The Financial Reporting Council (FRC) has published the 2018 UK Corporate Governance Code (2018 Code) and revised Guidance on Board Effectiveness (Guidance) in addition to feedback on the 275 responses it received to its December 2017 consultation. It has also published a version of the 2018 Code highlighting changes from the initial consultation draft. For our overview of the December consultation draft, please read our Governance & Compliance update issued at the time.
Significant changes from the consultation draft include:
The introduction to the 2018 Code has been revised to reflect the broadening focus of governance and recognition that governance arrangements must permeate the entirety of a group structure to be effective. It now specifies that the board of a parent company with a premium listing should ensure that there is adequate co-operation within the group to enable it to discharge its governance responsibilities under the Code, including the communication of the parent company's purpose, values and strategy.
The emphasis on reporting meaningfully when discussing the application of the Principles retains its prominence.
Section 1 – Board leadership and company purpose Workforce engagement W
hile the FRC supports and has retained the Government's three primary options for engaging with the 'workforce' (i.e. a director appointed from the workforce, a formal workforce advisory panel or a designated non-executive director) it now recognises that there may be other effective methods of engagement. To ensure that any additional methods are used effectively, a revised Provision requires companies to explain any alternative method used and why it is considered effective (Provision 5).
The Guidance states that 'workforce' in this context means: (i) those engaged on formal employment contracts (permanent, fixed-term and zero hour); and (ii) other members of the workforce who are affected by decisions of the board – in this context the board should consider including individuals engaged under contracts of service, agency workers, and remote workers regardless of their geographical location. Companies should be able to explain who they have included and why.
Culture and values
Further enhancing the focus of the 2018 Code on corporate culture, it is now a main Principle (and not a Provision) that boards should create a culture which aligns company values with strategy (Principle B).
It is the board's responsibility (and not, as proposed in the consultation draft, that of the remuneration committee) to ensure that workforce policies and practices are consistent with the company's values and support its long-term sustainable success (Principle E). In the context of reporting on culture, annual reports should include an explanation of the company's approach to investing in and rewarding its workforce (Provision 2).
Boards should describe in their annual report how the interests of stakeholders and the matters set out in section 172 of the Companies Act 2006 have been considered in board discussions and decision-making (Provision 5). Necessarily, engagement mechanisms should be kept under review. This ties in with the requirements of the Companies (Miscellaneous Reporting) Regulations 2018 published in June 2018.
Significant votes against
Despite concerns that it would not lead to meaningful disclosure, the FRC has retained the proposed requirement for an update to be provided on the views of shareholders and actions taken six months after a significant (20%+) shareholder vote against a board proposed resolution – this is in addition to the need to respond to such a vote when announcing the result of the shareholder meeting at which it was taken in the company's subsequent annual report and, if applicable, in the explanatory notes to the resolutions at the next shareholder meeting (Provision 4). The FRC has indicated that this Provision applies during 2019.
Section 2 – Division of responsibilities
Notwithstanding the chairman's unique status, the consultation draft proposed to extend the concept of independence to the chair beyond appointment and throughout the chair's tenure, with the effect that the chairman would become subject to regular 'independence' evaluation in the same way as all other non-executive directors.
In the 2018 Code, and on the basis of considerable feedback, the FRC acknowledges the 'special' role of the chairman and has chosen to revert to the current approach for the chair to be independent on appointment only (Provision 9). There is, however, a requirement that the chair should demonstrate objective judgement throughout their tenure (Principle F) and further prescription on the length of the chair's service (see Section 3 below).
Independence: Non-executive directors
Under the 2016 Code, a board has discretion to decide whether the test for independence is met by its non-executive directors. The consultation draft proposed a significant move away from this discretion by providing that non-executive directors (including the chairman) should not be considered independent where any of certain specified relationships / circumstances exist. By extension, it was proposed that the board would still retain the ability to 'explain' non-compliance.
The majority of views received by the FRC did not support this approach and, consequently, it has been dropped. Thus the 2018 Code reinstates the board's discretion to conclude that a non-executive is independent notwithstanding the existence of certain specified matters. Nevertheless, the FRC expects to see greater detail when companies report on the independent status of board members (Provision 10).
Board and committee composition
The 2016 Code provides that at least half the board (excluding the chairman) should comprise independent non-executive directors. It also provides a dispensation from this recommendation for those companies outside the FTSE 350. A 'smaller' company need only have at least two independent non-executive directors.
The 2016 Code also recommends that the audit and remuneration committees should each comprise at least three, or in the case of smaller companies two, independent non-executive directors. A further relaxation for smaller companies allows the company chairman to be a member of, but not chair, either committee in addition to the independent non-executive directors, provided he or she was considered independent on appointment as chair.
The consultation draft proposed that independent directors should constitute the majority of the board and that the audit committee and remuneration committees should comprise at least three independent directors. It also proposed to remove all dispensations for smaller companies.
In light of concerns that removing all exemptions may be overly burdensome for smaller companies, the 'majority of independents' recommendation has been dropped – thus, the current formulation in the 2016 Code remains – i.e. that at least half the board (excluding the chairman) should be independent. The FRC has, however, gone ahead with the removal of the smaller company exemption regarding overall board composition to encourage sufficient independent challenge (Provision 11).
The 2018 Code also contains greater flexibility for smaller companies in meeting their audit and remuneration committee composition requirements by reinstating the current position which permits, in each case, a committee comprised of at least two independent non-executive directors (Provisions 24 and 32). The chairman will, however, no longer be permitted to be a member of the audit committee (Provision 24).
In response to feedback concerning non-executive directors holding multiple directorships, the 2018 Code includes new wording designed to encourage boards and directors to consider carefully the commitments they make when taking on new appointments. The reasons for permitting a director to undertake significant additional external appointments should be explained in the annual report (Provision 15).
Section 3 – Composition, succession and evaluation
Given the 2018 Code will not extend the concept of independence to the chair beyond his or her appointment (and therefore will not effectively restrict the chair's tenure to nine years on a 'comply or explain' basis), the FRC has included a new Provision explicitly addressing the length of the chair's service. New Provision 19 recommends that a chair should not remain in post beyond nine years from the date of their appointment to the board. Time served on the board will count towards the nine year limit and will reduce the time that can be spent serving as the chair. However, the Provision does permit a limited extension to the term of the chair beyond nine years where the chair was already a board member prior to becoming chair (i.e. he/she was an internal appointment) and that appointment supports the company's succession plan and diversity policy.
The 2016 Code provides that the boards of FTSE 350 companies should be externally evaluated at least every three years. Companies outside the FTSE 350 are currently exempted from this recommendation.
The consultation draft proposed removing the dispensation for smaller companies by recommending all listed companies should subject their boards to periodic external evaluation. In response to concerns that there is currently insufficient capacity in the current board evaluation market, the FRC is no longer proposing to make it an absolute requirement for smaller companies to undertake external evaluations. However, the 2018 Code does encourage smaller companies to consider their regular use (Provision 21). Recognising that externally facilitated evaluations do not necessarily involve personal interviews with individual directors nor attendance at board meetings, the 2018 Code also recommends that 'the nature and extent of an external evaluator's contact with the board and individual directors' is disclosed in the nomination committee's report to enable a clearer assessment of the evaluation process (Provision 23).
Overall the responses received by the FRC were supportive of the approach taken to diversity with many respondents welcoming the new emphasis on the subject and the broader remit of the nomination committee. Accordingly, only limited changes have been made to the consultation draft. Most significantly, feedback suggested that recommending that the nomination committee provide in its report 'an explanation of how diversity supports the company in meeting its strategic objectives' was unclear and difficult to report against. In response, the FRC has included wording to align the nomination committee's reporting more closely with the current reporting requirements under paragraph 7.2.8A R of the Disclosure Guidance and Transparency Rules (DTRs), with a focus on the diversity policy, its objectives, the link back to strategy, the policy's implementation and progress on achieving diversity objectives (Provision 23).
Section 4 – Audit, risk and internal control
Equivalence with current Code
By way of reminder, there was little change proposed in this area as the Code had been updated in 2014 and 2016 to take account of the Sharman Report and the EU Audit Regulation and Directive respectively. The FRC was deliberating whether to remove, but has decided to retain, the areas of duplication between the 2018 Code, the Listing Rules and the DTRs (and has included a comparison of those overlapping requirements in Appendix B of the Guidance).
Financial and narrative statements
The Principle recommending that a board should establish formal and transparent policies and procedures to ensure the independence and effectiveness of internal and external audit functions has been extended to the board satisfying itself on the integrity of financial and narrative statements (Principle M).
Assessment of risk
In addition to conducting a robust assessment of the company's risks, the board should do the same in relation to 'emerging risks'. While a board is expected to describe in the annual report the principal risks the company faces (as is currently the case), it is also now required to set out what procedures are in place to identify emerging risks and explain how both are managed or mitigated (Provision 28).
Section 5 – Remuneration
Role of the remuneration committee
The consultation draft had proposed that the remuneration committee should have a new responsibility to 'oversee remuneration and workforce policies and practices', so that it can take these into account when setting the directors' remuneration policy. There had been concern that this would result in a significant increase in the responsibilities and workload of remuneration committees.
In the 2018 Code and after considerable feedback, this proposal has been limited to an obligation to 'review workforce remuneration and related policies and the alignment of incentives and rewards with culture, taking these into account when setting the policy for executive director remuneration' (Provision 33). The purpose of such review is further explained in the Guidance, as being:
to ensure workforce rewards, incentives and conditions are taken into account when deciding executive director and senior management pay;
to enable the remuneration committee to explain to its workforce how executive pay decisions reflect wider pay policy; and
to enable the remuneration committee to feedback to the board on workforce reward, incentives and conditions and support the board's monitoring of whether the company's policies and practices support culture and strategy.
The Guidance states that 'workforce' in this context is not limited to employment relationships, but also any 'other arrangement to do work or provide services personally'. Clearly there is an intention that this will capture some individuals who may be classified as 'workers' for employment law purposes, and possibly consultants, but the Guidance makes clear that the term 'workforce' is not meant to align with the relevant legal definitions.
The 2018 Code has retained the proposal that the chair of the remuneration committee should have served on a remuneration committee for at least 12 months (Provision 33).
The consultation draft had proposed that long term incentives should be subject to a combined vesting and holding period of at least five years. The 2018 Code has broadly retained this requirement, but has also included a requirement that any shares from long term incentives should only be released for sale on a phased basis (Provision 36).
The 2018 Code also states that there should be a formal policy for post-employment shareholding requirements encompassing unvested and vested shares - this goes further than the proposal in the consultation draft (which was only that post-employment periods 'may be appropriate') (Provision 36).
There was a provision in the consultation draft concerning how the remuneration committee should address the 'predictability' of remuneration; this concept is explained in the Guidance as enabling the company, the executive and shareholders to understand the potential range of rewards available in monetary terms. Although the 2018 Code does not go as far as to recommend a limit on executive remuneration, the Guidance makes clear that an overall limit is something that remuneration committees should be considering.
There is a stronger emphasis in the Guidance on the overall level of executive pay, and how remuneration committees should be mindful of external perceptions. The Guidance recommends that remuneration committees should assess the overall reasonableness of total rewards and use their discretion to adjust pay where it would not otherwise align with individual performance or meet the policy intention.
Guidance on Board Effectiveness
Key changes that have been made to the Guidance include:
changes to the language so that the tone is less prescriptive;
changes to the introduction to emphasise the importance of the Guidance in promoting high standards and to encourage its use of alongside the 2018 Code;
signalling the intent to update the Guidance more frequently as practice develops;
referencing through footnotes the Principles and Provisions related to the content of the Guidance; and
adding a new section on externally facilitated board evaluations (Section three).
The 2018 Code will apply to accounting periods beginning on or after 1 January 2019. Therefore, unless companies decide to adopt all or part of the new Code early, the first reporting will not be seen until 2020. Provision 4, however, relates to reporting on significant (20%+) votes at shareholder meetings and the FRC has stated that that it considers it appropriate to report on that provision during 2019. Likewise, future remuneration policies and changes to existing policies 'should be developed with reference to the 2018 Code and the Guidance'.
The Financial Conduct Authority is reviewing its Handbook and considering what consequential amendments are needed as a result of the changes to the 2018 Code.
Review and monitoring
The FRC intends to escalate its monitoring of practice and reporting once the 2018 Code takes effect, paying attention to the application of the Principles and compliance with the Provisions, including explanations. It expects that some companies will adopt the 2018 Code early which will help the FRC to determine whether additional guidance or support will be necessary. As stated above, the FRC intends that the Guidance will be more responsive than in the past and therefore take account of emerging trends and be used as a means to offer clarification. The FRC will also undertake more in-depth reviews of annual reports to engage with companies on their reporting against the 2018 Code.
Over the coming months the FRC will be embarking on an outreach programme to aid understanding of the 2018 Code by investors and proxy voting agencies and to support its implementation by companies and their advisors. It also intends to make the necessary consequential changes to the Guidance on Audit Committees and the Guidance on Risk Management, Internal Control and Related and Financial Business Reporting over the coming months. For the latter, it will also assess whether amendments are required in relation to internal controls and viability statements in light of the collapse of Carillon and the completion of the various investigations.
A consultation on changes to the UK Stewardship Code will follow later in 2018.