Blockchain law: A "Telegram" to SAFTs: "Beware!"
Robert Schwinger discusses one approach issuers have tried in order to avoid facing securities law requirements: SAFTs.
There have been a number of developments in the areas of corporate governance and narrative reporting since the spring of 2019. This briefing summarises some of the key recent developments that companies should be aware of.
In March 2019, Pensions and Investment Research Consultants Ltd (PIRC) published an updated edition of its UK Shareowner Voting Guidelines (Guidelines). Copies of the Guidelines can be purchased from PIRC – click here to access the relevant section of PIRC’s website.
PIRC has made several key changes compared to its 2018 guidelines, including those set out below.
Chair - PIRC will recommend opposing the re-election of a chair with a tenure of over nine years, regardless of whether they were independent on appointment. However, the Guidelines do state that voting recommendations on the chair’s election/re-election will be considered on a case-by-case basis, with consideration given to any justification provided by the company.
Committee independence - PIRC will oppose the re-election of a chief executive that sits on the nomination committee as it wants to encourage a balanced and impartial appointment process.
Diversity - PIRC will recommend abstaining on the re-election of a FTSE 350 company’s nomination committee chair where there is lack of disclosure on progress in line with the 2017 Parker review on getting directors from ethnic minorities onto FTSE 350 boards.
Commitment - Where PIRC has concerns about a director’s aggregate time commitments, it will withhold support for the director’s re-election unless the director has had a 100 per cent attendance record at board and committee meetings throughout the year. Where a director’s attendance record is below 90 per cent, PIRC may also not support the director’s re-election.
Meeting attendance - PIRC will recommend opposing the election/re-election of any director who misses any board or committee meeting without adequate or reasonable justification. Examples of reasonable justification are given and these include funeral attendance, hospital appointments, health-related issues or other serious unforeseen circumstances outside the director’s control.
Auditor rotation - Where an external audit is put out to tender, PIRC believes the current statutory auditor should not be included in the audit tender process. PIRC also believes audit firms (not just the audit partner) should rotate every five years and it may not support re-election of an auditor with more than five years’ tenure, regardless of whether the firm’s level of non-audit work would be considered acceptable.
Authorising audit fees - PIRC will recommend opposing the re-election of the audit committee chair where the nature of non-audit work has not been adequately disclosed.
Voting process - In terms of voting information to be made available after a shareholder meeting, PIRC will expect information to be provided about the number of shares in respect of which the vote was directed to be withheld.
Sustainability and corporate responsibility reporting - There is increased emphasis on environmental and social issues in the Guidelines. PIRC expects each listed company to publish a comprehensive assessment of its resilience to climate change as part of a meaningful environmental policy and it refers to work by the Bank of England on climate risk as a material financial risk, as well as the work of the Financial Stability Board’s Task Force on Climate Related Disclosures (TCFD).
In July 2019, the Financial Reporting Council (FRC) announced that it is supporting new research report produced by Cranfield University called the “Female FTSE Board Report” (Research) which has found that many FTSE 100 companies are implementing a tick box attitude to diversity.
The Research shows that while the percentage of women on FTSE 100 boards has risen to 32 per cent (an all-time high) and is now on track to reach 33 per cent by 2020, more needs to be done to promote diversity across all levels. The Research has also found that women serve shorter tenures than men (on average, female non-executive directors serve 3.8 years – with men serving five years) and are less likely to get promoted into senior roles, while just 11 per cent of women on boards are from Black, Asian or other Minority Ethnic backgrounds.
Key findings of the Research include those set out below.
FTSE 100: the percentage of women on boards has increased from 29 per cent to 32 per cent, with 292 women holding 339 directorships. The percentage of female non-executive directors (NEDs) is at an all-time high of 38.9 per cent, but the percentage of female executives is worryingly low at 10.9 per cent.
FTSE 250: The percentage of female directors has risen from 23.7 per cent to 27.3 per cent, while the number of all-male boards has dropped to three. The percentage of female NEDs is 32.8 per cent, but the percentage of female executive directors (EDs) is low at 8.4 per cent.
On the FTSE 100, 48 companies have reached the target of 33 per cent women on their boards. Kingfisher and Rightmove both have 50 per cent female representation at board level, and Schroders is the most improved company in the top 10, with 45 per cent women on its board, up from 27 per cent in 2018.
On the FTSE 250, 88 companies have reached the target of 33 per cent women on their boards, up from 59 last year.
The average tenure for female executive directors on FTSE boards is 3.3 years – half that of their male counterparts, who, on average, serve 6.6 years. The gap is slightly less at NED level, with the average tenure being five years for men and 3.8 years for women. Just 16 per cent of women have been in an NED role for more than six years, raising the question of if they are choosing to leave or being pushed off the board.
Wider diversity characteristics on the FTSE 100
Only 11 per cent of the women have a degree from Oxford or Cambridge. 76 per cent have an undergraduate degree, and 35 per cent of those also have a postgraduate degree.
13 per cent of women directors hold a recognised financial qualification, something often associated with the criteria for a NED appointment. 22 per cent hold an MBA degree, in which finance is a core subject.
There is a high degree of financial literacy as 55 per cent have held financial roles across finance, auditing, investment, treasury and banking.
The majority of female directors are British (55 per cent), with the remainder coming from 18 countries across the world.
Only 11 per cent are from Black or Ethnic Minority backgrounds.
The average age of female directors is 57.3, approximately two years younger than male directors, whose average age is 59.2. The gap is slightly larger for NEDs – 57.9 for women and 61.5 for men.
(Cranfield University - Female FTSE Board Report – Moving Beyond the Numbers)
(Cranfield University Press Release – Tick box attitude to women on ftse100 boards must-stop)
(FRC Press Release – More needs to be done to promote diversity)
In July 2019, the Hampton-Alexander Review published an update in relation to the number of female directors appointed to FTSE 350 company boards. Launched in 2016, the Government-backed Hampton-Alexander Review set FTSE 350 businesses a target of having 33 per cent of all board and senior leadership positions held by women by the end of 2020.
The key figures from the update are
The update notes the figures show that if progress matches the same gains made over the last three years then FTSE 100 companies are on track to reach the 2020 target and that, for the first time, the FTSE 250 could meet the 33 per cent target for women in senior leadership positions if current progress is maintained. It also notes that there are now only four all-male FTSE 350 boards, down from 152 in 2011.
Fourteen companies in the FTSE 350 have also been named by the Hampton-Alexander Review, in a new initiative to highlight those with one woman or less on their board.
The portal for FTSE 350 companies to submit their senior leadership gender representation data to the Hampton-Alexander Review opened at the start of July. Companies had until the end of July to lodge the gender split of their executive committee, and the direct reports to the executive committee, via the portal. The 2019 Hampton-Alexander Report will be published on November 13, 2019.
(Hampton-Alexander Review: Improving gender balance in FTSE leadership – FTSE 350 urged to keep up the pace to meet women on boards target, 01.07.19)
(Hampton-Alexander Review: Improving gender balance in FTSE leadership – FTSE 350 urged to keep up the pace to meet women on boards target press release, 01.07.19)
In March 2019, the Business, Energy and Industrial Strategy Committee of the House of Commons (BEIS Committee) published a report (Report) providing an update on trends in executive pay and examining the Government’s performance in addressing the pay gap between chief executives and company performance and employee pay.
The Report includes a number of recommendations under the categories of recent developments, structure of pay and engagement by companies on pay, including (amongst others) those set out below. See also the next summary for the Government’s subsequent response to the Report.
The new regulator which is to replace the FRC should clarify and strengthen its guidance on executive remuneration with a view to exerting significant downward pressure, avoiding unjustifiable payments and ensuring that, if they are made, they can be readily recovered. The new regulator should also monitor
Companies should be required to appoint at least one employee representative to the remuneration committee to ensure that there is full discussion of the link between executive pay and that of the workforce as a whole.
The pay ratio reporting requirements should be expanded to include all employers with over 250 employees and the lowest band should be included alongside the quartile data required.
Companies and partnerships should report on pay ratios in their 2019 annual report. The new regulator should take to task any company or firm that fails to explain adequately how they have taken into account pay ratios when determining levels of remuneration, particularly when pay ratios significantly exceed sector norms.
While the BEIS Committee welcomes the development of the Investment Association’s (IA’s) Public Register, it recommends that the new regulator should explore more effective sanctions than a letter from the IA where shareholder concerns on pay are ignored.
The new regulator should take on responsibility for monitoring the impact of the Wates Corporate Governance Principles for Large Private Companies (Wates Principles) and examine the case for greater disclosure around remuneration and for expanding its application more widely.
The BEIS Committee urges the publication of the independent study commissioned by the Government into share buybacks and recommends that remuneration reports include analysis of the impact on executive remuneration of any share buybacks during the reporting period.
Structure of pay
The BEIS Committee believes that executive pay should be simplified, more obviously geared to promoting companies’ long-term objectives and be linked more closely to that of the workforce as a whole. It recommends that remuneration committees should set, publish and explain an absolute cap on total remuneration for executives in any year. The new regulator should be more prescriptive and interventionist, where necessary, in pursuit of these objectives and be prepared to publicly call out poor practice or behaviour.
The new regulator should also
Engagement by companies on pay
Remuneration committees should engage early and meaningfully with major investors on executive pay and be prepared to make the case for pay reform and restraint in the interests of avoiding reputational damage, and the new regulator should seek to ensure that these activities are properly explained in remuneration reports.
The guidance in the new Stewardship Code should include a requirement for asset owners to provide much more detailed information about their objectives, including those in relation to executive pay. Proxy agents should tailor their policy guidelines and advice to individual investors so as to resist excessive and poorly designed pay policies and awards.
The new regulator should revise the Stewardship Code to ensure that it is able to not just encourage, but deliver, genuine and effective engagement between companies and their shareholders on executive pay in a way that requires both parties to discharge their responsibilities transparently and accountably.
In June 2019 the BEIS Committee published the Government's response to the BEIS Committee’s report “Executive rewards: paying for success” (Report) (summarised above).
The Government considers the BEIS Committee’s recommendations to be a useful contribution to the continuing public debate on high levels of executive reward. However, the Government believes that the current UK framework gives shareholders sufficient information and powers with which to hold companies to account on executive pay and notes that shareholders are increasingly demonstrating their readiness to voice dissatisfaction over executive pay when it is poorly structured or not matched by performance. In its response the Government also points to recent and ongoing reforms, including the introduction of pay ratio reporting requirements, the introduction of stronger UK Corporate Governance Code provisions, the implementation of the executive pay aspects of the Shareholder Rights Directive (2007/36/EC), as amended by Directive (EU) 2017/828 (SRD II) and the replacement of the FRC with a new regulator.
The Government notes that its priority at this stage is to focus on the effective implementation and assessment of recent reforms before considering significant further changes. However, it would consider further action in the future unless there is clear evidence that companies are taking active and effective steps to respond to significant shareholder concerns about executive pay outcomes.
The Government’s responses to recommendations made in the Report include (amongst others) those set out below.
In relation to the recommendation that the new regulator monitors how remuneration reports and better reporting against section 172 CA 2006 meet the aims of increased transparency and alignment of pay with objectives, the Government confirmed that this is its expectation as part of the new regulator's expanded and strengthened corporate reporting review function.
In response to the recommendation that the new regulator monitors companies’ compliance with the UK Corporate Governance Code with a view to making an assessment of which method of engagement with employees proves most effective and recommending changes, the Government envisages the new regulator prioritising an assessment of how effectively companies are reporting against new provisions in the UK Corporate Governance Code and notes that, based on that reporting, the regulator will be able to investigate the range of engagement techniques that companies have adopted in response to the revised UK Corporate Governance Code. However it notes that assessing the effectiveness of the engagement mechanisms themselves is a matter for companies and is an area on which shareholders should be ready to challenge management based on the new information being provided in annual reports.
In response to the recommendation that all companies should be required to appoint at least one employee representative to the remuneration committee, the Government is clear that it does not believe that one method would be suitable for all given the huge variety of UK companies and group structures.
In relation to the recommendation that pay ratio reporting requirements be expanded to include all organisations with over 250 employees and that the lowest pay band be included alongside the quartile data required, the Government notes that the introduction of pay ratio reporting for quoted companies is a significant reform and that it intends to monitor the impact of this new requirement when reporting first begins next year before considering any potential extension to other types of employer or extending pay ratio reporting to include the lowest pay band. It also notes that the Wates Principles should also encourage more voluntary disclosure.
In relation to the suggestion that primary responsibility for changing the environment on executive pay rests with asset owners, rather than asset managers, and the recommendation that the new Stewardship Code includes a requirement for asset owners to provide much more detailed information about their objectives, including those in relation to executive pay, the Government notes (amongst other things) that it believes that it is the role of both asset owners and managers as well as companies to consider pay and performance.
(BEIS: Executive rewards - paying for success. Government Response to the Committee’s Eighteenth Report of Session 2017–19, 13.06.19)
(Executive pay - BEIS Committee publishes Government response press release, 13.06.19)
In May 2019, the 2019 Remuneration Regulations were published together with an explanatory memorandum. The 2019 Remuneration Regulations implement Article 9a (right to vote on a company’s remuneration policy) and Article 9b (information to be provided in and right to vote on the remuneration report) of SRD II. They came into force on June 10, 2019.
Most of the requirements on directors’ remuneration reporting contained in SRD II were already implemented in UK law but, in order to implement Articles 9a and 9b to the extent that they were not already implemented, the 2019 Remuneration Regulations amended the CA 2006 and the Large and Medium-Sized Companies and Groups (Accounts and Reports) Regulations 2008 (2008 Regulations). The amendments include extending the scope of the UK’s executive pay framework to cover unquoted traded companies as well as quoted companies.
Other changes introduced to the existing executive pay framework include (amongst others) those set out below.
Directors’ remuneration policy
The remuneration policy must
The date and results of the shareholder vote on the remuneration policy must be put on the company’s website as soon as reasonably practicable and remain there for the life of the policy.
Directors’ remuneration report
The remuneration report must
Directors’ remuneration provisions
All payments to directors must be made in accordance with an approved remuneration policy. As a result, any payment to be made by way of an amendment to the approved remuneration policy must be approved by shareholders.
The remuneration of persons in the role of the chief executive officer and any deputy chief executive officer must be reported even if they are not a director on the board of the company.
(BEIS: Companies (Directors’ Remuneration Policy and Directors’ Remuneration Report) Regulations 2019, 29.05.19)
(BEIS: Companies (Directors’ Remuneration Policy and Directors’ Remuneration Report) Regulations 2019 explanatory memorandum, 29.05.19)
In 2019 the Department for Department for Business, Energy and Industrial Strategy (BEIS) published a question and answer document (Q&A) in relation to the 2019 Remuneration Regulations (see above for a summary of the 2019 Remuneration Regulations themselves). The purpose of the Q&A is to assist companies and interested stakeholders in understanding the reporting requirements introduced by the 2019 Remuneration Regulations.
The Q&A provides general guidance on
It also clarifies certain elements of these requirements, including (amongst other things) those set out below.
Requirement for remuneration policy to provide an indication of the duration of directors' service contracts or arrangements with directors - The Q&A explains that the term “arrangements” is not defined in SRD II but may be taken to mean any agreements to provide personal services that a company may enter into with directors for remuneration that do not constitute a service contract. It further explains that, where a director’s contract has no specified end date, this requirement can be met by stating that there is no fixed or indicative duration or by setting out the notice period.
Information expected to be provided on the “decision making process” for determining, reviewing and implementing the directors’ remuneration policy and whether this is already set out under paragraph 22 of Schedule 8 of the 2008 Regulations - The Q&A notes that Paragraph 22 of the 2008 Regulations already asks companies to provide information in the remuneration report about the role of the remuneration committee, including managing conflicts of interests, and that this, and any other relevant information contained in the remuneration report, may be included in the policy in order to meet the new requirement to explain the decision-making process that underpins it. SRD II does not elaborate further on what is expected in this explanation, meaning companies have flexibility to decide what would be helpful to shareholders to understand how the policy has been determined, and how it is to be implemented and reviewed. The Q&A also notes that, in order to avoid repetition, companies may wish to cross-reference to existing requirements under paragraph 22 of Schedule 8 of the 2008 Regulations.
Requirement to publish the results and date of the remuneration policy vote on the company website “as soon as reasonably practicable” - The Q&A notes that SRD II does not specify a precise time-frame, beyond stating that the voting outcome should be published “without delay”. However it notes that Article 14 of the original Shareholder Rights Directive (EC/2007/36) states that voting results on a poll must be published within 15 days of the relevant general meeting and that Listing Rule 9 requires premium listed companies to notify the Financial Conduct Authority (FCA) and issue an RNS announcement of their results “as soon as possible”. Companies should therefore seek to ensure that the voting result of the remuneration policy is published as soon as is reasonably possible following the voting results to comply with both the Regulations and, where applicable, the Listing Rules.
Requirement for the voting results to record the number of abstentions and whether this means those shareholders who formally record an abstention or those who just did not vote - The Q&A notes that the original Shareholder Rights Directive does not specify how abstentions should be counted and that companies may instead wish to only record, alongside the actual voting results, the number of shares that were submitted as a “vote withheld” (while recognising that this is not a vote under English law).
Requirement to report (in the remuneration report) the annual change in directors' remuneration compared to average employee remuneration over a rolling five-year period - The Q&A considers, amongst other things, whether a director who served on the board in the previous five years but not in the relevant financial year can be removed from the rolling five-year comparison. It notes that SRD II does not stipulate whether a director who leaves the board may be removed from the five-year comparison table going forward, meaning that companies may therefore use their discretion as to whether such directors should be removed after they have left the board. The Q&A highlights, however, that information on the remuneration of these individuals must remain available in the comparison tables for previously published remuneration reports, for the period during which they sat on the board.
How average employee pay should be calculated for the purpose of determining the annual change in average employee remuneration - As SRD II is silent on this, companies are free to calculate average employee remuneration by reference either to the “mean” or “median” of employee pay. The Q&A notes, however, that companies are encouraged to state which method they have used for the information of shareholders and other interested stakeholders.
In July 2019 the GC100 and Investor Group published an updated version of its Directors' Remuneration Reporting Guidance (Guidance). The revisions to the Guidance reflect the 2019 Remuneration Regulations (see above).
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 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.
In May 2019 the Institute of Chartered Secretaries and Administrators (ICSA) published a review (conducted at the request of BEIS) assessing the quality of independent board evaluation in the UK listed sector, identifying ways in which it might be improved and setting out a number of questions for consultation (Consultation Document).
The first part of the Consultation Document seeks views on the purpose of board evaluations. This is followed by a summary of the evidence on current practice in the conduct of, and reporting on, independent board evaluations in the listed sector. The Consultation Document then invites suggestions for actions that should be considered and, in particular, seeks views on whether there is a need for
Appendices C to E of the Consultation Document contain draft versions of a code of practice for independent reviewers and voluntary principles and guidance on disclosure for listed companies.
Purpose of board evaluation
It is proposed that the purpose of independent board evaluation should be defined as
Views are sought on this definition.
Code for service providers
The draft code starts with the definition of “independent board evaluation” to establish who is and who is not eligible to become a signatory. It then identifies the commitments that service providers would take on if they wish to become signatories. The main body of the draft code contains three sections covering “competence and capacity,” “independence and integrity” and “client engagement.” Each section consists of principles and good practice guidance.
The “competence and capacity” section is essentially a disclosure framework while the “independence and integrity” and “client engagement” sections set out certain minimum standards. These include (amongst other things) that signatories should not
Voluntary principles for listed companies
The Consultation Document considers that there may be merit in setting out some short principles to which companies would be invited to commit when engaging external reviewers, and that they should certify whether or not they followed the principles when reporting on the results of the board evaluation. ICSA has decided that the principles should not include a requirement on companies that adopt them only to engage external reviewers that are themselves signatories to the code of practice but welcomes views on that point.
Guidance for listed companies on disclosure
The main objective for producing guidance would be to assist listed companies seeking to comply with the UK Corporate Governance Code and provide their shareholders with information that they would find useful in assessing how diligently the board is seeking to improve its effectiveness. However, it is recognised that the existence of principles and guidance for listed companies would provide additional leverage for investors (and other stakeholders) to incentivise companies and board reviewers to sign up to the proposed principles and code of practice respectively.
The draft guidance covers both internal and external board evaluations. It sets out suggested good practice disclosures for all evaluations and then recommends additional disclosures for externally facilitated ones.
The consultation closed in early July. Once the responses have been considered, ICSA will publish a report containing its recommendations and revised versions of the draft codes and guidance if it is concluded that they are needed. That report will then formally be submitted to BEIS and it will be for BEIS to consider whether, and how, to act on the recommendations.
In May 2019 the IA published a report which presents findings on the prevalence of listed UK companies paying ordinary dividends without seeking shareholder approval. The research conducted by the IA was in response to a request from BEIS to investigate the concern (expressed in response to the consultation by BEIS in May 2018 on corporate governance and insolvency) that increasing numbers of companies are not seeking shareholder approval for dividend distributions at their AGMs, denying shareholders a critical opportunity to engage on the sustainability of the dividend payment.
The IA’s research shows that 22 per cent of FTSE All-Share companies that pay ordinary dividends are not holding annual shareholder votes on the payment of the final dividend or are paying only interim dividends. This practice is particularly common in the 20 largest companies in the FTSE All-Share and is widespread among investment companies. The approach is dominant in companies that issue quarterly or monthly dividends to meet investor demands for a regular income stream, and in those with large, complex, international structures where there are legal, regulatory or tax obstacles to putting forward a shareholder vote. In addition, the research revealed that there are often legitimate reasons for that decision and that making an annual vote on the payment of dividends mandatory may have an undesirable impact on certain companies and shareholders.
As a result, the report recommends that all listed companies, including those that put a dividend resolution to shareholders, should, as a minimum, publish a “distribution policy” setting out their long-term approach to making decisions on the amount and timing of returns to shareholders, including dividends, share buybacks and other capital distributions within the context of any relevant legal or financial constraints. This will enable shareholders to engage with companies on their approach to shareholder distributions, regardless of the timing and structure of these distributions. It will also enable companies to be transparent about how they structure these distributions in the context of their overall approach to capital management and give shareholders more detailed information about their approach in order to better hold them to account.
The IA will establish a working group to develop best practice guidance on distribution policies and will make recommendations to the Government on whether a shareholder vote on such policy and/or on yearly distributions should be mandatory. The distribution policy guidance is expected to be published in autumn 2019.
In April 2019, the Competition and Markets Authority (CMA) published its final report (Final Report) following its market study of the statutory audit services market. The market study was launched in October 2018 and the CMA published its provisional findings in December 2018.
The Final Report considers the reasons for shortcomings in audit quality in the UK. It notes that some of the problems with the market are caused by longstanding, deep-seated and intractable features and comments that audit committees are only a partial solution to the problem of companies playing the primary role in selecting their own auditors. The CMA considers the market to be a fragile one with high barriers to entry and a lack of resilience and choice. It also believes that accounting firms are less and less focused on audit. As a result, it makes four recommendations in the Final Report which are intended to increase the effectiveness of audit committees across the FTSE 350, increase resilience and choice in the market and address the problems in terms of focus on quality and choice, caused by audit firms having combined audit/non-audit services structures. The Final Report notes that the changes will need concerted action by the Government and will need to be overseen by the new regulator to be formed following the independent review led by Sir John Kingman. In addition, the Final Report notes that the changes it recommends should in time be complemented by what emerges from the review by Sir Donald Brydon into the quality and effectiveness of audit.
The recommendations in the Final Report are summarised below.
Recommendation 1 – Audit committee scrutiny
The CMA recommends that audit committees should come under greater scrutiny by the new regulator as this should increase their accountability and focus their selection and oversight of auditors on audit quality, while also mitigating any bias against non-Big Four firms.
The CMA recommends that the Government legislate so that the new regulator should have the powers and a requirement to mandate minimum standards for both the appointment and oversight of auditors. The regulator should then have the powers and the requirement to monitor compliance with these standards, including the ability to require information and/or reports from audit committees, as well as placing an observer on an audit committee if necessary. The regulator should also take remedial action where necessary, for example, by issuing public reprimands or making direct statements to shareholders in circumstances where it is unsatisfied with audit committees.
The CMA notes that this remedy could be complemented through enhancing engagement between audit committees and shareholders and it suggests that some of the recommendations of the BEIS Committee, which published a report “The Future of Audit” in April 2019 (see below for a summary of this report), could be implemented, for example, transparency of fees and requiring the auditor to present at the audited company’s annual general meeting.
The CMA notes that it did consider the more radical step of moving the responsibility for selecting auditors to an independent body and while it identified legal barriers to this change, it remains of the view that this would be worth keeping under consideration in the long-term.
Recommendation 2 – Mandatory joint audit
The CMA believes that to ensure both acceptable choice and improve resilience of the audit sector, between five and seven firms are needed to audit the largest companies in the UK in the medium to long-term, rather than the current four. As a result, the CMA recommends that the Secretary of State legislate to give the regulator flexible powers to implement a joint audit regime, key elements of the which are likely to be the following
So that challenger firms can gain experience and reputation with the biggest companies, the CMA recommends that the regulator should have the power to appoint peer reviewers for a selection of companies that are not included in the joint audit remedy. Apart from in exceptional circumstances, the reviewer should not be one of the Big Four, reviews should take place in real time and the peer reviewer should report to, and be accountable only to, the regulator. The peer reviewer should not sign the audit opinion and should not be liable for the accuracy of the accounts, and the regulator should consider how to select peer review targets.
The CMA did consider a market share cap remedy as a potential alternative way to break down the barriers to non-Big Four firms and while it would not exclude it as a possible solution in future, depending on how the market develops, it does consider that share caps present a number of problems and so has concluded, on balance, that the best route for early action lies with joint audit, plus the option for audit committees to choose between joint audit and a sole challenger auditor.
Recommendation 3 – Operational split between audit and non-audit practices of Big Four
The CMA recommends that the Government put in place an operational split between the audit and non-audit practices of the biggest firms in the UK, initially only the Big Four, but with the regulator able to add other firms in later years when they have grown closer to the Big Four’s size.
The regulator should be given the powers to design the specific details of the remedy and refine it over time but key elements of the operational split are likely include the following
The CMA also suggests that, as suggested by the BEIS Committee, a “cooling-off period” could be introduced after the end of an audit, during which the firm would not be allowed to carry out any non-audit work for the company concerned. It suggests that this be considered by the regulator in the context of its existing review of its Ethical Standard.
Recommendation 4 – Five year review of progress by new regulator
The CMA recommends that after five years of full implementation, the new regulator should review progress and assess the effectiveness of the overall package of remedies.
Other possible measures
There are a number of other ideas that the CMA is not including as part of its recommended package of remedies but which it does suggest merit careful consideration by the Government and/or the regulator. They include remuneration deferral and clawback for audit partners, audit firm ownership rules, technology licensing, measures to improve information for shareholders, notice periods and non-compete clauses that act as barriers to challenger firms growing, and introducing different requirements on tendering and rotation periods.
The CMA suggests that the Secretary of State should take forward these recommendations at the earliest opportunity. The CMA has decided to make recommendations rather than a market investigation reference partly because recommendations enable the sector to move forward without delay, while a market investigation could take up to two years from the point at which it starts and might conclude with recommendations in any event.
In April 2019, BEIS published a consultation paper (Call for Views) as part of the review by Sir Donald Brydon into the quality and effectiveness of audits in the UK.
The Call for Views notes that the Brydon review is primarily interested in questions around the purpose, scope and quality of audit, rather than the specific role of the audit regulator or the market through which audit services are provided, but it does invite input on some of the matters that the independent review of the FRC by Sir John Kingman and the CMA’s market study into the statutory audit market (see above for a summary of the CMA’s final report) have highlighted, such as the recommendations in Sir John’s report concerning companies’ internal control systems.
The Call for Views covers the areas set out below.
Definitions of audit and its users - It asks questions such as for whose benefit audit should be conducted and whether UK law should be amended to provide greater clarity regarding the purpose of an audit, and for whom it is conducted.
The expectation gap - This compares the requirements of audit in law and in international standards with what is currently expected of audit by shareholders, other stakeholders and wider society. It highlights perceived concerns that audit is not meeting existing requirements.
Audit and wider assurance - This chapter looks at the role of audit within the wider context of the assurance that companies are expected to provide to their shareholders regarding management of the business and its key risks. It seeks views on areas such as whether external auditors should make greater use of the work of internal auditors, and whether there should be a role for the external audit in assessing directors’ disclosures in areas beyond the financial statements.
The scope and purpose of audit - This chapter highlights and seeks views on various changes to the scope and purpose of audit and it asks whether auditors should have an expanded role in assessing the internal controls of an audited entity.
Audit product and quality - This questions the binary nature of audit opinions and looks at the possibility of graduated findings.
Legal responsibilities - This highlights and seeks views on the interplay between audit and the legal responsibilities of company directors. Questions include whether distributable and non-distributable reserves should be required to be disclosed in the audited financial statements, and how auditors should discharge their obligations relating to whether the entity has kept adequate accounting records.
The communication of audit findings - This chapter looks at how the auditor’s report is communicated and asks how this might be improved. It also asks whether, and if so how, greater transparency can be provided about the audit process and the auditor’s perspective.
Fraud - This chapter provides an overview of the extent to which auditors may reasonably be expected to detect fraud in their audit and asks whether it is reasonable and feasible to expect auditors to play a greater role in detecting material fraud.
Auditor liability - This chapter looks at the auditor’s liability for any costs or damages incurred by an audited entity, or by its shareholders or other affected parties, as a result of a negligent audit. It asks whether having differential liability over different aspects of reporting might aid an expansion of assurance.
Other issues - This chapter looks at a number of other matters related to the quality and effectiveness of audit, including the role of technology and shareholder engagement.
The Call for Views closed in early June 2019. It is noted that there are likely to be further calls for views and the need for deeper research as Sir Donald Brydon develops his conclusions.
In April 2019 the BEIS Committee published a report on the future of audit, following an enquiry that it launched in November 2018. The object of the enquiry was to examine how the three separate reviews of different aspects of the audit market, namely the Kingman review of the FRC, the CMA market study into the supply of statutory audit services and the independent Brydon review of the quality and effectiveness of audit, would complement each other.
The BEIS Committee makes a number of recommendations in its report, including those set out below.
The audit project
The FRC should make graduated findings mandatory. These refer to the auditor expressing an opinion on key management estimates and judgements in the accounts, describing them on a range from cautious to optimistic.
As part of his review, Sir Donald Brydon should consider extending the scope of audit to cover the entire annual report, albeit with different levels of assurance and reporting. Auditors should be encouraged and empowered by the new regulator to speak their mind openly and clearly in audit reports and call out poor management when they see it.
There should be a requirement in the new Stewardship Code for investors and asset owners to consider audit matters.
Auditors should make a presentation at the AGM to show how they have challenged management and exercised professional scepticism to underpin their audit opinion, and to raise any major issues.
The FRC and its successor should consider requiring companies to publish the audit report at the same time as results are announced, instead of waiting for the full annual report to be published.
Compliance with the capital maintenance regime is patchy is best and not adequately audited. The FRC should urgently remind directors and auditors of their duties relating to the accounts and impose severe sanctions for breaches. Auditors should be prepared to challenge management on their accounting of realised profits and distributable reserves.
In light of concerns that one of the reasons compliance with the capital maintenance regime is poor could be due to the lack of clarity over how the rules governing the payment of dividends are to be interpreted, the Government and the FRC should work together to resolve these issues as soon as possible and produce some prudent guidance for companies and auditors to follow.
The Government and the FRC should urgently produce a clear, simple and prudent definition of what counts as realised profits for the purpose of distributions and the BEIS Committee supports defining realised profits as realised in cash or near cash.
The BEIS Committee supports the Government’s proposal to require companies and auditors to take a more critical look at the valuation of goodwill for the purpose of distributions and recommends that the Government urgently take steps to tighten the net asset test.
Companies should be required to disclose the balance of distributable reserves in the annual accounts and break down profits between realised and unrealised.
The Government should adopt a complementary solvency-based system in which directors must state that dividend payments will not make the company insolvent or create cash flow problems.
Separating audit from non-audit
The CMA should, at the very least, implement its proposed operational split of audit and non-audit businesses to achieve the separation of economic interests.
The CMA should aim for full legal separation of audit and non-audit services. If the operational split is chosen instead, the CMA and the new regulator should conduct a review of the arrangements after three years to determine whether the split has ended cross-subsidies and improved culture, independence and transparency. If not, the CMA should then move to implement a full structural break-up of the Big Four into audit and non-audit businesses in the UK.
The FRC and its successor should require greater reporting on audit fees, potentially including the disclose of audit hours, staff mix, and rate per hour. Auditors should also report instances where they have performed additional procedures but have been unsuccessful at increasing their fee.
The FRC and its successor should be given more power over audit fees.
Ensuring independence, challenge and professional scepticism
The new regulator and the CMA should consider the potential independent appointment of auditors with a view to developing it as a viable remedy if other remedies and reforms fail.
The CMA should revisit increasing the frequency of audit rotations, which should be reduced to seven-year non-renewable terms that can only be terminated in exceptional circumstances.
The CMA should also seriously consider the benefits of a cooling-off period of three years across which non-audit services could not be offered after an audit engagement had ended.
Joint audits should be piloted in the upper reaches of the FTSE 100 in conjunction with the BEIS Committee’s preferred option of a market cap for the rest of the FTSE 350. Such audits should include a Big Four and a challenger firm.
In light of their strategic importance, the Government should examine the auditing of banks to explore whether additional safeguards are required in this sector.
The CMA should draw up detailed proposals for the introduction of a segmented market cap offering challenger firms a chance to take up a proportion of audits across the FTSE 350. This should be done on the basis that each firm should have an individual cap to avoid one of the Big Four keeping all of its clients and remaining dominant. The CMA should develop this proposal together with a pilot of joint audits in the first instance to allow challenger firms to take on some of the more complex FTSE 100 audits.
The CMA should work with the regulator to draw up proposals to mitigate the consequences of an audit market failure, especially if it involved one of the Big Four. However, the CMA should prioritise remedies that enable more challenger firms to enter the FTSE 350 audit market and develop their ability to undertake the full range of audit.
Regulation of audit
The new regulator should ensure that it has effective procedures and policies in place to encourage whistle-blowers to come forward when they have serious concerns and investigate them fully.
The Government should introduce the necessary legislation in Parliament to ensure that there are wider powers to intervene to prevent a significant market failure or lessen its impact if it cannot be averted. When there has been a major accounting and/or audit failure, the new regulator should conduct and publish a swift but comprehensive review of what went wrong to share lessons with the wider audit market.
While the new regulator should be proportionate in relation to sanctions, in the worst cases it should not be shy of imposing tough sanctions, including large fines.
In June 2019 the BEIS Committee published the Government's response (Response) to the BEIS report on the future of audit (the Report) (see above for a summary of the Report).
In the Response, the Government notes that it wants an open, competitive audit market, delivering the high-quality product needed by its users, underpinned by a highly effective regulator and that this is why it has commissioned three reviews to comprehensively review and update the regulatory framework for audit and corporate reporting, namely
The Response notes that the outcome of all of these reviews are, or will be, subject to public consultation by the Government and that the Government is committed to acting on their findings.
The Government also responds on specific recommendations made in the Report, including (amongst others) those set out below.
Recommendation that the FRC make graduated findings mandatory - The Response notes that the Government welcomed Sir John Kingman’s recommendation to consider requiring further enhancement to the independent auditor’s report to include “graduated” findings, however it is also noted that careful consideration would be needed to ensure the impact of such change ensures the promotion of positive action by audit firms. Sir Donald Brydon’s review also seeks evidence and views on the benefits that moving to a more graduated disclosure of audit findings could bring, and in the light of that further evidence the Government will consider making graduated findings mandatory.
Recommendation that there should be a requirement in the new Stewardship Code for investors and asset owners to consider audit matters - The Government is in agreement that the Stewardship Code must be improved. It notes that the FRC has recently consulted on a revised Stewardship Code and will bring forward a new Stewardship Code in light of responses (also taking account of Sir John Kingman’s recommendations in relation to stewardship) and that Sir Donald Brydon’s review is seeking views and evidence on how investors currently make use of audit as well as their likely future needs.
Recommendation that the FRC urgently reminds directors and auditors of their duties relating to the accounts and impose severe sanctions for breaches - most importantly, auditors must be prepared to challenge management on their accounting of realised profits and distributable reserves - The Government is considering whether companies should be required to disclose their available reserves and realised profits (see also below). It notes that this change would make the figures subject to audit and give auditors a clearer locus to challenge management on their accounting of realised profits and distributable reserves.
Recommendation that the Government and FRC should work together to resolve these issues as soon as possible and produce simple and prudent guidance for companies and auditors to follow and that the Government and FRC urgently produce a clear, simple and prudent definition of what counts as realised profits for the purpose of distributions - The Government recognises the need for greater clarity in the definition of realised profits and about the relationship between international accounting standards and the UK's capital maintenance regime. It will take full account of recommendations from Sir Donald Brydon’s review which is looking at the role of auditors in determining whether directors are complying with capital maintenance obligations and other requirements, and which has called for views on how perceived inconsistencies between international standards and company law capital maintenance might be resolved.
Recommendation that the Government urgently takes steps to tighten the net assets test - The Government notes that it is clear that companies need to exercise care over the valuation of goodwill, particularly where it is significant in determining whether a proposed dividend can be paid and that auditors should be demonstrating strong professional scepticism and challenging management robustly where they believe goodwill is overvalued and needs to be impaired. The Government will consider whether additional steps should be taken to tighten the net assets test as part of its consideration of ways to strengthen the framework governing dividend payments.
Recommendation that companies be required to disclose the balance of distributable reserves in the annual accounts and break down profits between realised and unrealised - The Government notes that a minority of companies already disclose their distributable reserves on a voluntary basis and that it encourages more companies to follow this good practice. It is, however, considering whether to go further and to make this a legal requirement and has taken careful note of the Report’s recommendation. The Government also notes (amongst other things) that it intends to consider the recommendations of Sir Donald Brydon’s review, alongside its own work, before reaching conclusions on whether (and, if so, how) to implement a new disclosure requirement taking account of the need for any requirement to be practical, proportionate and useful to investors.
Recommendation that the Government adopts a complementary solvency-based system, in which directors must state that dividend payments will not make the company insolvent or create cashflow problems - The Government will consider this recommendation, which is focused specifically on dividends, as part of its consideration of ways to clarify and strengthen the framework governing dividend payments. The Government notes, however, that the UK Corporate Governance Code already asks company boards to assess the prospects of a company over an appropriate time period and to state whether the company will be able to continue in operation and meet its liabilities as they fall due over the chosen period.
(BEIS: The Future of Audit - Government Response to the Committee’s Nineteenth Report of Session 2017 – 19, 07.06.19)
(BEIS: The Future of Audit - Government’s response "in danger of kicking vital reforms into the long grass", 07.06.19)
In July 2019 the Government published a consultation on recommendations made by the CMA in its final report on its market study into statutory audit services in April 2019 (see above).
The Government’s response to the recommendations, and some of the key points on which it is consulting, are summarised below.
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 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 would be 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 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
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 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.
In May 2019 the FRC launched a consultation on revisions to the Standards for Investment Reporting (SIRs) 1000-5000 and on an exposure draft for a new SIR 6000 dealing with Quantified Financial Benefits Statements (QFBSs).
The SIRs set the requirements and provide guidance for reporting accountants carrying out reporting engagements on UK investment circulars. Those engagements can include private reporting (for example, on working capital statements) and public reporting engagements on published financial information. SIR 1000 provides basic principles and procedures for all relevant engagements and SIR 2000-6000 provide additional principles and procedures for specific types of public reporting.
The purpose of the consultation is to revise the SIRs (which have not been updated since 2006-2008) to reflect changes in both retrospective and prospective legislation and regulation. These include changes to the Listing Rules and Takeover Code and changes to the Prospectus Rules in light of the new EU Prospectus Regulation, as well as the establishment of the FCA in place of the Financial Services Authority. References to “fair, balanced and understandable“ principles have also been included as criteria reporting accountants may consider when assessing an investment circular prepared by an entity which is required to or voluntarily complies with the UK Corporate Governance Code. New SIR 6000 is being introduced as the FRC believes the work carried out by reporting accountants to give an opinion on the proper compilation of a QFBS is sufficiently distinct to warrant it.
The consultation (which closed on July 26) requested feedback on all aspects of the consultation, with particular focus on whether the proposed revisions provide a sound framework for the work carried out by reporting accountants and meet stakeholder expectations, especially whether the current format of reporting is sufficiently transparent and informative about the opinions being given.
In July 2019 the FRC published a consultation (Consultation) on proposed changes to the UK’s Ethical and Auditing Standards. The revisions are the result of the FRC’s post implementation review of the efficacy of the standards, a process which included a call for feedback in November 2018, and a position paper in March 2019.
Key changes proposed include
The FRC recognises that there are a number of concurrent reviews of the UK audit market, including an independent review by Sir Donald Brydon looking at the quality and effectiveness of audit, and notes that its proposals are not intended to pre-empt the outcome of those reviews, or the direction of future government policy. Instead they are focused on improving current Ethical and Auditing Standards in light of experience since the last major revision in 2016, driving up the quality of audits being carried out in the UK, and continuing to promote public confidence in audit.
The consultation closes on September 27, 2019 and the revised standards are intended to apply to the audit of financial periods commencing on or after December 15, 2019.
(FRC: Enhanced Ethical and Auditing Standards – Feedback statement and Impact assessment, 15.07.2019)
(FRC: Enhanced Ethical and Auditing Standards - Exposure Drafts , 15.07.2019)
(FRC: Consultation on enhanced Ethical and Auditing Standards – press release, 15.07.2019)
In July 2019 the Chartered Institute of Internal Auditors (CIIA) launched a consultation on a draft of its new Internal Audit Code of Practice (Code). The Code is intended to provide an industry benchmark for best practice and a gauge for boards, audit committees and where appropriate UK regulatory authorities to assess the role, function and effectiveness of internal audit functions.
The Code makes 30 recommendations to strengthen internal audit covering the following areas
Specific recommendations include (amongst others)
The consultation is open until October 11, 2019.
In July 2019, BEIS published the draft Statutory Auditors, Third Country Auditors and International Accounting Standards (Amendment) (EU Exit) Regulations 2019 (Draft Regulations). The purpose of the Draft Regulations is to address deficiencies of retained EU law arising from the UK’s exit from the EU in relation to the application of international accounting standards under UK law, and the regulatory oversight and professional recognition of statutory auditors and third country auditors.
The Draft Regulations make amendments to the Statutory Auditors and Third Country Auditors (Amendment) (EU Exit) Regulations 2019, including
In addition, the Draft Regulations replace references to "UK-traded non-EEA companies" with references to "UK-traded third country companies" in certain areas of the Companies Act 2006, as well as amending Schedule 2 to the International Accounting Standards and European Public Limited-Liability Company (Amendment etc.) (EU Exit) Regulations 2019 so as to repeal additional directly applicable Commission Regulations adopting IFRS or amending EU adopted IFRS for application in the EU, and making minor amendments to the Accounts and Reports (Amendment) (EU Exit) Regulations 2019.
(Draft Statutory Auditors, Third Country Auditors and International Accounting Standards (Amendment) (EU Exit) Regulations 2019)
(Draft Statutory Auditors, Third Country Auditors and International Accounting Standards (Amendment) (EU Exit) Regulations 2019 - explanatory memorandum)
The UK’s Streamlined Energy and Carbon Reporting (SECR) framework was introduced in April 2019. This simplifies existing energy and carbon reporting policies while reducing the administrative burden imposed on companies. SECR replaces the Carbon Reduction Commitment Energy Efficient Scheme.
In March 2019 BEIS published an updated version of its guidance on environmental reporting. This now includes guidance to help companies comply with the Government’s new policy on streamlined energy and carbon reporting, including greenhouse gas reporting (see above). The Companies (Directors’ Report) and Limited Liability Partnerships (Energy and Carbon Report) Regulations 2018 (2018 Regulations) implement this policy and have introduced new legal obligations from April 2019.
Under changes introduced by the 2018 Regulations, for financial years commencing on or after April 1, 2019, large unquoted companies and large limited liability partnerships are obliged to report their UK energy use and associated greenhouse gas emissions as a minimum relating to gas, electricity and transport fuel, as well as an intensity ratio and information relating to energy efficiency action, through statements in their directors’ report. Quoted companies of all sizes will continue to be required to report their global greenhouse gas emissions and an intensity ratio in their directors’ report, but they are now also required to report their total global energy use and information relating to energy efficiency action, alongside the methodology used to calculate the new and existing disclosure requirements.
The guidance is designed to help those companies and limited liability partnerships in scope of the new requirements. It sets out steps to be taken when companies and limited liability partnerships are considering their environmental impacts and which key performance indicators to report on. It also provides guidance on the new streamlined energy and carbon reporting requirements and outlines additional voluntary information.
In May 2019 Institutional Shareholder Services (ISS) published its ESG Review 2019 (Review), an annual analysis of the state of adherence by companies across the globe to environmental, social, and governance (ESG) criteria. The Review’s findings demonstrate positive trends in corporate sustainability performance, and a continued rise in the number of reported controversies across all ESG topics.
The Review notes that the group of companies rated with medium or excellent performance now includes more than 67.5 per cent of covered companies in developed markets, representing an all-time high over the 11-year history of the review. Similar patterns can be observed among companies in emerging markets, albeit at a considerably lower level. The findings also show that 41 per cent of the assessed companies contribute positively to the United Nations Sustainable Development Goals (UN SDGs) through their products and services, of which 8 per cent contribute to the UN SDGs through their products and services to a significant extent.
However, the rise in the number of reported controversies across all ESG topics has continued, linked to the breach of established standards for responsible business conduct. This results from a maturing debate about human rights due diligence, increased awareness about standards, improved monitoring mechanisms and the expanding influence and reach of social media.
In June 2019 the European Commission (Commission) published new (non-binding) guidelines on corporate climate-related information reporting (Guidelines) alongside an accompanying Q&A, as part of its Sustainable Finance Action Plan. The guidelines are intended to provide companies with practical recommendations on how to better report the impact that their activities are having on the climate as well as the impact of climate change on their business, and are a supplement to the Commission's existing Guidelines on Non-Financial Reporting.
The Guidelines are intended for use by companies that fall under the scope of the Non-Financial Reporting Directive, but may also be useful for other companies that wish to disclose climate-related information. They are not intended to encourage stand-alone climate reporting, but to encourage companies to integrate climate-related information with other financial and non-financial information as appropriate in their reports.
Under the Non-Financial Reporting Directive, companies are required to disclose information on, amongst other things, environmental matters to the extent that it is necessary for an understanding of the company’s development, performance, position and impact of its activities (climate-related information can be considered to fall into the category of environmental matters for these purposes). Companies should consider using the proposed disclosures in the Guidelines if they decide climate is a material issue in this context. When assessing the materiality of climate-related information, companies should consider a longer-term time horizon than is traditionally the case for financial information and should not prematurely conclude climate is not a material issue simply because some climate-related risks are perceived as being long term in nature. When assessing the materiality of climate-related information, companies should consider their whole value chain, both upstream in the supply-chain and downstream. The Guidelines note that, given the systemic and pervasive impacts of climate change, most companies within the scope of the Non-Financial Reporting Directive are likely to conclude that climate is a material issue. Companies that conclude that it is not are advised to consider making a statement to that effect, explaining how that conclusion has been reached.
The Guidelines propose climate-related disclosures for each of the five reporting areas in the Non-Financial Reporting Directive (see further below). In addition, for each reporting area, they identify recommended disclosures that a company should consider using to the extent that they are necessary for an understanding of its development, performance, position and impact of its activities. Further guidance is also provided after the recommended disclosures for each reporting area – this consists of suggestions for more detailed information that companies may consider including as part of the recommended disclosures. Additional guidance is also provided for banks and insurance companies. The Guidelines note that, when deciding whether and to what extent they use the recommended disclosures and the more detailed suggestions, companies should take account of the principles of good non-financial reporting contained in the Commission’s Guidelines on Non-Financial Reporting, including the principles about disclosed information being material; fair, balanced and understandable; and comprehensive but concise.
The recommended disclosures for each reporting area set out in the Guidelines include those set out below.
Business model - Describe: the impact of climate-related risks and opportunities on the company's business model, strategy and financial planning; the ways in which the company’s business model can impact the climate, both positively and negatively; and the resilience of the company’s business model and strategy, taking into consideration different climate related scenarios over different time horizons, including at least a 2°C or lower scenario and a greater than 2ºC scenario.
Policies and due diligence processes - Describe: any company policies related to climate, including any climate change mitigation or adaptation policy; any climate-related targets the company has set as part of its policies, especially any greenhouse gas emissions targets, and how company targets relate to national and international targets and to the Paris Agreement in particular; the board’s oversight of climate-related risks and opportunities; and management’s role in assessing and managing climate-related risks and opportunities (explaining the rationale for the approach).
Outcomes - Describe: the outcomes of the company's policy on climate change, including the performance of the company against the indicators used and targets set to manage climate related risks and opportunities; and the development of greenhouse gas emissions against the targets set and the related risks over time.
Principal risks and their management - Describe: the company’s processes for identifying and assessing climate-related risks over the short, medium, and long term (disclosing how it defines short, medium, and long term); the principal climate-related risks the company has identified over the short, medium, and long term throughout the value chain, and any assumptions that have been made when identifying these risks (this should include the principal risks resulting from any dependencies on natural capitals threatened by climate change, such as water, land, ecosystems or biodiversity); processes for managing climate-related risks (including, if applicable, how they make decisions to mitigate, transfer, accept or control those risks) and how the company is managing the particular climate-related risks that it has identified; and how processes for identifying, assessing, and managing climate-related risks are integrated into the company’s overall risk management (an important aspect of this description is how the company determines the relative significance of climate-related risks in relation to other risks).
Key performance indicators - The Guidelines set out indicators that companies should consider disclosing (subject to the company’s materiality assessment and in order to facilitate greater comparability of disclosures of non-financial information by companies).
Companies should be able to use the Guidelines for reports published in 2020, covering the financial year 2019. Feedback on the use of the guidelines is expected to be gathered in the second half of 2020.(European Commission: Guidelines on non-financial reporting - reporting climate-related information, 18.06.19)
In June 2019 the TCFD published its 2019 Status Report (Status Report). The Status Report provides an overview of the extent to which companies, in their 2018 reports, included information aligned with the core TCFD recommendations published in June 2017 (2017 Recommendations), and follows on from the TCFD’s 2018 Status Report. The Status Report highlights key challenges associated with implementing the recommendations, and outlines some of the efforts the TCFD will consider undertaking in coming months to help address some of the implementation challenges.
In preparing the Status Report, the TCFD reviewed reports from over 1,000 large companies in a range of sectors and regions over a three-year period. In addition, the TCFD conducted a survey to understand companies’ efforts to implement the 2017 recommendations as well as users’ views on the usefulness of climate-related financial disclosures for decision-making. Although the TCFD found results encouraging, it is concerned that not enough companies are disclosing decision-useful climate-related financial information and considers that this could be problematic for financial markets if market participants do not have sufficient information about the potential financial impact of climate-related issues on companies.
The key themes and findings from the Status Report are as follows
On the whole, the TCFD welcomes the level of progress in implementing the 2017 recommendations among companies traditionally engaged on climate-related issues, but is still concerned that not enough companies are disclosing information about their climate-related risks and opportunities. As a result, the TCFD, amongst other things, encourages
Over the coming months, the TCFD will continue to promote and monitor adoption of the 2017 Recommendations and will prepare another status report for the Financial Stability Board in September 2020.
Other areas in which the TCFD is considering additional work are
In July 2019 BEIS published the Government’s Green Finance Strategy – Transforming Finance for a Greener Future (Green Finance Strategy). The Green Finance Strategy is, in part, a response to the recommendations of the Green Finance Taskforce published in March 2018 (TCFD Recommendations). It has three core elements
The Green Finance Strategy notes that the transition to a green financial system means fundamental changes to the way decisions are made across the economy. It sets out the actions the Government is taking to ensure climate and environmental factors are recognised and acted upon as a matter of strategic and financial imperative, and aims to ensure that current and future financial risks and opportunities from climate and environmental factors are integrated into mainstream financial decision-making and that markets for green financial products are robust in nature. It focuses on four elements: establishing a shared understanding; clarifying roles and responsibilities; fostering transparency and embedding a long-term approach; and building robust and consistent green financial market frameworks.
Actions that the Government is taking include (amongst other things) setting out its expectation that all listed companies and large asset owners will disclose in line with the recommendations of the TCFD Recommendations by 2022 and establishing a joint taskforce with UK regulators (chaired by Government) which will examine the most effective way to approach disclosure, including exploring the appropriateness of mandatory reporting.
The Government will continue to explore actions it can take to “green” the UK’s financial system and will publish an interim report by the end of 2020. The report will examine progress on the implementation of the TCFD Recommendations.
In May 2019 the final report (Report) of the independent review of the Modern Slavery Act 2015 (Act) was laid in Parliament. The review was launched in July 2018 and the Report was submitted to the Home Secretary in March 2019. It provides evidence and recommendations on areas of the Act which concerned the Independent Anti-Slavery Commissioner (Commissioner) and transparency in supply chains, amongst others.
Section 54 of the Act requires large commercial organisations supplying goods or services, and carrying on a business in the UK, to prepare a slavery and human trafficking statement for each financial year. In the statement the company must state the steps it has taken to ensure that slavery and human trafficking is not taking place in its business or its supply chains, or it must state that it has taken no such steps. The Review considered how to ensure compliance and improve the quality of modern slavery statements produced by eligible companies.
Guidance issued under section 54(9) of the Act (Guidance) suggests six areas that businesses are expected to report on. The Review acknowledges that these provisions have contributed to better awareness of modern slavery in companies’ supply chains, but notes that many eligible companies are not complying with the legislation at all. In light of these findings, the Review sets out a definitive list of recommendations for reform in order to ensure compliance and to improve the quality of modern slavery statements produced by companies.
The recommendations including the following
In addition to this, the review sought to determine how the Commissioner’s autonomy and freedom to scrutinise Government policy and promote efforts to tackle modern slavery could be strengthened, both in statute and in practice. The review team believes that the Commissioner’s primary roles in carrying out his/her statutory duties should be: to advise the Government on measures to tackle modern slavery; to scrutinise and hold the Government and its agencies to account on their performance; and to raise awareness and promote cooperation between sectors and interest groups.
The Government will consider the Report’s recommendations and will respond formally in due course.
In July 2019, the Government published its response (Response) to the final report (Report) of the independent review of the Act (see the summary above for further information on the Report).
In the Response, the Government notes that it welcomes the Report and its recognition that the Act is world-leading, that it is grateful to the reviewers and expert advisers for their work, and that it accepts the majority of the recommendations made. The Response then goes on to set out the Government’s detailed response to the recommendations made in the Report.
In relation specifically to the topic of transparency of supply chains, the Government’s responses to the recommendations on this area (recommendations 15 - 35) include, amongst others, those summarised below.
The Government agrees with the recommendation that it should establish an internal list of companies falling within the scope of section 54 of the Act and notes that it has identified a list of approximately 17,000 UK organisations, which are likely to fall within the scope of the legislation. The Government has used this information to write directly to the CEOs of those organisations with clear information to support effective reporting. However, it notes that only individual commercial organisations will have the full data required to definitively determine whether or not they are caught and the Government therefore agrees that organisations themselves should retain ultimate responsibility for determining whether they are required to produce a modern slavery statement.
In relation to improving the quality of modern slavery statements, the Response notes that a number of recommendations in the Report relate to the provision of guidance. In response to these recommendations, the Government commits to revise the statutory guidance on transparency in supply chains in 2020 following the planned consultation (a copy of the consultation, Transparency in Supply Chains Consultation, which closes on September 17, 2019 (the Consultation), can be found here) and in line with any subsequent amendments to the legislation. Relevant stakeholders will be engaged with in relation to the development of this guidance including, in particular, the Commissioner. The recommendation in the Report that statutory guidance should be strengthened to include a template of the information organisations within the scope of section 54 of the Act are expected to provide is accepted by the Government, but the Response notes that (in recognition of the fact that organisations will need to retain flexibility to set their own priorities based on the specific risks faced by their businesses) the template will be non-exhaustive and will evolve over time to reflect emerging best practice. The template will be included in the revised statutory guidance which will be published in 2020.
In relation to the recommendations suggesting amendments to the Act requiring organisations to report against the six areas currently recommended in guidance issued under section 54(9) of the Act (Guidance) and to remove the ability for an organisation to state they have taken “no steps” to address their modern slavery risk, the Response notes that the Government recognises that strengthening the content requirements for reporting could improve the quality of statements produced. It intends to consult to gather further views on the impact of any such changes ahead of any amendment to the legislation. The consultation will consider how to retain enough flexibility to accommodate the diversity of organisations within the scope of the legislation as well as how best to ensure alignment of the UK’s legislation with the requirements of other jurisdictions (see above for a link to the Consultation).
The Government does not agree with the recommendation that organisations should designate a board member to be accountable for the production of their modern slavery statement as the board’s role in approving a modern slavery statement is a collective responsibility.
The Government accepts the recommendations that there should be a central, Government-run reporting service for modern slavery statements, that statements should be dated and clearly state over which 12-month period they apply, and that the website hosting the service should clearly outline the minimum statutory reporting requirements. The Response notes that, in June 2019, the Prime Minister announced that the Government would create a central register of modern slavery statements and that this service will be available to organisations free of charge. When creating the registry, the Government will take into account lessons learned from gender pay gap reporting.
Although the Report did not recommend establishing a single reporting deadline and suggested reporting deadlines should continue to be in line with the end of an organisation’s financial year, in the Response the Government notes that the lack of a single deadline makes it challenging to effectively drive and monitor compliance. The Government therefore intends to create a single reporting deadline. It will consult on this to gather further evidence on the potential impact, including understanding the practical and resource implications for businesses, and will seek views on a potential appropriate annual reporting deadline (see above for a link to the Consultation). The Government does not agree with the recommendation that the CA 2006 should be amended to include a requirement for companies to refer to their modern slavery statement in their annual reports and that section 54 of the Act should be amended to impose a similar duty on non-listed companies that meet the relevant size threshold but would not be captured by CA 2006 reporting requirements. Nor does it agree with the recommendation that failure to fulfil modern slavery statement reporting requirements or to act when instances of slavery are found should be an offence under the Company Directors Disqualification Act 1986. The Government has concerns that these recommendations might lead to an overly compliance driven approach and encourage statements which are high-level with limited disclosure about instances of or risks of modern slavery identified. It believes that the enhanced transparency delivered by the creation of a central Government-run service for reporting and a single reporting deadline will address the concerns underlying these recommendations, by making it much easier for stakeholders to effectively scrutinise statements and hold organisations to account for their actions.
The Government partially agrees with the recommendation that the Commissioner should monitor organisations’ compliance with section 54 of the Act. The Response notes that the Home Office has the power to issue guidance and take enforcement action against non-compliant organisations and, as such, is best placed to monitor compliance with the law. However, the creation of a centralised registry will facilitate increased scrutiny and comparison of statements by the Commissioner (as well as other stakeholders), and the Commission will continue to hold the Government to account for its activity to ensure compliance with section 54 of the Act.
In relation to the recommendation that sanctions for non-compliance should be strengthened, the Government notes that the introduction of any new enforcement measures would need to be gradual and consistent with growing business awareness and that it would need to be ensured that any new enforcement sanctions are proportionate and support the overall aim that organisations take effective action to prevent and tackle modern slavery in their business and supply chains and report this activity in a transparent way. The Government wants to avoid any unintended consequences (such as creating an overly compliance driven approach which might dis-incentivise disclosure of risks identified) and will therefore consult to explore potential enforcement options and appropriate timeframes for enforcing compliance (see above for a link to the Consultation).
In response to the recommendation that the Government should set up an enforcement body to impose sanctions on organisations that do not comply with their reporting requirements, the Government commits to consulting to gather further evidence before making any legislative changes. The Response also notes that the Home Office is already working to tackle non-compliance, including through writing to the CEOs of the UK-based organisations that have been identified as falling within the scope of the Act to set clear expectations and provide guidance and by carrying out an audit of compliance.
The Report recommended that section 54 of the Act should be extended to the public sector. The Government agrees that certain public sector organisations should be required to produce annual statements. To ensure that its approach is proportionate, the Government will consult to gather further evidence from the public sector to identify the size and type of public sector organisations that should be brought into scope, as well as whether the duty on public sector organisations should mirror the duty on commercial organisations, ahead of any amendment to primary legislation. The consultation will also gather evidence to inform the most appropriate approval processes for these organisations given the differences between public and private sector governance (see above for a link to the Consultation).
In March 2019 the European Parliament resolved to adopt, with amendments, the European Commission’s 2016 proposal for a directive to amend the Accounting Directive (Directive 2013/34/EU) as regards disclosure of income tax information by certain undertakings and branches.
The changes to the 2016 proposal include the following
In July 2019 the Risk Coalition (a network of not-for-profit professional bodies and membership organisations committed to raising standards of risk governance and risk management in the UK) published a consultation on its draft principles and guidance for board risk committees and risk functions in the UK financial services sector (Draft Guidance).
The Draft Guidance aims to provide coherent, principles-based good practice guidance for board risk committees and risk functions and is intended to
The first part of the Draft Guidance identifies eight principles relating to what can reasonably be expected of a mature board risk committee and provides accompanying guidance on how each of the principles can be met. The eight principles identified by the Draft Guidance are set out below.
Board accountability - The board risk committee is an advisory committee to the board. Its aim is to facilitate focused and informed board discussions on risk-related matters. The board retains ultimate accountability for the adequacy and effectiveness of the organisation’s risk management arrangements.
Composition and membership - The board risk committee should be formed of independent non-executive directors and apply chair, membership, competence, performance evaluation and succession planning criteria as outlined in the UK Corporate Governance Code for board committees.
Risk strategy and risk appetite - The board risk committee should provide the board with advice on the continued appropriateness of the board-set risk strategy and risk appetite in light of the organisation’s purpose, values, corporate strategy and strategic objectives.
Principal risks and continued viability - The board risk committee should assess and advise the board on the organisation’s principal current and emerging risks and how these may impact the organisation’s corporate strategy and strategic objectives, and the continued viability of its business model.
Risk culture and remuneration - The board risk committee should consider and periodically report to the board whether the organisation’s purpose, values and board-approved risk culture expectations are appropriately embedded in the organisation’s risk strategy and risk appetite, and are reflected in observed behaviours and decisions.
Risk information and reporting - The board risk committee should assess and advise the board on the quality and appropriateness of the organisation’s risk information and reporting.
Risk management and internal control systems - In conjunction with the audit committee (where relevant), the board risk committee should monitor and periodically advise the board on the overall effectiveness of the organisation’s risk arrangements.
Chief risk officer and risk function independence - The board risk committee should safeguard the independence and oversee the performance of the chief risk officer and the second line risk function.
The second part of Draft Guidance focuses on the role and responsibilities of the chief risk officer and second line risk function. It sets out principles (and supporting guidance) in relation to the areas of: independent risk oversight; independent perspective; risk governance; risk reporting; corporate strategy and objectives; risk function independence and effectiveness; risk culture; innovation and change; and group risk functions.
While the scope of the Draft Guidance is limited to financial services, the Risk Coalition hopes the principles it establishes will also be seen as relevant to other sectors, and it welcomes consultation responses from those outside financial services.
The consultation asks respondents to consider a number of questions arising from the development of the Draft Guidance, including (amongst other things) in relation to: whether the responsibilities of the board risk committee are set out with sufficient clarity in Draft Guidance; the composition of the board risk committee; and how the board risk committee should be interacting with other board committees generally to ensure risk oversight at board level is conducted in the most effective way.
The consultation closes on September 20, 2019 and the Risk Coalition anticipates publishing a final version of the guidance in December 2019, along with a companion narrative piece discussing relevant key risk topics and themes which have emerged from the consultation.
In July 2019, the European Securities and Markets Authority (ESMA) published an updated version of its European Single Electronic Format (ESEF) Reporting manual (Manual).
The Transparency Directive (2004/109/EC), as supplemented by Commission Delegated Regulation (EU) 2019/815 (ESEF Regulation), requires annual financial reports containing financial statements to be prepared in a single electronic format for financial years beginning on or after January 1, 2020.
The Manual is intended to assist issuers and software vendors in creating Inline XBRL documents in compliance with the ESEF Regulation, to provide guidance on common issues that may be encountered when creating Inline XBRL documents and how to resolve them, and to promote a harmonised and consistent approach for the preparation of annual financial reports in the format specified in the ESEF Regulation.
Following feedback from market participants, ESMA has updated the Manual to expand and update the guidance included in the original version of the Manual published in 2017. A summary table of the updates is set out in Part II of the Manual.
ESMA notes that it will continue to monitor relevant market developments and gather feedback on issues frequently encountered, and will provide further guidance where relevant or necessary.
Robert Schwinger discusses one approach issuers have tried in order to avoid facing securities law requirements: SAFTs.
The COVID-19 pandemic has resulted in an unusual complex global economic dis-equilibrium where disruption seems to be the only constant.
While capital markets rely on companies to provide timely and accurate information, and investors, shareholders and others rely on companies to provide financial reports that have been through a rigorous audit process, government and regulators in the UK recognise that the COVID-19 pandemic is creating huge challenges for both corporate reporting and audit processes.