The Governance Agenda - Priorities for boards in 2021

It seems, finally, that the light glimmering at the end of the COVID-19 tunnel isn’t just an oncoming train with its throttle open. Let’s hope so. What is certain is that boards have more on their plate than ever and it’s no exaggeration to say that some of the issues are of acute importance. What follows are my views on some of the priority areas.

Corporate governance and the future of audit - time to have your say

While dealing with the present, it’s important to have one eye on the future. Most will already be aware of the government consultation on Restoring trust in audit and corporate governance precipitated by various corporate failures including Carillion, Patisserie Valerie and BHS. In principle, many proposals have merit; in practice, they will come at a considerable cost. Can the government walk the tightrope of reducing investment risk through proportionate "improvements" to governance and increases in compliance while at the same time promoting growth and investment? 

The longer time in which to respond to the proposals reflects the extent of them, so there’s still a reasonable period in which to make one’s views known. This is especially important on those issues which will have the most significant impacts, legally and financially:

• executive and external assurance on the effectiveness of internal controls;
• the scope and operation of company "Resilience Statements";
• the practical implications of "Audit and Assurance Policies";
• significant proposals as regards the enforcement of directors' duties and
• proposals intended to close the "audit expectations gap" - imposing obligations on both auditors and directors in relation to the detection and prevention of material fraud.

You can find more detail here.

Lord Hill’s UK Listing Review proposals to relax significantly certain aspects of the equity capital markets regime - including allowing dual class share structures and reducing the current free float requirements - are part of the government’s plans to stimulate growth. While Hill compellingly argues that his reforms are necessary to level the playing field with other jurisdictions, they come with the risk of watering down the effectiveness of our system of governance, specifically the ability of institutional shareholders to hold boards to account. There’s a growing body of evidence which concludes that companies with active significant shareholders are better governed and more successful over the long term. A tightrope indeed.

Once implemented, the reforms will be hard to row back from, both politically and practically. Do have your say. 

Risk, going concern and viability - clarity above all else

The impact of COVID-19 means that some businesses have thrived, some have just survived, and some are likely to be on borrowed time. For listed companies this demands a need for real clarity in communications with stakeholders, and particularly investors, on issues of risk, assessments of and any conditionality in relation to going concern assessments, and scenario analysis and assumptions in relation to statements of viability. All will be closely scrutinised by investors and the Financial Reporting Council (FRC) alike; resorting to boilerplate won’t cut it. An issue to interrogate when producing and finalising annual reports this year.

Corporate purpose - is yours meaningful and embedded?

With such significant levels of risk and, arguably, potential opportunity comes a need to reflect on business foundations. An increasingly popular view, certainly at the FRC, is that this starts with an evaluation and explanation of a company’s purpose, it’s "licence to operate".

There’s no legal obligation to state what that purpose is (although it's easy to see that changing), but related statements on issues such as strategy, culture, values, and stakeholder engagement are so much more meaningful when set in the context of a clearly articulated corporate purpose.

More importantly, clarity of purpose creates a logical grounding for decision-making. And yet, according to Grant Thornton’s 2020 Governance Review, only 6% of companies measure (or at least report) the impact of their corporate purpose, suggesting that purpose is not currently the "North Star" that it should be.

Many companies stated their purpose in their 2020 annual reports. However in doing so some laid bare a confusion between the concepts of purpose: why a company exists; vision: where it wants to be; and strategy (or mission): how it intends to reach those sunny uplands.

There should be no criticism attached to reappraising purpose. Periodic re-evaluation is good governance, after all. And in undertaking any review it’s crucial to involve relevant stakeholders, particularly employees, not least to ensure that there’s genuine ownership and use of the concept beyond the boardroom.

Corporate culture - moving beyond the warm words

The UK Corporate Governance Code (Code) recommends that boards assess and monitor culture, explain any activities and particularly any corrective action taken to address misalignment between desired culture and corporate purpose, values and strategy.¹ This creates an opportunity to show how important the issue is and how truly embedded a company’s purpose and, by extension, its values are.

And yet there’s clear room for improvement: in 2020 nearly half of the FTSE 350 failed to explain what sources of information and data points they use to monitor culture². According to the FRC, those that do rely excessively on employee surveys and board site visits; and while both have their place, they are only part of a meaningful monitoring programme. In short, other issues, both internal and external, need to be evaluated to create a complete picture and enable the board to judge and react to any misalignment.³ The quality of disclosure would suggest that’s not happening.

Climate change - the time is now

Many companies are starting to get to grips with the considerable issue of their response to climate change, not only the physical and transition risks but also the opportunities it presents. And then there’s reporting. The Financial Conduct Authority (FCA) has recently reminded issuers of their existing obligations of disclosure as regards ESG matters, including climate change. More significantly for those with a premium listing, the clock is ticking on a new era given the need for them to disclose on a (very limited) "comply or explain" basis in accordance with the Taskforce on Climate-related Financial Disclosures Recommendations in 2022. In fact, the Investment Association expects companies in "high risk" sectors⁴ to report this year and provide “decision-useful” information when they do so.

It is (yet another) issue that requires board level sponsorship and the genuine empowerment of management. It’s also vital for it not to exist in a silo; one’s approach to it needs to flow from purpose and be integrated with strategy. And long-term targets, many of which extend well beyond the likely tenure of board members, need to be accompanied by interim milestones so that progress can be measured and scrutinised along the way. The Climate Disclosure Standards Board’s and Sustainability Accounting Standards Board’s TCFD Good Practice Handbook and TCFD Implementation Guide remain key resources for those starting out.

Stakeholder engagement - be clear on what happened next

The issue of stakeholder engagement generally has come into sharp focus through the rise in the importance of ESG and the need to report on these issues through a combination of section 172 statements and various recommendations of the Code. While companies have generally done a  good job in setting out who their stakeholders are and how they have engaged with them, descriptions have tended to lack the crucial discussion of the impact of those interactions on the decision-making process, the subsequent actions taken and outcomes of those actions. Companies need to answer the questions: why did we engage?; what did we learn?; and what did we do with what we learnt? Without that information, it’s hard to assess whether stakeholders’ interests were taken into account when directors took significant decisions in accordance with their duties. Fundamentally, that’s the point of the reporting obligation.

Diversity, inclusion and succession - work still to do

While the government trumpets the FTSE 350 having exceeded the Hampton-Alexander Review target of 33% of women on boards, others, including the Institute of Directors have highlighted the lack of sufficient progress in fostering diversity at senior executive level. With notable exceptions, aspirational targets continue to be achieved through the appointment of female non-executives as opposed to the promotion of home grown executive talent. Arguably, it’s a case of hitting the target but missing the point. Progress on the equally important issue of ethnic diversity appears to have all but ground to a halt. And as for succession planning, all too often board departures precipitate a hiatus of some months suggesting those plans aren’t where they should be.

Against this backdrop, it is unsurprising that the quality of Nomination Committee reporting continues to leave a considerable amount to be desired. With the FCA stating that diversity is a regulatory priority, it’s time for diversity and inclusion policies to be refreshed, targets to be laid bare, and succession plans to be revised. 

Comply or explain - in the last chance saloon?

In many ways, the current consultation on audit and corporate governance can be looked on as a warning not to take the Code and its "comply or explain" flexibility for granted. The FRC has, in effect, sounded  the alarm by issuing yet another reminder of what a satisfactory explanation for departing from Provisions of the Code looks like. It has done so every year for well over a decade, with an increasing tone of exasperation, particularly as it has also started to hone in on instances of companies departing from the Code and yet providing no explanation at all.

The plea in mitigation is, for many companies, that departures from Code Provisions are infrequent occurrences making for unfamiliar disclosures and boilerplate explanations. That excuse needs to be consigned to history. It doesn’t take a great leap to imagine a further significant corporate failure precipitating a wholesale attack on the Code’s foundations – resulting in more prescription, more regulatory scrutiny, the need for more external assurance, all to the detriment of a company’s ability to shape its own governance. McKinsey research suggests that 30% of a company’s value is at stake from regulation - this includes downside risk from punitive regulation if the company is seen as failing stakeholders. For that reason, it’s vital that companies play their part on what some may see as a relatively perfunctory disclosure issue. I suppose a catastrophizing lawyer would say this, but the detail really does matter.

1. Provision 2.
2. Grant Thornton 2020 Governance Review, page 24.
3. The FRC’s Guidance on Board Effectiveness remains a good starting point.
4. High risk sectors are stated to be: "Financials; Energy; Transportation; Materials and Buildings; and Agriculture, Food and Forest Products".