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UK Government Proposals for Greater Board Accountability Under New ESG Whitepaper

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Background to proposed reforms

Against the backdrop of establishing the UK as a world class destination for investment and innovation post-Brexit, the UK Government has published a new whitepaper entitled 'Restoring trust in audit and corporate governance' seeking consultation on its various proposed reforms: https://www.gov.uk/government/publications/restoring-trust-in-audit-and-corporate-governance (the "Whitepaper").

The Whitepaper aims not only to learn from several recent high-profile collapses of British businesses, but also to firmly promote the UK Government's ESG strategy, including:

E (Environmental): inclusion of climate change risks, carbon emission disclosures and sustainability measures in the new corporate reporting regime (beyond the scope of this paper)

S (Social): new powers of regulator leading to increased board accountability and enhanced protection for employees and customers, and greater focus on public interest

G (Governance): more comprehensive corporate reporting regime, including wider scope of applicability and higher levels of board accountability for internal controls of the company

 

The current UK corporate governance regime

Directors of all UK companies (however large or small) are subject to the general directors' duties regime under the Companies Act 2006 (including promoting the success of the company, avoiding conflicts of interest, and acting with reasonable care, skill and diligence), in addition to common law duties and other duties relating to company reporting, recordkeeping, and auditing.

The boards of London-listed companies are further subject to a higher test of corporate governance under the UK Corporate Governance Code (the "Code"), requiring relevant companies to comply with its provisions or explain any digression. The level of expected compliance with the Code varies depending on the type of listing. Many companies who do not fall under the mandatory regime of the Code comply in any case, to demonstrate best practice to shareholders, stakeholders, and the public at large. The Code sets out standards of best practice in relation to matters such as corporate governance, board leadership and effectiveness, remuneration and accountability, and includes guidance for board members in relation to managing risk, the company's internal controls, company reporting and, for board members of certain financial institutions, solvency and liquidity risk management.

 

Expanding the scope of the UK corporate governance regime

The Whitepaper seeks to extend the scope of applicability of the UK corporate governance regime, both as regards substance and the companies which are caught thereunder. As regards the latter, the Whitepaper focuses on expanding the definition of public interest entities ("PIEs"). PIEs currently comprise:

(i) listed entities whose transferable securities are admitted to trading on a regulated market (for example, the Main Market of the London Stock Exchange);

(ii) credit institutions;

(iii) insurance undertakings; and

(iv) any entity designated as a PIE by an EU Member State (the UK has, prior to this point, not designated additional entities as such).

The Whitepaper proffers two options for expanding the definition of PIEs – it is important to note that both of which would seek to cover the largest private companies as PIEs:

Option 1: all companies (listed or not) having:

  • more than 2,000 employees; or

  • greater than £200 million turnover and a balance sheet of more than £2 billion

Option 2: all companies (listed or not) having both:

  • more than 500 employees; and

  • greater than £500 million turnover

The rationale behind including the largest private companies (and those relevant publicly listed companies not already subject to the mandatory Code regime, such as those entities listed on smaller markets such as AIM) is recognition of the vast economic and social impact they have in the UK, and the widespread implications on society should they fail.

 

Proposals to increase director accountability and introduce clawback arrangements to director remuneration

In the wake of several high-profile UK business failures, the Whitepaper covers proposals aimed at targeting board member's accountability for internal controls, dividends and capital maintenance, and toughening malus and clawback arrangements to provide better reassurance against rewards for failure.

In the event of a collapse of a business, whilst the general principle is that of collective responsibility of the board, as a whole (as emphasised in the Code and enshrined in relation to various acts and responsibilities set out in the Companies Act 2006), it may ultimately be determined that a director having specialist expertise (i.e. a qualified accountant) would be held to a higher level of accountability in relation to the finance of the company. The Whitepaper considers the idea of requiring board members of PIEs holding key financial and reporting roles (CEO, CFO, Chair and Chair of Audit Committee) to have fulfilled certain criteria before appointment to office, but concerns have been raised that this could undermine the collective responsibility of the board.

The Whitepaper outlines the UK Government's intention to replace the Financial Reporting Council (the "FRC") with a new regulator who will have new powers of enforcement in relation to breaches by PIE directors (taking into account the enlarged scope of this definition under new plans) of the existing statutory duties, including the duties to:

  • maintain adequate accounting records;

  • only approve accounts if the board is satisfied that they give a true and fair view; and

  • approve and sign the annual accounts (including approval of ancillary reports and statements relating to the audit).

As the position currently stands, the FRC has no direct powers to intervene in the event of a breach. The Whitepaper outlines the UK Government's plans to give the new regulator investigation and enforcement powers to hold company directors of PIEs to account. It is further recommended that new provisions be added to the Code such as the inclusion of certain minimum clawback conditions or "trigger points" in directors' remuneration arrangements to apply for at least two years after any such award is made in the event of serious director failings, including:

(i) material misstatement of results or performance calculations;

(ii) material failure of risk management and internal controls;

(iii) misconduct, or conduct leading to financial loss;

(iv) reputational damage; and

(v) unreasonable failure to protect the interests of employees and customers.

The UK Government is keen to also encourage companies to add to these minimum conditions to encapsulate circumstances which are relevant to the business / industry in which the company operates.

In addition to the new powers of enforcement, the UK Government would like to see the new regulator granted investigative powers to gather information and launch enquiries to establish whether a board member has breached a relevant requirement. In the event that a breach is found to have occurred, the intention is that the new regulator would have the authority to impose civil sanctions.

 

Key takeaways

An overhaul of the UK corporate governance regime was inevitable, and its implementation comes in the aftermath of the failure of several huge British businesses. The UK Government is keen to promote the UK as being open for business, investment and innovation, and its stance on corporate transparency and good governance has always been world leading. UK rules are considered strict enough to ensure adherence to the highest standards, without stifling creativity or the freedom of companies to operate as they desire (within the bounds of UK company law) – this balance must be carefully protected with the implementation of new rules.

Greater board accountability and proposed clawback provisions in the event of serious director failings should be welcomed, as it is a positive step towards affording greater protection to all stakeholders in a business (including employees, customers, and other companies engaged in that business). Giving directors greater 'skin in the game' is a sensible proposal, but the drafting of the resulting legislation should ensure that directors are not unnecessarily blamed nor held to an impossibly lofty calibre. If the new regime is too tough on directors individually (and departs too far from the principle of collective responsibility), it may be difficult for large companies to attract top talent to join the board (which is ultimately in the best interests of the business). The new regime must also ensure that it does not encourage directors to 'jump ship' at the first sign of trouble, to avoid the risk of personal economic or reputational consequences for staying at the helm and trying to navigate the company through choppy waters. Consequential issues around D&O insurance and liability allocation will also be brought to the fore with any toughened stance on board accountability.

Companies in the UK or overseas parent companies with UK subsidiaries who may fall under the new definition of PIEs should begin preparations now for the realities of complying with the Code and the associated changes that may be implemented following the outcome of consultation under the Whitepaper, especially the large costs involved (that were formerly reserved for the largest listed entities).

The consultation period under the Whitepaper runs until 8 July 2021, at which point we anticipate more clarity on the scope of the new requirements. The UK Government will therefore need to carefully consider and weigh up public concern and its ESG strategy, with economic recovery, ensuring that it is fulfilling its duties of promoting the success of, avoiding conflicts of interest, and acting with reasonable care, skill and diligence towards, British business and the British public alike.

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