The New UK Corporate Governance Code

The Financial Reporting Council (the FRC) has issued its new UK Corporate Governance Code (the new Code) and revised Guidance on Board Effectiveness (the new Guidance). Both documents are considerably restructured and updated.

They follow on from the FRC's comprehensive review and consultation issued in December 2017 to ensure that the Code remains fit for purpose, continues to improve the quality of corporate governance and achieves long-term success and trust in business. For more on the consultation, see our December 2017 client briefing. 

New Code highlights

Broader definition of governance and emphasis on the importance of:

• Positive relationships between companies, shareholders and other stakeholders.
• A clear purpose and strategy aligned with healthy corporate culture.
• High quality board composition and a focus on diversity.
• Remuneration which is proportionate and supports long-term success.

Designed to:

• Set higher standards of corporate governance to promote transparency and integrity in business.
• Attract investment in the UK for the long term, benefitting the economy and wider society.

As mentioned, the new Code and the new Guidance are substantially different from the previous versions. This briefing covers the key areas of change to the new Code and what it means for companies. We also mention some significant modifications from the consultation version and some of what the FRC has said in its feedback statement. We also note briefly the new Guidance.

Timing

The new Code is applicable to all companies with a premium listing, whether incorporated in the UK or elsewhere. It applies to accounting periods beginning on or after 1 January 2019. Unless companies choose to comply early, the first reporting will be seen in 2020. 

Notwithstanding the above, the FRC points out that the Provision on reporting on significant dissenting votes should be applied in 2019 and new remuneration polices or changes to existing ones in 2019 should be developed with reference to the new Code and Guidance. 

Key areas of change

The key areas of change in the Code remain broadly as discussed in our December briefing, and as set out in the table below. However, companies will be glad to see in particular that the FRC has rowed back quite significantly on its proposals as regards independence of the board and the chair. The key change here is that the chair of the board should not remain in post beyond nine years subject to a limited relaxation (see section on independence for more).

Structural changes

Shorter and sharper

Recognising that the current Code has evolved over time often incrementally following specific events, the FRC felt that it no longer fitted together as it would wish. Also, although there are new areas to be inserted, the FRC did not want to add to the Code's overall length. It has therefore set about producing a new Code that is shorter, sharper and fit for purpose.

The new Guidance

Notwithstanding the above, and the fact that the Code itself is now just 15 pages, it is relevant to mention the new Guidance, which is 45 pages (compared with the 2011 guidance at 18 pages). We consider that the new Guidance has become more important and that it will be more necessary now for companies to refer to it. 

As regards the status of the new Guidance, in the new Code the FRC states "We encourage boards and companies to use [the Guidance] to support their activities. The Guidance does not set out the right way to apply the Code. It is intended to stimulate thinking on how boards can carry out their role most effectively. The Guidance is designed to help boards with their actions and decisions when reporting on the application of the Code's Principles." 

The new Guidance itself states that its primary purpose is to stimulate boards' thinking on how they carry out their role and encourage them to focus on continually improving effectiveness. It states that it is not prescriptive or mandatory. That said, it does also go on to state that "The Guidance will also be helpful to a wide range of stakeholders when assessing the actions taken by the board in relation to the governance of the company."

Supporting the changes to the new Code, the new Guidance has been updated to include, amongst other aspects, new sections on relations with stakeholders including the workforce and on culture and also much updated sections on the role of the nomination committee, succession planning, evaluating the board and directors and externally facilitated board evaluations and oversight of workforce pay, conditions and policies. Many of the sections in the new Guidance have useful lists of questions for boards, or others, to consider. 

Renewed focus on Principles

Companies are very familiar with the structure of the current Code. It has Main Principles, which embody best practice and operate on a comply basis. Companies are required by the Listing Rules to state how they have applied the Main Principles so as to enable shareholders to evaluate how they have been applied (LR 9.8.6 (5)). This compares with detailed Provisions of the Code, which operate on a comply or explain basis, with companies either confirming their compliance or explaining their non-compliance (LR 9.8.6(6)). Supporting Principles occupy a space between Main Principles and Provisions.

The FRC considers that companies have focused too much on ticking the box as regards Provisions and not done enough hard thinking about what they need to do to apply the Principles. It seeks to address this as set out below. 

As regards the impact on companies of these changes, in its feedback statement the FRC mentions "increased monitoring activities" in which it will pay attention to the application of the Principles, to compliance with the Provisions and also to explanations of non-compliance. As regards explanations, it says that "a detailed explanation" of non-compliance is more useful to both shareholders and wider stakeholders. The new Code itself now deals more simply with what an explanation of non-compliance should cover, stating "Explanations should set out the background, provide a clear rational for the action the company is taking, and explain the impact the action has had."

A further impact, due to parts of the Supporting Principles now being moved into the Principles together with the addition of new Principles, will be more and different reporting for listed companies in their annual reports as regards how they apply the Principles. They will need to consider afresh whether their annual reports contain all the necessary disclosures. It is likely that some additions, at least, will be needed, and also that they may want to consider some restructuring of the corporate governance sections of their annual reports to marry up more with the format of the new Code. 

Culture and purpose

One of the highlights of the new Code that the FRC draws out is "A clear purpose and strategy aligned with healthy corporate culture". 

In its feedback statement, as regards purpose the FRC states that the aim of Principle A is to promote higher standards of corporate governance and set good practice in this area. It also notes concerns that Principle A was an attempt to reinterpret section 172 of the Companies Act 2006 (the Act). In response to these concerns, the FRC has added into the Introduction to the new Code that "Nothing in this Code overrides or is intended as an interpretation of the statutory statement of directors' duties in the Act."

Many companies will already consider that they contribute to wider society and they may also report, to an extent, on this. As regards the impact on companies of these changes, now that this is elevated to Principle status, companies may wish to reconsider either or both of how they contribute to wider society and how they report on that contribution.

As regards culture, companies will now need to report on matters such as how their boards ensure that purpose, values and strategy are aligned with culture and how directors act with integrity, lead by example and promote the desired culture (Principle B). Additionally, Provision 2, in the context of boards assessing and monitoring culture and of any corrective action that it has been necessary to take, requires additional disclosures in the annual report, giving an explanation of:

• the board's activities and any action taken; and
• the company's approach to investing in and rewarding its workforce.

Shareholder engagement

Engaging with shareholders already features in the current Code. The key change here relates to significant votes against board recommendations for resolutions, where Provision 4 makes a number of changes from the current Provision aimed at encouraging companies to take more effective action and report more promptly. 

As envisaged, the new Code includes a footnote noting the Investment Association's Public Register of FTSE All Share companies that have received over 20 per cent of votes against any of their resolutions. 

In its feedback statement, the FRC states that although many respondents challenged the need for a six-monthly update, it is needed to ensure that companies demonstrate that dialogue is ongoing and note any actions and outcomes. As Provision 4 does not refer to announcement for this update, but simply mentions publishing, it is assumed website publication will suffice.

As regards the impact on relevant companies of these changes, removal of the board discretion now means any vote that attracts 20 per cent or more dissent is automatically caught and companies must remember that initial, interim and final disclosures will need to be made.

Stakeholder engagement

A further highlight that the FRC notes in the new Code is "Positive relationships between companies, shareholders and other stakeholders".

The new Code is seeking to improve the quality of a company's relationships with a wide range of stakeholders and in particular with its workforce. As well as Principle D on the need for boards to foster effective engagement with, and participation from, shareholders and stakeholders, Provision 5 states that:

• the board must understand the views of the company's other key stakeholders and describe in the annual report how their interests and the matters set out in section 172 of the Act have been considered in board discussions and decision-making; and
• specifically for engagement with the workforce, companies should (i) either use one or a combination of the three listed engagement methods (a director appointed from the workforce; a formal workforce advisory panel; or a designated non-executive director) or (ii) explain what alternative arrangements are in place and why they are effective. 

In its feedback statement, the FRC notes that whilst it supported the Government's three primary methods for workforce engagement, there might be other effective methods and hence Provision 5 now allows for this as provided in (ii) above. 

As regards "workforce", the use of the word is purposeful and meant to capture the diversity of relationships between companies and those working for them. "Workforce" is explained in the new Guidance which states "Communication and engagement will involve those with formal contracts of employment (permanent, fixed-term and zero-hours) and other members of the workforce who are affected by the decisions of the board. For example, companies should consider including individuals engaged under contracts of service, agency workers and remote workers, regardless of their geographical location. Companies should be able to explain who they have included and why". 

The new Guidance also mentions the recently issued guidance on The Stakeholder Voice in Board Decision Making, published by the Investment Association (IA) and the Institute of Chartered Secretaries and Administrators (ICSA). For more on the IA/ICSA guidance, see our September 2017 Quoted Company Newsletter. 

As regards the impact on companies of these changes, these will include:

• Assessing who are their key stakeholders and why, and engaging with them to understand their views.
• Disclosing in the annual report how the interests of key stakeholders and the matters set out in section 172 of the Act have been considered in board discussions and decision-making.
• Keeping engagement mechanisms under review so they remain effective.
• Choosing who they regard as their "workforce" and explaining why.
• Choosing one of the three listed methods for engaging with the workforce, or an alternative (if the latter, also explaining why it is effective).

Independence

The FRC has, as mentioned, not proceeded with many of its proposed changes as regards independence, and in most instances has reverted to the position of the current Code. So, it remains the case that "at least half the board, excluding the chair, should be non-executive directors whom the board considers to be independent" (Provision 11). However, the current smaller companies exemption has been removed. 

It also remains the case that the board can consider a non-executive director independent notwithstanding the existence of some of the listed factors that are likely to impair his/her independence (Provision 10), so long as clear explanation is given. Although, note on this point that in its feedback statement, the FRC says that it expects to see greater detail when companies report on the independence status of such directors. 

It also remains the case that the chair must be independent on appointment when assessed against the Provision 10 criteria. What is new, both from the current Code and the consultation version, is Provision 19 on a limited tenure for the chair.

In the feedback statement, the FRC make clear that the nine year tenure applies equally to chairs who were previously non-executive directors on the board, and that their time served as a non-executive director will reduce the time they can serve as chair. This is subject to a limited extension to the term of the chair beyond nine years, if he/she was an existing non-executive director on their appointment as chair and if that extension helps support either or both of effective succession planning or the development of a diverse board. What is meant by "a limited time" in respect of the extension has not been quantified, leaving it open for companies to decide. The new Guidance does, however, suggest that the following questions should be considered:

• Does the chair continue to demonstrate objective judgement and promote constructive challenge amongst other board members?
• How long should the extension be and does this fit with wider succession planning and company objectives?
• Does extending the length of service complement diversity planning?
• Has there been engagement with major shareholders?

As regards the impact on companies of this change, any company with a chair of the board that is at, over or approaching nine years' tenure will have to start planning for the new chair, even if they consider that may be able to make use of the limited exemption.

Overboarding

In a change from the current Code and the consultation version, overboarding (non-executive directors holding too many positions) now features somewhat more prominently.

As regards impacts on companies of these changes, whilst the need for non-executive directors to be able to allocate sufficient time to discharge their responsibilities and disclose their other significant commitments prior to being appointed is not new, what is new is the need, in the next annual report, for the board to disclose their reasons for permitting significant appointments to be taken on by their non-executive directors. Boards should, therefore, when contemplating requests from their non-executive directors to take on significant appointments, be very mindful of the need to make this disclosure in the next annual report and of what it will say and how it is likely to be perceived.

Succession planning, diversity and the nomination committee

In the new Code, succession planning and the need for appointments to be made on merit and against objective criteria and to promote diversity are elevated to Principle status. Also, changes are made as regards nomination committees which are intended to improve their practices and reporting.

As regards impacts on companies of these changes, amongst other things they may need to consider are:

• how the work of their nomination committees in particular needs to be developed to achieve compliance with the new Code;
• whether to update the terms of reference of their nomination committees; and 
• the additional reporting that will be needed in the nomination committee report part of their annual reports. 

FTSE 350/smaller companies exemptions

The FRC had proposed to remove all exemptions for companies below the FTSE 350 and this is reflected in the new Code but subject to some exceptions. These include that for audit and remuneration committees in smaller companies, they are still permitted to have a minimum membership of only two. Also, as regards external facilitation of board evaluations, whilst for FTSE 350 companies this should still happen every three years, for other companies the requirement has been changed so that the chair should "consider" having a regular externally facilitated board evaluation.

As regards the impact on companies of this change, it means that for those smaller companies that had been taking advantage of the exemptions, they will need to either take steps to comply with the full Provisions or be prepared to explain their non-compliance.  The relevant areas are the following:

• Removal of the smaller company exemption in relation to at least half the board, excluding the chair, being independent non-executive directors (current B.1.2; new Provision 11).
• Removal of the below FTSE 350 cut-off in relation to the requirement that directors be subject to annual election by shareholders (current B.7.1; new Provision 18)
• The requirement for the chairs of companies outside the FTSE 350 to "consider" having a regular externally facilitated board evaluation (current B.6.2; new Provision 21).

Remuneration

Remit of the remuneration committee

The new Code adjusts the duties of the remuneration committee with regard to the oversight or setting of pay for the various categories of directors and employees as follows:

• Chair and executive directors
  The remuneration committee will continue, as it does now, to have responsibility for determining the policy on executive directors' remuneration and for setting remuneration for the chair of the board and the executive directors.
• Non-executive directors
  Following the consultation exercise, Provision 34 of the new Code now makes clear that the remuneration of non-executive directors should be determined in accordance with the company's articles of association or, alternatively, by the board.
• Senior management
  Senior management under the Code means the executive committee or the first layer of management below board level, including the company secretary. The current Code obligation to "recommend and monitor the level and structure of remuneration" for senior management has been expanded under the new Code to become a responsibility for "setting" such remuneration. Despite concerns raised in response to the consultation that this could undermine the chief executive, the FRC has confirmed the change will stay, as it considers this to be an appropriate part of the role and one that many remuneration committees already undertake.
• Workforce generally
  The FRC's draft version of the new Code proposed to widen the remit of the remuneration committee to include oversight of "remuneration and workforce policies and practices", taking these into account when setting the policy for director remuneration. The draft of the new Guidance made clear that these workforce policies would have gone well beyond pay to include policies on matters such as recruitment and retention, training and development, reskilling and flexible working. However, the FRC has responded to concerns that this was setting the remuneration committee's remit too widely and has revised the final version of the new Code accordingly to focus on pay rather than broader workforce policies (responsibility for the oversight of which remains with the board). The new Code now requires the remuneration committee to "review workforce remuneration and related policies and the alignment of incentives and rewards with culture, taking these into account when setting the policy for executive director remuneration". The final new Guidance expands on this obligation and confirms that "workforce" in this context means those engaged under an employment contract or a contract, or other arrangement, to do work or provide services personally.

Directors' pay policy and practices

New Provision 40 sets out a list of matters for the remuneration committee to address when determining directors' remuneration policy and practices. These fall under the headings of clarity, simplicity, risk, predictability, proportionality and alignment to culture.

Use of discretion

New Principle R in the new Code requires directors to exercise independent judgement and discretion when authorising remuneration outcomes, taking account of company and individual performance and wider circumstances. Under new Provision 37, remuneration schemes and policies should enable the use of discretion to override formulaic outcomes (for example where the measurement of any performance condition does not reflect actual company or individual performance over the relevant period). The FRC emphasises that the use of discretion is different from malus and clawback provisions, the latter normally being reserved for serious events occurring in circumstances specified in advance whereas discretion is likely to be exercised in a wider range of circumstances than originally foreseen.

The FRC considered whether the remuneration committee should be required to exercise discretion in a "reasonable" or "responsible" way rather than having unlimited discretion which could allow it to move the goalposts retrospectively. However, the FRC considers the risk of this to be low, given the various checks on remuneration committees, and has therefore decided not to qualify the use of discretion.

The new Guidance expands on the circumstances in which the remuneration committee's use of discretion might be appropriate and reflects the FRC's expectation that an active decision on whether to exercise discretion would become a normal part of the annual process to determine remuneration outcomes. The new Guidance also suggests that remuneration committees consider whether a cap on executive rewards is appropriate.

One issue thrown up during the consultation exercise is that employment contracts and scheme rules may prevent the exercise of discretion in practice even where it is allowed under the remuneration policy. The new Guidance notes the importance of ensuring that the terms of individual contracts and scheme rules do not prevent such adjustments. Provision 41 of the new Code requires the remuneration committee to describe in the annual report to what extent discretion has been applied to remuneration outcomes and the reasons why. The FRC expects this to include disclosure of anything that prevents the use of discretion where outcomes would otherwise have been adjusted.

Remuneration committee chair

To meet one of the Government's requests, the new Code provides that a remuneration committee chair must have served for at least 12 months on any remuneration committee.

Scheme design

Under new Principle P, remuneration policies and practices should be designed to support strategy and promote long-term sustainable success. Executive remuneration should be aligned to company purpose and values and be clearly linked to the successful delivery of the company's long-term strategy.

The FRC wishes to avoid encouraging companies, explicitly or implicitly, from adopting one form of remuneration scheme over another, for example long-term incentive plans (LTIPs) rather than restricted shares. The new Code has therefore been amended to remove any language which could be perceived as encouraging LTIPs.

Minimum vesting/holding periods

In response to a Government request, the recommended minimum combined vesting and post-vesting holding periods for executive share awards has been increased. Provision 36 of the new Code provides that executive share awards should be released for sale on a phased basis and be subject to a total vesting and holding period of five years or more. This has in any event already become fairly standard market practice to comply with institutional investor expectations. The FRC is not including in the five-year or more period any deferred element of an annual bonus which typically vests over a shorter period. Additionally, the language on post-employment shareholding requirements has been strengthened with remuneration committees required to formulate a formal policy on this, covering both unvested and vested shares, although no specific terms are set out.

Pension contributions

The FRC notes that it has been common in the past for executive directors to be offered more generous pension arrangements than other employees. Provision 38 of the new Code now expressly provides that pension contribution rates for executive directors, or payments in lieu, should be aligned with those available to the rest of the workforce.

Loss of office payments

Provision 39 of the new Code contains new wording requiring the remuneration committee to ensure compensation commitments in directors' terms of appointment do not reward poor performance. The committee should be robust in reducing compensation to reflect departing directors' obligations to mitigate loss.

Reporting obligations

A new Provision 41 sets out in some detail the matters to be included in the annual report when describing the work of the remuneration committee. These include a description, with examples, of how the remuneration committee has addressed the factors it is now required to take into account under Provision 40 of the new Code when determining executive director remuneration policy and practices. The remuneration committee must also give reasons why the remuneration is appropriate using internal and external measures, including pay ratios and pay gaps.