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Essential corporate news – week ending July 26, 2019

Publication July 2019


BEIS: Market study on statutory audit services - Initial consultation on recommendations by the CMA

On July 18, 2019 the Government published a consultation on recommendations made by the Competition and Markets Authority (CMA) in its final report on its market study into statutory audit services in April 2019. The recommendations addressed four areas of statutory audit services: audit committee scrutiny, mandatory joint audit and peer review, measures to mitigate the effects of the distress or failure of a Big Four firm, and the operational split between audit and non-audit.

The Government’s response to the recommendations, and some of the key points on which it is consulting, are summarised below.

Audit committee scrutiny

The CMA’s first recommendation highlighted the important role that audit committees play in appointing, supporting and challenging auditors and recommended that the role and effectiveness of audit committees should be subject to greater scrutiny by the new regulator to ensure that they select auditors based on quality of audit rather than any other criteria. It argued that this would increase the accountability of audit committees to shareholders and create greater focus on quality. To address concerns in this area, and to increase the effectiveness of audit committees, the CMA recommended that the regulator should be given powers to scrutinise audit committees in relation to both the appointment and oversight of auditors and, in particular, that it should have powers to mandate minimum standards for the appointment and oversight of auditors, monitor compliance with minimum standards, and take remedial action where necessary. It also made initial suggestions about the standards the new regulator could set in relation to audit tenders, the actions it could take to monitor compliance and the actions it could consider when taking remedial action.

The Government notes that it welcomes the CMA’s analysis of the issues in this area. It agrees that audit committees play an extremely important role, that there should be clear expectations and standards to ensure they deliver the best results for shareholders, and that there should be a role in this for the regulator.

In this context the Government is seeking views, amongst other things, on:

  • The powers of the new regulator, and how they would align with the proposals in Sir John Kingman’s review of the Financial Reporting Council.
  • The ways in which they should be exercised (including the conditions that should be met for the regulator to exercise its powers to take remedial action and the events which should trigger the regulator’s involvement).

Mandatory joint audit and peer review

The CMA’s second group of recommendations were intended to improve audit quality and increase the number of viable competitors for complex audit tenders. The joint audit proposal (which would require two audit firms to sign off the accounts of an audited entity) was designed to address the CMA’s concerns regarding a lack of choice and competition within the audit market by providing greater opportunity for challenger firms to participate in the market. Under these recommendations, the Secretary of State would give the new regulator powers to implement a joint audit regime (applicable to audits of FTSE 350 companies, subject to certain exceptions) and adapt it over time. The CMA also recommended that the regulator should have the power to appoint peer reviews of the audit engagements of those companies not subject to the joint audit requirement (with the peer reviewer appointed from a challenger firm).

The Government notes that it is grateful to the CMA for its proposals to address the problems faced by challenger firms in building their capacity and expertise in relation to the most complex audits and that it recognises the importance of providing meaningful and effective competition and choice in the statutory audit market. It makes the point that previous reforms have not significantly enhanced competition, and more needs to be done to create a more competitive market both in the short and long term as part of a strategy that connects to the market for audit clients beyond the FTSE 350. It believes that the CMA’s proposals are designed to achieve sustainable progress towards that aim in a reasonably short period of time, without depriving audit clients of choice in their selection of auditor.

In this context the Government is seeking views, amongst other things, on:

  • The CMA’s joint audit proposals (and the exceptions thereto) and suggestions for how a joint audit could be carried out most efficiently.
  • The capacity of challenger firms to provide joint audit services to the FTSE 350 and whether a staged approach is needed.
  • The CMA’s proposals for peer review and how the regulator should select which companies to review.
  • Any other measures needed to ensure that the statutory audit market remains open to wider competition in the long term.

Measures to mitigate the effects of the distress or failure of a Big Four firm

The CMA’s third recommendation suggested that the regulator should be given powers to obtain the information it needs to monitor the health of audit practices and intervene where a firm is likely to fail. With these powers, the regulator would aim to maintain competition in the event of the failure of a major firm. While there is no suggestion that the Big Four are likely to suffer a failure in the foreseeable future, the CMA concluded that it would be prudent for the new regulator to hold powers for that eventuality. It therefore recommended that the regulator should be given powers to: obtain timely and periodic submissions from the Big Four firms (and possibly the large non-Big Four firms) on their financial health, require audit committees to inform it of upcoming tenders and any other information that the regulator considers necessary, obtain and review the modified contingency plans from large audit firms, and require non-Big Four firms to draw up plans for how they could (if required) take on migrating auditors or audit clients from a distressed Big Four firm. The CMA also recommended giving the regulator flexibility to further determine what action to take if it identifies signs of distress, depending on the circumstances of the failing firm.

The Government agrees that there is more that the regulator could do to monitor and act on the health of audit firms, particularly while the statutory audit market remains so concentrated, and it is keen to implement a monitoring function that can support the market in an effective and competitive way. It notes that implementing solutions in this area will need careful consideration in order to avoid the moral hazard risks highlighted by the CMA in their report.

In this context the Government is seeking views on:

  • Factors the regulator should take into account when considering action in the case of a distressed statutory audit practice.
  • Powers of intervention the regulator should have in those circumstances and their duties in exercising them.

Operational split between audit and non-audit practices

The CMA’s fourth recommendation would require the Big Four firms to put in place a strategic and operational split between their audit and non-audit services. The aim of this recommendation is to ensure that auditors focus on conducting high quality audits, without their incentives being affected by the much greater revenue and profits which may accrue from the non-audit side of the firm. The CMA acknowledged that recent changes have mitigated concerns that audit firms are incentivised to use audit services to sell advisory and consultancy work, but concluded that there remain underlying tensions between audit and non-audit work. Under the CMA’s proposal, the Secretary of State would empower and require the regulator to establish an operational split and refine it over time. The CMA’s recommendation was that the split should initially apply to the Big Four but that the regulator should consider extending elements of the split to challenger firms.

The Government notes that it is grateful for the CMA’s ambitious recommendations and that it recognises the high risk of actual and perceived conflicts of interest that can occur where audit firms provide non-audit services to their audit clients. Going forward the Government is determined to identify and implement a powerful and proportionate package of measures to increase choice and capacity in the audit market.

In this context, the Government is seeking views, amongst other things, on:

  • The CMA’s analysis of the impacts on audit quality that arise from the tension it identifies between audit and non-audit services.
  • The manner and design of the operational split recommended by the CMA and the overall market impact of such measures.
  • Alternative or additional measures that would meet these concerns more effectively or produce a better market outcome.
  • Considerations the Government should take into account when considering the operational split recommendations.

Other possible measures

The Government notes that it is also considering the other recommendations made by the CMA in its report but which did not form part of its core package of remedies. It is seeking views on a number of aspects of these recommendations.

The consultation closes on September 13, 2019.

(BEIS: Market study on statutory audit services - Initial consultation on recommendations by the CMA, 18.07.19)

BEIS: Joint Committee report on draft Registration of Overseas Entities Bill - Government response

On July 18, 2019, the Department for Business, Energy and Industrial Strategy published the Government’s response to the recommendations set out in the report published by the House of Commons and House of Lords Joint Committee on the draft Registration of Overseas Entities Bill (Draft Bill) in May 2019. The Draft Bill aims to increase the transparency of who owns land in the UK and will establish a public register of beneficial owners of overseas entities that own or purchase land in the UK.

Points made by the Government in relation to recommendations made in the report include (amongst others) those summarised below.

Proposed definition of ‘legal entity’ and ‘overseas entity’ – the Government considers the definitions in the Draft Bill to be sufficiently wide, clear and flexible and, in order to ensure that as much clarity as possible is provided, intends to publish guidance to help: overseas entities; third parties transacting with overseas entities; and facilitators to understand the relevant requirements.

Decisions on legal personality of an entity - the Government is of the view that it is not appropriate for a UK agency (such as one of the land registries or Companies House) to ‘make decisions’ on the legal personality of a foreign entity. It is confident that overseas entities will know their own legal status and whether they are in scope.

Recommendation for a pre-clearance mechanism which confirms whether legal entities are registrable - the Government does not consider that a pre-clearance mechanism is required.

Concern that a 25 per cent ownership and voting threshold for the definition of beneficial ownership could undermine the aim of capturing the true beneficial owners of overseas entities and recommendation that the Government seriously consider the case for lowering this – the Government does not intend to lower the 25 per cent threshold. It notes that the threshold follows the UK’s ‘people with significant control’ (PSC) regime and is in line with global norms in beneficial ownership. The Government will, however, keep the threshold under review as it already does in respect of the PSC regime.

Recommendation that those types of entities which may be eligible for exemptions be identified on the face of the Draft Bill – although the Government understands the desire to provide clarity about who is within scope, its view is that listing types of entities which may be eligible for exemptions on the face of the Draft Bill could limit its ability to respond to changing circumstances. The Government accepts the recommendation that the power to exempt types of overseas entities should be subject to the affirmative resolution procedure to allow for greater scrutiny. The Government also confirms that it intends that the power to exempt a beneficial owner from the requirement to register will be used very rarely, and only in the interests of national security, the economic wellbeing of the UK or for the prevention or detection of serious crime. It is considering whether these circumstances should be laid out on the face of the Draft Bill.

Recommendation for the register to include a mechanism allowing users to ’flag’ suspicious or potentially incorrect information – the Government is in agreement with this recommendation.

Recommendation that the Draft Bill should make specific reference to the necessity to keep the register up-to-date – the Government acknowledges that, although the Draft Bill outlines the requirement for overseas entities (once on the register) to update their information annually with Companies House, in practice this may not happen. The Government will consider further how to ensure that the register is as accurate as possible at the point at which dispositions of land take place.

Recommendation that the Government should explore the viability of requiring regulated professionals to verify beneficial ownership information submitted to the register – the Government accepts this recommendation.

Recommendation that the Government should introduce civil penalties – the Government states that it will consider further the idea of civil penalties (in addition to criminal sanctions) as an alternative means of regulating behaviour.

(Department for Business, Energy and Industrial Strategy: Joint Committee report on draft Registration of Overseas Entities Bill - Government response, 18.07.19)

GC100 and Investor Group: Directors' Remuneration Reporting Guidance 2019

On July 22, 2019, the GC100 and Investor Group published an updated version of its Directors' Remuneration Reporting Guidance (guidance). The revisions to the guidance reflect the Companies (Directors’ Remuneration Policy and Directors’ Remuneration Report) Regulations 2019 (2019 Remuneration Regulations) which came into force on June 10, 2019, and, amongst other regulatory changes, implement provisions of the Shareholder Rights Directive (2007/36/EC), as amended by Directive (EU) 2017/828 (SRD II) in relation to the reporting of directors’ remuneration.

The main changes to the guidance include those summarised below.

Percentage change in remuneration of all directors - The guidance notes that the annual remuneration report must set out the percentage change in the remuneration awarded to each director, both executive and non-executive, between the preceding year and the reported year in relation to each of salary, benefits and bonus. Prior to amendments made to the Large and Medium-Sized Companies and Groups (Accounts and Reports) Regulations 2008 (2008 Regulations) by the 2019 Remuneration Regulations, this provision related only to the CEO but has now been expanded to cover all directors. In addition, the guidance has been updated to reflect the fact that the requirement in the 2008 Regulations to disclose details of the average percentage change in respect of employee remuneration now relates only to the employees of the parent company (rather than the group). In this context, the guidance notes that, where the parent company only employs a small proportion of the workforce, the company may wish to consider voluntarily disclosing the change in directors’ remuneration compared to a wider employee comparator group, if this will provide a more representative comparison.

Discussion of measures taken to avoid or manage conflicts of interest in relation to determination, review and implementation of the remuneration policy - The guidance has been amended to reflect the fact that, in accordance with the 2008 Regulations, a company’s directors’ remuneration policy must now explain the decision-making process followed for its determination, review and implementation, including measures to avoid or manage conflicts of interest and, where applicable, the role of the remuneration committee or other committees concerned. The guidance sets out examples of measures to avoid or manage conflicts of interest that may need to be disclosed in the policy.

Extension of coverage to include those considered to be CEO or deputy CEO, even where they are not appointed as directors – The guidance has been revised to reflect the fact that the 2008 Regulations now provide that (other than in respect of certain provisions) a chief executive officer (however described) or, where such a function exists, deputy chief executive officer (however described) is to be treated as a director regardless of whether or not they have been appointed as a director.

(GC100 and Investor Group: Directors' Remuneration Reporting Guidance 2019)

BPP Group: Best Practice Principles for Providers of Shareholder Voting Research & Analysis 2019

On July 22, 2019, the Best Practice Principles Group for Providers of Shareholder Voting Research and Analysis Group (BPP Group) published an updated version of its Best Practice Principles for Providers of Shareholder Voting Research and Analysis (principles). Alongside promoting the integrity and efficiency of processes and controls related to the provision of shareholder voting research and analysis, the principles are intended to foster greater understanding of the role of service providers in facilitating the voting decisions made by institutional investors.

The updated principles replace the original 2014 principles, and are the result of a thorough review process by the BPP Group, taking into account: the latest updated stewardship codes globally, the Shareholder Rights Directive (2007/36/EC), as amended by Directive (EU) 2017/828 (SRD II) the European Securities and Markets Authority’s 2015 follow-up report on the development of best practice principles for providers of shareholder voting research and analysis, and the input of investors, issuers and other stakeholders.

The key changes made include those summarised below.

Basis of application - The principles now operate on an ‘apply and explain’ basis, in line with SRD II, rather than the previous ‘comply or explain’ framework. This enables each signatory to explain how the principles relate to their specific circumstances and business model.

Principle one: service quality – This has been updated to include detailed requirements as to the content of disclosures regarding research methodology and any applicable "house" voting policies.

Principle two: conflicts-of-interest avoidance or management – This has been amended to require conflicts of interest policies to include procedures for the avoidance, as well as management, of conflicts of interest, and to require signatories to have a process in place to identify and disclose to their clients (on a case-by-case basis) actual or potential conflicts of interest or business relationships that may influence the preparation of their research, advice and voting recommendations and the actions that have been undertaken to eliminate, mitigate and manage these.

Principle three: communications policy – This has been amended to include requirements for signatories to explain their approach to communication with issuers, shareholder proponents, other stakeholders, media and the public and, if issuer communication has taken place, to inform clients about the nature of the dialogue with relevant parties in their research reports, which may include informing clients of the outcome of that dialogue.

New governance arrangements have also been introduced, including new monitoring and reporting arrangements.

(BPP Group: Best Practice Principles for Providers of Shareholder Voting Research & Analysis 2019, 22.07.19)


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