Listed companies have long been used to reporting against a corporate governance code. Since the publication of the Cadbury Report in 1992, listed companies have had to “comply or explain” against an evolving code of best practice. This sort of compliance is now accepted as the norm, where companies accept that they should comply with (rather than explain against) the current version of the UK Corporate Governance Code, except in exceptional circumstances.
Large private companies will now be expected to do the same. Companies over a certain size will be required to “apply and explain” a code of corporate governance for the first time – although the new rules do not specify which code. The Wates Corporate Governance Principles for Large Private Companies (the Wates Principles) published in December 2018 will therefore be welcomed by private companies subject to the new regime. It provides a principles-based code which is flexible enough to be adopted by a wide range of private businesses. We therefore expect that a large proportion of the c.1,700 companies which will be subject to the reporting requirement for the first time will adopt the Wates Principles.
What is less clear is whether we will see the market-practice of compliance with corporate governance codes develop among private businesses in the way that listed companies stepped into line after being forced to comply or explain. Private businesses are not accountable to public investors in the way listed companies are, nor are they under the same regulatory scrutiny. Without the same threat of embarrassing public rejection at AGMs, fall in share price or regulatory action, will the new rules change the governance of private businesses?
A new regime for private companies
All large qualifying companies will be required to include a statement of their corporate governance arrangements when reporting on their financial years starting on or after 1 January 2019.
Which companies qualify?
If a company satisfies either or both of the following requirements in a year, it will qualify under the new rules:
• if it has more than 2,000 employees;
• if it has:
– a turnover of more than £200 million; and
– a balance sheet total of more than £2 billion.
There are exemptions for companies which are already reporting their corporate governance statement and for charitable companies.
What is the reporting requirement for qualifying companies?
The directors’ report must include a statement (a “statement of corporate governance arrangements”) which states:
• which corporate governance code, if any, the company applied in the financial year;
• how the company applied such corporate governance code; and
• if the company departed from such corporate governance code, the respects in which it did so, and its reasons for so departing.
If the company has not applied any corporate governance code for the financial year, it must explain the reasons for that decision and explain what arrangements for corporate governance were applied for that year.
The Wates Principles
The Wates Principles were prepared at the request of the Government by a coalition of partners, chaired by James Wates CBE and with secretariat support from the Financial Reporting Council. They introduce six principles of good corporate governance that the coalition believes offer “sufficient flexibility for a diverse range of companies to explain the application and relevance of their corporate governance arrangements, without being unduly prescriptive”.
The principles focus on the following six categories:
1. Purpose and leadership: An effective board develops and promotes the purpose of a company, and ensures that its values, strategy and culture align with that purpose.
2. Board composition: Effective board composition requires an effective chair and a balance of skills, backgrounds, experience and knowledge.
3. Director responsibilities: The board and individual directors should have a clear understanding of their accountability and responsibilities.
4. Opportunity and risk: A board should promote the long-term sustainable success of the company, and establish oversight for the identification and mitigation of risks.
5. Remuneration: A board should promote executive remuneration structures aligned to the long-term sustainable success of a company.
6. Stakeholder relationships and engagement: Directors should foster effective stakeholder relationships aligned to the company’s purpose.
Guidance supports the above principles, although it is not prescriptive as to how to apply the principles.
Business as usual or new challenges?
Given the non-prescriptive approach taken, do the Wates Principles offer anything new to the many successful companies that have long understood the value creation of good governance? We think so. The Wates Principles offer a thoughtful approach to corporate governance, rather than presenting a “box-ticking” exercise. They therefore encourage the qualifying companies – including those that already run their businesses in a way that aligns the Wates Principles – to reflect on which aspects of governance works well for them and which they could work on. For these companies, the manner of reporting their approach to corporate governance will be the new challenge, and companies will be looking to early reporters to see how best to tackle this.
The more pertinent question is whether this flexible approach will change the behaviours of, or hold to account, companies (and their directors and shareholders) which have operated without regard to principles of good governance – often at the expense on their wider stakeholders. It is not yet clear who will hold the companies to account under this new regime. For listed companies, there is investor pressure to keep them in line. The same cannot be said for private companies, especially where there is a single or small group of shareholders who may have their own interests alone at heart. However, even those companies will find it difficult to resist change:
• Companies will have to report their approach publicly. The coalition is also considering a “name and fame” approach to praise good governance. It will therefore be visible to stakeholders if companies are not taking corporate governance seriously. This could have a negative impact on relationships with stakeholders which could in turn go to value (e.g. a less productive workforce, loss of customers). Even if there is no regulatory sanction for poor corporate governance, stakeholder pressure could lead to behavioural change.
• By being forced to report on how they have adopted a code, the board will be forced to reflect on their approach to governance. Even if no immediate changes are adopted, this process may encourage boards to challenge and question the status quo.
• The Wates Principles will encourage boards to reflect on the systems and controls they have in place. Although this will not prevent corporate failures and scandals, it may help companies to put in place processes to alert early warning signals.
Time will tell if large private companies will embrace the challenges of greater accountability to stakeholders that legislation has placed on them. However, companies will ignore their responsibilities at their peril. The governance of large companies has been high on the political agenda for Government. A more rigorous approach could be legislated for if companies are not seen to be taking their responsibilities seriously.
Smaller private companies
Smaller private companies are also likely to benefit from adopting some or all of the Wates Principles.
• The flexible approach allows the principles to be applied to a wide range of companies, without stifling smaller and more entrepreneurial businesses.
• Directors of all companies have a duty to promote the success of the company, having regard to a wide range of stakeholders and the impact of its operations on the community and environment. The Wates Principles provide a useful framework to allow directors to ask themselves whether they are satisfying this duty.
• The Wates Principles are about ensuring long term and sustainable value creation – something that may particularly resonate with family-owned businesses which look to preserve value through generations.
• Good governance puts in place processes and frameworks to protect a business. In this fast-paced world full of risks (from cyber-attacks to time-critical reputational matters) and enhanced regulations, clear lines of authority and risk management are critical to protect a business.
Good corporate governance does not alone create a successful and profitable business, nor does it prevent corporate failures. We see listed companies with good corporate governance track records fail. But good governance puts in place systems and frameworks for companies to react quickly to opportunities and crises. It protects your business, your directors and your stakeholders. Done well, good governance will set you apart from your competitors. Can you afford not to take it seriously?
If you require further information about anything covered in this briefing note, please contact Marie Bates, or your usual contact at the firm on +44 (0)20 3375 7000.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.