We are experiencing a period of financial turmoil not seen for decades. At the risk of stating the obvious, the intense damage inflicted on government coffers by responding to a pandemic, coupled with the fallout from the Russian invasion of Ukraine, has left our economy creaking.
As we plunge into a period of potential long-term belt-tightening, much of UK Plc will be bracing itself for turbulent times ahead. Navigating choppy waters will require companies to be alert to risks, both financial and geopolitical and those with strong leadership and solid corporate governance stand the best chance of emerging relatively unscathed, or for some, potentially stronger.
It is with that backdrop that the Financial Reporting Council (FRC) (the industry regulator setting UK standards for accounting and actuarial work) has released its Annual Review of Corporate Governance reporting (the review). The review considers how companies have reported on their governance in line with the principles and provisions of the UK Corporate Governance Code (the Code).
The Code came into effect on January 1, 2019, to assist the FRC with framing its efforts to monitor and promote the quality of corporate reporting, and the review considers the extent to which it is being complied with. The FRC’s assessment was based on a sample of 100 randomly chosen FTSE 350 and Small Cap companies and it found that while there have been year-on-year improvements in reporting, it is still only a select few companies that are able to meet the highest standards.
Code Compliance
The Code empowers companies to “comply or explain,” allowing them to depart from the standards set out in the Code if a transparent explanation of why is provided to shareholders. This principle recognizes that one approach does not necessarily fit all companies and that the transparent provision of explanations allows shareholders to carefully consider the circumstances of the departure.
The FRC review noted that an increasing number of companies are using the “comply or explain” principle and are consequently benefitting from the flexibility that the Code offers. This is evident as the number of companies claiming full compliance with the Code has halved since 2020. The increase in “non-compliance” is directly linked to an increased usage of the principle.
Despite the requirements for transparency, ambiguity is an issue. The FRC expects companies to explicitly set out any provisions with which they have not complied. Even where companies had documented their non-compliance, their explanations were rarely deemed to be “clear and meaningful.”
Culture & Values
Boards are expected to assess and monitor culture, yet while the FRC was encouraged to see more companies reporting on culture than in prior years, it found that very few provided detailed disclosure in relation to this.
The review also highlights that a significant number of companies fail to properly disclose their values, despite frequent reference to the term ‘values’ throughout their reports. Even where the values are specifically disclosed, companies are still struggling to draw links between culture, purpose, and values.
The FRC noted that an increasing number of companies are reporting on how their operations and activities impact their suppliers and communities. Nearly all companies mention modern slavery in their reports, but often this is only brief. Relatively few companies provided any information around who is responsible for ensuring the effectiveness of their modern slavery policy or provided any cross-referencing to their modern slavery policy itself.
The FRC had previously raised concerns that company engagement with shareholders was primarily in the form of information campaigns, as opposed to a two-way dialogue. Interestingly, in an environment where shareholder activism is on the increase, the review found this to be an ongoing issue with various companies stating that they simply share information via their website or annual report.
Division of Responsibilities and Board Composition
Previously, the FRC had raised an issue regarding a lack of clarity surrounding company diversity policies. This year, the review found that 89% of companies stated they had some form of diversity policy, meaning just 11% did not comment or were unclear.
Nonetheless, it was only a minority of companies that could provide clear information about the policy, covering what it was and its current progress. Further, while a company’s diversity and inclusion policy should be linked to the company’s strategy, the review found that very few companies were able to outline this link in their reports.
Despite the progress made in reporting on certain aspects of diversity, the FRC highlighted that more can be done to cement progress at all levels. The FRC encouraged companies to consider reporting more information about all forms of diversity – for example, LGBTQ+ received limited attention.
A key element of corporate governance is independent oversight. Despite this, 12% of companies stated that their chair had not been independent on appointment. While most companies could provide background as to this lack of independence, they were unable to provide a detailed explanation covering the risks, any mitigating actions they had taken, and when they intended to comply with the provision.
Audit and Risk and Internal Controls
As companies experience increasing financial pressure, reliance on the auditors to consider, amongst other things, the ability of an entity to continue as a going concern and the true value of its assets and liabilities becomes ever greater.
Following a string of high-profile corporate frauds and collapses, public scrutiny of the role of the auditor has increased. It is therefore heartening to note that fewer companies than in previous years failed to report on the effectiveness of the external auditor, and disclosures in this regard were of a higher quality. Nonetheless, boilerplate reporting was still found to be evident, and reporting in relation to the tender and length of tenure of the auditors was poor.
In terms of risk management, the FRC commended various companies for having relatively good disclosures in relation to their risk management procedures. The best reports provided information on the actions taken by different individuals or units during the year.
However, the review considered that many companies are not assessing emerging risks adequately, despite Covid-19 having served as an example of the importance of being prepared. Nearly 20% of companies did not confirm in their reports that they had carried out a robust assessment of emerging risks, less than 50% identified at least one emerging risk, and only 25% were able to explain what these risks were. Even when explanations were present, the FRC found them to be brief and general.
Remuneration
The remuneration of directors and senior management of companies has been a topic of some debate for years, given its often disproportionate quantum compared to the average employee in the same company. Shareholder activism in this regard has become increasingly prevalent.
The FRC found that almost all companies stated that their remuneration structures supported their company strategy, but the rationale for chosen performance measures was not typically well explained. There was an increase in material Environmental, Social, and Governance (ESG) metrics being included but the quality of reporting about the alignment of executive remuneration with the company’s purpose and values continues to be an area of concern for the FRC.
As was a common theme throughout the reports, the FRC found that there is room for improvement in terms of reporting on engagement. There were various generic statements about how companies ‘consider shareholders’ feedback’ in relation to remuneration. However, good reporting should include information on both actions – how the remuneration committee/Board engaged with shareholders – and impact – how the engagement affected remuneration policies
Conclusion
The purpose of the FRC’s report is to assess the quality of reporting against the Code. While progress was found to have been made year over year, which the FRC applauded, there are various areas that still require more attention. The FRC stipulates that companies would benefit from an increased focus on actions, outcomes, and impact, as opposed to simply describing processes and policies.
The most common pitfalls included:
- Continued use of vague, generic statements as opposed to utilizing specifics and real-life examples.
- Failure to use tables and diagrams, which can aid with understanding, improving clarity, and helping companies to ensure that issues are fully explored.
- Explanations of non-compliance not meeting the required “clear and meaningful” level.
The FRC highlighted that companies do not exist in isolation and has provided good practice examples in the review with the hope that companies will learn from each other, and reminded companies that, at present, no company reports exceptionally in all areas.
Strong corporate governance involves, among other things, engagement with stakeholders, independent oversight, and embracing diversity, all of which help companies to take onboard differing viewpoints and consider a variety of solutions to better face potential problems. Moreover, companies that further develop their explanations in their reports will have to undertake a higher level of self-evaluation regarding their policies and position, assisting in the identification of risk factors and their assessment of whether the actions taken to date have had the desired impact. Increased levels of transparency will also benefit companies in an age of increasing shareholder activism.
Given the current backdrop of financial turmoil and difficult trading conditions, companies that consider the FRC’s learning points are more likely to engage proactively with stakeholders and perhaps even prosper in the coming years.
© Copyright 2022. The views expressed herein are those of the author(s) and not necessarily the views of Ankura Consulting Group, LLC., its management, its subsidiaries, its affiliates, or its other professionals. Ankura is not a law firm and cannot provide legal advice.
