BEIS: Restoring trust in audit and corporate governance – Consultation on the government’s proposals
On March 18, 2021, the Department for Business, Energy and Industrial Strategy (BEIS) published a White Paper which sets out for consultation wide-ranging reforms which aim to modernise the UK’s audit and corporate governance regime.
Many of the proposed reforms in the White Paper stem from recommendations made by three independent reviews into audit and corporate reporting. These comprise the 2018 independent review of the Financial Reporting Council (FRC) led by Sir John Kingman, the 2019 review into the quality and effectiveness of audit led by Sir Donald Brydon, and the market study of statutory audit services led by the Competition and Markets Authority (CMA) in 2019. As a result, the proposed reforms include new measures in relation to directors, auditors and audit firms, shareholders and the audit regulator.
We will be preparing a detailed briefing on the White Paper, but the areas covered by the White Paper include the following:
Chapter 1 – The Government’s approach to reform
This chapter sets out the Government’s overall approach to reform. The audits and auditors of Public Interest Entities (PIEs), predominantly publicly-listed companies, are currently subject to a number of additional regulatory measures and this chapter sets out two options for expanding the PIE definition, both of which would expand it to include the largest private companies, as well as seeking views on other types of entity that could be included in a new PIE definition.
Chapter 2 – Directors’ accountability for internal controls, dividends and capital maintenance
In relation to internal controls, views are sought on the following three options (which are not intended to be mutually exclusive):
- Directors should be required to carry out a review of the effectiveness of their company’s internal controls each year and make a statement, as part of the annual report, as to whether they consider them to have operated effectively. The statement should disclose the benchmark system used and explain how the directors have assured themselves that it is appropriate to make the statement.
- The audit report should describe the work the auditor is already required to do to understand the company’s internal control systems to the extent needed to perform the audit, and to state how that work has influenced the audit, but without a formal auditor opinion on the internal controls’ effectiveness being required.
- The auditor should be required to provide a formal opinion on the directors’ annual attestation about the effectiveness of the company’s internal controls, potentially limited to key internal controls over financial reporting, or a sub-set of that.
The tentative preferred option would require a directors’ statement about the effectiveness of the internal controls, but (unlike the US’ approach to internal controls which mandates external auditor attestation in most cases) leave the decision on whether the statement should be assured by an external auditor to the directors, audit committee and shareholders.
The following reforms are proposed in relation to dividends and capital maintenance:
- Companies (the parent company in the case of a group) should disclose the total amount of reserves that are distributable, or – if this is not possible – disclose the “known” distributable reserve, which must be greater than any proposed dividend.
- In the case of a group, the parent company should provide an estimate of distributable reserves across the group.
- Directors should state that any proposed dividend is within known distributable reserves and that payment of the dividend will not, in the directors’ reasonable expectation, threaten the solvency of the company over the next two years.
The chapter also seeks views on proposals to give the new Audit, Reporting and Governance Authority (ARGA) powers in relation to how companies should calculate their distributable reserves. Currently, guidance in this area rests with the professional accountancy bodies.
Chapter 3 – New corporate reporting on resilience, assurance and payment practices
This chapter invites views on the following proposed new reporting requirements for directors of PIEs:
- An annual Resilience Statement, setting out how directors are assessing the company’s prospects and addressing challenges to its business model over the short-, medium- and long-term, including risks posed by climate change.
- An Audit and Assurance Policy, describing directors’ approach (over a rolling three year forward look) to seeking internal and external assurance of the information they report to shareholders, including any external assurance planned beyond the scope of the annual statutory audit.
Views are also sought on how company annual reports could include certain minimum reporting on supplier payment policies and practices.
Chapter 4 – Strengthening the supervision of corporate reporting
The key measures proposed are for ARGA to have powers to direct changes to company reports and accounts (rather than having to seek a court order as currently), increased transparency for the existing Corporate Reporting Review process and the extension of the Corporate Reporting Review process to the whole of the annual report and accounts. ARGA could then review areas not currently within the scope of its powers such as corporate governance statements and directors’ remuneration and audit committee reports, as well as voluntary elements such as the CEO and chairman’s reports.
Chapter 5 – Company directors
This chapter sets out proposals to give ARGA investigation and enforcement powers in relation to wrongdoing by directors of PIEs which would apply to breaches of statutory duties relating to corporate reporting and audit of PIES, including the power for ARGA to impose more detailed requirements for how directors should meet these duties.
There are also proposals to strengthen malus and clawback provisions within executive directors’ remuneration arrangements which would involve identifying minimum clawback conditions and have a minimum two-year application period. These conditions could include clawback for serious misconduct, a material misstatement of results or an error in performance calculations and failures of internal controls and risk management. These measures could be introduced through changes to the UK Corporate Governance Code.
Chapter 6 – Audit purpose and scope
This chapter sets out the Government’s proposals in response to the major reform of audit proposed by the Brydon Review, including changes relating to audit’s purpose, audit practice and the organisation of the audit profession. The proposals include a new corporate auditing profession to operate independently of the professional accountancy bodies, new overarching principles for auditors to reinforce good audit practice, a new duty on auditors to take a wider range of information into account in reaching audit judgements (in particular whether financial statements give a “true and fair view”), and new obligations on both auditors and directors relating to the detection and prevention of material fraud.
Chapter 7 – Audit committee oversight and engagement with shareholders
It is proposed that ARGA should have new powers to set and enforce additional requirements for audit committees of FTSE 350 companies in the appointment and oversight of auditors. Powers to give ARGA an independent ability to appoint an auditor where more serious problems exist with a company’s audits are also suggested.
New measures are also proposed to encourage and facilitate more meaningful engagement between a company and its shareholders on matters affecting audit quality. These include a formal mechanism by which shareholders of a quoted company can propose additional matters for emphasis within the scope of the company’s external audit, and proposals for better communication to shareholders following the resignation or dismissal of the auditor of a PIE.
Chapter 8 – Competition, choice and resilience in the audit market
Proposed reforms to increase choice, competition and resilience of the UK’s statutory audit market include:
- Greater regulatory powers and duties intended to increase choice and competition in the FTSE 350 audit market, initially through a managed shared audit regime and, if needed, taking a reserve power for a managed market share cap.
- Requiring operational separation between the audit and non-audit arms of certain firms which will include separate governance, financial statements prepared on an arm’s length basis, and regulatory oversight of audit partner remuneration and audit practice governance.
- Statutory powers for the regulator to proactively monitor the resilience of the audit market and audit firms, including powers to require audit firms to address any viability concerns that are identified. ARGA will also have the power to take enforcement action to address anti-competitive practices and an abuse of dominant position within the statutory audit market.
Chapter 9 – The supervision of audit quality
This chapter sets out plans to make ARGA responsible for approving statutory auditors of PIEs, rather than the professional bodies, proposals to improve transparency of ARGA’s Audit Quality Review reports on individual audits while providing safeguards for sensitive information, the Government’s intention to provide ARGA with new powers to require a UK group auditor to arrange access to overseas component auditors’ working papers where considered appropriate, and a request for views on how ARGA might access information covered by an audited entity’s legal professional privilege that is needed for ARGA’s inspections and investigations of statutory audit.
Chapter 10 – A strengthened regulator
This chapter sets out the framework for establishing ARGA which will replace the FRC and have as its general objective the protection and promotion of the interests of investors, other users of corporate reporting, and the wider public interest.
Chapter 11 – Additional changes to the regulator’s responsibilities
This chapter sets out further changes to ARGA’s responsibilities arising from recommendations in the Kingman review of the FRC. These include proposals for ARGA to have a new statutory role in the supervision of accountants and actuaries, replacing more informal arrangements; and proposals for a more pro-active role for ARGA in identifying and assessing serious issues relating to a company’s corporate reporting or audit by strengthening its information gathering and investigatory powers.
Responses to the questions raised in the White Paper are requested by July 8, 2021. Subject to the outcomes of the consultation, the Government will bring forward primary legislation to take forward the proposed reforms when parliamentary time allows.
(BEIS: Restoring trust in audit and corporate governance – Consultation on the government’s proposals, 18.03.2021)
(BEIS, Business Secretary launches major overhaul of UK’s audit regime in wake of big-name company collapses, 18.03.2021)
PIRC: Shareholder Voting Guidelines 2021
In March 2021, PIRC published its updated Shareholder Voting Guidelines 2021 which set out what PIRC considers constitutes good corporate governance best practice.
Changes from PIRC’s 2020 Shareholder Voting Guidelines include the following:
- Designated non-executive director (NED) Where a company has chosen to designate a director as responsible for workforce engagement, PIRC considers that the designated director has a responsibility to employees as well as other stakeholders to ensure meaningful data relating to workforce issues is adequately disclosed. Data relating to COVID cases should be disclosed and if there are fatalities, companies should disclose whether any of them are related to COVID. If the company has failed to disclose sufficient information relating to key employee metrics such as trade union relationships and/or the impact COVID has had on employees, including data relating to infections, track and trace and, if relevant, any fatalities due to COVID, or if the company are reporting on workforce engagement but not mentioning unions, PIRC will recommend abstention on the re-election of the Designated NED. Where there is no Designated NED, employee representatives or workforce advisory board, PIRC considers that the CEO has ultimate responsibility to stakeholders to ensure meaningful data relating to workforce issues has been adequately disclosed.
- Time commitment of directors – PIRC states that the COVID crisis has shown that there are times when multiple unrelated boards may have to call ad hoc or emergency meetings and all of them would require the Chair and directors’ full attention in order to be able to weather difficult situations. In light of these developments, PIRC considers information on attendance at boar and committee meetings of increased importance, and that a Chair should not hold more than one concurrent chair position because of the potential aggregate time commitment.
- Director skill sets – This is a new requirement. PIRC believes companies should disclose full skills matrices and if there are serious skills “blind spots” across the whole board, PIRC may begin to recommend holding the chair and members of the nomination committee accountable, as those most responsible for failures in board composition. PIRC may also recommend opposition to the election or re-election of directors if they do not have the appropriate disclosed skills required for principal committees of which they are members.
- Annual report – When a company is considered to be in a high-risk sector, with regards to exposure of staff to COVID, PIRC expects that full disclosure of causes of fatalities be provided, particularly where related to cases of COVID among staff. Adequate measurement of such cases is considered to be material for the financial resilience of the company in the long term and the absence of it may lead to a recommendation to oppose the approval of the annual report.
- Auditor managing whistleblowing hotline – PIRC considers appointing the company’s statutory auditor to manage the whistleblower hotline to be a conflict of interests, even if the auditor is considered independent as the auditor may be unlikely to report issues highlighted that contradict its previous assurance statements. PIRC believes this could lead to whistle-blowers being suppressed, particularly at companies where there are independence concerns regarding the statutory auditor. Starting in January 2022, PIRC will oppose proposed statutory auditors if they also manage the company’s whistleblower hotline.
- Remuneration Committees – PIRC considers that remuneration committee members should not be executive directors of other UK-listed companies and since 2017 has recommended abstaining on the election of such directors who sit on the remuneration committee. PIRC’s current policy for FTSE 350 companies states that if a company’s remuneration report or policy raises serious concerns (which would result in an oppose vote) then it is considered that chair of the remuneration committee should be held accountable for it when considering re-election, and will also receive an oppose vote. Beginning in January 2022, PIRC will apply this policy globally, such that if a company remuneration report or policy receives an oppose vote, then the remuneration committee chair will also receive an oppose vote. If the remuneration committee chair is not up for election, then any member of the remuneration committee up for election will instead receive an oppose vote.
- Inappropriate incentive outcomes – PIRC considers it inappropriate that companies that received financial support from government in the form of furlough or COVID-related loan or business rates relief, continue to pay a bonus to executive directors and consider it the responsibility of the remuneration committee chair to ensure inappropriate incentive outcomes are avoided.
- NED fees – PIRC believes this requires greater scrutiny and should be benchmarked (internally and externally) as executive pay is.
- Pay for a new world – PIRC believes that a simpler approach to pay should be taken so that companies have more time to deal with other important matters such as board diversity and climate change.
- Variable pay and alignment with shareholders – PIRC thinks that the alignment with shareholders for pay purposes is a fallacy due to the different risks and responsibilities, and it sets out its expectations for pay schemes to be approved at general meetings from January 1, 2022.
- COVID and existing pay schemes – As a minimum PIRC will not support bonuses where there have been: rescue rights issues with the suspension of pre-emption rights issues; receipt of furlough monies; other forms of state support including the coronavirus corporate finance facility.
- Investment trusts – There is a new section on share buyback authorities for investment trusts. These will not be supported unless an analysis of the effect of buybacks in prior years on reducing discounts is disclosed. If the company has not disclosed such a statement, opposition is recommended.
- Reporting on ESG issues – PIRC considers that it is key for the resilience of the company to outline a climate scenario (separate from an overall environmental policy) that sets out at a 2-degree Celsius scenario and states clearly what are the science–based policies and targets, in line with the Paris agreement. It includes in Appendix B information about reporting on Sustainable Development Goals.
The PIRC Shareholder Voting Guidelines 2021 can be purchased from PIRC.
(PIRC, Shareholder Voting Guidelines 2021, 03.2021)
Parker Review: Survey of ethnic diversity of FTSE 100 companies
On March 12, 2021, the Parker Review committee published the results of a joint survey undertaken with the Department for Business, Energy and Industrial Strategy (BEIS) in November 2020 into the ethnic diversity of FTSE 100 boards. Relying on the voluntary submission of data, the survey results show that significant progress has been made, with 74 FTSE 100 companies having ethnic minority representation on their company boards as of November 2, 2020 (the official feedback cut-off date) compared with 52 in January 2020.
The survey also shows the following:
- 21 FTSE 100 companies had no ethnic representation on their boards as at November 2020. Three did not respond to the survey and two were unable to provide information.
- By March 2021, a further seven FTSE 100 companies reported that they had appointed a director from a minority ethnic group.
- 124 out of the 998 board positions, across the FTSE 100 companies that responded to the survey, are held by 118 ethnic minority (12 per cent) directors, compared to 95 directors in 2020. 36 per cent of ethnic minority directors identify as British citizens, while 11 per cent sit on two or more FTSE boards (five sit on other FTSE 100 boards and the other eight sit on FTSE 250 boards). Of the 118 ethnic minority directors, 54 (46 per cent ) are women, which is an increase of 42 per cent compared to 2020.
- Progress remains slower in the key functional roles of boards. Across the FTSE 100 companies that responded to the survey, only five ethnic minority directors occupy a CEO position (compared to six ethnic minority directors that held CEO/Chair positions in 2020), all of whom are men. Two occupy a Chair role, one man and one woman, and four men occupy a CFO role.
The press release notes that FTSE 250 companies will be surveyed by the end of 2021 and have until 2024, in accordance with the Parker Review recommendations, to appoint at least one ethnic minority director to their boards.
(EY and BEIS, Significant progress on improving ethnic diversity of FTSE 100 boards reveals new data from Parker Review, 12.03.2021)
(Parker Review survey results as at 2 November 2020)
HM Treasury: Women in Finance Charter – Annual Review 2020
On March 17, 2021 HM Treasury published the latest annual review monitoring the progress of signatories to the Women in Finance Charter launched in 2016 as a result of recommendations resulting from a review of women in senior management across the UK financial services sector led by Dame Jayne-Anne Gadhia.
In becoming a Charter signatory, firms pledge to promote gender diversity by:
- Having one member of the senior executive team who is responsible and accountable for gender diversity and inclusion.
- Setting internal targets for gender diversity in senior management.
- Publishing progress annually against these targets on a page on the company's website dedicated to their Charter commitment.
- Having an intention to ensure the pay of the senior executive team is linked to delivery against these internal targets on gender diversity.
The annual review looks at progress by signatories in meeting their targets ahead of target deadlines and by 2020 deadlines. It also looks at whether signatories are monitoring the impact of COVID on their workforce, particularly on gender diversity and at data capture on the senior management population. The review also reports on what signatories are doing to drive progress and achieve their targets, and it puts the targets in context.
(HM Treasury: Women in Finance Charter – Annual Review 2020, 17.03.2021)
Glass Lewis: UK Corporate Governance Code – 2020 Compliance Review
On March 18, 2021 Glass Lewis published a paper which reviews the most common provisions of non-compliance in relation to the UK Corporate Governance Code (Code) among the FTSE 350 and smaller Main Market companies, respectively.
The review notes that the majority of FTSE 350 companies complied in full with the Code. Approximately 41 per cent of companies that deviated from the Code only failed to comply with only one provision. As far as smaller Main Market companies are concerned, there were lower overall rates of compliance outside with only a minority of those reviewed by Glass Lewis fully complying with the Code.
Among the FTSE 350, Code Provision 19 relating to chair tenure was the provision with lowest compliance. The review looks at the key Code provisions not complied with, some of the reasons for deviations and it explains the Glass Lewis approach to those deviations.
(Glass Lewis, UK Code Compliance Review – Glass Lewis Special Report)