Corporate governance Contents

Conclusions and recommendations

Context and background

1.The UK’s strong corporate governance regime is a considerable asset which enhances the reputation of the UK as a place to do business. The Government should therefore be very cautious about taking steps that risk adversely affecting the UK’s attractiveness as a place to invest. However, although the UK has a high international reputation in this field, there should be no complacency, nor any sense that improvements cannot be made. Within this context, the challenge is for businesses and Government to keep improving standards, without the impetus of high profile corporate scandals, in order to minimise the risks of future failings and to reflect both changes to the business environment and the rising expectations of society and stakeholders. The Government must help ensure that the UK stays ahead of the game in the light of changing business trends and practices. (Paragraph 8)

2.The fostering of a healthy culture in which to do business, particularly in terms of the means by which firms govern themselves and how they are accountable for the decisions they make lies behind the recommendations in this Report. Good company culture does not lend itself to easy measurement and cannot be enforced via a tick box exercise. Instead, the central tenets of good corporate governance should be embedded in the culture of all companies, so that it permeates activity at every level and in every sphere. It is cultural evolution, in line with the spirit of the Cadbury Report, that should be the long-term goal of Government, investors and companies. (Paragraph 12)

3.Corporate governance in the UK is still strong and remains an asset to the country’s reputation for doing business. We are conscious that a small number of highly damaging examples of corporate governance failure should not lead to a hasty and disproportionate response. We do not believe that there is a case for a radical overhaul of corporate governance in the UK. We do believe that there is scope for significant improvements in order to address the changing nature of company ownership in a globalised economy. We explore these in the remainder of this Report. (Paragraph 24)

Promoting good corporate governance

4.We believe that more effective measures are required to ensure that directors demonstrably take seriously their duties to have regard to other stakeholders and the long-term consequences of decisions. This can best be achieved by requiring more specific and accurate reporting, supported by robust enforcement. (Paragraph 30)

5.We recommend that the FRC amends the Code to require informative narrative reporting on the fulfilment of section 172 duties. Boards must be required to explain precisely how they have considered each of the different stakeholder interests, including employees, customers and suppliers and how this has been reflected in financial decisions. They should also explain how they have pursued the objectives of the company and had regard to the consequences of their decisions for the long term, however they choose to define this. Where there have been failures to have due regard to any one of these interests, these should be addressed directly and explained. (Paragraph 34)

6.The FRC should encourage companies to be more imaginative and agile in communicating digitally with stakeholders throughout the year and should actively push back on the use of boiler-plate statements in annual reports, using wider powers which we argue for in the next section. (Paragraph 35)

7.We recommend that the Financial Reporting Council works with business organisations to develop appropriate metrics to inform an annual rating exercise. This should publicise examples of good and bad practice in an easy to digest red, yellow and green assessment. Companies must be obliged to include reference to this rating in their annual reports. (Paragraph 40)

8.We recommend that the Government brings forward legislation to give the Financial Reporting Council the additional powers it needs to engage and hold to account company directors in respect of the full range of their duties. Where engagement is unsuccessful, we would support the FRC in reporting publicly to shareholders on any failings of the board collectively or individual members of it. If companies were not to respond satisfactorily to engagement with the FRC, we recommend that the FRC be given authority to initiate legal action for breach of section 172 duties. Given the broader powers we have recommended in this Report, the Government should consider re-establishing, renaming and resourcing appropriately the FRC to better reflect its expanded remit and powers. (Paragraph 42)

9.Rather than seek to introduce any new legislation, we would urge the Secretary of State to be more prepared than is presently the case to use existing powers where there is any suspicion of serious wrongdoing that may be in breach of the law. A public statement by Ministers to the effect of being considerably more pro-active in this areas may also have a welcome deterrent effect. (Paragraph 43)

10.We recommend that the Investor Forum seeks to become a more pro-active facilitator of a dialogue between boards and investors by engaging in regular routine dialogue in order to pick up on any widespread concerns, for example those identified by the new FRC rating system. (Paragraph 47)

11.Stakeholder advisory panels can be a useful forum in which meaningful collaboration, consultation and dialogue with all stakeholders can take place. We urge companies to consider establishing such bodies. We recommend that the Code should be revised to require a section in annual reports detailing how companies are conducting engagement with stakeholders. (Paragraph 54)

12.We welcome the assessments made and published relating to the performance of institutional investors in terms of their stewardship functions but believe that further action is required. We recommend that the FRC reviews its Stewardship Code with a view to providing: more explicit guidelines on what high quality engagement would entail; a greater level of detail in terms of requirements; and an undertaking to call out poor performance on an annual basis. (Paragraph 55)

13.We recommend that the Government consults upon new requirements on listed and large private companies to provide full information on advisors engaged in transactions above a reasonable threshold, including on the amount and basis of payments and on their method of engagement. (Paragraph 59)

14.Increased transparency and accountability are the best routes to promoting better stewardship, high quality engagement and public trust. We recommend that the FRC includes in its revised Stewardship Code stronger provisions to require the disclosure of voting records by asset managers and undertakes to name those that subsequently do not vote. (Paragraph 60)

15.We recommend that the FRC includes best practice guidance on professional support for non-executive directors when it updates the Code and that companies include training of board members as part of reporting on their people or human resources policy. (Paragraph 64)

16.We recommend that the FRC updates the Code to provide guidance on how companies should identify clearly and transparently the roles of non-executive directors where they have particular responsibilities and how they should be held to account for their performance. We further recommend that NEDs should be required to demonstrate more convincingly that they are able to devote sufficient time to each company when they serve on multiple boards. (Paragraph 65)

Private companies

17.We recommend that the Financial Reporting Council, Institute of Directors and Institute for Family Business develop, with private equity and venture capital interests, an appropriate Code with which the largest privately-held companies would be expected to comply. They should contribute to the establishment of a new body to oversee and report on compliance with the Code. We further recommend that the new Code includes a complaint mechanism, under which the overseeing body could pursue with the company any complaints raised about compliance with the Code. The scheme should be funded by a small levy on members. Should this voluntary regime fail to raise standards after a three year period, or reveal high rates of unacceptable non-compliance, then a mandatory regulatory regime should be introduced. (Paragraph 74)

Pay

18.We agree with the Prime Minister that high and unwarranted executive pay is an issue that needs to be addressed for the benefit of society as a whole. It is hardly consistent with her vision of an economy that works for everyone to see levels of pay for those at the top increasing at a rate that vastly exceeds increases for ordinary employees and which seemingly is at odds with the value created in the company. (Paragraph 81)

19.We recommend that companies make it their policy to align bonuses with broader corporate responsibilities and company objectives and take steps to ensure that they are genuinely stretching. Policy in this respect would be considered by the FRC in their corporate governance rating system. (Paragraph 86)

20.We conclude that LTIPs should be phased out as soon as possible. No new LTIPs should be agreed from the start of 2018 and existing agreements should not be renewed. (Paragraph 90)

21.We recommend that the FRC consults with stakeholders with a view to amending the Code to establish deferred stock rather than LTIPs as best practice in terms of incentivising long-term decision making. Overall, we recommend that this consultation should develop guidelines for the structure of executive pay with the following features:

22.We recognise that the job of leading a major company is extremely taxing and requires great skill and commitment. These roles, given their importance, should be appropriately rewarded. But overall pay levels have now been ratcheted up to levels so high that it is impossible to observe a credible link between pay and performance. At a time when average pay has remained relatively stable, these increases have served to undermine public trust in business. (Paragraph 99)

23.Deeper engagement alone may not be a powerful driver of pay restraint. We believe that the most effective remedy lies in the combined impact of the various measures we have outlined in this Report, including driving better stewardship through more transparency, better reporting, more employee involvement and tougher enforcement. If these measures and more responsible shareholder engagement does not have the desired effect, Government may have to consider more direct intervention. (Paragraph 103)

24.In our view, the current scale of opposition to remuneration reports and policies does not, at present, justify annual binding votes on pay levels. (Paragraph 105)

25.To incentivise the engagement of the otherwise uninterested, and to force effective action, we favour a strict approach to implementing this principle. Our preference is for the threshold for triggering a binding vote should be low and that companies should have one chance to resolve concerns, not two. A 25 per cent threshold would be consistent with the threshold for votes on a special resolution and would strike a reasonable balance in terms of the degree of leverage given to a single minority shareholder. It is reasonable to expect companies to address any serious and widespread concerns on remuneration by the following year. We recommend that the FRC revises the Code to include a requirement for a binding vote on executive pay awards the following year in the event of there being a vote against such a vote of over 25 per cent of votes cast. This requirement should be included in legislation at the next opportunity. (Paragraph 106)

26.Employee representation on remuneration committees would represent a powerful signal on company culture and commitment to fair pay. This option should be included in the Code and we expect leading companies to adopt this approach. (Paragraph 108)

27.Chairs should also be responsible for driving discussions aimed at delivering simpler structures and justifiable levels of remuneration and shareholders should be prepared to hold them to account if they have not engaged sufficiently to secure support for pay policies and annual reports. We recommend that any Chair of a remuneration committee should normally have served on the committee for at least one year previously. To further incentivise strong engagement, we recommend that the Chair of a remuneration committee be expected to resign if their proposals do not receive the backing of 75 per cent of voting shareholders. (Paragraph 109)

28.We recommend that companies should set out clearly their people policy, including the rationale for the employment model used, their overall approach to investing in and rewarding employees at all levels throughout the company, as well as reporting clearly on remuneration levels on a consistent basis. The FRC should consult with relevant bodies to work up guidance on implementing this recommendation for inclusion in the Code. (Paragraph 112)

29.We recommend that the FRC works with other relevant stakeholders on the detail and amends the Code to require the publication of pay ratios between the CEO and both senior executives and all UK employees. We further recommend that the Government requires that equivalent pay ratios should be published by public sector and third sector bodies above a specified size. (Paragraph 115)

30.We agree with the Prime Minister and the majority of respondents that executive pay is causing damage to the generally good reputation of British business. Too often pay awards appear impossible to justify in relation to performance and when set against pay levels lower down. This serves to undermine public trust in business, the engine of economic productivity and prosperity. There is a tension here between competitive businesses making rational business decisions in their own interests and the wider societal impacts of these awards. Government has a duty to monitor this tension and address it when it judges necessary in the public interest. But all parties need to be sensitive, and respond to, the shifting sands of opinion about fairness of rewards. There are some welcome signs that some businesses and investors are seeking to respond, but we do not have confidence that progress will be made without further pressure being exerted through the measures we recommend in this Report. It is now up to businesses to respond positively, in their own interests, to adjust to raised expectations in relation to executive pay. (Paragraph 116)

Composition of boards

31.Much has been achieved in increasing the number of women directors on boards since Lord Davies’ recommendations in 2011. However, there is still one board in the FTSE 100 that has no women directors, and the increase in women that has occurred has been primarily in non-executive roles. The number of women executive directors is still very low, with only six women CEOs in the FTSE 100. We support the current work by the Hampton-Alexander Review, especially its recommendation that the Government should, in consultation with business, consider how best to clarify or supplement the definition of ‘senior managers’ to have a more consistent, meaningful metric, based on the Executive Committee or its nearest equivalent in each company. (Paragraph 124)

32.Companies need to ensure that women are encouraged from early on in their careers, through mentoring, meaningful work experience, and proper flexible working, to ensure they are equipped to progress to executive director posts. Firms also need to communicate how they are approaching the encouragement and engagement of women throughout the organisation. The FRC should take this into account as part of its rating system. (Paragraph 125)

33.Also we support the Hampton-Alexander Review’s recommendation that the FRC should amend the UK Corporate Governance Code, so that all FTSE 350 listed companies are required to disclose in their annual report the gender balance on the Executive Committee and direct reports to the Executive Committee. (Paragraph 126)

34.We believe that the aims and targets of the Hampton-Alexander Review should go further and, in support of the Equality and Human Rights Commission’s objective, we recommend that the Government should set a target that from May 2020 at least half of all new appointments to senior and executive management level positions in the FTSE 350 and all listed companies should be women. Companies should explain in their annual report the reasons why they have failed to meet this target, and what steps they are taking to rectify the gender inequality on their Executive Committees. (Paragraph 127)

35.For companies seeking a competitive advantage, the directors and non-executives running them, and those setting the strategic context in which they operate, should be empathetic to the needs and requirements of all those involved, including employees, workers, suppliers and customers. It makes business sense to recruit directors from as broad a base as possible, across the demographic of the UK. We recommend that the FRC embeds the promotion of the ethnic diversity of boards within its revised Code. At the very least, we recommend that wherever there is a reference to gender, the FRC should include a reference to ethnicity, so that the issue of ethnic diversity on boards is made explicit in the revised Code, and is given as much prominence as gender diversity. (Paragraph 132)

36.In accordance with the spirit of the McGregor Smith review, we recommend that the Government should legislate to ensure that all FTSE 100 companies and businesses publish their workforce data, broken down by ethnicity and by pay band. (Paragraph 133)

37.The more similar that individual directors think, act, and look, the more likely it is that they are not going to challenge each other, or innovate, or think imaginatively. Directors should not be appointed to the board solely on the basis of one particular background or area of expertise. Greater cognitive diversity promotes more effective challenge and more informed decision-making and we recommend that the FRC works with others to provide improved guidance on this aspect of diversity in the context of board membership. (Paragraph 136)

38.We support measures to enhance the executive pipeline, ensuring that talented people within an organisation are encouraged and supported at an early stage of their careers, and beyond, into middle and senior management. (Paragraph 138)

39.The revised Code should have the issue of board diversity as a key priority and there should be a public explanation of the reasons why members are part of the board. The Code should require boards to cover in their annual reports information diversity on their boards and in the workforce, covering diversity of gender, ethnicity, social mobility, and diversity of perspective. Annual reports should be required to include a narrative on the current position, and an emphasis on what steps the company has taken, and will continue to take to enhance the diversity of the executive pipeline, with agreed targets. This narrative should include how accurately the board mirrors the diversity of both the workforce and the customer base. (Paragraph 139)

40.The detailed narrative of board diversity in annual reports should be a working document throughout the year, informing the board, the Nomination Committee, middle and senior managers, and the workforce and other stakeholders, about the seriousness that companies are taking diversity and succession issues. The revised Code should make this requirement explicit. (Paragraph 140)

41.Having a single worker on a board will not address the fundamental issue of the company’s engagement with the workforce, and could risk being seen as a token nod towards employee participation at board level. However, we believe that employees can bring a different perspective and challenge to the board, and are more likely to encourage a long-term perspective. This issue needs to be seen in the context of recognising where success and value are created in an organisation, such as its staff, and having an HR function that is explicitly aligned with a firm’s strategic direction and has sufficient influence at the highest level. (Paragraph 145)

42.We recommend that companies should be recruiting non-executive and executive directors from the widest possible net of suitable candidates, which should include recruiting internally. Successful companies, both here and abroad, have shown that this can work for the benefit of the company as a whole, and we encourage more companies to appoint workers on boards. We believe that, just as the drive for women directors has overcome initial doubts, it should become the norm for workers to serve on boards. (Paragraph 146)

43.We are not minded to recommend the compulsory requirement for companies over a certain size to include a worker on board. There are numerous difficulties to overcome including, for example, how the term ‘worker’ is defined and how the post would be filled. However, there is nothing in law that prevents workers serving on boards, and the diversity of board members, including workers on boards, should be encouraged. There are already long-established boards where this is the norm, for example John Lewis, First Group, and the NHS Foundation Trust Boards. They do not appear to have suffered from some of the disadvantages that sceptics have suggested. Employees appointed to boards should be directors in their own right, with the necessary skills and aptitudes to play a part as a full board member rather than a representative of the workforce. They would not be a delegate, but would provide the same strategic evaluation and challenge that every director should bring. (Paragraph 147)

44.We recommend that the revised Code states explicitly that the procedure for the appointment of new directors to the board should be by open advertising, and by an external search consultancy, and detailed explanations should be given if one or both of these requirements is not met. (Paragraph 151)

45.We recommend that the FRC should be given the extra role of overseeing the rigour of the evaluation process to ensure that it is genuinely independent, thorough and consistent across companies. The FRC should highlight best and worst practice among Nomination Committees. (Paragraph 152)

Conclusion

46.These reforms are not intended to create onerous new requirements, but to establish arrangements to ensure that the better enforcement of the Companies Act 2006, to improve the voice of other stakeholders, including employees, and to require companies to engage in a more open and transparent manner with the public. Their aim is to ingrain permanently the values and behaviours of excellent corporate governance into the culture of British business. (Paragraph 154)



4 April 2017