The FRC Consults on Changes to the UK Corporate Governance Code (24 May 2023)
In May 2023, the FRC published a consultation paper, which proposed revisions to the UK Corporate Governance Code (the "Code"). Under the FRC's Listing Rules, only premium listed companies are required to apply the Code; however, many non-premium listed companies choose to follow the Code, for example, because it can make them more attractive to investors. In summary, the Code is a code of corporate governance that operates on a "comply or explain" basis. (i.e. premium listed companies that do not comply with the provisions of the Code are required to explain why this is the case).
The consultation paper primarily focusses on Section 4 of the Code (Audit, Risk and Internal Control), but also proposes minor changes to the other sections. An overview of each section of the Code is provided below, along with a summary of the substantive updates proposed.
- Section 1 - Board leadership and company purpose
Section 1 deals with the board's function and its role in establishing the company’s purpose, values and strategy. Specifically, it discusses the board’s role in moulding a company’s culture and the requirement for the board to engage with shareholders and other stakeholders.
The FRC plans to introduce a new to introduce a new "Principle D", which lays out its expectation that companies should focus on activities and results to demonstrate the effect of governance practices for the benefit of company stakeholders when reporting on their governance activity. The FRC has also proposed minor amendments intended to bring greater concentration to ESG issues, particularly companies’ climate ambitions and transition planning.
- Section 2 – Division of Responsibilities
Section 2 of the Code considers the role of members across the board and the division of responsibilities across different layers of leadership of the company’s business.
In particular, the consultation paper records the increased concern from investors about the number non-executive directors of listed companies. Given this concern, the FRC proposes amending the current "Principle L" ("Principle K" in the revised Code), to specify that the annual board performance review should consider each director’s commitments to other organisations, and how directors are able to make adequate time available to discharge their duties effectively. Additionally, the FRC proposes to amend Provision 15 to recommend that annual reports include more information on the other commitments held by directors.
- Section 3 – Composition, Succession and Evaluation
Section 3 of the Code deals with the composition of the board (including diversity), appointments and succession planning.
The FRC is proposing that the current Principle J should deviate from the current approach of stipulating particular diversity characteristics that should inform companies’ appointments and succession plans. Instead, the revised Code will encourage companies to promote equal opportunity, and diversity and inclusion of all protected and non-protected characteristics including cognitive and personal strengths. Further, the FRC is proposing amendments to current Provision 23, to provide better clarity on the approach by the succession planning and board and senior management appointments. Finally, the FRC is also proposing that the current Provision 21 be amended to recommend that the chair commission an external board performance review rather than merely consider this (as currently provided by the Code). This pro-active language is unlikely to change much for FTSE 350 companies, however, as they should conduct such a review every three years regardless.
- Section 4 – Audit, Risk and Internal Control
Section 4 of the Code deals with the internal and external audit process, financial and business reporting, risk management and internal control and the audit committee.
The FRC's proposals here, are arguably the most important recommendations made by the FRC. They link directly with the Governments 2022 white paper ‘Restoring trust in audit and corporate governance’ which, after a series of large recent corporate failures at companies such as BHS, Carillion & Thomas Cook,[JS1] , set out plans to further strengthen the UK’s audit and corporate governance framework to empower shareholders and ensure they can rely on information published by UK companies.
The FRC's Section 4 proposals focus on:
- the audit and assurance policy
- audit committees and external audits
- sustainability reporting
- risk management and internal controls
- going concern reporting
- the resilience statement
Whilst audit committees are given responsibility in relation to reporting on sustainability matters, the majority of the FRC's proposals here relate to increasing their accountability and the standards of their reporting.
- Renumeration
Section 5 of the UKCG Code deals with remuneration policies and practices, the role and responsibilities of the remuneration committee and the use of remuneration consultants.
The FRC proposes the following amends:
- Principles P, Q and R should be revamped to strengthen the link between remuneration and ESG objectives.
- References to pay ratios and pay gaps should be removed from the Code, in the hope that this will avoid duplication of disclosure for the many companies who already separately report on gender and (in many cases) ethnicity pay ratios and pay gaps.
- The insertion of a new provision setting out what should be covered by the remuneration report when it comes to malus and clawback.
What does this mean?
To some extent, these proposed changes certainly have shareholders in mind[1]. The focus of the proposed changes to Section 2 on controlling overboarding can be seen to have been driven by the fact that overboarding can negatively affect shareholders both in the short term and long term. Taking as an example Elon Musk's appointment and resignation as Twitter CEO and the correlated decline and rise in Tesla’s share price, it is clear that overboarding can negatively affect shareholders through share price decline and fluctuation. In the longer-term, share price will be negatively affected as directors have their attention spread too thinly, which could lead to poor decision making. Nevertheless, despite such a shareholder-focused amendment in respect of the way in which directors should govern, the FRC's proposed changes focus heavily on other stakeholder interests. The suggested changes to Section 1 and 5 have ESG in mind whilst those proposed in relation to Section 3 champion diversity. This greater focus on other company stakeholders beyond shareholders mirrors the emerging trends in corporate governance. ESG, for example, is becoming an increasingly large part of corporate governance as informed by investing habits, with Blackrock for instance, saying it will look to exit investments with high environmental risks.
Off the back of these proposed updates and with concerns around ESG and diversity becoming more prevalent, it will be interesting to see whether corporate governance in the UK will stray from an enlightened shareholder approach; an approach where directors prioritise the interests of shareholders whilst considering the interests of other stakeholders, such as employees and the environment. Might there come a point where executive decisions at companies are focussed more on ESG than maximising profit for shareholders, for instance?
