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Corporate Governance Reform

Published Friday, December 15, 2017

The Government announced nine reforms to corporate governance that it wants to bring into effect by June 2018. This briefing discusses the Government's plans, related work in this area and other proposals.

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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 board composition, remuneration, shareholder and stakeholder relations, accountability and audit.

The Code applies to public listed companies – private companies are not concerned. In law companies are primarily accountable to their shareholders, and the Code is mostly, 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.

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:

  • To act within powers
  • To promote the success of the company
  • To exercise independent judgment
  • To exercise reasonable care, skill and diligence
  • To avoid conflicts of interest
  • Not to accept benefits from third parties
  • 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

The first paragraph of the Code says that the purpose of corporate governance is ‘to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the company’.

But recent proposals for reform 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 (if not more than) from concerns about the effective management of companies.

Similarly, the current Code only applies to public companies with a premium listing, but the Government’s consultation included proposals to extend the Code to large private companies. So the proposed reforms go beyond the Code to look at corporate governance more widely.

 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. There is an additional proposal regarding the powers of the Financial Reporting Council – an issue that was raised independently by respondents and by the BEIS Committee.

The Business, Energy and Industrial Strategy (BEIS) Select Committee published its report on corporate governance on 5 April 2017. The corporate governance inquiry followed the Committee’s investigations into major corporate failings at BHS and Sports Direct.

The Committee made 28 recommendations across a number of areas. Board diversity and executive pay received the highest number of recommendations, with eight and five respectively. Of the 28 recommendations, the Government accepted four in full and partly accepted another four. It rejected seven and responded to the remainder by saying that these recommendations were for others to consider.

Pay ratios

The Government proposes that public companies listed on the stock exchange should report annually the ratio of CEO pay to the average pay of their UK workforce, along with a narrative explaining changes to that ratio from year to year. To illustrate, a ratio of 50 means that the CEO is paid 50 times the average pay in the company.

This briefing calculates pay ratios in the UK based on available data for 319 companies (most of the FTSE 350). In 2016, the average ratio between CEO pay and average employee pay was 57. The highest ratio was as high as 826 at WPP PLC (a world leader in advertising and marketing services), and as low as 2 at IP Group PLC (a group that partners with universities to build tech businesses based on intellectual property).

Analysis 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 heavily in the narrative that companies will be required to provide along with their ratios.

Commons Briefing papers CBP-8143

Author: Federico Mor

Topics: Companies, Industrial relations, Regulation

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