The Governance Paradox

Introduction

The Financial Reporting Council published its new UK Corporate Governance Code on 16 July 2018, following on from a long Green Paper/White Paper and FRC consultation process. A measure of the interest which corporate governance generates is the level of commentary on the Consultation document - the FRC received 275 responses.

There is much to admire in the new Code and the accompanying Guidance on Board Effectiveness. One can only applaud the themes of openness, inclusiveness and sustainability which underpin many of the Principles and Provisions in the new Code. Moreover, the 'Questions for Boards' and other practical features of the Guidance are thoughtfully framed and will doubtless be useful for Boards and Committees.

The paradox is that, whilst the new Code is undoubtedly 'shorter and sharper', it clearly increases to a material extent the governance burden on the boards of premium listed companies. In fairness, this is not something that the FRC seek to hide as is clear from, for example, the blog of Paul George at the FRC which says that the new Code 'sets a higher standard for UK corporate governance that businesses must now step up to'. And, indeed, that is consistent with much Governmental and third-party commentary around the need to restore trust in business and tackle the 'fat catery' of business leaders.

But here’s the question. Will the higher hurdles and increased disclosures lead to better outcomes? Or will they lead to exactly the box-ticking and pro-forma compliance which the FRC is looking to avoid? Annual Reports today are long documents, existing compliance burdens are high and Governance and Remuneration Reports are already not for the faint hearted. The FRC is looking for higher quality reporting but is the engine already at peak revs?

And will the increased burden hasten the trend for businesses to be held privately rather than publicly (at a time when private equity is flush with funds to invest)? And might the most talented candidate NEDs think better of the listed world?

Have we, in short, arrived at 'Governance overload'?

Time will tell.

In the meantime, what are the key areas which boards should be focussing on now in order to be ready for the first reporting cycle under the new Code which will be in 2020, as the new Code applies to accounting periods beginning on or after 1 January 2019?

Reporting on the Application of the Principles

The new Code does away with the distinction between Main and Supporting Principles, a welcome simplification, and focuses on eighteen Principles grouped around the five themes of:

• Board Leadership and Company Purpose
• Division of Responsibilities
• Composition, Succession and Evaluation
• Audit, Risk and Internal Control
• Remuneration.

The new Principles are much more substantive than the existing Main Principles and companies will be required to state how they have applied the Principles in a manner that would enable shareholders to evaluate how the Principles have been applied. This will involve reporting on how the board has set the company’s purpose and strategy, met objectives and achieved outcomes through the decisions it has taken. The Code is looking for the articulation of actions taken and resulting outcomes and for cross-referencing to those parts of the annual report that describe how the Principles have been applied.

There is an overlap with the disclosure required under the Companies Act Strategic Report provisions (and the FRC Guidance issued on 31 July 2018) but this should be manageable. The larger challenge will be to craft disclosure around the Principles which then meshes in a non-repetitive way with the 'comply or explain' disclosure in relation to the Provisions.

For example, wording in relation to Principle B – 'The board should establish the company’s purpose, values and strategy, and satisfy itself that these and its culture are aligned' – will need to sit appropriately with the compliance statement in relation to Provision 2 - 'The board should assess and monitor culture...' Not an awful challenge, but a new level of enquiry and explanation.

It would be wise for companies, when considering their reporting in 2019, to undertake a shadow exercise of determining what their 'Principles' disclosure would look like the following year so that they are prepared.

More specifically, not all FTSE companies have developed a crisp exposition of 'purpose' (which then underpins a convincing description of strategy) or the core values which the business lives by. Now is the time to focus on that.

C Saul PLC makes sub-frames and drivelines for traditional sports cars but, in a world which will be increasingly all about electric cars, has the firm articulated a purpose and strategy which will ensure sustainability? Have we inculcated a culture which will motivate the whole team to give of their best and, tellingly, are we capable of describing that in a non-clichéd way?

The '20 per cent or more' Vote Against Resolutions

It is regrettable that Provision 4 remains from the Consultation draft as it effectively turns all resolutions recommended by the board of a premium listed company into special resolutions. Not only will this level of vote against a resolution require the company to say what actions it intends to take to consult shareholders in order to understand the reasons behind the result, but an update on actions taken in response is required within six months from the relevant shareholder meeting and then a further disclosure in the next annual report.

Our view is that this is overreaching and inappropriate. But it is what it is.

And an important point to note is that the FRC expect that companies will begin reporting on this basis 'during 2019', per section 1.11 of the FRC’s Feedback Statement, and so it needs to be on the short-term agenda of boards and company secretaries.

Section 172

Provision 5 requires the board to understand the views of other key stakeholders and describe in the annual report how their interests and the matters set out in Section 172 of the Companies Act 2006 have been considered in board discussions and decision making. This is accompanied by incoming companies legislation requiring a statement as to how directors have had regard to the matters set out in Section 172 in performing their duty to promote the success of the company.

We have previously expressed concern about the 'hindsight risk' here. Inevitably directors’ performance of their duties will be judged with the benefit of hindsight. This means that the drafting of the Section 172 disclosures will need to be circumspect and may err to the general rather than the specific - in case an overly specific description of factors leading, for example, to an acquisition which later goes bad omits a factor which subsequently turns out to be the root of the problem.

Workforce Consultation

Provision 5 goes on to state that for engagement with the workforce one of the following methods 'should be used':

• Director appointed from the workforce
• Formal workforce advisory panel
• Designated non-executive director

In the Consultation draft the equivalent provision indicated, tantalisingly, that one of these should 'normally' be used. The removal of this adverb, together with wording in Provision 5 indicating that if one of these methods is not chosen the board should 'explain' why it considers its alternative method to be effective, suggests that the reality is that companies will need to choose one of the three methods.

Accordingly, companies should move promptly to make a final decision as to which method they will use and what mechanics will be needed to support the chosen method. For example:

• What will the procedures be for choosing a workforce advisory panel?
• How (and how often) will it be consulted?
• What happens if its advice is not taken (particularly if this is a regular occurrence)?

A communication strategy around workforce engagement will also need to be developed.

And Who Are The 'Workforce'?

The term 'workforce' is broader than 'employees', as used in Section 172, and this led to concerns in the consultation process. Paragraph 50 in the Guidance on Board Effectiveness states that it is for the company to decide who is included within the definition and that the company must explain why it has reached its conclusions. Companies should, per the Guidance, consider including those engaged under contracts of service, agency workers and remote workers, as well as employees.

So, this is a topic for companies to address in the short term. And it brings complexities with it. If for example agency workers are included, should they be represented on the formal advisory panel (if there is one) and, if so, should their voice be as loud as that of employees?

The Chair

One of the most controversial changes introduced in the new Code is the requirement that the Chair 'should not remain in post beyond nine years from the date of their first appointment to the board'. In a limited concession to the concerns expressed during the consultation, the Code provides that the period can be extended 'for a limited time', particularly in those cases where the chair was an existing non-executive director on appointment (although in these circumstances a clear explanation will need to be provided).

This provision will affect a significant number of existing chairs (more than 50 in the FTSE 350) and their companies will need to turn their minds now to whether they plan to comply, with the consequent implications for a chair succession process, or 'explain'.

Succession

The new Code contemplates an expanded remit for the nomination committee in terms of ensuring that plans are in place for orderly succession to board and senior management positions (and Paragraph 101 of the Guidance suggests that putting succession plans in writing can be helpful) and in overseeing the development of a diverse pipeline for succession. Diversity is cast as 'diversity of gender, social and ethnic backgrounds, cognitive and personal strengths'. The annual report will need to describe the work of the nomination committee in developing a diverse pipeline and in the implementation of the company’s policy on diversity and inclusion.

Paragraphs 86 to 101 of the Guidance are helpful, for example around skills audits, talent management and engagement between middle management and NEDs. It would be wise for boards to move now to consider whether they need to update succession plans in light of the incoming requirements of the Code and the associated Guidance.

Evaluation

Themes of succession planning, diversity and the need for contribution and constructive challenge are reflected in suggestions for a rather more forensic, and at the same time empathetic, approach to board evaluation.

Evaluations based solely on questionnaires are discouraged and there are some interesting ideas in Paragraph 116 of the Guidance around the benefits of looking to ensure that externally facilitated evaluations are more than a compliance exercise

• Peer reviews of directors
• Views from beyond the boardroom (eg advisors)
• A subsequent review by the evaluator with the board to check on progress against agreed actions

Chairs should feel empowered to be creative and searching in designing evaluation processes.

The Viability Statement

There are no changes to the viability statement provisions within the Code (Provision 31), although the Guidance does point audit committees to the (helpful) Financial Reporting Lab report issued in November 2017 for a discussion of best practice in this area. The Feedback Statement mentions, moreover, that current investigations into the collapse of Carillion may lead to a further consultation around viability – so this is something to watch out for.

Remuneration

The already hard-working Remuneration Committee will have more work to do under the new Code. It is required to set senior management remuneration as well as pay for the board. It is also tasked with 'reviewing workforce remuneration and related policies' with a view to taking these into account in setting executive director and senior management pay, helping the committee to explain to the workforce how executive pay reflect wider pay policy and allowing the committee to feed back to the board on workforce pay and conditions. At least 'oversight' of workforce remuneration and related policies, within the remit of the committee in the Consultation draft, has been assigned to the full board in the new Code (Principle E).

Share awards should be subject to five-year vesting and holding periods, the committee should develop a policy for post-employment shareholding requirements and, with the Persimmon experience in mind, share schemes should enable the use of discretion to avoid formulaic outcomes (and the committee should be mindful of 'external perceptions' arising from its decisions). This Provision remains unchanged from the Consultation draft and will not necessarily be easy to address as existing employment contracts and schemes may prevent the exercise of discretion in practice (even if the policy allows for it).

The challenge for the remuneration committee is further ratcheted up by the requirement that the annual report should describe, with examples, how the committee has dealt with the factors in Provision 40 which are that executive director remuneration policy and practices should address - (i) clarity, (ii) simplicity, (iii) risk, (iv) predictability, (v) proportionality and (vi) alignment to culture. This will be no mean feat.

Given the expanded role of the remuneration committee and, particularly the prospect of reporting on the Provision 40 factors, companies should begin now preparing for the new requirements and consider whether existing remuneration policies need amendment.

A Final Thought

Whilst one may be concerned about a sense of weary exhaustion and 'Governance overload', the themes of purpose, culture, diversity and stakeholder engagement are of course important both to sustainability and to ensuring that the right values are lived in the UK’s leading businesses, particularly given that the upheaval of Brexit will add many stresses to the machine which is 'UK PLC'.

So, the coming eighteen months will need to be used thoughtfully bearing in mind that 'time spent in reconnaissance is seldom wasted'.

Chris Saul is founder of Christopher Saul Associates, an advisory firm providing independent trusted advice to senior executives and key stakeholders within publicly quoted and privately owned businesses and professional service firms. Chris was Senior Partner at Slaughter and May from 2008 to 2016.