Corporate governance reform: the new UK Corporate Governance Code

By Alyson Whale

The new Code incorporates changes stemming from the government’s consultation on corporate governance reform, as well as the Financial Reporting Council’s (FRC) work on corporate culture, issues raised by the Department for Business, Energy and Industrial Strategy’s Commons Select Committee in its report on corporate governance, and recent reviews on gender and ethnic diversity.

The new Code will apply to accounting periods beginning on or after 1 January 2019 but companies may adopt all or part of it early.

The key messages are:

• the overarching importance of good governance in delivering long-term sustainable performance
• the board’s responsibility for establishing a healthy corporate culture
• improved shareholder and wider stakeholder engagement
• diversity in board succession planning
• proportionate remuneration which supports long-term success, with clearer reporting requirements.

Key changes

The FRC says the new Code sets a higher standard that businesses must step up to meet. Set out below are some of the key changes which will be introduced by the new Code.

Structure

• The new Code has been restructured to provide clarity and refocus emphasis on an updated set of core Principles. The FRC wanted to address a current tendency to focus on the ‘comply or explain’ provisions, which support the Principles. The preamble to the new Code emphasises the importance of high quality contextual reporting on the application of the Principles, including signposting and cross-referencing to relevant parts of the annual report that describe how the Principles have been applied.
• Reporting on the Principles should be supported by high quality reporting on the provisions (of which there are fewer than in the existing version of the Code). These will continue to operate on a ‘comply or explain’ basis. The commentary on how to report explanations has been refreshed; explanations should be viewed as a positive opportunity to communicate rather than an onerous obligation.
• The concept of supporting principles has been removed; some current supporting principles have become Principles or provisions, or have been moved to the FRC’s updated Guide to Board Effectiveness.
• The new Code is divided into five sections:
  • Section 1 - Board leadership and company purpose
  • Section 2 - Division of responsibilities
  • Section 3 - Composition, succession and evaluation
  • Section 4 - Audit, risk and internal control
  • Section 5 - Remuneration.

Section 1 - Board leadership and company purpose

Culture and strategy

• New and revised Principles emphasise the board’s responsibility to embody and promote the desired corporate culture. The importance of a healthy culture in delivering long-term sustainable performance and trust in business permeates throughout the new Code. The board should establish the company's purpose, values and strategy, and satisfy itself that these and its culture are aligned. Directors must act with integrity, lead by example and promote the desired culture. The board should ensure that workforce policies and practices are consistent with the company’s values and support its long-term sustainable success, and the workforce should be able to raise any matters of concern. A new provision states that the annual report should include an explanation of the company’s approach to investing in and rewarding its workforce.

Shareholder and stakeholder engagement

• A new Principle requires the board to ensure effective engagement with, and encourage participation from, shareholders and stakeholders.
• A new provision requires the board to understand the views of the company’s other key stakeholders and describe in the annual report how their interests and the matters set out in section 172 Companies Act 2006 have been considered in board discussions and decision-making. This supports the proposed new regulations which will require companies of a significant size to explain how their directors comply with their duties under section 172. Specifically in relation to engagement with the workforce, one or more of the following methods should be used: a director appointed from the workforce; a formal workforce advisory panel; or a designated non-executive director. If the board has not chosen one or more of those methods it should explain what alternative arrangements are in place and why it considers that they are effective. The term ‘workforce’ is used to capture a wider group than those with formal contracts of employment.
• A revised provision deals with significant shareholder dissent. When more than 20% of votes are cast against the board recommendation for a resolution, the company should explain, when announcing voting results, what actions it intends to take to consult with shareholders in order to understand the reasons behind the result. In addition, the company should publish an update on the views received from shareholders and actions taken no later than six months after the shareholder meeting. The board should then provide a final summary in the annual report (and, if applicable, in the explanatory notes to resolutions at the next shareholder meeting) on what impact the feedback has had on the decisions the board has taken and any actions or resolutions now proposed. The recently launched public register maintained by the Investment Association records details of significant votes against resolutions and related updates on the actions a company is taking.

Section 2 - Division of responsibilities

• Proposals in the consultation draft which would have seen a change of emphasis to the application of the independence criteria set out in the Code have not been included in the new Code. The draft provisions would have removed the board discretion when applying the criteria and also proposed that the chair should no longer be considered independent on appointment and should satisfy the independence criteria throughout their tenure. The FRC took into account feedback and the new Code maintains the existing position on these issues but does introduce a tenure period for the chair (see Section 3 below).
• The new Code strengthens the consideration which should be given to ‘overboarding'. Requirements include that the board should take into account other demands on directors’ time when making any new appointment and that additional external appointments should not be undertaken without prior approval of the board, with the reasons for permitting significant appointments explained in the annual report.

Section 3 - Composition, succession and evaluation

• A new Principle to promote diversity in the boardroom and guard against ‘group think’; appointments and succession plans should be based on merit and objective criteria, and promote diversity of gender, social and ethnic backgrounds, cognitive and personal strengths. The nomination committee’s remit will be broadened in this context to oversee the development of a diverse pipeline for succession. The annual report should, amongst other disclosures, describe the work and progress of the committee in this context and include details of the gender balance of those in senior management (the first level of management below board level) and their direct reports.
• A new provision introduces a maximum tenure for the chair stating that the chair should not remain in post beyond nine years from the date of their first appointment to the board. This period can be extended for a limited time to facilitate effective succession planning, particularly in those cases where the chair was an existing non-executive director on appointment. If extended, a clear explanation should be provided.

Section 4 - Audit, risk and internal control

• There are no significant changes introduced by the new Code.

Section 5 - Remuneration

• The chair of the remuneration committee should have previously served on a remuneration committee for at least 12 months.
• The remuneration committee will have a wider remit (but not as wide as suggested in the consultation draft). Its responsibilities will include reviewing workforce remuneration and related policies and the alignment of incentives and rewards with culture, taking them into account when setting executive director remuneration. Its remit should include the setting of remuneration for senior management (the first level of management below the board) but not for non-executive directors.
• A recommended minimum vesting and post-vesting holding period for executive share awards of five years (up from the current three years) to encourage focus on longer-term outcomes.
• A new provision requires remuneration schemes and policies to make provision for boards to override formulaic remuneration outcomes.
• A new provision that pension contribution rates for executive directors, or payments in lieu, should be aligned with those available to the workforce.
• The annual report should, amongst other disclosures:
  • describe what engagement with the workforce has taken place to explain how executive remuneration aligns with wider company pay policy
  • describe, with examples, how the remuneration committee has addressed the various factors the Code requires it to consider when determining executive remuneration policy and practices (clarity, simplicity, risk, predictability, proportionality and alignment to culture)
  • explain to what extent discretion has been applied to remuneration outcomes and the reasons why.

Smaller companies

The existing Code (2016 Code) contains a number of exemptions or relaxations for smaller companies (below FTSE 350 throughout the prior year). The new Code changes the position for some of these (although the FRC has pulled back on the original proposals that would have seen all relaxations removed).

Key provisions include:

• Re-election - under the new Code, all directors should be subject to annual re-election. Under the 2016 Code this applies only to FTSE 350 companies.
• Board composition - under the new Code, at least half the board, excluding the chair, should be independent non-executive directors. Under the 2016 Code, smaller companies were exempted from this requirement and required instead to have a minimum of two independent non-execs.
• Externally facilitated board evaluation - under the 2016 Code, FTSE 350 companies should have an externally facilitated board evaluation at least every three years. Under the new Code, the emphasis is changed. For all companies, including smaller companies, the chair should consider having a regular externally facilitated board evaluation (for FTSE 350 companies this should happen at least every three years). Smaller companies are therefore encouraged to do this rather than subject to a requirement.
• Audit committee composition - under the new Code, the reduced minimum of two independent non-executive directors (rather than three for FTSE 350 companies) is retained. However, the relaxation which allows an independent chair of a smaller company to be a member of the audit committee has been removed.
• Remuneration committee composition - under the new Code, the reduced minimum of two independent non-executive directors (rather than three for FTSE 350 companies) is retained. The provision applying to all companies which allows the chair (provided they were independent on appointment) to be a member (but not chair) of the remuneration committee has also been retained.

Guidance on Board Effectiveness and UK Stewardship Code

To support the new Code, the FRC has also published updated Guidance on Board Effectiveness (new Guidance). The new Guidance follows the structure of the new Code and should be read alongside it to stimulate boards' thinking (in particular, the new Guidance includes the use of ‘questions for boards’) and add clarity and explanation.

Following an initial high-level review of the UK Stewardship Code at the time of the Code consultation, the FRC intends to consult on changes to it later in the year.

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.