The following post is based on a recent Gibson Dunn memo, available here, that was originally published on August 27, 2013.

Updates to the UK Stewardship Code

The UK Stewardship Code, which “sets out the principles of effective stewardship by investors”, was also updated in September 2012 to provide greater clarity on the meaning of stewardship and the respective responsibilities of asset owners and asset managers.  The Stewardship Code’s stated objectives are “to help to build a critical mass of investors with a long-term focus that . . . monitor and engage with the companies in which they invest; to increase the quantity and quality of engagement; and to increase accountability . . . to clients and beneficiaries”[1].  The updated Stewardship Code took effect on October 1, 2012, with the principal updates from the previous (July 2010) version focussing on the delegation of investors’ responsibilities to service providers, engagement with proxy voting or other voting advisory services and the mechanisms under which asset managers can become insiders (and institutional investors that wish to become insiders should indicate their willingness to do this and the mechanism by which this could be done in their stewardship statement).

New Investor Working Group

More recently, and perhaps reflective of increasing shareholder activism in the UK[2], approximately 15 of the UK’s largest institutional shareholders announced plans to create an investor forum working group, an alliance intended to encourage institutional shareholders to work cooperatively and thus have greater influence on corporate governance matters at listed companies.  This new working group, referred to as the Investor Working Group on Collective Engagement, is being supported by the Investment Management Association, the Association of British Insurers (the “ABI”) and the National Association of Pension Funds (all influential institutional shareholder bodies in the UK) and is due to present its recommendations by the end of November 2013.

ABI Report on Improving Corporate Governance and Shareholder Engagement

On July 25, 2013, the ABI (which represents the UK’s insurance, long-term savings and investment industries) published its report on improving corporate governance and shareholder engagement (the “ABI Report”)[3].  The ABI Report reviews the existing roles and responsibilities in corporate governance and shareholder engagement in relation to listed companies and makes recommendations on how these may be enhanced.  The ABI Report sets out a number of key recommendations and observations, including that:

1.         Corporate governance reporting by companies should focus more on the application of the Governance Code, rather than just compliance with provisions (i.e. a substance-over-form approach is required).

2.         When explaining deviations from the Governance Code (under the “comply-or-explain” principle), disclosures should be company-specific (both contextually and historically), be supported by a convincing and understandable rationale, include mitigating action to address any additional risk(s) that may arise as a result of non-compliance, be time-bound and be subject to on-going review and those disclosures should also explain how the alternative practices implemented by the relevant company are consistent with principles of good governance more generally.

3.         Companies should be encouraged to consult their largest shareholders on major board appointments and improve nomination committee reporting in their annual report and accounts.

4.         In a transactional context, executive directors should inform the appropriate non-executive director(s) of the proposed transaction as early as possible. In any case, this should occur when an approach is received from a possible bidder or when management first actively considers a transaction in respect of which a shareholder approval is to be sought.  In addition, the non-executive directors should be provided with a narrative description of discussions between the company and the transaction counterparty and such narrative should be summarised in the circular to shareholders.

5.         Differentiated voting or dividend rights (based on the length of time for which an investment has been held) are likely to result in a number of unintended consequences and are likely to affect the interests of minority shareholders adversely rather than stimulate longer-term ownership.

Corporate Governance for AIM Companies

Earlier this year, the Quoted Companies Alliance (the “QCA”) updated its Corporate Governance Guidelines for AIM Companies (the “QCA Code”).  Compared to the previous QCA Code, published in 2010, the updated QCA Code places more emphasis on board effectiveness and shareholder engagement.  The QCA Code is based on the key elements of the Governance Code and is intended to operate for AIM companies on the same comply-or-explain basis as the Governance Code for Premium-listed companies, albeit in a somewhat more flexible manner.  The QCA Code sets out the 12 broad principles for good corporate governance and six characteristics of an effective board along the same lines as the Governance Code.  It focuses on delivering growth in long-term shareholder value whilst maintaining a flexible, efficient and effective management framework within an entrepreneurial environment.  Of those companies that came to AIM in late 2012 and early 2013, around half have publicly stated an intention to comply with the provisions of the Governance Code; the vast majority of the remainder are looking to comply with the QCA Code, demonstrating a clear intention of those companies coming to the UK’s junior market to undertake quality reporting, clear disclosure and engage positively and constructively with their stakeholders.

Part B: EU and UK Developments in Board Diversity

Proposed EU Directive on Gender Balance on the Boards of European Companies

In November 2012, the European Commission proposed a Directive that set a target of 40 per cent. female representation in (i) non-executive board positions by 2020, and (ii) listed public undertakings (being entities over which public authorities exercise a dominant influence) by 2018[4].  Although six Member States (including the UK) sought a review of the proposed Directive claiming that action would be more appropriately taken on a national level, they were unsuccessful and the Directive will pass to the European Parliament and Council for consideration.  The proposal states that, if a company fails to reach the 40 per cent. threshold, it would need to use a new board selection procedure that prioritises qualified female candidates when there are candidates with equal qualifications (although small and medium-sized enterprises would be exempt from the requirement).  The Directive also would require listed companies to set “flexi-quotas”, or company-specific, self-regulatory targets, for female representation among executive directors by 2020 (again, 2018 for listed public undertakings).  To facilitate this process, the Commission announced in December 2012 that the European Business Schools’ Women on Boards Initiative would publish its “Global Board Ready Women” list of approximately 8,000 women who are qualified to serve immediately on the boards of publicly listed companies in an online database, administered by the Financial Times Non-Executive Directors’ Club on the professional networking website LinkedIn.

UK Disclosure Requirements

In the UK, the Governance Code includes new disclosure requirements relating to board gender diversity, including the requirement that companies include in their annual report “a description of the board’s policy on diversity, including gender, any measurable objectives that it has set for implementing the policy, and progress on achieving the objectives”.  The Governance Code also states that board evaluations should consider, among other things, the board’s diversity, including gender.  These new requirements follow discussions relating to imposing formal gender quotas and the release in February 2011 of a UK Government-backed report that set a target of minimum 25 per cent. female board representation at FTSE-100 companies by 2015.  As of March 2013, women account for 17.3 per cent. of all directorships (an increase of approximately 65 per cent. over the last three years).

Part C: Auditor Rotation and Related Reforms

UK Corporate Governance Code Requirements

As mentioned above, the updated Governance Code includes a new requirement that “FTSE 350 companies should put the external audit contract out to tender at least every ten years”.  However, the Financial Reporting Council (the “FRC”), the independent regulator responsible for the Governance Code, has subsequently stated that the tendering process should not presumptively lead to a change in auditor.  In addition, the Governance Code requires that specific relevant disclosures are included in the annual report, including (i) how an auditor maintained independence if the auditor also provided non-audit consulting services, (ii) the “significant issues that the [audit] committee considered in relation to the financial statements (and how these issues were addressed)”, and (iii) how the audit committee has evaluated “the effectiveness of the external audit process and the approach taken to the appointment or reappointment of the external auditor, and information on the length of tenure of the current audit firm and when a tender was last conducted”.  As with the rest of the Governance Code, these provisions apply on a “comply-or-explain” basis. 

Mandatory Auditor Rotation: the Recommendations of the UK Competition Commission

In February 2013, the UK Competition Commission (“CC”) issued a report that contemplates mandatory audit firm rotation.  The report suggested possible remedies to address competition problems in the UK audit industry that the CC found during an investigation of the supply of statutory audit services to large UK companies.  The potential remedies proposed by the CC include mandatory tendering and compulsory audit firm rotation, along with prohibition of “Big Four” only clauses that restrict use of an auditor to one of the four major industry leaders (i.e. PwC, Deloitte, Ernst & Young and KPMG, which between them are estimated to audit in excess of 95 per cent. of the UK’s FTSE 250).  Following opposition by the FRC and others, the CC proposed in June 2013 alternative remedies, including requiring the FRC to promote competition in the audit industry.  The initial period for comments on the proposed remedies closed in June 2013, and the CC issued its provisional decision on July 22, 2013[5].  In that provisional decision, the CC confirmed that it would not recommend that large UK companies be required to change their auditors every five years, although it did recommend that FTSE 350 companies should put their statutory audit engagement out to tender at least that often (with that obligation capable of being deferred by up to an additional two years in “exceptional circumstances”).  The provisional decision also included a recommendation that large UK companies undertake an annual shareholder vote on whether those companies’ audit reports contain sufficient information (again, seeking to promote transparency and proper disclosure of relevant issues by listed companies).  The CC will publish the full provisional decision on remedies shortly and consider all responses before publishing its final report by no later than October 20, 2013.

On July 30, 2013, the UK Financial Times reported that Hargreaves Lansdown (one of the leading providers of financial and investment services for retail investors in the UK with over £30 billion of assets under management) is encouraging large companies to switch audit firm regularly.  It criticised the historic tendency for such relationships to stretch on unchallenged for decades at many FTSE 100 companies (principally on the basis that such a tendency reduces the overall contribution and objectivity of the external audit function).  However, Hargreaves Lansdown also stated that it does not recommend the mandatory rotation of auditors after a fixed period, preferring to maintain flexibility so that those changes do not occur at an inconvenient time for businesses, such as during or in the run-up to a fundraising round.  Hargreaves Lansdown recently switched its audit contract from Deloitte to PwC after just seven years.

Part D: Remuneration Reform

EU and UK Bonus Restrictions and Remuneration Policy

In April 2013, the European Parliament approved restrictions on bonus payments paid by financial institutions to executives and other “material risk takers”[6].  The limits are 100 per cent. of annual salary, or 200 per cent. of annual salary if shareholders explicitly approve (the requirement is for the bonus to be approved by the higher of (i) 66 per cent. of shareholders holding at least 50 per cent. of the capital in the relevant company, and (ii) shareholders holding at least 75 per cent. of the capital in the relevant company) the bonus (although then at least 25 per cent. of any bonus in excess of annual salary must be deferred for at least five years).  The new rules are very broad in scope, applying to both the Europe-based employees of any bank, buildings society or investment firm as well as worldwide employees of European banks, building societies and investment firms that are classified as “material risk takers” (i.e. employees whose professional activities have a material impact on the risk profile of the relevant financial institution).  The European Banking Authority adopted draft regulations in May 2013 that further broadened the rules to include anyone who (i) receives a bonus of more than €75,000 and is equivalent to at least 75 per cent. of their annual salary, and (ii) anyone earning more than €500,000.  The new rules are expected to become effective on January 1, 2014.  In addition, the EU Action Plan states that the Commission will propose in late 2013 giving shareholders a binding vote on remuneration policy and the remuneration report.  The key architect behind these reforms is Michel Barnier, the EU Commissioner for Internal Market and Services, who in 2012 stated that he also envisioned a vote on two key ratios used to determine compensation, those being the ratio of the compensation of the highest paid employees to that of the lowest and the ratio of variable to fixed compensation.

The UK’s “Crackdown on Misconduct” for Senior Banking Personnel: Bonus Clawback and Criminal Sanctions

In addition to an increased focus on restricting compensation in the financial sector, the UK Government has announced its intention to table draft legislation to impose criminal sanctions and jail sentences on bankers that are found guilty of “reckless misconduct in the management of a bank”.  These proposals will be included in the UK’s banking reform Bill, to be published later in the year, which the UK Chancellor George Osborne has also indicated is likely to include provisions to provide for bonus deferral for up to 10 years and 100 per cent. bonus “clawback” when a bank is bailed out by the Government.  However, the likely effectiveness of these provisions will remain to be determined (and is doubted by many commentators) as prosecutors are likely to find it extremely challenging to prove that senior managers have acted recklessly “beyond reasonable doubt” and relevant firms will still be able to determine for what periods any such bonuses are to be deferred.  That said, these developments build on an increasingly robust stance taken by the UK Government and the Financial Conduct Authority (formerly the Financial Services Authority)[7] to tackle reckless, dishonest and fraudulent behaviour, including those in relation to financial and accounting matters, with a view to rebuilding and maintaining investor and market confidence. 

BIS’s Consultation on Transparency and Trust and the G8 Action Plan

On July 15, 2013, the UK Department for Business, Innovation and Skills launched a consultation on company ownership, transparency and trust (the “Transparency Consultation”)[8].  The Transparency Consultation considers a range of proposals to enhance the transparency of UK company ownership and increase trust in UK business, with a view to preventing illegal activity, increasing accountability and providing businesses, investors, employees and consumers with the confidence that companies are acting fairly.  The Transparency Consultation builds on the recently concluded G8 Summit at Lough Erne, Northern Ireland, at which leaders of the G8 economies agreed new measures to clamp down on money-laundering, tax evasion and tax avoidance, including the G8 Action Plan to prevent the misuse of companies and legal arrangements[9].

The Enterprise and Regulatory Reform Act and “Say-on-Pay”

The UK’s Enterprise and Regulatory Reform Act 2013 (the “ERR”) was enacted in April 2013 and takes effect on October 1, 2013.  The ERR provides for a two-step process for say-on-pay.  First, shareholders will get a binding vote on the company’s executive pay policy.  Once shareholders approve the policy, the company may only make payments as permitted by the policy.  A new shareholder vote on the pay policy is required in any year in which a company changes its policy or every three years, whichever comes first.  Second, shareholders will continue to get an advisory vote on pay policy implementation; this means that shareholders will be able to signal their approval or disapproval of executive compensation for the previous year.  Should that vote fail to achieve the required majority, shareholders will have a binding vote on the pay policy the next year.  Under the ERR, directors who authorise compensation in excess of the amounts permissible under the company’s pay policy will be held personally liable for refunding the excess to the company and may also be held liable for damages, although directors can avoid liability if they can show that they acted honestly and reasonably in approving the compensation in question.  In addition, the UK has recently implemented regulations governing the content and format of remuneration reports, with those new rules to take effect on October 1, 2013.  Going forward, companies will be required to include in their annual report (i) a clear table which summarises executive compensation agreements and termination provisions, (ii) a description of how executive pay will be keyed to performance that falls above, below, or at targets set by the company, and (iii) the extent to which shareholder views and employee pay conditions affected the board’s decisions on remuneration policy.

Part E: Raising Standards of Transparency and Engagement with UK Public Companies

ABI Report on Encouraging Equity Investment

On July 11, 2013, the ABI published its report on encouraging equity investment (the “ABI Investment Report”)[10].  The ABI Investment Report investigates the role and importance of the UK public equity markets and in particular focuses on the functioning of the IPO market as well as secondary capital raising for companies listed in the UK and how the ABI believes it can be improved.  The ABI Investment Report sets out a number of key recommendations and observations, including that:

1.         Prospective issuers should engage with potential investors in the early stages (up to a year or more before a planned IPO) of any fundraising process.

2.         There should be, as a matter of good practice, greater disclosure in the prospectus of all the fees paid for an IPO, including any maximum incentive fee.  This should include a breakdown of fees as a percentage of the size of the offering, and those fees that are independent of size, such as, but not limited to, the fees of independent financial advisers, lawyers and accountants. Syndicate members’ individual fees should also be disclosed.

3.         Controlling shareholders should have liability for the IPO prospectus for companies seeking a Premium listing.  This should cover (i) a controlling shareholder or shareholders acting in concert with holding(s) of over 50 per cent. pre-IPO.  The ABI Investment Report recommended that the threshold be set at this level because, in a private company, the shareholders are not as dispersed as in a public company where 30 per cent. is taken as the usual level of de facto control, and (ii) any pre-IPO shareholder who will be party to a relationship agreement post-IPO.  This proposal would require a change to Chapter 6 of the UKLA Listing Rules.

The ABI Investment Report also discusses the key differences between a Premium and Standard listing on the LSE’s Main Market and a listing on AIM or the High Growth Segment[11].

The full article can be accessed here.