Major governance reform is coming

The UK’s corporate governance landscape is changing – and the government’s 232-page white paper, Restoring trust in audit and corporate governance, plays a central role.

Published in March 2021, the document sets out wide-ranging proposals to strengthen the framework for major companies and the way they are audited. Consultation on the proposals closes on 8 July.

Four areas are addressed:

• Company reporting on governance and finances
• The auditing of these reports
• Changes to audit and the audit market
• Oversight by a new regulator.

Restore public trust

The government’s prime objective is to restore public trust in big business following high-profile corporate collapses such as BHS and Carillion, which have damaged the credibility of annual reports and statutory auditing.

The reforms are designed to provide greater assurance that large companies are governed responsibly, including more reliable and informative reporting of performance. They will also reinforce the attractiveness of UK capital markets.

The white paper proposes significant widening of the scope of regulation by expanding the definition of public interest entities (PIEs) beyond publicly listed companies to include all large businesses of public importance. It supports the recommendations of three recent reports: the Kingman review of the Financial Reporting Council (FRC); the Competition and Market Authority’s Statutory audit services market study; and the Brydon Review into quality and effectiveness of audit.

The government aims to drive meaningful and lasting change. This requires a holistic approach, encompassing directors, auditors, shareholders and the regulator.

AB has addressed elsewhere the key proposals relating to regulation and audit reform. Here, I set out implications for directors and shareholders.

Implications for directors

The white paper states that the current framework is inadequate to hold directors to account in the rare but serious cases where they neglect their reporting responsibilities. The powers of the proposed new Audit, Reporting and Governance Authority address this, as do proposals to ensure that remuneration can be recovered following serious director failings.

Important proposals address three perceived reporting weaknesses in PIEs:

• New reporting and attestation requirements covering internal controls. The white paper contains three options for strengthening the UK’s controls framework. The government’s preference is for an annual review by directors of the company’s controls and risk management, resulting in a statement in the annual report on their effectiveness. Unlike the US approach (which mandates external auditor attestation), the decision on whether this statement is assured by an auditor would be taken by the directors, audit committee and shareholders.
• Dividend and capital maintenance decisions. The proposals will require more transparent reporting on distributable reserves. The directors will have to make a formal statement about the legality and affordability of any proposed dividend, confirming that it is within known distributable reserves and will not, in the directors’ view, threaten company solvency over the next two years.
• Resilience planning. There is a proposed new statutory requirement on PIEs to publish an annual ‘resilience statement’ showing how directors are assessing their company’s prospects and addressing challenges to the business model. Resilience should be addressed over the short, medium and long term, including climate-change risks.

Implications for shareholders

The UK Stewardship Code has improved the quality of investor engagement. In addition to the proposals around audit reform, the white paper proposes measures focusing on improving stewardship over audit:

• Companies will be required to set out their approach to audit in a public audit and assurance policy on which shareholders will have an advisory vote.
• Shareholders will have the opportunity to propose to the audit committee areas of emphasis to be considered within the auditor’s annual audit plan.

One recurring aspect of commentary on the white paper is whether the UK will soon have its own Sarbanes-Oxley (SOX) style of governance regime. The proposed tougher regulations are one reason for this; another is the new reporting and attestation requirements covering internal controls, which is a key provision of SOX.

Confidence in company reporting depends on the effectiveness of the internal controls and risk management systems that directors put in place and oversee. The government is considering how the UK’s established internal controls framework could be strengthened and is looking to learn lessons from the US system.

One of the three reform options mirrors the s404 provisions in SOX. However, this is not the government’s preferred option, and is unlikely to be chosen for a variety of reasons including proportionality, cost and the desire to retain the UK’s holistic view of risk and controls.

Fraud is another factor that erodes trust in company reporting. Directors are primarily responsible for preventing and detecting fraud in their companies. There are significant new obligations in the white paper for directors of PIEs to report on the steps they have taken to prevent and detect material fraud, thereby complementing the proposals for auditor reporting on fraud.

The UK’s current framework has proved inadequate in holding directors to account. This will change with Arga. The white paper reforms will be phased in over time. They combine clearer reporting with stronger enforcement and will have the effect of sharpening directors’ accountability.