The Corporate Governance Green Paper: enlightened capitalism tempered by prudent reality

The government published its Green Paper on Corporate Governance in the UK on 29 November 2016.  Its publication follows several months of speculation as to the nature and extent of the new Prime Minister’s plans to address the perceived excesses of some elements of capitalism, whilst promoting growth in a climate of significant macro-economic uncertainty.  As Theresa May writes in her introduction to the Green Paper:

“the Government I lead will be unequivocally and unashamedly pro-business..  But for people to retain faith in capitalism and free markets, big business must earn and keep the trust and confidence of their customers, employees and the wider public… These are issues which are about competitiveness, and creating the right conditions for investment, as much as they are issues about fairness.”

The Green Paper tempers the ambitions of the Prime Minister’s initial announcements in this area, and in particular her stated intention to put worker representatives on boards.  Instead, it suggests a number of proposals for consideration in three key corporate governance policy areas.

The Government stresses that legislation is not the only possible outcome of the consultation.  In its words:

“The Government does not have preferred options at this stage. We want to use responses to the Green Paper to help us understand the strengths and weaknesses of the different options and build a better evidence base before deciding which of them to develop further… This Green Paper is designed to frame a discussion, so that we can move quickly to consider whether changes are appropriate at this time. Where there is a view that change is appropriate it may not be the case that regulation by Government is needed to secure it. One of the strengths of our system of corporate governance has been the use of non-legislative standards adopted by business itself.”

Effective regulation of executive pay for quoted companies

Questions around executive pay restraint have been at the heart of the corporate governance debate for a number of years.  In its Green Paper, the Government looks at five potential strands to achieve its ambition to “achieve executive pay which is long term, fair and transparent, and related to performance“.

Tightening quoted company shareholder oversight established by the 2013 reforms

The Green Paper looks at the 2013 reforms to quoted company pay (in the UK, broadly speaking these addressed companies listed on the Main Market of the London Stock Exchange).  The 2013 reforms mandated a binding vote on directors’ remuneration policies, as well as the continued annual advisory vote on the directors’ remuneration report.

Whilst noting that votes in favour of relevant pay resolutions average 93% of votes cast, and that only one company has lost a binding vote on its pay policy (albeit that six companies have lost advisory votes on their remuneration reports), the consultation asks whether the  2013 reforms have gone far enough in acting as an effective control on executive pay.  It proposes several options for reform (in broadly descending order of intrusiveness on the power of boards to set their own pay):

• make all or some elements of the executive pay package subject to a binding vote. This could be the full remuneration report, or could refer only to variable pay elements of the pay award;
• require or encourage quoted company pay policies to (a) set an upper threshold for total annual pay (from all elements of remuneration), and (b) ensure a binding vote at the AGM where actual executive pay in that year exceeds the threshold;
• require the existing binding vote on the executive pay policy to be held more frequently than every three years, but no more than annually, or allow shareholders to bring forward a binding vote on a new policy earlier than the mandatory three year deadline; or
• strengthen the UK Corporate Governance Code to provide greater specificity on how companies should engage with shareholders on pay, including where there is significant opposition to a remuneration report.

Improving shareholder engagement on pay

In addition to suggesting means to strengthen shareholder powers on pay, the government also wants to look at ways of encouraging shareholders to make full use of their existing and any new powers on pay, and engage in active stewardship of the companies they own.  The government notes that currently, on average, 28% of FTSE 100 votes are not exercised on executive pay resolutions.

This is clearly a more difficult area in which to modify behaviour by legislation, but some interesting ideas are proposed, including:

• building on the voluntary voting disclosure principles of the existing UK Stewardship Code to provide for mandatory disclosure of fund managers’ voting records at AGMs, and the extent to which they have made use of proxy voting;
• establishing senior “shareholder” committees to engage with executive remuneration arrangements – the relationship of this committee with the role of the board is unclear in the Green Paper, but the government notes it would need “careful consideration given its potential impact on our long-established unitary board structure“; and
• facilitating “retail” (i.e. non-institutional) investor engagement through reducing friction in the exercise of voting rights introduced by standard nominee shareholder arrangements.

Extending the role of the remuneration committee

The government  recognises the “challenging” role of remuneration committees in balancing a range of competing interests and considerations in setting executive pay, but believes that some committees are not  “sufficiently or visibly pro-active in consulting formally with shareholders and with the company’s workforce. There are concerns too, that some lack the authority or inclination to take positions that may not align with the CEO or wider executive team’s expectations.”

In order to address these perceives shortcomings, the government puts forward two proposals:

• requiring the remuneration committee to consult shareholders and the wider company workforce in advance of preparing its pay policy; and
• requiring the chairs of remuneration committees to have served for at least 12 months on the committee, on the basis that “remuneration committees need to have extensive knowledge of the company, the personalities of the executives, and the shareholder base in order to be truly effective“.

Increasing transparency on executive pay

The Green Paper looks at whether the 2013 pay reforms (which apply to quoted companies and require them to produce a single annual pay figure for each member of the executive board) could be strengthened through:

• requiring disclosure of executive pay to workforce pay ratios; and
• reducing the ability of companies to rely on “commercial sensitivity” exemptions to the existing requirement to disclose bonus targets, either by increasing non-legislative pressure on future reporting through relevant governance bodies such as the FRC, or by requiring retrospective disclosure of previous targets within a specified date range.

Refining the operation of long term incentive plans

The government notes investor criticism of some aspects of current long term incentives plans, which are “the model of choice for almost all quoted companies. They aim to align directors’ incentives with the long-term interests of the company, on the basis of share awards which must be held for a set number of years, usually at least three years.” These criticisms include the relative crudeness of success measures such as earning per share (EPS) or total shareholder return (TSR), and the encouragement of short-termism through short holding periods.  The government invites comments on:

• promoting the use of ‘restricted share’ awards as an alternative to LTIPs, with vesting based on continued employment rather than attaining performance measures in order to align executives’ interests with long term increase in value;
• extending minimum LTIP holding periods to five years; and
• requiring a share award “basket” with a value of at least 2 x gross salary to be built up before awards are capable of exercise.

“Strengthening the employee, customer and wider stakeholder voice”

The Green Paper argues that a consideration of wider stakeholder interests benefits both companies and society as whole.  Whilst acknowledging that stakeholder interests are enshrined in the statutory statement of directors’ duties to promote the success of the company under section 172 Companies Act 2006, the Paper looks at four options for encouraging wider stakeholder engagement.

Creating stakeholder advisory panels

The government suggests that company boards could create stakeholder advisory panels for directors to “hear directly from their key stakeholders and amplify voices with different backgrounds and perspectives to those more commonly found in the boardroom“. These  panels could operate in a number of ways to enable them to input into the board’s decision making process, including:

• providing a forum for consultation prior to directors’ meetings;
• by the panel attending directors’ meetings themselves; and
• through enabling panels to raise issues with the board on their own initiative.

Using non-executive directors to bridge the stakeholder gap

In this model, existing non-executive directors would be designated to engage directly with stakeholders to ensure that the voices of key interested groups, especially that of employees, is being heard at board level, either alone or as part of a designated board committee.

Appointing individual stakeholder representatives to company boards

Whilst noting its successful adoption by one company, this option is put forward with a significant lack of enthusiasm.  This reflects the chilly response from businesses to the Prime Minister’s original proposals to put worker representatives on boards.  The Green Paper highlights criticisms of the initial proposals, including on the grounds of tokenism, the pushing of real decision making away from the proper forum of the boardroom, and the reality that appointees would be subject to the same duties as all other directors (including confidentiality) which would restrict their ability to report back on board discussions.  Accordingly the government is specifically “not proposing to mandate the direct appointment of employees or other interested parties to company boards.”

Strengthening reporting requirements related to stakeholder engagement

The Green Paper discusses the current obligation on all companies (other than those treated as “small” for reporting purposes) to prepare a strategic report to provide shareholders with information that will enable them to assess how the directors have performed their duties under section 172 of the Companies Act 2006. But “there are no further details on how this should be done, which often leads to a lack of clear and transparent information about the steps that companies are taking to fulfil their duties to have regard to workers, suppliers or customers, and other requirements under section 172“.  The Government invites ideas for how additional reporting of the wider section 172 interests could best be introduced.

Extending corporate governance requirements to large privately-held businesses

In its final policy strand, the Government wants to explore whether and to what extent the UK’s largest, privately-held businesses should meet higher minimum corporate governance and reporting standards. It notes that the “UK’s strongest corporate governance and reporting standards are focused on public companies where the owners or shareholders are distant from the executives running the company. These standards provide independent shareholders with reassurance that the company is being run in their interests and that they have the information needed to hold the executive to account“, and that to date the differing ownership structure of private companies has meant that the governance standards expected of listed companies has not been extended to these businesses.  However, the renewed focus on stakeholder interests and the Government’s view that  “society has a legitimate expectation that companies will be run responsibly in return for the privilege of limited liability” has led the Government to revisit where the corporate governance demarcation line is drawn.  The options under consideration are:

• applying enhanced governance standards through a new voluntary code for private companies – essentially a modified version of the UK Corporate Governance Code reflecting the different circumstances of private companies; and
• ensuring disclosure requirement are applied more consistently based on the size of the business, rather than whether or not it is publicly quoted or traded.

Whilst the Government is inviting input on what threshold should apply to any future governance requirements for private businesses, the Green Paper does highlight the number of private companies and LLPs with over 1,000 employees, which perhaps provides some indication of the size of business the Government has in mind.

Osborne Clarke comment

The proposals on pay are a pragmatic list of options to increase shareholder participation in directors’ pay. A number of the proposals, for example additional holding periods for LTIPs, 2 x shareholding guidelines and better disclosure on annual bonus targets are already good practice across much of the FTSE 350.  Many business groups have welcomed the “targeted” use of binding votes on pay, as such a targeted binding vote regime would focus attention on the most important cases and strengthen the hands of shareholders to have the final say on executives’ pay.

With the exception of binding votes on pay, it is to be hoped that most of these proposals are dealt with via the UK Corporate Governance Code and/or institutional shareholder bodies taking a more active role, rather than by further legislation.  However, it is now up to companies and investors to respond to the challenge, be clear that they are willing to make changes themselves and help move much of the focus away from executive pay and towards the more positive aspects of UK business.

On wider stakeholder engagement, the softening of the Prime Minister’s initial proposals to mandate worker representation on boards is very welcome.  The thoughtful alternatives put forward provide a constructive framework to advance discussion of the proper role that the consideration of stakeholder interests should play in the prudent management of companies.

Finally, the extension of corporate governance requirements to private businesses requires careful thought.  There is a risk that the initiative will (if it ends up at the more prescriptive end of spectrum) either unhelpfully add to the regulatory burden on private companies, or (at the other end) be largely ignored or result in relatively meaningless “boilerplate” compliance and disclosure.