Corporate governance reform: the Government proposals are published

The Government has published nine headline proposals for corporate governance reform. These rely heavily on further action to be taken by the Financial Reporting Council, in particular, through changes to the UK Corporate Governance Code. Companies are to be encouraged to take greater account of shareholder views on executive pay and of their responsibilities to other stakeholders.

The Government also intends to introduce some new reporting requirements through secondary legislation (including pay ratios) and to invite relevant industry bodies to develop practical guidance on directors’ duties and voluntary best practice principles for large private companies. At the same time, the FRC, Financial Conduct Authority and Insolvency Service are to work more closely together to ensure the most effective use of existing powers to sanction directors and ensure the integrity of corporate governance reporting.

Businesses of all types will need to consider how to deal with these measures, as and when they are developed. Nevertheless, it is helpful that proposals which seemed likely to cause legal and practical difficulties have been dropped, such as increasing the duties of directors, requiring companies to put employee representatives on their boards and further restrictions on executive pay.

The reforms are intended to be brought into effect by June 2018 and to apply to company reporting years beginning after that date. The FRC has already confirmed that it supports the government’s proposals and will deal with them when consulting on the UK Corporate Governance Code later this year.

Executive pay

Issues of concern identified include: a rise in executive pay outstripping corporate performance, a minority of companies disregarding negative shareholder votes on pay, remuneration committees failing to take account of wider workforce pay and conditions when setting executive remuneration and the complexity and uncertainty of executive pay, especially when it comes to long-term incentive plans.

The Government proposes to:

1. Invite the FRC to revise the UK Corporate Governance Code to:

  • be more specific about the steps that premium-listed companies should take when they encounter significant shareholder opposition to executive pay policies and awards (and other matters),
  • give remuneration committees a broader responsibility for overseeing pay and incentives across the company and require them to engage with the wider workforce to explain how executive remuneration aligns with wider company pay policy (using pay ratios to help explain the approach where appropriate), and
  • extend the recommended minimum vesting and post-vesting holding period for executive share awards from 3 to 5 years to encourage companies to focus on longer-term outcomes in setting pay.

2. Introduce secondary legislation to require quoted companies to:

  • report annually the ratio of CEO pay to the average pay of their UK workforce, along with a narrative explaining changes to that ratio from year to year and setting the ratio in the context of pay and conditions across the wider workforce; and
  • provide a clearer explanation in remuneration policies of a range of potential outcomes from complex, share-based incentive schemes.

3. Invite the Investment Association to maintain a public register of listed companies encountering shareholder opposition to pay awards of 20% or more, along with a record of what these companies say they are doing to address shareholder concerns.

In addition, the Government intends to commission a review of share buybacks and the extent to which these artificially affect performance targets and inflate executive pay. The review also aims to consider concerns that share buybacks interfere with the allocation of surplus capital to productive investment. More details are to be announced shortly.

Strengthening employee, customer and supplier voice

According to the Government, there is strong support for improving the extent to which stakeholders are heard in the boardroom, because this should lead to more sustainable business performance, as well as reassuring the public that companies recognise their responsibilities to employees, suppliers, customers and wider society.

Section 172 of the Companies Act 2006 requires the directors of a company to have regard to these wider interests in pursuing the success of the company. The Government aims to make this duty work more effectively through improved reporting, changes to the Code and increased awareness, as set out in the following proposals:

  • secondary legislation is to be introduced to require all companies of a significant size, (whether private or public) to explain how their directors comply with the requirements of Section 172 to have regard to employee and other interests;
  • the FRC will be asked to develop a new Code principle which establishes the importance of employee and stakeholder voice at board level as key to running a sustainable business. There will also be a specific Code provision, against which premium-listed companies will need to “comply or explain”. This will require companies to introduce one of three employee engagement mechanisms: a designated non-executive director; a formal employee advisory council; or a director from the workforce; and
  • industry will be asked to participate in creating solutions, including joint guidance from ICSA and the Investment Association on practical ways for companies to engage with employees and other stakeholders and new GC100 advice and practical guidance on how to deal with the S.172 CA 2006 duty.
Private businesses

In response to concerns about the extent to which large privately-owned businesses can be held accountable for matters affecting their employees, suppliers, customers and other stakeholders, the Government proposes developing best practice standards for all large entities, regardless of their legal status.

The proposals include:

  • inviting the FRC to work with the Institute of Directors, the CBI, the Institute for Family Businesses, the British Venture Capital Association and others to develop a voluntary set of corporate governance principles for large private companies, and
  • introducing secondary legislation to require all companies of a significant size (unless already subject to existing reporting requirements) to disclose their corporate governance arrangements in their Directors’ Report and on their website, including whether they follow any formal code. The Government will also consider extending a similar requirement to large LLPs.
Other issues

To deal with concerns about whether the FRC has the powers, resources and status to undertake its functions effectively the Government intends to ask the FRC, the Financial Conduct Authority and the Insolvency Service to conclude new or revised letters of understanding with each other before the end of this year to ensure the most effective use of their existing powers to sanction directors and ensure the integrity of corporate governance reporting. The Government will also consider whether further action is required.

Next steps and timing

The FRC has confirmed it will consult on amendments to the UK Corporate Governance Code later this Autumn. The necessary draft secondary legislation is to be laid before Parliament before March 2018 and the Government has promised that, where necessary, there will be consultation on the detail of this secondary legislation. The work on developing voluntary corporate governance principles for large private companies is intended to commence in this Autumn.

The current intention is to bring the reforms into effect by June 2018 to apply to company reporting years commencing on or after that date.

Background

The Government’s Green Paper consultation on corporate governance reform was issued last November (see here for our alert) and responses to this form the basis of the current proposals. Evidence for the actions proposed has also been taken from the Parliamentary Select Committee’s report on Corporate Governance published last April.