U.K. corporate governance reforms

Back in July 2016 when she was campaigning to become leader of the Conservative Party, Theresa May delivered a barnstorming speech in Birmingham that outlined her vision to reform corporate Britain.

May said that the United Kingdom needed “deep economic reform,” which included “getting tough on irresponsible behaviour in big business” and refusing to accept that “anything goes.” Her plans included having workers’ representatives on boards, simplifying bonus structures, checking that incentives are aligned with long-term strategy, making shareholder votes on corporate pay binding rather than advisory, and ensuring full disclosure of bonus targets and outlining the ratio between the CEO’s pay and the average company worker’s pay.

13 months is a long-time in politics, however—particularly for an embattled Prime Minister. When the government published its package of proposed reforms on 29 August, which will come into force in June 2018, the content was decidedly less radical than that contained in May’s Birmingham speech, and not all of the original proposals have survived intact (or at all).

Added to that, even putting these proposals into practice may not be easy. Implementing the reform proposals will require the government to pass secondary legislation, the Financial Reporting Council (the United Kingdom’s corporate governance regulator) to make changes to the Corporate Governance Code, voluntary industry action among business and shareholder groups, and improved co-ordination between regulators to enforce the rules and sanction companies and directors.

In its Corporate Governance Reform paper, the government has set out a range of headline proposals 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. And there are plenty of changes for compliance professionals to take note of.

“There needs to be a recognition that all company directors, not just those of listed companies, are subject to the legal duty set out in the law whereby boards must take stakeholder and ethical issues into account when making strategic decisions.”
Philippa Foster Back, Director, Institute of Business Ethics

Within the past 20 years the typical annual pay of a FTSE100 CEO has quadrupled, and there is still a nagging feeling that boardroom pay is linked to short-term performance rather than long-term goals, despite the requirement for shareholders to approve executive remuneration policies every three years and for companies to list executive salaries and rewards as a single figure.

To curb spiralling executive remuneration and to ensure that pay rewards are linked to improved performance, the government says that it will 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 policies (by using pay ratios where appropriate).

Moreover, the government wants the Investment Association—the trade body that represents U.K. investment managers—to maintain a public register of those listed companies that have experienced one-fifth or more of their investors voting against executive pay schemes, along with a record of what these companies say they are doing to address shareholder concerns. The government also wants the Financial Reporting Council (FRC) to revise the U.K. Corporate Governance Code so that it is more specific about the steps that premium listed companies should take when they encounter significant shareholder opposition to executive pay policies and awards.

Other measures that the government says it will introduce include extending the recommended minimum vesting and post-vesting holding period for executive share awards from 3 to 5 years to encourage companies to focus on longer-term outcomes in setting pay. It will also introduce secondary legislation to require quoted companies to report annually the ratio of CEO pay to the average pay of their U.K. workforce, along with a narrative explaining changes to that ratio from year to year, and setting the ratio in the context of pay and conditions across the wider workforce.

According to an analysis by the think-tank the High Pay Centre and the Chartered Institute of Personnel and Development, the ratio between FTSE 100 CEOs and the average pay of their employees was 129:1 last year.

In addition to these proposals, the government will take forward its manifesto commitment 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.

During her campaign to replace David Cameron as Tory leader following his resignation in the wake of the Brexit referendum vote, May had championed having worker representation on company boards. This subsequently changed to having executives give regard to some form of “employee voice” in the running of the business—not quite as radical.  Section 172 of the Companies Act 2006 already requires the directors of a company to have regard to wider interests in pursuing corporate strategy, but respondents to the government’s green paper thought that this requirement could be “beefed up” through improved reporting, Code changes, raised awareness, and more guidance.

KEY PROPOSALS AT A GLANCE

Below is a brief summary of the U.K. corporate governance proposals.
On pay
Quoted companies must report annually the ratio of CEO pay to the average pay of their UK workforce.
Remuneration committees will have a broader responsibility for overseeing pay and incentives across their company, and must explain how executive remuneration aligns with wider company pay policy (by using pay ratios where appropriate).
The Investment Association will maintain a public register of those listed companies that have experienced one-fifth or more of their investors voting against executive pay schemes.
The FRC will revise the UK Corporate Governance Code so that it is more specific about the steps that premium listed companies should take when they encounter significant shareholder opposition to executive pay policies and awards.
On strengthening the employee, customer and supplier voice
All companies of “significant” size (private as well as public) must explain how their directors comply with the requirements of section 172 of the Companies Act about how they “have regard to employee and other interests.”
The FRC will develop a principle for companies to adopt—on a “comply or explain” basis—one of three employee engagement mechanisms: a designated non-executive director; a formal employee advisory council; or a director from the workforce.
Guidance on practical ways in which companies can better engage with employees and stakeholders will be published at the end of September.
On corporate governance in private companies
The FRC, working with industry bodies, will develop a voluntary set of corporate governance principles for large private companies.
Large companies will need to disclose their corporate governance arrangements in their Directors’ Report and on their website, including whether they follow any formal code.
Source: gov.uk

As a result, the government has put forward proposals to give employees, customers, and wider stakeholders a greater voice in how companies are run. Firstly, it wants to 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.

Secondly, the government wants the FRC to develop (following consultation) a new principle for inclusion in the Corporate Governance Code that establishes the importance of strengthening the voice of employees and other non-shareholder interests at board level. The new provision will require premium listed companies to adopt—on a “comply or explain” basis—one of three employee engagement mechanisms: a designated non-executive director; a formal employee advisory council; or a director from the workforce.

Thirdly, the government wants professional associations and business groups like the Institute of Chartered Secretaries and Administrators, The Governance Institute, and the Investment Association to issue joint guidance on practical ways in which companies can better engage with employees and stakeholders. That guidance will be published later this month. The government will also invite the general counsels from FTSE100 companies—known as the GC100 group—to complete and publish new advice and guidance on the “practical interpretation” of the directors’ duties as laid out in section 172 of the Companies Act 2006.

Another problem that Prime Minister May has vowed to tackle head-on is that of the lack of effective corporate governance regulation in large owner-managed or unlisted companies. Following the collapse of once-great retail giant BHS, the government is keen to avoid a repeat scenario of how its owners—Sir Philip Green and then Dominic Chappell—were able to pay themselves millions of pounds at the expense of the company, its pension scheme, and employees.

The government has therefore set out two proposals. Firstly, it wants the FRC to work with such business groups as the Institute of Directors (IoD), the Confederation of British Industry (CBI), the Institute for Family Businesses, the British Venture Capital Association, and others to develop a voluntary set of corporate governance principles for large private companies, chaired by “a business figure with relevant experience.”

Secondly, the government wants to introduce secondary legislation to require those companies of a “significant size” that are not already subject to any existing requirement to disclose their corporate governance arrangements in their Directors’ Report and on their Website, including whether they follow any formal code. The government will also consider extending a similar requirement to limited liability partnerships (LLPs), such as law and accountancy firms, “of equivalent scale.”

The term “significant” has not yet been defined, but it could be used to encapsulate a company’s employee numbers, its economic and market impact, its level of public interest, whether it delivers essential public services, has massive debts, or the number of pension beneficiaries it has.

Passing legislation is one issue, however—investigating wrongdoing and enforcing the rules is another. Business groups and investor bodies have long questioned whether the FRC has the powers, resources, and status to undertake its remit effectively. Sadly for the regulator, the government has made no mention of giving it any extra money.

Instead, the government thinks that better coordination between the FRC, the Financial Conduct Authority, and the Insolvency Service might be the way forward. It wants them to conclude new or, in some cases, revised letters of understanding with each other before the year is out to ensure the most effective use of their existing powers to sanction directors and ensure the integrity of corporate governance reporting.

The FRC intends to consult on amendments to the U.K. Corporate Governance Code in the late autumn, while the government will present draft secondary legislation (where required) before Parliament by March 2018 so that the new rules come into immediate effect from June 2018.

Business bodies like the CBI, ICSA, and The Governance Institute largely support the proposals. The Institute of Business Ethics has also welcomed them, particularly the government’s desire to improve corporate governance in large, privately owned businesses. “There needs to be a recognition that all company directors, not just those of listed companies, are subject to the legal duty set out in the law whereby boards must take stakeholder and ethical issues into account when making strategic decisions,” says its director, Philippa Foster Back.

But the proposals have also met with a fair deal of criticism, particularly since they are not as tough as May first promised on her campaign trail or as the Conservatives put in their election manifesto.

The Trades Union Congress, the U.K.’s umbrella organisation for trades unions, has called the proposals “feeble,” while the GMB Union—one of the country’s biggest—has called the government’s retreat from having worker representation on boards a “pathetic climb down,” adding that “the Tories have once again sided with the fat cats over the workers.”

Some experts are also critical of some of the reforms, particularly around executive pay. Keith Grint, professor of public leadership and management at Warwick Business School, says that the government’s reforms concerning the ratio of CEO pay to average employee earnings “are unlikely to change very much.” “The ratio has been growing for decades, shows no sign of decreasing, has never been related to any kind of company performance, and manifests radical differences from the ratios that Germany or Japan have,” he says.