In Autumn 2016, the government published its green paper on corporate governance reform, consulting on three specific aspects: executive pay; strengthening the employee, customer and supplier voice; and corporate governance in large privately-held businesses.
The government published its response to the consultation on 29 August 2017, setting out measures which are intended to “improve corporate governance and give workers and investors a stronger voice.” It identifies nine headline proposals for reform, over broadly the same three areas.
We summarise the package of main policy measures which the government intends to take forward and comment below.
1. New CEO pay ratios for quoted companies, and issues around LTIPs
Quoted companies will be required to report annually the ratio of CEO pay to the average pay of their UK workforce, together with accompanying narrative reporting. The government considers that this would provide a “valuable and dynamic reference point to help companies demonstrate…how executive remuneration relates to wider workforce pay“.
The new pay ratio reporting requirement would cover UK employees only (although multinational companies may choose to also publish a broader ratio, covering all group employees). A draft statutory instrument will be published later this year. It will be interesting to see the methodology to be used. Whilst a single figure pay ratio is simplistic and means little across different sectors, it does focus the attention of both investors and remuneration committees.
The government also intends to require companies to provide a clearer explanation of potential outcomes from complex share–based schemes, to tackle the issue of some LTIPs generating awards which are out of line with the original expectations of investors.
Responding to concerns raised during the consultation and a recommendation by a Department for Business, Energy and Industrial Strategy (BEIS) Committee in April 2017, the government is not convinced that the abolition of LTIPs is justified. It notes that properly designed LTIPs can provide a powerful driver of long-term executive decision-making, but suggests that companies should avoid conforming rigidly to a “standard” LTIP model, and should consider other structures which may be more appropriate.
2. Revision of the Code in relation to certain executive pay matters
The government intends to invite the Financial Reporting Council (FRC) to revise the UK Corporate Governance Code (the Code) in a number of respects.
Premium listed companies will need to be more specific about the steps they should take when they encounter significant shareholder opposition (such as a shareholder vote of 20% or more against the Directors’ Remuneration Report) to executive pay policies and awards.
Remuneration Committees should also have broader responsibility for overseeing pay and incentives across the company, and engage with the workforce to explain how executive remuneration aligns with wider company pay policy.
The FRC will also be asked to consult on the proposal that chairs of remuneration committees should normally have served for at least 12 months on a remuneration committee.
In relation to share-based awards, the government agrees with the BEIS Committee that the recommended minimum vesting and post-vesting holding period should be extended from three to five years, and the FRC will be invited to consult on this proposal. Many companies are now operating their plans on this basis in any event.
3. New public register of listed companies encountering shareholder opposition to pay awards of 20% or more
The Investment Association will be invited to implement its proposal to maintain a public register of listed companies encountering shareholder opposition to pay awards of 20% or more, together with a record of what those companies say they are doing to address shareholder concerns.
Whilst this is to be welcomed, it is worth noting that the register will simply pull together information about shareholder votes which is already publicly available and, for larger companies, often covered extensively in the press at the time. Again, however, this will focus the mind of investors and remuneration committees.
Strengthening the employee, customer and wider stakeholder voice
4. All companies of significant size to explain how their directors comply with section 172 Companies Act
Section 172 Companies Act 2006 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 consultation responses for making this duty work more effectively.
The government agrees with the recommendation made by the BEIS Committee earlier this year that informative narrative reporting should be required in this area. The reporting requirements on how directors are having regard to stakeholders are to be strengthened.
The operation of the new reporting requirement will be considered further – in particular which companies should be subject to it. Possibilities include a threshold based on employee numbers, with the government’s initial suggestion of those with more than 1,000 employees.
It is intended that all companies of significant size (private and public) will be required to explain how their directors comply with their section 172 obligations to have regard to employee and other interests. It is unclear what this new requirement adds to the exciting legislative framework and it is to be hoped that this requirement does not simply lead to standard boiler plate wording.
5. FRC to consult on the development of a new Code principle to encourage stakeholder engagement
The FRC will be invited to consult on the development of a new Code principle establishing the importance of strengthening the voice of employees and other non-shareholder interests at board level as an important component of running a sustainable business.
This will include considering a specific Code provision requiring premium listed companies to adopt (on the existing “comply or explain” basis) an employee engagement mechanism – either:
- a designated non-executive director;
- an employee advisory council (this is particularly interesting, in the context of the continental European model of works councils); or
- a director from the workforce.
The original proposal for the workforce to have formal board representative has been dropped, in favour of a softer, disclosure-based approach.
6. Encourage industry-led solutions on practical ways for companies to engage with their employees and stakeholders
Industry guidance should be completed on practical ways in which companies can engage with their employees and other stakeholders and the interpretation of section 172 directors’ duties.
Corporate governance in large privately-held businesses
7. Companies of significant size to disclose their corporate governance arrangements
UK companies (both public and private) of significant size will be required to disclose their corporate governance arrangements (on a “comply or explain” basis against their chosen corporate governance framework) in their directors’ report and on their website, subject to carve outs for listed companies already required to disclose their governance arrangements under the Listing Rules or the Transparency Rules.
The government’s initial view is that this would apply to companies with over 2,000 employees, and it is considering extending a similar requirement to LLPs of equivalent scale. The government estimates that this would result in a maximum of around 1,400 UK companies being subject to the new disclosure requirement.
8. New voluntary set of corporate governance principles for large private companies to be developed
The government has also invited the FRC to work with relevant bodies (including the Institute of Directors and the CBI) to develop a voluntary set of corporate governance principles for large private companies, with this work intended to start in the autumn. The government does not expressly set out the size of companies intended to be covered by the new governance principles, but sets out its expectation on those companies which will be subject to mandatory corporate governance reporting, as discussed below.
The development of the new principles is not intended to displace existing or future industry-developed codes and guidance, such as the BVCA principles for private-equity backed companies, or even corporate governance approaches developed individually by companies. Companies will accordingly be “free to identify and adopt the corporate governance framework that best suits their business needs.”
9. Effective enforcement of the corporate governance framework
A number of consultation responses raised questions over whether the FRC has the power and resources to undertake its functions effectively. Letters of understanding between the relevant bodies are to be reviewed to ensure the most effective use of their existing powers to sanction directors and ensure the integrity of corporate governance reporting.
Separately, the government is bringing together various recent work and projects on diversity issues (including the McGregor-Smith review: race in the workplace) into a newly-established Business Diversity and Inclusion Group, under the leadership of a BEIS minister.
Osborne Clarke comment
The proposed approach of “strengthening corporate governance through non-legislative, code-based provisions and voluntary industry action” is to be welcomed, in that it will continue the UK’s tradition of using transparency and disclosure rather than legislative compulsion to drive corporate governance change.
The Prime Minister has been accused of watering down her initial plans to tackle excessive executive pay, with some questioning whether they will give workers and investors the strong voice which she first envisaged. The proposals are certainly less radical than those originally proposed during her leadership and election campaigns (in particular the proposal to put workers on company boards was modified and then subsequently dropped in the face of industry pushback and concerns around the feasibility of the initiatives). In light of recent comments from the Investment Association that the 2013 reforms on listed company pay appear to be working, the proposals to hold companies more closely to account in response to shareholder revolts on pay under the existing framework may well achieve their intended effect of accelerating executive pay restraint.
The proposed disclosure of CEO pay ratios is interesting and has already attracted much press attention. It is easy to see that CEO pay ratios will be alluring to the media, and provide some hard factual information for stakeholder groups across society to help to set executive pay in context.
The proposals on private company governance are broadly welcome. Whilst “comply or explain” disclosure will be an additional regulatory burden on those larger companies to which it will apply, the government’s approach of allowing companies to choose an appropriate framework is, in our view, a sensible and proportionate approach to greater transparency in this area.
Similarly, the proposals to foster greater transparency in relation to compliance with directors’ section 172 duties seems to strike the right balance, as in reality there is a tendency to let active consideration of the wider “stakeholder” factors slip.
There is some anecdotal evidence that the government’s initiatives over the last few years to foster a “race to the top” through greater transparency in other areas of corporate activity (notably in greater responsibility for ethical supply chains under the Modern Slavery Act) is working, and the proposal carries on this policy approach. The perennial challenge will be to ensure that the new disclosure requirements drive appropriate change, and do not just result in boilerplate disclosure and a “box-ticking” mentality – outcomes for which listed companies already subject to wide-ranging disclosure requirements are often criticised.
The package of reforms is intended to be brought in by June 2018. This will be a tight timetable, with work starting on the new voluntary corporate governance principles for large private companies and FRC consultations in the coming months. Draft secondary legislation required to bring in a number of the reforms is expected by next spring. We’ll keep you updated on developments.