BEIS White Paper on Audit Reform: will directors take on more personal liability?

13 December 2021

In Part 1 of our two-part series on the Department for Business, Energy and Industrial Strategy's (BEIS) White Paper on audit and corporate governance reform (Restoring Trust in Audit and Corporate Governance), we focussed on whether the proposals regarding corporate governance are likely to make the UK a more or less attractive destination for investors.

In Part 2 of this series, we look in more detail at the particular issues which may be faced by directors of UK companies as a result of the proposed changes. We also consider the recent criticisms of the White Paper and what this could mean for the proposals.

A move away from collective responsibility? 
One particular proposal under consideration is that individual directors, rather than boards collectively, should be responsible for the accuracy of their company’s financial statements. The proposed reforms in this area are similar to those introduced by the Sarbanes-Oxley Act in the US following the Enron accounting scandal in 2001. The UK has recently seen a number of its own controversies affecting the audit industry, including in relation to companies such as Carillion, Thomas Cook and Patisserie Valerie. Under the proposed regime, sanctions would include fines and bans for what are regarded as major derelictions of a director’s duty to uphold corporate reporting and audit standards.  

Concerns expressed
Since it was announced by the Government, this proposed shift towards making individual directors responsible for the accuracy of their company’s financial statements has faced criticism from a number of key industry stakeholders. Typical of the concerns expressed about this new focus was a comment by The Institute of Directors (IoD).  It declared that: “We are strongly of the view that the board as a whole should retain collective responsibility for oversight of the internal control, risk management framework and financial reporting as a whole. This responsibility should not be concentrated on specific corporate officers e.g. the CEO and CFO, as is the case with Sarbanes-Oxley in the United States.”

According to the Financial Times and other sources, it’s now expected that these proposals will be dropped or at least be watered down.

The Daily Telegraph has recently reported that: “Instead of introducing new legal requirements, officials will try to improve financial reporting and internal controls by insisting that directors make an annual statement about their effectiveness.”

Deterring talent, limiting diversity?
Any shift away from collective board responsibility for financial matters towards specific board roles has the potential to discourage those who don’t have a financial background from taking on a directorship.  

The same could be true for non-executive director (NED) roles. Already, according to a survey of NEDs from FTSE companies, published by EY, 78% of those surveyed reported that the role of the NED has become more time consuming in recent years. “We expect these pressures to further increase as boards respond to the immediate and longer-term impacts of COVID-19,” said EY. 

In 2017, the Government commissioned Sir John Parker to review the ethnic diversity of UK boards. The report found that, of the 1,050 director positions in FTSE 100 companies, there were only 85 non-white directors and more than 50% of FTSE 100 companies did not have any directors of colour. Further, seven of those companies account for over 40% of the directors of colour. The report recommended that each FTSE 100 and FTSE 250 board should have at least one director of colour by 2021 and by 2024, respectively. In an update to the report, published last year, Sir John Parker advised: “there is still much more work to be done to reap the undeniable benefits that diverse leadership provides.”

There is clearly still a long way to go to reach the Government’s targets and one of the key criticisms of the White Paper is that by targeting specific board roles and moving away from collective responsibility of the board, those who don’t have a financial background or potential NEDs may be discouraged from taking on a directorship. The Government however, believes that the risk of deterring candidates from non-financial backgrounds is minimal and suggests that the new regulatory body (the Audit, Reporting and Governance Authority (ARGA), see below) could look to mitigate this risk when exercising its enforcement powers by acting proportionately and by taking into account a director’s background and the size of the entity concerned.

A further concern is that the potential liability of directors will increase by such a degree that taking on the role of director will not be worth the increased risk, admin and cost. For example, during the Covid-19 pandemic, the cost of directors and officers (D&O) insurance premia has increased by 41% year-on-year in 2020 according to S&P Global Ratings and, when implemented, the proposed reforms will likely have the effect of increasing these even further.

A new regulatory body
The Government’s plans to create a new regulatory body, ARGA, to replace the Financial Reporting Council (FRC) appear to be going ahead.  It proposes giving the beefed-up regulator the power to take action against a company’s directors and/or its audit committee for breaching their duties.  There is also a suggestion that shareholders should be given greater rights to understand why an auditor has been removed by questioning the auditor and the directors. 

The Government had also been considering bringing more entities within the scope of these reforms by broadening the current definition of a Public Interest Entity (PIE). This would mean that some large private companies would also be affected by the changes. The White Paper puts forward two options in this regard. The first option would mean that those private companies with more than 2,000 employees or a turnover higher than £200m and assets above £2bn would be classed as PIEs.  Under the second option, the requirement would be more than 500 employees and a turnover greater than £500m.  AIM-quoted businesses with a market capitalisation of over €200m and certain other entities (such as Lloyds syndicates) would also be classed as PIEs. These suggestions were based on a number of recommendations of the Brydon Review of 2019.  

The Government is expected to choose the second of these options and publish guidance for companies as to when they might fall within the definition. For example, a company might be required to meet the thresholds for three consecutive financial years or to meet the thresholds for two out of the last three years before qualifying as a PIE. It’s expected that, if the second of these options is pursued as expected, this will amount to only about 1,000 more companies (than those currently classed a PIE) falling within the definition, compared to the extra 4,000 or so originally envisaged.  It’s worth noting though that, by including limited partnerships and private companies turning over more than £500million and employing over 500 people, the scope would encompass the country’s largest accountancy and law firms.

Whatever the outcome of the consultation, the general direction of travel is clear. The Government wants to reduce the risk of further accounting scandals and large scale corporate failures by increasing the ability – and the requirements – for directors to have greater visibility across company finances and financial controls.  As Roger Barker, director of policy and corporate governance at the IoD, put it in a comment to the Daily Telegraph, “Even if the Government decides to pull back from creating a new statutory obligation for directors around internal controls, this is still a key issue for which boards are ultimately responsible.”

Directors need to be clearer about their responsibilities 
Directors may assume that they will automatically be covered by their company’s insurance and by ensuring that they tick the legal boxes required of the board as a whole.  However, this approach is increasingly-likely to prove insufficient – especially with growing regulations affecting all companies’ ESG commitments. Directors of public companies and those which fall into the newly expanded PIE category will need to think carefully about whether they’re adequately covered by their company’s current D&O insurance.  

Whatever the final rules look like, directors need to be clear about their duties and responsibilities and should always seek professional advice. 

FURTHER INFORMATION

If you would like any further information or advice about the topic discussed in this blog, please contact our Directors and Officers team.

 

ABOUT THE AUTHORS

James Fulforth is a partner and head of the corporate and commercial department. James advises on corporate transactions, including angel, VC and PE investments, mergers and acquisitions, joint ventures, and re-organisations. He is an advisory board member of Angel Academe, the angel investor group, and regularly acts for founders of and those investing in early-stage and startup ventures.

Luke Gregory works on a broad range of corporate and commercial matters including advising on company incorporation, bespoke articles of association and shareholder agreements, corporate governance, and Companies Act procedures such as off-market share buybacks and the removal of company directors.

 

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