Comments and Suggestions on the FRC “Proposed Revisions to theUK Corporate Governance Code”
(Answers to the 12 questions set out in theconsultation document by the FRC in April 2014)
Corporate Governance Special Interest Group
British Academy of Management
June 2014
The Corporate Governance Special Interest Group (CGSIG) of British Academy of Management was formed in 2008 and is currently chaired byProfessor Stephen J. Perkins (). It aims to advance theory and practice in corporate governance and encourage inter-disciplinary research from a variety of disciplinary and theoretical perspectives.The CGSIG has grown to have a more vibrant community with over 120 members who are mainly leading scholars and experts in therelevant subject area. Many of the CGSIG members have both academic expertise and practical knowledge and experiences.
This commentary has been produced by CGSIG members based on their leading research in corporate governance over decades and their experiences in regulatory and policy advice and in corporate governance and business practice.The team thatpreparedthe commentary include:William Sun (Chair), Samuel Idowu, Tim Ruttand Jia Liu. For any inquiry please contact Dr.William Sun by email at .
The FRC Consultation Questions
SECTION 2: DIRECTORS’ REMUNERATION
Question 1: Do you agree with the proposed changes in Section D of the Code?
Question 2: Do you agree with the proposed changes relating to clawback arrangements?
Question 3: Do you agree with the proposed change relating to AGM results? Is the intention of the proposed wording sufficiently clear?
Question 4: Do you agree with the proposed amendments to the Schedule?
SECTION 3: RISK MANAGEMENT AND GOING CONCERN
Question 5: Do you agree with the changes to the Code relating to principal risks and monitoring the risk management system?
Question 6: Do you agree that companies should make two separate statements? If so, does the proposed wording make the distinction between the two statements sufficiently clear?
Question 7: Do you agree with the way proposed Provision C.2.2 addresses the issues of the basis of the assessment, the time period it covers and the degree of certainty attached?
Question 8: Do you have any comments on the draft guidance in Appendix B on the going concern basis of accounting and / or the viability statement?
Question 9: Should the FRC provide further guidance on the location of the viability statement?
Question 10: Should the recommendation that companies report on actions being taken to address significant failings or weaknesses be retained? If so, would further guidance be helpful?
SECTION 5: LOCATION OF CORPORATE GOVERNANCE
DISCLOSURES
Question 11: Should the option of giving companies the possibility of putting the full corporate governance statement on their website be considered further? If so, are there any elements of the corporate governance statement that should always be included in the annual report?
Question 12: Are there any disclosure requirements in the Code that could be dropped entirely?
SECTION 2: DIRECTORS’ REMUNERATION
Question 1: Do you agree with the proposed changes in Section D of the Code?
We support the change made to the Main Principle D.1 and no change made to the Main Principle D.2. But in the Supporting Principles of D.2 we question the proposed new provision: “The remuneration committee should take care to recognise and manage conflicts of interest when receiving views from executive directors or senior management, or consulting the chief executive about its proposals.”
The question is how the remuneration committee could manage such conflicts of interest. The remuneration committee looks independent in form, as it is composed of independent non-executive directors. Yet, it is doubtful that independent directors are actually independent of executive directors (CEO in particular), given that independent directors are selected by them and appointed by the board. If the remuneration committee would be able to manage the conflicts of interest, the committee’s composition ought to change to including representatives of principal shareholders and key stakeholders, who are truly independent of executive directors.
Question 2: Do you agree with the proposed changes relating to clawbackarrangements?
The wording of the proposed amendment in D.1.1 is basically appropriate and relevant. But we believe that it is necessary (despite the FRC saying they do not intend to do this) for the Code to specify a few examples of circumstances where the clawback of the variable element of remuneration would be deemed necessary. A list of examples (with a note to specify that the list is only indicative, not exhaustive) would make things clearer in this regard. The clawback arrangements should not be limited to exceptional circumstances of misstatement or misconduct, and should be designed to relate them to the long term performances of the company and individuals.
Question 3: Do you agree with the proposed change relating to AGM results? Is theintention of the proposed wording sufficiently clear?
The Code needs to specify a percentage that constitutes what is meant by “a significant proportion of shareholders” voted against a resolution at any general meeting. Doing so would make things clearer to companies and their shareholders. To leave this to the board’s opinion would leave the problem unaddressed.
The proposed provision states that the company should explain “what actions it intends to take to understand the reasons behind the vote result”. It is not clearhere if “to understand the reasons” is the end point of the actions taken, or the start pointof a series of actions to take in order to fully address shareholders’ concerns. Thus, the provision should make it clearer that the company should take a series of actions to address shareholders’such concerns. Only actions for “understanding” the reasons behind the vote result without actual responses are far from enough.
Question 4: Do you agree with the proposed amendments to the Schedule?
Wegenerally support the proposed amendments to the Schedule. But the real question is how many shares directors should continue to hold and for how long to hold after directors leave the company. The FRC may indicate some best practices in the Schedule to provide further guidance on this matter.
SECTION 3: RISK MANAGEMENT AND GOING CONCERN
Question 5: Do you agree with the changes to the Code relating to principal risks andmonitoring the risk management system?
Answers to Question 5 and relevant comments and suggestions on the Main Principle of C.2 are divided into four themes below.
Theme 1: “Principal Risks” vs.“Significant Risks”
By definition “Principal Risks” mean the main or the most important risks in contrast to generally important or secondary risks. The current revised“main principle”of C.2 seems to indicatethat the board is not responsible for any other important risks the company is willing totake. However, we think that the board should have a main duty to govern and control all the risks, or at least, all the important risks.
The term of “Significant Risks” is different from “Principal Risks”. Significant risks are the risks that are notable, important, or have a major effect. It would imply that the board is responsible for determining any meaningful risks it is willing to take, including the most important, the moderately important and the less important (but still important) risks.
So we would suggest that the “significant” risks in the Code should not be replaced with “principal” risks. The FRC explained that the replacement is to be in consistence with the wording of the Strategic Report. However, we note that the “principal risks” used in Section 414C(2)(b) of the Companies Act 2006 is regarding the requirement for a company to disclose its “principal risks and uncertainties” as part of its Strategic Report. Here the wording is about the identification and disclosure of principal risks with an implication of risk assessment and control, rather than aboutrisk taking. So the wording here is in a different usage. While it needs to disclose its principal risks facing the company, the board may not just need to take responsibility for determining the nature and extent of the “principal risks” it is willing to take, but also any “risks” or any “significant risks” it is willing to take.
Hence, there are two options for the answer to the first half of Question 5: “Do you agree with the change to the Code relating to principal risks?”
Option 1: The “significant risks” will not be changed. It would mean that the board is responsible for determining the nature and extent of any notable and important risks it is willing to take.
Option 2: The “significant risks” will bechanged into “risks” without any adjectiveright before it. It would mean that the board is responsible for determining the nature and extent of any risks it is willing to take.
Either option is justifiable. But option 2 looks more prudent.
Theme 2: Risk Treatment
The first half of the“main principle”of C.2 is purely regarding risk taking. It would be fully agreeable that some kind of risk taking isstrategically needed to do business. But not every risk should be taken or is worth being taken, since some risks could be harmful or fatal to business. Therefore, when determining any significant risk it is willing to take, the board should explain the nature, classification and characteristics of the risks and how they are distinguished from other risks that should be avoided or mitigated. This taskis based on a risk treatment policy that the board should normally have, namely, how the board identifies, classifies and treats all the risks that the company has faced, is facing, or will be possibly facing. Risk treatmentincludes risk avoidance, risk reduction, risk sharing and risk retention. It would be inappropriate if the board determines risk retention, yet, ignores other risk treatments. Only risk assessment and mitigation as stated in new Code Provisions C.2.1 and C.2.2 is far from enough. A comprehensive risk treatment policy and strategy is needed. The second part of the Main Principle of C.2 is regarding risk management and control systems, which is different from a risk treatment policy.
Therefore, we suggest that the current “Main Principle” of C.2 should state a risk treatment policy conducted by the board. Thewhole Main Principle article of C.2 could be revised as:
“The board should have a risk treatment policy and is responsible for determining the nature and extent of the significant risks it is willing to takewhat risks will be retained, avoided, mitigated, or shared and transferred in achieving its strategic objectives. The board should maintain sound risk management and internal control systems.”
The new Code Provision C.2.1 should be revised accordingly as:
“C.2.1 The directors should explain in the annual report how they have identified, classified and treated different risks facing the company, and confirm in the annual report that they havecarried out a robust assessment of the principal risks facing the company – including those that would threaten its business model, future performance, solvency or liquidity – describe those risks and explain how they are being managed or mitigated.”
Theme 3: Negative Effects ofRisk Taking
Even though some risks can be taken or need to be taken, those risks may have both positive and negative effects. Moreover, huge or excessive risk taking could be a great threat to any business. The 2008 global financial crisis was a vivid example. Hence, when determining the risk retention strategy, the board needs to explain and confirm what measures it will be taking to avoid excessive risk taking and prevent any negative consequences or potential threats derived directly or indirectly from the risk taking.
An additional Code Provision should be added to the Code as C.2.2:
“C.2.2 When determining the significant risks it is willing to take, the board should confirm and explain what measures will be taken to prevent excessive risk taking and manageany negative effects of the risks taken.”
Current new C.2.2 should be changed to C.2.3, and the current new C.2.3 to C.2.4 accordingly.
Theme 4: Monitoring Risk Management Systems
The proposed revisions to the Code by the FRC already stated clearly in its consultation document that “boards have a responsibility to monitor the risk management and internal control systems on an ongoing basis, and not rely solely on an annual review” (p. 9). Yet, the revised Code Provision C.2.3. does not explicitly indicate that the monitoring of the risk management and internal control systems is on an ongoing basis. It follows that “at least annually, the board should carry out a review of their effectiveness and report on that review in the annual report”. This gives us an impression that the monitoring is much more based on the annual review. To make the provision more clearly as it intends to, the current new C.2.3 provisionshould add“on an ongoing basis” to the first sentence. It should read:
“C.2.3 The board should monitor the company’s risk management and internal control systems on an ongoing basis and, at least annually, carry out a review of their effectiveness, and report on that review in the annual report.”
Question 6: Do you agree that companies should make two separate statements? If so, does the proposed wording make the distinction between the two statementssufficiently clear?
And
Question 7: Do you agree with the way proposed Provision C.2.2 addresses the issues of the basis of the assessment, the time period it covers and the degree ofcertainty attached?
We answer the Question 6 and 7 together as they are interrelated.
We agree that companies should make two separate statements on going concern and future viability. This is mainly because the statement in the provision of C.1.3 is for the accounting purpose with a narrow assessment. The new Code Provision C.2.2 is for the company’s strategic risk management and public disclosure with a much broader assessment.
Yet the Code should make a clearer distinction between the accounting-based statement and the strategic-based statement on the company’s viability. The proposed wording in C.1.3 and C.2.2 does not make the distinction between the two statements sufficiently clear. Therefore we suggest that:
In the Code Provision C.1.3, it needs to define clearly what the company’s viability is for the accounting purpose (e.g., solvency and liquidity risks and any material uncertainties), with a cross reference to relevant accounting standards.
In the newly suggested Code Provision C.2.2, it needs to clearly definethe strategic viability of the company in a longer term. Apart from the viability assessment for the accounting purpose, it needs to add more detailed criteria for a broader viability assessment on a strategic basis. The board should explain what factors have been taken into account when forecasting long-term viability.
While the former is based on the viability assessment over a period of at least 12 months, the latter should be based on a broader risk and viability assessment over a strategic period of at least 3-5 years. The new Code Provision C.2.2 needs to specify the strategic period and the board needs to provide justifications for the assessment period.
The words “reasonable expectation” in C.2.2 tend to be subjective and arbitrary because the term “expectation” means “belief” or “hope”. The wording here could change into: “they are reasonably confident”. This shows a more objective, yet realistic, judgement by the board, which also moves away from the wording “they have a high level of confidence” as already objected by many as unrealistic.
Considering all the above comments, the new Code Provision C.2.2 can be revised as:
“Based on the strategic viability assessment of the company for a period of at least 4 years, taking account of the company’s current position and significant risks [may add more assessment criteria here], Tthe directors should state whether, taking account of the company’s current position and principal risks, they have a reasonable expectationare reasonably confidentthat the company will be able to continue in operation and meet its liabilities as they fall due, drawing attention to any qualifications or assumptions as necessary. They should indicate the exactperiod covered by this statement, and why they consider that period to be appropriate”.
Question 8: Do you have any comments on the draft guidance in Appendix B on thegoing concern basis of accounting and / or the viability statement?
If our comments on question 6 and 7 are acceptable, the draft guidance in Appendix B should reflect those suggested changes accordingly.
Question 9: Should the FRC provide further guidance on the location of the viabilitystatement?
A further guidance on the location of the viability statement is needed. It would be appropriate to include it in the Strategic Report, since this is a strategic visibility statement as explained in the answers to Question 6 and 7.
Question 10: Should the recommendation that companies report on actions being taken to address significant failings or weaknesses be retained? If so, would furtherguidance be helpful?
Companies report on actions taken to address failings or weaknesses identified from the review on risk management and internal control systems should be retained in the Guidance. This is because without actions taken, the whole review process is incomplete. Furthermore, the strategic viability assessment in the Strategic Report also needs to address such issues. If there is anything particularly related to confidentiality and materiality, the board should make judgement and explain why certain information cannot be disclosed. A further guidance on this would be helpful.