FRC spells out governance flaws and bids for more powers

Earlier in January the United Kingdom’s Financial Reporting Council (FRC) published its annual report on corporate governance, “Developments in Corporate Governance and Stewardship 2016,” against what it called a “backdrop of falling public trust in business.”

Using tougher language than normal, the report said that although compliance with the U.K. Corporate Governance Code was high, “when boards choose not to follow provisions too many explanations are of poor quality.” “This suggests that some boards still need to do more,” adding that more focused reporting by boards on how they discharged their responsibilities was needed.

The regulator believes that more can (and should) be done to improve corporate governance and reporting. For example, it wants boards to aim for more in-depth analysis of risk scenarios and provide context for their timeframes, while also addressing the need to improve succession planning and diversity, as well as for boards to be better informed about the link to strategy and business value.

To improve corporate reporting further, the FRC has asked the government to consider giving it more powers so that its remit is not just limited to the top 350 U.K.-listed companies, financial reporting, or disciplining directors with a purely financial function. It also wants companies to report more details on stakeholder engagement (see sidebar).

Generally speaking, the tone of the annual report is upbeat. Compliance with the Corporate Governance Code remains high, with 90 percent of FTSE 350 companies reporting compliance with all—or all but one or two—of its 54 provisions.

The FRC report has even seen the majority of companies comply with new provisions only recently added into the Code. For example, some 91 percent of FTSE 350 members have malus and/or clawback policies in place that allow them to withhold or recover bonuses (usually triggered by reputational damage and risk management issues)—a standard that was only introduced in 2014.

However, it is difficult to assess how well they would work in practice, and how readily they would be enforced, as—so far at least—no company has yet invoked such a provision.

Other recent additional reporting requirements have been taken up less successfully, such as the need for companies to produce a “viability” statement, brought in to focus a company’s assessment and management on the financial and non-financial risks it faces, such as climate change and cyber-security. The statement should cover a period that the company expects to remain solvent and in operation, given its current position and principal risks.

“The FRC believes more focused reporting by boards on how they discharge their responsibilities is necessary and has asked for more oversight powers from government to help achieve this.”

FRC Annual Report

On the positive side, it seems that companies are gaining greater risk management insights as a result. The report says that “the quality of companies’ internal dialogue on risk” has “improved with the addition of financial modelling into what, for some, had been a more conceptual treatment of risk.”

However, the FRC found that only half the companies included in its sample review had produced “satisfactory” viability reports. It also found that companies seem to be gravitating to producing a viability report for the next three years, even if their business cycles vary significantly. The regulator also found that modelling approaches varied, and some boards and management teams were more engaged in the process than others. The regulator suggested that companies provide more “meaningful” disclosures so that investors can understand how the “underlying analysis” was performed and what judgments the company made to compile the statement.

The report also reiterated that there are areas that have consistently been flagged up as problems for years that are still proving difficult for companies to comply with. For example, the Code’s provision for at least half the board, excluding the chairman, to be independent non-executive directors is one of the recommendations most frequently not complied with. Five companies in the FTSE100 still fail to comply with this provision (a further 21 companies in the FTSE350 also failed to comply), while four FTSE100 companies also failed to explain why they do not have an independent chairman, which the Code considers best practice.

Under the United Kingdom’s “comply or explain” approach—introduced 25 years ago—companies aren’t penalised for not following the Code’s recommendations: They just have to state their case as to why compliance was not appropriate for them. It is meaningful disclosure that is key. However, the FRC found that many of those that did not follow the provision on quotas for independent directors simply did not explain the reason why, other than repeat pithy phrases from the regulator’s own guidance.

FRC PROPOSALS FOR STRENGTHENING POWERS

The U.K.’s corporate governance watchdog wants the government to expand its oversight powers—particularly around requirements for directors of public and private companies to promote the business’s success for the benefit of shareholders, and with regard to staff, suppliers, customers and other stakeholders.
“The FRC believes more focused reporting by boards on how they discharge their responsibilities is necessary and has asked for more oversight powers from government to help achieve this,” it said in its annual report.
In a letter to the Department for Business, Energy, & Industrial Strategy (BEIS) dated 30 November, the regulator set out its proposals for the government to increase its monitoring and enforcement powers.
Firstly, the FRC wants to amend the Corporate Governance Code to require companies to disclose in their annual reports how they have gone about taking stakeholder interests into account. Such a step would need the government to change the regulations on corporate reporting.
Secondly, the FRC wants to see a corporate governance code developed for large private companies, so that these organisations are subject to the same kind of requirements as listed companies.
Thirdly, the FRC also wants to broaden its monitoring and enforcement powers so that it can check governance information in annual reports, and not just details surrounding financial statements and strategic reporting.
Finally, the FRC also wants to expand its remit so that it can take action against directors other than those who are “auditors, accountants or actuaries” where the “evidence suggests that they are equally culpable of a breach of the regulations.”
The regulator also wants a code of conduct for directors that covers ethical standards—and which is complementary to the existing duties of directors as spelled out under the Companies Act—to be developed, and has said that it is “willing to take a lead in this”. If not, it has asked the government to extend the directors disqualification regime under the Company Directors Disqualification Act, which is currently limited mainly to insolvency issues.
—Neil Hodge

Furniture retailer DFS at least made a decent stab at explaining why the chairman could not be deemed to be fully independent—he had previously been the operating partner of Advent, the private equity firm that had bought the company in 2010 and floated it in 2015. This means that the company has not had an independent chairman for six years and is not set to consider one for at least a few years more.

The FRC also found that while there has been a 24 percent increase in the number of resolutions with a “significant” minority vote against the board’s recommendations (an indicative threshold of 20 percent is often used, but it is not set in stone), company reporting on such issues is “insufficient” and “requires improvement.”

The report says that in 2016 there were 67 shareholder resolutions with votes of more than 20 percent against, seven of which did not pass (five related to remuneration policies). Of those 60 resolutions that passed with a significant minority vote against, 20 companies did not make any statement about how they intended to engage with shareholders following the vote, even though it has been a requirement to disclose how such practices are conducted since 2014.

The FRC evidently believes that there is room for improvement in how boards ensure good corporate governance, reporting, and engagement with stakeholders. But it also looks increasingly obvious that encouraging companies to act the way the regulator thinks they should is not quite working out and is taking longer than hoped.

Changes are on the near horizon, and there is already an indication of the areas that will be targeted first. Prime Minister Theresa May has called for a corporate governance shake-up in business, including a crackdown on excessive pay and obligations for workers to have a voice (rather than an actual seat, as was earlier pledged) on company boards.

In November the government published a green paper on corporate-governance reform, seeking views on executive pay, how companies should listen to and incorporate the views of employees and customers, and how corporate governance in large private businesses can be improved and monitored more effectively by regulators and stakeholders. Once the consultation period ends on 17 February, the government will decide on what kind of reforms to implement and which body (or bodies) to hand regulatory oversight. Experts agree that some form of change is coming: It is just unclear how radical it will be.

Leading shareholder advisory consultancy PIRC has expressed support for shareholder committees, and in January institutional investor the Pensions and Lifetime Savings Association (PLSA) urged investors to take a tougher stance on those who set executive pay policy.  In October, trade body the Investment Association, whose members manage over £5.7 trillion (U.S.$7.2 trillion) in assets, called for the publication of pay ratios and told FTSE 350 companies that it expects them to improve disclosure of bonus targets. “We will continue to oppose complex executive remuneration structures, which are failing to motivate the people who run companies to deliver the best long-term returns to their shareholders,” said CEO Chris Cummings.

Unquestionably, changes need to be made in the wake of recent high-profile corporate governance scandals where United Kingdom regulators and enforcement agencies have been mocked for being “toothless.” In the case of retailers BHS and Sports Direct, neither has resulted in any criminal prosecutions, fines, or disqualification of directors. The only criminal offence that Sports Direct technically committed was non-payment of the minimum wage; everything else was legal. With regard to BHS, Members of Parliament are still asking for former owner Sir Philip Green to honour the £571m (U.S.$721.4m) pension deficit revealed last April that 11,000 ex-employees are dependent on (he has until March to reach a deal with the U.K. Pensions Regulator, before legal proceedings may—or may not—begin).