Governance compliance on the rise, but more is not always better

This year saw a rise in full compliance with the U.K. Corporate Governance Code among FTSE 350 companies to a new high of 62 percent, up from 57 percent in 2015, according to Grant Thornton’s 15th Corporate Governance Review. Areas of greatest non-compliance were centered around the independence of directors and chairs. The Code requires half the board, excluding the chair, to be independent non-executive directors (NEDs), but 9.4 percent of the FTSE 350 do not comply with this provision. In addition, non-compliance with the requirement for an independent chair actually went up to 6.5 percent, from 4.8 percent in 2015. More importantly, however, 90 percent of the FTSE 350 comply with all but one or two provisions. Other areas of non-compliance were failure to meet audit or remuneration committee membership criteria. On the other hand, compliance is still low in both 2015 and 2016 for new entrants to the FTSE 350.

Strategic report requirements were introduced in 2014 by the Financial Reporting Council, and the number of FTSE 350 companies that now fully comply with all strategic report provisions has risen to 57 percent from 50 percent in 2015. But the report criticizes how long these reports have become. The average length of the annual report is now 162 pages, up from 157 pages in 2015 and 120 in 2009. There was a wide variation in length, from 490 pages for HSBC to just 43 for IT company Softcat. The upfront narrative section continues to be the longest section. The report notes that companies frequently “complain about the growing length of annual reports and yet continue to add to them rather than using the opportunity to rethink how they might provide clearer information to the users. Meanwhile investors largely accept what is given to them and often ask for more rather than better.”

While compliance has risen, the report says that only 16 companies do it properly in a connected, transparent, and informative way. Also more than half of companies still do not provide a high-quality, forward-looking statement, though this has fallen from almost three-fifths in 2015. Descriptions of the future development of a company’s business are also improving with 7.5 percent giving a detailed description and 40.9 percent a good one, compared to 5.4 percent and 35.3 percent, respectively, in 2015.

“It is encouraging to see increasing levels of compliance with the U.K. Corporate Governance Code.”
Sir Win Bischoff, Chair, Financial Reporting Council

Risk disclosures are beginning to improve, as only 4 percent give the same principal risk disclosures as last year, down from 24 percent in 2015. Even more impressively, 99 percent report what mitigating actions they can and will take to combat risk, and the number of ‘principal’ risks is down along with better explanations of what they are; this suggests that companies are focusing more attention on truly identifying what their principal risks are rather than simply giving a blanket list.

The report’s authors see a correlation between “good disclosures of business context and external environment and robust discussion of the key performance indicators (KPIs) that frame performance.” Almost half, 47 percent, of FTSE 350 companies do a good job of reporting on both elements. However, almost half of FTSE 350 companies simply state what KPIs they use, but do not explain why these are relevant indicators of strategic progress, how they are calculated, what next year’s targets will be and, most importantly, how they link to strategy and associated risks. “Explaining the links between strategy, KPIs, and directors’ remuneration can provide meaningful insight into executive incentives and support the long-term sustainability of a business,” says the report. While 95 percent of companies discuss the link between executive remuneration and company strategy in their annual report, most of this disclosure is found in the remuneration report; only 11 percent of the FTSE 350 discuss this in their strategic reports.

All but one of the 249 companies that were required to provide a viability statement this year did so, but 52 percent kept it to a minimum. Only 13 companies, 5 percent, went further, giving greater detail and “adding sufficient qualitative and quantitative analysis to their risks assessment so as to enable the reader to appreciate the effect of such an occurrence,” which is more in the spirit of what the FRC was asking for. Surprisingly, 10 of these 13 companies were FTSE 250 companies, most from the technology and utilities sectors.

Only 20 percent of companies provide good or detailed discussion on organisational culture, while 35 percent give some reference to it. But most companies make no reference to it at all. Analysing this reporting on culture by sector gives some stark differences. Some 70 percent of technology companies make no reference to it at all, while almost half of utilities companies say that culture is embedded at every level of their organisation and is part of their approach to responsible business. The financial sector improved the most compared with 2015, with 87 percent of companies (70 percent in 2015) discussing culture in their annual reports. The report concludes that this is a reflection of the work in this this area by the Financial Conduct Authority (FCA).

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Shareholder engagement, despite the FRC’s focus on it, is declining, as only 36 percent of businesses “clearly demonstrate how they engage with shareholders,” which is down from 55 percent in 2015. The report notes that disclosure around company engagement with shareholders has decreased year on year since 2010. Other findings are that:

58 percent of board chairs state that they discuss strategy and governance with major shareholders

Only 12 percent of companies specifically mention dialogue or face-to-face contact with investors

41 percent mention one-way engagement such as investor presentations

The report notes that it is important to speak to shareholders when things are going well, not just when there are issues to address.

More comprehensive diversity disclosures are up significantly, as 76 percent of companies mention aspects of board diversity other than gender, such as ethnicity, race, cultural backgrounds, sexuality, and religion, as well as a breadth of skills and experience. This is up from 55 percent in 2015, a more than 20 percent increase.

While it is not a requirement of the code, the report still finds it a surprise that 14 FTSE 350 companies have no nominations committee and only just over a third of smaller companies, FTSE 250, have decent descriptions of their nomination committee’s function. Worse still, only 15 percent of companies provide any real insight into considerations and plans for future succession. The report says that succession planning is a growing regulatory focus, and it examined this area as part of the work of the nomination committee. Overall, most companies (78 percent) had “basic or general descriptions of succession planning,” noting that it was part of the role of the nomination committee. But there was little specific detail about how it occurs, even though there were many new appointments during the year in question.

The report also looked at executive pay and the work of the remuneration committee. It found that the number of companies with a clawback provision in place for incentive pay increased again, with 90 percent now stating they have one, compared to 86 percent in 2015 and 75 percent in 2014. No company, however, has actually invoked a clawback provision yet. The growing trend toward aligning remuneration with the longer-term interests of the company continues, with 96 percent of the FTSE 350 doing so and reporting a long-term incentive plan. And there was a huge increase in the use of share-based awards from 2014 to 2015, especially in the FTSE 100.

In addition, the use of non-financial metrics in incentive pay increased to 65 percent, up from 46 percent in 2015. Of these, just over 40 percent of companies include personal metrics, nearly a third use strategic metrics, and 21 percent use “other non-financial metrics not directly connected to strategy.”

Almost two-thirds of companies provide good or detailed explanations about how auditors’ objectivity and independence is safeguarded. The EU Audit Directive and Regulation was introduced on 17 June this year, but many companies have chosen not to adopt its provisions earlier than required, so data on audit tenure and rotation, for example, reflects two different regulatory environments. Some 58 percent of companies committed to putting their external audit contract out to tender at least every 10 years, compared to 50 percent last year. The number of companies not stating clearly when their auditor was last changed, however, has declined to 18 percent, compared to 26 percent last year. On the other hand, nearly a third of companies in the FTSE 350 have not rotated their auditor for more than a decade.