The Government published its Green Paper on Corporate Governance Reform yesterday. The Green Paper signals a number of significant potential changes to corporate governance structures in the UK.
The Government published its Green Paper on Corporate Governance Reform yesterday. The Green Paper signals a number of significant potential changes to corporate governance structures in the UK, including in relation to:
- executive pay;
- giving greater voice to employees, consumers and other stakeholders in the boardroom; and
- the extension of certain listed company corporate governance features to large private companies.
The Green Paper follows a series of speeches by the Prime Minister over the course of the Summer and Autumn in which she highlighted her commitment to make changes to existing UK corporate governance rules as part of her agenda for “responsible capitalism” and to increase public trust in business. As she puts it in the introduction to the Green Paper, her aim is to introduce “a new approach to strengthen big business through better corporate governance”.
In some respects, the proposals are not as far-reaching as originally suggested. Perhaps most notably, the Green Paper reflects Mrs May’s comments at the recent CBI conference that she was not in favour of introducing mandatory rules to give board seats to employee and consumer representatives (notwithstanding previous suggestions to the contrary in her speech to the Conservative Party conference in early October).
The Green Paper contains a range of important proposals on which the Government is seeking views. The proposals are open for consultation until 17 February 2016. It is likely that there will then be a White Paper setting out formal legislative proposals.
If you would like to discuss the Green Paper, or any part of it, we would be delighted to arrange to visit you.
Further detail on each of the principal proposals in the Green Paper is set out below.
1. Executive pay
The Green Paper explores a number of possible options to address executive pay, which is described as an “area of significant public concern”. These are grouped under five sub-headings – (i) shareholder voting and other rights; (ii) shareholder engagement on pay; (iii) the role of the remuneration committee; (iv) transparency in executive pay and (v) long-term executive pay incentives.
(i) Shareholder voting and other rights
This is one of the more significant areas of possible reform. The Green Paper sets out various ways in which the current voting and remuneration regime could be amended so as to increase shareholders’ voting rights. The suggestions include:
- requiring an annual binding vote in respect of all or some elements of remuneration (for example, just the variable elements of pay). This could either apply to all companies or just those that have encountered significant shareholder opposition to the annual remuneration report. The Green Paper rightly notes that a binding vote on pay itself (rather than pay policy) would require payments to be made conditional on shareholder approval or there would need to be a mechanism to reduce future remuneration to reflect any amount that was not approved by shareholders;
- introducing an “escalation process” where there is a shareholder vote against (including a significant minority vote against) remuneration arrangements in a previous year (or years). The Green Paper sets out two alternatives:
- the company could be forced to hold a binding vote – in the hope that the “threat” of a binding vote would force better engagement with shareholders; and
- if the annual vote is lost, then the next policy vote could require a 75% “supermajority”. This echoes a proposal that was considered, and rejected, by Vince Cable when the 2013 reforms were formulated.
The Green Paper nods to the Australian “two strike” system, whereby if a company has more than 25% of shareholders vote against the remuneration arrangements in two consecutive years, the shareholders can (by a 50% majority) vote to “spill the board”.
- requiring companies to set a maximum total compensation threshold so that if they wished to pay in excess of this maximum level, they would need shareholder approval. To a large extent, this reflects the existing regime where investors are increasingly requiring companies to state maximum pay levels. The Green Paper acknowledges that share price increases in share awards would need special treatment under such a regime;
- requiring an annual vote on the remuneration policy or allowing shareholders to require a policy vote earlier than it would otherwise be due. This seems one of the less likely alternatives as it will potentially drive short-termism – both amongst management teams and investors;
- an update to the Corporate Governance Code to include additional guidance on how companies should consult with shareholders, particularly following a poor vote on the remuneration report.
(ii) Shareholder engagement on pay
The Government is concerned that around 28% of FTSE 100 shareholders do not vote on remuneration resolutions. The Green Paper sets out a couple of possible ways in which shareholders may be encouraged to vote on pay. The first – that it become mandatory for institutional shareholders to disclose their voting records – does not necessarily address the Government’s concern. The other two proposals – the establishment of a senior “Shareholder Committee” to scrutinise remuneration and finding other ways to facilitate retail shareholders to exercise their voting rights – are not fleshed out in the Green Paper. The Government may find that strengthening shareholder votes (described above) and/or encouraging worker representation (described below) will have the knock on consequence of effecting greater shareholder engagement, without the need for any direct action on the point.
(iii) The role of the remuneration committee
A potentially surprising suggestion is that remuneration committees need to do more to consult with shareholders on remuneration policies. The Green Paper’s proposal for how this might be encouraged implies that this is something the Government thinks should be addressed through guidance rather than legislation. So we may see additional language added to the Corporate Governance Code on this point by the Financial Reporting Council.
Views are also sought on whether it should be a requirement that the chair of the remuneration committee serve on the committee for at least 12 months before taking up that position (consistent with the Executive Remuneration Working Group’s suggestion). This is likely to be another matter for guidance rather than legislation.
(iv) Transparency in executive pay
The proposals here relate to the much-anticipated CEO pay ratio but also, more significantly, to disclosure of bonus targets.
- The Green Paper gives no more detail on what disclosure of the “pay ratio” between the CEO and the wider workforce and the executive team might entail. However, there is a suggestion that the calculation of average pay within the wider workforce could be limited to UK-based employees (the Green Paper states that one of the unintended consequences of disclosing a pay ratio is that companies may be incentivised to offshore work, suggesting that overseas employees would be excluded). The Green Paper also questions whether the pay ratio would provide any meaningful commentary on a company’s pay practices and seeks inputs on how it could be used to genuinely improve the ability of shareholders to take an informed view on pay outcomes.
- On the disclosure of bonus targets, the Green Paper seeks views on whether this should be made mandatory or left to investor pressure. The Green Paper does acknowledge that there may be legitimate cases for non-disclosure if it would damage a company’s commercial prospects.
(v) Long-term executive pay incentives
The Green Paper casts doubt on how effective current remuneration arrangements are at incentivising long-term performance. The paper’s two primary suggestions are: considering whether restricted shares (granted at a level of around 50% of a typical LTIP) could be used more widely; and requiring share options to be held for a minimum of five years from grant. These reflect suggestions made by the Executive Remuneration Working Group.
2. Strengthening the employee, customer and wider stakeholder voice
The Government acknowledges the range of interests to which directors are required to have regard under existing company law, including in particular the requirements of section 172 of the Companies Act 2006, but believes that “new ways of connecting boards to a wider range of interested groups need to be explored”.
The Green Paper therefore sets out a range of options for strengthening the voice of employees, customers and other interested parties at boardroom level and “building confidence that section 172 of the Companies Act 2006 is properly understood and applied”.
These options represent a partial retreat from comments made by the Prime Minister at the Conservative Party conference in early October, which appeared to suggest that she was contemplating giving formal board rights to employee and consumer representatives. The Green Paper expressly acknowledges that companies should have the right to appoint stakeholder representatives to the board on a voluntary basis but indicates that there will be no requirement to do so. We believe it is unlikely that many companies will take up this option, and very few have done so to date.
The Green Paper describes various other options, which the Government is at pains to point out are not mutually exclusive.
Stakeholder advisory panels
A panel would be formed for directors to hear directly from their key stakeholders. Little detail is given on how a panel might be structured, although it is suggested the composition could be tailored to fit the needs of the business. Engagement could happen in a number of different ways. Examples given in the Green Paper include scheduling advisory panel engagements on relevant topics prior to board meetings; inviting advisory panel members to offer views to board meetings when relevant agenda items are scheduled; or giving the panel the right to initiate discussions on important topics with a power to request directors to attend panel meetings to answer questions. The Government believes that this approach would offer greater transparency into how well a company is addressing its stakeholder issues, particularly if implemented alongside a strengthening of relevant reporting requirements.
Giving an existing non-executive director responsibility for ensuring the voice of key interested groups is heard at board level
Under this structure, the Government envisages that a board-level committee would be set up with the status to ensure that executive decision-making takes appropriate account of employee, supplier or consumer issues. It is not envisaged under this option that stakeholder representatives would themselves sit on this committee but there would clearly need to be strong communication channels and reporting mechanisms (including, the Government suggests, by the publication of a separate report by the committee in the company’s annual report).
Strengthening reporting requirements relating to stakeholder engagement
The Green Paper suggests that stronger reporting requirements could be designed to raise general awareness of the duties owed by directors and to provide greater confidence that boardroom decisions are being taken with regard to wider stakeholder interests. For example, companies might be required to provide information on how often, and by which mechanism, company boards are giving consideration to different stakeholder interests (this information might be both backward-looking and also set out future objectives). In practice, it is difficult to see how any of the options described in the Green Paper would be fully effective without an enhanced reporting obligation to demonstrate how relevant views are being taken into account.
The Government leaves open in the Green Paper how these options would be implemented, including whether legislation would be required, and whether stakeholder engagement mechanisms should be subject to size thresholds or other criteria.
3. Corporate governance in large privately-held businesses
The Green Paper notes that there are approximately 2,500 private companies and 90 LLPs with more than 1,000 employees. These businesses are not required to meet the same corporate governance and reporting standards as listed companies, yet the consequences when things go wrong can be equally severe. The mere fact that a company is in private ownership does not lessen the impact on other stakeholders. Additionally, the Government notes that good corporate governance is beneficial and helps to build a company’s reputation and ensure its long-term success.
The options set out in the Green Paper in relation to privately-held businesses are not set out in any great detail and appear somewhat tentative. The key questions on which the Government is seeking responses through the consultation process are:
- whether enhanced standards of corporate governance should be applied more widely and, if so, how. Should the Corporate Governance Code for premium listed companies be extended to large private companies, or should the FRC or a business organisation such as the Institute of Directors be mandated to develop a separate governance code, more specifically tailored to the needs and challenges faced by privately-held businesses; and
- whether non-financial reporting requirements should be applied on the basis of a size threshold rather than the legal form of a business.