February 7, 2012
Introduction: The Financial Reporting Council ("FRC"), the independent regulator responsible for promoting corporate governance in the UK, published its annual report at the end of last year assessing the impact and effectiveness of the new UK Corporate Governance Code ("CGC") and the new Stewardship Code ("SC") (the "Codes"), setting out proposals for reform and improvement in best practice.
Which Companies Have Been Appraised? By way of quick reminder, the new UK Corporate Governance Code (the successor to the Combined Code on Corporate Governance) was published in May 2010 and applies to all companies (whether incorporate in the UK or elsewhere) with a premium listing of equity shares on the London Stock Exchange[1], in respect of accounting period beginning on or after 29 June 2010. The CGC contains main and supporting principles and specific code provisions — listed companies are required to produce a statement in their annual report stating how they have applied the main principles of the CGC and whether or not it has complied with all relevant Code provisions and if not, explaining why not. The SC, published in July 2010, sets out good practice for institutional investors when engaging with investee companies. The SC replaced a previous schedule to the Combined Code and was removed and given its own "Code" status in recognition of the increasing importance of shareholder engagement. The Codes are founded on the "comply or explain" basis — an approach which has been the subject of much academic and professional debate in recent years.
‘Report Card ‘Summary: The report indicated that generally, compliance with both Codes has been good with 50% of FTSE 350 companies complying fully with the CGC with a further 234 signatories to the SC.
The report noted that there were a number of things companies did well (particularly under the CGC) such as: (i) using external advisers to evaluate board effectiveness[2]; (ii) the increase in number of chairmen and committee chairs making personal statements in annual reports and thereby taking more care and responsibility[3]; and (iii) the annual re–election of directors.
However, the report does set out certain areas for improvement for companies and investors alike. These include: (i) the quality of reports by the audit and remuneration committees (statements in the latter often failed to link how the remuneration policy adopted and applied fitted in with overall company strategy); (ii) the unimpressive level of investor engagement in long term issues of the company[4]; and (iii) the quality of reasons for not complying with the Codes. The report states that while in 70% of cases, explanations for non-compliance with the CGC is informative, in other cases, they are only perfunctory, with a limited number of companies completely failing to provide any explanation at all.
The report anticipates dealing with these concerns through amendments to the specific provisions of the Codes and related guidance. These revisions are in addition to those envisaged by the UK government’s Business Secretary recently (see our Client Alert dated 31 January 2012). Although the Codes may become more prescriptive as a result of these proposed changes, reassuringly (for some), the FRC does not recommend moving from the ‘comply or explain’ approach to a statutory Code(s) … or at least, not as yet[5].
Proposed key changes to the Codes and related guidance (to be effective as of October 2012), include:
- Disclosure of Diversity: Changing the CGC to require the boards of premium listed companies to disclose their diversity policies. This represents an initiative by the FRC to implement the recommendation made to it by Lord Davies in his February 2011 report on gender equality in the boardroom (http://www.bis.gov.uk/assets/biscore/business-law/docs/w/11-745-women-on-boards.pdf.) . The FRC also reinforced its view that companies of all sizes should "look beyond the usual suspects" when seeking suitable candidates for non-executive directors, to enhance the diversity and effectiveness of the board. The FRC has encouraged companies to comply with this requirement before October 2012.
- Clear Criteria: Revising the CGC to make clear the criteria that companies should refer to when preparing statements explaining non-compliance with the CGC. The FRC is also considering what steps could be needed to ensure that such criteria is consistently applied, such as inviting shareholders to contact the Financial Reporting Review Panel if a company fails to respond to a request for a clearer explanation on why a company has not complied with the CGC.
- Ramping up Risk Controls: Updating the ‘Turnbull Guidance[6]‘ on risk management and internal control to provide more clarity on how companies can understand their exposure to risk and ’embed the right risk culture’ throughout its organisation. The report pointed out that in particular, company reporting in this area should focus on strategic and major operational risks inherent in a company’s business model and strategy, rather than generic risk.
- Amplifying Audit Committees: Extending the remit of reporting by audit committees (which is likely to require specific disclosure of how audit committees discharge their responsibilities and make key decisions in annual reports). There will also be a requirement in the CGC for a company’s external audit to be put to tender at least every ten years[7].
- Crafting (Going) Concern Commentary: Changes to the way which directors are required to report on whether a company’s business is a going concern. This is following the initial recommendations of the Sharman Panel of Inquiry in November 2011 on going concern and liquidity risk reporting[8]. The FRC is likely to consult on this further later this month.
- Promulgating Policies: Strengthening the language in the SC to clarify the different roles of asset managers and asset owners as investors in companies, the provisions and policies relating to conflicts of interest[9], collective engagement, use of proxy voting agencies, and possibly requiring investors to disclose their stock lending policy.
- Collusion & Concertedness: Potential revisions to the SC to encourage increased investor engagement with companies. The report states that currently, investors focus on membership of collective bodies, rather than how investors are joining forces at critical moments to ensure that boards acknowledge and respond to their concerns. The FRC acknowledged that some investors have lingering concerns that engagement as between shareholders could mean that investors are deemed to be "acting in concert", which could have adverse consequences under, for example, the UK Code on Takeovers and Mergers. The FRC has stated that while the UK Panel on Takeovers and Mergers and the Financial Services Authority have made public statements offering comfort on this point the FRC is of the view that there is scope for more comfort and guidance to be provided to investors — we share this view.
The final form of many of these changes are to be subject to/the subject of various consultations during this year[10]. The FRC has reassured companies and investors that once the changes anticipated by the report (and the ones set out in the Business Secretary’s announcement[11]) are implemented, it does not intend to make further revisions to the Codes until 2014 at the earliest. Until that time, the FRC has said that it intends to facilitate awareness of the Codes, engage with investors and companies, and work with other regulators to address concerns.
A link to the FRC report can be found at http://www.frc.org.uk/press/pub2671.html.
[1] Companies with shares admitted to trading on the Alternative Investment Market (AIM) of the London Stock Exchange and other quoted companies are not required to apply the SGC (although larger AIM companies have sought to use the CGC as an aspirational benchmark and endeavour to comply with as much of the provisions as possible). The Corporate Governance Guidelines for Smaller Quoted Companies published by the Quoted Companies Alliance set out the key corporate governance principles for AIM companies.
[2] The report acknowledged the dilemmas facing companies due to the relatively new market for these evaluation services, and the quantity and varying quality of such services available. The report makes clear that to the extent that companies do use an external adviser to evaluate its board, at a minimum, the identity of such advisor should be disclosed in the company’s annual report.
[3] The report did note that some of these statements paid too much focus on process and procedure rather than the real thinking behind key board decisions taken during the course of the year.
[4] The report provides an interesting insight into some of the issues precluding investor engagement, such as cases when companies have re-incorporated abroad but remain listed in the London, and moved the location of their annual meetings abroad. The report also considers some concerns that investors have regarding increased engagement such as lack of resources and/or client demand, the risk of acting in concert, and the risk of being made insiders.
[5] There has been on-going criticism (for instance by the EU in its 2011 Green Paper on Corporate Governance of Listed Companies), as to whether the ‘comply or explain’ model still works, and whether compliance with the Codes should be mandatory. The FRC confirms in its report that it is of the view that the comply or explain approach is still working, however was quick to point out that investors and companies would need to demonstrate a commitment to changing behaviour and driving up standards to avoid these becoming ‘hard law’.
[6] In September 1999, the Institute of Chartered Accountants in England and Wales (ICAEW) published guidance on internal controls, the Turnbull report. This guidance provided assistance to directors of listed companies on implementing the internal control recommendations set out in the UK Corporate Governance Code and ensuring that they had in place effective risk management and internal control systems for the management of risks significant to the fulfilment of their business objectives. The guidance was overhauled in 2005 post Enron.
[7] On the theme of external audit, this requirement may very well change eventually subject to the results of the Office of Fair Trading’s referral of the market for statutory audit services by large companies in the UK to the Competition Commission for investigation.
[8] See link to Sharman Panel of Inquiry here.
[9] The report states that few signatories to the SC state that they categorically seek to place the interests of their clients first.
[10] The report envisages a number of consultations in this regard, such as Professor John Kay’s consultation on the effect of the UK equity markets on the competitiveness of the UK, and the consultation on company law reform.
Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have about these developments. Please contact the Gibson Dunn lawyer with whom you work, or any of the following lawyers in the firm’s London office:
Selina S. Sagayam (+44 20 7071 4263, [email protected])
James A. Cox (+44 20 7071 4250, [email protected])
Leila Greer-Stapleton (+44 20 7071 4255, [email protected])
© 2012 Gibson, Dunn & Crutcher LLP
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