Corporate Governance Reform – Government publishes nine point plan

The Department of Business, Energy and Industrial Strategy has published the Government's response to its November 2016 Green Paper on corporate governance reform. This takes into account the April 2017 Report of the Department's Select Committee. For more detail on the content of the Green Paper and the Select Committee Report, please see our updates issued at the time of their publication.

By way of reminder, the aim of the Green Paper consultation was to consider what changes might be appropriate in the UK's corporate governance regime to help ensure improved business performance and create "an economy that works for everyone". The Government's response sets out nine principal proposals (as numbered below) for reform across three specific aspects of corporate governance:

• Executive pay;
• Strengthening the employee, customer and supplier voice; and
• Corporate governance in large privately-held businesses.

Executive pay

The Government believes that executive pay has risen faster than corporate performance and that "a persistent small minority of businesses continue to disregard the views of shareholders on pay each year". The Government also states that there are "few signs that many remuneration committees take seriously enough their existing obligations to take account of wider workforce pay and conditions in setting executive remuneration". For these reasons, the Government proposes to:

1. Ask the Financial Reporting Council (FRC) to revise the UK Corporate Governance Code (Code) to:

• be more specific about the steps that premium listed companies should take when they encounter significant shareholder opposition to executive pay policies and awards (and other matters);
• give remuneration committees a broader responsibility for overseeing pay and incentives across their company and require them to engage with the wider workforce to explain how executive remuneration aligns with wider company pay policy (using pay ratios to help explain the approach where appropriate); and
• extend the recommended minimum vesting and post-vesting holding period for executive share awards from three to five years to encourage companies to focus on longer-term outcomes in setting pay.

2. Introduce secondary legislation to require quoted companies to:

• report annually the ratio of CEO pay to the average pay of their UK workforce, along with a narrative explaining changes to that ratio from year to year and setting that ratio in the context of pay and conditions across the wider workforce; and
• provide a clearer explanation in remuneration policies of a range of potential outcomes from complex, share-based incentive schemes.

3. Invite the Investment Association to maintain a public register of listed companies encountering shareholder opposition to pay awards of 20% or more, along with a record of what these companies say they are doing to address shareholder concerns.

The Government states that further action will be considered unless there is evidence that companies are taking active and effective steps to respond to significant shareholder concerns about executive pay outcomes. This many mean further binding votes on remuneration.

The Government also intends to commission an examination of the use of share buybacks to ensure that they cannot be used artificially to hit performance targets and inflate executive pay.

Strengthening the employee, customer and wider stakeholder voice in boardroom decision-making

Section 172 of the Companies Act 2006 (section 172) already requires directors to have regard to wider interests in pursuing the success of the company, but a large number of respondents to the consultation thought that this aspect of the legal framework could be made to work more effectively through improved reporting, Code changes, raising awareness and more guidance. The Government intends to:

4. Introduce secondary legislation to require all companies of significant size (private as well as public) to explain how their directors comply with the requirements of section 172 to have regard to employee and other interests.

5. Invite the FRC develop a new Code principle establishing the importance of strengthening the voice of employees and other non-shareholder interests at board level as an important component of running a sustainable business. The FRC have also been asked to consider a specific Code provision requiring premium listed companies to adopt, on a "comply or explain" basis, one of three employee engagement mechanisms being either:

• a designated non-executive director;
• a formal employee advisory council; or
• a director from the workforce.

6. Encourage industry-led solutions by asking ICSA: The Governance Institute and the Investment Association to complete their joint guidance on practical ways in which companies can engage with their employees and stakeholders. The GC100 will also be asked to complete and publish new advice and guidance on the practical interpretation of section 172.

The Government believes that putting in place higher expectations for the largest companies should encourage the development and uptake of good practice in the wider business community.

Corporate Governance in larger private companies

The consultation revealed broad support for action to encourage high standards of corporate governance in the UK's largest private companies "reflecting the significant impact that these companies have on employees, suppliers, customers and others, irrespective of their legal status". In addition to the disclosure obligations proposed at point 4 above, the Government intends to:

7. Invite the FRC to work with the IoD, the CBI, the Institute of Family Businesses, the BVCA and others to develop a voluntary set of corporate governance principles for large private companies; and

8. Introduce secondary legislation to require companies and, possibly, LLPs, of significant size to disclose their corporate governance arrangements within their Directors' Report and on their website, including whether they follow any formal code. The Government's initial view is that these requirements should apply to companies with more than 2,000 employees unless they are subject to an existing corporate governance reporting requirement.

Powers of oversight and sanction

9. The Government has asked the FRC, the Financial Conduct Authority and the Insolvency Service to conclude new or, in some cases, revised letters of understanding with each other as soon as possible to ensure the most effective use of their existing powers to sanction directors and to ensure the integrity of corporate governance reporting. Once these have been put in place, the Government will consider whether further action is required, in particular, whether the FRC needs further powers of oversight and sanction.

Diversity

The response statement also sets out the steps currently being taken to improve boardroom diversity and the Government's reaction to the Select Committee's recommendations in this area – in particular, it has rejected the Committee's recommendation that from May 2020 at least half of all new appointments to senior and executive management positions in the FTSE 350 and all listed companies should be women.

Next steps

Implementation will require a combination of changes to the Code (the responsibility of the FRC), voluntary industry action, secondary legislation and action by relevant regulators.

The FRC will consult on changes to the Code in the "late Autumn" and the Government intends to lay before Parliament the draft secondary legislation before March 2018 having consulted as necessary. Work on the code of governance for larger private companies will also commence in the Autumn.

The Government's intention is that the reforms will come into effect by June 2018 and will apply to company reporting years beginning on or after that date.

Comment

There has been wide-spread reaction to the publication of these proposals, much of it focusing on the fact that it represents a watering down of the Prime Minister's commitment to put workers on boards. And while many of the Select Committee's recommendations were made in relation to the Code and may well, therefore, be taken forward by the FRC in its review, other proposals, particularly as regards further binding votes on executive remuneration and a bar on the use of LTIPs, also appear to be have been shelved for the time being. That will be a relief to many. Nevertheless, it appears likely that the FRC's proposed changes to the Code will be significant and far-reaching and require considerable work to digest and implement – we will release an update on those proposals as soon as they're published.

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