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, 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; (ii) the increase in number of chairmen and committee chairs making personal statements in annual reports and thereby taking more care and responsibility; 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; 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.
Proposed key changes to the Codes and related guidance (to be effective as of October 2012), include:
The final form of many of these changes are to be subject to/the subject of various consultations during this year. 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) 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.
 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.
 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.
 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.
 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’.
 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.
 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.
 See link to Sharman Panel of Inquiry here.
 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:
© 2012 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.