released in July 2010 and sets out good practice for institutional investors on engagement with investee companies. The FRC is proposing the following key changes to the Stewardship Code:

  • Clarify what is meant by stewardship

The FRC is proposing to add wording in the introductory sections of the Stewardship Code and guidance to Principle 1 clarifying what is meant by stewardship, its purpose and how it relates to governance.

  • Clarify the respective responsibilities of asset owners and asset managers

The FRC is proposing to add wording throughout the introductory sections of the Stewardship Code to clarify the differing responsibilities of asset managers and asset owners. This includes an express recognition that asset owners have a stewardship obligation to their beneficiaries while specific stewardship activities by asset owners and asset managers will vary depending on their circumstances.

  • Ask investors to disclose their policy on stock lending and whether they recall lent stock for voting purposes

A reference to stock lending has been added to Principal 6 of the Stewardship Code asking signatories to disclose their policy on stock lending and specifically whether they recall lent stock for voting purposes.

  • Other asset classes

The introductory section of the Stewardship Code is to be amended to encourage institutional investors with several types of funds or investments to explain which of their funds or products are covered by the approach described in their statements and disclose whether they adopt a stewardship approach with regard to other asset classes in which they invest (not just UK equities), including corporate debt.

  • Other changes

Additional changes are proposed to other provisions of the Stewardship Code including those dealing with conflict of interest, collective engagement, use of proxy or other voting advisory services, assurance reports and insider information.

International Standards on Auditing

The FRC consultation paper on suggested revisions to the International Standards on Auditing (UK and Ireland), proposes:

  • enhancing auditor communications by requiring the auditor to communicate to the audit committee information that the auditor believes the committee will need to understand the significant professional judgments made in the audit; and
  • extending auditor reporting by requiring the auditor to report, by exception, if the board’s statement of why the annual report is fair and balanced is inconsistent with the knowledge acquired by the auditor in the course of performing the audit, or if the matters disclosed in the report from the audit committee do not appropriately address matters communicated by the auditor to the committee.  

Next steps

The deadline for responding to the consultations is 13 July 2012 and, depending on the results of the consultations, the FRC expects the proposed changes to apply for financial years beginning on or after 1 October 2012.