The importance of Corporate governance in the United Kingdom has undergone significant evolution and refinement, especially in recent years. The UK Corporate Governance Code, which sets the standards of good practice in relation to board leadership and effectiveness, remuneration, accountability, and relations with shareholders, is a testament to the UK’s commitment to maintaining the highest standards of corporate governance.
The 2018 Corporate Governance Code was updated in January 2024, following a limited consultation that focused on a number of changes. This updated 2024 Code, which applies to financial years beginning on or after 1 January 2025, reflects the UK’s adaptive approach to corporate governance, ensuring that the framework remains relevant and continues to foster an environment of trust, transparency, and accountability.
The 2024 Code is separated into five sections: Board Leadership and Company Purpose; Division of Responsibilities; Composition, Succession and Evaluation; Audit, Risk and Internal Control; and Remuneration, and it operates on a ‘comply or explain’ basis. This edition of the Code includes a small number of changes from the 2018 Code. Provision 29 now asks boards to make a declaration in relation to the effectiveness of their material internal controls. A new Principle has been included to encourage companies to report on outcomes and activities. A number of provisions have been removed related to Audit Committees as these provisions are now within the Audit Committees and the External Audit: Minimum Standard.
One of the key aspects of the UK’s corporate governance model is the ‘comply or explain’ approach. This principle requires companies to either comply with the code or explain why they have not, which allows for flexibility and acknowledges that there may be legitimate reasons for non-compliance in certain circumstances. This approach has been influential and is considered a hallmark of the UK’s corporate governance system.
The Financial Reporting Council (FRC) plays a pivotal role in maintaining and updating the UK Corporate Governance Code. The FRC’s efforts to strengthen the code, particularly in response to the government’s consultation on Restoring Trust in Audit and Corporate Governance in 2022, demonstrate a proactive stance in enhancing the quality of risk management, internal controls, and the board’s consideration of corporate governance activities to achieve strategic objectives.
The latest revisions to the code include a new principle encouraging companies to report on outcomes and activities, and a provision asking boards to make a declaration regarding the effectiveness of their material internal controls. These changes underscore the importance of not just having a set of rules but also ensuring that these rules lead to tangible outcomes that enhance corporate governance practices.
Corporate governance is not just a concern for large, publicly traded companies; it is relevant for all businesses. While the UK Corporate Governance Code is specifically applicable to companies with a premium listing on the London Stock Exchange, many other companies choose to follow the code voluntarily. Moreover, large private companies are required to disclose their corporate governance arrangements under The Companies (Miscellaneous Reporting) Regulations 2018.
The focus on the importance of corporate governance in the UK reflects a broader global trend towards greater transparency, accountability, and sustainability in business practices. As companies face increasing scrutiny from investors, regulators, and the public, the UK’s corporate governance framework serves as a model for balancing the interests of various stakeholders and ensuring long-term, sustainable success.
For more detailed information on the UK Corporate Governance Code and its application, readers can refer to the resources provided by the FRC. The evolution of corporate governance in the UK is a clear indicator of the country’s dedication to fostering robust business practices that not only promote financial stability but also contribute to more inclusive societies.
The UK Corporate Governance Code serves as a benchmark for corporate governance standards in the UK, emphasizing the importance of good practices in board leadership and company purpose, division of responsibilities, composition, succession and evaluation, audit, risk and internal control, and remuneration. The Code operates on a ‘comply or explain’ basis, which allows companies the flexibility to deviate from the Code’s provisions, provided they offer a transparent explanation for doing so.
Key principles of the UK Corporate Governance Code
- Board Leadership and Company Purpose: The board should promote the purpose of the company, ensure that the company’s values and strategy are aligned with its culture, and meet its responsibilities to shareholders and stakeholders alike.
- Division of Responsibilities: There should be a clear division of responsibilities at the head of the company, ensuring a balance of authority and no individual has unfettered powers.
- Composition, Succession, and Evaluation: Boards should be composed of an effective combination of skills, experience, independence, and knowledge of the company to enable them to discharge their duties and responsibilities effectively.
- Audit, Risk, and Internal Control: The board should present a fair, balanced, and understandable assessment of the company’s position and prospects and maintain a sound system of risk management and internal control.
- Remuneration: Executive remuneration should be aligned to the long-term success of the company and its values, and should be designed to promote effective risk management.
These principles are designed to foster trust and transparency between companies and their stakeholders, ensuring the long-term sustainability and success of businesses within the UK’s market economy. For a more comprehensive understanding of the Code and its provisions, the Financial Reporting Council’s official documentation provides detailed guidance.
The ‘comply or explain’ approach is a cornerstone of the UK Corporate Governance Code, offering flexibility and promoting transparency in how companies apply the principles of the code. This approach allows companies to either adhere to the code’s provisions or, if they do not, to provide a clear explanation for their non-compliance.
How companies typically comply with the code
This is how companies typically comply with the code:
- Adherence to Provisions: Companies start by striving to comply with the provisions of the code as closely as possible. This involves aligning their corporate governance practices with the recommendations set out in the code.
- Disclosure: If a company chooses not to follow a specific provision, it must disclose this fact in its annual report and accounts. The disclosure is not merely a statement of non-compliance but should include a reasoned explanation.
- Explanation of Non-Compliance: The explanation should provide shareholders with a clear understanding of why the company has chosen a different path. This might include describing the context, the specific circumstances of the company, and how alternative measures are consistent with the overarching principles of the code.
- Engagement with Shareholders: Companies often engage with their shareholders to discuss governance arrangements, especially when deviating from the code’s provisions. This engagement is crucial for maintaining shareholder trust and support.
- Review and Monitoring: Companies regularly review their governance practices against the code’s provisions. This ongoing process helps ensure that their practices remain appropriate and effective over time.
- Reporting Outcomes: The updated 2024 Code encourages companies to report on outcomes and activities, which means that companies are expected to provide insights into how their governance practices have impacted their performance and strategy.
The ‘comply or explain’ approach is not about rigidly following rules but about ensuring that companies have governance frameworks that are most effective for their particular circumstances. It recognizes that one size does not fit all and that companies can be successful with different governance models, provided they are transparent about their practices and the reasons for any deviations from the standard code.
For more detailed insights into how companies apply the ‘comply or explain’ approach, the Financial Reporting Council’s website offers a wealth of information and guidance.
Example
An ‘explain’ statement is a key feature of the UK Corporate Governance Code’s ‘comply or explain’ approach. It allows a company to articulate its reasons for deviating from a specific provision of the Code. Here is a hypothetical example of what such a statement might look like:
To our shareholders,
In accordance with the UK Corporate Governance Code, we present our ‘explain’ statement concerning our deviation from Provision 18, which relates to the composition of the Audit Committee.
As per the Code, the Audit Committee should comprise at least three independent non-executive directors. However, our company has appointed only two independent non-executive directors to this committee during the reported period.
The decision to operate with a smaller Audit Committee was made in the context of our company’s current stage of development and the specific challenges we faced over the past year. Given the specialized nature of our industry and the scarcity of individuals with the requisite expertise, we found it challenging to recruit additional directors who met the independence criteria without compromising the necessary industry experience.
We believe that the current members of the Audit Committee possess a deep understanding of the sector and the complex financial mechanisms relevant to our business. Their expertise has been invaluable in navigating the intricate issues we encountered, which were exacerbated by the unique economic pressures of the past year.
We have taken measures to mitigate the risks associated with having fewer members on the Audit Committee. These include the implementation of additional oversight mechanisms and the engagement of external advisors to assist the committee in its duties.
Our commitment to good corporate governance remains steadfast, and we continue to seek qualified candidates to expand the Audit Committee. We anticipate resolving this deviation from the Code’s provisions in the upcoming financial year.
We appreciate our shareholders’ understanding and are open to engaging further on this matter.
This example illustrates how a company might explain its reasons for not complying with a particular provision of the Code. The statement provides context, justifies the company’s decision, outlines the mitigating actions taken, and indicates a commitment to aligning with the Code’s provisions in the future. It’s important to note that each ‘explain’ statement will be unique to the company’s circumstances and should be crafted to provide shareholders with a clear and comprehensive understanding of the situation.
Importance of Corporate Governance and the Shareholders’ Response
Shareholders’ responses to ‘explain’ statements in the context of the UK Corporate Governance Code can vary, but they generally expect clear and rational explanations for any deviations from the code. The ‘comply or explain’ approach is designed to foster an environment of transparency and accountability, allowing shareholders to understand the reasons behind a company’s governance choices.
When a company provides an ‘explain’ statement, shareholders typically:
- Evaluate the Explanation: Shareholders assess the explanation provided to determine if it is reasonable and justifiable given the company’s specific circumstances.
- Engage in Constructive Dialogue: Investors may engage in discussions with the company to better understand their governance practices and the rationale behind not complying with certain provisions of the code
- Consider Company’s Individual Circumstances: Shareholders and their advisors are encouraged to consider the company’s unique situation when evaluating ‘explain’ statements, rather than adopting a one-size-fits-all approach to corporate governance.
- Exercise Voting Rights: Shareholders may use their voting rights at annual general meetings to express their approval or disapproval of the company’s governance practices.
- Seek Additional Information: If the explanation is not satisfactory, shareholders may request further information or clarification from the company’s board.
- Monitor Company’s Performance: Shareholders often monitor the company’s performance to ensure that the alternative governance arrangements are effective and do not adversely affect the company’s long-term success.
- Use Stewardship Code as a Guide: In line with the UK Stewardship Code, investors should engage constructively and discuss any departures from recommended practice with the company.
It’s important to note that while some investors may accept well-reasoned explanations, others may view deviations from the code more critically, especially if they believe it could negatively impact the company’s performance or governance standards. In some cases, persistent non-compliance without satisfactory explanations can lead to shareholder activism or a loss of investor confidence.
Ultimately, the effectiveness of the ‘comply or explain’ approach hinges on the quality of the explanations provided and the active engagement of shareholders in the governance process. Companies are encouraged to be as transparent and detailed as possible in their explanations to maintain trust and support from their investors.
If you require advice on corporate governance, contact one of the Ashbrooke team.
