Less box ticking, more explaining – the FRC publishes its Annual Review Report

The FRC has published its Annual Review Report and with it comes the clear message that a ‘tick box’ approach is not the key to compliance with the Corporate Governance Codes.

The purpose of the Report was two-fold: 1) to give an assessment of corporate governance in the UK by considering the quality of reporting against the 2016 UK Corporate Governance Code (‘the 2016 Code’) and 2) to comment on any ‘early adoption’ by FTSE 100 companies of the 2018 UK Corporate Governance Code (‘the 2018 Code’).   For the latter, the FRC set out its expectations for companies reporting on the 2018 Code which will be the main focus of this blog.

The FRC report that during their review it became apparent that, ‘many companies simply concentrated on achieving strict compliance with the Provisions’, an approach which gives little insight into governance practices. The majority of companies considered declared themselves fully Code compliant. However, the FRC found that, ‘many annual reports lacked information on the outcomes of governance policies and practices, including any areas for future improvement’. The FRC highlight that the 2018 Code reaffirms the importance of applying the Principles in a way that shareholders can evaluate; application of the Principles requires a company to demonstrate actions taken and how such actions link to their strategy and purpose. Companies have been encouraged to do more than simply state they comply with the Provisions and, instead, provide examples to allow clearer insight into a company’s practices, to ultimately ensure confidence in investors. The FRC report that investors agreed with their view that: ‘a company is compliant if it chooses to depart from one or more Provisions, but only where ample explanation is provided’.

In respect of early adoption of the 2018 Code, the FRC examined the annual reports of FTSE 100 companies with December 2018 and March 2019 year ends, which covered 82 entities, almost all of which acknowledged the 2018 Code. The FRC comment that the quality of reporting was ‘mixed’, with corporate culture and workforce engagement being the most frequently discussed areas.

We have set out below the expectations of the FRC and its guidance for optimum compliance with the 2018 Code going forward, as arising from its report. Whilst we have focused on some of the main criticisms to emerge from the FRC’s review, it is clear there have been positive movements towards adoption of the 2018 Code, as acknowledged by the FRC itself. Nonetheless its report makes clear there is some way to go.

Purpose

Relevant Provision of the 2018 Code 

Principle B:  ‘the board should establish the company’s purpose, values, and strategy, and satisfy itself that these and its culture are aligned.’

Main FRC Criticisms

(Around half of the FTSE 100 companies sampled provided purpose statements; the quality of these varied greatly.)

• There was a tendency to conflate mission and vision with purpose; mission and vision rely on a company’s purpose to provide the reasons behind their goals;
• What appeared to be slogans or marketing lines were substituted for a company’s purpose or purpose was restricted to achieving shareholder returns and profit, suggesting, ‘many companies have not fully considered purpose and its importance in relation to culture and strategy, nor have they sufficiently considered the views of stakeholders in their purpose statements.’

FRC Expectations going forward and guidance

The best reporting described purpose by considering it alongside culture and strategy in a way that demonstrated the company had thought about purpose effectively. The Lab 2018 report, ‘Business model reporting; Risk and viability reporting – Where are we now?’ provides examples of purpose statements by FTSE 100 companies that received positive responses from some investors and clearly described how stakeholder value is created.

 

Culture

Relevant Provision of the 2018 Code 

Provision 2: ‘The board should assess and monitor culture. Where it is not satisfied that policy, practices or behaviour throughout the business are aligned with the company’s purpose, values and strategy, it should seek assurance that management has taken corrective action.’ 

Main FRC criticisms

• Only a small number of boards disclosed that they already receive reports on culture to aid discussions and only a few reported that it had a specific agenda item on alignment of culture with values and strategy. This lack of discussion at board level, ‘perhaps links back to some of the poorer articulations or company purpose discussed earlier’;
• Overall there was limited discussion of assessing and monitoring culture. Of those that did, the main tool used appeared to be employee engagement surveys, with the main metric being completion rates of such surveys;
• Very few companies cite more than three metrics used to monitor and assess culture.

FRC expectations going forward and guidance

Whilst employee engagement surveys are beneficial, they only provide a snapshot of information and should not be used in isolation.

In respect of metrics for monitoring and assessing culture, linking different sources of information together will help companies better understand their culture. Companies’ internal audit procedures can provide an independent and objective assessment of their operations in this context.

 

Workforce Engagement

Relevant Provision of the 2018 Code

Provision 5: ‘the board should understand the views of the company’s other key stakeholders and describe in the annual report how their interests…have been considered in board discussions and decision making.’

Main FRC Criticisms

It was not clear how much thought was given to the effectiveness of the method chosen for engagement with workforces: ‘[t]here was little analysis of whether the likely method for engagement was the best one for the company to ensure that boards were made aware of key issues raised by the workforce.’

FRC expectations going forward and guidance

2020 reports should make it clear how the methods used have achieved the objective of Provision 5 and include details or real examples of what a company has done to consider and, if appropriate, take forward matters raised by the workforce. 

 

Section 172 Reporting

Relevant provision of the 2018 code

Provision 5 links engagement with stakeholders with reporting on s.172 of the Companies Act 2006, now required by The Companies (Miscellaneous Reporting) Regulations 2018; a s.172 statement needs to be incorporated within the Strategic Report. 

Main FRC Criticisms

There was limited discussion of the issues that were important to or raised by stakeholders, and consequently to what extent boards had considered these and the impact they had made to strategy.

FRC expectations going forward and guidance

‘Reporting must cover the concerns raised by stakeholders, how companies have understood the issues, and how they have thought carefully about how these impact on the long-term success of the company.’

 

Chair Tenure

Relevant Provision of the 2018 Code 

Provision 19: ‘The chair should not remain in post beyond nine years from the date of their first appointment to the board. To facilitate effective succession planning and the development of a diverse board, their period can be extended for a limited period, particularly in those cases where the chair was an existing non-executive director on appointment. A clear explanation should be provided.’

Main FRC criticisms

It was concerning there were around 18 chairs that had been on the board for 18 years or more based on data as at 31 October 2019 of the FTSE 250.

FRC expectations going forward and guidance

Companies are expected to set out their rationale for this situation and their proposals for the future composition of their boards.

 

Succession Planning

Relevant Provision of the 2018 code

Provision 18: ‘the board should set out in the papers accompanying the resolutions to elect each director the specific reasons why their contribution is, and continues to be, important to the company’s long-term sustainable success.’

Main FRC criticisms

• Most companies simply noted that the role of the nominations committee was to keep appointments under consideration;
• The reports reviewed lacked detail on succession planning, with many companies focussing more on their appointment process (including usage of external recruitment agencies) rather than providing information on how they plan for the various types of succession that exist;
• After reviewing 40 AGM notices to determine how companies were justifying the re-election of board members to their shareholders, around half of the AGM notices simply listed the biographies of each individual, referred to the annual report, or said nothing about how they contribute to long-term success.

FRC expectations going forward and guidance

The best AGM notices clearly set out the reasons for an individual’s re-election, specifically linking their contributions to company strategy, risks, or similar key issues referenced in the annual report. More companies are expected to consider Provision 18 in detail for this year’s AGM notices.  

 

Diversity

Relevant Provision of the 2018 Code:

Provision 23: requires companies to describe, ‘the policy on diversity and inclusion, its objectives and linkage to company strategy, how it has been implemented, and progress on achieving the objectives.’

Main FRC Criticisms

• It was not always clear whether there were targets related to diversity at board and senior management level and, if so, what actions were being taken to achieve these targets or wider objectives;
• There was limited reporting of diversity beyond gender. While several FTSE 100 companies did comment on ethnic diversity and included plans and targets to improve this area only one or two reported on their approach to age, disability and/or LGBT+ diversity.

FRC expectations going forward and guidance

Targets and the actions taken to achieve these or wider objectives will be looked at more closely in the future.

An increase in more detailed commentary on all aspects of diversity is expected in the future.

 

ReMuneration

Principle P: ‘remuneration policies and practices should be designed to support strategy and promote long-term sustainable success. Executive remuneration should be aligned to company purpose and culture and be clearly linked to the successful delivery of the company’s long-term strategy.’	Main FRC Criticisms All companies reviewed used financial KPIs to measure annual bonus and LTIP awards.  FRC expectations going forward and guidance: Better practice examples included strategic or individual non-financial KPIs that align with long-term horizons and specified the use of vesting periods for incentives. There is some movement towards the use of additional non-financial metrics, such as diversity, culture and health and safety targets. The inclusion of these non-financial metrics as a valuable measurement to achieve long-term success is encouraged going forward.
Provision 33: The remuneration committee, ‘should review workforce remuneration and related policies, and the alignment of incentives and reward with culture, taking these into account when setting the policy for executive director remuneration.’	Main FRC Criticisms: The ‘clear majority’ of companies sampled had yet to provide any information in their annual reports about engagement. FRC expectations going forward and guidance:  The 2018 Code asks remuneration committees to report on their engagement with the company’s workforce. This year’s annual reports should offer much more detail on both the way in which remuneration committees have engaged with the workforce, and importantly the effect of this engagement.
Provision 37: ‘Remuneration schemes and policies should enable the use of discretion to override formulaic outcomes. They should also include provisions that would enable the company to recover and/or withhold sums or share awards and specify the circumstances in which it would be appropriate to do so.’	Main FRC Criticisms: A minority of the companies reviewed are yet to disclose their arrangements. FRC expectations going forward and guidance: Having malus/clawback provisions are vital for remuneration committees in terms of exercising their oversight duties, those companies that have not yet published full details are encouraged to do so.
Provision 38: ‘the pension contribution rates for executive directors, or payments in lieu, should be aligned with those available to the workforce.’	Main FRC Criticisms: Some companies have outlined their pension contribution rates, but have not explained how they will align them with their workforce or what their workforce’s contribution rate is; others are yet to disclose the pension contribution rates of their executive directors or their workforce. FRC expectations going forward and guidance:  Given many remuneration polices are up for shareholder approval in 2020, the FRC expects more change here.

 

About the authors

Charlotte Judd is an Associate Solicitor in the Regulatory  department. She assists and advises on matters spanning the department’s three core service areas, namely legal services regulation,  defending regulated individuals, organisations and corporates and advice for regulators and public bodies .

Julie Matheson is a Partner in the Regulatory team, specialising in defending professionals in the financial and legal fields.  She has particular expertise in defending accountants and accountancy firms in regulatory proceedings brought by the FRC, ICAEW and ACCA.  She also regularly provides advice on FCA conduct issues, particularly under the Senior Managers and Certification Schemes.