Corporate Governance Reform

Definition of corporate governance

Corporate governance is the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies.

The UK Corporate Governance Code

The Code sets out good practice that boards should adopt to be effective, accountable, transparent and focused on sustainable success over the longer term. The Code covers a wide range of areas, from board leadership and composition to the remuneration of executives and stakeholder engagement.

The Code applies to public listed companies – it does not concern private companies. In law, companies are primarily accountable to their shareholders, and the Code is largely, though not only, written to protect and benefit shareholders.

The Code consists of principles rather than detailed rules. Companies must apply these principles but have latitude over how they do so. Indeed, a key job of a company’s board is to decide how to apply the Code’s principles, and communicating their approach to shareholders and other stakeholders.

A fundamental feature of the application of the Code is the “comply or explain” principle. Under this principle, companies are required to comply with official guidance, or to explain why they have not done so. Comply or explain preserves flexibility for businesses that wish to deviate from best practice as laid out in the guidance. But the deviations must be duly noted, and justified, in the company’s annual report.

In May 2020, the Government introduced a Corporate Insolvency and Governance Bill to help businesses deal with aspects of the coronavirus crisis. The Bill would temporarily allow companies to hold annual general and other meetings remotely. It would also give companies longer to submit updated information to Companies House.

Directors’ duties

A key component of the corporate governance framework in the UK are the duties that company directors must discharge in law under the Companies Act 2006. The seven general duties of directors are:

1. To act within powers
2. To promote the success of the company
3. To exercise independent judgment
4. To exercise reasonable care, skill and diligence
5. To avoid conflicts of interest
6. Not to accept benefits from third parties
7. To declare an interest in a proposed transaction or arrangement

The duty to promote the success of the company (section 172 of the Act) requires directors to act in the best interests of the company’s members (i.e. the shareholders in companies limited by shares), but also to have regard to other stakeholders, including employees, suppliers, customers, the community and the environment.

Reform

Narrowly defined, the purpose of corporate governance is ‘to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the company’ (p1 of the 2016 Corporate Governance Code).

But recent reforms have had a much wider purpose and scope than simply facilitating long-term success. For example, the impetus to reform executive pay has come from concerns about social justice as much as from concerns about the effective management of companies.

A consultation on corporate governance reform was launched on 29 November 2016. On 29 August 2017, the Government published its response to the consultation. It proposed eight reforms across the three areas of pay, employee and stakeholder voice, and the governance of large private companies. All eight proposals have been implemented since. The Companies (Miscellaneous Reporting) Regulations 2018 brought into effect the reforms that required legislation, starting in 2019.

The Government also agreed to look at the powers of the Financial Reporting Council (FRC) – an issue that was raised independently by respondents to the consultation and by the BEIS Select Committee. On 17 April 2018, the Government launched an independent review of the FRC, led by Sir John Kingman. The review examined the role, governance and powers of the FRC, and reported on 18 December 2018. The review recommended that the FRC be replaced with an independent statutory regulator, accountable to Parliament, with a new mandate, new clarity of mission, new leadership and new powers.

Pay ratios

The Government requires public companies with more than 250 UK employees and listed on the stock exchange to report annually the ratio of CEO pay to the median pay, 25^th-percentile and 75^th-percentile pay of their UK workforce, along with a narrative explaining changes to that ratio from year to year. To illustrate, a median pay ratio of 50 means that the CEO is paid 50 times the median pay in the company. Pay ratio data will first be reported in 2020.

Analysis in this briefing of alternative, currently available data shows that:

• A company’s ratio is partly predicted by the number of employees: larger companies have higher ratios – they are less equal.
• Differences in ratios between companies are also explained by the type of industry they are in – not just by company size. Some industries employ much higher proportions of highly-skilled, well-paid employees (e.g. finance), while others, like retailers, have large numbers of relatively less well-paid staff. The remuneration of chief executives also varies across industries.
• When looking at individual companies, ratios can fluctuate a lot from year to year. These fluctuations are due to the high volatility of top CEO pay, while pay in the wider workforce is more stable.

Taken together, company size, industry and the volatility of CEO pay can largely explain a company’s ratio, and changes from year to year. One can expect these factors to feature in the narrative that companies will provide along with their ratios.