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Corporate Governance for Smaller AIM Companies

As a director of a small AIM company, what standards of corporate governance should you apply?

This is not always an easy question to answer. Smaller listed companies often have to balance the need for systems and procedures to safeguard corporate governance against the flexibility and entrepreneurial dynamic that is so often necessary to ensure the growth of small listed companies. It is for this reason that the investor community generally accepts that the standards of corporate governance, which are appropriate for large listed companies, are not in all cases appropriate for smaller companies listed on AIM. It is also why directors of such smaller companies are afforded a measure of discretion in the application of corporate governance standards to their particular circumstances. Directors of AIM companies should nonetheless aspire to high standards of corporate governance, and a number of corporate governance rules and guidelines have been formulated for application to smaller AIM companies, and these are considered further below.

Corporate governance developments

Following a series of consultations, in 2010 the Financial Reporting Council published the UK Corporate Governance Code. Partly to reflect the publication of this Code, in September 2010 the Quoted Companies Alliance (QCA) published the Corporate Governance Guidelines for Smaller Quoted Companies (the QCA Guidelines) (replacing previous QCA Guidelines applying to AIM companies). Given these changes (together with the ever increasing scrutiny of the corporate governance procedures being adopted by listed companies), now is an opportune time to take stock of how these changes affect smaller quoted companies and to consider more generally what corporate governance standards smaller AIM companies should be seeking to meet.

The view of the London Stock Exchange on corporate governance rules applying to smaller quoted companies

Whereas the Listing Rules require companies on the Official List of the London Stock Exchange (LSE) to either comply with the UK Corporate Governance Code, or to explain why they have not done so, the AIM Rules for Companies (AIM Rules) contain no such requirement. Due to the variety of AIM companies (both in terms of relative size and nature), the LSE accepts that it is not appropriate to impose a uniform set of corporate governance rules on them. The LSE has, in support of this view, referred to an AIM company's nominated adviser as being in an excellent position to work with its AIM listed clients to form a view on the most appropriate corporate governance standards that should apply by reference to factors such as size, business sector, jurisdiction and stage of development. That said, the LSE regards the UK Corporate Governance Code as the standard to which all public companies should aspire, and supports the use of the QCA Guidelines by AIM companies.

The sources of corporate governance standards for smaller AIM companies

The three primary sources of corporate governance guidelines and rules which are specifically applicable to smaller AIM companies are as follows:

AIM Rules;
The QCA Guidelines; and
The Corporate Governance and Voting Guidelines for AIM Companies published by the National Association of Pension Funds (NAPF).

Each of the above is considered further below.

The AIM Rules

A company listed on AIM is required to comply with the AIM Rules. We do not consider here in any detail the content of the AIM Rules. In the context of corporate governance considerations, however, it is helpful, as a reminder, to note that the AIM Rules do contain a number of continuing obligations relating to restrictions on dealings and disclosure.

Restrictions on dealings

The AIM Rules require a company to ensure that its directors and group employees, who are likely to be in possession of unpublished price-sensitive information, do not deal in the company's securities during a close period (being the 2 months preceding publication of the company's annual results and half-yearly results, 1 month preceding any quarterly results, and any other time when the company is in possession of unpublished price-sensitive information or it becomes reasonably probable that it will be required to disclose such information under the AIM Rules).

Disclosure obligations

A company applying for admission to AIM must either make a statement as to whether it complies with the corporate governance regime in its country of incorporation or, if not, an explanation as to why it does not. There is, however, no continuing obligation in the AIM Rules to report on compliance with corporate governance standards following admission. The QCA Guidelines and the NAPF Guidelines do, on the other hand, expect an element of compliance or explanation (see further below).

There are a number of continuing disclosure obligations contained in the AIM Rules requiring, for example, disclosure of new developments concerning, amongst other things:

changes in financial condition or sphere of activity;
business performance or expectation of business performance which, if made public, would be likely to lead to a substantial movement in the share price;
dealings by directors;
changes in the holdings of significant shareholders; and
the resignation, dismissal or appointment of any director, nominated adviser or broker, (see Rule 17 of the AIM Rules for the list of disclosure obligations). In addition, half yearly reports must be prepared and published and each AIM listed company is required to disclose the information set out in Rule 26 of the AIM Rules on its website.

The QCA Guidelines

The QCA seeks to promote the interests of smaller quoted companies (i.e. those outside the FTSE 350). In 2005 it published a set of corporate governance guidelines for AIM companies which was revised in 2007 and replaced, in September 2010, by the QCA Guidelines for Smaller Quoted Companies. Though not a mandatory set of rules, the QCA Guidelines aim to fill the gap of corporate governance guidelines in respect of smaller quoted companies.

Annual corporate governance statement

The QCA Guidelines state that smaller quoted companies would be "well advised" to publish a corporate governance statement annually that describes how they achieve good governance by reference to a set of "Minimum Disclosures" set out in the QCA Guidelines (see Appendix). This statement should:

be in a company's annual report and accounts or, failing that, there should be a report on the company's website; and
as a minimum, describe how each of the QCA Guidelines is put into practice by the Company and any additional corporate governance structures and procedures that the company applies beyond this basic level. Where the company is not able to achieve this, the corporate governance statement should describe how the features of good governance are being achieved.

The QCA Guidelines endorse the 'comply or explain' approach and note that the they represent minimum best practice for smaller quoted companies, and boards should therefore consider carefully, and provide a reasoned explanation for, any deviations from the QCA Guidelines.

The twelve QCA guidelines

There are twelve guidelines set out in the QCA Guidelines which represent good practice and need to be considered:

Structure and process: The company should put in place the most appropriate governance methods, based on its corporate culture, size and business complexity. There should be clarity on how it intends to fulfil its objectives and, as the company evolves, so should its governance.
Responsibility and accountability: It should be clear where responsibility lies for the management of the company and for the achievement of key tasks. The board has a collective responsibility for the long term success of the company, and the roles of the chairman and the chief executive should not be exercised by the same individual.
Board balance and size: The board must not be so large as to prevent efficient operation. A company should have at least two independent non-executive directors (one of whom may be the chairman, provided he or she was deemed independent at the time of appointment) and the board should not be dominated by one person or a group of people. The QCA Guidelines provide criteria that should be applied to determine independence in Appendix A.
Board skills and capabilities: The board must have an appropriate balance of functional and sector skills and experience available to it in order to make the key decisions expected of it and to plan for the future. The board should be supported by committees (audit, remuneration and nomination) that have the necessary character, skills and knowledge to discharge their duties and responsibilities effectively. The QCA Guidelines state that at least one member of the audit committee should have "recent and relevant financial experience".
Performance and development: The board should periodically review its performance, its committees' performance and that of individual board members. This review should lead to updates of induction evaluation and succession plans. Ineffective directors (both executive and non-executive) must be identified and either helped to become effective, or replaced. The board should ensure that it has available the skills and experience it needs for its present and future business needs. Membership of the board should be periodically refreshed.
Information and support: The whole board and its committees should be provided with the best possible information (accurate, sufficient, timely and clear) so that they can constructively challenge recommendations to them before making their decisions. Non-executive directors should be provided with access to external advice when necessary.
Cost-effective and value added: There will be a cost in achieving efficient and effective governance; however this should be offset by increases in value. There should be a clear understanding between boards and shareholders of how this value has been added. This will normally involve the publication of key performance indicators, which align with strategy and feedback through regular meetings between shareholders and directors.
Vision and strategy: There should be a shared vision of what the company is trying to achieve and over what period, as well as an understanding of what is required to achieve it. This vision and direction must be well communicated, both internally and externally.
Risk management and internal control: The board is responsible for maintaining a sound system of risk management and internal control. It should define and communicate the company's risk appetite, and how it manages the key risks, while maintaining an appropriate balance between risk management and entrepreneurship. Remuneration policy should help the company to meet its objectives whilst encouraging behaviour that is consistent with the agreed risk profile of the company.
Shareholders' needs and objectives: A dialogue should exist between shareholders and the board so that the board understands shareholders' needs and objectives and their views on the company's performance. Vested interests should not be able to act in a manner contrary to the common good of all shareholders.
Investor relations and communication: A communication and reporting framework should exist between the board and all shareholders such that the shareholders' views are communicated to the board, and shareholders in turn understand the unique circumstances of, and any constraints on, the company.
Stakeholder and social responsibilities: Good governance includes a response to the demands of corporate social responsibility (CSR). This will require the management of social and environmental opportunities and risks. A proactive CSR policy as an integral part of the company's strategy can help create long-term value and reduce risk for shareholders and other stakeholders.

The NAPF Guidelines

In March 2007, the National Association of Pension Funds (NAPF) published the Corporate Governance and Voting Guidelines for AIM Companies (the NAPF Guidelines) and these have not yet been updated to reflect the publication of the UK Corporate Governance Code. The starting point for the NAPF Guidelines was the Combined Code and the NAPF policy and guidelines which are based on it. NAPF acknowledges that it may not be appropriate for AIM companies, particularly small AIM companies, to be subject to the same corporate governance standards as larger companies on the Official List of the LSE. The NAPF Guidelines are, therefore, intended to provide guidance to companies and shareholders on those issues which the NAPF believes are of key importance and where practice may reasonably differ from the Combined Code.

Pre-emption rights

According to the NAPF Guidelines, the NAPF's policy is that AIM companies should seek annual approval from shareholders for the issuance of shares on a non pre-emptive basis. While the NAPF recognises that there will more often be good reasons for waiving pre-emption rights among smaller companies (for example for reasons of cost, shareholder structure or speed) companies should consult with leading shareholders in advance, provide them with a full justification for a decision to seek authority to issue stock above the 5 per cent annual limit and should account for its usage in the subsequent annual report.

Disclosure standards

The NAPF Guidelines state that companies should seek to apply the disclosure standards set by the Combined Code but acknowledges that this may not be appropriate for some smaller companies. The NAPF expects companies to disclose their corporate governance policies and the following (as a minimum) in the annual report or by reference to the company's website:

Directors' names, other directorships and brief biographical details (including executive or non-executive status).
The names of the chairman, the deputy chairman (where there is one), the chief executive, the senior independent director and the chairmen and members of the nomination, audit and remuneration committees (where these committees exist).
The names of the non-executive directors whom the board determines to be independent with reasons where necessary.

In fact, these requirements are similar to the disclosure requirements in rule 26 of the AIM Rules.

The roles of chairman and chief executive

For the NAPF, the functions of the chairman and chief executive are different; they should be clearly distinguished and not confused or compromised by being combined. That said, the NAPF Guidelines go on to state that a pragmatic approach is justified if a vote against a director combining these roles might be considered detrimental to the company. As regards a chief executive going to become the chairman of the same company, the NAPF Guidelines state that this should not occur, but that if it does, the Company must disclose in the annual report its reasons for the appointment and describe the selection process.

Board composition

The NAPF's policy for companies with larger boards is that there should be at least two independent directors, excluding the chairman. However, the NAPF states that a less stringent requirement is appropriate for AIM companies with boards of no more than 4 directors. Such board might consist of the chairman, the chief executive and, at most, two non-executive directors, of which one should be independent throughout the term of his appointment.

Where the roles of chairman and chief executive are combined, the NAPF Guidelines require the appointment of a senior independent director to ensure an independent voice on the board.

Composition of committees

The NAPF Guidelines state that the audit, remuneration and nomination committees should ideally comprise only independent non-executive directors, and there should at least be a majority of independent directors on all committees. While the chairman may be a member of the audit, remuneration or nomination committees, he must satisfy the independence test and should not be chairman on those committees (see below for further NAPF guidance on independence).

Independence of directors

Like the QCA Guidelines, the NAPF Guidelines encourage all companies to use the independence criteria in the UK Corporate Governance Code, but the NAPF states that some of the criteria of the UK Corporate Governance Code may require more flexibility when applied to AIM companies due to the particular circumstances faced by such companies. The NAPF therefore states that independence could be compromised in the following ways:

Where a director's shareholding in an AIM listed company exceeds 3 per cent (the threshold is set at 1 per cent for companies listed on the Official List);
Where a director receives remuneration other than fees paid in cash or shares (e.g. participation in the company's share option plan, a performance related pay scheme or membership of a company's pension scheme); though note that the NAPF Guidelines state that companies can use fully paid shares as part of the remuneration of non-executive directors and the NAPF:
- acknowledges that it is common for smaller AIM companies to have issued options to non-executive directors either historically, on a flotation or as a one-off grant; and
- excludes one-off grants (if the quantum is not material) from the assessment of independence.
Whereas the UK Corporate Governance Code states that if a director has served on the board for 9 years, this may compromise his independence, the NAPF policy for AIM companies is one of flexibility in cases where tenure is between nine and twelve years, and tenure is the only factor affecting a director's independence.

Remuneration

In respect of remuneration, the NAPF Guidelines are consistent with NAPF policy for companies listed on the Official List: they require the establishment of a system of remuneration which clearly aligns the interests of the executive directors with those of the shareholders and this should be easy to explain and transparent. A significant part of executive remuneration should be linked to performance and performance conditions attaching to any bonuses or long-term incentive plans should be disclosed. The NAPF Guidelines also strongly encourage AIM listed companies to put remuneration reports to vote at AGMs.

Conclusion

Directors of smaller AIM Companies should consider the various sources of corporate governance guidelines described above and, having taken advice from professional advisers where necessary, determine the extent to which it is appropriate to implement recommended measures. Where directors determine that (for example because of the small size of the company) it is not appropriate to adopt certain recommendations, then they should seek to explain these decisions in the company's annual report.

We thank the Quoted Companies Alliance for giving their permission to reproduce sections from their Guide. To purchase The Quoted Companies Alliance's Corporate Governance Guidelines for Smaller Quoted Companies (September 2010) click here.

Harbottle & Lewis LLP

February 2011

The content of this note does not constitute legal advice and should be treated as general guidance only. If you require any further information in relation to any of the issues dealt with in this note, please contact Tim Parker on +44 (0)20 7667 5187 or tim.parker@harbottle.com or Charles Lévêque on +44 (0)20 7667 5057 or charles.leveque@harbottle.com.

Appendix

Minimum disclosures required by the QCA Guidelines

The annual report should include the following:

A report by the chairman of how the QCA Guidelines are applied to provide for the company's long-term success.
The number of board meetings (normally monthly) and of the committees and individual directors' attendance at them.
A statement of how the board operates to set, develop and execute the company's strategy, 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.
The identity of all the directors and their roles and committee memberships.
The identity of those directors the board considers to be independent and the reasons why it has determined a director to be independent notwithstanding factors which may appear to impair that status (Appendix A of the QCA Guidelines sets out a list of factors which might impair a director's independence).
The relevant skills and experience that the executive and non-executive directors bring to the board to enable shareholders to take an informed decision on the balance of the board and the election and re-election of directors.
A brief description of each committee's work to demonstrate that there is robust oversight of the executive directors on governance matters, such as audit and risk management, remuneration and directors' appointment.
A description of any board performance evaluation procedures that the board applied, focusing on its objectives and outcomes and including a summary of how the evaluation procedures have evolved from the previous year, the results of the evaluation and action taken or planned as a result.
A Business Review detailing its strategy and how this is communicated to and brought into all areas of the business.
An audit committee report explaining the major tasks undertaken and demonstrating how independent oversight of both management and external auditors has been exercised.
A summary of risk management and internal control systems and activities, and explanation of how these relate to strategy and link into key performance indicators, remuneration policies and CSR activities.
An explanation to shareholders of how auditor objectivity and independence is safeguarded, particularly if the auditor provides significant non-audit services.
A remuneration committee report explaining how the company's remuneration practices align the interests of senior management with those of shareholders.

In addition to the above, the following information should be available to shareholders on the company's website:

A description of the chairman's and chief executive's roles and responsibilities and, in particular where the chairman and the chief executive are the same person, the role of the senior independent director (SID).
A list of matters reserved for the board.
The terms and conditions of appointment of non-executive directors.
The audit, remuneration and nomination committees' terms of reference explaining their roles and the authority delegated to them by the board (and where the whole board acts as the nomination committee, it should explain its processes).
An explanation of the role of any external advisers to the board or its committees and any internal advisory responsibilities, such as the company secretary's and the SID's role in advising and supporting the chairman. Where the company secretary is also a director, the company should provide an explanation.
A brief summary of information received by the board and by individual committees.
The annual report and other governance-related material including notices of general meetings.
Where votes at a general meeting are by a show of hands, the votes by proxy received by the company, including abstentions or votes withheld, should be reported as soon as practicable after the meeting. Where votes are conducted on a poll, the actual votes, including votes withheld or abstentions, should be reported as soon as practicable after the poll.