Ashurst Governance & Compliance update - Issue 1

1. Changes to the UK market abuse regime

The Financial Services Act 2021 (Act) has been published. This makes the following changes to the UK's civil and criminal market abuse regime:

• Manager and associated persons transaction notifications. The Act makes a sensible change to the regime relating to the notification of transactions by persons discharging managerial responsibilities (PDMR) and those closely associated with them (PCA). When a PDMR or a PCA notifies an issuer that it has transacted in the issuer’s securities, the issuer will have two working days from receiving the notification to notify the market, rather than three business days from the date of the transaction as is currently the case. Note that a PDMR and a PCA must continue to notify the Financial Conduct Authority (FCA) and the issuer of the transaction within three business days of the date of the transaction.
• Insider lists. The Act clarifies that both an issuer and anyone acting on its behalf/its account are responsible for keeping an insider list.
• Enhanced sentencing. The Act also increases the maximum penalty for the criminal offences of insider dealing (under the Criminal Justice Act 1993) and market manipulation (under the Financial Services Act 2012) from seven to ten years.

The increases in criminal penalties take effect on a date yet to be determined. The other changes take effect from 29 June 2021.

Ashurst practice point: While the changes to transaction notification requirements are welcome in principle, they are unlikely to make a great deal of difference in practice given that the timeframe within which both a PDMR and a PCA must inform the FCA of any dealing remains (effectively) unaltered and the fact that many secretariats undertake such notifications for PDMR and PCAs in any event.

2. Glass Lewis publishes approach to 'Say on Climate' votes

Glass Lewis has published a position paper on companies' adoption of an annual shareholder vote on their climate strategies. In doing so, it notes that a number of both management and shareholder proposals dealing with a 'Say on Climate' are to be put to shareholders during the current AGM season. It also notes that there are two main varieties of management-sponsored proposals which either:

• establish a policy that would create the framework for the adoption of an annual vote on climate disclosure / strategy, or Say on Climate at future AGMs; or
• request shareholder approval of a company’s climate transition plan.

These are in contrast with shareholder proposals which broadly only request that companies adopt a Say on Climate proposal at future AGMs.

Various examples of each type of both management and shareholder proposal are set out.

Whilst Glass Lewis believes that there are benefits in adopting Say on Climate proposals – not least because they tend to precipitate the production of 'robust' Task Force on Climate-related Financial Disclosure (TCFD)-aligned reports - it is concerned at the prospect of various unintended consequences, including where investors lacking capacity or technical ability rubber stamp climate strategies which do not align with broader climate goals.

Given these concerns, Glass Lewis will look closely at the proposals being put to shareholders and will:

• generally recommend voting against management and shareholder proposals requesting that companies adopt a policy that provides shareholders with an annual Say on Climate vote on a plan or strategy; and
• when companies bypass that step and place their climate plans up for an advisory vote, Glass Lewis will evaluate those plans on a case-by-case basis. Specifically, it will look for context to have been provided as to how the company views the roles of the board and shareholders in executing these plans. In addition to evaluating governance, Glass Lewis will also evaluate companies' climate plans or ambitions. In instances where it believes that plans insufficiently address issues related to climate change, it may, instead of abstaining, recommend that shareholders vote against such plans.

3. IBE publishes board briefing on 'Ethics of Diversity'

The Institute of Business Ethics (IBE) has published 'Board Briefing: Ethics of Diversity' which presents a summary of the key conclusions and recommendations from the IBE's December 2021 report on ethics and the diversity of boards.

The IBE recommends that boards should:

• understand and explore the diversity of thought and experience on the board;
• ensure that the company's push for diversity and inclusion is a strategic and commercial imperative;
• look critically at the culture in the boardroom;
• review nomination and succession planning processes for all board and executive committee appointments;
• look critically at the individual roles assigned to board members;
• learn from the experience of improving gender balance on boards and from other sectors;
• understand the company's stakeholders and actively listen and respond to them;
• communicate aims and milestones internally and externally;
• learn from a 'more challenging' board evaluation; and
• recognise inequalities and racism as systemic risks to the economy and see diversity and inclusion as an opportunity for long term change.

4. QCA publishes ESG guidance for small and mid-sized companies

The Quoted Companies Alliance (QCA) has published a guide which provides small and mid-sized quoted companies with advice on the practical steps they can take to develop how they examine and disclose their approach to relevant environmental, social and governance (ESG) issues. The guide seeks to complement the QCA's Corporate Governance Code without being prescriptive.

The core message of the guide is that smaller companies should not consider ESG either as a compliance burden or as an agenda that only relates to larger companies. In fact, the QCA believes that, for smaller companies, their relative freedom from the 'burden' of ESG reporting regulations provides them with greater flexibility and, in turn, a compelling opportunity to 'tell their ESG story in an authentic, compelling and coherent manner' attracting new investors with a longer-term orientation. In doing so, the QCA recommends that companies examine five steps noted below, and provides corresponding practical actions to take in each case:

• Develop a clear purpose statement.
• Undertake an ESG materiality assessment.
• Be aware of what others are saying and be prepared to respond.
• Understand what data your company has and what data it will need to gather.
• Take control: decide what to disclose and where; be proactive in communicating.

The guide is available for free in electronic form to QCA members or for a fee of £85 + VAT for non-members.

5. ecoDa updates its guidance and principles for unlisted companies

The European Confederation of Directors' Associations (ecoDa) has published an updated version of its 'Corporate Governance Guidance and Principles for Unlisted Companies in Europe' focusing on ESG issues and why governance matters in unlisted companies. The non-binding guidance is aimed at start-ups, single owner-manager companies, family businesses, private equity-owned companies, joint ventures, and subsidiary companies, and addresses the issues involved in designing an appropriate corporate governance framework.

The updated guidance includes a self-evaluation questionnaire designed to facilitate the periodic assessment of the degree of application of the voluntary corporate governance principles, as well as define plans for the future.

6. AFME publishes report on ESG disclosures

The Association for Financial Markets in Europe (AFME) has published a 'Report: ESG Disclosure Landscape for Banks and Capital Markets in Europe'. The report sets out key elements of the EU regulatory landscape for ESG disclosures, as well as the Taskforce on Climate-related Financial Disclosures framework. In doing so, the AFME provides practical information on how financial institutions can navigate the requirements, many of which overlap.

7. EU Commission adopts sustainable finance package

The European Commission has adopted a package of measures designed to help improve the flow of money towards sustainable activities across the EU. The package of measures is comprised of:

• Political agreement being reached on the text of the EU Taxonomy Climate Delegated Act, which introduces a set of technical screening criteria to define which activities substantially contribute to two of the environmental objectives under the Taxonomy Regulation - i.e. climate change adaptation and climate change mitigation. It currently includes sectors such as energy, forestry, manufacturing, transport and buildings but it will continue to evolve over time. It is intended that the Delegated Act will apply from 1 January 2022.
• A proposal for a Corporate Sustainability Reporting Directive, which aims to make sustainability reporting by companies introduced by the Non-Financial Reporting Directive more detailed and consistent. It will also extend the EU's sustainability reporting requirements to all large companies and all listed companies. The Commission has also proposed the development of one set of standards for large companies and separate proportionate standards for SMEs, which non-listed SMEs can use voluntarily. According to the Commission, this would increase the number of companies in the EU subject to the regime from around 11,000 at present to nearly 50,000.
• Six amending Delegated Acts on fiduciary duties, investment and insurance advice which will ensure that financial firms including advisers, asset managers and insurers include sustainability in their procedures and their investment advice to clients.

Note that the proposals would not apply in the United Kingdom but would impact on UK companies whose securities are admitted to trading on a European exchange or which carry on business in the EU. It will be for the UK government to determine how closely it aligns the UK regime in due course.

8. FCA publishes new webpage focused on climate change and sustainable finance

The FCA has published a new webpage incorporating resources and information on the FCA's strategic approach to sustainable finance and climate change founded on three core themes which mirror the priorities of:

• Transparency - Promoting good disclosures along the investment chain.
• Trust - Ensuring that the market delivers sustainable finance instruments and products that genuinely meet investors’ sustainability preferences.
• Tools - Government, regulators and industry all working together to share experience, develop guidance and tools, and provide mutual support as the challenges of climate change are addressed.

9. FRC publishes research on workforce engagement

The Financial Reporting Council (FRC) has published: 'A Review of Company Reporting and Practice: Workforce Engagement and the UK Corporate Governance Code'. This presents the findings of research conducted in relation to the workforce engagement practices and reporting of FTSE 350 companies and specifically the recommendation for boards to ensure effective workforce engagement under the UK Corporate Governance Code 2018 (Code). The research was conducted by Royal Holloway, University of London, and the Involvement and Participation Association and contains numerous case studies describing differing approaches and elements of good practice.

Of the three core recommended options for workforce engagement set out in Provision 5 of the Code: a worker director, a designated NED, and a formal workforce advisory panel, the review found that:

• 68% had adopted one or more of these options, and of these:
• 40% had appointed a designated NED;
• 12% had established an advisory panel;
• 16% had combined an advisory panel with a designated NED; and
• only one company had appointed a worker director, adding to the four FTSE 350 firms with worker directors that pre-dated the recommendations of the Code.
• 32% had not adopted any of the three suggested options, instead choosing either to adopt permitted 'alternative arrangements' or claim that their existing engagement mechanisms were adequate to satisfy the Code’s recommendations. The review points out that while some of this group have long-standing and effective structures for workforce engagement developed over several years (many of which were in fact similar in form to an advisory panel), others rely heavily on staff surveys combined with ad hoc forms of informal engagement such as site visits and town halls.

Key findings include:

• Advisory panels provide examples of innovation and take a range of forms, and were used to discuss a wide variety of issues commonly relayed to the board via either a senior executive or designated NED. Those without Panels relying solely on a designated NED demonstrated some ambiguity regarding the NED's role and how they should interface with existing engagement structures with some even appearing to have few formal ways to engage with the workforce.
• Those worker directors who were appointed to the board appeared to play a valuable role, engaging fully in board deliberations and discharging their legal duties without issue, as well as honouring the trust placed in them with confidential information.
• Changes in workforce engagement have been more of an evolution than a revolution, with many companies amending existing practices that have been in place for several years. Indeed, some appear to have taken the path of least resistance and have done little to develop even rudimentary engagement mechanisms.
• Most companies rely on several channels of communication with the workforce, usually including an engagement survey and other HR engagement initiatives.
• In the vast majority of cases, decisions on approaches to workforce engagement were made by the board without consultation with the workforce itself, and for most firms there were significant gaps in reporting around what the outcomes or impact of workforce engagement had been.

The key lessons for companies include:

• Representativeness and breadth of coverage – ensure that the employee voice reflects the geography and demography of the workforce.
• Depth of coverage is crucial – properly integrate different engagement and voice channels, including collective forms of employee representation.
• Provide for regular and structured input from the workforce, especially during periods of rapid change.
• Workforce representatives, whether sitting on a panel or as worker directors, should be chosen with some input from the workforce.
• Energies should be focused principally on the substance of workforce engagement, not the process.
• Agenda setting is best when there is a balance between topics of management interest and topics of workforce interest.
• A meaningful dialogue with the workforce also requires an effective feedback loop, based on informed employee voice.

The report notes that, to really make workforce engagement effective, boards first need to reflect properly on the purpose they want that engagement to serve; it also notes with disappointment that many FTSE 350 annual reports appear to downplay the importance of workforce engagement.

The report does, however, identify pockets of good practice, innovation and fresh thinking and a willingness to evolve engagement mechanisms over time.

Ashurst comment: The FRC believes that it is still relatively "early days" when it comes to assessing workforce engagement and that, while there are examples of good practice for others to draw on, there is also evidence that many companies have some way to go in order to create the "meaningful, regular" dialogue that lies at the heart of the Code's recommendation. What is clear is that the FRC will continue to focus on the issue, work which will start by interrogating why a company believes its chosen engagement methodology is the right one and how effective it is in practice.

10. FRC reports on directors' remuneration reporting

The FRC has published a report on directors' remuneration reporting based on research undertaken by the University of Portsmouth Faculty of Business and Law. The research examined the remuneration policy disclosures made by a sample of FTSE 350 companies during periods both before and after the introduction of the 2018 (ie current) version of the UK Corporate Governance Code. In addition, the research analysed shareholder voting on companies' revised remuneration policies at their 2020 AGMs and assessed the impact of the Code's new Principles and Provisions in this area. The report draws attention to where improvements in remuneration reporting need to take place.

The research found improvements in terms of the quantity of information reported, including that companies are now disclosing more information generally and specifically reporting on:

• engagement with the shareholders and, to a lesser extent, the wider workforce; and
• alignment with long-term shareholder interests.

However, the research also found:

• Although a number of companies reported risks that related to excessive awards, most of these companies failed to explain their plans to mitigate these risks.
• While most companies now show evidence of linking individual awards with the delivery of strategy and long-term performance, fewer companies provided evidence that they did not reward poor performance in their remuneration policies.
• The use of non-financial KPIs has increased but companies need to improve how they explain their relevance and the metrics used.
• Some companies declined to state the workforce pension contribution rate. 32% of companies had aligned all their executive director pension contributions with the workforce but this was less than the FRC was expecting by now.
• There was often insufficient detail on how each element of Code Provision 40 (clarity / simplicity / risk / predictability) has been accounted for when determining the remuneration policy for the next reporting cycle. The FRC expects more disclosure here
• Many companies stated that, when setting the directors' pay policy, they had taken into account workforce remuneration and the alignment of incentives and rewards but then failed to provide more detail. The engagement tended to be a one-way process with little room for feedback from the workforce or evidence that the views of the workforce had been taken into account in setting the directors' remuneration policy. The FRC wants to see improvement in this area. Specifically, it wants companies to separate engagement on executive remuneration policy from engagement with the workforce on other matters (also see separate item above on a recent FRC report on workforce engagement).

Ashurst comment: The FRC was generally pleased with the way that companies are implementing the changes brought about in the new version of the Code, and its comments on the shortcomings of boilerplate or inadequate explanations are familiar criticisms, although an analysis of 2021 reports will no doubt show greater compliance. While directors' remuneration issues this year for investors have tended to be about quantum or COVID-19 specific issues rather than Code compliance, the Code still remains the core document against which companies have to disclose each year – and, as the Government has proposed that it is extended to provide for a list of minimum reasons in which directors' variable remuneration can be recovered, it is likely that the Code will be subject to change in this area in the near future.

11. FRC launches project to explore the use of scenario analysis in corporate reporting

The FRC has announced the commissioning of a project to explore the use of scenario analysis by FTSE 350 companies with the objective of understanding more about the processes through which companies develop their scenario analyses, how these processes shape the outcomes produced and how those outcomes inform companies' strategic planning and decision-making. The overriding purpose of the project is to guide the FRC’s future regulatory strategy and its delivery. It will investigate both climate and non-climate applications of scenario analysis and the extent of scenario reporting in 2020/21 annual reports.

12. A round up of financial reporting developments

• Interim reporting thematic: The Financial Reporting Council has published a report setting out the findings of its thematic review of interim reporting, noting areas of good practice and making suggestions for ways in which interim reporting could be improved. The report finds that:
  
  • Companies have heeded the recommendations of the previous FRC thematic reviews and the joint statement by the FRC, Financial Conduct Authority and Prudential Regulation Authority on corporate reporting in light of COVID-19. In particular, companies have enhanced their disclosures in relation to going concern and the statement of cash flows and related notes.
  • Most companies sampled provided detailed explanations of their use of Alternative Performance Measures and reconciliations to GAAP measures.
  • Areas highlighted for improvement include the provision of better and clearer explanations of balance sheet movements and of the impact of significant events on financial statements.

• Cash flow statements thematic: The FRC has published a report focusing on errors in cash flow statements, and the measures taken by audit firms to strengthen their auditing of these statements as a result. The report notes that while audit firms have taken appropriate steps where errors have been identified, the increase in recent cases suggests that further action is needed.

• Annual review of FRS 101: The FRC has completed its annual review of FRS 101 (Reduced Disclosure Framework) making limited amendments. The amendments:
  
  • Provide certain disclosure exemptions relating to IAS 16 (Property, Plant and Equipment) and maintain consistency with IAS 1 (Presentation of Financial Statements).
  • Remove a reference to paragraphs 39 and 40 of IAS 1, which were only applicable to accounting periods beginning before 1 January 2013.