Matthew Stratton Partner
Corporate Governance Code 2018
A new Corporate Governance Code designed to attract long-term investment to the UK and promote integrity in business will apply to premium listed companies*, for financial years beginning on or after 1 January 2019.
Setting the scene
Following the publication in summer 2016 of reports by two House of Commons committees on the failure of major high street retailer BHS and the employment practices at UK premium listed sports-goods retailer Sports Direct, the House of Commons Business, Energy and Industrial Strategy Committee launched an inquiry seeking to address systemic corporate governance problems in the UK.
One of the inquiry’s recommendations was that the Financial Reporting Council (FRC) amend the UK Corporate Governance Code to require companies to describe in their annual reports how directors have fulfilled their duties under section 172 of the Companies Act 2006 (CA 2006). The expectation is that the new Corporate Governance Code (the 2018 Code) issued by the FRC, which increases the governance requirements of boards, will help prevent large-scale corporate failures. UK Government Business Secretary Greg Clark said:
“These changes will drive improvements in how boardrooms engage with employees, customers and suppliers as well as shareholders, delivering better business performance and public confidence in the way businesses are run. They will help the UK remain the best place in the world to work, invest and do business.”
The 2018 Code
The 2018 Code is shorter than its predecessors and it is hoped will be easier for companies to follow. It contains five sections which are split into 18 principles and further provisions. Broadly, the areas covered by the five sections of the 2018 Code are:
1. Board leadership and company purpose
The board’s role is to promote the long-term success of the company. It should: (a) consider opportunities and risks relevant to the future success of the business; (b) promote a culture that is in line with the company’s values; (c) engage with wider stakeholders, for example, creditors and suppliers, and consider their interests in decision making; and (d) enhance engagement with employees, for example, by considering appointing a director from the workforce, assigning an independent non-executive director (NED) to engage with the workforce, or by establishing a formal workforce advisory panel. The objective of this principle is for boards to assess the basis on which the company deals with its workforce/stakeholders and how it generates and preserves value over the long term.
2. Division of board responsibilities
The board is collectively responsible for the governance of the company. At least half of the board (excluding the chair) should be NEDs, one of whom should be appointed as a senior NED to act as a sounding board to the chair and as an intermediary for the other directors and shareholders. Having a mix of executives and NEDs on the board should ensure that no individual or group of individuals dominates decision making. NEDs should also have a prime role in appointing and removing executive directors (mainly through a Nomination Committee). Each director’s specific responsibilities should be publicly available.
3. Board composition, succession and evaluation
The board should demonstrate how succession planning practices and the appointment of senior management and the board are based on merit and objective criteria (including how they promote diversity in gender, social and ethnic backgrounds). It should also demonstrate that the board and committees contain an appropriate combination of skills, experience, knowledge and independence.
This means that: (1) appointments should be subject to a formal, rigorous and transparent procedure; (2) the board should be evaluated annually for its composition, diversity and effectiveness; (3) the chair should not remain in post beyond nine years; (4) directors should be reappointed annually; and (5) a Nomination Committee should be constituted to promote diversity in the talent pipeline and the gender composition of senior managers.
4. Company audit, risk and internal control
Companies should establish formal and transparent policies to ensure the independence and effectiveness of audits, and to satisfy themselves on the integrity of financial statements. The board should also carry out robust risk assessments.
In order to achieve the above, an Audit Committee should be established, comprising NEDs (at least one of which should have financial experience), in order to: (1) monitor the integrity of the company’s financial statements; (2) review internal accounting/risk controls and audit functions; and (3) review the external auditors’ independence and effectiveness.
Remuneration should support a company’s strategy and promote long-term sustainable success.
To that end, companies should appoint a Remuneration Committee of NEDs to set and review workforce and board remuneration, ensuring that incentives are aligned to the long-term performance of the company.
Sections 4 and 5 of the 2018 Code are a restatement of existing practice, since in reality, premium listed companies have had Audit and Remuneration Committees for a number of years.
By applying the principles and more detailed provisions (as broadly outlined above) on a ‘comply or explain’ basis in their annual reports, the expectation is that companies will demonstrate how their governance contributes to their long-term success and achieves their wider objectives.
Since the Government considered a one-size-fits-all approach to corporate governance inappropriate, a cross-party group was charged to develop separate corporate governance principles for large private companies**. Named the Wates Corporate Governance Principles for Large Private Companies (the Wates Principles), these are broadly similar in approach to the 2018 Code, and are also due to come into force in January 2019.
The 2018 Code and the Wates Principles have both been written to enable large companies to comply with the new Companies (Miscellaneous Reporting) Regulations 2018 on corporate governance. These will come into force on 1 January 2019, and amongst other things, will require directors to explain in their annual reports how they had regard to the matters set out in section 172 CA 2006 when performing their duties and outline their corporate governance arrangements.
The 2018 Code is a continuation of self-governance by principles rather than governance through rigid rules or legislation. It remains to be seen whether this ‘light touch’ approach will tackle the behaviours that lead to large company collapses.
The 2018 Code does not include certain recommendations received from industry and unions during the consultation process such as directors being required to undertake continued professional development, or companies being required to have worker representation on boards. The latter suggestion was promised but then dropped by the Government in late 2017 though has recently faced renewed calls for reconsideration following the collapse of Carillion, a global construction conglomerate that went into liquidation in January 2018 with almost £7 billion of liabilities.
It appears that the Government and the FRC will continue to take a keen interest in corporate governance, with the Stewardship Code being the next in line to be updated. Therefore, whilst neither the 2018 Code nor the Wates Principles will apply to small and medium enterprises, those entities may wish to incorporate appropriate elements of it to ensure their boards conduct themselves in accordance with ‘best practice’ in a changing corporate governance landscape.
* All companies listed on the Main Market of the London Stock Exchange meeting the premium listing requirements of the Listing Rules sourcebook, which is part of the Financial Conduct Authority’s Handbook.
** A UK company that has either (i) more than 2,000 employees, or (ii) a turnover of more than £200 million and a balance sheet of more than £2 billion.