How Does the New U.K. Combined Code of Corporate Governance Compare with Sarbanes–Oxley?
by Richard Smerdon and Laurence Hazell

Introduction

The meltdown in effective corporate governance represented by the collapse of Enron, the crisis at WorldCom, and the demise of Arthur Andersen had regulatory authorities on both sides of the Atlantic—in the world’s largest economy and arguably the world’s oldest capital market—scrambling for an effective response.

[There are] significant differences in the ways [corporations] are formed and regulated in the United States and the United Kingdom.

In the United States, Congress and the President hastily ratified the Sarbanes-Oxley Act, plainly worried about the effects of these corporate and accounting scandals on market confidence. The U.K. government went into overdrive as well, against the backdrop of pension fund failures, egregious losses of shareholder value at some LSE companies, and a gathering storm about “fat-cat” compensation packages (even though these are far less generous than those available in the United States), lest a similar scandal erupt at home.

Sarbanes-Oxley and the latest iteration of the U.K.’s Combined Code on Corporate Governance (there had been two previous editions in 1992 and 1998) are almost exactly one year apart in enactment and introduction. Despite the fact that both have yet to take full effect, an industry has already sprung up to offer advice on, and criticize, these latest governance innovations. Such debate is best left to the protagonists. Our aims are more modest.

First, we think it might be useful to outline how Sarbanes-Oxley and the Combined Code fit into their respective legal and regulatory frameworks, which will involve an overview of the way the law works in relation to corporations in the United States and the United Kingdom. (Readers should be aware of our trepidation as mere English lawyers talking about U.S. law.) Second, we will take some of the key features of each statute (for example, those relating to director independence and the role of board audit committees) as emblematic of each country’s approach to some fundamental governance issues. Last, we will try to assess the extraterritorial effects of Sarbanes-Oxley for companies incorporated in the United Kingdom with securities listed on a U.S. exchange.

The U.S. and U.K. Legal and Regulatory Backgrounds

The many close ties between the two countries in terms of history, legal tradition, culture, and language hide some quite striking differences that, of course, have their own roots in the past as well. In fact, the sheer speed and amount of information about modern corporations and their finances in the global marketplace can obscure significant differences in the ways they are formed and regulated in the United States and the United Kingdom.

Although the United Kingdom in fact comprises three distinct law districts (England and Wales, Scotland, and Northern Ireland), the law relating to companies and their officers is, for most practical purposes, identical. The Companies Act 1985 (and its proposed “White Paper” whole-scale revision) establishes how companies may be formed and sets out and circumscribes their powers and responsibilities.¹

However, corporate governance in terms of standards or rules of best practice is not enshrined in statute, either as guidelines or as specific injunctions about corporate administration or behavior. That is left to the Combined Code and exchange listing conditions. There are two main reasons for this.

First, codes and listing rules are more adaptable than primary legislation and can respond more nimbly to changes in thinking about good and effective corporate governance. Second, by not having the force of law, persuasion rather than enforcement (with all its associated costs) becomes the means to accomplish desired corporate governance standards and goals.

Nevertheless it is vital to understand that central government retains a key role in two crucial respects. First, bodies like the Financial Services Authority (FSA) and its associated subdivisions are creatures of statute, and ultimate responsibility for them lies with U.K. ministries like the Treasury and the Department of Trade & Industry (DTI).² Second, it is an all-important public perception in the United Kingdom that central government retains oversight. In fact any perceived absence of a central government role in the regulation of corporate enterprise would provoke widespread criticism that politicians were asleep on the job.

By contrast, in the United States, the authority of states to constitute and regulate corporations has been jealously guarded as one example of “states’ rights.” In this respect, Sarbanes- Oxley is a landmark statute because it marks the first substantial inroad of federal legislation into the actual governance of corporations. In fact, much of the criticism of Sarbanes-Oxley— although cast as concern about hasty legislation by panicked politicians—may owe its intellectual genesis to the perceived threat of federal interference in states’ affairs. And although much of the detailed rule making is left to the SEC to formulate (and enforce), this federal body clearly now has a governance mandate for all U.S. corporations and listed foreign issuers that exceeds its initial focus on timely disclosure of market relevant corporate information.

The 2003 Combined Code

On July 23, 2003, the London-based Financial Reporting Council (FRC)³ published the final text of the revised Combined Code.⁴ The revised Code will apply to reporting years commencing on or after November 1, 2003, and aims to “enhance board effectiveness and to improve investor confidence by raising standards of corporate governance.”

Every company listed on the London Stock Exchange is required to observe the “Listing Rules”—the rules laid down by the U.K. Listing Authority (UKLA).⁵ It is worth emphasizing that the UKLA, not the LSE, is responsible for monitoring and enforcing the Listing Rules; this fact may have some relevance for American readers given recent events at the NYSE. UKLA is itself a division of the Financial Services Authority, and both bodies are the creation of the Financial Services and Markets Act 2000.6

Listing Rule 12.43A requires listed companies to state in the Annual Report:

• how they have applied the Principles of the [then effective] Combined Code; and
• if they have complied with the Provisions of the [then effective] Combined Code, and if not, why not.

Failure to make these statements will, in theory, result in de-listing, but that has not happened to date. No penalty in financial or other terms attaches to the company or directors. Punishment really lies in loss of reputation for the company concerned. The press and, sometimes, institutional shareholders and governance rating agencies pick up on failures and omissions, and the attendant publicity usually forces compliance.

When the corporate scandals erupted in the United States, the U.K. government wanted to show that it was working to forestall anything similar from happening at home. This concern did not occur in a vacuum, as noted above. Bluntly put, the government came to the conclusion that there were enough bad smells in the U.K. corporate kitchen to warrant a proactive rather than reactive approach.

So the government asked a respected investment banker, Mr. Derek Higgs, to do a review of the role and effectiveness of non-executive directors, asked the Financial Reporting Council to produce guidance for audit committees, and set up a “Co-ordinating Group on Accounting Practices” to look at current accounting practice. Reports of all these committees were published in an orchestrated fashion in January 2003.⁷

Punishment [for failure to comply with the Combined Code] really lies in loss of reputation for the company concerned.

To everyone’s surprise, Mr. Higgs, who was billed as a middle of the road pragmatist, steeped in the City of London tradition, produced a swingeing report on the inadequacies of the nonexecutive director community and made a lot of recommendations for improvement. He produced a completely revised “Combined Code” of governance best practice that ran about twice the length of the then current Code with a much more prescriptive tone than its predecessor.

There was a short respectful silence and then uproar from companies and the securities industry saying that the proposed Code would stifle entrepreneurial activity and amount to little more than a “charter for box tickers.” Many wellknown companies said they could not accept some of the recommendations and would simply refuse to observe them. At that point the Financial Reporting Council stepped forward and in very short order got out a fresh draft of the Combined Code, which managed to somehow achieve the impossible by including most of the Higgs recommendations while gaining a grudging consensus from companies and the market.

So, the revised Code now incorporates most of the proposals detailed in Derek Higgs’ Review and also the FRC’s “Smith Report” on audit committees. The language has been softened, incorporating what are called “Main Principles,” followed by “Supporting Principles,” further fleshed out by corresponding “Provisions.”

Remember that companies have to state in their annual reports how they have applied the Principles (and now the Supporting Principles) and if they have complied with the Provisions, and if not, to explain why not. Although this regime may appear somewhat complex, it is actually intended to provide companies with a greater degree of flexibility in how they implement the Combined Code.

The form of the disclosures has been left open, allowing companies to decide independently how they demonstrate compliance of their policies on corporate governance, but companies are encouraged to give informative and helpful explanations. Also, the revised Code recognizes that there may be satisfactory justifications for departures from its mandates and subsequent breach will not automatically result in de-listing threats.

One example generally is better than a hundred descriptions. Here is Main Principle A1:

Every company should be headed by an effective board, which is collectively responsible for the success of the company.

One of the Supporting Principles to that Main Principle is:

As part of their role as members of a unitary board, non-executive directors should constructively challenge and help develop proposals on strategy. Non-executive directors should scrutinise the performance of management in meeting agreed goals and objectives and monitor the reporting of performance. They should satisfy themselves on the integrity of financial information and that financial controls and systems of risk management are robust and defensible. They are responsible for determining levels of remuneration of executive directors and have a prime role in appointing, and where necessary removing, executive directors and in succession planning.

One of the corresponding [i.e., disclose if you comply or otherwise explain why not] Provisions to those Principles is:

The board should meet sufficiently regularly to discharge its duties effectively. There should be a formal schedule of matters specifically reserved for its decision. The annual report should include a statement of how the board operates, including a high level statement of which types of decisions are to be taken by the board and which are to be delegated to management.

Another new Supporting Principle, targeted at institutional investors, states that when evaluating a company’s governance, institutional shareholders should consider a company’s explanation for departure from the Combined Code, bearing in mind the size and complexity of the company and the nature of the risks and challenges it faces. The revised Code also emphasizes that institutional shareholders “should avoid a box ticking approach to assessing a company’s corporate governance” and be prepared to enter a dialogue if they do not accept a company’s governance position.

Although it might appear a little jaundiced to say it, we think it likely that this structure will assist the press and governance ratings agencies to pick up any departures from the Code, without bothering to tell their readers and clients about any explanation proffered by the company for its different approach. Time will tell.

Significant Features of the Revised Combined Code

Board structure

At least half of the board, excluding the chairman, should consist of independent nonexecutive directors. A new definition of independence, as proposed by Derek Higgs, has been included. To be independent, a non-executive director must be determined by the board to be “independent in character and judgment,” and also there must be “no relationships or circumstances which could affect or appear to affect the director’s judgment.”

Code Provision A.3.1 states:

The board should identify in the Annual report each non-executive director it considers to be independent. . . . The board should state its reasons if it determines that a director is independent notwithstanding the existence of relationships or circumstances which may appear relevant to its determination, including if the director:

• Has been an employee of the company or group within the last five years;
• Has, or has had within the last three years, a material business relationship with the company either directly, or as a partner, shareholder, director or senior employee of a body that has such a relationship with the company;
• Has received or receives additional remuneration from the company apart from a director’s fee, participates in the company’s share option or a performance related pay scheme, or is a member of the Company’s pension scheme;
• Is connected with any of the company’s advisers, directors or senior employees;
• Holds cross-directorships or has significant links with other directors through involvement in the other companies or bodies;
• Represents a significant shareholder; or
• Has served on the board for more than nine years from the date of the first election.

It is worth emphasizing that the revised Code has relaxed some of the provisions applicable to smaller companies—that is, those listed below the level of the “FTSE 350.” (The “FTSE index,” i.e., FTSE 100, FTSE 350, FTSE 500, etc., is the U.K. equivalent of the Dow. Companies whose market capitalizations are below those of the top 350 listed companies are deemed to be “smaller.”) In particular, the presence of only two independent non-executives on the boards of smaller companies will be deemed sufficient independent representation.

Chief executive becoming chairman

Higgs’ proposal that the Chief Executive should not go on to become the Chairman has been retained. This is distinct from the Principle that the chair and chief executive positions should not be held by the same person. The issue of succession has become controversial in the United Kingdom because of a number of recent instances where the chief executive has gone on to become chairman overseeing a new CEO but found it impossible to give up executive responsibility. The new CEO has been terrorized into becoming a cipher for the chairman, and the companies concerned have suffered from a lack of direction. However, a concession is possible where a board considers the appointment particularly appropriate and consults with major shareholders at the time of appointment and outlines its reasoning in the annual report.

Non-executive directors (NEDs)

NEDs must submit themselves for re-election every three years following first appointment. They may be submitted for re-election beyond six years, but must first be made subject to a particularly rigorous review. Re-election after nine years is permitted but there is a presumption that such a person is no longer “independent” unless the board provides a convincing explanation to the contrary.

Chairman/senior independent director

The revised Combined Code clarifies the roles of chairman and senior independent director, emphasizing the chairman’s role in providing leadership at regular meetings with non-executive directors (i.e., executive sessions of the board without executive directors present) and ensuring communication between the shareholders and the board.

Each board should appoint a senior independent non-executive director, who should be available to shareholders if they have issues that have not been resolved. This person also should attend meetings with major shareholders to listen to their views and develop an understanding of their concerns.

Nomination committee

The nomination committee should comprise a majority of independent NEDs. The board chairman may chair the nomination committee. The revised Code details a formal, rigorous, and transparent procedure for the appointment of new directors. A person should not chair more than one FTSE 100 company, and an executive director should neither participate as a nonexecutive director of more than one FTSE 100 company nor become chairman of such a company.

Induction and professional development

Boards will need to ensure that NEDs are appointed on merit after a rigorous and widened selection process including due diligence into whether they possess the relevant skills and experience.

A comprehensive induction program should be provided to new NEDs. The Combined Code emphasizes continuing professional development and regular evaluation of the performance of boards and individuals, making the chairman responsible for both.

Audit

In addition to recommending and monitoring the independence of auditors, the audit committee will have a greater role in monitoring the integrity of the company’s financial reporting. One member of the committee must possess recent and relevant experience in finance, and training should be available to all. As before, all audit committee members must be independent NEDs.

Remuneration

The remuneration committee should comprise at least three members, all of whom should be independent NEDs. Remuneration for NEDs should reflect the time commitment and responsibilities of their role, as outlined in their terms of appointment, and avoid rewarding poor performance in the event of premature termination.

It is worth reminding American readers that U.K. companies now have to submit a yearly remuneration report on executive pay. Under legislation called the Directors’ Remuneration Report Regulations 2002, this report must set out the company’s remuneration policy for executive directors as well as highly detailed disclosures. The regulations were introduced after the government became frustrated by what it saw as a failure by corporate Britain and its seemingly complacent institutional shareholders after repeated government warnings to rein in executive pay, as well as the damages paid out to departing poorly performing executives.

The compensation policy (not, it is emphasized, specific compensation packages) must be submitted to shareholders for approval at the Annual General Meeting. While votes on the report are not binding on the company, it has certainly provided a satisfactory lightning rod for substantial shareholder and public disquiet about executive pay. Indeed, shareholders of Glaxo Smith Kline voted against the policy (containing U.S.-style alleged “rewards for failure,” as they have become known in the United Kingdom), at the July 2003 Annual Meeting and the board has been shamed into going back to the drawing board to renegotiate the compensation terms of the CEO.

The 2002 Sarbanes-Oxley Act (and Associated SEC Rules)

President Bush signed Sarbanes-Oxley into law on July 30, 2002. Since then, many of its provisions have become effective, although the timetable is somewhat complex and, it appears, has yet to run its full course. Both here in the United States and abroad, the certification provisions have received the most publicity, although Sarbanes-Oxley covers much more ground than these alone.

Certifications

Sections 302 and 906 deal with the certification of financial and other information contained in a company’s quarterly and annual report. Section 906 requires CEOs and CFOs to confirm in a written statement accompanying each periodic report containing financial statements filed with the SEC that said report “fully complies with sections 13(a) and 15(d) of the Securities Exchange Act of 1934 and the information contained in the periodic report fairly presents, in all material respects, the financial condition and results of the operations of the issuer.”

Interestingly, this section does not indicate that the certification can be qualified in any way as to the knowledge of the corporate officer warranting its accuracy. This is significant because criminal penalties apply only when the officer has actual (and we presume constructive) knowledge of non-compliance with the criteria in the section. It appears that some foreign issuers have added a knowledge qualifier to their statements, presumably seeking an explicit extra level of protection, should this turn out to be available to them.

The Section 302 certification applies both to the contents of the periodic report and to matters regarding internal and disclosure controls. This certification may not deviate from the form required by SEC rules. It requires, inter alia, the following statements by the certifying officers of the corporation:

• that he/she has reviewed the report;
• that, based on his/her knowledge, the report does not contain any untrue statement of a material fact or omit a material fact such as to make the report misleading;
• that based on his/her knowledge, the financial statements “fairly present” the financial condition, results of operations, and cash flows of the issuer.

In its final rule on this last point, the SEC said that “fair presentation” is not limited to confirming that generally accepted accounting principles have been met. It is not clear to what extent this obligation would exceed the U.K.’s “true and fair view” requirement. What is beyond doubt though is that the certifying officers of the corporation must carry overall responsibility for instituting and maintaining disclosure controls and procedures at the company and must also attest that they have made all relevant disclosures to the company’s auditors.

So far as U.K. companies are concerned (and this may apply to issuers in other non-U.S. jurisdictions as well) it appears to us that the only report that needs to be certified is the annual report on Form 20-F. The final rule regarding the Section 302 certification clarified that Form 6-K filings (for example, ongoing corporate communications and disclosures made pursuant to U.K. law and filed with the local stock exchange) need not be certified. We have not been able to determine if the SEC has specifically exempted 6-K filings from the Section 906 certification requirement, but some commentators have suggested that is the case.

Boards of directors and their committees

Sarbanes-Oxley maintains a central focus on the audit and related functions of publicly listed corporations, and perhaps that is not surprising given the nature of the breakdowns in corporate governance at U.S. corporations that led to this legislative initiative. In fact, Sarbanes-Oxley does not address the role and authority of independent directors, except with regard to audit committee activities, but both the NYSE and NASDAQ have proposed listing standards (respectively, 303A of the Listed Company Manual and Proposed Rule 4350(c)), mandating that a majority of the board must comprise independent directors, with the audit committee composed exclusively of independents.

Section 301 of Sarbanes-Oxley and Section 10A(m) of the Exchange Act direct the SEC to adopt regulations that require the stock exchanges and NASDAQ to prohibit the listing of any security of a company that does not have an audit committee that complies with certain standards. The focus appears to be on two disqualifying criteria: whether a director has accepted compensatory fees from the company or any subsidiary (other than director fees), and whether the candidate director can be regarded as an “affiliated person.” An affiliate is defined as “a person that directly, or indirectly though one or more intermediaries, controls, or is controlled by, or is under common control with, the person specified.”

It is worth noting that investment companies are not covered by this provision, but nevertheless remain subject to the “interested person” test set out in Section 2(a)(19) of the Investment Company Act of 1940. The Sarbanes-Oxley audit committee provisions offer a safe harbor, whereby a person who is not an executive officer of, and is not the beneficial owner of more than ten percent of any class of voting securities of, the company would be deemed not to control the company.

It is open to the exchanges and NASDAQ to adopt additional independence criteria and, as intimated earlier in relation to the full board, both major exchanges have signaled their intent to do so. Perhaps the most well known of these is the requirement of an explicit statement of audit committee responsibilities set out in written form as a Charter. Many companies now append this to their proxy statement and/or make it available in other company materials such as the annual report or the corporate Web site.

Sarbanes-Oxley also requires that the audit committee have authority to engage independent counsel and other advisers, as the committee, at its sole discretion, considers necessary. The committee—or if there is no committee, the full board—must also pre-approve, for all companies whose securities trade in the United States, the provision of all audit services and all permitted non-audit services by the auditor (and associated persons). Finally, all companies must indicate in their annual and quarterly reports whether the audit committee includes at least one member who is an “audit committee financial expert,” and if it does not, why not.

[T]here are signs that the British government is prepared to abandon the voluntary best practice approach and legislate.

While Sarbanes-Oxley does not address the role or composition of other board committees, both the NYSE and NASDAQ have proposed rules covering the independent composition and duties for compensation and nominating/corporate governance committees. However, the NASDAQ permits one member of such a committee to not meet the test of independence in exceptional circumstances. As far as we have been able to determine, the NASDAQ does not require a written charter for the compensation committee.

Listing standards sufficient to comply with Sarbanes-Oxley’s requirements have been proposed by the exchanges and NASDAQ and must be approved by the SEC by December 1, 2003. In general, listed issuers must be in compliance with these standards by the earlier of the first Annual General Meeting after January 15, 2004, or October 31, 2004. Foreign private issuers and small business issuers (defined in Rule 12(b)-2 of the Exchange Act) have until July 31, 2005, to comply.

Prohibition on loans

Something familiar to U.K. readers that Sarbanes-Oxley specifically addresses is a prohibition on personal loans to directors or officers of the company. Loans (and “quasiloans”) to directors are prohibited by the U.K.’s 1985 Companies Act (and reiterated in the White Paper revising U.K. company law). However the wording and extent of Sarbanes-Oxley differs. Accordingly, different exceptions will apply and practitioners advising clients will need some precise navigation skills. In any event, purveyors of $6,000 shower curtains should take note.

Accounting oversight

Finally, returning to the key focus on audit and accounting issues, the Public Company Accounting Oversight Board has been established with responsibilities that include, among other things, overseeing the auditors of public companies subject to U.S. securities law. Consequently, any foreign accounting firm that prepares audit reports for issuers (U.S. or non-U.S.) whose securities are sold in the United States is subject to U.S. reporting requirements and rules set down by the PCAOB to the same extent as U.S. accounting firms.

Each Approach Has its Merits

From the standpoint of two English lawyers, the difference between the United Kingdom’s codes of best practice and “comply or explain” approach, and the United States’ highly complex and detailed regulatory regime with stiff penalties, is obvious and striking. Which is right? Perhaps that is an unfair question. Clearly each approach is a reflection of the culture and tradition of its country of origin.

However, there are signs that the British government is prepared to abandon the voluntary best practice approach and legislate where it thinks that corporate Britain and its institutional investors are not fixing a problem—as in the case of the earlier mentioned Directors’ Remuneration Report Regulations 2002. Legislation is also threatened if institutions continue to fail to vote at Annual Meetings. In addition, the European Union is discussing a program of legislation on governance matters that will be enacted over the next five years or so.

As residents and observers of U.S. corporate life, we also observe the sighs of anguish and the tree-felling operation going on as companies struggle to deal with disclosure and paper trail requirements of Sarbanes-Oxley. Real interest in the United States in the notion of codes of best practice that could serve as both pragmatic and effective corporate governance guidelines has come too late and, given the political fallout from the scandals, probably had little chance of success anyway.

The fact is that Sarbanes-Oxley will never be repealed, and the Europeans will continue to love Codes, but our best bet is that, depressingly, in the end legislation will prove to be the only really effective weapon against governance malpractice.

Richard Smerdon (richard.smerdon@osborneclarke.com), Solicitor, is a Partner with the London firm of Osborne Clarke, and heads the firm’s corporate law division in the Palo Alto office. Laurence Hazell (Laurence_Hazell@standardandpoors.com), Barrister, is Director of Governance Services with Standard & Poor’s. Both of the authors are members of the ABA International Developments Subcommittee on Corporate Governance.