In the post-Lehman era a crisis has developed in the UK’s corporate governance regime. The crisis is widespread – stretching from the banks, where the Prudential Regulation Authority is seeking to make senior bankers more accountable, and potentially criminally liable if a bank fails, to companies such as Tesco and the ongoing investigation into its accounting irregularities – and is something of which every company director needs to be aware.
Keeping the Code
In the last six years an increasing level of accountability has been placed on those in charge of companies in the UK, which has been cemented more recently with the latest set of amendments to the UK Corporate Governance Code (the 2014 Code). The issues surrounding the banks and Tesco just go to prove why such safeguards are necessary and, arguably, should have been put in place sooner.
The most significant changes in the 2014 Code relate to executive remuneration and the assessment and reporting of going concern and ongoing viability and risk.
Risk and going concern
Companies have long been required to adopt the ‘going concern’ basis of accounting, meaning the directors must form the view that the business will be able to continue as a going concern for at least the next 12 months. One question that was asked repeatedly during the financial crisis was how could a company that had not reported any issues in their last set of financial results suddenly find itself in severe financial difficulties?
The 2014 Code now provides that:
- Directors must confirm in their annual report that they have carried out a robust assessment of the principal risks affecting the company’s business model, future performance, solvency or liquidity.
- Directors should monitor the company’s risk management and internal control systems on a continuing basis in addition to the existing requirement to review their effectiveness at least annually and report on that review in the annual report.
- Directors should make a longer term viability statement in the annual report. This should state whether the directors have a reasonable expectation that the company will be able to continue in operation and meet its liabilities as they fall due, drawing attention to any qualifications or assumptions as necessary.
In practice, sound risk management and internal control systems will need to be put in place well in advance of finalising the financial statements in order to meet the original rationale of the recommendations, namely that a company is managed to avoid distress whilst taking well judged risks.
Since the global crisis of 2008 the focus has been on ensuring that remuneration structures do not reward excessive risk-taking or short-term behaviour at the expense of longer term interests. Under the 2014 Code, pay should now be designed to promote the long-term success of the company. There is also a specific requirement to include provisions that would enable performance adjustment or post-vesting clawback in performance-related pay schemes. The impact of such provisions could be significant to the motivation of executives where remuneration may be recovered long after payment.
Who is affected?
Only companies with a premium listing of shares on the London Stock Exchange are required to comply with the 2014 Code but many smaller quoted companies, including those listed on AIM, choose to comply in order to attract greater investment. There is nothing to stop smaller, private companies from adopting the key principles outlined in the Code and many may well benefit from doing so. Such advantages would, however, need to be carefully balanced against any associated increase in administration or cost.
Where will it end?
Whilst an increased level of accountability for directors and a direct correlation between the financial performance of the company and executive remuneration makes sense, it remains to be seen what the impact of this will be on an organisation’s ability to attract high calibre candidates. There are, currently, no criminal sanctions for failure to comply with the Code but, given the recommendations by both the Prudential Regulation Authority and the government of criminal sanctions for bankers guilty of ‘reckless misconduct’, are we just one financial collapse away from such a regime for all company directors?