Radical Revisions to FRC Corporate Governance Code and Guidance on Board Effectiveness

The Financial Reporting Council has delivered radical revisions of the UK Corporate Governance Code and of the Guidance on Board Effectiveness (the Code and the Guidance respectively).

The Code and Guidance have been substantially recast, with a focus on making 'tick-box' approaches and boilerplate reporting much more difficult.  To this end the Guidance is laced with over eighty penetrating open-ended questions for boards to consider. The new rules come into force as regards accounting periods beginning on or after 1 January 2019.

Our note concentrates on four important themes involving change:

• Long term sustainable success
• Board skills knowledge and experience
• Interacting with the workforce and
• Remuneration issues

Long Term Sustainable  Success

For years there has been trenchant criticism of short-termism and opportunism among UK company leaders and their shareholders at the expense of sustainable growth.  Recent examples include utilities accused of asset stripping that will leave their companies vulnerable when interest rates rise.  But examples go back many years.

The Code now begins:

"A successful company is led by an effective and entrepreneurial board, whose role is to promote the long-term sustainable success of the company, generating value for shareholders and contributing to wider society." (Code Principle A)

"The board should ensure that workforce policies and practices are consistent with the company’s values and support its long-term sustainable success."  (Code Principle E)

Boards have to report on this. The Provisions that elaborate Code Principles A to E provide:

The board should assess the basis on which the company generates and preserves value over the long-term. It should describe in the annual report how opportunities and risks to the future success of the business have been considered and addressed, the sustainability of the company’s business model and how its governance contributes to the delivery of its strategy."  (Code Provision 1)

This approach is underpinned by the Guidance, which begins by describing an effective board.

"An effective board defines the company’s purpose and then sets a strategy to deliver it, underpinned by the values and behaviours that shape its culture and the way it conducts its business. It will be able to explain the main trends and factors affecting the long-term success and future viability of the company – for example technological change or environmental impacts – and how these and the company’s principal risks and uncertainties have been addressed."  (Guidance 1) 

Whilst this respects the formal wording of s172 of the Companies Act 2006 with all its ambiguities, boards subject to the FRC will either have to comply with the Code on this or explain that, and why, they will not.

What remains is the potential for major shareholders to drive undesirable short-termism in the board.  The FRC intends to consult on revisions on the Stewardship Code.  In our view this problem cannot be resolved without drawing in the FCA to regulate issues between investment professionals and their ultimate clients, particularly as regards the disparity between the often short bonus-driven time horizons of investment professionals and the far longer horizons of retail investors saving for the long term to retirement.  Some have suggested more draconian measures such as the Loi Florange.

Board Skills Knowledge and Experience

The history of corporate disasters, including the 2007/8 Banking Crisis, is littered with boards that lacked key skills, knowledge or experience, a pattern that persists.   In an attempt to stem this steady flow, the FRC has tackled board composition.  They have three aims: to encourage NED teams that have an adequate combined skill-set; to encourage diversity of perspective; and to increase strength of NED character. The Code now provides:

"...Both appointments and succession plans should be based on merit and objective criteria and, within this context, should promote diversity of gender, social and ethnic backgrounds, cognitive and personal strengths." (Code Principle J)

"The board and its committees should have a combination of skills, experience and knowledge. ... " (Code Principle K)

These dry anodyne principles are reinforced in the Guidance, which includes a new emphasis on character - with courage heading the list.

The boardroom is not supposed to be a comfortable place:

"The boardroom should be a place for robust debate where challenge, support, diversity of thought and teamwork are essential features. Diversity of skills, background and personal strengths is an important driver of a board’s effectiveness, creating different perspectives among directors, and breaking down a tendency towards ‘group think’." (Guidance 16). 

Directors should be chosen to add value and effectiveness:

"Appointing directors who are able to make a positive contribution is one of the key elements of board effectiveness. Directors will be more likely to make good decisions and maximise the opportunities for the company’s success if the right skillsets and a breadth of perspectives are present in the boardroom. Non-executive directors should possess a range of critical skills of value to the board and relevant to the challenges and opportunities facing the company." (Guidance 87)

 Diversity, soft skills and character matter:

"Diversity of personal attributes is equally important. The nomination committee will want to ensure the board is comprised of individuals who display a range of softer skills, such as [sources of intellect, critical assessment and judgement, courage, openness, honesty, tact, ability to listen, ability to forge relationships, ability to develop trust and strength of character]" (Guidance, 91 combined with Figure 7)

 The Nomination Committee should be systematic in working out what the board needs, then set out to find them.  Competent boards will also create a person description setting out the personal attributes they seek.

"... The nomination committee should evaluate the skills, experience and knowledge on the board, and the future challenges affecting the business, and, in the light of this evaluation, prepare a description of the role and capabilities required for a particular appointment. .... It is important to build a proper assessment of values and expected behaviours into the recruitment process." (Guidance, 92)

"Skills matrices that map the existing skill-set against that required to execute strategy and meet future challenges can be an effective way of identifying skills gaps. They are a useful tool for role evaluation and succession planning." (Guidance 93)

 Boards should make efforts to attract recruits beyond the 'usual suspects':

"Publicly advertising board appointments and working with recruitment consultants who have made a commitment to promote diversity are examples of ways in which the nomination committee can access a more diverse pool of candidates from which to appoint. Attention also needs to be paid to how the interview process is conducted so that candidates with diverse backgrounds are not disadvantaged." (Guidance 94)

The Nomination Committee is asked four questions

• "Have we assessed what skillset is required for the board and its committees?
• Do we reassess the make-up of the board as a result of emerging trends?
• Do we take account of the technical skills and knowledge required by the committees when recruiting members?
• How often is a skills audit undertaken and are we keeping up with the pace of change?"  (Guidance before 92)

Interacting with the Workforce

The back story to these reforms includes public and political debate around how boards take account of relationships with stakeholders other than shareholders, and the workforce in particular.  Separately we have long raised the 'unknown known' problem - the all too common situation where the workforce knows important things that, for a variety of reasons, they will not, or dare not, tell their leaders.  The FRC has tackled both issues.  

The Code provides:

"The board should ensure that workforce policies and practices are consistent with the company’s values and support its long-term sustainable success. The workforce should be able to raise any matters of concern."  (Code Principle E)

"... The annual report should explain ... the company’s approach to investing in and rewarding its workforce." (Code Provision 2)

The board's engagement with the workforce is expected to include one or more of a director appointed from the workforce; a formal workforce advisory panel and/or a designated non-executive director (Code Provision 5).

"There should be a means for the workforce to raise concerns in confidence and – if they wish – anonymously. The board should routinely review this and the reports arising from its operation. It should ensure that arrangements are in place for the proportionate and independent investigation of such matters and for follow-up action." (Code Provision 6)

Boards are encouraged to draw the workforce into a collaboration when setting values because "Ownership of the values will be stronger if a collaborative approach is taken and both the leadership and the workforce are involved in a two-way process to define the company’s values (Guidance 18).  Similarly the Guidance advocates using "multiple qualitative and quantitative sources" to avoid gaining an incomplete picture of culture. "The workforce will be a vital source of insight into the culture of the company" (Guidance 23).

The FRC echoes our longstanding concern that boards are commonly in the dark about important things that the workforce knows but will not tell them - what we call the 'Unknown known' problem.  The FRC exhorts boards to make both whistle-blowing and more routine 'speaking up' safe for those with information to impart.

"Having policies in place that encourage individuals to raise concerns is a core part of an ethical and supportive business culture.  Whistleblowing policies that offer effective protection from retaliation ... are essential components of this. ..." (Guidance 57)

"Companies need to create an environment in which the workforce feels it is safe to raise concerns. Common fears include being negatively labelled, sidelined for promotion or bonuses, and even loss of employment. Leaders need to ensure there are no negative repercussions as a result of doing so." (Guidance 58)

"It is equally important to encourage individuals to speak up. Speak-up arrangements help build trust, act as an early warning system and help to manage risk. It is critical for success that leaders actively listen and feedback how the matter raised has been considered, including any action taken. Companies may want to consider the benefits of extending such arrangements beyond the workforce to external parties, like customers and suppliers. (Guidance 59)

One of the questions for boards to consider in this area is:

"What evidence do we have that the chief executive is willing to listen, take criticism and let others make decisions?" (Guidance below 26)

Remuneration issues

A crucial issue for behavioural risk specialists such as ourselves is the risk that executive reward systems to create incentives that encourage behaviour that is against organisation's best interests and that encourage treating the organisation's interests as pawns in a bigger game: the gaming of incentive schemes.  A long-running sore with the public and with politicians is the divergence between C-suite pay and workforce pay.  The FRC has tackled both.

As usual the FRC's approach begins with the Code.

"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 values, and be clearly linked to the successful delivery of the company’s long-term strategy." (Code Principle P)

Remuneration Committee chairs are required to have had at least 12 months' service on a Remuneration Committee. (Code Provision 32).  The Committee should "review workforce remuneration and related policies and the alignment of incentives and rewards with culture, taking these into account when setting the policy for executive director remuneration." (Code Provision 22)

FRC Guidance on executive pay is now robust, encouraging rules that require the holding of shares awarded for long periods.  Foreshadowing the holding of shares well into retirement:

"Remuneration schemes should promote long-term shareholdings by executive directors that support alignment with long-term shareholder interests. Share awards granted for this purpose should be released for sale on a phased basis and be subject to a total vesting and holding period of five years or more. The remuneration committee should develop a formal policy for post-employment  shareholding requirements encompassing both unvested and vested shares." (Code Provision 36)

 The Code steers Remco towards clarity, simplicity, risk awareness and alignment with culture:

"When determining executive director remuneration policy and practices, the remuneration committee should address the following:

• clarity – remuneration arrangements should be transparent and promote effective engagement with shareholders and the workforce;
• simplicity – remuneration structures should avoid complexity and their rationale and operation should be easy to understand;
• risk – remuneration arrangements should ensure reputational and other risks from excessive rewards, and behavioural risks that can arise from target-based incentive plans, are identified and mitigated; 
• alignment to culture – incentive schemes should drive behaviours consistent with company purpose, values and strategy.  ..."  (Code Provisions 40)

Remco is expected to supervise all aspects of reward, including the relationshiop between workforce pay and executive pay.

"The remuneration committee is also tasked with reviewing workforce remuneration and related policies. The purpose of this review is to:

• ensure the reward, incentives and conditions available to the company’s workforce are taken into account when deciding the pay of executive directors and senior management;
• enable the remuneration committee to explain to the workforce each year how decisions on executive pay reflect wider company pay policy; and
• enable the remuneration committee to feedback to the board on workforce reward, incentives and conditions, and support the latter’s monitoring of whether company policies and practices support culture and strategy." (Guidance 130)

In setting executive pay, Remcos are expected to "focus on the strategic rationale for executive pay and the links between remuneration, strategy and long-term sustainable success",  avoiding "pay structures based solely on benchmarking to the market, or the advice of remuneration consultants, as there is a risk this could encourage an upward ratcheting effect on executive pay."  (Guidance 133 and 134)

Once again, the theme of long term success reappears, with what is probably the most effective way of ending the gaming of incentives: forcing executives to hold shares until well after they leave.  New leaders tend to search for time bombs bequeathed by their predecessors.

"It is important that the remuneration committee takes steps to counteract the risk of incentives that are detrimental to the long-term success of the company. Packages that are structured to ensure exposure to the long-term share value, including for two to three years after leaving the company, can support alignment with shareholders and encourage executive directors to focus on the impact of their decisions over the long-term." (Guidance 135)

The FRC has asked Remcos to consider a suite of questions that probe:

• alignment of executive pay with wider company pay policy
• the extent to which workforce incentives support culture and encourage desirable behaviour?
• How Remco has explained to the workforce the relationship between executive pay and wider company pay policies 
• whether their pay policy strengthens long-term thinking
• how they have addressed Provision 40 of the Code 
• how performance measures support long-term thinking 
• whether the choice of any measure may encourage negative behaviour and if so, what steps have been taken to manage the risks (Guidance after 132, 136 and 37) 

If you wish to understand the rationale behind most of these changes, you will find it explained in "Rethinking Reputational Risk - How to Manage the Risks that can Ruin Your Business, Your Reputation and You" by Anthony Fitzsimmons and the late Derek Atkins. 

Should you wish for an external board evaluation focused on helping your board to avoid the pitfalls that bring down companies and their boards time after time, please get in touch.

Anthony Fitzsimmons
Reputablity LLP
London

www.reputability.co.uk
www.reputabilityblog.com