Shake-up of Corporate Governance Code - December 2017

What are the key proposed changes?

Removal of exemptions for companies below the FTSE 350

• The exemptions in relation to companies below the FTSE 350 will be removed – under the revised Code, all listed companies will be subject to all the Principles and Provisions of the Code. Currently, exemptions apply in relation to provisions relating to board composition, board evaluation, annual re-election of directors, and audit and remuneration committee composition.
• All directors will therefore be expected to be subject to annual re-election.
• The FRC is consulting in particular on the removal of the exemption in relation to independent board evaluation. The revised Code will state that all companies should have an externally facilitated board evaluation at least every three years. The removal of this exemption will inevitably impose a financial and logistical burden on those companies who do not currently need to comply with this requirement.

Shareholder dissent

Where more than 20% of votes have been cast against a resolution, the company should:

• explain what actions it intends to take to consult with shareholders to understand the reasons behind the result; - publish an update no later than six months after the vote; and
• provide a final summary in the annual report, or in the explanatory notes to resolutions at the next meeting, on the impact of the feedback on the decisions of the board, and any proposed actions or resolutions.

These actions, which have been included to cater for significant shareholder opposition in relation to executive pay, are aimed at ensuring that the company fully understands the reasons for its shareholders voting against a resolution, and will be able to discuss these matters further with them.

Long term incentivisation

• There is an emphasis in the proposals on promoting longer term shareholdings – the vesting and holding period requirement for share-based remuneration will be extended from three to at least five years. Although many companies already impose a combined vesting/holding period of five years as a matter of practice, the fact that this is now required will affect directors who receive shares as part of their bonus.
• The proposals include a new provision under which remuneration schemes and policies should provide boards with discretion to override formulaic outcomes i.e. remuneration committees should have the power to cap the value of the incentives after they have been awarded. The draft guidance specifically notes that rewards driven by currency movements not management would be expected to be capped.
• None of these changes call for the amendment of existing schemes (and a company could not unilaterally amend a scheme) but they are the direction of travel for new schemes.

Employee interaction

• Boards will have to establish a method for gathering the views of the workforce, namely one of the three employee engagement mechanisms set out in the Green Paper on Corporate Governance Reform: a director appointment from the workforce; a formal workforce advisory panel; or a designated nonexecutive director. The FRC has taken account of feedback that there should be flexibility for individual companies to choose the right mechanism or combination of mechanisms.

Employee remuneration

• The remuneration committee will have a broader remit, taking on responsibility for oversight of company remuneration and workforce policies and practices for the employees as a whole. The accompanying guidance states that, in some cases, it may be more appropriate to delegate some of the oversight for workforce policies to other committees, such as a sustainability committee, corporate responsibility committee or people committee.

Experience of remuneration committee chairs

• Remuneration committee chairs should have served for at least 12 months on a remuneration committee before becoming chair.

Revised guidance on independence and tenure

• The revised Code will state that independent non-executive directors, including the chair, should constitute the majority of the board (as opposed to "at least half the board, excluding the chairman" constituting the majority of the board).
• Currently, the Code provides that the board may determine a director to be independent notwithstanding the existence of certain relationships or circumstances, including where the director has served on the board for more than nine years. This presumption of independence will be removed and the revised Code will state that non-executive directors, including the chair, should not be considered independent for the purposes of board and committee composition, if any of the specified factors (including the nine year rule) are relevant.
• The FRC notes that, although the Code does not refer to tenure, many companies and investors use the nine year criterion for independence as a "de facto" tenure period. It confirms that this is the right approach and, in normal circumstances, it would not expect either an independent director or chair to be on a board for more than nine years in total, including where a non-executive goes on to become the chair. This will be particularly controversial for those chairmen who have not yet served nine years in their current role but previously held non-executive positions which would bring them within the nine year rule. We expect that some companies may therefore choose to explain their non-compliance in relation to this.

New requirements on diversity

• For the first time, the Code will encourage companies to build diversity (not only of gender but also of social and ethnic backgrounds) across the workforce, and, in particular, in the executive pipeline. Companies will have to include in their annual report details of actions taken to increase diversity and inclusion.

When will the changes take effect?

The consultation will close on 28 February 2018. The FRC aims to publish a final version of the Code by early summer 2018 and the new Code will apply to accounting periods beginning on or after 1 January 2019.

Why is the Code changing?

The proposed changes outlined above take into account and reflect:

• the findings of the FRC’s 2016 Culture Report, which looked at corporate culture and the role of boards;
• the issues raised by the Green Paper on Corporate Governance Reform;
• the recent Hampton-Alexander and Parker Reviews on diversity; and
• input the FRC has received from a broad range of stakeholders.

What will the new Code look like?

The revised, "sharper" and more concise Code will re-focus on the application of the Principles, with particular emphasis on stakeholders, integrity, corporate culture and diversity. It will be divided into five sections (with slightly different headings from the current five sections): Leadership and purpose; Division of responsibilities; Composition, success and evaluation; Audit, risk and internal control; and Remuneration. The current section entitled "Relations with shareholders" will be integrated within the revised Code, which emphasises the importance of shareholder engagement.

Appendix C of the consultation ("Summary of Changes from 2016 Corporate Governance Code") helpfully indicates where the Principles and Provisions in the current Code have been incorporated into the revised Code or into the Guidance on Board Effectiveness or where they have been deleted.

What other changes are proposed?

The FRC's Guidance on Board Effectiveness, which was published in 2011, will be rewritten to support the proposed changes to the Code, and should be read alongside the revised Code. Some aspects of the current Code, for example the induction of new directors and the role of the nomination committee, have been moved to the Guidance. The FRC states that this does not lessen their importance, but that the practices are well embedded in company behaviour. The revised Guidance contains more practical information on decisionmaking, such as questions for boards in relation to each area (remuneration, workforce engagement, and decision-making, and questions for remuneration committees). It also contains a section on relations with the workforce and wider stakeholders, including examples of workforce engagement activities.

In its paper, the FRC also includes an initial high-level consultation on the Stewardship Code, with a view to formally consulting on changes in 2018.