The Business, Energy and Industrial Strategy Committee has published its long-awaited report on its inquiry on corporate governance following on from “major corporate governance failings at BHS and Sports Direct“. The report considers “whether the UK corporate governance framework is fit for purpose, whether it provides the right structures to assist businesses in making high quality decisions for the long term (taking the wider interests of society fully into account)“.
Whilst the Committee’s proposals are only recommendations at this stage, it is clear that they chime with many of the UK Prime Minister’s recent comments on industrial policy and strategy, and would seem likely to attract cross-party support. It is therefore probable that at least some of these proposals will be adopted following the forthcoming UK general election.
The key proposals
Whilst the Committee talks about the strength of UK corporate governance and it being “at the leading edge of international standards” (and despite saying “we do not believe that a radical overhaul of the current framework is necessary“), there are some potentially ground-breaking recommendations.
Detailed reporting on directors’ compliance with their duty to promote the success of the company
The Committee recommends that the Financial Reporting Council amends the UK Corporate Governance Code to require informative narrative reporting on how directors have complied with their duty to promote the success of the company, which is set out in section 172, Companies Act 2006.
The expanded requirements would include an obligation on boards to explain precisely how they have considered each of the different stakeholder interests set out in that section (to which the directors must “have regard”, including the long term consequences of the decision, the interests of employees, the need to foster business relationships and the impact of the company’s operations on the community and the environment) and how this has been reflected in financial decisions. The Committee does not recommend any changes to section 172 itself.
Whilst the UK Corporate Governance Code currently only applies to companies with a premium listing on the London Stock Exchange, in its correspondence with the Committee the FRC suggests there is a case for reporting on section 172 compliance to also be mandatory for private companies.
It is proposed that the FRC is given additional powers to engage and hold to account company directors in respect of the full range of their duties. Where engagement is unsuccessful, this would include reporting publicly to shareholders any failings of the board. Where companies do not respond satisfactorily to engagement with the FRC, the FRC be given the authority to initiate legal action against directors for breach of their section 172 duty – the Committee hopes that “the prospect of investigation by an expanded FRC in respect of section 172 duties is a much more effective deterrent than the remote prospect of legal action by shareholders.”
Greater transparency in governance standards
The Committee is proposing that a rating system is developed which will publicise examples of good and bad corporate governance practice by companies. Reference to the rating would be published in a company’s annual report.
Voluntary code for large private companies, with the threat of a mandatory regime
The Committee recommends that a voluntary code of corporate governance is drawn up for large private companies (with “large company” meaning companies with over 2,000 employees). Compliance with this code will be overseen and reported on by a new body. If the voluntary regime fails to raise standards after a three year period, or there are high rates of unacceptable non-compliance, a mandatory regime should be introduced.
Abolishing LTIPs and acknowledging shareholder pay revolts for listed companies
The Committee suggests that the structure of executive pay be simplified. Long-term incentive plans should be phased out as soon as possible and the FRC should consult with stakeholders with a view to amending the UK Corporate Governance Code to establish deferred stock rather than LTIPs as best practice in incentivising long-term decision making. The FRC should also revise the Code to include a requirement for a binding vote on executive pay awards the following year in the event that 25% or more of votes cast oppose the annual advisory resolution on the directors’ remuneration report.
New gender diversity targets for listed companies
The Committee recommends that the government should set a target that, from May 2020, at least half of all new appointments to senior and executive management level positions in the FTSE 350 and all listed companies should be women. An explanation for any failure to meet this target should be included in the annual report.
Osborne Clarke comment
Whilst the proposals are wide-ranging, from a director’s perspective, the proposals for independent enforcement of section 172 duties is particularly eye-catching. These duties are owed to a company and specifically not to any of the wider stakeholders identified in that section. It is difficult to envisage in practice how the FRC would determine a company’s best interests – by comparison, the English courts have traditionally been reticent to second-guess the exercise of directors’ judgement (which is often finely balanced between a number of considerations) in the absence of clear bad faith or wrongdoing, and it is hard to see why that exercise would be any easier for a regulator.