The FRC has published its proposed new UK Corporate Governance Code and updated guidance on board effectiveness for consultation. As expected, there is a particular focus on the themes of corporate and board culture, stakeholder engagement, sustainability, remuneration and diversity.

In recognition of the role that stewardship can play in improving best practice the FRC has also asked some high level questions about the future direction of the Stewardship Code. It plans to consult on specific changes to the Stewardship Code next year.

The government’s corporate governance review

The FRC’s review is part of a wider project to reform aspects of the UK’s governance landscape. In late August the government published a response to its November 2016 green paper which was designed to stimulate a debate on options for strengthening the UK’s governance framework. Many of the more controversial proposals in the green paper were dropped and none of what remains will require primary legislation. Instead, the government plans to implement the changes through a combination of secondary legislation and new and updated codes and guidance which it has mandated the FRC and other bodies to develop.

What are the key changes?

The key changes include provisions requiring 'compliant' companies to:

  • adopt a method for obtaining workforce views – the proposed Code suggests this will normally entail identifying a designated non-executive director, the creation of a formal workforce advisory panel, or the appointment of a director from the workforce;
  • establish a whistleblowing procedure under which the workforce can report anonymously;
  • take ongoing action when they encounter significant shareholder opposition to resolutions;
  • look again at the independence of individual non-executive directors and the chair;
  • intensify their efforts to promote diversity;
  • ensure their remuneration committee takes on a broader role – the proposed Code extends the committee’s remuneration-setting responsibilities to include senior management as well as directors and gives it oversight responsibility for remuneration and workforce policies and practices for the wider workforce; and
  • ensure that any newly appointed chair of their remuneration committee has 12 months’ prior remuneration committee experience.

Who does the Code apply to?

The FRC proposes no change to the scope of application of the Code, except that it has removed exemptions for smaller companies (for example, around board composition). The Code continues to apply to all companies with a premium listing of equity shares, whether or not incorporated in the UK.

Timing

The deadline for comments is 28 February 2018. The FRC is then hoping to publish the final version of the Code in July 2018 with the expectation that it will apply for reporting years beginning on, or after, 1 January 2019.

Key focus – rewriting the principles

The FRC’s rewrite has focused on the Code’s principles, which have been recast in broader, more fundamental terms around the FRC’s key themes. The Code itself has been restructured into five sections to reflect these themes:

  1. Leadership and purpose
  2. Division of responsibilities
  3. Composition, succession and evaluation
  4. Audit, risk and internal control
  5. Remuneration

Structurally, the confusing distinction between main and supporting principles has been removed and many of the 2016 Code’s more specific principles (for example, the need for director training, timely information, insurance and access to independent professional advice) have been subsumed by more general wording. Furthermore, whilst the proposed Code retains ‘provisions’ to back up many of its principles, not all principles have an associated provision and many of the 2016 Code’s specific provisions have either been extensively rewritten, or removed from the proposed Code.

Where a provision has been removed it is because the FRC was of the view that the relevant provision is well established as good practice and compliance levels are high so it no longer needs to be included in the Code. In practice the difference is, however, often more apparent than real as the FRC has included a number of the existing provisions in its proposed guidance as a reminder to boards that good practice and procedure should be followed. For example, provision C.3.3 of the 2016 Code (which requires the terms of reference of the audit committee to be made available) has been removed from the proposed Code, but the draft guidance makes it clear that the terms of reference for all committees should be set out clearly and made available. Whilst the FRC makes it clear that the guidance is not binding, in practice many companies will follow it.

The review’s main themes – how the Code is changing

1. Leadership and purpose

The changes proposed in this area reflect the outcomes of the FRC’s recent ‘culture coalition project’ which looked at the board’s role in developing corporate culture to deliver long-term success. The FRC proposes new principles providing (in broad terms) that:

  • the board’s function is to promote the long-term sustainable success of the company, generate value for shareholders and contribute to wider society;
  • the board should establish the company’s purpose, strategy and values, and satisfy itself that they are aligned with its culture;
  • the board should ensure effective engagement with, and encourage participation by, shareholders and stakeholders;
  • the board should establish controls to assess and manage risks, ensure the company has the resources to meet its objectives, and measure performance against them;
  • directors must act with integrity and lead by example in the best interests of the company; and
  • the workforce should be able to raise concerns in relation to management and colleagues where they consider that conduct is not consistent with the company’s values and responsibilities.

These principles are backed by related provisions – for example, board monitoring and assessment to ensure that actual behaviour is aligned with the company’s values, and additional annual report disclosures. The draft guidance includes a number of suggestions and questions for boards to consider when setting and monitoring a company’s culture.

In the draft guidance the FRC also puts forward a number of suggestions designed to help boards make sound decisions. In the case of significant decisions, it proposes extra steps that a board may wish to put in place. These extra steps include providing fuller board papers to help directors who are not directly involved in a particular project to assess its merits and Freshfields Bruckhaus Deringer LLP The FRC’s Governance Code Consultation December 2017 3 ensuring that board minutes document the detail of the discussion that led to the relevant decision.

2. Workforce and other stakeholder engagement

The introduction to the proposed Code emphasises that directors should build and maintain a successful relationship with, and be responsive to, the views of shareholders and other stakeholders to achieve long-term success. New principles and provisions reinforce this. For example:

  • boards should adopt a method for obtaining the views of the workforce – the relevant provision suggests this will normally entail the identification of a designated non-executive director, the creation of a formal workforce advisory panel, or the appointment of a director from the workforce; and
  • companies should establish a mechanism for the workforce to raise concerns in confidence and anonymously (ie a whistleblowing procedure) and boards should ensure arrangements are in place for investigation and follow-up action.

The government itself has not proposed any change to the duty in section 172 of the Companies Act 2006 to promote the success of the company for the benefit of its members, which requires directors to have regard to employees’ interests and the need to foster business relationships with suppliers, customers and others, amongst other things. It does, however, plan to legislate to require companies to explain in their strategic reports how the directors have complied with the duty.

The proposed Code has a similar provision: the board should explain how it has engaged with the workforce and other stakeholders, and how their interests and the matters set out in section 172 influenced the board’s decision-making. It is noteworthy that in the proposed Code, in order to capture the complexity of modern contractual relationships between companies and individuals undertaking work for them, the FRC has used the term ‘workforce’ rather than ‘employees’. Furthermore, the guidance emphasises that communication and engagement should involve the whole workforce, including for example agency workers and contractors, and not just employees.

The draft guidance also contains more information about how the views of a wider range of stakeholders might be heard in the boardroom and cross refers to the joint guidance on this area recently issued by ICSA, the Governance Institute and the Investment Association.

3. Significant votes against resolutions

The 2016 Code’s provision for a company to respond to significant votes against resolutions at general meetings has been expanded. Whether a vote against is ‘significant’ will no longer be for the board to decide. Going forward, if more than 20% of votes have been cast against a resolution:

  • the company should explain when announcing the voting results what actions it intends to take to consult shareholders to understand the reasons behind the result;
  • the company should publish an update within six months; and
  • the annual report or notes to resolutions at the next meeting should summarise what impact the feedback has had on board decisions and any actions or resolutions now proposed.

As previously announced, the Investment Association is setting up a public register of companies that have had significant votes against resolutions. The register will also record what companies say they are doing to address concerns.

4. Board composition, refreshment and independence

The proposed Code places particular emphasis on regular refreshment of the board, independence and effective succession planning for the board and senior management.

The FRC has recast the provisions dealing with the independence of individual non-executive directors, including the chair. The 2016 Code lists specific criteria which should be taken into account by the board when considering the independence of non-executive directors and the chair.

Under the proposed Code, if any one of those specific criteria are met, that individual director ‘should’ not be considered to be independent. The board should continue to identify in the annual report those directors it considers independent. Whilst companies still retain the ability to offer an explanation if they consider an individual to nonetheless be independent, in practice under the proposed Code companies will have much less discretion when determining independence than has historically been the case. The proposed Code also provides that the independent non-executive directors, including the chair (who in the FRC's view is now considered independent at all times unless the specified criteria determine he or she is not), should constitute the majority of the board. If a company decided that, in fact, the chair was not independent, this provision would mean that a company would need to appoint two further independent non-executive directors to be compliant with this majority independent provision.

The Code no longer provides that any term beyond six years for a non-executive director should be subject to ‘particularly rigorous review’ – this is instead absorbed into the new general principle that board membership should be regularly refreshed.

The proposed Code still provides for annual re-election of all directors of all companies. More information should, however, be given to shareholders with a director’s re-election resolution: the company should provide specific reasons why the director’s contribution is important for the company’s long-term success. The combination of the need to submit all directors for annual re-election, the related disclosure requirement and the proposed new way in which the independence criteria for non-executive directors and the chair will work will likely lead to greater focus on this area.

5. Board and director performance

The proposed Code has a new principle that regular evaluation of the board should consider its balance of skills, experience, independence and knowledge, its diversity and how effectively members work together to achieve objectives. Individual evaluation should address whether the director continues to contribute effectively. This is similar to the provisions of the 2016 Code, but the proposed Code also requires the chair and directors to act on the outcome of evaluations and more disclosures about evaluations in the annual report. Evaluations should still be externally facilitated at least every three years.

The provisions about directors’ time commitments have been strengthened. The proposed Code states that directors should not undertake significant external appointments without prior board approval, and requires additional information in the annual report. This replaces the 2016 Code’s provision that non-executive directors should disclose other significant commitments before appointment, with a broad indication of the time involved, and keep the board informed of changes. Whilst the proposed Code does not set a cap on the number of directorships a non-executive director may hold, it does restate the provision that a full-time executive director should not take on more than one non-executive directorship of a FTSE 100 company, and extends this bar to ‘equivalents’. In addition, the draft guidance includes a suggestion that the nomination committee might want to consider setting an upper limit on the number of other non-executive appointments it considers the chair and other non-executives may take on without compromising their effectiveness.

The draft guidance deals with the topic of director inductions and ongoing development. It states that the chair’s responsibilities include ensuring that all directors receive a full induction, undertaking regular reviews and agreeing development needs with each director to ensure that they continually update their skills and knowledge.

6. Non-executive directors

The proposed Code has a recast list of non-executives’ responsibilities. A new principle states that non-executive directors should provide constructive challenge and strategic guidance, offer specialist advice and hold management to account. They are also responsible for appointing and removing executive directors, and should scrutinise and hold to account the performance of management and individual directors against agreed performance objectives. The draft guidance makes it clear that non-executive directors should avail themselves of opportunities to meet major shareholders, key customers and members of the workforce from all levels of the organisation.

7. Expanded nomination committee role

The proposed Code makes no change to the nomination committee’s chair requirements, but now states that it should have at least three members, bringing it into line with the audit and remuneration committees. The proposed Code does, however, envisage a change in the committee’s role. It emphasises that it not only leads the process for board appointments, but should also ensure plans are in place for an orderly succession to board and senior management positions, and oversee the development of a diverse pipeline for succession.

8. Diversity

The proposed Code asks boards to intensify their efforts in this area and consequently has more explicit statements and a greater emphasis on diversity. Principle J states that both board appointments and succession plans should be based on merit and objective criteria, and adds that they should promote diversity of social and ethnic backgrounds and cognitive and personal strengths, as well as diversity of gender.

In addition, in its draft guidance the FRC has made it clear that it expects the nomination committee to play an active role in setting and meeting diversity objectives and strategies – for example, by making a commitment to use more diverse shortlists and interview panels and having dedicated initiatives with clear targets for areas which lack diversity.

Under the proposed Code more information is required in the annual report about the nomination committee’s role in relation to diversity – this requirement now applies with equal emphasis to all types of diversity (the 2016 Code emphasises only gender). This new provision implements some of the recommendations made by the Parker Review Committee in its final report into ethnicity on UK boards which was published in October 2017. The report should:

  • describe how board evaluation has been conducted, with details of outcomes, actions taken, and how it has influenced board composition;
  • explain how diversity supports the company in meeting its strategic objectives;
  • explain the process used in relation to appointments, the committee’s approach to succession planning and how both support building a diverse pipeline with reference to Principle J;
  • explain what other actions the committee has taken to oversee the development of a diverse pipeline for future succession to board and senior management appointments; and
  • include the gender balance of those in senior management and their direct reports.

Technically the reporting requirements under section 414C(8)(c) of the Companies Act 2006 already require the strategic report to provide the gender breakdown for each of the board, senior managers and employees so the last requirement does not expand current requirements much, if at all. There is, however, a view that this requirement is not uniformly interpreted and the new provision has been included to address that inconsistency. The BEIS Select Committee’s April 2017 report on corporate governance reform recommended that the FRC embed the promotion of ethnic diversity on boards into the Code, at the very least by making a reference to ethnicity where there is a reference to gender. For now this is the one instance in the proposed Code where a diversity requirement applies only to gender. This may, however, change as the FRC has specifically asked whether the Code should encourage companies to provide data on levels on ethnic diversity in their pipelines.

9. Remuneration

The proposed Code gives the remuneration committee a broader role. As well as directors, its remuneration-setting responsibilities now extend to senior management (the executive committee or the first layer of management below board level, including the company secretary). It will also have oversight responsibility for remuneration and workforce policies and practices for the wider workforce. In its August 2017 response (see above) the government invited the FRC to give remuneration committees broader responsibility for overseeing pay and incentives across their company. The proposed Code goes further than this – ‘workforce policies and practices’ is a wide term encompassing the full range of HR policies – and oversight of these would push the committee out of remuneration and into the wider HR space. The draft guidance envisages that the term captures policies that have an impact on the experience of the workforce and drive behaviours, referring specifically to policies around recruitment and retention, promotion and progression, performance management, training and development, reskilling and flexible working. Although the proposed Code provides that this oversight responsibility falls to the remuneration committee, the guidance states that this responsibility could, alternatively, be delegated to another committee with relevant responsibilities, eg a sustainability committee or corporate responsibility committee. If this responsibility is given to the remuneration committee, this will result in the committee having a significantly larger role than it does presently. If boards choose to delegate it to a different committee, the relevant committees will need to adopt an integrated approach to ensure that the oversight piece feeds into the remuneration committee’s consideration of executive remuneration.

The annual report should describe the work of the remuneration committee. A list is provided of what should be included - some of this simply reflects the current Companies Act reporting requirements for directors’ remuneration reports. In addition, the description should explain the company’s approach to investing in, developing and rewarding the workforce, and what engagement has taken place with the workforce to explain how executive remuneration aligns with wider company policy.

Under the proposed Code remuneration committee chairs should be independent and have served for at least 12 months on a remuneration committee before becoming chair. The requirement for 12 months’ previous experience was expected and was heralded by the government response. However, if the committee is delegated the broader oversight role, there may be some sense in allowing a person with broader relevant experience (in HR or compensation) to become the chair – it will be interesting to see to what extent companies rely on the ‘comply or explain’ principle in relation to this requirement.

The proposed Code states that remuneration schemes and policies should provide boards with the discretion to override formulaic outcomes and should allow the company to apply clawback and malus to awards, where appropriate. It lists the items the remuneration committee should address when determining executive director remuneration policy and practices, which is broken down by key themes: (i) clarity, (ii) simplicity, (iii) predictability, (iv) proportionality and reward for individual performance, and (v) alignment to culture. The requirements for clarity, simplicity and predictability are presumably designed to encourage remuneration committees to veer away from complex LTIP structures – a move suggested by the government response – in favour of simpler incentive structures using restricted shares. The proposed Code also states that the range of possible award values should be identified and explained at the outset and that the total rewards available should not be excessive.

There is a positive emphasis, both in the proposed Code and the draft guidance, on promoting longer-term shareholdings – the proposed Code increases the holding period requirement for share-based remuneration from three to five years and states that longer periods (including post-employment periods) may be appropriate. This change was expected but will have limited impact for the many companies which have already included a two year post-vesting holding period into their incentive plans as a response to recent institutional investor pressure for this change to be made. The draft guidance goes further, stating that packages that are structured to ensure exposure to the long-term share price over five to seven years and for two to three years post-employment can support shareholder alignment.

10. Audit, risk and internal control

The FRC has recast the Code’s provisions about the company’s risk and internal control framework and audit independence, with emphasis on the need for the board to satisfy itself that internal controls are robust and allow for prudent and effective risk management and mitigation. The board should establish formal and transparent policies and procedures to ensure independence of internal and external audit functions.

There are no relevant changes to the provisions about audit committee composition.

Provisions about going concern and viability statements are also unchanged. In its draft guidance, the FRC does, however, in line with its publications on this area, remind companies about the need to consider a range of factors when deciding on the period for their viability statements and offers suggestions on how companies should develop those statements.

Stewardship Code – pre-consultation

The FRC has asked some high-level questions about the format and content of the Stewardship Code in advance of a consultation on specific changes in 2018. For example, the FRC asks:

  • on format, whether there should be separate codes applicable to the three categories of signatories to the Stewardship Code (asset managers, asset owners and service providers) in order to make expectations of best practice stewardship more explicit, and whether the ‘comply or explain’ approach of the Governance Code should be used in relation to the Stewardship Code; and
  • on content, (i) how the Stewardship Code could encourage the investor’s role in building a company’s long-term success; (ii) whether it would be appropriate to extend the investor’s focus for monitoring and engagement to wider stakeholders, (iii) whether board and pipeline diversity should be included as an explicit investor expectation; and (iv) whether the Stewardship Code should request that investors consider a company’s performance and reporting on adapting to climate change.