The last few years have seen some high-profile scandals at the likes of BHS and Carillion, raising serious questions over the role of governance and auditing in the collapse of those businesses. The public outcry was met by promises from the government for an overhaul of audit and boardroom rules. On 31 May 2022, the Government published “Restoring Trust in audit and corporate governance”, outlining its key proposals in this area, the main one being to expand the net for “public interest entities” (PIEs) – large businesses of public importance – to increase regulation. In this briefing, we focus on the key recommended measures.
Which large private companies will be affected?
The new PIE definition will bring into scope large private companies or LLPs with 750 or more employees (on a global basis) and an annual turnover of at least £750m (the 750:750 threshold). Companies with shares traded on AIM or other multilateral trading facilities will be deemed to be PIEs if they meet the 750:750 threshold (but not if they are smaller). It is estimated that 600 businesses will be brought into the PIE category.
What is the practical effect of being a PIE?
Companies will be subject to tighter regulatory control in areas such as corporate reporting, payment of dividends and audit requirements. The reforms propose the creation of a new regulatory body, the Audit, Reporting and Governance Authority (ARGA) which will succeed the Financial Reporting Council. ARGA will be given twin objectives: to protect and promote the interests of investors, other users of corporate reporting and the wider public interest, and also to promote effective competition in the market for statutory audit work.
What will this mean for directors of PIEs?
They will have greater responsibility to report on the effectiveness of a company’s internal controls and fraud prevention measures. The FRC will be invited to include in the UK Corporate Governance Code an explicit directors’ statement about the company’s internal controls and their effectiveness. Alongside the new Code provisions, the regulator will be asked to work with companies, investors and auditors on guidance on matters such as acceptable standards and benchmarks. However, proposals which would have gone much further, and required directors to be personally liable for internal controls over financial reporting (along the lines of the Sarbanes-Oxley Act in the US) have been dropped.
If the UK Corporate Governance Code is the main channel for reforms, does this mean private companies are not affected?
No, large private companies are affected if they meet the threshold to be PIEs. The Government acknowledges that using the Code as a vehicle for reform is the tried-and-tested approach to strengthening corporate governance, providing a “comply or explain” approach to improve transparency and accountability to investors. Although it currently only applies to premium listed companies, it has a wider influence on other codes and best practice principles developed for other types of companies. These include the QCA Corporate Governance Code and the Wates principles for large private companies.
The law on dividends and capital maintenance is brought into sharper focus
Paying a dividend leaves a company with fewer assets with which to meet its liabilities to creditors, and corporate law imposes strict rules on dividends being payable only from profits. But companies such as Carillion were found to have racked up large debts and sold assets in order to continue paying dividends to shareholders, with seeming disregard for the company law rules on capital maintenance. The new regulator, ARGA, will be tasked with issuing guidance on a clear definition of “realised” profits and losses so directors have clarity on the level of distributable reserves. There will be new rules requiring PIEs meeting the 750:750 threshold to disclose their distributable reserves (for UK groups, this will relate to the parent company) and explain the long-term approach of the board to the amount and timing of shareholders’ returns. Directors of PIEs will also be required to make an express statement confirming the legality of proposed dividends and any already paid. There was a proposal for there to be mandatory disclosure of a group’s capacity to pay dividends, taking into account those reserves that could be distributed up the group to the parent company, but this has been rejected as a legal requirement.
Will corporate reporting also be tightened up?
Yes, a number of changes are proposed for PIEs meeting the 750:750 threshold. A new statutory Resilience Statement will be introduced setting out the directors’ approach to managing risk and developing resilience over the short, medium and long term. The Government intends to legislate for companies to report on matters that they consider a material challenge to resilience over the short and medium term, explaining how they have assessed materiality. In addition, PIEs will need to publish an audit and assurance policy every three years, setting out their internal auditing and assurance process. This will not be subject to an advisory shareholder vote (contrary to the White Paper proposal) but it will be mandatory for companies to state within the audit and assurance policy how shareholder and employee views have been taken into account.
How will directors of PIEs be held to account for these new rules?
The Government intends to give the new regulator, ARGA, powers to enforce the statutory directors’ duties of PIE directors relating to corporate reporting and audit. It is promised that the new civil enforcement regime will be targeted, proportionate and transparent, and directors will only be accountable for what could reasonably be expected of a person in their position. All PIEs are in scope of the new directors’ enforcement regime. Note that if a subsidiary meets the 750:750 threshold, this will bring its parent company into the fold, so the directors of both parent company and subsidiary will be subject to the new enforcement regime. A parent company will also be a PIE if UK incorporated and its consolidated accounts meet the new threshold, even if the parent does not meet the PIE definition in its own right.
We do not yet have a precise timetable for the reforms, but the Government has indicated that the changes will be implemented on timescales that give relevant companies time to plan and prepare. The timescale is likely to stretch over several years, with the changes being implemented via a mix of primary and secondary legislation and amendments to the UK Corporate Governance Code.