UK: UK Corporate Update – Corporate Governance

Last Updated: 12 July 2012
Article by Jerry Walter and Richard May

Corporate governance issues continue to dominate the business landscape in the UK. In this update we focus on three major recent developments. They remain subject to consultation (or, in the case of directors' remuneration, to parliamentary debate and approval), but they seem likely to be implemented in substantially the form currently proposed.

Proposals on Directors' Remuneration

The UK Government recently announced significant proposed changes to the rules on directors' remuneration for UK-listed companies. The changes are intended to promote constructive engagement by shareholders with companies in relation to remuneration ("say on pay"), to allow shareholders effectively to challenge excessive pay, and, more generally, to encourage improved pay discipline.

Essentially, companies will be required to include additional information about their remuneration policy in their annual reports and to make that policy subject to a binding vote at least once every three years. This is in addition to the annual advisory vote on the implementation of the remuneration policy, the requirement for which will remain unchanged.

The changes are expected to be implemented in late 2013.

Binding vote on remuneration policy

Under the proposals, a company's remuneration policy will need to be approved by shareholders. Shareholder approval will also be required if the company wishes to change its policy, and it will only be permitted to make payments within the limits set by the approved policy. The vote must take place annually unless that policy is not changed, in which case it must happen at least once every three years. The vote will require an ordinary resolution.

The UK Government has suggested that this will encourage companies to devise a policy for the "long term" and "put downward pressure on pay ratcheting." In that regard, much will presumably depend on how the relevant policy is defined, and on how prescriptive the implementing regulations are.

Under the proposals, a company's remuneration policy must include:

  • a table setting out the "key elements of pay" and relevant "supporting information", including how each supports the achievement of strategy, maximum potential value and performance metrics;

"information on employment contracts" (which we assume will take the form of a detailed description of each director's employment contract);

  • scenarios describing what directors will get paid for performance above, on and below target;
  • information on percentage change in profits, dividends and the "overall spend" on pay;
  • the "principles on which exit payments will be made", including how they will be calculated, whether the company will distinguish between types of leaver or circumstances of exit, and how performance will be taken into account; and
  • material factors which have been taken into account when setting the remuneration policy, including employee pay and shareholder views.

Advisory vote on implementation of remuneration policy

In addition to the binding vote, there will continue to be an annual advisory vote on the implementation of the remuneration policy, including amounts paid in respect of remuneration in the previous year. If this vote is not passed, this will trigger a binding vote on the policy the following year.

Under the proposals, a company's (annual) implementation report must include:

  • a "single total figure" of remuneration for each director (i.e., the actual amount received by the director in that year, including contributions to pension arrangements);
  • details of performance against metrics for long-term incentives;
  • total pension entitlement (for defined benefit pension plans only);
  • exit payments made in that year;
  • details of variable pay awarded in that year;
  • total shareholding of directors;
  • a chart "comparing company performance and CEO pay"; and
  • information on who has advised the remuneration committee.

Exit payments

Finally, it is proposed that where a director leaves a company, it should be required promptly to announce that fact to the market, together with details of any termination payment to the relevant director.

The terms of any such payment will then also be reported in the implementation report and so will be subject to the advisory vote (see above).

Next steps and related developments

The proposed changes will be introduced into the forthcoming Enterprise and Regulatory Reform Bill.

The UK Government also intends to consult on simplified regulations on how companies must report directors' remuneration, including measures to make such reports clearer and more transparent for investors.

Separately, the UK Financial Reporting Council (FRC) has announced that it intends to consult on some related changes to the Corporate Governance Code. These include a proposal that where a "substantial minority" of shareholders vote against either a binding or an advisory vote on remuneration, companies should be required to publish a statement indicating what they propose to do in order to address shareholder concerns.


Given recent events (and, specifically, the so-called "Shareholder Spring"), there has been speculation that, as the UK Government hopes, companies and institutional investors will "early adopt", implementing the proposals outlined above, before the legislation is implemented next year. However, whether or not they do so, the proposals represent a challenge and an opportunity for both companies and shareholders.

Companies will need to ensure that their policies include all of the new information, and to engage with their key shareholders so as to head off any potentially "problematic" issues.

Institutional shareholders will need to review and develop their frameworks for engaging with, and for exercising stewardship over, investee companies in relation to remuneration.

As a step towards the UK Government's stated aims of long-term thinking and transparency in relation to director remuneration, and of a reduction in upward pay pressure, these proposals are therefore to be welcomed.

Consultation on Proposed Changes to UK Corporate Governance Code

In April, the UK Financial Reporting Council (FRC) launched a consultation on proposed changes to the UK Corporate Governance Code (Code). The main proposals are:

  • to require FTSE 350 companies to put the contract for external audit out to tender at least once every 10 years;
  • to require boards to set out in the annual report why they consider the audit report to be fair, balanced and understandable;
  • to amend the Code to encourage more information reporting by audit committees; and
  • to give more guidance on the explanations that should be provided to shareholders where a company does not follow the Code's provisions.

The Code (formerly the Combined Code) sets out standards of good practice in relation to board leadership and effectiveness, remuneration, accountability and relations with shareholders. All companies with a premium listing in the UK are required under the Listing Rules to report in their annual report and accounts on how they have applied the Code.

The FRC proposes to issue a revised version of the Code in December.

Tendering for audit contracts

The FRC has proposed that companies should be required to put the contract for external audit out to tender at least once every 10 years. The FRC recognises that care needs to be taken over transitional arrangements in order to avoid problems that could result if all of the companies that have not put their external audit contracts out in tender were to do so in the first year. The FRC proposes that the timing of the tender could either be linked to the time when the current audit engagement partner is due to rotate or the length of time since the previous audit contract was put out to tender. In this case, the proposal is that where a company has put the audit contract out to tender in or after 2000, the tender process could be deferred until the latter stages of the incoming audit engagement partner's term (i.e., for a further five years).

The FRC believes that the combined effect of these proposals would be to defer the date for tendering the audit contract of a significant number of FTSE 100 companies until 2018 or later.

Annual report to be fair, balanced and understandable

The FRC proposes to extend the audit committee's remit to include consideration of the whole annual report (including the narrative report) in order to determine whether it provides the information which is required to assess the company's performance and prospects, and whether the annual report, as a whole, is fair and balanced.

Description in annual report about discharge of responsibilities of audit committee

The FRC proposes that a separate section of the annual report should describe the work of the audit committee in discharging its responsibilities, including:

  • significant issues considered in relation to the financial statements and how these were addressed;
  • an assessment of the external auditor's effectiveness and the approach taken to the appointment or reappointment of the external auditor's effectiveness; and
  • where the auditor provides non-audit services, an explanation of how auditor objectivity and independence are safeguarded.

Quality of explanations

In order for the "comply or explain" principle to remain credible, the FRC considers it important for companies to provide clear and meaningful explanations when they deviate from the Code, so that shareholders can understand the reasons for doing so, and judge whether they are happy with the company's approach.

The FRC proposes to include wording in the Code to make it clear that where a company is deviating from the Code, it should set out the background, and provide a rationale for the action taken and any mitigating action taken to address additional risk and maintain conformity with the relevant principle.

Consultation on Proposed Changes to UK Stewardship Code

In April, the FRC launched a consultation on the UK Stewardship Code (Stewardship Code).

Changes to the Code are proposed in three areas:

  • the aim and definition of stewardship;
  • delineation of the responsibilities of different types of institutional investor; and
  • addressing some minor issues.

The Stewardship Code sets out aims of good practice on engagement between institutional investors and investee companies. The Code applies to firms who manage assets on behalf of institutional shareholders (e.g., pension funds, insurance companies, investment trusts and other collective investment vehicles). Those firms are expected to disclose on their websites how they have applied the Code. In addition, since December 2010, all UK-authorised asset managers have been required to produce a statement of commitment to the Stewardship Code or to explain why it is not appropriate to their business model.

The FRC proposes to issue a revised version of the Stewardship Code in December.

Meaning of stewardship

It is proposed to revise the Code to make it clear that:

  • the aim of stewardship activities is to promote the long-term success of companies so that the providers of capital to companies prosper;
  • in listed companies, the board has primary reasonability for stewardship, but investors play a significant role in holding the board to account; and
  • stewardship activities include monitoring and engaging with companies on matters such as strategy, performance risk, remuneration and corporate governance, and this requires a purposeful dialogue with companies on these matters, as well as on issues that are the immediate subject of votes at general meetings.

The role of different types of institutional investor

The FRC proposes to add wording to the Code to clarify the position of asset owners and asset managers. Following this approach, references to "institutional investor" will be replaced with references to "asset owner" or "asset manager", as appropriate. Institutional investor will continue to be used where the Code refers both to asset owners and asset managers.

For these purposes, "asset owners" include pension funds, insurance companies, investment trusts and collective investment vehicles. The FRC recognises that asset owners set the tone for stewardship and can influence behavioural changes that lead to better stewardship by asset managers and companies. The proposed changes require asset owners to clearly communicate their policies on stewardship to their managers and to hold them to account for their stewardship activities.

"Asset managers" have day-to-day responsibility for managing investments. As a result, the FRC believes that they are well placed to influence companies' long-term performance through stewardship. The proposed changes require assets managers to disclose how they discharge their stewardship responsibilities on behalf of clients. Asset managers will also be expected to have the policies described in their stewardship statements independently verified.

Separately, the Institute of Chartered Accountants in England and Wales has published a stewardship supplement to Technical Release AAF 01/06 covering assurance reports on internal controls of service organisations made available to third parties. The FRC encourages asset managers to adopt this standard or an equivalent.

Other issues

Conflicts of interest

The FRC proposes to amend the Code to require institutional investors to implement an "effective" policy on managing conflicts of interest in their stewardship. (The current, weaker requirement is for a "robust" policy).

Proxy voting and other advisory services

The FRC believes that disclosure in relation to proxy voting services could be improved. It proposes to amend the Code to require signatories to the Code not only to disclose whether they use proxy voting and advisory service, but also the extent to which they use, rely on and follow the adviser's recommendations.

Stock lending

The FRC recognises the importance of stock lending to stewardship. It proposes to amend the Code to require signatories to disclose their policy on stock lending and, in particular, whether they recall lent stock for voting purposes.

Other asset classes

The FRC proposes to amend the Code to require institutional investors with several types of funds or investments to explain which of these are covered by their statements, and to disclose whether they adopt a stewardship approach.

Signatories' statements

Finally, it is proposed that signatories should be required to review their policy statement annually and update it where necessary to reflect changes in actual practice, to disclose the statement on their website, and to indicate when it was last reviewed.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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