Corporates collapse and public trust
Corporate liquidations and scandals are not a new concept. In 1866, the UK experienced its first banking crisis, when Overend, Gurney and company collapsed owing £11 million, equivalent to just over £1 billion today.
In the 20th century, Polly Peck and MG Rover Group are two examples of companies where the directors failed to make decisions centred on the best interests of the company. Both companies entered administration, causing economic and social hardship for their former employees and creditors.
More recently, the liquidations of BHS in 2016 and Carillion in 2018 have led to the credibility of directors’ reporting standards and statutory auditing practices to be questioned by investors, company stakeholders and the wider public.
Restoring trust in audit and corporate governance
To address these concerns, the Secretary of State for Business, Energy and Industrial Strategy, Kwasi Kwarteng released the much-anticipated white paper, ‘Restoring trust in audit and corporate governance’ on 18 March 2021.
The paper summarises the government’s strategy to hold the directors of large companies to account, prevent fraud and empower shareholders. The basis for the recommendations were sourced from three previous independent reviews, instigated by the government: The Independent Review of the Financial Reporting Council, a Statutory Audit Services Market Study and the Independent Review of the Quality and Effectiveness of Audit.
Audit, reporting and governance authority
The independent reviews found the market for audit services is dominated by a few main accountancy firms, and the existing regulator of auditors, accountants and actuaries, the Financial Reporting Council (FCR), lacked powers and should be replaced. In addition, the information, analysis, and data in company reports lacked transparency. Oddly, the FCR employs the UK Corporate Governance Code (UKCGC) to promote transparency and integrity in UK companies, as opposed to enforceable legislative powers, a fact highlighted by the independent reviews.
Rather than overhaul the existing regulator, the government has recommended the formation of a new body - the Audit, Reporting and Governance Authority (ARGA), the FCR governance code approach will be replaced by legislative powers.
Which companies will the changes affect?
The government believes the ARGA should focus on public interest entities (PIEs), broadly this encompasses companies listed on a regulated market based in the UK. The drawback of the current definition of PIE is it excludes large private limited companies (such as BHS) from more stringent regulation. Therefore, it is intended to widen the PIE definition to include companies both listed and private, based on a mix of employee numbers and turnover.
Scope of directors affected?
One of the key Government proposals is the inclusion that all directors will fall under the new regime and is not therefore limited to the key director roles in the company, for example the Chief Executive Officer, Chief Financial Officer, and the Chair.
What are the key points for directors?
Directors will be responsible for internal company controls
The government is concerned that several corporate failures were brought about in part because of weak internal reporting controls and the lack of robust risk management systems.
Consideration was given to implementing a US style Sabanes-Oxley Act 2002 system to replace the current (non-statutory) obligations under UKCGC. It was concluded this approach would stifle entrepreneurship and over-regulate large companies. The government’s preferred option requires directors to carry out an annual internal review and provide disclosures via a control effectiveness statement.
The ARGA would hold statutory powers to investigate the directors’ disclosures on internal controls, and if necessary, order amendments to the report or appoint an external auditor. Directors who produced inaccurate annual internal reports would face sanctions if it were proven they had failed to establish and maintain an adequate internal control structure and risk management systems.
Dividend and capital maintenance
The government noted several cases where a company paid large dividends payments and then promptly issued a profits warning. The rules on dividend payments are complex, typically, they can only be paid from realized profits or losses (RPL), for example, you cannot borrow money to pay a large dividend.
Companies are able to circumvent the dividend rules as there is no fixed definition of ‘realised profits and losses’ and more importantly, the term has no formal legal status. How a company accounts for its (RPL) and therefore the level of dividends paid is defined by professional accounting bodies who provide guidance to its members. In addition, companies are not required legally to disclose their (RPL) data which leads to a lack of accounting transparency.
The government is proposing the ARGA will define and prepare guidance on (RPL), once agreed, the rules will be implemented by changes to the Companies Act 2006 or by statutory instrument. To overcome the issue of transparency in drafting company accounts, directors will be required to issue a mandatory disclosure of reserves and dividends, prior to any distribution.
Enforcement against company directors
The Companies Act 2006 includes statutory duties that directors must follow, in some cases these are supported by legislation and failure to adhere to the duty is a criminal offence. The majority of cases against directors who fail to adhere to their duties are brought by The Insolvency Service, who have the power to disqualify directors.
The Financial Conduct Authority (FCA) have a range of powers and may take enforcement action against directors, however, the FCA is limited broadly to firms it regulates.
Who will enforce the directors’ duties rules?
The government is proposing legislation to allow the ARGA to investigate and sanction breaches of duty by PIE directors, in other words they will actively enforce the requirements of the Companies Act 2006. Striking off directors will still fall within The Insolvency Service remit; the new regulator will work with the FCA to prevent overlapping of the new regulations.
Clawback and malus provisions
Normally, public limited companies will include clawback and malus provisions if for example a director inflates performance results, to instigate a performance related bonus payment. Surprisingly, there are no mandatory requirements in the UKCGC to include any such provisions. The government is proposing any PIE directors remuneration arrangements must include clawback provisions based on the following trigger points:
- material misstatement of results or an error in performance calculations;
- material failure of risk management and internal controls;
- conduct leading to financial loss;
- reputational damage; and
- unreasonable failure to protect the interests of employees and customers.
The new regulator will be funded by a statutory levy and is expected to be fully implemented by 2023. The consultation closes on the 8 July 2021.