FRC proposes new UK Corporate Governance Code

The Financial Reporting Council has published for consultation a shorter, sharper UK Corporate Governance Code that places greater emphasis on stakeholders (particularly the workforce), diversity, integrity, corporate culture and how a company’s overall governance contributes to its long-term success. All premium listed companies will need to report against the revised Code in respect of accounting periods beginning on or after 1 January 2019.

The proposed new Code is open for consultation until 28 February 2018 and the FRC aims to publish the final version by early summer 2018. However, because the FRC says it has had extensive discussions with the Government, and the proposals have also been subject to a pre-consultation exercise involving a broad range of stakeholders, the FRC is unlikely to change its proposals radically.

In updating the Code, the FRC has responded to a number of recent reports and initiatives, including the Government’s Green Paper Consultation on Corporate Governance Reform, which was published in August; the House of Commons’ Business, Energy and Industrial Strategy Committee’s Report on Corporate Governance, which was published in April; the FRC’s own 2016 report on Corporate culture and the role of boards; and the Hampton-Alexander Review and Parker Review reports on diversity.

At the same time, the FRC has published for consultation a revised version of its related Guidance on Board Effectiveness. It has also initiated a high-level consultation on the future direction of the UK Stewardship Code, with a formal consultation on proposed changes due next year.

No changes are proposed at this stage to the FRC’s other related Guidance on Audit Committees and Guidance on Risk Management, Internal Control and Related Financial and Business Reporting.

Proposed changes to the Code

Structure

The FRC has fundamentally re-written the Code. The revised version is shorter and more concise than the existing version, comprising 17 Principles and 41 Provisions divided into five sections:

Section 1 - Leadership and purpose

Section 2 - Division of responsibilities

Section 3 - Composition, succession and evaluation

Section 4 - Audit, risk and internal control

Section 5 - Remuneration

Structurally, at least, the changes are the most extensive since the Code was overhauled after the Higgs report in 2003. In terms of substance, many of the existing Principles and Provisions will be retained but in a re-cast form; others will be moved into the Guidance on Board Effectiveness (because the FRC believes the desired practices are already embedded in company behaviour, not because they are no longer important); and a small number will be deleted altogether. Most of the proposed changes are in the first three sections, which broadly correlate to Sections A (Leadership) and B (Effectiveness) in the existing Code. The existing Provisions relating to audit, risk and internal control will remain largely unchanged.

Content

Proposed changes to the Code include:

• More emphasis on a company explaining to its shareholders how it has applied the Principles – for example, why the board has implemented certain structures, policies and practices. The Principles should then be linked to the company’s strategy and business model, and related to outcomes achieved. Companies should then state the extent to which they have complied with the Provisions, and explain any non-compliance, taking into account their own particular circumstances.
• The board should establish a method for gathering the views of the workforce (which could include workers, agency workers and contractors, as well as employees). This could be a director appointed from the workforce; a formal workforce advisory panel; or a designated non-executive director. Companies are free to choose the method that best suits their particular circumstances – or indeed to explain why they do not use any of these methods. (For background on this see our LawNow published on 12 December 2016, “Government consultation on strengthening the voice of employees and other stakeholders in large companies and improving corporate governance in large unquoted companies”.)
• The board should explain in the annual report how it has engaged with the workforce and other stakeholders, and how their interests and the matters set out in section 172 of the Companies Act 2006 have influenced the board’s decision-making. Section 172 sets out the primary duty of directors to promote the success of their company for the benefit of its members as a whole, taking into account various factors – e.g. the long term consequences of decisions; the interests of the company’s employees; the impact of the company’s operations on the community and environment; the need to foster good relationships with suppliers and customers; and the desirability of maintaining a reputation for high standards of business conduct.
• The chair of the board should seek regular engagement with major shareholders to understand their views on governance and performance against strategy. The chairs of the remuneration, audit and nomination committees should engage with shareholders on significant matters for which their committee is responsible.
• Boards as a whole, and nomination committees in particular, will be more strongly encouraged to ensure that they consider the importance of diversity - in gender, social and ethnic background - when making appointments, planning for board succession and managing the executive pipeline. Among other things, all companies will have to include in their annual report details of actions taken to increase diversity and inclusion (although they will not be expected to provide data on levels of diversity other than for gender), and of the gender balance on the executive committee and among those who report directly to it.
• Where more than 20% of votes have been cast against a resolution, the company should explain the steps it intends to take to consult shareholders in order to understand the reasons behind the result. As an interim step, no later than six months after the vote, an update must be published. As the final step, in the annual report, or in the explanatory notes to resolutions at the next meeting, the board should explain how it has responded to the feedback received.
• Companies below the FTSE 350 will be subject to all the Principles and Provisions of the Code. (Currently, such companies do not need to comply with certain provisions relating to board composition, board evaluation, annual re-election, and audit and remuneration committee composition.)
• The rules on the independence of non-executive directors and chairs will be strengthened. In particular:

o The chair of the board must demonstrate independence and meet the stated independence criteria throughout their tenure (not only on appointment).

o All directors should be subject to annual re-election. (At present, companies below the FTSE 350 do not need to comply with this Provision.)

o If a non-executive director or the chair does not meet the criteria in the Code for independence, they should not be considered independent. (Under the existing Code, the board is entitled to conclude that a director is independent in character and judgement even if they do not meet the criteria.) However, the FRC seeks views on whether nine years is the right period after which a director should prima facie no longer be considered independent.

Where an individual is appointed as an independent non-executive director and after, say, five years steps up to become chair of the board, their period in office as a non-executive will count towards the nine years. As a result, if the “nine year rule” is retained, under the Code the individual would cease to be treated as independent, and would be expected to resign from the board, after only four years. Unless this Provision is changed, some companies will probably choose to explain why they do not comply with it.

• As the chair must be considered independent at all times, the new Code will specify that, for all companies, “independent non-executive directors, including the chair, should constitute the majority of the board.” (At present, for FTSE 350 companies, “at least half the board, excluding the chairman, should comprise non-executive directors determined by the board to be independent”. For companies below the FTSE 350, the board should include at least two independent non-executive directors.)

In relation to executive remuneration and the role of the remuneration committee, various changes are also proposed: these are discussed in our LawNow article published on 6 December 2017, “Revised UK Corporate Governance Code - Remuneration aspects”.

Documents

The FRC’s consultation paper, including the proposed new Code and Guidance on Board Effectiveness, can be found here.