We need a regulator that ensures directors and auditors meet their legal obligations

Sarasin & Partners' Natasha Landell-Mills gives a qualified opinion on the UK government’s audit reform proposals

For years, the audit industry and its regulator, the Financial Reporting Council, appear to have turned the other way as a crucial law on capital maintenance in companies has been widely overlooked. This has likely contributed to some large and damaging bankruptcies, and a loss of confidence in audit and corporate governance.

It is, therefore, welcome to see capital maintenance put front and centre when the government recently set out its proposals for restoring trust in audit and corporate governance. The problem is that rather than strengthening capital maintenance, the proposals fall dangerously short. 

Preventing unnecessary insolvencies is an issue we should all care about. It matters to workers, suppliers, customers, investors, creditors and the taxpayer, too often left to foot the bill of company failures. While companies will inevitably come and go in any dynamic economy, recent bankruptcies such as Carillion, Thomas Cook and London Capital and Finance have pointed to flaws in the way companies are accounting for their profits and capital. This has permitted hidden risks to build up, in some cases to the point of no return.

Duty of directors

Proposals put forward last week by the Department for Business, Energy and Industrial Strategy (BEIS) rightly highlight the duty of directors to protect capital, and the centrality of company law restrictions on dividend payments to achieving this. Specifically, directors are prohibited from paying dividends that eat into a company’s capital base, taking into account expected losses and liabilities.

BEIS noted: “The legal framework is well established, but high-profile examples of companies paying out significant dividends shortly before profit warnings and, in some cases, insolvency, have raised questions about its robustness and the extent to which the dividend and capital maintenance rules are being respected and enforced.”

While BEIS has correctly diagnosed a serious problem, the actions proposed to prevent directors paying out excessive dividends – apparently based on the advice of the audit industry – are perplexingly weak. In fact, they appear out of line with the current legal requirement.

Part 23 of the 2006 Companies Act sets out detailed requirements that directors must follow to protect capital. These rules are not found in accounting standards, so that following the International Financial Reporting Standards (IFRS) will not on its own deliver adherence to the legal requirement, as BEIS acknowledges in its report.

Critical to the capital protection regime is the ‘Net Asset Test’ laid out in Section 831, which prohibits dividends being paid out of ‘undistributable reserves’. Undistributable reserves include the capital paid in by shareholders plus accumulated unrealised profits. In other words, profits companies might book today under IFRS, but will not actually receive in cash until some time in the future would not, under the law, be available for distribution.

The Act further mandates that capital should be set aside as ‘undistributable’ to cover likely losses and liabilities, even where the timing or amount is uncertain. This includes expected losses that are left out of IFRS accounts – but often discussed in the notes to the accounts. The remaining accumulated capital can be safely paid out as dividends to shareholders in the knowledge that the company will be resilient to anticipated losses and liabilities. This is prudent.

Importantly, Section 836 of the Act then explicitly states that the amount of ‘undistributable reserves’ must be included in the published audited accounts, so executives are able to justify to investors – and indeed all stakeholders – that dividends paid out are affordable (and also legal).

These rules underpin business resilience. They also ensure full transparency, accountability and, therefore, market integrity.

No legal requirement

Given this legal framework, the BEIS proposal that directors will henceforth need to report their distributable reserves at company level ‘if possible’ feels half-hearted. In the event that these reserves are ‘not known’ then they should publish what is known, and then limit dividends to this amount. 

While this is clearly sensible, given the existing legal requirement, why do directors not know their distributable reserves? Should the number for ‘undistributable reserves’ not already be in the audited accounts for all to see, as required under s836 of the Act? Are directors properly breaking down their profits between unrealised and realised portions, as required by the Act? Have they provisioned for likely losses and liabilities beyond just those that are included in their IFRS accounts?

In a legal opinion sought by institutional investors on the topic in 2015, George Bompas QC was unequivocal on the fallacy of the audit industry’s and FRC’s position – repeated in the BEIS consultation document – that there is no legal requirement to disclose distributable reserves.

“The difficulty with this proposition is that it is simply not what was provided for by the Companies Act 1980, or by the replacement Companies legislation, all of which presupposes that properly prepared accounts will enable the user to determine what is distributable and what is not…” (paragraph 19).

For companies that combine several subsidiaries into a Group, BEIS indicates that directors should ‘estimate’ the total ‘distributable reserves’. In addition, they can choose which subsidiary distributable reserves to include. And yet for each of those underlying companies, the legal requirements apply. Directors should know and report their undistributable reserves, taking into account any restrictions relating to intra-company transfers. This should not be a matter of estimation. In fact, it should be audited.

A third proposal by BEIS is to seek an attestation from directors that any proposed dividend will not threaten solvency within next two years. Once again, this would be a good thing, if it were not for the fact that the Companies Act already requires foreseeable losses and liabilities to be accounted for, without a two-year time limit. So, we must ask why just two years? What happens if a likely loss is looming in two years three months? Do directors ignore that?

Finally, BEIS is seeking views on whether the newly empowered regulator should set the guidance for the calculation of what is distributable or not. Of course, it should. To leave the audit industry to write its own guidance, as is currently the case, is precisely why we have such confusion over the requirements today.

In the same vein, it is a worry that BEIS relied on advice from the industry in drawing up the proposals put forward this consultation. There should be no question that the government should be writing the rules that directors and auditors must follow.

As the public considers the BEIS proposals for restoring trust in audit and corporate governance, one thing should be self-evident: trust in companies depends intrinsically on strong capital protection. We need a regulator that is empowered and resourced to ensure directors and auditors meet their obligations under UK company law; and they need to be clear about what the law requires. Somewhere along the line this core function has been lost. What is most unnerving about the government’s audit reform proposals is not just that the proposals are deficient but that capital maintenance requirements are today a matter of consultation, not enforcement. 

Natasha Landell-Mills is head of stewardship at Sarasin & Partners and an ESG Clarity editorial panellist.