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What will be on the governance radar in 2011

In today’s business environment, conditions for many remain challenging. Corporate governance continues to be a key issue for investors, other stakeholders and commentators and remains high up on most board agendas. Businesses themselves are changing, bringing new risks while, at the same time, business faces the challenge of increasing demand for better quality disclosures. The ability to communicate a robust corporate governance position remains a crucial factor in successful reporting. 

2010 has been a fast and furious year in governance terms with some reviews still underway, others pending and more anticipated change in the pipeline. Producing high-quality disclosures remains challenging. The last two years have seen major governance reviews in both the UK and the rest of the world as governments seek ways to improve the regulation and governance of companies. In the UK, the seminal reviews were those set up by the Financial Services Authority (FSA) and headed by Sir David Walker, rapidly followed by the Financial Reporting Council (FRC) on the UK Corporate Governance Code (the Code).

The Code applies to accounting periods beginning on or after 29 June 2010 and, as a result of the new Listing Regime introduced in April 2010, applies to all companies with a Premium Listing of equity shares regardless of place of incorporation. The reviews have culminated in the Code and the introduction of a Stewardship Code and 2011 will see these codes bed in.

Key governance highlights for the 2011 reporting season are:

Remuneration

Executive remuneration is always contentious but is particularly so in periods when a company’s performance weakens in line with market conditions. In the financial sector we will see enhanced remuneration reporting with the revised FSA Remuneration Code due in late December 2010 and an overall greater emphasis on remuneration disclosure. In remuneration reporting, few companies adequately explain their processes on remuneration. As shareholders will be concerned that the interests of directors may not be aligned to their own, greater explanation in the report and accounts would be useful.   

Re-election

The Code recommends that all directors of FTSE 350 companies should be subject to annual re-election, while the FRC encourages companies outside of the FTSE 350 to consider their policy on director re-election. Some are sceptical about this new provision and view it as a potential charter for mischief-making but behind it lies the desire to help the shareholder community take a more active and direct involvement in the make-up of their boards. As with all other Code provisions, companies are free to explain rather than comply if they believe that their existing arrangements ensure proper accountability and underpin board effectiveness. It is helpful that the likes of Hermes and Railpen have said publicly that they would back those boards who do not comply. However, the fact remains that greater thought will need to be given as to how to handle the re-election issue.    

Role of Institutional Shareholders

Post financial crisis, a principal conclusion drawn by the FRC was that the impact of shareholders monitoring the Code could, and should, be enhanced by better communication between boards of listed companies and their shareholders. To further this aim, the FRC assumed responsibility for the Stewardship Code that provides guidance on good practice for investors. Institutional shareholders are free to choose whether or not to engage and disclosures made should assist companies to understand the approach and expectations of their major shareholders. With shareholders being more transparent in this way, there is an opportunity for companies to be more forthcoming about the level of engagement that they have with their investors. This development provides an opportunity for companies to increase their disclosures in this area and to explain all their initiatives and efforts in creating the shareholder dialogue. Very many companies do fantastic work in this area yet few actually communicate what they do: this is an area where companies could, and should, disclose more. 

Risk

Risk management is high on the corporate agenda. We all know that risk management procedures designed for boom times may not be suitable for recessionary periods and vice versa: differing economic conditions require different management responses and it is essential to focus on the top risks and keep them live. 

For some, the financial crisis represented the ultimate stress test in risk management. In the aftermath, many companies have reviewed the performance of their risk management programmes to determine what modifications are needed. Many have also reviewed how much risk that they are willing to take (their risk appetite) and have used key risk indicators to help them manage the ‘risks that matter’. In addition, many have looked to ensure that their internal and external controls are optimised. This presents a great opportunity to review the disclosures made on risk management and to really focus on the quality of the disclosure to tell the risk management story.

There is a conceptual difference between internal control, which is historical in outlook, and risk management, which is forward looking. The skills required to cover both are very different and this may be one reason behind having separate audit and risk committees. There is no right or wrong model and each company needs to decide how best to handle board delegation in these areas, given its unique circumstances. Better disclosure in these areas would be beneficial.

Reporting on the business model

Under Code provision C.1.2, the directors should include in the annual report an explanation on the business model (the basis on which the company generates or preserves value over the longer term) and the strategy for delivering the objectives of the company. For some businesses, this may be a more complicated disclosure than for others but it is worth paying it enhanced attention in the coming reporting season.   

Review of Boards

Performance evaluations have been in the Code for some time but the three-yearly external facilitation element contained in Code provision B.6.2 is a new provision and one which FTSE 350 companies will have to take into account. Investors need to know a board’s effectiveness and good corporate communication can do much to convey the board’s message to investors and stakeholders on what outcomes arise from evaluation. At a minimum, the board should consider providing the following details:

  • what was reviewed as part of the evaluation (including the rationale behind the decision);
  • who conducted the evaluation including the rationale behind their selection;
  • the nature of the evaluation process;
  • the key findings and lessons learned; and
  • any follow up action required, and by whom.

There is much to be gained in communicating what board review procedures are in place and this should be seen as a positive opportunity for corporates to tell a great story.

Reporting

Investors and analysts see non-executive directors as a critical control mechanism. More than ever, investors are looking for increased and better-quality communication with boards and expect to see more proactive, broader and more meaningful communication with companies. Investors will increasingly look to non-executive directors to influence the whole board to communicate and address emerging concerns as well as to act as an important filter to check communications prior to market disclosure.

FRC Guidance on Audit Committees

In July 2010, the FRC began consultation on limited changes to the guidance to provide advice to audit committees on determining whether a company’s auditor should be permitted to provide non-audit services. The consultation closed in October 2010 and revised guidance is intended for publication in December 2010. This is one to watch and, while it will probably not impact year-end reporting, it will be extremely useful and is a much needed revision in this area. 

In summary, corporate governance is likely to remain high on corporate agendas for the foreseeable future. There is likely to be considerable benefit for those companies willing to work hard on their governance disclosures in terms of closer engagement with their shareholders.  

Vanessa Jones

November 2010