tolley’s csr company service uk corporate governance … · tolley’s csr company service uk...

Tolley’s CSRCompany Service

UK Corporate GovernanceCode: 2014 Update

Martin Webster

Partner, Pinsent Masons LLP

Members of the LexisNexis Group worldwide

United Kingdom LexisNexis, a Division of Reed Elsevier (UK) Ltd, Lexis House,30 Farringdon Street, London, EC4A 4HH, and 9–10, St. AndrewSquare, Edinburgh, EH2 2AF

Australia Reed International Books Australia Pty Ltd trading as LexisNexis,Chatswood, New South Wales

Austria LexisNexis Verlag ARD Orac GmbH & Co KG, Vienna

Benelux LexisNexis Benelux, Amsterdam

Canada LexisNexis Canada, Markham, Ontario

China LexisNexis China, Beijing and Shanghai

France LexisNexis SA, Paris

Germany LexisNexis GmbH, Dusseldorf

Hong Kong LexisNexis Hong Kong, Hong Kong

India LexisNexis India, New Delhi

Italy Giuffrè Editore, Milan

Japan LexisNexis Japan, Tokyo

Malaysia Malayan Law Journal Sdn Bhd, Kuala Lumpur

New Zealand LexisNexis New Zealand Ltd, Wellington

Singapore LexisNexis Singapore, Singapore

South Africa LexisNexis, Durban

USA LexisNexis, Dayton, Ohio

© Reed Elsevier (UK) Ltd 2014

Published by LexisNexis

All rights reserved. No part of this publication may be reproduced in any material form (includingphotocopying or storing it in any medium by electronic means and whether or not transiently or incidentallyto some other use of this publication) without the written permission of the copyright owner except inaccordance with the provisions of the Copyright, Designs and Patents Act 1988 or under the terms of alicence issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N8TS. Applications for the copyright owner’s written permission to reproduce any part of this publicationshould be addressed to the publisher.

Warning: The doing of an unauthorised act in relation to a copyright work may result in both a civil claim for damagesand criminal prosecution.

Crown copyright material is reproduced with the permission of the Controller of HMSO and the Queen’s Printer forScotland. Any European material in this work which has been reproduced from EUR-lex, the official European Unionlegislation website, is European Union copyright.

ISBN Z000050578578

Printed and bound in Great Britain by Hobbs the Printers Ltd, Totton, Hampshire

Published December 2014

Visit LexisNexis at www.lexisnexis.co.uk

UK Corporate GovernanceCode: 2014 Update

Contents

5

1 Introduction 7

2 The board 13

3 The chairman 18

4 Non-executive directors 20

5 Remuneration 24

6 Risk and accountability 27

7 Shareholders 31

6

Tolley’s CSR Company Service

7

UK Corporate Governance Code: 2014 Update

1 Introduction

What is corporate governance?“Corporate governance” is one of those terms which has no precise definitionand which carries a variety of meanings. Most narrowly, it refers to the UKCorporate Governance Code (“the Code”), a detailed set of principles whichapply to companies with a premium listing in the UK. More broadly, theterm can take in much of company law and best practice, or, indeed, anyset of relationships between a corporate body, those who run it and thosewho may be regarded as its stakeholders.

In its opening paragraph, the Code offers its own definition:

“The purpose of corporate governance is to facilitate effective,entrepreneurial and prudent management that can deliver thelong-term success of the company.”

This booklet looks at the Code and describes the position as at 1 October 2014.

The Cadbury CodeThe very first version of a UK corporate governance code, a mere two pagesproduced by a committee led by Sir Adrian Cadbury in 1992, set out whattoday’s Code still refers to as the classic definition:

“Corporate governance is the system by which companies aredirected and controlled.”

Cadbury analysed the various responsibilities within a company as follows:

◆ boards of directors are responsible for the governance of their companies;

◆ the responsibilities of the board include setting the company’s strategicaims, providing the leadership to put them into effect, supervising themanagement of the business and reporting to shareholders on theirstewardship;

◆ the board’s actions are subject to laws, regulations and the shareholdersin general meeting; and

◆ the shareholders’ role is to appoint the directors and the auditors and tosatisfy themselves that an appropriate governance structure is in place.

Subsequent reviews of the Code have not changed these principles, thoughmore detail has been added, often as a reaction to successive corporatefailures and boardroom scandals.

8


The Code now also acknowledges that shareholders and the beneficial ownersbehind them are not the only investors with an interest in good governance.The preface to the Code encourages companies “to recognise the contributionmade by other providers of capital and to confirm the board’s interest inlistening to the views of such providers”. Bond holders and other providers ofdebt are often the same people as equity holders, with the same wish to seea company well run.

The 2013/14 reviewThe Financial Reporting Council (“FRC”) is part of the UK’s independentregulatory structure for companies and acts as the guardian of the UK CorporateGovernance Code. Its latest review of the Code was concerned largely withtwo topics: risk and internal controls, as highlighted by the financial crisis of2008/09 and various resulting corporate failures; and the perennial issue ofdirectors’ remuneration.

In addition, the preface to the 2014 edition of the Code emphasises theimportance of the board setting the correct “tone from the top” and establishingthe culture, values and ethics of the company. Reference is also made in thepreface to the way diversity on the board can encourage constructive debate,given the differences in approach and experience which directors fromdifferent backgrounds bring to their discussions. Diversity in this contextshould not be limited to gender and race.

Changes in the 2014 CodeThe changes to the new Code apply to accounting periods beginning on orafter 1 October 2014. They include the following:

◆ The previous Main Principle D.1, which said that levels of remunerationshould be sufficient to attract, retain and motivate directors of thequality required to run the company successfully, has been dropped.

◆ In place of the previous Main Principle D.1 is a new Principle thatperformance-related elements should be transparent and rigorouslyapplied, as well as stretching.

◆ New Code Provision D.1.1 provides that performance-related payschemes should include provisions that enable the company, in certaincircumstances, to recover sums paid or to withhold the payment of anysum, and they should specify when it would be appropriate to do so.

◆ The obligation for the remuneration committee to consult the chairmanand/or chief executive about their proposals for executive directorshas been dropped, in favour of guidance that the remunerationcommittee should recognise and manage conflicts of interest whenreceiving the views of executive directors and senior management ontheir pay proposals.

9


◆ Schedule A to the Code, giving guidance on the design of performance-related remuneration for executive directors, has been revised.

◆ Code Provision E.2.2 provides that when, in the opinion of the board, asignificant proportion of votes has been cast against a resolution at ageneral meeting, the company should explain when announcing theresults what actions it intends to take to understand the reasons behindthe vote.

◆ Code Provision E.2.4 now states that general meetings, other than AGMs,should be called on at least 14 working days’ notice.

◆ The previous single statement by directors on going concern requiredby Code Provision C.1.3 has been split into two – a confirmation thatthe company is a going concern on an accounting basis; and a longer-term viability statement covering a period significantly greater than12 months.

◆ Code Provision C.2.1 states that the directors should confirm they havecarried out a robust assessment of the principal risks facing the company,including those that would threaten its business model, futureperformance, solvency or liquidity; and that the directors should describethose risks and explain how they are being managed or mitigated.

◆ New Code Provision C.2.3 requires the board to monitor the company’srisk management and internal control systems, and, at least annually,to carry out a review of the effectiveness of those systems and to reporton that review in the annual report.

Who does the Code apply to?The Code applies to all companies (whether incorporated in the UK or not)with a premium listing in the UK. Those with a standard listing (even if UKincorporated) are outside its scope, as are all AIM companies, those whoseshares are traded on other markets or not traded at all, and all privatecompanies. They may wish to follow all or part of the Code as an example ofbest practice, but they are under no obligation to do so.

Structure of the CodeTo understand the obligations which arise from the Code and the way itworks, it is necessary to understand the Code’s structure, which comprises:

◆ Main Principles – these are the core of the Code and set out the mainterms of what boards and their shareholders should be doing;

◆ Supporting Principles – these build on the Main Principles and providebackground as to how the objectives laid down in the Main Principlesshould be achieved; and

10


◆ Code Provisions – these give detailed guidance as to how to apply thePrinciples and are the nuts and bolts of compliance with the Code.

How is the Code enforced?The Code is not a rigid set of rules to be kept to at all costs; nor is it entirelyvoluntary. There are three ways its terms are applied to companies:

◆ The Listing Rules (LR 9.8.6R and 9.8.7R) require a statement in acompany’s annual report as to how the Main Principles have beenapplied. There is no choice here – a company does not have the optionof saying a Main Principle is irrelevant or that it does not wish to applythe principle.

◆ In the case of the more detailed Code Provisions, the same ListingRules give a choice, either to state in the annual report that each ofthe relevant provisions has been complied with throughout the yearunder review, or to state that a particular provision has not been compliedwith and to give the reasons for non-compliance (and the period ofnon-compliance). This is the “comply or explain” basis of the Codediscussed below.

In either event, if a company does not report how it has applied theMain Principles, or fails to comply or explain in respect of the CodeProvisions, it will be in breach of the Listing Rules and so subject todisciplinary action by the Financial Conduct Authority (“FCA”) in itsguise as the UK Listing Authority.

◆ More practically, compliance is in the hands of shareholders. If theydo not like what the directors are doing, the Code encourages them toengage with the board, either with the executive directors or throughthe chairman or the non-executive directors, as appropriate, to discusstheir concerns. If agreement cannot be reached, the shareholders havethe ultimate sanction of using their votes, either to defeat a proposalfrom the board, to vote down a remuneration report or policy on mattersof pay, or even to remove directors from the board.

Comply or explainThe “comply or explain” regime is the essence of the Code’s approach tocorporate governance. The broad principles are set out and must be adheredto, but there is considerable flexibility as to the detail of how that is done.Most companies will follow the Code Provisions and so “comply”, but wherea board believes that is not appropriate and it can apply the principles in adifferent way, there is liberty to “explain” that different approach. In theFRC’s words, the Code Provisions describe one route by which the Code’sprinciples might be met, but they are not the only route.

11


The Code encourages shareholders to be responsive to a company’sexplanations and to take into account the surrounding circumstances. Thereis a recognition that smaller listed companies and those coming to the marketmay find some of the Code Provisions disproportionate or less relevant totheir circumstances. Shareholders should not adopt a box-ticking approachand treat every failure to comply as a breach of the Code. The Code is onlybreached if a Main Principle is ignored or the explanation for a departurefrom a Code Provision is inadequate or unconvincing. Instead, shareholdersneed to engage with a company, to exchange views and to be responsive towhat is said.

The FRC has responded to criticism from investors and from the EuropeanCommission as to the quality of some explanations by emphasising therequirements for a good explanation – see the FRC’s February 2012 paper“What Constitutes an Explanation under ‘Comply or Explain’” (available onthe FRC website: https://www.frc.org.uk).

In summary, an explanation should:

◆ show how what the company does in place of compliance with a CodeProvision is nonetheless consistent with the Main Principle to whichthat provision relates, how it contributes to good governance andpromotes the delivery of business objectives;

◆ set out the background and provide a clear rationale for the action thecompany is taking; and

◆ describe any mitigating actions taken to address any additional riskand maintain conformity with the relevant principle.

If the non-compliance with a Code Provision is for a limited period only, thecompany should explain when it expects to get back to full compliance.

Disclosure and Transparency RulesNote also that the FCA’s Disclosure and Transparency Rules (“DTRs”) containmandatory requirements relating to:

◆ audit committees (DTR 7.1); and

◆ corporate governance statements (DTR 7.2).

Most of the requirements of these DTRs will be met if the relevant provisionsof the Code are complied with.

Useful informationThe full text of the 2014 Code and useful material relating to its latest revisionscan be found on the FRC website.

12


Schedule B to the Code brings together in one list all the governance-relateddisclosure requirements contained in the Code, the Listing Rules and theDTRs.

The FRC also published in 2011 “Guidance on Board Effectiveness” ofrelevance to sections A and B of the Code on the leadership and effectivenessof boards. This was developed with the Institute of Chartered Secretaries andAdministrators and replaces the previous Higgs Guidance. It can be foundon the FRC’s website.

13


2 The board

The role of the boardThe board is at the centre of effective corporate governance. Main PrincipleA1 of the Code states as follows:

“Every company should be headed by an effective board whichis collectively responsible for the long-term success of thecompany.”

To achieve that long-term success, the board is to:

◆ provide entrepreneurial leadership within a framework of prudent andeffective controls, enabling risk to be assessed and managed;

◆ set the company’s strategic aims;

◆ ensure that the necessary financial and human resources are in placefor the company to meet its objectives and review managementperformance; and

◆ set the company’s values and standards and ensure that its obligationsto shareholders and others are understood and met.

A board should agree a formal statement of those matters which are reservedfor its decision and may also detail the extent of the delegated powers itgives to executives. The Code Provisions call for a statement in the annualreport describing how the board operates, with a summary of what types ofdecisions are to be taken by the board and what is delegated to management.

The annual report should also give details of the number of meetings of theboard and its committees during the year and the attendance record ofindividual directors.

The board’s compositionMain Principle B.1 lists four factors which need to be reflected in a boardand its committees: skills, experience, independence and knowledge of thecompany.

A board needs to be large enough to reflect these different requirements, butnot so large that it becomes unmanageable. Code Provision B.1.2 providesthat at least half the board, excluding the chairman, should be independentnon-executive directors (see Chapter 4 of this booklet for what is meant by“independent”).

14


Put another way, the number of independent non-executives needs to matchor exceed the number of executive directors. This should ensure that noindividual or small group dominates the board.

Companies outside the FTSE 350 for the whole of a year have the option toreduce the number of independent non-executives to two, though manychoose to have more.

It is not uncommon to see boards with only two executives, the CEO and thefinance director, with the rest of the board comprising non-executives. Neitherthe Code nor other guidance argues against such a board make-up, leavingit to individual boards to decide what is right for them in each case.

Appointments to the board“Buggins’ turn” and the old-boy network have long been decried as ways ofrecruiting directors. Rather, “there should be a formal, rigorous and transparentprocedure for the appointment of new directors to the board” (Main PrincipleB.2).

Selections should be made on objective criteria and search companies orpublic advertisements used (an explanation is required in the annual reportif those recruitment methods are not used when appointing a chairman ornon-executive director). Where an external search consultancy has beenused, it should be identified in the annual report, with a note as to whetherit has any other connection with the company.

Appointments should be made “with due regard for the benefits of diversityon the board, including gender”. There is no suggestion that quotas should beintroduced, but the Government in particular is keen to see more women onlisted company boards. Better diversity is seen as likely to improve the qualityof decision-making and reduce the risk of “group think”.

Thought also needs to be given to succession planning for directors andsenior management, ensuring what is termed “progressive refreshing” of theboard and allowing unexpected vacancies to be filled without undue delay.

Nomination committeeA nomination committee of the board “should lead the process for boardappointments and make recommendations to the board” (Code ProvisionB.2.1). Note that this does not give delegated authority to the committee toappoint new directors. (Audit and remuneration committees, by contrast, dohave delegated authority from the board in certain areas.) The committeeshould have publicly available terms of reference and the work of thecommittee is to be described in the annual report.

Part of the committee’s job is to decide what gaps need to be filled whenmaking a new appointment, having assessed the board’s balance of skills,

15


experience, independence and knowledge of the company. The descriptionof the committee’s work in the annual report should describe the board’spolicy on diversity, including (but not limited to) gender, and set out anymeasurable objectives that have been set to implement the policy and theprogress in achieving those objectives.

The nomination committee may have executive directors as members butindependent non-executive directors should be in a majority. The chairmanof the board may chair the nomination committee but should step asidewhen the committee is appointing a successor. Alternatively, the committeemay be chaired by an independent non-executive director.

As with all committees, only its members are entitled to attend, thoughothers may be there by invitation.

InductionNew directors are not expected to arrive fully fledged. There is a recognitionthat they need to go through a tailored induction process (Main PrincipleB.4) which is usually the responsibility of the company secretary. In particular,directors new to the industry or business sector should be helped to learnwhat the company does and how it makes its money. Meetings with majorshareholders should be arranged so there is early familiarisation and anexchange of views.

New executive directors may have the necessary specialist knowledge butthey may need help with other boardroom skills or training in their legalduties and responsibilities.

TrainingTraining needs to be part of an ongoing process. Main Principle B.4 saysdirectors “should regularly update and refresh their skills and knowledge”. Itis a particular responsibility of the chairman to ensure this happens and heneeds to review with each director their training and development needs(perhaps as part of the evaluation process – see below).

SupportDirectors need to be supported in their role. They need a flow of informationwhich is sufficiently complete and received in a timely manner (Main PrincipleB.5). So important is this requirement that specific responsibility for it isgiven to the chairman, though it will be the company secretary who ensuresthe necessary processes are followed. Where the information flows areinadequate, directors need to say so.

At times, directors, and particularly the non-executives, may needprofessional advice which is independent of the company’s own advisers.This should be at the company’s expense and may be facilitated by the

16


company secretary. Board committees will also need support – for example,remuneration and risk committees may need to pay for specialist advice.

Company secretaryThe company secretary has an increasingly important role in advising theboard on corporate governance, though the supporting principles to MainPrinciple B.5 say this advice is to be given “through the chairman”.

All directors need to have access to the advice and services of the companysecretary. Appointment and removal of the company secretary is not adecision for the chairman or chief executive alone, but should be made bythe board as a whole.

EvaluationMain Principle B.6 refers to performance evaluation not just of directors, butalso of the board as a whole and its committees. There should be an annualreview of how they work, their membership, their terms of reference, andtheir successes and failures.

The evaluation of the board should consider the balance of skills amongstdirectors, their experience, independence and knowledge of the company.Also to be considered are the board’s diversity (including gender), how itworks together as a unit and other factors which are relevant to the board’seffectiveness.

It may be tempting to downplay evaluations and see them just as part of thedevelopment and training process for directors, but the Code is clear thatevaluations need to be “formal and rigorous”, to question whether a directormakes an effective contribution to the board and still has sufficient time forthe job. Where appropriate, the chairman should act on the results by seekingresignations and appointing new directors. Evaluation of the chairman’sperformance is the responsibility of the non-executive directors, led by thesenior independent director and in consultation with the executive directors.

In the past, annual director evaluations have often consisted of conversationsbetween an individual and the chairman. That is seen as too cosy anarrangement and Code Provision B.6.2 requires that, at least every threeyears, FTSE 350 companies should have evaluations of the board, itscommittees and directors which are “externally facilitated” – that is, someonefrom outside the company should be involved in the process to provide anelement of independent assessment.

Note that the reference to external evaluation is in a Code Provision, soFTSE 350 companies have the option either to comply or to explain if theybelieve they can satisfy the requirement for formal and rigorous annualevaluations in some other way. In any event, all companies need to describein the annual report how evaluations are carried out. Where an external

17


facilitator is used, they should be identified and any other connections withthe company disclosed.

Annual re-electionAll directors of FTSE 350 companies should be subject to annual re-election.The requirement remains a comply or explain provision but most suchcompanies do comply. Smaller companies just have to comply with MainPrinciple B.7 – “All directors should be submitted for re-election at regularintervals, subject to continued satisfactory performance” – and that willcommonly mean they only face shareholders every three years. They are,nonetheless, also encouraged to consider the merits of annual elections.

Whatever the frequency of re-election, sufficient information on those beingput forward needs to be given to shareholders, with a rationale from theboard for each candidate and confirmation from the chairman that the outcomeof the individual’s performance evaluation justifies re-election. The boardalso needs to identify each year in the annual report those non-executivedirectors it considers to be independent (Code Provision B.1.1).

Insurance coverThe Companies Act 2006 (“CA 2006”) permits a company to arrange andpay for insurance cover for its directors. Code Provision A.1.3 says thatinsurance should be put in place. Note that it is just as important to keep thisunder regular review, both as to the risks met by the policy and the amountof cover provided.

The Code does not mention the provision of indemnities by a company infavour of its directors, but these are also permitted by CA 2006 (with somerestrictions) and enabling provisions are contained in most company articles.A separate form of indemnity should be entered into for each director. Aclaim by a director under an indemnity may be settled more quickly than aclaim under insurance, leaving the company to bring a matching claimunder the policy.

18


3 The chairman

The roleThe Code has always highlighted the key role played in good corporategovernance by chairmen. Chairmen are encouraged to use their annualstatements to report how the principles in Sections A and B of the Code havebeen applied in practice. This is where departures from Code Provisions canbe detailed, with the chairman explaining the reasons why to shareholders.

Main Principle A.3 states:

“The chairman is responsible for leadership of the board andensuring its effectiveness on all aspects of its role.”

The chairman needs to ensure the board’s agenda gives sufficient time tostrategy and other “big picture” issues, without getting bogged down in matterswhich should properly be left to management. The chairman is also seen assetting the tone of board discussions, promoting a culture of openness anddebate. Given the role of the non-executive directors in providing constructivechallenge to the executives (see the next chapter in this booklet), it is forthe chairman to facilitate those discussions and to ensure good relationsbetween all directors.

See the previous chapter in this booklet for the chairman’s role in ensuringdirectors have the information they need, and in their training anddevelopment and performance evaluation. The chairman is also likely toplay a leading part in the nomination committee in selecting new directorsand succession planning. Chapter 7 of this booklet discusses the chairman’sresponsibility to ensure effective communication with shareholders.

AppointmentThe board’s nomination committee will usually lead the search for a newchairman, drawing up a job specification with an assessment of the timecommitment required. The Code provides no guidance on what thatrequirement might be but recognises that the chairman may need to spendmore time during a crisis. The chairman’s other commitments should bedisclosed to the board and detailed in the annual report, both initially and asthey change.

When appointed, the chairman should satisfy the test of independence fornon-executive directors (Code Provision A.3.1) described in the next chapterof this booklet. This will not be complied with where a chief executivebecomes chairman of the same company, a move which companiessometimes seek to justify with the argument that only a former chief executivehas the knowledge and experience to be an effective chairman.

19


Where a chief executive does succeed as chairman, major shareholdersneed to be consulted in advance and the board’s reasoning explained in thenext annual report.

Division of responsibilitiesIn the past it was not uncommon for one individual to occupy the roles ofboth chairman and chief executive. That is no longer the case. Main PrincipleA.2 states:

“There should be a clear division of responsibilities at the head ofthe company between the running of the board and the executiveresponsibility for the running of the company’s business. No oneindividual should have unfettered powers of decision.”

Note that the Main Principle stops short of saying the two roles should not beheld by the same person. That prohibition is left to a Code Provision which,of course, is subject to the “comply or explain” regime. Nonetheless, mostinstitutional shareholders are clear they do not like to see the roles combined.

The division of responsibilities between the two posts should be in writtenform and agreed by the board. The chairman needs to have a relationship oftrust with the chief executive and to be able to provide support withoutcrossing the line and assuming an executive role.

20


4 Non-executive directors

The roleMain Principle A.4 states:

“As part of their role as members of a unitary board, non-executivedirectors should constructively challenge and help developproposals on strategy.”

The UK’s unitary board model, strongly supported by the Code, means thatall directors sit on the same board and discuss the same agenda, giving thenon-executives a regular opportunity to quiz their executive colleagues. Ina two-tier board structure the non-executives sit on a supervisory boardseparate from the executive arm. (The Code nonetheless suggests that thechairman should on occasion meet the non-executives without the executivedirectors present.)

To provide the necessary constructive challenge to the executives, non-executive directors need to have a good understanding of the company, theworld in which it operates and the issues it faces. They need to gain the trustand respect of all executives, both on the board and below board level. TheCode adds the following further responsibilities:

◆ scrutinising the performance of management in meeting agreed goalsand objectives;

◆ monitoring the reporting of performance;

◆ being satisfied as to the integrity of financial information;

◆ being satisfied that the financial controls and systems of riskmanagement are robust and defensible;

◆ determining appropriate levels of remuneration for executive directors;

◆ having a prime role in appointing and, where necessary, removingexecutive directors, and in succession planning; and

◆ understanding the views of major investors, both directly and throughthe chairman and senior independent director.

The Higgs Guidance on board effectiveness (now replaced by the FRC’s“Guidance on Board Effectiveness”) summarised the role neatly by sayingan effective non-executive director “questions intelligently, debatesconstructively, challenges rigorously and decides dispassionately”.

21


IndependenceThe Code distinguishes between those non-executive directors who areindependent and those who are not. Only the former can serve on audit andremuneration committees and satisfy the necessary ratios on the board andnomination committee.

It is the responsibility of the board to determine whether a non-executive is“independent in character and judgement”. Guidance is given in CodeProvision B.1.1, which adds that the board will need to explain why itconsiders the independence test satisfied if there are circumstances whichsuggest otherwise, including if a director:

◆ has been an employee of the company or group in the last five years;

◆ has (or had in the previous three years) a material business relationshipwith the company, either directly or as a partner, shareholder, directoror senior employee of a body that has such a material businessrelationship;

◆ has received additional remuneration from the company (apart from adirector’s fee), participates in a share option or performance-relatedpay scheme, or is a member of the company’s pension scheme;

◆ has close family ties with any of the company’s advisers, directors orsenior employees;

◆ holds cross-directorships or has significant links with other directorsthrough involvement in other companies or bodies;

◆ represents a significant shareholder; or

◆ has served on the board for more than nine years from the date of firstelection.

The key point is that these categories are not definitive and a decision as toa director’s independence remains for the board to make. It is something theboard needs to assess each year and confirm in the annual report.

Terms of appointmentAppointments are usually for a three-year period, subject to re-election at anAGM. A second term may follow, making six years in all. Code ProvisionB.2.3 says that re-appointment beyond six years should be subject to“particularly rigorous review” and take into account the need for “progressiverefreshing of the board”.

Terms in excess of six years are common, and some directors survive thenine-year cut off despite the suggestion this compromises their independence.

22


For companies outside the FTSE 350, Code Provision B.7.1 says non-executivedirectors should stand for re-election each year once their ninth anniversaryis passed.

Remuneration for non-executive directors needs to reflect their timecommitment and responsibilities (Code Provision D.1.3). An additional feewill usually be paid for chairing a committee. The board, or a board committeewhich might include the chief executive, should decide the level of fees fornon-executive directors, within the limits set by the company’s articles (CodeProvision D.2.3). Share options and other performance-related pay arediscouraged (and can be relevant to a director’s independence – see above).If options are granted, shareholder approval should be sought in advanceand the shares held for at least a year after stepping down from the board.

Non-executive directors are not employees but they should have a letter ofappointment which is available for inspection at the company’s registeredoffice and at the AGM.

Time commitmentThe letter of appointment for a non-executive director should set out theexpected time commitment for the role. The Code gives no guidance onwhat that should be but nomination committees should satisfy themselvesthat the requirement continues to be met.

Executive directors who serve elsewhere as non-executives should not chairor be on the board of more than one FTSE 100 company. The remunerationreport needs to disclose whether the director retains such earnings and, if so,how much they are.

Pre-appointment due diligenceThose offered a non-executive position need to do their homework beforeaccepting. A pre-appointment due diligence checklist can be useful to ensurethe new director will be suited to the company and the necessary degree oftrust will be present. Financial information should be examined and meetingsheld with the key players.

In regulated financial services companies, non-executive directorappointments are treated as “controlled functions” and are subject to theprior approval of the regulator.

Senior independent directorOne of the independent non-executive directors should be appointed by theboard as senior independent director (or “SID”). Code Provision A.4.1 saysthe SID is a sounding board for the chairman and an intermediary for otherdirectors when necessary (presumably when there is unhappiness about thechairman).

23


The SID takes the lead on the evaluation of the chairman. The SID also actsas an intermediary between shareholders and the board if normal channelsto the chairman or other board members haven’t worked or are inappropriate.

ResignationIf a non-executive director has concerns on any topic before the board whichcannot be resolved, and resigns as a result, a written statement of thoseconcerns should be given to the chairman and circulated to the board. Suchconcerns should, in any event, be recorded in the board minutes.

24


5 Remuneration

General principlesRemuneration has long been a point of tension between companies andtheir shareholders, and continues to be so. Main Principle D.1 has been re-written in the October 2014 version of the Code, dropping the previouswording that levels of remuneration should be sufficient to attract, retainand motivate directors of the quality required to run the company successfully(a form of words now seen as open to abuse as a justification for over-generouspay packages). The new Principle states simply that executive directors’remuneration should be designed to promote the long-term success of thecompany (a concept that was previously set out in a supporting principle). Inaddition, performance-related elements of directors’ pay should be“transparent, stretching and rigorously applied”. Before 2014, only the word“stretching” was used; the new words perhaps reflecting a view that manybonus and share plans have become unnecessarily complicated and opaque,and that directors have sometimes been given the benefit of the doubt whereperformance targets have been missed.

Directors should not be involved in setting their own remuneration. Instead,the process for developing policy on executive remuneration and decidingpackages for individual directors needs to be formal and transparent (MainPrinciple D.2).

Remuneration committeeA remuneration committee of the board should have delegated authority toset remuneration for all executive directors and the chairman, includingpension rights and compensation payments. The committee should alsorecommend and monitor the level and structure of senior managementremuneration – “senior management” here means the layer of managementimmediately below board level, though the board can widen the definitionif it wishes.

The committee should comprise at least three independent non-executives;outside the FTSE 350, two is enough. The chairman may also be a member(provided he was classed as “independent” when appointed) but may notchair the committee.

The previous reference to the committee consulting the chairman and/orchief executive on its proposals for executive directors has been droppedfrom the October 2014 version of the Code as possibly compromising thecommittee’s independence and its full delegated authority. Instead, thecommittee is warned that, when receiving views from executive directorsand senior management and when consulting the chief executive on itsproposals, it needs to recognise and manage the obvious conflicts of interest.

25


The terms of reference of the committee need to be available (they are oftenplaced on a company’s website), and any remuneration consultants used bythe committee should be identified in the annual report, together with astatement as to whether they do other work for the company (Code ProvisionD.2.1).

Considerations for the remuneration committeeThe committee needs to position remuneration levels in the context of whatother companies are paying, looking at entities in the same sector and of acomparable size and keeping in mind the risk of an upwards-only ratchet aseveryone follows the highest payers, with no corresponding improvement inboth corporate and individual performance. At the risk of stating the obvious,the Code says the committee should avoid paying more than is necessary.Salary and employment terms elsewhere in the group also need to be lookedat to avoid too great a disconnect.

Poor performance should not be rewarded, so the committee is told to“carefully consider” the compensation payments which may result whenexecutives leave, including pensions. The Code calls for a “robust line” tobe taken on reducing compensation to reflect a departing executive’s dutyto mitigate loss.

Notice periods should be set at a maximum of 12 months. Longer periodsmay be needed to entice new recruits joining the company, but should reduceto no more than a year once the initial period has run.

Performance-related payRemuneration committees should follow the further guidance on the designof performance-related remuneration for executive directors set out inSchedule A to the Code. A determination needs to be made as to theappropriate balance between both fixed and performance-related pay andbetween remuneration which is paid immediately and that which is deferred.A new requirement (Code Provision D.1.1) states that performance-relatedschemes should allow the company in certain circumstances to recover sumsalready paid out, and to withhold sums not yet paid, and those circumstancesshould be specified.

Schedule A says that consideration should be given to long-term incentiveschemes for directors, whether in the form of share options or other types ofscheme. Grants under shares plans and other long-term incentive schemesshould be phased (rather than one block award) and should not vest in lessthan three years; the committee should consider requiring directors to hold aminimum number of shares and to hold them for a further period after vestingor exercise, even when they have left the company (subject to the need tofund acquisition costs and tax).

26


Performance conditions, including non-financial metrics, should be “relevant,stretching and designed to promote the long-term success of the company”.Reflecting the increased emphasis on risk, incentives need to be compatiblewith risk policies and systems.

Benefits other than basic pay should not be pensionable, and the pensionconsequences of salary increases and other changes need to be taken intoaccount, especially for directors nearing retirement.

Other considerationsNote that there are many other considerations to take into account onremuneration, including:

◆ the FCA’s remuneration code which applies to the largest financialinstitutions;

◆ the Listing Rules (on disclosure and approval of share schemes);

◆ regulations under CA 2006 (as to what needs to be disclosed);

◆ the requirement for a remuneration report subject to an advisory voteat the AGM;

◆ the requirement for a binding vote on remuneration policy; and

◆ guidance from investor bodies such as the Investment ManagementAssociation (formerly the ABI, to be renamed the Investment Associationin 2015).

27


6 Risk and accountability

AccountabilityThe Code places great emphasis on communication with shareholders anddirectors’ accountability to the company’s owners. Main Principle C.1 requiresa fair, balanced and understandable assessment of the company’s positionand prospects in statutory reports, market announcements and reports toregulators. Indeed, the directors have a responsibility to establish arrangementsthat will enable them to ensure that the information presented is fair, balancedand understandable.

The annual report and accounts should contain an explanation of the directors’responsibility for preparing the document. In addition, the directors shouldstate that they consider the document, taken as a whole, is fair, balancedand understandable and provides the information necessary for shareholdersto assess the company’s position and performance, business model and strategy.The audit committee, where asked to do so by the board, should provideadvice as to whether this requirement is satisfied.

Going concern and viability statementThe pre 2014 requirement that directors report in annual and half-yearlyfinancial statements that the business is a going concern has been replacedby two separate obligations: the first, a statement confirming that the businessis a going concern on an accounting basis; the second looking for a morewide-ranging assessment of the viability of the business over time. This latterrequirement stems from the view that corporate failures in recent years haveshown the accounting statement alone is not enough to alert investors tolikely troubles ahead.

The requirements for the accounting statement are set out in Code ProvisionC.1.3 which expands the previous wording to require that at the half yearand year end directors should state whether they consider it appropriate toadopt the going concern basis of accounting in preparing the financialstatements. They should also identify any material uncertainties about thecompany’s ability to continue to adopt the going concern basis over at leastthe 12-month period from the date of approval of the statements.

The requirement for the longer-term viability statement is set out in newCode Provision C.2.2. Taking into account the current position of the companyand its principal risks, the annual report needs to contain the following:

◆ the directors’ explanation as to how they have assessed the prospectsof the company;

28


◆ what period they have chosen for that assessment (FRC guidance saysthe period should be “significantly longer than 12 months” from thedate of approval of the statements);

◆ why the directors consider that period to be appropriate (its lengthshould be determined taking account of, among other factors, the natureof the business and its stage of development, its investment and planningperiods, and any previous statements made by the board, especiallywhen raising capital);

◆ a statement by the directors whether they have a reasonable expectationthat the company will be able to continue in operation and meet itsliabilities as they fall due over their chosen period of assessment;

◆ any qualifications or assumptions made by the directors in arriving atthat statement.

Useful guidance on these requirements is contained in the FRC’s new“Guidance on Risk Management, Internal Control and Related Financialand Business Reporting” which is available on the FRC website.

Risk management and internal controlVarious company failures in the last few years have focused attention oncorporate risk. The board needs to decide the nature and extent of the principalrisks it will take to achieve its strategic objectives (Main Principle C.2).Having decided those risks, it needs to maintain sound systems for riskmanagement and internal controls. The directors need to confirm in the annualreport that they have carried out a robust assessment of the principal risksfacing the company, including those that would threaten its business model,future performance, solvency or liquidity. The directors should describe thoserisks and, for the first time, the 2014 version of the Code requires anexplanation in the annual report as to how those risks are being managedand mitigated (Code Provision C.2.1).

A new Code Provision C.2.3 in the 2014 version of the Code contains anexplicit requirement that the board should monitor the company’s riskmanagement and internal control systems (including financial, operationaland compliance controls and any other material controls), not just annuallybut on a continuing basis. The directors should at least annually conduct aformal review of the effectiveness of those systems and report on the reviewin the annual report.

Guidance on risk and internal controls is contained in the same FRC documentnoted above. This makes the point that CA 2006, s 463 provides a safe harbourfor directors from liability to investors and other third parties for thesestatements, provided they are contained in or cross referenced to the strategicreport, directors’ remuneration report or the directors’ report. Directors are

29


only liable to the company for untrue or misleading statements in thosereports, or for omissions from them, and only if they knew the statementswere untrue or misleading or they knew the omission was a dishonestconcealment of a material fact.

Audit committeeThe board needs to have formal and transparent arrangements as to how itapplies these principles of corporate reporting, risk management and internalcontrol, and for its relationship with the company’s auditors (Main PrincipleC.3).

An audit committee should comprise at least three independent non-executivedirectors. Outside the FTSE 350, this can be reduced to two and the chairmanmay be an additional member (but not chair the committee) provided theindependence criteria were satisfied when he was appointed chairman.

At least one member of the committee should have “recent and relevantfinancial experience”, usually an accountancy qualification or executiverole in finance. Where that is not the case, independent advice might needto be drafted in.

The committee needs to have written terms of reference, publicly available,detailing its delegated authority from the board and its role and responsibilities,including the following:

◆ monitoring the integrity of the company’s financial statements andannouncements and reviewing any significant financial reportingjudgements they contain;

◆ keeping under review internal financial controls and (unless there is aseparate risk committee) other internal control and risk systems;

◆ monitoring and reviewing the effectiveness of the internal audit function– where that does not exist, the committee should consider each yearwhether such a resource is needed and explain in the annual reporttheir reasons for not having one;

◆ making recommendations as to the appointment and removal of externalauditors, their remuneration and other terms of engagement – in theunlikely event the board does not follow a committee recommendation,both views need to be put to shareholders;

◆ reviewing and monitoring the external auditor’s independence andobjectivity and the effectiveness of the audit process;

◆ developing and implementing policy on the supply of non-audit servicesby the external auditor;

30


◆ reviewing whistleblowing arrangements for staff to raise concerns aboutpossible improper behaviour, ensuring that there are arrangements inplace for proportionate and independent investigation and forappropriate follow-up action; and

◆ reporting to the board on how the committee has discharged itsresponsibilities.

The annual report should describe the work of the committee, including:

◆ the significant issues the committee considered in relation to thefinancial statements and how those issues were addressed;

◆ an explanation of how the committee has assessed the effectiveness ofthe external audit process and the approach taken to the appointmentor reappointment of the external auditor, with information on the lengthof tenure of the current audit firm and when a tender was last conducted;

◆ where non-audit services are provided by the external auditor, anexplanation of how auditor objectivity and independence is safeguarded.

The FRC’s “Guidance on Audit Committees” was updated in September 2012and is available on the FRC’s website.

A “comply or explain” provision (Code Provision C.3.7) says that FTSE 350companies should put their external audit contract out to tender at leastevery ten years. These provisions have been overtaken, for financial yearsbeginning on or after 1 January 2015, by the Competition and MarketAuthority’s Order, the Statutory Audit Services for Large Companies MarketInvestigation (Mandatory Use of Competitive Tender Processes and AuditCommittee Responsibilities) Order 2014, which requires audit contracts tobe put out to tender at least every ten years. Transitional provisions in theOrder align it with EU rules that require a change of auditor at least every 20years.

There is no requirement in the Code for a risk committee although largefinancial services companies will often separate out from the audit committeecertain risk responsibilities to a new committee. The FRC has taken the viewthat clarity as to a business model is desirable and Code Provision C.1.2 saysthe annual report should have an explanation from the board of its businessmodel (defined as “the basis on which the company generates or preservesvalue over the longer term”) and its strategy for delivering the company’sobjectives.

31


7 Shareholders

The UK Stewardship CodeThe UK Stewardship Code was introduced in 2010 following the FRC’sconclusion that the impact of shareholders in monitoring the UK CorporateGovernance Code should be enhanced. It was drafted by the InstitutionalShareholders’ Committee (“ISC”), a forum of trade associations representingUK institutional shareholders, and revised in September 2012. Its aim is toenhance the quality of dialogue between institutional investors andcompanies to help improve long-term returns to shareholders, reduce therisk of catastrophic outcomes due to bad strategic decisions, and help withthe efficient exercise of governance responsibilities.

The Stewardship Code is designed to apply to both institutional investors(such as pension funds, insurance companies and investment trusts) and thosewho invest as agents on behalf of others (for example, fund managers). Theymay choose not to apply the Stewardship Code but should publicise theirreasons for not doing so. Those who do apply it are listed on the FRC’s website.

The Stewardship Code comprises seven Principles with additional guidanceon each. Institutional investors should:

◆ publicly disclose their policy on how they will discharge theirstewardship responsibilities – this includes their policies on the use ofproxy voting services and company explanations for departures fromthe Code;

◆ have a robust (publicly disclosed) policy on managing conflicts of interestin relation to stewardship;

◆ monitor their investee companies, so they know when to enter into adialogue with their directors – this includes being satisfied thatindependent non-executive directors provide adequate oversight.Investors should not be made insiders without their agreement;

◆ establish clear guidelines on when and how they will escalate theiractivities as a method of protecting and enhancing shareholder value;

◆ be willing to act collectively with other investors where appropriate;

◆ have a clear policy on voting and disclosure of voting activity; and

◆ report periodically on their stewardship and voting activities – agentsshould report as agreed with their clients and principals should reportannually to those to whom they are accountable.

32


Dialogue with shareholdersSection E of the UK Corporate Governance Code contains obligations for theboard in its relations with shareholders. The board is responsible for ensuringa satisfactory dialogue with shareholders, based on the mutual understandingof objectives (Main Principle E.1). Most shareholder contact will be with thechairman, chief executive or finance director, but the chairman needs toensure that all board members are aware of major shareholders’ views. (Thereis, nonetheless, a recognition that directors have a duty to treat all shareholdersequally and only to disclose price-sensitive information to the market as awhole.)

The chairman has a particular role in discussing governance and strategywith major shareholders. The senior independent director also needs to meetshareholders to understand their issues and concerns.

The annual report should describe how directors keep abreast of shareholderopinion, whether through meetings with investors, analysts’ or brokers’briefings or otherwise.

General meetingsThe AGM is another tool to engage with investors and encourage theirparticipation (Main Principle E.2). The AGM notice and related papers shouldbe sent to shareholders at least 20 working days before the meeting (whichwill be longer than the 21 clear days required by CA 2006). All directorsshould attend and the chairmen of the audit, remuneration and nominationcommittees should be ready to answer shareholders’ questions.

There should be separate resolutions on matters which are “substantiallyseparate” (Code Provision E.2.1), rather than bundling them into one resolution.Proxy forms need to allow for votes to be withheld, in addition to being castfor or against a resolution, though it should be made clear that a withheldvote is not a vote in law and so does not affect the proportion of votes for oragainst.

Many AGMs now take all votes by poll, but where there is a vote on a showof hands the company needs to announce after the vote at the meeting andon its website the number of shares covered by proxies and the number ofvotes for, against and withheld.

New wording added in the 2014 version of the Code to Code Provision E.2.2says that when, in the opinion of the board, a significant proportion of voteshas been cast against a resolution, the company should explain when itannounces the result (even though the resolution may have passed) whatactions it intends to take to understand the reasons behind the result. Notethat this provision is not confined to AGMs or votes on remuneration, thoughit is a response to substantial votes having been cast against directors’remuneration reports. The FRC’s intention is to encourage companies to

33


engage further with shareholders so they assess their concerns. There is noguidance from the FRC as to what a significant proportion of votes might be.

The Code has, for some time, required an AGM notice to be sent toshareholders at least 20 working days before the meeting. Code ProvisionE.2.4 has been amended in the 2014 version of the Code to say that notice ofother general meetings should be sent at least 14 working days in advance.No explanation has been given for this change. It contrasts rather oddly withthe requirement in CA 2006, s 307A for a “traded company” to give 21 days’notice, which may be reduced to 14 if shareholder consent has been givenby special resolution at the preceding AGM and facilities are provided forelectronic voting.

34


tolley’s csr company service uk corporate governance … · tolley’s csr company service uk...

Documents