Ashurst Governance and Compliance Update - Issue 29

1. FRC consults on a new minimum standard for audit committees

The FRC has published a consultation on its draft proposal for a minimum standard for audit committees of UK incorporated, premium listed companies included in the FTSE 350 index.

The consultation follows the government's response to its Restoring Trust in Audit and Corporate Governance White Paper, which set out its intention to give the FRC's successor body – the Audit, Reporting and Governance Authority (ARGA) - statutory powers to mandate minimum standards for audit committees. More detail on the government's response and proposed reforms can be found in AGC update, Issue 20; more detail on the work of the FRC as set out in its July Position Paper can be found in AGC update, Issue 22.

The purpose of the standard is to increase performance across audit committees in the FTSE 350, ensuring a consistent approach and supporting a 'well-functioning audit market'. The FRC is now seeking the views of its stakeholders on the draft standard, particularly those of FTSE 350 companies.

The standard focuses on the role of the committee as regards the external audit, specifically:

• the appointment of the auditor and the associated tendering process;
• the ongoing oversight of the audit and the auditor; and
• reporting on the work of the audit committee in respect of the audit and compliance with the standard.

The standard should be read in conjunction with the UK Corporate Governance Code and the FRC Guidance on Audit Committees; it is not intended as a replacement. Audit committees should continue to follow the Code and associated guidance on a 'comply or explain' basis.

Following the consultation, the plan is for the standard to be available to committees on a voluntary basis by the end of 2023, ahead of the planned legislation that will make the standard mandatory. Companies aspiring to join the FTSE 350 are encouraged to follow it on a voluntary basis. Even where a company has no plans to grow to that size, if it is subject to mandatory tendering and rotation of audit firm appointments, the FRC suggests that it may wish to apply the standard in any event.

Comments on the standard should be submitted to the FRC by close of business on 8 February 2023.

2. FRC sets out the principles for 'public interest test' in its review work

The FRC has published a set of principles that it will use to assess whether the public interest is best served by carrying out regulatory, supervisory and enforcement work that is outside of its primary 'regulatory perimeter'.

In the response to its White Paper on Restoring Trust in Audit and Corporate Governance, the government committed to expanding the definition of a public interest entity (PIE) to include companies with over 750 employees and a turnover of over £750m. The FRC expects that much of the scope of ARGA’s work will be determined by this new definition. However, the government also recognised there will be exceptional circumstances where ARGA should take regulatory action in areas of public interest that are not within this regulatory focus.

The principles form the basis of the public interest considerations ARGA will take into account when determining whether it would be appropriate to act. Broadly, the principles focus on whether, taken together:

• there is a need to take regulatory action to maintain justifiable public confidence, for example in relation to regulated professions, corporate reporting or corporate governance as a whole;
• the nature, extent, scale and gravity of the matter gives rise to a serious public concern and currently or potentially:
  • concerns a body of 'systemic importance' or a public company;
  • affects a significant number of people;
  • causes (or has the potential to cause) significant financial loss or other harm; and/or
  • relates to criminal, illegal, fraudulent or unethical behaviour;
• it would be proportionate to undertake the action or activity, giving due consideration to whether the relevant regulatory action is being taken by another regulator.

The FRC has committed to producing a yearly report explaining how its regulatory scope applies to each of its functions, highlighting where it has taken any decision to go beyond it. The principles themselves will be subject to periodic review.

3. UK Transition Plan Task Force publishes consultation on Disclosure Framework and Implementation Guidance

The UK Transition Plan Taskforce (TPT) has published for consultation a draft Disclosure Framework and Implementation Guidance which set out recommendations to support companies when preparing and disclosing climate transition plans. The TPT has also launched a 'Sandbox' for companies and financial institutions to help users and preparers create their own transition plans. By way of reminder, the TPT was announced by the government at COP26 to develop the gold standard for private sector climate transition plans.

Current market context

Companies are not currently required to publish a transition plan, albeit that it is an expectation of reporting against recommended TCFD disclosures. In short, the FCA's Listing Rules require in-scope listed companies to report against the TCFD recommendations and recommended disclosures, and similar TCFD-aligned disclosures are now required of a wider cohort of companies, including larger private companies, in the new 'non-financial and sustainability information statement' which must be located in their strategic report.

Disclosure Framework

The Framework makes draft recommendations for companies and financial institutions on developing their climate transition plans. It emphasises the need for short-term action by companies and financial firms and a consideration of how to prepare for the economy-wide transition to net-zero.

In summary, the TPT recommends that a good transition plan should address:

• an entity's ambitions to mitigate, manage and respond to the changing climate and to leverage opportunities of the transition to a low greenhouse gas (GHG) and climate resilient economy, including GHG reduction targets;
• short, medium and long-term actions the entity plans to take to achieve its strategic ambition, alongside details on how those steps will be financed;
• governance and accountability mechanisms that support delivery of the plan and robust periodic reporting; and
• measures to address material risks to, and leverage opportunities for, the natural environment and stakeholders, such as the workforce, supply-chains, communities or customers which arise as part of these actions.

Implementation Guidance

The Guidance sets out the steps to be taken in developing a transition plan, as well as when, where, and how to disclose it. Entities should publish standalone transition plans at least every three years, or sooner where significant changes are made to the plan. Progress on or amendments to plans should be reported annually as part of existing TCFD reporting or International Sustainability Standards Board-aligned disclosures in general purpose financial reporting. Transition plans must be clearly separate from other existing disclosure obligations or reports (i.e. presented as an appendix or separate document).

Next steps

The Framework and Guidance are open for public consultation until 28 February 2023. Feedback from the consultation and the Sandbox will then be used to finalise the Framework and Guidance which the FCA intends to draw on to strengthen its transition plan disclosure expectations for listed companies, asset managers, and regulated asset owners. The FCA will also consult at some point in the next two years on changes to the Listing Rules to reference the final ISSB standards, once adopted in the UK.

Item contributed by Lorraine Johnston, Partner in our Financial Regulation team

4. Centre for Climate Engagement launches Law and Climate Atlas

Ahead of COP27, the Centre for Climate Engagement at Hughes Hall, University of Cambridge has launched the Law and Climate Atlas – an online resource to help lawyers 'drive the transition to net zero'.

The Atlas maps intersections between climate change and law to bring focus to how climate change impacts many different areas of law – and how each area, and those providing legal advice on them, can help to drive change.

5. Glass Lewis publishes 2023 proxy voting policy guidelines

Glass Lewis has published its 2023 proxy voting policy guidelines for the UK which set out its approach to assessing all topics on the annual general meeting agenda. This follows ISS's consultation on its own guidelines which we covered in AGC update, Issue 28.

Changes from the 2022 Glass Lewis guidelines include:

• External commitments / overboarding: A director will be considered to have a potentially excessive commitment level when they serve as an executive officer of any public company while serving on more than one additional external public company board. Glass Lewis previously considered a director to be overcommitted if they had more than two additional external roles on public company boards.
  
  Note that non-executive board chair positions at UK companies will continue to count as two board seats given the increased time commitment generally associated with these roles. The guidelines are also unchanged as regards Glass Lewis' view that a non-executive director will be considered to be overboarded if (s)he is appointed to more than five public company boards in total.
  
  The change brings Glass Lewis more closely into alignment with ISS which considers an executive director to be overboarded if they are also a non-executive chair at another company.
• Director accountability for climate-related issues: Glass Lewis believes that climate risk is a material risk for all companies and that companies, particularly those whose greenhouse gas emissions represent a financially material risk, should provide clear and comprehensive disclosure of their risks, including how they are being mitigated and overseen.
  
  Where companies with increased climate risk exposure have not provided thorough TCFD-aligned climate-related disclosure and/or have not explicitly and clearly defined board oversight responsibilities for climate-related issues, Glass Lewis may recommend voting against a responsible member of the board or other relevant agenda item(s).

Additional issues to note include:

• Gender diversity at board level: The guidelines note the FTSE Women Leaders targets and those of the Parker Review are now largely enshrined in new disclosure obligations in the Listing Rules. These are of application, on a 'comply or explain' basis, to in-scope listed companies for financial periods commencing on or after 1 April 2022.
  
  Glass Lewis will monitor progress towards best practice in 2023, and will consider recommending against the nomination committee chair in subsequent years in cases where a board has made insufficient progress, and has not disclosed any cogent explanation or plan to address the issue. In egregious cases where a board has failed to address legitimate shareholder concerns regarding the diversity of ethnicity and national origin at board level, it may also recommend that shareholders vote against the re-election of the chair of the nomination committee.

• Issuing shares without pre-emptive rights: The guidelines take account of the revised Statement of Principles issued by the Pre-Emption Group.
  
  In line with the revised Principles, Glass Lewis will support:
  • proposals to disapply pre-emptive rights for a maximum of 10 per cent of the issued ordinary share capital of the company for general use. 
  • authorities requesting up to 20 per cent of current issued share capital when the board provides an assurance that the portion of the authority in excess of 10 per cent will be limited for use in connection with an acquisition or specified capital investment.
  • proposals where an additional two per cent of current issued share capital is requested for the purposes of 'follow-on' issuances (as defined by the Pre-Emption Group), under either, or both, of the 10 per cent limits.
  
  In undertaking any such issuance, Glass Lewis expects the Pre-Emption Group’s guidance to be followed, for example, on issues such as consultation, structuring and disclosure. Where a company completes a significant issuance and fails to adhere to best practice, Glass Lewis may consider recommending against subsequent general authorities to issue shares non-pre-emptively.
  
  As regards specific authorities to issue shares for a specific purpose outside of routine authorities, Glass Lewis has clarified its approach. In short, it will review proposals on a case-by-case basis, considering the total number of shares to be issued and the dilutive impact on shareholders; the issuance price and discount/premium; and the intended use of proceeds from the issuance in the context of the company’s financial position and business strategy.

Other clarifications to the guidelines include:

• Board composition / independence: Glass Lewis clarifies that employee representatives will not be included in calculations of whether half the board is independent.
• Cyber risk oversight: Glass Lewis believes that cyber risk is material for all companies and that a company’s stakeholders would benefit from clear disclosure regarding the role of the board in overseeing issues related to cybersecurity.
  
  While voting recommendations will not be made on the basis of a company’s oversight or disclosure concerning cyber-related issues, Glass Lewis may recommend voting against the re-election of appropriate directors in instances where cyber-attacks have caused material risk to shareholders and the company’s disclosure or oversight is found to be insufficient.
• Pensions: Glass Lewis expects pension provisions for executive directors, both those newly appointed and incumbent executives, to be in line with those available to the majority of the wider workforce by the end of 2022, absent a cogent rationale. This is in line with the views of the Investment Association – see Item 6 on Directors' Remuneration later in this update.
• Combined Incentive Plans: Omnibus plans should generally have a minimum vesting period of three years, at least part of the award should be in the form of equity or equity-based instruments, quantitative underpin/gateway conditions should apply to deferred awards, and there should be some strategic rationale provided for the plan.
  
  Where a company is amending its incentive structure to adopt a combined incentive plan while removing existing variable incentive plans, it is expected that there will be a substantial reduction in the total target and maximum award opportunity, appropriately reflecting the reduction in the risk profile of the plan.
• Linking executive pay to environmental and social criteria: Glass Lewis believes that shareholders of companies which have not included explicit environmental or social indicators in their incentive plans would benefit from additional disclosure on how the company’s executive pay strategy is otherwise aligned with its sustainability strategy.
• Remuneration Committee discretion: Glass Lewis recognises the importance of the remuneration committee’s 'judicious and responsible' exercise of discretion over incentive pay outcomes to account for significant events that would otherwise be excluded from performance results of selected metrics of incentive programmes. Nevertheless, it believes that companies should provide thorough discussion of how such events were considered in the committee’s decisions to exercise discretion or refrain from applying discretion over incentive pay outcomes.
  
  Again, use of remuneration committee discretion is an issue highlighted by the Investment Association, see Item 6 below.

6. IA publishes annual guidance on executive remuneration for 2023

The Investment Association has published its annual updated Principles of Remuneration for 2023, as well as a letter to remuneration committee chairs.

The letter highlights the IA's view of the principal issues of concern to investors which committees should consider, including the following:

• Stakeholder context to be considered: When setting remuneration levels, remuneration committees should take into account factors such as the increased cost of living, the war in Ukraine, and the rise in energy prices. Shareholder and stakeholder 'experience' should be factored into remuneration decisions, and remuneration committees should approach the need to incentivise executives within that context. Remuneration committees should also communicate clearly the approach they have taken.
• Inflation-linked increases should be avoided: Given the rise in inflation, remuneration committees should show restraint in respect of executive director salary increases. Salary increases in line with inflation (which will have an impact on a director's total remuneration package) may not be appropriate, especially at a time when many employees will be forced to make significant sacrifices. If salary increases are needed (and all increases will need to be justified), then committees should consider increases below the rate of salary increases given to all employees.
• Variable pay restraint: Restraint should also be shown in respect of increases to variable pay. Any increases should be explained in the context of the business and delivery of company strategy. Economic uncertainty may also impact performance conditions. For example, wider performance targets and discretion may be required in order for companies to achieve appropriate outcomes.
• Avoiding windfall gains: The IA notes that remuneration committees are likely to be in the process of making vesting decisions in relation to long-term incentive awards granted in the 2020 Covid-19 pandemic. During the pandemic, more shares than usual were awarded by companies to reflect the fall in share prices. Therefore, it is important that remuneration committees consider whether vesting outcomes for these awards need to be reduced to ensure that overall outcomes are appropriate and windfall gains avoided. The remuneration report should explain the reasons for any reduction in the number of shares vested or conversely the rationale behind a decision not to adjust for windfall gains.
• Explaining use of ESG performance metrics: The IA notes the increase in the use of ESG-related performance metrics in respect of variable remuneration, particularly where companies have made net-zero commitments. It is important that companies articulate how they are incorporating ESG performance conditions, and how their approach to the use of ESG metrics will evolve in the future. ESG performance metrics should be linked to company strategy, be quantifiable and avoid unnecessary complexity.
• Alignment of pension contributions: By the end of 2022, the IA expects executive directors' pension contributions to be aligned with those available to the majority of the company’s workforce. The IA warns that in 2023, IVIS (the IA's corporate governance research arm) will 'red top' any remuneration policy or report where this is not the case.

There have not been any significant changes to the Principles of Remuneration themselves. However, there has been a minor update relating to non-executive director fees: the Principles set out investor support for non-executive directors to be paid fees which reflect the reality of time commitment, complexity and skillset required for their role.

7. EU Parliament adopts Corporate Sustainability Reporting Directive

Overview

The EU Parliament has adopted the new Corporate Sustainability Reporting Directive (CSRD). CSRD will replace the Non-Financial Reporting Directive (NFRD) and lead to more extensive non-financial reporting requirements for a larger number of companies. Specifically, CSRD provides for more detailed disclosures regarding the impact of a company's business on environment, human rights and social standards. Disclosures will be subject to audit by the company's statutory auditor.

The EU Commission adopted a first proposal for CSRD on 21 April 2021. The proposal was amended based on a provisional political agreement by the EU Council and the EU Parliament on 21 June 2022. A major change compared to the initial draft was the extension of the Directive's scope to include undertakings that are governed by the laws of a non-EU member state (including, therefore, the UK), and which generate a net turnover of more than EUR 150 million in the EU and have a subsidiary or branch in the EU. For more information on the proposals, please see Item 5 of AGC update, Issue 26.

The adopted version of CSRD does not provide for substantial changes compared to the proposal as amended on 21 June 2022.

Next steps

It is expected that the European Council will approve Directive on 28 November 2022 in order that it can be published in the EU Official Journal and become effective at the beginning of 2023. EU member states must then transpose its provisions into national law with a view to the requirements having operative effect in 2024 albeit on a phased basis as follows:

• For companies incorporated in a member state which are already subject to the reporting requirements of the NFRD: from 1 January 2024.
• For companies incorporated in a member state that qualify as "large undertakings" (defined in Art. 3 para. 4 of the Accounting Directive (Directive 2013/34/EU)) which are currently not subject to the reporting requirements of the NFRD: from 1 January 2025.
• For small and medium-sized companies incorporated in a member state and which are listed in the EU, small and non-complex credit institutions and captive insurance undertakings within the EU: from 1 January 2026.
• Non-EU incorporated companies in scope of the CSRD: from 1 January 2028.

Item contributed by Astrid Keinath, Counsel in our Frankfurt Corporate Governance team