A string of major UK corporate bankruptcies, including BHS (2016), Carillion (2018), Patisserie Valerie (2018) and Thomas Cook (2019), each of which collapsed unexpectedly and soon after having received certificates of good health from their respective auditors, served as a catalyst for a process of independent review, consultation and recommendations on “Rebuilding Confidence in Auditing and Corporate Governance”.
A government consultation was published in March 2021, and the government response setting out what proposals it would take forward and how, followed in May 2022. The current regulator, the Financial Reporting Council (FRC), endorsed these proposals, including the creation of a new body, the Audit, Reporting and Governance Authority (ARGA) to succeed the FRC, in a position published in July 2022.
The proposals for change made throughout this process are very varied. A series of proposals relate to a plan to overhaul the audit market, in order to improve independence, quality and competition between auditors. Other proposals within the same framework relate more directly to the corporate governance responsibilities of directors of UK companies (and equivalent directors of other qualifying entities). Over the next few years, the result should be better corporate disclosure, greater director accountability for internal controls and capital management, and greater director accountability for those things.
Change of scope. The first important change is that a number of large private companies that are not currently subject to corporate governance regulations will come within the scope of these rules. This comes as a result of a change in the definition of “public interest entities” which are considered large enough to require this regulation. While currently companies listed on a regulated market, credit institutions and insurance companies already fall under the definition, it will be widened so that public and private companies and LLPs with more than 750 employees and an annual turnover of over £750 million are also considered public. entities of interest.
Internal controls and maintenance of capital. Second, board accountability for their organization’s internal controls—that is, financial, operational, and compliance systems—needs to be strengthened. During the consultation period, this part of the reform was compared to the introduction of the US Sarbanes-Oxley Act of 2002 following the Enron scandals of 2001 and WorldCom of 2002. In the end, the government decided not to legislate on directors’ statements on internal controls and instead the FRC will conduct a consultation in 2023 on amendments to the UK’s Corporate Governance Code (Code) to incorporate this requirement, which will be therefore required on a ‘compliance or explain basis. Proposals that would have required auditors to certify internal controls were not adopted, but directors will have to explain the basis of their assessment of internal controls – the FRC will prepare guidance on how to address this issue.
Directors will also need to provide more disclosure and accountability for their organization’s capital maintenance and distributions. Although the legal rules regarding the maintenance of required capital do not change, the ARGA will be given formal responsibility for providing guidance on what counts as “realized profits” and “realized losses”, which are the terms used to calculate a company’s distributable reserves. Eligible companies will have to disclose what their distributable reserves are, as well as their long-term approach to the amount and timing of returns to shareholders. Any dividend must be justified by an explicit declaration from the directors confirming the legality of these dividends.
Additional reports. Third, a new set of corporate reports will be required of eligible entities. These new reporting requirements reflect the most pressing current concerns of stakeholders in the current environment. The first new report is the “resilience statement”, to be included in their strategic report. This requires an organization to outline what it considers important to its resilience in the short to medium term and explain how it determined what was important.
Reflecting the major risks of the modern era, all of these entities will need to consider a specific range of issues, including climate change and digital security risk when preparing the resilience statement. In addition, eligible companies will be required to publish an “Audit and Assurance Policy”. This new report will explain to stakeholders how the company ensures the quality of the information it reports to shareholders.
Performance and Liability. With respect to directors’ reporting and auditing obligations, ARGA will for the first time be granted civil enforcement powers. This power, which will give ARGA the right to investigate and sanction misconduct, will apply to all directors, including non-executive directors, of all public interest entities. These new powers require legislation, so while ARGA may begin to prepare guidance for administrators in the meantime, their enforcement authority will likely appear at the earliest in the 2023-24 legislative session.
The increased director reporting and certification requirements that will come into effect should also allow for greater shareholder scrutiny and more stewardship and shareholder activism, and even litigation. Close monitoring and investor engagement with companies is explicitly encouraged in the UK’s corporate governance framework, as set out in the Stewardship Code. The FRC notes in its most recent position paper that, as the Stewardship Code was last updated in 2020, the FRC intends to allow another year before conducting a new review. .
The Code, however, was last significantly updated in 2018. Companies that have adopted it, either as a requirement for blue chip listed companies or because they choose to do so voluntarily , are required to “comply or explain”, allowing investors and other stakeholders to assess how the principles of the Code have been applied. The FRC will consult in 2023 on changes to update the Code for application in periods beginning on or after January 1, 2024. The revisions are necessary to implement some of the developments discussed above, and will also include updates to existing provisions to encourage the adoption of a broader range of circumstances (beyond gross negligence or misstatements material) in which executive compensation could be withheld or clawed back.
The UK government and regulators are at an inflection point in their multi-year process to “restore confidence” in the UK’s corporate governance system, as well as in the system of auditing and reporting. The most recent publications set out the proposals that will be implemented to do this. Legislation will be needed for some measures, including the expansion and strengthening of the regulator, the transition from the FRC to become the ARGA.
Nevertheless, the reforms maintain the general structure of the corporate governance framework in the UK. Corporate governance in the UK will continue to be primarily principles-based, with an emphasis on reporting and explaining to ensure that obligations are met, and the principles and guidance to be followed will be in all defined by the regulator and therefore more flexible and more easily scalable than legislative rules.
Thus, in the short term, the FRC will make revisions to the Code focusing on strengthening the current reporting mechanisms and improving the effectiveness of internal control throughout the year, making the necessary revisions to reflect broader responsibilities, including for broader environmental, social and governance reporting. Given that the FRC’s intention is for the revised Code to become effective on or after January 1, 2024, consultation on a revised Code and supporting documents is expected to begin in early 2023.
Reprinted from: Financial Worldwide | October 2022
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.