Wednesday 17 September 2014

The UK Corporate Governance Code 2014: some initial thoughts



The FRC issued the UK Corporate Governance Code 2014 without consulting me on the timing, with the result that, having been out all morning, I started answering tweets about it before I’d had the chance to read the whole thing.  Now that I have paused to read the new Code, I feel that I can comment more intelligently.[1]

Before I dive into the new remuneration provisions, which are obviously the most interesting to me (and, I should imagine, to most people, given that they are the section that is most changed) I thought I’d report briefly on some of the other changes that caught my attention. 

Some are intriguing.  For example, the preface (para 3) states that “diversity…includes, but is not limited to, gender and race.”  On the one hand this is great – the treatment of diversity as synonymous with having women on the board has been irritating me for some time.  But it is notable that this preface is the only place in the Code where race is mentioned.  Reference to gender diversity appears in Principle B2 about board appointments, and in Principle B6 on board evaluation, but that is the only diversity embedded in the Code itself.

Likewise, the FRC in its press release refers to “the importance of the board’s role in establishing the ‘tone from the top’ of the company in terms of its culture and values”.  This is obviously fundamental to governance, as we have all learned that a box-ticking approach is frustratingly ineffective.  However, although the phrase ‘tone from the top’ appears in the preface, other amendments in this area must have been in quite subtle wording changes that I missed on my necessarily quick reading.

A significant change reflects the revised views of going concern[2].  In Section C on Accountability, the requirement in presenting annual and half-yearly reports is for directors to consider going concern for a period of at least 12 months from the date the accounts are signed.  The sentiment echoes previous Codes, but the level of direction has increased in line with regulation.  Likewise, the provisions in Section C regarding risk assessment and internal controls have been extended considerably, and appropriately.  And there are some interesting, more stylistic, adjustments to wording such as referring to “principal” risks rather than “significant ones”.  

Still in section C, at C.3.4 there is a change of something I had never noticed before.  Previously, the audit committee had to advise on whether the annual report, as a whole, fairly provided information for shareholders to assess the company’s performance, business model and strategy.  That last phrase now reads, “the company’s position and performance, business model and strategy”.  Quite right too, let’s hear it for the balance sheet.

Let’s now move on to the main act…


Directors’ remuneration

The Code’s wording on executive directors’ remuneration (Section D and Schedule A) has changed dramatically. Gone is the requirement (introduced in the 1995 report of the Greenbury Study Group) for it to be, “sufficient to attract, retain and motivate directors of the quality required to run the company successfully”, whilst avoiding the dangers of “paying more than is necessary for this purpose”.  From a purely selfish point of view, that’s a shame.  Not because that wording was so good, but because I had a whole lecture segment asking people to try to explain how the holy trinity of ‘attract, retain and motivate’ could possibly be achieved, and now that lecture will have to go.  Worse still, everything I’ve ever written on ‘the Goldilocks number’, which is sufficient but not excessive, will now have to be rethought![3] 

Another big change in the provisions regarding remuneration is the removal of the phrase “A substantial proportion of executive directors’ remuneration should be structured so as to link rewards to corporate and individual performance”.[4]  This is a good thing.  Although the original intention was sound – trying to ensure that executives did not receive undue reward for poor performance – the resultant layers of performance-based pay have had the unfortunate consequence of increasing overall remuneration significantly.  Furthermore, the phrase sits uneasily in a post-crash environment, given the role that high bonuses for bankers appear to have played in encouraging risk-taking.  As regulations now limit the level of bonuses in the banking firms, it was inappropriate that the 2012 Code still encouraged them, and good that the wording has been retired.

So that’s what’s gone.  What do we have in its place?

The main principle has become:

Executive directors’ remuneration should be designed to promote the long-term success of the company.  Performance-related elements should be transparent, stretching and rigorously applied.

It is worthwhile also setting out the supporting principles:

The remuneration committee should judge where to position their company relative to other companies. But they should use such comparisons with caution, in view of the risk of an upward ratchet of remuneration levels with no corresponding improvement in corporate and individual performance, and should avoid paying more than is necessary.

They should also be sensitive to pay and employment conditions elsewhere in the group, especially when determining annual salary increases.

I rather like that.  Sure, I can foresee a lot of complications ahead, but in a principles-based governance system, it says what it means, which is useful.

And in Schedule A, which fills out more detail about the remuneration, I am joyful that the sub-section on balance gives the outline of a 2x2 matrix, the bedrock of any business school.  It requires the remuneration committee to determine an appropriate balance between fixed and variable remuneration (the horizontal axis of my matrix) and immediate and deferred remuneration (my vertical).  I’m looking forward to populating these with examples…

Schedule A carries over some provisions from the 2012 Code, and revises some others.  In summary, it all seems sensible:
·         Executive share options should (generally) not be offered at a discount
·         Traditional share option schemes should be weighed against other types of long-term incentive scheme (ltis)
·         Any proposed new ltis should
o    be approved by shareholders
o    should preferably be a replacement for a previous scheme (a sort of one-in-one-out process)
o    should not lead to potentially excessive rewards
·         For share-based pay, the committee should consider making the executives hold a minimum number of shares, and hold the vested shares for a subsequent period
·         Only basic salary should be pensionable.

Having set out what the new Code says, my initial impression is that I quite like it, but that it will be difficult to manage. 

In considering the remuneration provisions, I am struck by the phrase, “should be designed to promote the long-term success of the company”.  There is currently an active debate going on about what corporate ‘success’ means, and whether it refers to the company’s business or relates to or includes (or indeed only includes) success for shareholders.  Leaving that aside, the phrase “long-term” is slippery in remuneration, as the corporate business cycle might extend beyond the tenure of any individual executive.  Such circumstances lead to the need (or maybe just the desire) to reward executives for interim performance… which in turn requires defining appropriate long-term measures and targets, and short-term measures and targets that sit within them.

I can’t see the Code leading to executive pay becoming much less complex any time soon. But, given that this blog is a snap reaction to a document that has been a long time in development, I reserve the right to give a more considered opinion over the next few weeks or months.


[2] Reflecting the Sharman Panel of Inquiry into Going concern.
[3] See Bender, R., The Platonic Remuneration Committee (March 10, 2011). Available at SSRN: http://ssrn.com/abstract=1782642
[4] This phrase in its original form was introduced in the Combined Code 1998.  The word ‘substantial’ was added to the phrase in the 2003 Code.

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