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Tolley’s CSRCompany Service

The UK CorporateGovernance Code

Martin Webster

Partner and Head, Corporate Governance Unit

Pinsent Masons LLP

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The UK CorporateGovernance Code

Contents

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1 Introduction 7

2 The board 12

3 The chairman 17

4 The non-executive director 19

5 Remuneration 23

6 Risk and accountability 26

7 Shareholders 29

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Tolley’s CSR Company Service

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The UK Corporate Governance Code

1 Introduction

What is corporate governance?“Corporate governance” is one of those terms which has no precise defini-tion and which carries a variety of meanings. Most narrowly, it refers to theUK Corporate Governance Code, a detailed set of principles which apply tocompanies listed in the UK. More broadly, the term can take in much of UKcompany law and best practice, or, indeed, any set of relationships betweena corporate body, those who run it and those who may be regarded as itsstakeholders.

This booklet focuses on the UK Corporate Governance Code and describesthe position as at 1 June 2010. In its opening paragraph, the Code offers itsown definition:

“The purpose of corporate governance is to facilitate effective,entrepreneurial and prudent management that can deliver the long-term success of the company.”

The Cadbury CodeThe very first version of a UK corporate governance code, a mere two pagesproduced by a committee led by Sir Adrian Cadbury in 1992, set out whattoday’s Code still refers to as the classic definition:

“Corporate governance is the system by which companies aredirected and controlled.”

Cadbury analysed the various responsibilities within a company as follows:

◆ boards of directors are responsible for the governance of their com-panies;

◆ the responsibilities of the board include setting the company’sstrategic aims, providing the leadership to put them into effect,supervising the management of the business and reporting to share-holders on their stewardship;

◆ the board’s actions are subject to laws, regulations and the share-holders in general meeting; and

◆ the shareholders’ role is to appoint the directors and the auditors andto satisfy themselves that an appropriate governance structure is inplace.

Subsequent reviews of the Code have not changed these principles, thoughmore detail has been added, often as a reaction to successive corporatefailures and boardroom scandals.

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The Walker ReviewThe 2008/09 banking crisis led the UK government to commission a reviewof corporate governance by Sir David Walker, the former banker and regula-tor. Running to 180 pages, this is a comprehensive examination of the sub-ject but its main focus is on UK banks and other financial industry entities.As a result, many of Walker’s recommendations for improved corporate gov-ernance have limited application for smaller companies and those outsidethe financial services sector. Nonetheless, the 2010 review of the Code bythe Financial Reporting Council (“FRC”) examined which of Walker’s pro-posals might have wider application to all listed companies.

2010 Code reviewThe FRC is part of the UK’s independent regulatory structure for companiesand acts as the guardian of the UK Corporate Governance Code. Its reviewcame to two main conclusions:

◆ much more attention needs to be paid to the spirit of the Code aswell as its letter; and

◆ the impact of shareholders in monitoring the Code should be en-hanced by better interaction between the boards of listed companiesand their shareholders.

This has led the FRC to emphasise the need to refocus attention on the Codeprinciples, which, it says, should take precedence over its more detailedprovisions. Boards and investors are encouraged to look at the big picturein terms of compliance, rather than fixate on the minutiae or adopt abox-ticking approach to individual rules. In addition, the FRC’s recognitionof the role of shareholders has led it to assume responsibility for a steward-ship code which gives guidance on good practice for investors (see Chapter7 of this booklet).

Main changes in the 2010 CodeThe headline changes to the new Code, compared to the 2008 version,include:

◆ when appointing new directors, boards should have regard to thebenefits of diversity, including gender;

◆ there is renewed emphasis on the leadership role of the chairman,the responsibility of the non-executive directors to provide construc-tive challenge, and the time commitment expected of directors;

◆ the chairman should hold regular development reviews with eachdirector and board evaluation reviews for FTSE 350 companiesshould be externally facilitated at least every three years;

◆ all directors of FTSE 350 companies should stand for re-election ateach annual general meeting (“AGM”);

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◆ chairmen should report personally in the annual report on how theprinciples relating to the leadership and effectiveness of the boardhave been applied;

◆ to improve risk management, the annual report should explain thecompany’s business model, and the board should be responsible fordetermining the nature and extent of the risks it is willing to take;and

◆ performance-related pay should be aligned to a company’s riskpolicies and systems, as well as to the company’s long-term inter-ests.

Who does the Code apply to?With the change to premium and standard (in place of primary and second-ary) listings, the new Code applies to all companies (whether incorporatedin the UK or not) with a premium listing in the UK. Those with a standardlisting (even if UK incorporated) are outside its scope, as are all AIM compa-nies, those whose shares are traded on other markets or not traded at all, andall private companies. They may wish to follow all or part of the Code as anexample of best practice, but they are under no obligation to do so.

Structure of the CodeTo understand the obligations which arise from the Code and the way itworks, it is necessary to understand the Code’s structure which comprises:

◆ Main Principles – these are the core of the Code and set out the mainterms of what boards and their shareholders should be doing;

◆ Supporting Principles – these build on the Main Principles andprovide background as to how the objectives laid down in the MainPrinciples should be achieved; and

◆ Code Provisions – these give detailed guidance as to how to complywith the Principles. They are the nuts and bolts of compliance withthe Code.

How is the Code enforced?The Code is not a rigid set of rules to be kept to at all costs; nor is it entirelyvoluntary. There are three ways its terms are applied to companies:

◆ The Listing Rules (LR 9.8.6R and 9.8.7R) require a statement in acompany’s annual report as to how the Main Principles have beenapplied. There is no choice here – a company does not have theoption of saying a Main Principle is irrelevant or it does not wish tocomply with it.

◆ In the case of the more detailed Code Provisions, the same ListingRules give a choice, either to state in the annual report that each ofthe relevant provisions has been complied with throughout the yearunder review, or that a particular provision has not been complied

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with and to give the reasons for non-compliance (and the period ofnon-compliance). This is the “comply or explain” basis of the Codediscussed below.

In either event, if a company does not report how it has applied theMain Principles, or fails to comply or explain in respect of the CodeProvisions, it will be in breach of the Listing Rules and so subject todisciplinary action by the Financial Services Authority (“FSA”) in itsguise as the UK Listing Authority.

◆ More practically, compliance is in the hands of shareholders. If theydo not like what the directors are doing, the Code encourages themto engage with the board, either with the executive directors orthrough the chairman or the non-executive directors, as appropriate,to discuss their concerns. If agreement cannot be reached, theshareholders have the ultimate sanction of using their votes, either todefeat a proposal from the board, to vote down a remuneration reporton matters of pay, or even to remove directors from the board.

Comply or explainThe “comply or explain” regime is the essence of the Code’s approach tocorporate governance. The broad principles are set out and must be adheredto, but there is considerable flexibility as to the detail of how that is done.Most companies will follow the Code Provisions and so “comply”, but wherea board believes that is not appropriate and it can apply the principles in adifferent way, there is liberty to “explain” that different approach. In theFRC’s words, the provisions describe one route by which the Code’s princi-ples might be met, but they are not the only route.

The Code encourages shareholders to be responsive to a company’s explana-tions and to take into account their particular circumstances. There is arecognition that smaller listed companies and those coming to the marketmay find some of the provisions disproportionate or less relevant to theircircumstances. Shareholders should not adopt a box-ticking approach andtreat every failure to comply as a breach of the Code. The Code is onlybreached if a Main Principle is ignored or the explanation for a departurefrom a Code Provision is inadequate or unconvincing. Instead, shareholdersneed to engage with a company, to exchange views and to be responsive towhat is said.

Disclosure and Transparency RulesNote also that the FSA’s Disclosure and Transparency Rules (“DTRs”) containmandatory requirements relating to:

◆ audit committees (DTR 7.1); and◆ corporate governance statements (DTR 7.2).

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Most of the requirements of these DTRs will be met if the relevant provisionsof the Code are complied with.

Useful informationThe full text of the Code and useful material relating to its 2010 revision canbe found on the FRC website (http://www.frc.org.uk/).

Schedule B to the Code brings together in one list all the governance relateddisclosure requirements contained in the Code, the Listing Rules and theDTRs.

The Higgs Guidance, last reissued in 2006, gives further guidance on com-pliance with the Code for boards and non-executive directors. At the time ofwriting, that guidance is being reviewed and updated by the Institute ofChartered Secretaries and Administrators, with a final version expected inOctober 2010.

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2 The board

The role of the boardThe board is at the centre of effective corporate governance. Main PrincipleA1 states:

“Every company should be headed by an effective board which iscollectively responsible for the long-term success of the company.”

To achieve that long-term success, the board is to:

◆ provide entrepreneurial leadership within a framework of prudentand effective controls, enabling risk to be assessed and managed;

◆ set the company’s strategic aims;◆ ensure that the necessary financial and human resources are in place

for the company to meet its objectives and review managementperformance; and

◆ set the company’s values and standards and ensure that its obliga-tions to shareholders and others are understood and met.

A board should agree a formal statement of those matters which are reservedfor its decision (see the ICSA website – http://www.icsa.org.uk – for a draft)and may also detail the extent of the delegated powers it gives to execu-tives. The Code Provisions call for a statement in the annual report describ-ing how the board operates, with a summary of what types of decisions areto be taken by the board and what is delegated to management.

The annual report should also give details of the number of meetings of theboard and its committees during the year and the attendance record of indi-vidual directors.

The board’s compositionMain Principle B.1 lists four factors which need to be reflected in a boardand its committees: skill, experience, independence and knowledge of thecompany.

A board needs to be large enough to reflect these different requirements, butnot so large that it becomes unmanageable. Code Provision B.1.2 providesthat at least half the board, excluding the chairman, should be independentnon-executive directors (see Chapter 4 of this booklet for what is meant by“independent”). Put another way, the number of independent non-execu-tives needs to match or exceed the number of executive directors. This shouldensure that no individual or small group dominates the board.

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Companies outside the FTSE 350 for the whole of a year have the option toreduce the number of independent non-executives to two, though manychoose to have more.

It is not uncommon to see boards with only two executives, the CEO and thefinance director, and four or more non-executives. Neither the Code nor theWalker Review argue against such a board make-up, leaving it to individualboards to decide what is right for them in each case.

Appointments to the board“Buggins’ turn” and the old-boy network have long been decried as ways ofrecruiting directors. Rather, “there should be a formal, rigorous and transpar-ent procedure for the appointment of new directors to the board” (MainPrinciple B.2).

Selections should be made on objective criteria and search companies orpublic advertisements used (an explanation is required in the annual reportif they are not when appointing a chairman or non-executive director). Alate amendment to the Code in 2010 requires that appointments should bemade “with due regard for the benefits of diversity on the board, includinggender”. There is no suggestion that quotas should be introduced, but theFRC is keen in particular to see more women on listed company boards.Improved diversity, it says, can improve the quality of decision-making andreduce the risk of “group think”.

Directors also need to think about succession planning for the board andsenior management, ensuring what is termed “progressive refreshing” of theboard.

Nomination committeeA nomination committee of the board “should lead the process for boardappointments and make recommendations to the board” (Code ProvisionB.2.1). Note that this does not give delegated authority to the committee toappoint new directors. (Audit and remuneration committees, by contrast, dohave full delegated authority from the board.) The committee should havepublicly available terms of reference and the work of the committee is to bedescribed in the annual report. Part of its job is to decide what gaps need tobe filled when making a new appointment, having assessed the board’s bal-ance of skills, experience, independence and knowledge of the company.

The nomination committee may have executive directors as members butindependent non-executive directors should be in a majority. The chairmanof the board may chair the nomination committee but should step asidewhen appointing a successor. Alternatively, the committee may be chairedby an independent non-executive director.

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As with all committees, only its members are entitled to attend, thoughothers may be there by invitation.

InductionNew directors are not expected to arrive fully fledged. There is a recognitionthat they need to go through a tailored induction process (Main PrincipleB.4) which is usually the responsibility of the company secretary. In particu-lar, directors new to the industry or business sector should be helped to learnwhat the company does and how it makes its money (Walker referred to“thematic business awareness sessions”). Meetings with major shareholdersshould be arranged so there is early familiarisation and an exchange ofviews.

New executive directors may have the necessary specialist knowledge butneed help with other boardroom skills or training in their legal duties andresponsibilities.

The Higgs Guidance contains a useful induction checklist.

TrainingTraining needs to be part of an ongoing process. Main Principle B.4 saysdirectors “should regularly update and refresh their skills and knowledge”. Itis a particular responsibility of the chairman to ensure this happens and heneeds to review with each director their training and development needs(perhaps as part of the evaluation process – see below).

SupportDirectors need to be supported in their role. They need a flow of informationwhich is sufficiently complete and received in a timely manner (Main Prin-ciple B.5). So important is this requirement that specific responsibility for itis given to the chairman, though it will be the company secretary who en-sures the necessary processes are followed. Where the information flows areinadequate, directors need to say so.

At times, directors, and particularly the non-executives, may need profes-sional advice which is independent of the company’s own advisers. Thisshould be at the company’s expense and may be facilitated by the companysecretary. Board committees will also need support – for example, remu-neration and risk committees may need to pay for specialist advice.

Company secretaryThe company secretary has an increasingly important role in advising theboard on corporate governance, though the supporting principles to MainPrinciple B.5 say this advice is to be given “through the chairman”.

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All directors need to have access to the advice and services of the companysecretary. Appointment and removal of the secretary is not a decision for thechairman or chief executive alone, but should be made by the board as awhole.

EvaluationMain Principle B.6 refers to performance evaluation not just of directors, butalso of the board as a whole and its committees. There should be an annualreview of how they work, their membership, their terms of reference, andtheir successes and failures.

It may be tempting to downplay evaluations and see them just as part of thedevelopment and training process for directors, but the Code is clear thatevaluations need to be “formal and rigorous”, to question whether a directormakes an effective contribution to the board and still has sufficient time forthe job. Where appropriate, the chairman should act on the results by seek-ing resignations and appointing new directors. Evaluation of the chairman’sperformance is the responsibility of the non-executive directors, led bythe senior independent director and in consultation with the executive di-rectors.

In the past, annual director evaluations have often consisted of conversa-tions between an individual and the chairman. That is now seen as too cosyan arrangement and Code Provision B.6.2 requires that, at least every threeyears, FTSE 350 companies should have evaluations of the board, its com-mittees and directors conducted by an external facilitator. Other companiesare free to continue with wholly internal reviews.

Note that the reference to external evaluation is in a Code Provision, soeven FTSE 350 companies have the option either to comply or to explain ifthey believe they can satisfy the requirement for formal and rigorous annualevaluations in some other way. In any event, the annual report needs todescribe how evaluations are carried out. Where an external facilitator isused, any other connections with the company should be disclosed. (Thequestion of potential conflicts of interest for evaluators is something the FRCis continuing to consider.)

The Walker Review suggested that major shareholders might also be con-sulted as part of the evaluation process. The Higgs Guidance has furtherinformation on performance evaluation, including a list of possible ques-tions.

Annual re-electionFor many years, directors have been required to submit themselves forelection by shareholders at the first AGM after their appointment, and atthree-yearly intervals thereafter. The Walker Review recommended that

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the chairman of a bank or other large financial institution should be sub-ject to annual election, to emphasise the key role the chairman plays.

This proposal was criticised as singling out the chairman when the UK’sunitary board model makes all directors collectively responsible for boarddecisions. In response, the new Code recommends all directors of FTSE 350companies be subject to annual re-election (smaller companies are alsoencouraged to consider such a policy). The FRC recognises that some com-panies may need a transitional period before moving to annual elections.

As with external evaluation, this is a Code Provision and so the “comply orexplain” regime applies. Indeed, it would seem relatively straightforward tocomply with Main Principle B.7 – “All directors should be submitted for re-election at regular intervals, subject to continued satisfactory performance”– without going to the lengths of annual elections.

Whatever the frequency of re-election, sufficient information on those beingput forward needs to be given to shareholders, with a rationale from theboard for each candidate and confirmation from the chairman that the out-come of the individual’s performance evaluation justifies re-election.

Insurance coverThe Companies Act 2006 permits a company to arrange and pay for insur-ance cover for its directors. Code Provision A.1.3 says that insurance shouldbe put in place. Note that it is just as important to keep this under regularreview, both as to the risks met by the policy and the amount of coverprovided.

The Code does not mention the provision of indemnities by a company infavour of its directors, but these are also permitted by the Companies Act(with some restrictions) and enabling provisions are contained in most com-pany articles. A separate form of indemnity should be entered into for eachdirector. A claim by a director under an indemnity may be settled morequickly than a claim under insurance, leaving the company to bring a match-ing claim under the policy.

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3 The chairman

The roleThe Code has always highlighted the key role played in good corporategovernance by the chairman and that has been re-emphasised by Walkerand the 2010 Code review. Chairmen are encouraged to use their annualstatements to report how the principles in sections A and B of the Code havebeen applied in practice. This is where departures from Code Provisions canbe detailed, with the chairman explaining the reasons why to shareholders.“Boiler-plate” or standard explanations should be avoided.

Main Principle A.3 states:

“The chairman is responsible for leadership of the board and ensuringits effectiveness on all aspects of its role.”

The chairman needs to ensure the board’s agenda gives sufficient time tostrategy and other “big picture” issues, without getting bogged down in matterswhich should properly be left to management. The chairman is also seen assetting the tone of board discussions, promoting a culture of openness anddebate. Given the role of the non-executive directors in providing construc-tive challenge to the executives (see the next chapter in this booklet), it isfor the chairman to facilitate those discussions and to ensure good relationsbetween all directors.

See the previous chapter in this booklet for the chairman’s role in ensuringdirectors have the information they need, and in their training and develop-ment and performance evaluation. The chairman is also likely to play aleading part in the nomination committee in selecting new directors andsuccession planning. Chapter 7 of this booklet discusses the chairman’s re-sponsibility to ensure effective communication with shareholders.

AppointmentThe board’s nomination committee will usually lead the search for a newchairman, drawing up a job specification with an assessment of the timecommitment required. The Walker Review thought the chairman of a majorbank should devote two-thirds of his time to the job and, in any event, giveit priority over other commitments. The Code is not as precise but recognisesthat the chairman may need to spend more time during a crisis. The chair-man’s other commitments should be disclosed to the board and detailed inthe annual report, both initially and as they change.

When appointed, the chairman should satisfy the test of independence fornon-executive directors described in the next chapter of this booklet (CodeProvision A.3.1). This will not be complied with where a chief executive

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becomes chairman of the same company, quite a common move in largebanks where the argument is made that only a former chief executive hasthe knowledge and experience to be an effective chairman.

Where a chief executive does succeed as chairman, major shareholdersneed to be consulted in advance and the board’s reasoning explained in thenext annual report.

Division of responsibilitiesIn the past it was not uncommon for one individual to occupy the roles ofboth chairman and chief executive. That is no longer the case and MainPrinciple A.2 states:

“There should be a clear division of responsibilities at the head ofthe company between the running of the board and the executiveresponsibility for the running of the company’s business. No oneindividual should have unfettered powers of decision.”

Note that the Main Principle stops short of saying the two roles should not beheld by the same person. That prohibition is left to a Code Provision which,of course, is subject to the “comply or explain” regime. Nonetheless, institu-tional shareholders do not like to see the roles combined and most recentlyput pressure on Marks & Spencer to conform.

The division of responsibilities between the two posts should be in writtenform and agreed by the board. The chairman needs to have a relationship oftrust with the chief executive and to be able to provide support withoutcrossing the line and assuming an executive role.

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4 The non-executive director

The roleMain Principle A.4 states:

“As part of their role as members of a unitary board, non-executivedirectors should constructively challenge and help develop proposalson strategy.”

The UK’s unitary board model, strongly supported by the Code and backedby the Walker Review, means that all directors sit on the same board anddiscuss the same agenda, giving the non-executives a regular opportunity toquiz their executive colleagues. In a two-tier board structure the non-execu-tives sit on a supervisory board separate from the executive arm. (The Codenonetheless suggests that the chairman should on occasion meet the non-executives without the executive directors present.)

To provide the necessary constructive challenge to the executives, non-executive directors need to have a good understanding of the company, theworld in which it operates and the issues it faces. They need to gain the trustand respect of all executives, both on the board and below board level. TheCode adds further responsibilities:

◆ scrutinising the performance of management in meeting agreedgoals and objectives;

◆ monitoring the reporting of performance;◆ being satisfied as to the integrity of financial information;◆ being satisfied that the financial controls and systems of risk man-

agement are robust and defensible;◆ determining appropriate levels of remuneration for executive directors;◆ having a prime role in appointing and, where necessary, removing

executive directors, and in succession planning; and◆ understanding the views of major investors, both directly and through

the chairman and senior independent director.

In summary, the Higgs Guidance says an effective non-executive director“questions intelligently, debates constructively, challenges rigorously anddecides dispassionately”.

IndependenceThe Code distinguishes between those non-executive directors who are in-dependent and those who are not. Only the former can serve on audit andremuneration committees and satisfy the necessary ratios on the board andnomination committee.

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It is the responsibility of the board to determine whether a non-executive is“independent in character and judgement”. Guidance is given in CodeProvision B.1.1, which adds that the board will need to explain why theyconsider the independence test satisfied if there are circumstances whichsuggest otherwise, including if a director:

◆ has been an employee of the company or group in the last fiveyears;

◆ has (or had in the previous three years) a material business relation-ship with the company, either directly or as a partner, shareholder,director or senior employee of a body that has such a materialbusiness relationship;

◆ has received additional remuneration from the company (apart froma director’s fee), participates in a share option or performance-related pay scheme, or is a member of the company’s pensionscheme;

◆ has close family ties with any of the company’s advisers, directors orsenior employees;

◆ holds cross-directorships or has significant links with other directorsthrough involvement in other companies or bodies;

◆ represents a significant shareholder; or◆ has served on the board for more than nine years from the date of

first election.

The key point is that these categories are not definitive and a decision as toa director’s independence remains for the board to make. It is somethingthey need to assess each year and confirm in the annual report.

Terms of appointmentAppointments are usually for a three-year period, subject to re-election at anAGM. A second term may follow, making six years in all. Code ProvisionB.2.3 says that re-appointment beyond six years should be subject to “par-ticularly rigorous review” and take into account the need for “progressiverefreshing of the board”.

Terms in excess of six years are common, and those in excess of nine yearsare not uncommon, despite the suggestion this compromises a director’sindependence. For companies outside the FTSE 350, Code Provision B.7.1says non-executive directors should stand for re-election each year oncetheir ninth anniversary is passed.

Remuneration for non-executive directors needs to reflect their time com-mitment and responsibilities (Code Provision D.1.3). An additional fee willusually be paid for membership or chairing of a committee. The board, or acommittee including the chief executive, should decide the level of fees fornon-executive directors, within the limits set by the company’s articles. Shareoptions and other performance-related pay are discouraged (and can be rele-

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vant to a director’s independence – see above). If options are granted, share-holder approval should be sought in advance and the shares held for at leasta year after stepping down from the board.

Non-executive directors are not employees but they should have a letterof appointment which should be available for inspection at the company’sregistered office and at the AGM. The Higgs Guidance contains a sampleletter.

Time commitmentThe letter of appointment for a non-executive director should set out theexpected time commitment for the role. The Code gives no guidance onwhat that should be. The Walker Review reported that 25 days was usual fora large bank or insurance company, and first argued for an increase to aminimum of 30 or 36 days. The recommendation was modified once it waspointed out it was impractical for executives serving as non-executives onother boards, so now “several”, not all, bank non-executives need to acceptsuch an increased commitment.

Executive directors who serve elsewhere as non-executives should not chairor be on the board of more than one FTSE 100 company. The remunerationreport needs to disclose whether the director retains such earnings and, if so,how much they are.

Pre-appointment due diligenceThose offered a non-executive position need to do their homework beforeaccepting. The Higgs Guidance has a useful pre-appointment due diligencechecklist to ensure the new director will be suited to the company and thenecessary degree of trust will be present. Financial information should beexamined and meetings held with the key players.

In FSA regulated companies, non-executive director appointments are treatedas “controlled functions” and are subject to the prior approval of the regulator.

Senior independent directorOne of the independent non-executive directors should be appointed by theboard as senior independent director (or “SID”). Code Provision A.4.1 saysthe SID is a sounding board for the chairman and an intermediary for otherdirectors when necessary (presumably when there is unhappiness about thechairman).

The SID takes the lead on the evaluation of the chairman. The SID alsoacts as an intermediary between shareholders and the board if normal chan-nels to the chairman or other board members haven’t worked or are inappro-priate.

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ResignationIf a non-executive director has concerns on any topic before the board whichcannot be resolved, and resigns as a result, a written statement of thoseconcerns should be given to the chairman and circulated to the board. Suchconcerns should, in any event, be recorded in the board minutes.

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5 Remuneration

General principlesRemuneration has long been a point of tension between companies andtheir shareholders. Successive versions of the Code have ratcheted up therules and Main Principle D.1 now makes three points:

◆ levels of remuneration should be sufficient to attract, retain andmotivate directors of the quality required to run the company suc-cessfully;

◆ a company should avoid paying more than is necessary; and◆ a significant proportion of executive directors’ remuneration should

be structured to link rewards to corporate and individual perform-ance.

Directors should not be involved in setting their own remuneration. Instead,the process for developing policy on executive remuneration and decidingpackages for individual directors needs to be formal and transparent (MainPrinciple D.2).

Remuneration committeeA remuneration committee of the board should have delegated authority toset remuneration for all executive directors and the chairman, includingpension rights and compensation payments. The committee should also rec-ommend and monitor the level and structure of senior management remu-neration – “senior management” here means the layer of management im-mediately below board level, though the board can widen the definition if itwishes.

The committee should comprise at least three independent non-executives;outside the FTSE 350, two is enough. The chairman may also be a member(provided he was classed as “independent” when appointed) but may notchair the committee.

Although the committee has full delegated authority, it should consult thechairman and/or chief executive on its proposals for executive directors,while avoiding any conflicts of interest.

The terms of reference of the committee need to be available (they are oftenplaced on a company’s website), together with a statement as to whetherany consultants used by the committee do other work for the company (CodeProvision D.2.1).

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Considerations for the remuneration committeeThe committee needs to position remuneration levels in the context of whatother companies are paying, looking at entities in the same sector and of acomparable size and keeping in mind the risk of an upwards-only ratchet aseveryone follows the highest payers. Salary and employment terms else-where in the group also need to be looked at to avoid too great a disconnect.

Poor performance should not be rewarded, so the committee is told to “care-fully consider” the compensation payments which may result when execu-tives leave, including pensions (post the furore over Sir Fred Goodwin andRBS). The Code calls for a “robust line” to be taken on reducing compensa-tion to reflect a departing executive’s duty to mitigate loss.

Notice periods should be set at a maximum of 12 months. Longer periodsmay be needed to entice new recruits joining the company, but should re-duce to no more than a year once the initial period has run.

Performance-related payAnnual bonuses should have performance conditions which are “relevant,stretching and designed to promote the long-term success of the company”,rather than short-term gains (see Schedule A to the Code). Upper limits forbonuses should be set and disclosed. Part payment in shares held for a sig-nificant period is a suggested variation.

Long-term incentive schemes for directors are also to be considered, whethershare options or other types of scheme. Grants of shares and other deferredremuneration should be phased (rather than one block award) and should notvest in less than three years; directors should be encouraged to hold theshares for a further period (subject to the need to fund acquisition costs andtax).

New incentive schemes, and new grants under existing schemes, shouldhave “challenging performance criteria reflecting the company’s objectives”.Non-financial performance metrics should be included, though only wherethought appropriate. Reflecting the Walker Review and the Code’s increasedemphasis on risk, incentives need to be compatible with risk policies andsystems.

Where remuneration is linked to results which turn out to have been mis-stated or where there has been misconduct by the executive, the ability toreclaim sums paid may become an issue, and the committee needs to con-sider such possibilities when designing packages. It will be easier to clawback deferred entitlements rather than sums already paid.

Benefits other than basic pay should not be pensionable, and the pensionconsequences of salary increases and other changes need to be taken intoaccount, especially for directors nearing retirement.

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Other considerationsNote that there are many other considerations to take into account on remu-neration, including:

◆ the FSA’s remuneration code which applies to the largest financialinstitutions;

◆ the Listing Rules (on disclosure and approval of share schemes);◆ regulations under the Companies Act 2006 (as to what needs to be

disclosed);◆ the requirement for a remuneration report subject to an advisory vote

at the AGM; and◆ guidance from investor bodies such as ABI and RiskMetrics.

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6 Risk and accountability

AccountabilityThe Code places great emphasis on communication with shareholders anddirectors’ accountability to the company’s owners. Main Principle C.1 requiresa balanced and understandable assessment of the company’s position and pros-pects in statutory reports, market announcements and reports to regulators.

The annual report and accounts should contain an explanation of the direc-tors’ responsibility for preparing the document and a statement by the audi-tors of their responsibilities. Annual and half-yearly financial statements needto report that the business is a going concern, with the necessary supportingassumptions or qualifications. (See “Going Concern and Liquidity Risk: Guid-ance for Directors of UK Companies 2009”, available online at http://www.frc.org.uk/corporate/goingconcern.cfm.)

Risk management and internal controlThe 2008/09 banking crisis focussed attention on corporate risk. The boardneeds to decide the nature and extent of the significant risks it will take toachieve its strategic objectives (Main Principle C.2). Having decided thoserisks, it needs to maintain sound systems for risk management and internalcontrols. The effectiveness of those systems should be reported to sharehold-ers and reviewed at least annually, including financial, operational and com-pliance controls.

The Turnbull Guidance on internal control (available on the FRC website athttp://www.frc.org.uk/corporate/internalcontrol.cfm) gives help in applyingthe Code in this area. It is due to be updated during the second half of 2010.

Audit committeeThe board needs to have formal and transparent arrangements as to how itapplies these principles of corporate reporting, risk management and inter-nal control, and for its relationship with the company’s auditors (Main Prin-ciple C.3).

An audit committee should comprise at least three independent non-execu-tive directors. Outside the FTSE 350, this can be reduced to two and thechairman may be an additional member (but not chair the committee) providedthe independence criteria were satisfied when he was appointed chairman.

At least one member of the committee should have “recent and relevantfinancial experience”, usually an accountancy qualification or executiverole in finance. Where that is not the case, independent advice might needto be drafted in.

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The committee needs to have written terms of reference, publicly available,which describe its delegated authority from the board and its role and re-sponsibilities, including:

◆ monitoring the integrity of the company’s financial statements andannouncements and reviewing any significant financial reportingjudgements they contain;

◆ keeping under review internal financial controls and (unless there isa separate risk committee) other internal control and risk systems;

◆ monitoring and reviewing the effectiveness of the internal auditfunction – where that does not exist, the committee should considereach year whether such a resource is needed and explain in theannual report their reasons for not having one;

◆ making recommendations as to the appointment and removal ofexternal auditors, their remuneration and other terms of engagement– in the unlikely event the board does not follow a committeerecommendation, both views need to be put to shareholders;

◆ reviewing and monitoring the external auditor’s independence andobjectivity and the effectiveness of the audit process;

◆ developing and implementing policy on the supply of non-auditservices by the external auditor – where non-audit services areprovided, the annual report needs to disclose this and explain howauditor objectivity and independence are safeguarded; and

◆ reviewing whistle-blowing arrangements for staff to raise concernsabout possible improper behaviour, ensuring that there are arrange-ments in place for proportionate and independent investigation andfor appropriate follow-up action.

The annual report should describe the work of the committee. The FRC’s“Guidance on Audit Committees” is available online (at http://www.frc.org.uk/corporate/auditcommittees.cfm).

Risk committeeThe Walker Review recommended that banks and life assurance companiesin the FTSE 100 should have a risk committee separate from the audit com-mittee, served by a risk officer and with a risk report included in the annualreport.

This was not thought necessary by the FRC for non-financial companies.Instead, it agreed with the House of Commons Treasury Select Committeewhich wanted to see companies “setting out their business model in a shortbusiness review, in clear jargon-free English, to detail how the firm has made(or lost) its money and what the main future risks are judged to be”.

As a result, Code Provision C.1.2 says the Business Review should have anexplanation from the board of its business model (defined as “the basis onwhich the company generates or preserves value over the longer term”) andits strategy for delivering the company’s objectives.

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Further guidance can be found in the Accounting Standard Board’s “Report-ing Statement: Operating and Financial Review”, paras 30–32 (availableonline at http://www.frc.org.uk/asb/publications/documents.cfm?cat=7).

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7 Shareholders

IntroductionTo encourage better shareholder engagement with boards, the Walker Re-view recommended the FRC should take responsibility for a StewardshipCode which institutional shareholders would be required to observe on a“comply or explain” basis. This would replace Schedule C of the Code cov-ering much the same ground.

The FRC’s own conclusion was that the impact of shareholders in monitoringthe Code should be enhanced. At the time of writing, a consultation on theStewardship Code has been carried out and an announcement on the nextsteps is awaited. In the meantime, Schedule C continues to apply.

The Stewardship CodeThe Stewardship Code was drafted by the Institutional Shareholders’ Com-mittee (“ISC”), a forum of trade associations representing UK institutionalshareholders. Its aim is to enhance the quality of dialogue between institu-tional investors and companies to help improve long-term returns to share-holders, reduce the risk of catastrophic outcomes due to bad strategic deci-sions, and help with the efficient exercise of governance responsibilities.

The Code remains subject to amendment by the FRC but is designed toapply to both institutional investors (such as pension funds, insurance com-panies and investment trusts) and those who invest as agents on behalf ofothers (for example, fund managers). They may choose not to apply theCode but should publicise their reasons for not doing so. Those who do applyit will be listed on the ISC’s website. It is hoped this will include sovereignwealth funds and other overseas investors (who own at least 40% of UKshares).

The Code comprises seven Principles with additional guidance on each.Institutional investors should:

◆ publicly disclose their policy on how they will discharge theirstewardship responsibilities. This includes their policies on the use ofproxy voting services and company explanations for departures fromthe Code;

◆ have a robust (publicly disclosed) policy on managing conflicts ofinterest in relation to stewardship;

◆ monitor their investee companies, so they know when to enter into adialogue with their directors – this includes being satisfied thatindependent non-executive directors provide adequate oversight.Investors should not be made insiders without their agreement;

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◆ establish clear guidelines on when and how they will escalate theiractivities as a method of protecting and enhancing shareholdervalue;

◆ be willing to act collectively with other investors where appropriate;◆ have a clear policy on voting and disclosure of voting activity; and◆ report periodically on their stewardship and voting activities – agents

should report as agreed with their clients and principals should reportannually to those to whom they are accountable.

Dialogue with shareholdersSection E of the Code contains obligations for the board in its relations withshareholders. The board is responsible for ensuring a satisfactory dialoguewith shareholders, based on the mutual understanding of objectives (MainPrinciple E.1). Most shareholder contact will be with the chairman, chiefexecutive or finance director, but the chairman needs to ensure that allboard members are aware of major shareholders’ views. (There is, nonethe-less, a recognition that directors have a duty to treat all shareholders equallyand only to disclose price-sensitive information to the market as a whole.)

The chairman has a particular role in discussing governance and strategywith major shareholders. The senior independent director also needs to meetshareholders to understand their issues and concerns.

The annual report should describe how directors keep abreast of shareholderopinion, whether through meetings with investors, analysts’ or brokers’ brief-ings or otherwise.

The AGMThe AGM is another tool to engage with investors and encourage their par-ticipation (Main Principle E.2). The AGM notice and related papers shouldbe sent to shareholders at least 20 working days before the meeting (whichwill be longer than the 21 clear days required by the Companies Act 2006).All directors should attend and the chairmen of the audit, remuneration andnomination committees should be ready to answer shareholders’ questions.

There should be separate resolutions on matters which are “substantiallyseparate” (Code Provision E.2.1), rather than bundling them into one resolu-tion. Proxy forms need to allow for votes to be withheld, in addition to beingcast for or against a resolution, though it should be made clear that a with-held vote is not a vote in law and so does not affect the proportion of votesfor or against.

Increasingly, AGMs are taking all votes by poll, but where there is a vote ona show of hands the company needs to announce after the vote at the meet-ing and on its website the number of shares covered by proxies and thenumber of votes for, against and withheld.

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