Governance Code Reform
Changes to Watch Around the Globe
One challenge in following governance changes is that they are not globally the same. Our national philosophies about governance affect how we set our structures, regulations and compliance conditions. Based on our research, we recognize five main philosophies.
Checks and Balances - belief that distributing power will avoid abuse
Behavior -define clear ethics, moral rules and hire with
integrity
Market Discipline - the market pressure improves governance
Rules and Processes - apply strong rules/processes,monitor them
Marketing Ordering - let the market sector fix it and governance will
improve, e.g., overall the banks by banking
self-regulation
To our point, consider the shifts in approach before and after the financial crisis. Before the crisis, the orientation of economists and the European Tabaksblat Commission emphasized checks and balances and market discipline.
In reaction to the crisis, dramatic shifts occurred toward emphasis on rules, market ordering and behaviors.
Countries started experiments, based on beliefs about what would improve governance. The Netherlands shifted from market to norms and behaviors. The UK focused on checks and balances, processes and KPIs. The US shifted from checks and balances to rules and processes, which China began a shift from state owned enterprises to public entities, while struggling with related party transactions and a lack of checks and balances.
In truth, we don’t know what will significantly improve governance. Nonetheless, experiments help us learn and we are committed to studying results over time to discover what best practices emerge.
Among the latest trends is governance code reform, based on national conditions and philosophy about which practices to adopt or uphold. Here are examples of what is underway.
The United Kingdom implemented governance reforms that started on January 1, 2019 and will require reports in 2020 based on actions from this year. The reforms include deeper accountability and broader sweep of those accountable. For example:
- The reform widens the purpose of governance from facilitating effective entrepreneurial and prudent management to now include issues of social justice, one of which is pay reform. The government requires public companies with more than 250 UK employees and listed on the stock exchange to report annually the ration of CEO pay to the median pay, 25th and 75th percentile to their UK workforce, along with narrative explaining changes to that ratio annually, to first be reported in 2020.
- Administration of the code will be changing as well. Historically, the code is administered by the Financial Reporting Council (FRC), which also is responsible for the Stewardship Code, regulation of auditors, accountants and actuaries and for a wide range of other company-related regulatory activities. The government plans to replace the FRC with an independent statutory regulator with stronger power.
- Focus for improvements include: a) helping boards better account of stakeholder views with guidance about board’s duties to both consider stakeholder views and to incorporate their interests in discussion and decision-making, b) linking executive compensation with performance, and c) extending regulatory enforcement to ensure disciplinary action will be taken against directors in instances of financial reporting breaches.
- Employees can designate an existing non-executive director (already on the board), a workforce advisory committee, or a workforce representative on the board.
- Large private companies are now required to conform to six principles in the reform codes. Large private companies are to adopt principles on an “apply and explain” basis that address standards expected related to: purpose and leadership, board composition, director responsibilities, opportunity and risk, remuneration and stakeholder relationships and engagement.
In addition, guidance on board effectiveness has been updated to emphasize that boards’ duties to improve their effectiveness— not just their compliance. Meanwhile the voluntary principle of “comply or explain” is itself being tested as the Kingman Review reconsiders the Financial Reporting Council’s powers and its twin role as both the government-designated regulator and the custodian of a voluntary code. Proxy advisors, who are growing more powerful, are also frequently voting against firms choosing to “explain” rather than comply.
Earlier this year, the Investor Stewardship Group (ISG) instituted the Corporate Governance Principles, intending to set consistent governance standards for the US market. Version 2.0 of the Commonsense Principles of Corporate Governance was also published. US companies will now best consider proactive disclosure of how they comply with these sets of principles. These principles are “comply or explain” expectations, which is a shift from the “comply or else” efforts such as the Sarbanes-Oxley Act.
Discussions in Canada are underway to investigate a shift from principal-based governance to a more regulatory-based approach. The history of values-based approaches are not producing desired results in key governance topics, such as diversity. To move the dial, Canada has instituted a new definition of diversity and goals to achieve.
Changes in the EU differ in focus. Denmark’s code now recommends that remuneration policies be approved at least every four years and bars retiring CEOs from stepping into the chairman or vice chairman role. Compliance rates for the German Corporate Governance Code appear strong, except for executive remuneration and board composition recommendations. Investor engagement and pressure on these matters is likely, including calls for enhanced disclosure. Next year, the German code may include amendments regarding director independence and executive compensation. Revisions to the Netherland’s governance code address long-term value creation and culture as key factors within the governance framework.
Brazil is working to reconstruct compliance practices and address governance reforms. Securities regulator, CVM, issued new guidelines about indemnity agreements between companies and board members and other company stakeholders. The guidance cautions companies about potential conflicts of interest, and warns directors to pay close attention to these new policies. Brazilian public companies must now file a comply-or-explain governance report as a disclosure requirement. Stewardship is a key topic among directors; e.g., the Association of Capital Market Investors is actively asking CVM and key influencers to hold companies fully accountable to set governance standards.
India is pushing for regulatory reform, in hopes it will compel global investors and stem corruption. In 2018, the Securities and Exchange Board of India (SEBI) adopted provisions put forward by the Kotak Committee, which emphasize improvements in transparency and financial reporting. The schedule for reforms is staggered, with compliance dates between now and April, 2020.
The Japanese government is pushing corporate governance improvements, with policymakers’ focus on improving board accountability. Regulatory bodies, including the Financial Services Agency, continues to lead reforms, with several new comply-or-explain guidelines added to the Amended Corporate Governance Code, implemented in 2018. These guidelines focus on transparency related to minimum independence requirements, established objective CEO succession and dismissal process, and the elimination of cross-shareholdings.
It’s wise to pay attention to these code reform changes underway in specific regions. Preparing for changes and compliance will be different based on where you conduct business. Time will tell which reforms produce valuable results.
-------------------------------
References
Russell Reynolds Associates 2019 Global & Regional Corporate Governance Trends
Source: Frijns 2009
2019 ISGframework
ParlimentUK House of Commons Library #8143 1/2019
For more information about best practices in governance, contact us to learn more about our Global Governance support.
