Refresh, not reform: Consultation on changes to the UK Corporate Governance Code

• The FRC's Minimum Standard for Audit Committees in relation to external audit, which applies to FTSE 350 companies, contains several sections that are identical to some of the current Code provisions in relation to external audit. The FRC is therefore proposing that these provisions are deleted to avoid duplication and that the revised Code instead refers to the Standard. It acknowledges that this will bring into scope non-FTSE 350 companies that that are subject to the Code but would not otherwise be caught by the Standard. The FRC states that many such companies already follow some of the requirements.

The remit of the audit committee will be expanded to include narrative reporting, including sustainability reporting and, where appropriate, ESG metrics, where such matters are not reserved for the board.

• There will be a new Principle making the board responsible not only for establishing, but also maintaining, the effectiveness of the risk management and internal control framework. The board will be required to declare whether it can reasonably conclude that the risk management and internal control systems have been effective throughout the reporting period. This change is aimed at ensuring the review of effectiveness is not merely a snapshot at a particular point in time, emphasising instead its ongoing nature. It is expected that companies will report on material weaknesses – the FRC's updated Guidance on Risk Management, Internal Control and Related Financial and Business Reporting will discuss what may constitute a "material weakness" but it is ultimately a call for the board. The FRC states that the guidance will set out "possible structures, responsibilities, actions and recommendations" whilst remaining flexible enough for companies to adapt it to their circumstances. The consultation sets out some of the matters that will be covered in the updated guidance, including the proposed definition of "material weakness".
  
  
• The Government's plan to introduce a new "Resilience Statement" for PIEs also has implications for the Code, in particular the Code's so-called "Viability Statement". There will be a new Provision asking the board to explain how it has assessed the future prospects of the company. Companies complying with the Resilience Statement requirements (which will be set out in the Companies Act 2006) will already be compliant with this new Provision; whereas non-PIEs that choose not to have a Resilience Statement and to explain why not will need to report in a way that is proportionate to the requirement or set out the basis for the assessment in the annual report.

• The proposals will strengthen the Code in recognition of the increasing demands on directors' time and to support the diversity of skills and experience on boards. The FRC proposes two options on which it seeks feedback:
   
• • There will be a new requirement that the annual board performance review should consider each director's commitments to other organisations and how directors are able to make sufficient time available to effectively discharge their role.
    
    
  • Annual reports should include more information on directors' other commitments– for example, board positions , committee roles and the potential number of commitments each year – and how these are managed. While most listed companies are already doing this in light of institutional investor guidance, the proposed changes go further and provide clarity which should be helpful to investors.

• As the FRC notes, institutional shareholder guidelines already set out the expectations on time commitments. We believe this is the best place for such expectations and agree that the FRC should not be looking to introduce a more prescriptive requirement as regards time commitment, as this maintains a more flexible regime that can be adapted to companies' needs and can be amended on an annual basis should investor expectations change.

• The FRC proposes changes to strengthen the Code without introducing additional targets or duplicating existing regulation, such as the Listing Rules requirements in relation to diversity reporting, and hopes that the changes will help companies be more proactive rather than reactive when it comes to succession planning.
  
  
• The FRC is adding a reference to "inclusion" in its Principles in this section to encourage companies to consider diversity beyond gender and ethnicity.
  
  
• It is also amending its Provisions in this section to improve transparency to understand the role of any targets or initiatives companies are using to achieve greater diversity and inclusion in their boards and executive management.

• The FRC is adopting the term "board performance review" instead of "board evaluation" to emphasise that externally facilitated reviews are forward-looking and represent a continual process of self-improvement for boards.
  
  
• The FRC will incorporate into its own guidance many aspects of the draft guidance issued by the Corporate Governance Institute.
  
  
• Under the new Code, the Chair will be required to commission, rather merely consider having an externally facilitated board performance review.

• There is greater emphasis on transparency as regards the procedure for developing policy on executive remuneration and determining director and senior management remuneration.
  
  
• The proposed new Code provides that remuneration outcomes should be clearly aligned to company performance, purpose and values, including ESG objectives. Although the specific reference to ESG is a welcome addition to the Code, this reflects what some listed companies are already doing.
  
  
• Workforce pay and conditions are included in the new Code as factors which remuneration committees should have regard to in determining executive pay. Again, in reality, many remuneration committees already take these factors into consideration.

Malus and clawback provisions enable companies to reduce or recover an employee's remuneration in certain circumstances.  They have been a feature within the financial services industry for some time and are increasingly expected by shareholders outside this sector and appear in institutional investor protection committee guidelines.  Without specifically referencing malus and clawback, the Code currently requires that remuneration schemes and policies should include provisions that would enable the company to recover and/or withhold sums or share awards and specify the circumstances in which it would be appropriate to do so.

The Government had invited the FRC to consult on how to provide greater transparency around malus and clawback.  It also asked whether there should be a prescribed minimum list of circumstances in which malus and clawback should apply.  Historically, malus and clawback has typically been applied in cases of material misstatement of financial results and serious misconduct of the relevant individual but, more recently, companies have been encouraged its use in a wider range of circumstances (including for example, material failure of risk management or corporate failure).  Having taken the opportunity for a fresh look at these provisions, the FRC is proposing the following:

• It notes the desire for increased clarity in the Code on malus and clawback but recognises the risk in prescribing a "one-size-fits-all" approach for every remuneration committee to follow.  Therefore, rather than prescribe a minimum list of circumstances in which malus and clawback should apply, the proposed new Code will include a requirement that "Director contracts and/or other agreements or documents which cover director remuneration should include malus and clawback".
  
  
• A new Code Provision will require annual reports on remuneration to contain more detail in relation to malus and clawback, namely a description of the provisions including :
  
  (i) the minimum circumstances in which they can be used;
  
  (ii) the minimum period in which they will apply (and why this is considered suitable);
  
  (iii) whether they have been used in the last financial year (and if so giving a clear explanation of the reason); and
  
  (iv) the use of malus and clawback in the past five years. 
  
  
• The FRC notes that many companies already disclose some of this information (particularly the minimum circumstances and period in which malus and clawback can apply) but they believe there is greater scope for transparency without removing a remuneration committee's flexibility to decide what is most suitable for their company.  We await further guidance on the level of detail companies will need to provide when describing their use of malus and clawback.

The FRC also asks for views on whether any Code changes are needed to support progress in relation to artificial intelligence, on the basis of the Government's White paper on this topic in March 2023.

The consultation closes on 13 September 2023, with the new Code expected to apply to financial periods beginning on or after 1 January 2025 to allow companies sufficient time for implementation. 

As part of its market engagement, the FRC will host a series of roundtables throughout the consultation period. These will focus on three main topics: internal controls (including the Resilience Statement and viability, and risk management and internal controls); boards (including diversity, over-boarding and nomination committees); and leadership and reporting (including sustainability, culture, strategy, and impacts and outcomes reporting). The schedule for these roundtables and how to apply is on the FRC website: Consultations | Financial Reporting Council (frc.org.uk).

Travers Smith will be responding to the consultation through its membership of the Company Law Committee of the City of London Law Society.