The Business, Energy and Industrial Strategy (BEIS) Committee inquiry into corporate governance focused on three key areas: directors' duties, executive pay, and board composition. The Committee's conclusion is that there is no need for a radical overhaul of corporate governance in the UK but there is scope for significant improvement. We look at some of its key recommendations below.
A multitude of reviews
The inquiry was launched last October, just before the government published its own green paper consultation on corporate governance. Despite overlapping in time and scope, the two reviews are distinct. The government has yet to publish the outcome of its consultation, which focuses on executive pay, employee and stakeholder voice, and large privately-held businesses. The government may be influenced by some of the Committee's recommendations but we will have to wait and see if they decide to take any forward.
In February, the Financial Reporting Council (FRC) also announced plans for a fundamental review of the UK Corporate Governance Code (Code) later this year. The FRC has stated that it will take account of the Committee's recommendations, many of which involve the FRC making changes to the Code, and the government's response, when carrying out its review of the Code. In its response to the Committee's report, the FRC noted that "The depth and breadth of the [Committee's] recommendations, if fully adopted, will have significant implications for the FRC’s remit, resources and funding".
Directors' duties and FRC powers
- The FRC should amend the UK Corporate Governance Code to require informative narrative reporting on the fulfilment of duties under section 172 of the Companies Act 2006. This duty obliges directors to promote the success of the company and in doing so have regard to the interests of its employees and other stakeholders.
- The amended Code should require boards to explain precisely how they have considered each of the different stakeholder interests; how this has been reflected in financial decisions; and how they have pursued the company's objectives and had regard to the consequences of their decisions for the long term. Any failure to have due regard to stakeholders' interests should also be explained.
- The FRC should push-back on companies' use of boilerplate statements in annual reports and encourage digital communication with stakeholders throughout the year.
- The FRC should have additional powers to engage and hold directors to account. Where engagement is unsuccessful the FRC should report publicly to shareholders on any failings of the board. The FRC should also have authority to initiate legal action for breach of section 172 duties.
This idea of empowering the FRC to hold directors to account supports the FRC's own stance on the issue. In the FRC’s response to the government’s green paper, the FRC advocated a more effective enforcement mechanism for holding directors to account and expressed willingness to become part of the necessary enforcement machinery. Our update on the FRC's plans for a fundamental review of the UK Corporate Governance Code gives more detail.
The Committee recommends that the FRC should work with business organisations to develop an annual corporate governance rating system. Using a traffic light system, this should publicise examples of good and bad practice in an easy to digest red, yellow and green assessment. Companies should be obliged to include their rating in their annual reports.
- Companies should be encouraged to establish stakeholder advisory panels to provide a useful forum for dialogue and consultation. The FRC should amend the Code to require companies' annual reports to include details of how they are conducting engagement with stakeholders.
- The FRC should review its Stewardship Code to provide more explicit guidelines on what high quality engagement entails and publicise poor performance annually. A revised Stewardship Code should also require disclosure of voting records by asset managers, publicising those that do not vote.
- The Committee recommends that the FRC consults with stakeholders to develop guidelines for a simpler structure for executive pay, with emphasis on salary plus long-term equity.
- LTIPs should be phased out as soon as possible; no new LTIPs should be agreed from the start of 2018 and existing arrangements should not be renewed. The FRC should amend the Code to establish deferred stock rather than LTIPs as best practice for incentivising long-term decision making.
- There should be limited use of short-term performance-related cash bonuses. Bonuses should be aligned with wider corporate responsibilities and objectives and should be genuinely stretching. The FRC should consider policy on bonuses in the recommended corporate governance rating system.
Votes on executive pay
The Committee is of the view that a regime of annual binding votes on pay levels is not currently justified. Instead it recommends that where over 25 per cent of votes are cast against the executive pay award in one year, then a binding vote is required the following year.
Pay ratio reporting
The report recommends that the FRC should make amendments to the Code to introduce controversial pay ratio reporting, comparing CEO remuneration against both senior executives and all UK employees.
In its green paper on corporate governance, the government indicated that pay ratio reporting should only be introduced if done in a way which genuinely improves the ability of shareholders to understand company pay policies. It highlighted the risk of outsourcing/offshoring (to exclude the lowest paid workers from the calculation) as a potential unintended and undesirable consequence.
Board composition and diversity
The Committee recommends that the Code is revised to make board diversity a key priority and to require:
- a public explanation of the reasons why board members have been selected
- annual reports to include diversity information (gender, ethnicity, social mobility, and diversity of perspective). This should include an explanation of the current position, the steps taken and to be taken to enhance diversity of the executive pipeline, agreed targets, and detail of how accurately the board mirrors both the workforce and customer base.
It also recommends that the FRC should be given a role overseeing the director appointment evaluation process, with power to publicly highlight best and worst practice among nomination committees.
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 within the FTSE 350 and listed companies should be women. If a company fails to meet this target it should include the reasons for failure in its annual report and explain what steps it is taking to rectify gender inequality on its executive committees.
- The FRC should embed the promotion of ethnic board diversity within the Code, giving it as much prominence as gender diversity.
- The government should legislate to ensure that all FTSE 100 businesses publish their workforce data, broken down by ethnicity and by pay band.
Workers on boards
In line with the government's approach, the Committee is in favour of employee board members but does not recommend a compulsory regime. It encourages more companies to appoint workers to boards and believes that it should become the norm. Where an employee is appointed to the board the Committee thinks they should be a full director, with the necessary skills, rather than merely a delegate or representative of the workforce.
The FRC, together with other relevant parties, should develop a voluntary corporate governance code for the largest privately-held businesses. Reporting under the code would be on a comply or explain basis. If a voluntary regime fails to raise standards of governance after an initial three year period, or if there are high levels of non-compliance, then a mandatory system should be introduced.
The FRC has indicated that it would be happy to develop a regime for private companies. In its response to the government's green paper on corporate governance it said "The FRC stands ready to develop a governance framework for larger private companies. This would need to be tailored to take into account their specific and different ownership and governance arrangements. It should be underpinned by regulation as the Code is with the Listing Rules, recognising that private companies and their shareholders have a close relationship."
How can Burges Salmon help?
We provide specialist corporate advice to businesses on all aspects of corporate governance. If you would like to discuss corporate governance reform, and how it may affect your business, please speak to your usual contact at Burges Salmon or Nick Graves.
This update was written by Alyson Whale.