20 July 2023
Financial Reporting Council issues consultation paper
The Financial Reporting Council (FRC) recently published a revised version of the UK Corporate Governance Code for consultation.
The revised code retains the same five sections as the current version. However, there is enhanced focus on outcomes reporting, directors’ responsibilities, and environmental, social and governance (ESG) concerns.
Businesses must focus on outcomes over activity
The FRC has previously made clear that it considers a focus on activities to the exclusion of outcomes, particularly in the case of governance practices to be a flaw in corporate reporting. The new proposal sets an expectation that companies should, when reporting on their governance activity, focus on outcomes and the impact of that activity.
By asking companies to make outcomes and impact explicit, more nuanced reporting will emerge in this area, to the benefit of stakeholders and observers. Leaders should be able to explain why a company’s chosen governance practices assist in its strategic endeavours, and provide practical examples. Putting this in writing is likely to require additional thought when it comes to year-end reporting. That, of course, is the intention.
Organisations should weave ESG into overall strategies
There is now an expectation that the annual report will describe the sustainability of the company’s business model, how environmental and social matters are considered in its governance, and how this contributes to the delivery of its strategy, including climate ambitions and transition planning. This added emphasis on ESG and the embedding of reporting in the revised code highlights the importance that stakeholders now put on the issue.
A key role of the board remains to assess the basis on which the company generates and preserves value over the long term, so the question boards will be expected to answer is: ‘What is the impact of the E, S and G on your business model and your overall strategy in the macro context of climate change and sustainability?’
Organisations to which the code currently applies will already be reporting on their arrangements against the recommendations of the Taskforce on Climate-related Financial Disclosures, where there will be considerable overlap. Nevertheless, reporting on how governance links to strategy and climate ambitions is likely to require a more holistic, ‘golden thread’ approach than currently observed.
What role will the audit committee play?
It remains to be seen how best practice will develop around the use of committees in the context of sustainability. Cross-organisation working groups, dedicated sub-committees of the board, and the involvement of a risk committee (if extant) are approaches seen across listed companies.
In the FRC’s view, ‘the audit committee has experience in setting policies and frameworks which could be adapted to ESG metrics, and (…) is best positioned to oversee ESG disclosures, controls, processes, and assurance (…). Connection between the oversight of financial and ESG reporting is likely to be helpful.’
New Provisions 26 and 27 envisage additional roles for the audit committee in monitoring the integrity of narrative reporting, including sustainability matters and contributing to the annual report on the assurance of ESG metrics (including sustainability).
And what about the renumeration committee?
There is similar ESG overspill into the role of the remuneration committee, that the annual report should now include ‘an explanation of how the strategic rationale for executive directors’ remuneration policies, structures and any performance metrics supports company strategy and (…)[ESG] objectives.’
Combined with a malus and clawback provision, the FRC clearly expects remuneration committees to take a much firmer grip of executive pay, linking it to ESG criteria, overarching strategy, and monitoring, and a refusal to reward a lack of progress.
This will require an in-depth understanding of strategic aims and key performance indicators, with boards likely to need external support.
Demands on directors’ time must be considered
This increasing complexity – particularly in the interpretation of environmental data but also, the FRC suggests, in cyber risk/protection and data security – means that it is important that directors have sufficient time to devote to their role.
The current version of the code specifies that non-executive directors should have sufficient time to meet their responsibilities (Principle H), and demands on a director’s time should be considered when appointing or agreeing to additional roles (Provision 15).
The consultation includes two strengthening proposals: a requirement that the annual board performance review considers each director’s commitments to other organisations and how they are able to make sufficient time available to discharge their role effectively (new Principle K); and a revision to Provision 15 (new Principle 13), requiring more information on directors’ other commitments and how they are managed to be provided in the annual report.
Both proposals seek to formalise elements that should be an inherent part of meaningful board reflection. The FRC’s view is that additional, focussed reporting is likely to result in greater transparency for stakeholders.
Equality, diversity, and inclusion – still more work to be done
In April 2022, the Financial Conduct Authority (FCA) published its Policy Statement on diversity and inclusion for boards and executive management. The Listing Rules now require certain companies to report, on a ‘comply or explain’, basis whether they have achieved targets for women and ethnic minority representation on the board. Certain revisions proposed to the code dovetail with that position.
Work continues around developing gender and ethnic board representation – so while expansive wording is appropriate, there is no suggestion that the expected achievements have yet been made.
Boards should take responsibility for internal controls
The code proposes that the board should provide in the annual report a ‘declaration of whether the board can reasonably conclude that the company’s risk management and internal control systems have been effective throughout the reporting period and up to the date of the annual report’. This includes an explanation of the basis for making the statement, a description of any material weaknesses or failures identified and the remedial action being taken. This would be a departure from the current code, although it is in line with the government’s view that imposition of responsibilities on directors should not be legislative but regulatory.
Again, arguably this is a declaration of an obligation already imposed on any board as a result of its members’ fiduciary duties, but the board will want to work closely with its audit committee and assurance professionals before making such a statement.
Revised guidance and application
The code is supported by the Guidance on Audit Committees and Guidance on Board Effectiveness, both of which are under review to align with revisions to the code. New guidance documents will be made available when the new Code becomes applicable, for accounting periods beginning on or after 1 January 2025.