In the 25 years since the Cadbury Report was published to outline good corporate governance practices for U.K.-listed companies, there have been 14 subsequent reports and revised guidances on the subject. Get ready for yet another.
Even before Theresa May took over as Prime Minister, there have been calls to re-examine and rake over the country’s system of corporate governance and regulatory oversight. A committee of Members of Parliament is the first to set out its stall ahead of the government.
The House of Commons Select Committee on Business, Energy, & Industrial Strategy (BEIS) started its inquiry into the state of U.K. corporate governance last September. In its letter to the MPs sitting on it, the Financial Reporting Council (FRC) set out its proposals about how the government could increase the regulator’s monitoring and enforcement powers.
Firstly, the FRC wanted to amend the Corporate Governance Code so that companies would be required to disclose in their annual reports how they have gone about taking stakeholder interests into account.
Secondly, the FRC wanted 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 said it wanted 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.
Fourthly, the FRC also wanted to expand its remit so that it could 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.” Such measures would include disqualification. The regulator also wanted to develop an ethical code of conduct for directors.
Now that the BEIS Committee has issued its report, the FRC can see that MPs want to grant most of its wishes: “The Committee’s proposals pick up many of the FRC’s recommendations to help restore trust in business,” says the regulator in a statement. But it is ultimately up to the rest of Parliament and the government to decide if they want to proceed with actual reform, and when they might want to.
The select committee report, issued on 5 April, backs more disclosure about how companies take wider stakeholder interests into account during decision-making, and presses the government to allow the FRC to help develop a voluntary governance code for large, privately held businesses and family businesses to follow. It even favours giving the FRC a wider remit, greater enforcement powers (including against directors), and more resources to deliver the goods. Although the powers that MPs recommend the regulator to use against directors are not quite aligned to what the FRC originally had in mind, the only areas where the committee stopped short was recommending that the FRC could disqualify directors, or develop a code of ethics for them.
“We are reviewing the report but we are conscious that the government is also running its own consultation on corporate governance as well. However, we believe that the recommendations put forward support the UK’s corporate governance regime and recognise that the FRC should have expanded powers.”
Paul George, Executive Director, FRC
Generally, the BEIS committee report praises the state of corporate governance in the U.K., as well as its oversight. But it adds that, rather than seeking to introduce new legislation or “a radical overhaul of corporate governance,” a tougher message needs to be sent out to those boards that flout the law, with a call for the Secretary of State for Business, Energy and Industrial Strategy (BEIS) Greg Clark MP to be “more prepared than is presently the case” to use existing powers to bring directors to book for violations of U.K. company law. “A public statement by Ministers to the effect of being considerably more proactive in this area may also have a welcome deterrent effect,” adds the committee of MPs.
Believing that “there is scope for significant improvements in order to address the changing nature of company ownership in a globalised economy,” the BEIS committee wants the government to bring forward legislation to give the FRC “the additional powers it needs to engage and hold to account company directors in respect of the full range of their duties.”
One way to do this is for the FRC to take action against board members for non-compliance under Section 172 of the Companies Act, says the committee report. Under this section, a director is required to act “in a way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole.” In doing so, directors are required to “have regards to” a number of considerations, including the interests of employees, relationships with suppliers, customers and others, and “the likely consequences of any decision in the long term.”
Under the BEIS committee proposals, boards would be required to explain precisely how they have considered each of the different stakeholder interests and how this has been reflected in financial decisions. They would also need to explain how they have pursued the objectives of the company and had regard to the consequences of their decisions for the long term (however they choose to define this). “Where there have been failures to have due regard to any one of these interests, these should be addressed directly and explained,” says the BEIS report.
Other key BEIS Committee recommendations in brief
On large private companies
Following the BHS/Sir Philip Green fiasco, which saw a retail giant sold to a serial bankrupt for £1 after being effectively asset-stripped, MPs now want greater corporate governance requirements to be thrust upon large privately-held companies. The committee’s report recommends that the FRC, together with business membership organisations the Institute of Directors and Institute for Family Business, develops an “appropriate Code” of corporate governance that they can comply with, which will be overseen by a separate, newly-established body. The regime would initially be voluntary, but large privately-held companies would be subject to mandatory governance requirements if standards failed to improve after a three-year trial period, or if high rates of unacceptable non-compliance were uncovered.
The BEIS committee also wants listed and large private companies to provide full information on advisors engaged in large or complex transactions (or “above a reasonable threshold” as the report says, though “reasonable” is not defined), including on the amount and basis of payments and on their method of engagement.
The FRC should include best practice guidance on professional support for non-executive directors when it updates the Code. Companies should also include training of board members as part of reporting on their people or human resources policy.
The FRC should update the Corporate Governance Code to provide better guidance on how non-executive directors can be held to account for their performance.
NEDs should be required to demonstrate more convincingly that they are able to devote sufficient time to each company when they serve on multiple boards.
On stewardship and engagement
MPs want investors to be more proactive in challenging boards over corporate governance and strategy, and want the FRC to revise its Stewardship Code—which outlines how investors can better engage with boards about how companies are run in the interests of all stakeholders—to develop more explicit guidelines and requirements on what high quality engagement between investors and boards would entail, as well as include an undertaking for investors to call out poor performance on an annual basis.
The Stewardship Code should have new provisions to force asset managers to disclose their voting records so stakeholders can see which asset managers do not vote.
MPs also want companies to consider setting up “stakeholder advisory panels” as a way of encouraging employees, customers and other stakeholders to raise concerns more readily and for boards to be prepared to address them more directly. Additionally, MPs are pressing for the Corporate Governance Code to be revised to make it a requirement that annual reports include a section detailing how companies are conducting engagement with stakeholders.
Source: House of Commons
However, there are two key problems. Firstly, there are no legal sanctions under Section 172 for failing to have regard to stakeholder interests—and none are being proposed. Furthermore, the FRC’s powers are limited to regulating corporate reporting—not corporate actions. “Our role is to hold companies to account for the adequacy of their disclosures about how they report the way in which they take stakeholder interests into account. We do not visit companies and audit the way they do this in practice,” says Paul George, executive director at the FRC.
George suggests that if the FRC does need to take punitive measures against boards that fail to comply with the Section 172 requirements, then its capabilities need to be spelled out in much the same way as another part of the legislation, namely Section 414D of the Companies Act, which relates to the directors’ requirement to approve and sign the strategic report. This has specific financial penalties in place for executives if they fail to comply, which the FRC can enforce.
Under Section 414D, the strategic report must be approved by the board and signed on its behalf by a director or the secretary of the company. If a strategic report is approved that does not comply with the requirements of the legislation, every director of the company who knew that it did not comply—or was reckless as to whether it complied—and failed to take reasonable steps to secure compliance with those requirements or prevent the report from being approved commits an offence.
Another weapon that BEIS is keen for the FRC to develop to push for better reporting is a “traffic light” annual rating system that assesses good and bad examples of corporate governance in terms of “red,” “yellow,” and “green” which companies would need to include in their annual reports.
George is unsure how such a system would be implemented or work in practice, and is unaware of any other financial regulator using such a method to assess corporate governance. The FRC declined to name any misgivings it might have with the proposal, but there are some obvious concerns—the main one being that such a rating system could become a numbers game.
For example, there is a danger that the success of the U.K.’s Corporate Governance Code—and of the FRC’s enforcement record—would be judged on the number of “green” and “red ratings” it gave out: if there were no “red” reports, the FRC’s regime would be considered “light touch.” Furthermore, as U.K. corporate governance is based on “comply or explain,” companies have the right to justify why they do not follow particular aspects of the Code’s provisions. Consequently, a “red” rating would be at odds with the “comply and explain” principle.
While the FRC broadly welcomes the BEIS Committee’s recommendations, it is aware that they may never materialise and could even be ignored, particularly as Brexit looms closer on the political radar. The government is also conducting its own consultation on the state of U.K. corporate governance, and there is no timeline for delivery of any proposals.
“We are reviewing the report but we are conscious that the government is also running its own consultation on corporate governance as well,” says George. “However, we believe that the recommendations put forward support the U.K.’s corporate governance regime and recognise that the FRC should have expanded powers,” he adds.