The Government has issued a consultation paper  regarding statutory audits and financial reporting. The consultation makes proposals in relation to four areas, namely directors, auditors and audit firms, shareholders and the audit regulator. We have previously summarised the proposals impacting the purpose and scope of an audit.

This post will focus upon the matters affecting directors’ duties, and how the proposals may interact with the existing frameworks and enforcement powers that are in play when a company enters into an insolvency process.

Current Regime

To recap (at a very high level), the current directors’ duties and enforcement regime is broadly as follows:

1. Directors are subject to the statutory and common law fiduciary duties, such as the duty to promote the success of the company, and to act with reasonable care and skill when exercising their role as a director.

2. When a company enters the “twilight zone” i.e. is or is close to becoming insolvent, those duties change, so that the directors are required to exercise those duties for the benefit of the company’s creditors as a whole, rather than its members. The directors will also need to be conscious of continuing to trade when approaching or entering the twilight zone, as they risk claims being brought against them if they fall foul of the various offences in the insolvency legislation, such as wrongful trading. Those additional considerations are explained here.

3. If the directors have breached those duties and the company enters an insolvency process, then the administrator or liquidator can issue claims against the directors personally for breach of duty. If those claims are successful, then the directors can be ordered to personally pay funds into the insolvency for the benefit of the company’s creditors.

4. If the directors’ behaviour is particularly inappropriate, then following the administrator or liquidator submitting their report to the Secretary of State regarding the directors’ conduct, then the Secretary of State can commence disqualification proceedings against the directors, which could lead to the directors being banned from being involved in the formation or management of any company for up to 15 years.

Public Interest Enterprises (“PIEs”)

The consultation focuses upon PIEs, which currently mainly comprise listed companies (excluding AIM-listed entities), credit institutions and insurers. The Government appears to want to:

1. widen the existing definition of PIEs (which could include private companies) so that it includes “large companies”, which it estimates would increase the number of companies falling within the definition by between 1,000- 2,000 depending on the definition used; and

2. subject directors of PIEs to greater scrutiny regarding the company’s finances and its financial reporting.

Relevant ProposalsNormal

The consultation indicates that legislation will be introduced to include the following:

1. a new regulator will be created to replace the FRC as regards audit matters and financial reporting. The regulator will have the power to impose additional requirements and behavioural standards on directors of PIEs regarding corporate reporting and the audit process;

2. directors of PIEs will be subject to enhanced reporting requirements e.g. the procedures that they have in place to detect and prevent fraud;

3. the new regulator will have powers to directly enforce any breaches of duties by directors of PIEs relating to the company’s accounting and reporting practices, and can require the directors to amend the company’s financial statements . The directors could be subject to fines, reprimands, or orders preventing them from acting as a director of a PIE;

4. the new regulator will be able to enforce those duties even where the company has not entered into an insolvency process; and

5. directors of PIEs will need to confirm that in their reasonable opinion, any proposed dividend will not threaten the insolvency of the company over the next two years.

Commentary

On its face, it appears that the consultation is a case of placing greater scrutiny and accountability on directors of large companies as regards financial reporting. If a company enters into an insolvency process, then under the existing insolvency legislation, the insolvency practitioner already has powers to bring claims against directors for breaching their duties. Those claims could include failing to properly manage the company’s finances, or to misrepresent the company’s financial position in its financial statements.

It remains to be seen:

1. whether any additional duties (or clarification of existing duties) will require significant changes of behaviour from directors of large companies, or will it be a case of re-emphasising the importance/scope of the existing duties?;

2. will any enforcement action by the new regulator following an insolvency impact upon any claims by the insolvency practitioner against the directors, in order to realise funds for the creditors?;

3. will these changes drive any change of behaviours in companies that fall outside the PIE definition, even though they will not be subject to the additional requirements?

We will comment further once the draft legislation is published in due course.