FRC wants end to ‘lip service’ on FTSE board independence

The Financial Reporting Council’s (FRC’s) latest analysis suggests that while compliance with the UK corporate governance code remains high, some FTSE 350 companies are paying no more than lip service to requirements regarding board independence and need to improve their explanations of why they choose not to follow provisions

The regulator’s annual report on corporate governance and stewardship found that the number of FTSE 350 companies reporting full compliance with all provisions has increased from 57% to 62% since 2015, with 90% reporting full compliance with all but one or two of the code’s provisions.

As in previous years, the code provision which is most often not met is the requirement for at least half the board, excluding the chairman, to be independent, non-executive directors. This was not the case in 26 FTSE 350 companies in 2016 compared to 42 in 2015, and the FRC warns that this has a subsequent impact on compliance with provisions relating to committee memberships.

Indeed, the second most commonly overlooked provision relates to audit committee membership, where 25 FTSE 350 companies currently fail to meet independence requirements. FRC analysis shows that 95% met the minimum provisions for audit committee composition in both 2016 and 2015; but for small cap and fledgling companies the proportion is lower, rising from 93% in 2015 to reach 94% currently.

The FRC is critical of the way in which companies report such deviations from the code, saying that overall ‘too many explanations are of poor quality.’ Around a fifth of explanations were essentially repetitions of the code provision, the regulator says, and gave no information as to why this arrangement was considered acceptable.

The FRC also assessed companies’ response to the need to report a longer-term view of prospects in the form of a viability statement, as 2016 was the first full year of reporting against this new code provision.

The regulator developed criteria to assess the quality of reporting in a sample of viability statements from ten FTSE 350 sectors covering nearly 100 companies, but found very little variation in time horizon. Two thirds of companies picked three years and the remainder mostly opted for a five year horizon, although the FRC says it is aware of two companies outside its sample who assess risks over a 10 year period.

The report states: ‘The lack of variation between sectors was surprising. For example, there was little difference between mining and retail despite their different business cycles.

‘While there were some good explanations of why a three-year period was selected, there was a tendency to choose it as it matched the business planning/strategy period and this gave a greater level of assurance.

‘The FRC encourages companies to provide clearer disclosure of why the period of assessment selected is appropriate for the particular circumstances of the company.’

Of a total of 89 viability statements reviewed, half (43) were judged ‘satisfactory’ and 13 rated ‘comprehensive’, while 29 were ‘minimal’ and four were classed as ‘poor’.

Out of nine banks, only one scored ‘comprehensive’ in this regard, while six were ‘satisfactory’, and two ‘minimal’. The same number of non-life insurers were assessed, with none judged ‘comprehensive’ in viability reporting, three rated as ‘satisfactory’, five as ‘minimal’ and one was given a ‘poor’ rating.

In its analysis the FRC said there was room for improvement in explaining what qualifications and assumptions have been made and the quality of reporting of the principal risk linkages. More meaningful disclosures are also needed to understand how the underlying analysis was performed and what judgements the company made in arriving at its viability statement.

The report states: ‘While there may have been some reluctance in this first year to provide extensive information, it would now be helpful for shareholders to engage with companies to discuss what improvements they wish to see so to stem any criticism of future “boilerplate” reporting.’

On behalf of the FRC, McKinsey & Company interviewed 16 companies across a range of sectors about their approach to the preparation of the viability statement. This found modelling approaches varied: some companies were unwilling to model scenarios (as opposed to individual sensitivities), one-off catastrophic events, and mitigations. The level of engagement by management, the board, and its committees also varied, from treating it as a ‘box-ticking’ exercise to an integral part of the strategy development process.

The FRC says it is encouraging companies to share more detail on their modelling approach, and also highlights growing investor interest in more detailed reporting on risks in areas such as climate change and cyber security. In addition, the FRC’s Financial Reporting Lab will be launching a project in 2017 to look at best practice reporting in viability statements and disclosures of risk.

The FRC’s report includes analysis of the 2016 AGM season which showed generally reduced support for remuneration resolutions and concern about a lack of transparency in the link between executive pay and performance. It found that 12 FTSE 100 companies received less than 75% support for their remuneration policy and report resolutions last year.

However, there does not appear to be a correlation between significant votes against remuneration resolutions and the votes against the chair of the remuneration committee. The highest recorded vote against a FTSE 100 remuneration committee chair was 10.29%, but the average was around 2%. The FRC warns that this area is attracting increasing investor and government focus, and companies should be clear about how they report on remuneration arrangements.

Paul George, the FRC’s executive director of corporate governance and reporting, said: ‘The code is 25 years old. It has served the UK well by attracting capital and through evolving with the market and the needs of investors. We must continue to ensure that business behaviour, underpinned by strong and respected corporate governance principles, develops over the next quarter of a century and beyond.

‘The need to maintain the UK’s position as a centre of excellence for business and a destination of choice for global investors has never been more important. The FRC stands ready to revise the UK corporate governance code and associated guidance in 2017.’

The FRC report, Developments in Corporate Governance and Stewardship 2016, is here.

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