Two years ago, I suggested that a House of Commons Select Committee report spelled trouble for company directors and potential joy for the plaintiff’s bar. Now that prospect has become a lot more real.
Concerns about the effectiveness of the Financial Reporting Council (FRC) as the watchdog for auditors and the guardian of the U.K. Corporate Governance Codes were first expressed by the House of Commons. These fears intensified following a number of high profile corporate collapses. This led to the publication of a report in December 2018 by Sir John Kingman, which was highly critical of the FRC’s role. Now the Business Secretary, Greg Clark, has announced radical plans to abolish the FRC and replace it with a tougher, more independent body with a much wider range of powers. The new body is to be known as the Auditing, Reporting and Governance Authority (ARGA).
Why directors should be worried
As things stand, the only public company directors over whom the FRC has jurisdiction are those with an accounting qualification. Under the proposals, ARGA’s jurisdiction will extend to all CEOs, CFOs, chairs and audit committee chairs, regardless of their qualifications. Moreover, directors will be responsible for certifying the material accuracy of the financial statements, and the effectiveness of internal controls along similar lines to the Sarbanes-Oxley Act in the U.S.
Although we don’t know exactly what enforcement powers ARGA will be granted, we have a pretty good idea based on the Kingman Review, in which recommendations 36-38 provide that:
“…the Government, working with the new regulator, should task the regulator to develop detailed proposals for an effective enforcement regime in relation to Public Interest Entities that holds relevant directors to account for their duties to prepare and approve true and fair accounts and compliant corporate reports, and to deal openly and honestly with auditors…”
“The regime for non-member directors should follow the principles of the Audit Enforcement Procedure, with the same threshold for action to be taken, and a graduated range of sanctions. To achieve this, the regulator should set out relevant requirements or statements of responsibilities in relation to auditing and corporate reporting in order that directors are individually accountable for their roles,” and
“…[although] action relating to director disqualification should continue to rest with the Insolvency Service …the FRC should have the necessary powers to investigate directors and refer cases to the Insolvency Service, working closely with them to ensure effective action is taken where necessary.”
A regulatory shift in the duty of care?
Taken together and combined with the government’s avowed intent to make ARGA more interventionist and prescriptive than the Financial Reporting Council, this is a formidable prospect for senior board members. Directors have always borne primary responsibility for the truth and fairness of accounts so these proposals make sense in those terms. I can’t help thinking though that this perhaps marks a shift in emphasis here in the U.K. (at least in regulatory terms if not legal ones) from the mixed subjective and objective standard of care on which a director’s conduct is judged to a more objective standard in which it may simply not be open to directors to raise the defense that they did not have the necessary accounting qualifications to understand the technical issues, whatever they are.
I am reminded of the well-known Judgment of the Australian Court in the Centro case, in which all the directors–including those with no accounting skills–were found liable for inaccuracies in the company’s financial statements. The judge concluded that the directors were all “intelligent, experienced and conscientious people.” He also concluded that:
“In the light of the significance of the matters that they knew, they could not have, nor should they have, certified the truth and fairness of the financial statements, and published the annual reports in the absence of the disclosure of those significant matters. If they had understood and applied their minds to the financial statements and recognized the importance of their task, each director would have questioned each of the matters not disclosed. Each director, in reviewing financial statements, needed to enquire further into the matters revealed by those statements.”
“The central question in the proceeding has been whether directors of substantial publicly listed entities are required to apply their own minds to, and carry out a careful review of, the proposed financial statements and the proposed directors’ report, to determine that the information they contain is consistent with the director’s knowledge of the company’s affairs, and that they do not omit material matters known to them or material matters that should be known to them,” and
“A director is an essential component of corporate governance. Each director is placed at the apex of the structure of direction and management of a company. The higher the office that is held by a person, the greater the responsibility that falls upon him or her. The role of a director is significant as their actions may have a profound effect on the community, and not just shareholders, employees and creditors.”
There’s nothing in this extract from the judgment which an English High Court Judge would necessarily take issue with. And it is possible that the soon to be tightened regulatory framework in the U.K. may hasten the day in which we have our own Centro case.
There’s a lot more
The Kingman Review and the Consultation about the role of ARGA as the U.K.’s new accounting regulator marks a much more wide-ranging set of changes and aspirations than those I have focused on. Among the most eye-catching of the other new changes are the ideas that ARGA should:
- Be a statutory body with powers such as those to make direct changes to accounts rather than apply to the court to do so, and more comprehensive, visible reviews for greater transparency including on the question as to a company’s conduct and management
- Take more control over the appointment of auditors
- Have strategic direction and duties to protect the interests of customers and the public by setting high standards of statutory audit, corporate reporting and corporate governance, and by holding companies and professional advisors to account
- Regulate the biggest audit firms directly, rather than those being delegated
- Have a new, diverse board and strong leadership to change the culture and rebuild respect of those it regulates
What does the future hold?
The U.K. government consultation on the proposed radical overhaul of accounting regulations is due to last until June 11, 2019. The implementation of the new regime will require primary legislation. For that reason (even leaving Brexit to one side) it is not possible to predict when it will be in place. One thing is certain though: The plaintiff’s bar, and indeed the international litigation funding community, will be watching these developments with considerable interest. History (and geography in the case of the U.S. and Australia) suggest that the more aggressive the regulatory regime, the greater the likelihood of civil claims against directors.