Combined Code review: UK Corporate Governance Code

Practical Law UK Legal Update 8-502-2682 (Approx. 9 pages)

Combined Code review: UK Corporate Governance Code

by PLC Corporate

Background

On 28 May 2010, the Financial Reporting Council (FRC) published the UK Corporate Governance Code (Code) together with a report on the consultation of the Code (May 2010 report), which summarises the main issues raised during the consultation process.

During 2009 and early 2010, the FRC conducted an extensive review of the effectiveness of the Combined Code on Corporate Governance (Combined Code). This review had been planned for 2010 but was brought forward to run parallel with the review being undertaken by Sir David Walker of corporate governance in the UK banking sector, which had been commissioned by the Government as a result of the financial crisis. Although Sir David Walker's terms of reference related specifically to the banking sector, the consultation process generated significant discussion on the applicability of his proposals to all listed companies. As a result, Sir David Walker's final report addressed how far his recommendations might be adopted by the FRC as part of its review of the Combined Code (see Legal update, Walker Review final report: recommendations for all listed companies).

The FRC published a final report on its review together with a draft revised Combined Code, which it proposed to rename the UK Corporate Governance Code (draft Code) for consultation in December 2009 (see Legal update, Combined Code review: FRC final report and consultation). The FRC concluded in its final report that the Combined Code and related guidance were generally "fit for purpose" although required some updating. The FRC also announced that it proposed to adopt some of Sir David Walker's recommendations that it considered were appropriate to all listed companies.

The FRC's consultation on the draft Code ended in March 2010 and the final version of the Code reflects a number of comments made during the consultation process. PLC worked closely with the GC100 (the association for general counsel and company secretaries in the FTSE100) in drafting the GC100's response to the FRC's consultation on the revised UK Corporate Governance Code and some of the views expressed by the GC100 are reflected in the summary of key changes to the draft Code below.

As recommended by Sir David Walker, the FRC has also accepted the remit of developing a Stewardship Code that will set out good practice for institutional investors when engaging with UK listed companies and published a consultation on the form of Stewardship Code, which closed on 16 April 2010 (see Legal update, Stewardship code for institutional investors: FRC consultation).

For general background on the Combined Code, see Practice note, The Combined Code: overview. PLC will shortly be publishing a practice note overview on the Code, together with new practice notes on each section of the Code.

Conclusions of the FRC's review

In its May 2010 report, the FRC states that it generally received positive responses to its draft Code. In particular, there was strong support from respondents for the proposal to promote better board behaviour by refocusing attention on the Code's principles and encouraging boards to think more about how to apply the principles in order to best discharge their responsibilities. A summary of the key changes to the draft Code is set out below.

In its consultation, the FRC requested views as to whether the requirements in the Code that certain information should be disclosed in the annual report could be satisfied if disclosed on the company's website. Some respondents were against this proposal as they felt it would reduce the quality of information available in the annual report. The FRC has therefore decided not to make any changes but will give further consideration to this as part of its project to reduce the complexity of annual reports.

Key changes to the draft Code

A summary of the key changes made to the draft Code is set out below. For a list of all changes made to the Combined Code, see box, Changes to the Combined Code.

Annual re-election of all directors of FTSE 350 companies (Provision B.7.1)

Many respondents were divided in their views as to whether the Code should include a provision that the full board should stand for annual re-election. Many were concerned that complying with such a provision would promote a short term approach, create the potential to destabilise the board and that the logistics at annual general meetings would become more onerous. Those in favour of annual re-election felt that it held the board to account and would promote more robust engagement with shareholders.

The FRC concluded that it was appropriate that shareholders should have the annual opportunity to express their views on the performance of the directors and has included a provision that all directors of FTSE 350 companies should be subject to annual re-election. In the Preface, the FRC also encourages boards of smaller companies to consider their policy on director re-election.

Between January and May 2010, only seven FTSE 100 companies have proposed full board re-election, see What's Market: FTSE 100. This highlights that many companies will face significant change and may need to amend their articles of association if they wish to comply with this new provision.

Board evaluation of FTSE 350 companies to be externally facilitated every three years (Provision B.6.2)

Another area that caused debate and disagreement among respondents was the FRC's proposal that evaluation of the board should be externally facilitated at least every three years (new Provision B.6.2). In its response, the GC100 questioned how this new provision would sit with Main Principle B.6 that boards should undertake a formal and rigorous annual evaluation and were concerned that the existing pool of external facilitators was small. The FRC has decided to retain this new provision, but acknowledges that in the short to medium term there will be concerns about the availability of board evaluation services and will continue to monitor the market.

Appointments to the board - diversity (Supporting Principle B.2)

The FRC has amended the proposed wording in supporting principle B.2 to make it clear that boards should be encouraged to consider the diversity of the board, including the gender mix, when making new appointments. The FRC believes that diversity, defined broadly, in the board can improve the quality of decision making.

Disclosure of the business model (Provision C.1.2)

In the draft Code, the FRC proposed a new Provision C.1.2 that an explanation of the company's business model and the strategy for delivering the objectives of the company should be included in the annual report. Although some respondents felt that this new provision was not required as a well drafted Business Review should include an explanation of how the company generates revenues and profit, the FRC believes that there is a gap in the requirement for boards to report on the company's strategy. The FRC has therefore retained this provision and encourages companies to include a description of the business model alongside the Business Review.

Risk management (Main Principle C.2)

Respondents generally agreed with the proposed new principle that the board should be responsible for determining risk. However, some questioned what was meant by the proposed terminology, for example "risk appetite". In its May 2010 report, the FRC confirmed that it was its intention to simply state that it was the responsibility of the board to consider how much risk the company should take and has therefore reworded the principle to provide that the "board is responsible for determining the nature and extent of the significant risks it is willing to take in achieving its strategic objectives".

Design of performance related remuneration for executive directors (Schedule A)

In its response, the GC100 expressed concern with the proposed wording in Schedule A that payouts or grants under all incentive schemes should be subject to challenging performance criteria reflecting the company's objectives "including non-financial performance metrics", as some companies may for valid reasons choose not to use non-financial metrics for long-term incentives. In its May 2010 report, the FRC confirms that it had only intended to recommend that such metrics should be used "if appropriate" and has amended the Schedule accordingly.

The FRC has also removed its proposed wording that the "criteria for paying bonuses should be risk adjusted", following some responses which questioned the feasibility of risk-adjusting the payment of bonuses outside the financial services sector. The FRC has however retained the requirement that incentives should be compatible with risk policies and systems.

Next steps

The Code will apply to all companies with a premium listing, regardless of where they are incorporated, with reporting years beginning on or after 29 June 2010.

The FRC has indicated that it expects to announce the outcome of its consultation on the Stewardship Code at the end of June 2010.

As indicated in its final report published in December 2009, the FRC will be conducting a limited review and consultation on the Turnbull Guidance on internal control later in 2010. For a summary of the Turnbull Guidance, see Practice note, Internal control: the Turnbull guidance.

ICSA is also in the process of reviewing the Good Practice Suggestions from the Higgs Report, which was last reissued in 2006. ICSA's first consultation on the scope of the review closed in April 2010, see Legal update ICSA launches consultation on its review of the Higgs Guidance. ICSA expects to publish a further consultation on the revised guidance in June 2010 with the aim of submitting final guidance to the FRC by October 2010.

The next review of the Code will be in 2013.

Source: Financial Reporting Council: UK Corporate Governance Code and Financial Reporting Council: Report on consultation on UK Corporate Governance Code (May 2010), each published 28 May 2010.

Changes to the Combined Code

Title and introduction

The new code will be called the UK Corporate Governance Code.
The Combined Code's preamble has been replaced with a new section on the purpose of corporate governance, a preface from the FRC which explains how boards should follow the spirit of the Code and an explanation of the "comply or explain" approach.
The chairman is encouraged to report personally in the annual report on how the principles in Sections A and B, relating to the role and effectiveness of the board, have been applied (Preface).

Section A: Leadership (formerly "The Board")

Role of the board, division of responsibilities, the chairman and non-executive directors.

The board is collectively responsible for the long-term success of the company (Main Principle A.1)
The following supporting principles have been given greater prominence by being upgraded to main principles:
- The chairman is responsible for leadership of the board and ensuring its effectiveness on all aspects of its role (Main Principle A.3).
- As part of their role as members of a unitary board, the non-executive directors should constructively challenge and help develop proposals on strategy (Main Principle A.4).
All directors must act in what they consider to be the best interests of the company, consistent with their statutory duties (Supporting Principle A.1).
The chairman should ensure that adequate time is available on the board's agenda for discussion of all agenda items, in particular strategic issues. The chairman should promote a culture of openness and debate (Supporting Principle A.3).
The senior independent director should provide a sounding board for the chairman and to serve as an intermediary for the other directors when necessary (Provision A.4.1).

Section B: Effectiveness (new section)

The composition of the board, appointments to the board, commitment, development, information and support, evaluation and re-election.

The board and its committees should have the appropriate balance of skills, experience, independence and knowledge of the company to enable them to discharge their respective duties and responsibilities effectively (Main Principle B.1).
The board should include an appropriate combination of executive and non-executive directors (and, in particular, independent non-executive directors) (Supporting Principle B.1).
The search for board candidates should be conducted, and appointments made, on merit, against objective criteria and with due regard for the benefits of diversity on the board, including gender (Supporting Principle B.2).
All directors should be able to allocate sufficient time to the company to discharge their responsibilities effectively (a Supporting Principle in the Combined Code, this has been upgraded to a Main Principle) (Main Principle B.3).
To function effectively, all directors need appropriate knowledge of the company and access to its operations and staff (Supporting Principle B.4).
The chairman should regularly review and agree with each director their training and development needs (Provision B.4.2).
Evaluation of the board of FTSE 350 companies should be externally facilitated at least every three years. A statement should be made available of whether an external facilitator has any other connection with the company (Provision B.6.2).
All directors of FTSE 350 companies should be subject to annual election by shareholders (Provision 6.7.1).

Section C: Accountability (formerly "Accountability and audit")

Financial and business reporting, risk management and internal control and audit committee and auditors.

An explanation in the annual report of the directors' responsibility for preparing the annual report as well as the accounts (Provision C.1.1).
Inclusion in the annual report (ideally in the same part as the Business Review) of an explanation of the basis on which the company generates or preserves value over the longer term (the business model) and the strategy for delivering the objectives of the company (Provision C.1.2).
The directors should report in annual and half-yearly financial statements that the business is a going concern (Provision C.1.3).
The board is responsible for determining the nature and extent of the significant risks it is willing to take in achieving its strategic objectives. The board should maintain a sound system of risk management and internal control systems (Main Principle C.2).
The board should annually conduct a review of the effectiveness of the company's risk management and internal control systems (Provision C.2.1).

Section D: Remuneration (formerly Section B)

The level and components of remuneration and procedure.

The performance-related elements of executive directors' remuneration should be stretching and designed to promote the long-term success of the company (Supporting Principle D.1).
Remuneration for non-executive directors should not include share options or other performance-related elements (Provision D.1.3).

Section E: Relations with shareholders (formerly Section D)

Dialogue with shareholders and constructive use of the AGM.

The chairman should ensure that all directors are made aware of their major shareholders' issues and concerns (Supporting Principle E.1).
Non-executive directors should be offered the opportunity to attend scheduled meetings with major shareholders (Provisions E.1.1).
Information on proxy appointments to be given to the meeting and made available on a website where a vote has been taken on a show of hands (Provision E.2.2).

Schedule A: Provisions on the design of performance related remuneration for executive directors

Performance conditions for annual bonuses should be designed to promote the long-term success of the company.
Payouts or grants under all incentive schemes, including new grants under existing share option schemes, should be subject to challenging performance criteria reflecting the company's objectives, including non-financial performance metrics where appropriate. Remuneration incentives should be compatible with risk policies and systems.
Consideration should be given to the use of provisions that permit the company to reclaim variable components in exceptional circumstances of misstatement or misconduct.

Schedule C: Engagement principles for institutional shareholders (formerly Section E)

This Schedule will be removed from the Code when the Stewardship Code for Institutional Shareholders comes into effect.

Schedule B of the Combined Code: Liability of non-executive directors

This has been removed and guidance on this issue will be incorporated in the revised Higgs Guidance being produced by ICSA.

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