After what has probably been the most exhausting proxy season for investors and issuers alike, the regulatory momentum shows no sign of easing. The new UK Corporate Governance Code goes live for all companies reporting to shareholders on or after 1 October 2014.
Regarding the changes, the Financial Reporting Council (FRC) CEO Stephen Haddrill commented that the updated Code is, “designed to strengthen the focus of companies and investors on the longer term and the sustainability of value creation.” The revisions aim at enhancing accountability of the Board and transparency of the information shareholders receive. The changes largely reflect the general direction and views of emerging best practice and shareholders’ views and expectations and can be grouped into five key areas.
1) Going Concern Statement
The revised Code partly implements the reforms proposed by Lord Sharman in his 2012 report on Going Concern and Liquidity Risks, the report has been the subject of much debate on the assessment and reporting of risk and business prospects between investors, issuers and regulators since its publication. A new requirement for a “viability statement” has been introduced in addition to the going concern statement. Companies can choose where to include the viability statement, although it is likely to be included in the strategic report to shareholders and therefore covered by the “safe harbour” provisions in the Companies Act 2006.
The viability statement presents the most interesting revision and will provide the structure for an improved and broader assessment of long-term solvency and liquidity which is expected to look forward significantly longer than 12 months. However, directors can only report on the information they have available in the ‘here and now’, after all directors cannot predict the future. Nonetheless, the statement will encourage long-term thinking and provide Companies with the ability to conduct a narrative qualitative assessment of the long-term health of the Company in addition to the going concern statement and the strict accounting standards that it comes with.
2) Risk Management and Internal Control
In addition to the new viability statement the requirements relating to the principle risks facing their business and the explanation of how they are being managed or mitigated have been strengthened, companies are encouraged to demonstrate that a “robust assessment” has been undertaken in these regards. Companies are also now required to provide a clear report on the outcomes of the effectiveness review of the overall risk management and internal control systems.
3) Remuneration
In line with developing best practice there is an increased focus on the alignment of executive remuneration with the long-term success of the Company with the lead responsibility resting with remuneration committees. The changes present a shift of focus from the attraction and retention of directors to a focus on “aligning reward with the sustained creation of value”. Some of the changes introduced in Schedule A to achieve this focus include the consideration of requiring directors to hold shares for a period after leaving the company and whether periods longer than three years are appropriate for the exercising of share options. Although investors concerned with high pay levels will be disappointed that “a company should avoid paying more than is necessary” has been moved from the main principles into the supporting principles.
However, investors will welcome the new requirements that Boards will now need to ensure that arrangements are in place to enable them to “recover or withhold variable pay when appropriate to do so” on a comply-or-explain basis. Best practice in clawback arrangements are evolving rapidly and also come off the back of the publication of new policy statement on clawback by the Prudential Regulation Authority (PRA) in July which will come into force on 1 January 2015. The new PRA rules introduces a minimum seven year period starting from the date of award for clawback and includes deferred bonus payments and will apply to banks only.
4) Shareholder Engagement
To encourage company shareholder dialogue companies will now need to explain when publishing general meeting results how they intend to engage with shareholders when a significant percentage of shareholders have voted against any resolution. This may seem a straight forward provision and one may expect companies to already do this, although experience suggests otherwise. What actually constitutes a significant percentage is left open to interpretation by companies. Withheld and abstention votes are not included in considering the level of shareholder dissent although such votes demonstrate a withholding of support for management by shareholders. Finally it is important that companies avoid boiler-plate statements regarding the reporting of engagement.
5) Other Issues
The preface has been revised to emphasise the importance of the board in establishing the correct “tone from the top” in corporate governance. The board should set standards and the directors should act in accordance with those standards in order to encourage good governance throughout the organisation.
The FRC has stated that board diversity will come back on the agenda in the 2016 Code Consultation. The FRC highlights the importance of diversity in ensuring the effective functioning of boards through achieving a dialogue which is both challenging and constructive. The 2016 Code consultation will follow the publication of Lord Davies’ fourth and final annual progress report on the attainment of the target of 25% women on FTSE boards in 2015. The Cranfield School of Management’s 2014 progress report expressed an expectation that the FTSE100 and FTSE250 should reach the Davies target by 31 December 2014. Legal and General Investment Management has already intimated that it will be strengthening its voting stance based on diversity issues.
Conclusion
The FRC normally reviews every two years whether the Code needs to be updated and has already noted that in addition to Board diversity further Code changes will be likely in 2016 as a result of the Government’s implementation of the EU Audit Directive and as follow up to the report by the Competition and Markets Authority (formerly the Competition Commission) on the market for audit services in FTSE 350 companies.
The ongoing development of corporate governance in the UK doesn’t look to be grinding to a halt in the near future. Overall, however the Code changes largely follow existing or emerging institutional best practice placing emphasis on long-term sustainable value creation. This should reassure those companies who are concerned that investors continue to make governance more complex or unnecessarily demanding or that the UK is simply gold-plating EU directives.
Further Reading:
Financial Reporting Council (2014) “The UK Corporate Governance Code”. Published 17 September 2014 (https://www.frc.org.uk/Our-Work/Publications/Corporate-Governance/UK-Corporate-Governance-Code-2014.pdf)
Financial Reporting Council (2014) “Feedback Statement – Revisions to the UK Corporate Governance Code”. Published 17 September 2014 (https://www.frc.org.uk/Our-Work/Publications/Corporate-Governance/Feedback-Statement-Revisions-to-the-UK-Corporate-G.pdf)
Last Updated: 3 October 2014