24 March 2021

Audit reform and directors’ liability

UK directors could be held liable for ensuring the accuracy of company financial statements, with directors of large businesses facing fines and even bans from board positions if they fail to do so, under plans being considered by the Department for Business, Energy and Industrial Strategy (“BEIS”).

BEIS released its plans on 18 March in a white paper titled “Restoring trust in audit and corporate governance” (the “White Paper”), which also sets out proposals for wide-ranging reforms to the auditing sector. The Government has opened a 16-week consultation period (closing 8 July), during which time interested parties can provide BEIS with feedback on these plans.

Background

Reform has been in the Government’s sights for a while, more so following several domestic scandals (BHS, Patisserie Valerie and Carillion). The Government’s view on Carillion was particularly damning: in 2018 Rachel Reeves and Frank Field led a review into its collapse, where they noted wider cultural and systemic failings. They concluded that the UK needed “radical reforms to our creaking system of corporate accountability” and an end to the “parasitical” relationship between companies and auditing firms.

In recent years the Government also commissioned a number of reports to examine the auditing sector and how it impacts UK companies, including the Sir John Kingman report on deficiencies in any oversight of the sector (18 December 2018), a BEIS select committee report on the future of auditing (2 April 2019), a Competition and Markets Authority report on the lack of competition between auditing firms (18 April 2019) and the Sir Donald Brydon report on the quality of auditing practices (December 2019).

The Government’s groundwork now appears to be taking a more robust direction with legal proceedings being brought by it in January against Carillion’s former directors, some of whom may be barred from acting on UK boards in future. The case captures a range of directors: those who were no longer on the board at the time of the company’s collapse, directors who had been brought in to rescue the company and even non-executive directors.

When the Rt Hon Kwasi Kwarteng was appointed Business Secretary in January this year he stated that audit and corporate governance reform was “one of his initial priorities”. With the release of the White Paper, Mr Kwarteng has emphasised that “restoring business confidence, but also people’s confidence in business, is crucial to repairing our economy and building back better from the pandemic”. Strengthening investor confidence and public trust will likely determine whatever plans the Government ultimately adopts.

White Paper key points

The White Paper is very extensive. The Government has raised queries to stakeholders throughout (these are helpfully collated on page 221 of the White Paper).

Main points from the White Paper include:

Director liability

  • Non-execs. The White Paper seems to apply to non-executives as to any other director. This follows the Government’s approach on the Carillion case, where non-execs were caught by the Government’s claim. The White Paper does however make some distinction between directors of PIEs (defined below) and other companies.
  • PIEs. The current legal definition of public interest entities (or “PIEs”) – entities trading on a regulated market, credit institutions and insurance undertakings – is fairly narrow and all PIEs are currently subject to greater auditing regulation. In the White Paper the Government suggests widening the definition of PIEs to capture larger private companies (identified by turnover or number of employees – for example, to capture companies with a turnover of more than £200 million and a balance sheet of more than £2 billion).
  • Internal controls. All companies may need to introduce new internal controls over their financial management, but the Government has noted this could vary depending on a company’s listing and PIE status. For all companies, the Government wants directors to assess their company’s internal controls and identify deficiencies in their annual reports. In some circumstances, auditors may be instructed to review internal controls, for example, where requested by the shareholders or after regulator intervention. The White Paper also recommends that premium listed companies, and eventually all PIEs, provide their shareholders with a detailed audit and assurance policy and a resilience statement (considering main business risks, which may include climate change factors).
  • Dividends and distributions. Directors should be clearer with shareholders on distribution practices. This suggestion includes plans to introduce new reporting requirements on distributable reserves (with financial statements to include more extensive commentary) and for directors to make a more detailed statement each time they approve a distribution as to how the company’s solvency might be affected.
  • Public interest statement. The Government does not currently plan to introduce a requirement for companies to produce any statement setting out their responsibilities to the public, but has asked for stakeholder feedback on this in the White Paper.
  • Sanctions. The White Paper sets out how:
    • Directors of all companies may be subject to minimum clawback conditions in their remuneration arrangements (which would apply for at least two years after a payment is made). Currently, 90% of FTSE 350 companies have made their directors subject to some such provisions. The Government is considering making all listed companies subject to clawback provisions (and seems to imply that all companies should adopt the principle). The Government also wants to extend the grounds for clawback – to be triggered by material misstatement of financial results, misconduct, material failure of risk management and internal controls, conduct leading to financial loss, reputational damage or unreasonable failure to protect the interests of employees and customers.
    • PIE directors may be subject to greater regulation by ARGA (see below) (working in tandem with the Financial Conduct Authority and Serious Fraud Office). Sanctions against PIE directors could include reprimands, fines, orders to take action to mitigate the effect of a breach and, in the most serious of cases, some prohibition on acting as a director of a PIE entity.

Details of the new watchdog

The UK’s Financial Reporting Council (“FRC”) currently oversees the auditing sector but has been called a “ramshackle house” by Sir John Kingman and “asleep at the wheel” by Rachel Reeves. Sir John Kingman advised that the Government set up a new watchdog (the Audit, Reporting and Governance Authority (“ARGA”)) and BEIS has made a start on this. ARGA is not expected to launch until April 2023, but the White Paper notes it will oversee all companies (focusing on PIEs), with powers to publicly publish any of its findings and correspondence. ARGA will also have authority to oversee the Big Four changes noted below. The Government believes ARGA could be funded by way of a statutory levy funded by market participants – the FRC will consult on levy plans separately.

“Big Four” changes

Much of the auditing market is dominated by the “Big Four” (KPMG, Deloitte, PwC and EY). The Government is keen on FRC plans that audit services should be a separate, independent practice within the Big Four (the concern being a perception that the Big Four have encouraged (and rewarded) audit partners to focus on wider client relationships that may lead to more profitable engagements rather than being more challenging and sceptical in undertaking their audit and not being solely focused (and rewarded) for the quality of their audit work). Some firms have already started this – for example PwC has created a clearly delineated audit service within its business audit practice and Deloitte has announced an independent governance structure to oversee audit services. The Government is also determined to increase competition between the largest auditing firms – in the White Paper it has noted it may look to larger companies to assist with this (these companies may be required to engage smaller auditing firms to conduct their audits). A cap on the Big Four’s market share of FTSE 350 audits is also being considered. ARGA would have authority to oversee all such changes.

Timing for reforms

As noted above, the consultation period is currently underway. The White Paper emphasises that changes may then be enacted during a transition period, with some measures being phased in if they will have a significant impact on UK businesses. The Government has noted that other measures “that do not directly impact on businesses” (including establishing ARGA) could be brought into effect more quickly.

Potential impact

Interestingly, the reforms look something akin to the United States’ Sarbanes-Oxley Act (“SOX”) (introduced in 2002) which also dealt with auditor independence and director responsibility of financial statements. SOX applies to publicly traded companies (as well as auditing firms) – other entities need to comply with some but not all of its provisions. Directors can ultimately face fines and imprisonment, though in reality the US government has brought very few charges against company directors using SOX and made even fewer prosecutions. What SOX has changed is business practice – particularly in internal systems for the approval of financial reports and in record storage.

Compliance with any audit reforms will likely involve more cost to UK companies, whether the SOX approach is used or not. Any cost the new regime brings to auditing firms will likely be passed on in some way to their clients and the reforms could result in direct costs to companies too, for example in an increase to D&O insurance premiums, in time away from core business activities to introduce new systems, in IT storage costs and in professional advice required to understand the new rules.

The question then remains of just how serious the Government will be in prosecuting non-compliant directors. If the Carillion case is anything to go by, BEIS really does mean business.

Lucy MacArthur is a Senior Associate in the Corporate team.

Disclaimer

This note reflects our opinion and views as of 24 March 2021 and is a general summary of the legal position in England and Wales. It does not constitute legal advice.

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