Following the high profile losses suffered by the banking industry in 2008 and the general kickback which has occurred in relation to remuneration policies of executives, both in the banking industry and more generally, there are likely to be very significant changes in the way publicly traded companies in the UK, ie companies whose shares are traded on the Official List of the London Stock Exchange, are governed in the next 18 months. Consequently, while corporate governance is relevant to all types of companies this review is primarily focused on the publicly traded regime in the United Kingdom and the likely changes which will be seen next year.
One fundamental longstanding tenet of UK corporate governance is however unlikely to change and that is that the rules of governance will remain principle based rather than prescriptive.
In addition to the overlying statutory duties which are contained in the UK’s Companies Act 2006 which largely replaced the common law duties which existed prior to that Act (see below), the UK Regulator for publicly traded companies, the Financial Services Authority (“FSA”), has issued a number of practice codes, the most important of which is the Combined Code on Corporate Governance which contains a code of best practice relating, inter alia, to the way in which internal controls of the company are reviewed and managed with particular focus on effective risk management. This code is not, as stated above, rules based, but instead there is a “comply or explain” requirement. Consequently to the extent that a company does not comply with the Combined Code, it needs to set out its reasons in its annual report. However, increasingly investor protection watchdogs are attacking companies to the extent that they do not comply with the Combined Code and are encouraging their members to vote against or abstain on resolutions at annual meetings of companies.
The Combined Code is also supported by a number of specific rules relating to ongoing continuing obligations of publicly traded companies known as the Listing Rules and various disclosure and transparency requirements known as the Disclosure Rules and Transparency Rules (“DTRs”). In addition, in the UK, there are a number of investor protection groups, the most important of which is the Association of British Insurers who issue guidelines on various matters, primarily remuneration and pre-emption rights, which they expect listed companies to comply with.
Dealing first however with the legal statutory duties of directors. Underlying a director’s duty is the fundamental principle that a director is in a fiduciary position of trust and therefore the duties that the director has are owed to the company itself, rather than to its shareholders.
The Companies Act 2006 largely replaced the common law rules which had existed for many centuries in the UK creating seven statutory or general rules.
These are contained in sections 170 to 181 of the Companies Act 2006.
They include a requirement that directors act within the powers for a proper purpose (section 171). In other words a director must act in accordance with the company’s constitution which includes the articles of association, the resolutions of shareholders.
Directors have a duty to exercise independent judgement (section 173) and specifically a director is encouraged to take advice from advisors in reaching a decision though his duty must not be infringed by delegation to others, for example sub-committees of executive directors.
Directors have a duty to exercise reasonable care, skill and diligence (section 174). There are both relevant objective and subjective tests reflecting the individual director’s knowledge, skill and experience. Experienced directors must be particularly aware of the subjective standard reflecting their knowledge and experience. For example an independent director who was previously a finance director of another company would expect to have more knowledge in relation to audit and financial reporting requirements than an independent director who was previously in sales. However, there is also an objective standard where a director should not be appointed unless they are able to demonstrate that they have the basic knowledge of their responsibilities to be a director.
Section 176 requires directors not to accept benefits from third parties. However this duty is not breached if the benefit cannot reasonably be regarded as likely to give rise to a conflict of interest. For example it would be reasonable for the director to accept reasonable corporate hospitality.
A director must declare an interest in proposed transactions and arrangements (section 177). This declaration must be done before companies enter into the arrangement and the director must declare both the nature and extent of the interest.
The most important however general duty which has been introduced by the Companies Act 2006, which is otherwise known as “the enlightened shareholder value duty” is the duty to promote the success of the company for the benefit of its members as a whole (section 172). The Act contains non exhaustive criteria to consider in this regard. There is however no statutory definition of “success” but it is, as stated above, likely to equate to a long term increase in value for shareholders.
The six limbs that directors must consider are (a) the long term consequences of their acts, (b) the interests of employees, (c) the consequences on business relationships, (d) the impact on community and the environment, (e) the maintaining of high standards of business conduct and (f) acting fairly as between their shareholders. This duty is generally regarded as replacing the common law duty to act bona fide in the best interests of the Company.
While it is not clear how existing case law will be used to interpret this duty, commentators have said that the original case law on acting in the best interests of the Company remains valid.
When providing guidance on this duty, the UK Government indicated that the decision as to what will promote the success of the Company is up to the director’s good faith and judgement and commentators broadly agree that it is important now for a director to show some sort of paper trail showing why a decision was made. Therefore, adequate procedures must be put in place to show how a director came to a decision so that if a challenge is brought subsequently he is able to justify his decisions and the factors considered in reaching them. Consequently we have seen a move to properly minute at Board meetings key decisions made by the Board, including a reference to specifically referring to the enlightened shareholder value duty and an explanation as to the context of the matters considered in order to resolve to make the decision. This often refers to prior Board or discussion papers.
In addition to the Companies Act, there are a number of other specific statutes which lay down specific requirements for directors, the failure of which can result in criminal sanctions. These include the Criminal Justice Act 1993, Financial Services and Markets Act 2000, Insolvency Act 1986, the Corporate Manslaughter and Corporate Homicide Act 2007 and the Health and Safety Work etc. Act 1974. A full list of director’s duties is available at Eversheds.com.
Refocusing, however, on the Combined Code which is, as stated above, the core piece of regulation which focuses on corporate governance for publicly traded companies in the United Kingdom. The Listing Rules require publicly traded companies to state in their annual report and accounts how they have applied the main principles and supporting principles of the Combined Code. Companies must state whether or not they have complied with the provisions, and if they have not complied, give reasons for non compliance (the comply or explain culture). In addition to this general obligation, DTR 7.2 requires companies to publish a corporate governance statement containing a description of the main features of the company’s internal control and risk management systems in relation to financial reporting systems, certain accounting information and the composition and operation of the company’s boards and committees.
Certain fundamental parts of the combined code are as follows:
• Each company should be headed by an effective board which is collectively responsible for promoting the success of the company. The board should set out the company’s strategic aims, its beliefs and standards and ensure its obligations to shareholders and others are met and fully understood.
• The board should publish a high level of statement of matters specifically reserved to it for decision and should ensure that the board and its committees meet regularly.
• The Code requires each director to bring an independent judgment to bear to make decisions objectively in the interests of the company, basically repeating the statutory duty contained in the Companies Act referred to above. A non executive director, i.e. an independent director is expected to constructively challenge and contribute to the development strategy, to scrutinise management performance, to satisfy himself on the integrity of financial information and ensure the financial controls and risk and management systems are robust and defensible.
• It is expected that independent directors would hold separate meetings without executive directors or the chairman being present.
• The role of the chairman is pivotal in setting the tone of the board and, accordingly, under the Combined Code, the post of chairman and chief executive should not be held by the same person, and ideally a chief executive should not move on to become the chairman in due course;
• The Combined Code recommends at least half the board, excluding the chairman, should be independent directors. The Combined Code sets out various criteria for determining whether or not a director is independent for the purposes of the Code.
• Amongst the independent directors, there should be a senior independent director who should be available at all times to shareholders in order to address any concerns they may have if contacts through the usual channels, i.e. the executive directors to chairman are not adequately dealing with particular issues.
A number of committees are required to be set. These include nomination committees, remuneration committees and audit committees.
Directors are required to submit themselves for re-election at least every three years and the continued appointment of an independent director after six years should be subject to vigorous review. An independent director should not serve more than nine years, and if they do they must be subject to annual re-election.
The audit committee must contain at least three independent directors and it should monitor the integrity of the financial systems of the company and any significant financial reporting requirements. It should review the internal financial control and risk management control systems, review the scope of effectiveness of the audit, and the independence and objectivity of the auditors and develop policies for the supply of non audit services to external audit firms.
The remuneration committee is required to set the remuneration policies of a company. It must strike a balance between packages that will attract, retain and motivate the executive directors but ensure the company is not paying more than the market rate. A significant portion of remuneration should be performance related and the remuneration committee should ensure that remuneration is designed to align a director’s interest with those of the shareholders at large.
The Combined Code provides also that there should be regular dialogue between the company and shareholders based on a mutual understanding of the company’s and members’ objectives and it encourages institutional shareholders to take responsibility to make use of their voting power at annual meetings.
Linked to this is a requirement for the directors’ remuneration report to be included in the company’s audited accounts and for an indicative vote on that report to be taken at each Annual General Meeting.
In the 2009 Annual General Meeting round, there has been significant focus on remuneration reports and indeed a number of reports have actually been defeated, primarily where institutions through pressure groups have been concerned with performance related bonuses, particularly where bonuses have been satisfied otherwise by way of shares.
The defeat of a remuneration report resolution, however, does not mean that a company technically needs to do anything about remuneration. The vote is only an indicative vote and directors’ packages are not directly affected by the voting down in the report. However, there is a view that where there is a substantial minority or even a majority of people who vote against the report, the company has to take action and there are a number of companies that are currently reconsidering their remuneration practices, talking actively with their shareholders, in the anticipation that at the 2010 annual meeting, there will be an alignment resulting in remuneration reports being voted through.
Following the financial crisis which resulted in severe losses suffered by the banking industry in 2008 the UK government in February 2009 asked for general review to be carried out on corporate governance in UK banks. This review, called the Walker Review, was published in July 2009 and is open for consultation until October 2009. The review is expected to be finalised in November 2009. While the review focused on corporate governance of banks and other financial institutions the writers of the report have said that the review is probably applicable in broad terms to all companies. The Financial Reporting Council (“FRC”) has commented favourably in relation to the core recommendations and have indicated that they would be looking to make changes to the Combined Code.
The Walker Review maintains that the right approach to UK corporate governance is the “comply or explain” approach ie here is the code you either follow the code or explain why you are not following it.
The Walker Review made 39 recommendations relating to board sizes, composition and qualifications of directors, the functions of the board, evaluation of performance of the board, the role of institutional share holders and the governance of risk and remuneration. Broadly the review’s principal conclusions were that the Combined Code remains fit for purpose but that a number of changes need to be made to ensure that there is an effective challenge on executive directors by independent directors before decisions are taken on major risk and strategic issues. In particular the Walker Review has emphasised that close attention should be paid to the time commitment and composition of independent directors to ensure the right mix of financial industry capability and high level experience in other major businesses is reflected on amongst the independent directors.
Walker also encourages that the institutional shareholder should be more engaged to promote the long term improvement of the performance of companies and that the FRC should develop a set of principles of best practice relating to the stewardship of companies by institutional shareholders.
Further Walker suggested that a separate board risk committee should be established to advise on the full remit of risk exposure which would include looking at overall strategy counter party risk, economic, financial, cultural and regulatory risk and how a company’s current processes mitigate those risks. This goes significantly further than the current Combined Code guidance on internal controls. Finally Walker also encourages a board to be more active in overseeing remuneration policies and states that the remit of a board remuneration committee should be extended beyond board members to cover the remuneration framework for the entire business with particular greater focus on long term variable remuneration for directors and senior executives.
In light of the Walker report it is almost certain there will be significant changes to the Combined Code. At the end of July 2009 the FRC issued a progress report which invited views on various aspects of the Combined Code and its application. The FRC intends to publish a final report at the end of 2009 and a revised combined code to be implemented with effect from mid 2010. This will be the first major revision of the combined codes to 2003. Areas that the FRC have said that they will particularly review and revise are:
1. Responsibilities of the chairman and independent directors.
2. Board balance and composition.
3. Frequency of director election (there is likely to be a proposal for annual reselection).
4. How a board gets information from its business.
5. What tools are needed to help a board develop and support its functions.
6. External board evaluation.
7. Risk management and internal controls and remuneration.
While maintaining the “comply and explain” approach the FRC have asked specifically for reviews on the quality of disclosure by companies and the nature and engagement between board and shareholders. There has been some talk about changing the word “comply” to “apply” or explain to avoid the potential box ticking approach which some commentators allege is taking place.
It is an exciting time to be looking at corporate governance in the UK. I personally strongly feel that there needs to be some sort of global alignment on corporate governance and that the UK approach “comply or explain” is probably the right one.