The reach of The Combined Code on Corporate Governance

The Financial Reporting Council (FRC) may be the custodian of the Code but compliance is a matter for the Listing Rules Produced by the Financial Services Authority, these Rules regulate companies with a full listing on the London Stock Exchange.

The Code does not apply to:

companies whose shares are traded on AIM or other markets not covered by the Listing Rules;
a listed company incorporated outside the UK (though such companies do have a lesser reporting obligation).
There is, though, nothing to stop such companies complying with the Code if they choose to do so. Shareholder pressure, or simply a wish to conform with “best practice”, may lead many “exempt” companies to follow some or all of the Code’s recommendations. Most of the Code’s principles, if not all the detailed provisions, provide a sound basis for the governance of many companies.

Indeed, the Code’s reach increasingly extends beyond its immediate “target group”. The Code has been the impetus for the development of a more formalised approach to governance in other sectors. Universities have produced their own governance code; public sector bodies have guidance from the Independent Commission on Good Governance in Public Services. And mutual life companies are expected to follow guidelines on governance produced in the wake of the Equitable Life inquiry.

The Code and the annual report
The Code is divided into “main principles”, “supporting principles” and “provisions”. The main principles are general statements of corporate life, which, at times, come close to motherhood and apple pie in their level of general acceptability. The first, for example, states: “Every company should be headed by an effective board, which is collectively responsible for the success of the company”. Supporting principles expand on the main principles and give more guidance. But it is the Code’s provisions that state the detailed requirements necessary, in the view of the Code’s authors, to make sure the principles are upheld.

The Listing Rules seek to give the principles and provisions some force by placing two requirements on UK listed companies:

the annual report and accounts must contain a statement explaining how the company has applied the main and supporting principles. (It is taken for granted that the principles are accepted; the only room for debate is over how they are applied.)
the report and accounts must state whether the company has complied with the provisions throughout the year covered by the report. If the company has not complied with all of the provisions, or if it has complied with them for only part of the year, the departures must be listed and reasons for the non-compliance given.
The comply or explain rule
This brings us to a key feature of the listed companies’ Combined Code, copied to an extent by other codes derived from it: its regime of “comply or explain”. UK listed companies must comply with the Code’s detailed provisions or explain why they do not. Ignoring the Code is not an option; but if you have good reason to deviate from its terms, you may do so and leave it up to your members/shareholders to decide whether your reason is good enough. If you can talk to shareholders and demonstrate that departures from the Code’s provisions are in the company’s best interests, then non-compliance is unlikely to become a big issue.

Shareholders have no specific sanction if they disapprove of what you are doing, short of voting against the Directors’ Remuneration Report if the debate is over boardroom pay, or voting one or more directors off the board – a somewhat extreme step. What they can do, though, is apply pressure with the aim of persuading the board to change its mind.

As the case of the supermarket chain Morrisons shows, this can be most effective at those junctures when a company needs the support of its shareholders. (See box below.)

If the shareholders are not big enough or well organised enough to exert pressure or if they are unwilling to take the opportunities they have to do so, then the board can decide how much it complies. The key point is that the Code and its provisions are not compulsory; they are there for guidance and represent best practice.

Case study: Morrisons – How shareholders can change governance
A few years ago, the supermarket chain Morrisons seemed unencumbered by corporate governance principles. The company, led by the septuagenarian Sir Ken Morrison as full-time executive chairman, had no non-executive directors, no audit or remuneration committees and no shame in explaining that it did not think these were necessary. It was a FTSE 100 company and very much in the public eye. Institutional shareholders might not have liked its public defiance of generally accepted principles, but Morrisons was successful, and there was little they could do about it.

Things began to change after Sir Ken decided to bid for rival chain Safeway in 2003. The chairman needed to raise the money for the bid from shareholders, and one of the conditions they imposed was that he should at least appoint two non-executive directors. Over a year later and just before the AGM, two new non-executives duly appeared (though one resigned 10 months later). One institutional shareholder group commented, recognising the uphill task they still faced: “we welcome this step towards better corporate governance and hope to see formal board meetings established in due course.”

Since then, further steps have been taken to make management structures “more satisfactory to the City”. And following a number of profit warnings and acknowledged failures in its internal controls, the company now has a full complement of board committees manned by four independent non-executives (though they still do not equal in number the six executive directors).

This is adapted from the second edition (2007) of The Director’s Handbook, edited by Martin Webster of Pinsent Masons and available to buy from the Institute of Directors.