Corporate governance for large private companies

2018 saw the genesis of a new corporate governance code for UK private companies, in the wake of what the Financial Times (March 27, 2018) described as "lingering public resentment at those responsible for the 2008 financial crisis and more recent anger at the collapse of BHS and Carillion".  James Wates CBE (now Sir James Wates) took on the role of chair of a coalition of organisations tasked with drawing up a new corporate governance code for private companies.

At the launch of the draft Wates Corporate Governance Principles, the FRC stated:

"Private companies benefit from limited liability status but are not subject to the same reporting requirements and accountability as publicly listed companies. But just like public companies, if problems occur in large private companies they can affect a wide range of stakeholders including customers, the workforce, pensioners, suppliers and the community. Trust in business has been dented following several high-profile failures, and there is keen public interest in seeing companies operate with higher standards, greater transparency and accountability, and fair treatment of stakeholders."

The brief below explores the final Wates Principles and the Wates Report and considers how they assist large private companies with the corporate reporting changes introduced by The Companies (Miscellaneous Reporting) Regulations 2018.  The new requirements apply to company reporting for financial years ending on or after 31 December 2019.  

The Wates Principles are intended to help large private companies to meet their obligations under The Companies (Miscellaneous Reporting) Regulations 2018 (Regulations).

There are six Principles, relating to:

1. Purpose and leadership
2. Board composition
3. Director responsibilities
4. Opportunity and risk
5. Remuneration
6. Stakeholder relationships and engagement

Disclosure of Corporate Governance arrangements

The Wates Report explains the new requirements in the Regulations.  First, it notes that the Regulations require companies of a certain size to disclose their corporate governance arrangements.  This requirement applies to all companies that satisfy either or both of the following conditions:

• More than 2,000 employees; and/or
• A turnover of more than £200 million, and a balance sheet of more than £2 billion.

If a very large private company satisfies either or both of the conditions above for the financial year ending on 31 December 2019, then it must include a statement of corporate governance arrangements, in accordance with paragraph 26 of the Regulations:

26. (1) The directors’ report must include a statement (a “statement of corporate governance arrangements”) which states:

(a) which corporate governance code, if any, the company applied in the financial year,

(b) how the company applied any corporate governance code reported under sub-paragraph (a), and

(c) if the company departed from any corporate governance code reported under sub-paragraph (a), the respects in which it did so, and its reasons for so departing.

(2) If the company has not applied any corporate governance code for the financial year, the statement of corporate governance arrangements must explain the reasons for that decision and explain what arrangements for corporate governance were applied for that year.

Most private companies will not be large enough to meet the threshold(s) above and therefore be subject to the new corporate governance reporting requirement. However, any private company considering its corporate governance arrangements can choose to apply the Wates Principles.  Good corporate governance is something from which all companies can benefit.  

Other new reporting requirements introduced by the Regulations

In addition to the new requirement for very large private companies to include a corporate governance statement, some other relevant reporting requirements have been introduced.  These are also discussed in the Wates Report, which states: "…the Wates Principles offer companies an effective way of linking their corporate governance statement to the other reporting requirements.  Explanations of the application of the Wates Principles combined with and cross-referred to other reporting will together achieve an interest in transparency from large private companies and contribute to building trust".  It also notes that the FRC's Guidance on the Strategic Report can support companies in meeting these and other reporting requirements.

To summarise, the other new reporting requirements are as follows:

For a private company which does not qualify as medium-sized in relation to a financial year, its annual report for that financial year must contain the following:

1. Statement in the strategic report of how the directors have complied with their duty to have regard to the matters in section 172(1)(a) to(f) Companies Act 2006.  Section 172 sets out the directors' duty to promote the success of the company.  A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole.  In doing so, he must have regard to a non-exhaustive list of matters which are set out in sub-section (1) (a) to (f).  These are as follows:

a. The likely consequences of any decision in the long term,
b. The interests of the company's employees,
c. The need to foster the company's business relationships with suppliers, customers and others,
d. The impact of the company's operations on the community and the environment,
e. The desirability of the company maintaining a reputation for high standards of business conduct,
f. The need to act fairly as between members of the company.

The new requirement is therefore to report on the way in which the directors have had regard to these matters.

2. Statement in the directors' report summarising how the directors have had regard to the need to foster the company's business relationships with suppliers, customers and others, and the effect of that regard, including on the principal decisions taken by the company during the financial year.  This overlaps to a certain extent with the requirement above, but expands on it, because the requirement is not only to state how the directors have had regard to this matter, but also how that regard has impacted on key decisions taken by the board during the period.  This can be provided in the strategic report, rather than the directors' report, where the directors consider it to be of strategic importance to the company, and incorporated into the directors' report by cross-reference.

3. Additionally, if the company has more than 250 UK employees, it is required to include a statement as part of the directors' report summarising how the directors have engaged with employees, how they have had regard to employee interests and the effect of that regard, including on the principal decisions taken by the company in the financial year.  Again, this overlaps to a certain extent with the first requirement and also expands upon it in a similar fashion, requiring a statement of how the directors have engaged with the company's employees, and how the regard which they have had to employee interests has actually impacted on key decisions taken during the year.  Again, this can be provided in the strategic report, rather than the directors' report, where the directors consider it to be of strategic importance to the company.

What does the Wates Report say about reporting on the new requirements?

The Wates Report contains a useful section (on page 8) entitled "How to Report".  It states: "A company that adopts the Wates Principles should follow them using an 'apply and explain' approach in a way that is most appropriate for their particular organisation.  Accordingly, boards should apply each Principle by considering them individually within the context of the company's specific circumstances.  They should then be able to explain in their own words how they have addressed them in their governance practices."  And further on page 8: "By providing broad Principles with supporting Guidance, the intention of the Wates Principles is to move beyond a 'tick box' approach to describing and explaining how the implemented practices achieve the Principles and explain the outcomes."  There is also some useful guidance for subsidiary companies:

"Subsidiary companies meeting the tests set out in the Regulations are required to make a corporate governance statement. Directors of these companies are subject to section 172 like any other director, but it is recognised that parent companies may in some cases influence policies. For example, remuneration practices and policies may be set by the board of the parent company. In such cases, any explanation that demonstrates application of the Principles could refer to the parent company’s corporate governance statement, if that report explains the governance procedures of the subsidiary."

The Wates Principles

Principle One: 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.

Guidance on purpose, values and culture is set out on pages 11-12 of the Wates Report.  Practical steps to implement this might include:

• Defining the company's purpose, and documenting the steps taken to promote dialogue about the purpose with the workforce and wider stakeholders around the stated purpose, and being proactive to ensure that this takes place.
• Defining the values and culture that inform this. Values should be explained and integrated into the different functions and operations of the business.  Culture can be defined as a combination of the values, attitudes and behaviours manifested by the company in its operations and relationships with its stakeholders.  The board, shareholders and management must make and maintain a commitment to embedding the desired culture throughout the organisation.
• Monitoring the culture – effective ways of doing this include (but are not limited to) employee surveys, engagement with trade unions, absenteeism rates, exit interviews and board feedback sessions.

Principle Two: Board composition

Effective board composition requires an effective chair and a balance of skills, backgrounds, experience and knowledge, with individual directors having sufficient capacity to make a valuable contribution. The size of a board should be guided by the scale and complexity of the company.

Guidance is set out on pages 13-14 of the Wates Report.  Based on the guidance, reporting on this Principle might cover:

• The chair and how he or she fulfils their role of leading the board.
• The balance and diversity of the board – explaining how they have the appropriate combination of skills, backgrounds, experience and knowledge that promotes accountability and incorporates objective thought, which in turn provides constructive challenge.  Explain how the board collectively demonstrates a high level of understanding relevant to the company's business needs and stakeholder interests.
• How appointments to the board promote diversity.
• The company's policy on diversity and inclusion.

With regard to effectiveness, there is guidance on how the directors may maintain objectivity in complex situations, particularly where there is an influential shareholder.  Reporting could for example cover how the company "demonstrate[s] a commitment to the ongoing professional development of the board".  Further, there should be reporting on how directors embrace such opportunities and ensure that they have sufficient time to discharge their duties.  

Principle Three: Director responsibilities

The board and individual directors should have a clear understanding of their accountability and responsibilities. The board's policies and procedures should support effective decision-making and independent challenge.

Guidance on this appears on pages 15-16 of the Wates Report.   Based on the guidance, reporting on this might cover:

• The policies and practices that govern the internal affairs of the company – these may include matters relating to the authority, accountability, role and conduct of directors; any conflicts of interest and how these are to be managed.
• How the chair and the company secretary periodically review the governance processes to confirm that they remain fit for purpose and consider any initiatives which could strengthen the governance of the company.

The guidance states that transparent corporate governance policies and practices can clarify the relationship between the company and its owners, including that of a parent company and its subsidiary, in order to deliver long-term success.

There is also guidance on the use of committees; and on the integrity of information.

Principle Four: Opportunity and risk

A board should promote the long-term sustainable success of the company by identifying opportunities to create and preserve value, and establishing oversight for the identification and mitigation of risks.

Guidance on this Principle is set out on pages 17-18.  Based on the guidance, reporting on this Principle might cover:

• The board's assessment of how the company creates and preserves value over the long-term, including both tangible and intangible sources of value, and the stakeholders that contribute to it.  This should include processes for the identification of future opportunities for innovation and entrepreneurship.
• Risk management, including reputational risk.

Principle Five: Remuneration

A board should promote executive remuneration structures aligned to the long-term sustainable success of a company, taking into account pay and conditions elsewhere in the company.

Guidance on this Principle appears on pages 19-20 of the Wates Report. Reporting on this Principle might cover:

• How the company ensures that remuneration for directors and senior managers is aligned with performance, behaviours, and the achievement of company purpose, values and strategy.  In setting director remuneration, consideration should be given to remuneration throughout the organisation to reinforce a sense of shared purpose.
• The board's policies on remuneration structures and practices, which should take account of the broader operating context, including the pay and conditions of the wider workforce and the company's response to matters such as the gender pay gap.
• If director pay is controlled by a parent company, the company should explain this and cross-refer to information elsewhere which explains the policy in relation to the subsidiary.

Principle Six: Stakeholder relationships and engagement

Directors should foster effective stakeholder relationships aligned to the company's purpose. The board is responsible for overseeing meaningful engagement with stakeholders, including the workforce, and having regard to their views when taking decisions.

Pages 21-22 of the Wates Report set out guidance on this Principle. Based on the guidance, reporting on this Principle might cover:

• How the company is a sustainable business which benefits wider society, as well as creating and sustaining long-term value for shareholders/stakeholders.  This could include consideration of how the company's activities impact both current and future stakeholders, which could, for example, include impacts on the environment.
• How the company carries on dialogue with stakeholders, such as the workforce, customers and suppliers and also other material stakeholders specific to the company, such as regulators, Governments, pensioners, creditors or community groups.
• A fair, balanced and understandable assessment of the company's position and prospects, on an annual basis.
• The channels to receive appropriate feedback from stakeholders.
• The formal and informal channels that enable them to engage in meaningful two-way dialogue with the workforce.  Workforce policies and practices should be aligned with the company's purpose and values.
• How the board demonstrates that the company has undertaken effective engagement with material stakeholders and how such dialogue has been considered in its decision-making.

Conclusion

The Wates Principles represent a serious and thoughtful attempt to implement steps that might increase the public's confidence in business.  This "…can only be achieved if companies think seriously about why they exist, how they deliver on their purpose, and then explain – in their own words – how they go about implementing the Wates Principles. That is the sort of transparency that can build the trust of stakeholders and the general public." (From the Foreword to the Principles, by Sir James Wates). It will be interesting to see whether large private companies will indeed use the Principles to "look themselves in the mirror", as Sir James hopes.  However, commentators have pointed out that it is unclear how the new corporate governance requirements or the Principles will be policed.  And if challenging market conditions turn the steady flow of companies going bust into a torrent (and the Centre for Retail Research lists 34 so far in 2019), then public confidence may ebb away further, irrespective of uptake of the Principles.