FRC consults on Stewardship Code

March 28, 2019

The Financial Reporting Council (FRC) has published a consultation paper on a new Stewardship Code that sets substantially higher expectations for investor stewardship policy and practice.  The proposed changes call for higher transparency regarding institutional investors’ stewardship activities and encourages more engagement with companies.  The proposed changes have significant potential consequences for investment organisations and the companies in which they invest.

What is happening?

Under the proposed changes, all signatories of the Code would be required to make public disclosures about their stewardship activities.  This could address current concerns about investors’ inadequate engagement with the companies they own.  Although we currently have several corporate governance codes which require companies to engage with shareholders, they place no such obligation on investors.

Other key proposed changes include requiring signatories to establish an organisational purpose, strategy, values and culture.  This aligns the draft 2019 Code with the UK Corporate Governance Code, which it is designed to complement.   The draft Code also makes explicit reference to environmental, social and governance (ESG) factors.  Signatories are expected to take into account material ESG factors, including climate change, when fulfilling their stewardship responsibilities.

All signatories would be required to make public disclosures about their stewardship activities and their assessment of how effectively they have achieved their stated objectives.  Reporting would be in two parts: a Policy and Practice Statement upon signing the Code and an annual Activities and Outcomes Report.

Shareholder Rights Directive

The FCA is also undergoing a consultation, proposing regulatory measures to implement the provisions of the amended Shareholder Rights Directive (“SRD II”).  The Directive comes into effect in June 2019 and, assuming a transition period for EU Withdrawal is agreed, will need to be transposed in the UK.

SRD II also aims to improve the effectiveness of stewardship and long-term decision-making in listed companies.  It will do this chiefly by improving the transmission of information in the investment process; therefore, major business impacts on listed companies, institutional investors and intermediaries are expected.  Through increasing transparency and awareness, the SRD II hopes to shed light on the extent to which investors fulfil their responsibility as stewards, of both the companies they hold shares in and the assets they manage for their clients.

Tasked by SRD II, the European commission has published draft guidelines which recommend a standardised presentation of remuneration reports, subject to consultation until 21 March 2019.  We have summarised the key points in the guidelines:

• Introduction – a general overview (key events, changes in directors, changes in policy or its application) followed by more details on the performance and business environment and major decisions on remuneration and, where applicable, how the vote or views of shareholders on the previous report were taken into account.

• Remuneration – reporting each component, divided into fixed, one-year variable and multi-year variable pay

• Performance metrics and outcomes – for variable pay plans, including minimum and maximum targets, actual performance and how any discretion was applied.

• Share-based remuneration – share-based remuneration tables.

• Malus and clawback provisions

• Comparison of annual change in each director’s remuneration with company performance and average employee remuneration over five years

• Response to AGM voting – how the vote at the previous general meeting was taken into account.

Joint discussion paper

As you may have expected, the FRC and the FCA have teamed-up to tackle the issue of stewardship, publishing a discussion paper on ‘Building an effective regulatory framework for stewardship’.  The paper aims to advance the discussion about what effective stewardship should look like, expectations for financial services firms, and how this can be best supported by the UK’s regulatory framework.  The paper notes that some benefits of effective stewardship – eg higher long-term investment returns – accrue not only to the firm that incurs the cost of exercising stewardship, but also to all other investors.  As such, some investors may not exercise stewardship as fully as they otherwise might and instead ‘free-ride’ on the stewardship of others.

The FRC’s proposed Stewardship Code aims to both increase the expectations set by SRD II and expand its scope.  The ‘new rules that are due to come into effect under SRD II intend to enhance transparency about how equity investors exercise stewardship and “raise the bar” for stewardship across the market.  However, we are considering whether the UK regulatory framework should aspire to go further than the provisions of SRD II’.

Beyond the EU

The EU is not alone in taking steps to improve stewardship.  In November, the US Securities and Exchange Commission (SEC) held a roundtable addressing whether the capital markets system can be improved – in context of the principal/agent problem and investor participation.  The three topics for discussion were the proxy voting process, shareholder proposals and proxy advisory firms.

Why should remuneration committees be interested in the proposals?

The consultations currently taking place have significant implications for remuneration committees.  Under the FRC’s proposed changes, signatory fund managers would be urged to look harder at whether companies fit their investment strategies.  Remuneration structures and performance targets play a large role in this.  Further, they would be required to take a more active approach in engaging with and influencing committees.

Committees should also take note of the proposed Stewardship Code’s focus on ESG issues.  In December, Shell announced that they will be linking executive pay and carbon emissions, becoming the first energy company to do so.  If investors are required to take ESG factors into account, we will likely see more and more companies linking ESG criteria to executive pay in the future.

The steps taken under SRD II to increase transparency and awareness will have a similar effect, but remember that the requirements under SRD II are compulsory for listed companies and asset managers in the EU (whereas the FRC’s Stewardship Code is voluntary).  Remuneration committee members should be paying particular attention to the European Commission’s remuneration report guidelines.

What they should be doing in response?

Remuneration committees have a responsibility to communicate with investors.  Some committees may find it difficult to engage with their investors; some of the more common complaints we have heard include failures to respond (either at all or in a timely fashion) and the use of proxy advisors, who are more remote from the company.  The proposed changes discussed in this article have the power to change this – hopefully, committees will have provided input to the consultations in order to get the best outcome.  They should also be prepared to take advantage of any changes, if and when they come into effect.

MM&K are experts in advising remuneration committees on a range of issues surrounding corporate governance, regulatory and disclosure requirements.  We have a wealth of experience helping committees communicate with investors.  For queries and further information, please contact Paul Norris or Damien Knight.

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