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In 2012, as a recently elected MP, Kwasi Kwarteng co-authored “Britannia Unchained: Global Lessons for Growth and Properity”, a political pamphlet which championed risk-taking and innovation in the UK economy, and which ever since has led some to label him a fervent Brexiteer. Appointed as the Business Secretary in January 2021, only a few months later his department (BEIS) published one of the longest and most ambitious government White Papers in recent years, the aim of which is to “restore trust in audit and corporate governance”. Whilst Kwarteng has been keen to stress that greater governance will not be at the expense of entrepreneurship, some commentators have been sceptical.
Now that we’re nearing the time when the outcome of the consultation is expected to be announced, Part 1 of this blog focuses on the detail of the proposals regarding governance whether they are likely to make the UK a more or less attractive destination for investors. Part 2 of the blog will look in more detail at the particular issues which may be faced by directors of UK companies, as a result of the changes.
Julie Matheson’s blog on the implications on audit firms and auditors arising out of the White Paper can be found here. Julie’s blog focuses specifically on how some of the proposals will impact the regulatory obligations of mid-tier audit firms and how, in practical terms, it seeks to change the way they practise.
The Government’s consultation period for the White Paper ran from 18 March 2021 to 8 July 2021 during which interested parties including investors, shareholders, creditors, firms regulated by the Financial Reporting Council (FRC) and large public and private companies and their directors were invited to submit their views on the proposals.
The White Paper is the culmination of three independent reports commissioned by the Government in recent years - Sir John Kingman’s Independent Review of the FRC, the Competition and Market Authority (CMA)’s Statutory Audit Services Market Study and Sir Donald Brydon’s Independent Review of the Quality and Effectiveness of Audit. These were commissioned following a number of prominent corporate failures, including Arcadia, BHS, Carillion and Patisserie Valerie.
The White Paper is being sold to the public on the premise that the proposed reforms will “safeguard British jobs”, “avoid company failures” and “reinforce the UK’s reputation as a world-leading destination for investment”. When announcing the White Paper, Kwarteng stated “the UK is consistently placed as one of the leading destinations for foreign investment in Europe and around the world, but in recent years, investor and public confidence in how businesses are governed has been undermined” and the Government intends to achieve this by taking a two-pronged approach - audit reform and corporate governance reform.
Directors are ultimately responsible for the management and day to day running of their company. Taking on a directorship, particularly holding office in a large or public listed company comes with a plethora of duties, including promoting the success of the company and various duties in relation to the preparation and auditing of the company’s accounts and reports.
The Government’s position is that the current corporate governance framework is not fit for purpose as it doesn’t sufficiently hold the directors of such companies to account. They claim that under the current regime the investigation and enforcement powers of regulators are limited. For example the FRC, which is responsible for publishing the UK Corporate Governance Code (a key source of principles and provisions of good corporate governance), doesn’t have enforcement powers in respect of directors’ duties unless that director is a member of a professional body, such the Association of Chartered Certified Accountants (ACCA) or the Institute of Chartered Accountants in England and Wales (ICAEW).
The White Paper seeks to address these issues by increasing directors’ accountability in key management areas.
The most prominent proposals in the White Paper relating to directors are:
Directors would be required to carry out an annual review of the effectiveness of their company’s internal controls and make a statement as part of the annual report as to whether they consider the internal controls to have operated effectively.
Directors would need to explain in their statement the benchmark system that has been used to make the assessment and set out how they have assured themselves that it is appropriate to make the statement.
This recommendation is based on a system implemented in the United States under the Sarbanes-Oxley (SOX) regime. Under SOX the directors of public companies are required to assess and report annually on the effectiveness of their company’s internal control structure and their procedures for financial reporting. SOX places responsibility for a company’s financial statements and internal controls with the company’s CEO and CFO. This idea has been criticised on the basis that adopting an enforcement regime which treats certain board members differently from others and holds them to different standards would risk undermining collective board responsibility. The White Paper suggests that in the alternative a hybrid model could be more appropriate. Under a hybrid model the board could be required to consider and sign off any attestation made by the CEO and CFO about the effectiveness of the internal control system.
The legal framework governing the payment of dividends is well established. In order for a company to be able to pay a dividend, it must have sufficient (justifiable) distributable reserves. Because paying a dividend impacts a company’s ability to satisfy its liabilities to its creditors by effectively reducing the company’s available assets, before paying a dividend, the directors must take their duties into account, for example the duty to act within their powers and their duty to promote the success of the company. Any director who authorises the payment of an unlawful dividend, could be in breach of their duties and may be personally liable to reimburse the company.
In light of certain high-profile companies paying dividends and then going on to issue profit warnings or becoming insolvent, such as Arcadia, the Government proposes that companies be required to disclose the total amount of distributable reserves or the known distributable reserves which must be greater than any proposed dividend and, in the case of a group, the parent company would be required to provide an estimate of distributable reserves across the group.
The directors will need to provide a statement that any proposed dividend is within the known distributable reserves and that payment of the dividend will not, in the directors’ reasonable opinion, threaten the solvency of the company in the next two years.
The definition or ‘Public Interest Entity’ or ‘PIE’ comes from EU law and broadly encompasses public companies listed on a regulated market, such as the Main Market of the London Stock Exchange, and any other companies the Government may ordain to be of significant importance, as a result of, for example, their nature, size or number of employees. The statutory audits of PIEs are subject to more rigorous regulation than other companies and the Government proposes to extend the definition of PIE to include certain larger companies regardless of whether they are listed on a regulated market. The revised definition would ensure that certain large private companies or those listed on other markets such as AIM (e.g. BHS and Patisserie Valerie respectively) are subject to the more stringent audit processes.
It is proposed that the directors of PIEs prepare an annual resilience statement, setting out how the directors are assessing the company’s prospects and addressing challenges to its business model over the short, medium and long-term, and separately an audit and assurance policy, describing the approach the directors are taking (over a rolling three year forward looking period) to seek internal and external assurance of the information they report to shareholders.
The Government proposes to replace the FRC with a new statutory regulator - the Audit, Reporting and Governance Authority (ARGA). The Government proposes to give the new regulator investigation and enforcement powers to hold company directors of PIEs to account for breaches of their duties in relation to corporate reporting and audits, including the duty to keep adequate accounting records (s.386 Companies Act 2006), the duty to approve accounts only if they give a true and fair view (s.393), the duty to approve and sign the annual accounts (s.414), and the duty to approve the directors’ report (s.419).
In reality prosecutions of directors of solvent companies for breaching their duties are few and far between. This is because of the significant resources required to investigate complaints and bring prosecutions. The Government hopes that ARGA’s investigation and enforcement powers will complement rather than replace those already available to the Financial Conduct Authority (FCA) and the Insolvency Service and ease the burden on those agencies.
If a director is found to have breached their financial reporting duties or other requirements under the new proposals, that director may face sanctions including reprimands, fines, orders to take action to mitigate the effect of a breach, or to make declarations as to non-compliance and in the most serious of cases, temporary prohibition on acting as a director of a PIE.
Whilst not mandatory, the UK Corporate Governance Code states that for premium listed companies, directors’ remuneration policies should include malus and clawback provisions - i.e. provisions which would enable the company to recover and/or withhold sums otherwise paid or payable to a director (e.g. a bonus), in the event of certain trigger events, such as a misstatement of financial results or an error in performance calculations.
Linked to the creation of ARGA and its proposed enforcement powers, the Government proposes to strengthen malus and clawback arrangements to avoid rewarding failure. It will do this by recommending the list of trigger events included in directors’ remuneration arrangements are expanded to include matters such as conduct leading to financial loss, reputational damage, and unreasonable failure to protect the interests of employees and customers. The arrangements would have a minimum period of application of at least two years after a payment is made.
One of the primary aims of the proposals is to safeguard the interests of investors and to make the UK a more attractive destination in which to invest and do international business. In fact, once established, ARGA’s general objective will be to protect and promote the interests of investors and others who place reliance on corporate reports.
While there will always be a risk that companies could fail, the reforms should provide comfort to investors in larger companies despite the additional administrative and regulatory burdens on those involved in the management of the company. Whilst the introduction of the reforms is likely to be a complex and time consuming exercise, the reforms will allow investors to receive more accurate information and, through the new annual resilience statement and the audit and assurance policy, allow them to see beyond the figures to get a fuller picture of company’s financial health. The experience of greater governance in the US has been to increase confidence and to allow investors to build value in the longer term, but it is generally accepted that the new rules are unlikely to be as onerous as SOX so far as company directors are concerned.
Many of the proposed reforms only target large and public listed companies and therefore investors in and directors of startups should not immediately feel the effect of the reforms. As we shall explore in more detail in Part 2 of this blog, there is still a high degree of ignorance amongst UK directors regarding the potential burdens and liabilities of serving as a director, and good corporate governance at an early stage provides a good foundation on which the business can grow. On the other hand, many fast growing companies choose the UK because of its comparative lack of red tape, and also for the option of listing on one of its markets at a later stage. Any increase in regulation for PIEs, or any extension of the definition of a PIE, may give founders food for thought when choosing where to start their business. Whilst some will see opportunities trading post-Brexit in the longer term, after the disruption to supply lines in the last few months, there’s no doubt that trading in the UK is becoming more challenging for many businesses, even before these changes.
With many companies struggling to make it through the Covid-19 pandemic and with the full fall-out of Brexit only now starting to be felt, many would argue that increasing director responsibility at such a time is illogical. However, realistically the reforms will need quite some time to be implemented. BEIS has indicated that the earliest the White Paper will be acted on is likely to be in or around September 2022 with even that lengthy timeframe being subject to finding sufficient parliamentary time to progress matters.
Despite the uncertainty created by the Covid-19 pandemic and Brexit, the UK remains an attractive destination for investment, particularly in the fintech industry where almost £18 billion was invested in UK companies in the first half of 2021, a 200% increase on 2020’s figures. Much of this money has come from institutional investors, one of the groups most likely to take comfort from the White Paper reforms, and comes amidst calls by the Prime Minister and the Chancellor for such investors to help drive the UK’s recovery from the pandemic.
If you would like any further information or advice about the topic discussed in this blog, please contact our Corporate and Commercial team.
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.
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.
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