UK Corporate Governance Code

History of UK Corporate Governance Code

The past twenty years have been time of significant changes in Corporate Governance regulation for Ireland and the United Kingdom. Also this changes stroke the jurisdictions of greatest importance to Irish companies. This period has brought both an increasing change, such as the gradual enhancement of the corporate governance code (since its first introduction in 1998), and more fundamental change, such as the significant alteration raised by Sarbanes-Oxley Act in 2002.

Corporate failure, especially the one that is linked to perceived breakdowns in governance, has played a significant role in causing change in governance regulations. Corporate collapse in UK in the early 1990s appeared to fit this pattern, which prompted the implementation of the Cadbury Code and its successors. The derivations of the current code arise from the report of the committee on the financial aspects of Corporate governance (the Cadbury report, 1992) to which was attached a code of best practice. In turn, the report produced on a committee headed by chairman of Cadbury Schweppes, Sir Adrian Cadbury, was a response to major corporate scandal when Polly Peck, a major UK company, went bankrupt after years of falsifying finical reports. Hence the reports covered financial, auditing and corporate governance matters and made the next recommendations:

·      the CEO and chairman of companies should be separated;

·      boards should have at least three non-executive (independent) directors, two of whom do not have personal and financial links and obligation to executives;

·      each board should have an audit committee composed of non-executive directors (oid.com).

Following that, this was developed through a series of works, including Greenbury report, which made recommendations on executive pay and a code of best practice.

In 1995 committee chaired by chairman of Mark & Spenser Sir Richard Greenbury responded to public anger over increasingly high executive pay, especially in public organisations that had been privatised, by producing the Greenbury report.

It was decided to review progress in three years and so in 1998 a third committee chaired by Sir Ronald Hampel, chairmen of ICI plc consolidated both reports into a "Combined Code"(Crann, A.J.,Lecture notes).

According to it:

·      the chairman of the board should have be seen as the leader of the non-executive directors;

·      institutional investors should consider voting the shares they held at meetings;

·      all kinds of remunerations, including pensions, should be disclosed.

In the next decade as a response to the problem caused by the collapse of Enron in the US, banker Derek Hicks was asked to report on the role of the effectiveness of the non-executive directors. His report, published in January 2003, suggested amendments to the combined code, and was focused on what non-executives directors should do.

At the same year, a committee  under Sir Robert Smith, reported on guidance for audit committees. In July 2003 finical reporting council taken into account both reports, issued the revised Combined code. Since then the combined code of 2003 has been updated at regular intervals. The most recent one was in September 2012. However, since the previous version issued in may 2010, the code bears a new title - the UK Corporate Governance Code.

It is known that the UK Corporate Governance Code is the primary framework for Corporate Governance practiced in Republic of Ireland.

The main principles of Corporate Governance Code

The UK Corporate Governance Code is divided into the following: main principles, supporting principles and provisions. In a report a company has to state how it applies with main principles and supporting principles. As for the Code provisions, a company has to state whether they comply with the provisions or not. In the case of the last, a company should provide an explanation, giving the reasons of not complying. It is the Code provisions that contain the details on matters such as separation of the role of chairman and chief executive; the ratio of nonexecutive directors and the composition of the main board committees.

Under the heading "Leadership" the first main principle of the code focuses its attention on the roles required to be conducted by the heads of the board of the company. According to it: "Every company should be headed by an effective board which is collectively responsible for the long-term success of the company"  (frc.org.uk, UK CG Code, September '12). It also states that there should be a clear division of responsibilities at the head of the company between the running of the board and the executive responsibility for the running of the company’s business. No individual should have free powers of decision. The chairman is responsible for leadership of the board as well as ensuring its effectiveness on all aspects of its role. Also the code clearly indicates that being the members of a unitary board, non-executive directors should constructively challenge and help develop proposals on strategy.

Effectiveness, which is the second principle set out in the code, refers to the quality of the performance of the board. This section explains that "The board and its committees should have the appropriate balance of skills, experience, independence and knowledge of the company to enable them to deliver their respective duties and responsibilities effectively" (frc.org.uk, UK CG Code, September '12). Based on it, every company should have a strict,  formal, and transparent procedure for the appointment of new directors to the board.

Another responsibility of the board directors is that those should regularly update and refresh their skills and knowledge. The communication with the board should be in a timely manner and the information communicated must be of an appropriate quality in order to enable the members of the board to discharge their duties successfully and in time.

The board should undertake a formal and rigorous annual evaluation of its own performance. Also the annual evaluation should be carried out on its committees and individual directors. All directors should be submitted for re-election at regular intervals.

The third principle of the Code is related to the Accountability within the board. This section insists that "the board should present a fair, balanced and understandable assessment of the company’s position and prospects"(frc.org.uk, UK CG Code, September '12). Determination of the nature and extent of the important risks is essential, especially of those that the bard wished to take in order to achieve its goal. The board should also maintain internal control systems.

Another instruction for the board is establishing of transparent and formal arrangements for maintaining an appropriate relationship with the company’s auditors as well as for considering how the board should apply the corporate reporting, risk management and internal control principles.

The fourth main principle is Remuneration. It clearly directs the board that its levels of payments should be sufficient to retain, motivate and attract directors. However a company should also "avoid paying more than is necessary"(frc.org.uk, UK CG Code, September '12).

The level of the salary received by the executive directors should be in such way that it depends on the achievements of the organisation. Another directions, related to this matter states that there must be a transparent and formal procedure to develop remuneration policy as well as administering the remuneration packages to the individual directors with accordance to their performance. The last but not least point under this heading is that a director should not be involved in deciding upon a  level of his/her own salary.

Relations With Shareholders, which is the final principle set out in the Code, concentrated around such topic as a cooperative two-way communication between the corporate board and the shareholders of the corporation. It is clearly specified the "mutual understanding of objectives" is compulsory between the both sides. The board as a whole has responsibility for ensuring that a satisfactory dialogue with shareholders takes place. In order to deliver this the board should use the annual general meeting so to communicate with the investors and to encourage their participation.

The above principles at first were generally used only by the quoted companies on the London Stock Exchange, however soon it was noticed that its regulations had an impact onto governance of organisations outside the commercial corporate sector (according to UK CGC Factsheet). Once the Code of Practice is ignored, the quoted companies are panelised under the listing Rules (UKLA).

Observation on the Code of Corporate Governance

Since its first introduction to the companies of the Code of Practice there always was and remains an "explain or comply" issue. The "comply" part is usually interpreted as an explicitly to disclose a compliance to shareholders. However more complicated becomes with  "explain" part where the companies usually prefer to interpret the code in such a way that they are noncompliant with particular provisions and simply chose to explain why they are non-compliant and what are the alternative measures they have taken to ensure that they are nonetheless implementing the principles of the code.

The research of Grant-Thornton has show that the companies are still choosing to interpret "explain" in much narrower sense where they merely note which provisions they are not compliant with, and in some cases giving a reason for this non-compliance, but in most cases not describing the alternative governance measures put in place (Grant-Thornton Corporate Governance Review 2011). Based on the same report the percentage of the companies who claim a full compliance with the code of Corporate governance decreases with every year. 

In 2011 The Financial Reporting Council (FRC) addressed the criticism and published an explanation on how to interpret the "comply or explain" issue. However the companies continue having some misunderstandings.

Instruction of the code are detailed however not clear enough. Though in 2012 FRC reviewed the code and brought some changes to it, it appeared that there are still some confusions with regard to the instruction. For instance the respondents-consultants were confused whether the FRC wanted boards to describe their assessment process, or simply to state that the considered the annual report and accounts was fair, balanced and understandable.

Also there were some requests for the phrase “fair, balanced and understandable” Some respondents were unclear as to how the proposal differed from the existing requirements in the Companies Act for the accounts to give a true and fair view and for the business review to contain “a fair review of the company’s business and… a balanced and comprehensive analysis” of the company’s performance and position. A small number of respondents considered. Another issues that stroke the respondents was the term “users”, where it was unclear whether "users" either needed to be qualified, more clearly defined or replaced with “shareholders” (Feedback on CGC, September 2012).

The text of the code usually places the word "should" with the same, to my opinion, insisting on the company carrying out one or another action. However "if not comply then explain" issue gives a choice to a company, leading the Corporate Code of Practice to  a point where it becomes a non-mandatory rule (not forcing the corporate body to comply).

Based on the above, I believe that FRC should clearly identify the border between comply and explain in order to avoid any misunderstandings and discrepancies, with the same preventing companies avoiding the compliance with Code.