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Restoring trust in audit and corporate governance: dividends, capital maintenance and directors’ remuneration

  • United Kingdom
  • Corporate
  • Financial services disputes and investigations
  • Financial services


The latest in our series of briefings examining the UK Government White Paper on financial reporting and corporate governance reform - Restoring trust in audit and corporate governance (“BEIS White Paper”) looks at the Government’s proposals to increase transparency around capital maintenance and dividends, and the consequences of these proposals for directors. If enacted, these changes will be of interest to directors particularly of listed and AIM companies, although some of the proposed changes would also apply to private companies.

We also consider the proposal to strengthen malus and clawback provisions to ensure that directors’ remuneration can be withheld or recovered in the event of serious director failings.

Dividends and capital maintenance

The UK Government is seeking views on proposals for strengthening the law on dividends and capital maintenance in a way that is proportionate, ie in terms of the costs that additional reporting, disclosure and audit requirements would entail. The issue has been much commented on - there have been high profile examples of companies paying out significant dividends shortly before profit warnings, and even insolvency, calling into question the robustness of the current regime and how well this is respected and enforced. The proposals are aimed at addressing weaknesses in the current rules, rather than replacing them with a new framework such as a solvency test.

The White Paper identifies the following issues arising from the current framework:

  • There is no statutory definition of realised profits and losses. Instead, it falls to joint guidance issued by the ICAEW and the ICAS on Realised and Distributable Profits. The guidance is widely accepted but has no formal legal status.
  • There is a transparency issue – accounting standards do not have a concept of realised or unrealised profits, so this is not apparent from the face of the financial statements (unless disclosed voluntarily).
  • Thirdly, the law is backward looking and does not provide any guide to the company’s future performance.

Proposals for reform

  • Responsibility for defining realised profits and losses

The Government believes that the new regulator to be established to replace the Financial Reporting Council, the Audit, Reporting and Governance Authority (ARGA), should take on responsibility for preparing the guidance on generally accepted accounting practice for determining realised profits. It is thought that this would strengthen the legal status of the definition.

There are two options set out in the White Paper:

  • Giving ARGA a duty to prepare guidance on what should be treated as realised profits and losses. The Companies Act 2006 (2006 Act) would provide that, in interpreting what are realised profits and losses according to generally accepted principles, regard should be had to the guidance from the regulator; or
  • Giving ARGA the power to make binding rules as to the meaning of realised profits and losses. The rules would be made by reference to the prevailing general principles and may require the consent of the Secretary of State.
  • New disclosure requirements in the financial statements

The proposals here are twofold:

  • Firstly, individual companies (or the parent company in the case of a group) would be required to disclose in the annual report the amount of reserves that are distributable. This figure would therefore be subject to audit.
  • Secondly, a parent company would have to estimate and disclose the amount of potential distributable profits across the group that could, in principle, be passed up to the parent company to pay future dividends to shareholders. Again, this disclosure would be subject to audit.

The Government envisages these requirements applying to listed and AIM companies only.

New directors’ statement about the legality of proposed dividends and effect on future solvency

This proposed statement is intended to address comments that the current regime is too backward looking and does not consider future cash demands on the business and other future threats to solvency. It also increases the accountability of directors.

The Government proposes that the directors be required to make a statement covering:

  • Confirmation that in proposing the dividend, the directors have: (a) satisfied themselves that the dividend is within known distributable reserves; and (b) have had regard to their general duties under s172(1) of the 2006 Act (including the need to have regard to the likely consequences of any decision in the long term) and their wider common law and fiduciary duties.
  • Confirmation that it is the directors’ reasonable expectation that payment of the dividend will not threaten the solvency of the company over the next two years in the light of the risk analysis undertaken and the directors’ knowledge of the company’s position at the date the dividend is proposed. Where relevant, directors should also confirm that the dividend is consistent with the proposed Resilience Statement (see our briefing here for an explanation of the Resilience Statement, which we will cover in more detail in a subsequent briefing).

The White Paper notes that there is a case in principle for extending the requirement for a directors’ statement beyond listed and AIM companies to apply to all Public Interest Entities (PIEs) (our briefing here comments on the proposed expanded scope of PIEs), or even all ‘large’ companies for the purposes of the 2006 Act. Large companies are essentially those that meet two out of three of the following criteria: net turnover of more than £36 million, a balance sheet total of more than £18 million or more than 250 employees.

The Government has also considered whether there should be a requirement to include improved information for investors about a company’s distribution policies. However, the conclusion at this stage is that the enhanced disclosure requirements along with the requirement for a directors’ statement outlined above will provide further encouragement for companies to provide a fuller narrative about dividend decisions and capital allocation strategies, and therefore additional formal disclosure requirements are unnecessary at this time.

Impact of the proposals

The question as to whether a company has sufficient distributable profits to make a proposed distribution can sometimes fall between legal and accounting analysis. The proposals to grant responsibility for the guidance on this to ARGA should therefore provide greater certainty and ultimately comfort for the directors. At first sight, there is a question as to why the Government is proposing to limit the new disclosure requirements around distributable reserves to listed and AIM companies. Private companies engaged in transactions such as intra-group reorganisations would also often benefit from greater certainty on the amount of distributable reserves. However, as the White Paper notes, this has to be balanced against the increased costs that would result from enhanced disclosures and audit. The Government therefore proposes to introduce this requirement for listed and AIM companies only, given the increased importance of dividend transparency to external investors.

Many directors will be familiar with the concept of a solvency statement in the context of capital reductions under taken by private companies for example, and this is a similar concept. Whilst the statement covers legal obligations with which directors must already be compliant, the statement is intended to focus the minds of the directors when proposing a dividend. It may also provide evidence of breach of duties (eg in the event of a future insolvency), so directors would need to be mindful of the consequences of providing such a statement and ensure that they have received appropriate accounting and legal advice.

Directors’ remuneration: malus and clawback of executive pay

In the White Paper, the Government also sets out its proposals to give ARGA investigation and enforcement powers to hold directors of companies falling within the expanded definition of PIEs to account. The Government intends to legislate to provide ARGA with powers to investigate and sanction breaches of corporate reporting and audit-related responsibilities by PIE directors. We will be exploring these proposals in a separate briefing. The Government believes this regime can be complemented further by strengthening malus and clawback arrangements to allow director remuneration to be withheld or recovered in the event of serious failings.

  • What are malus and clawback provisions?

Malus provisions typically allow a company to reduce or cancel a senior executive’s bonus or share award before it has been paid out (or the shares issued or transferred). In contrast, clawback provisions allow the company to recover a bonus or share award after it has been paid out. Clawback is therefore legally and practically more difficult to operate than malus.

These provisions are normally contained in the rules of senior executive share plans and bonus arrangements and often also in directors’ service contracts and/or remuneration policies.

  • Current position

Outside of the financial services sector, the position on malus and clawback is set out in the UK Corporate Governance Code (Code). The Code (which applies on a “comply or explain” basis) states that for premium listed entities, variable remuneration schemes and policies should include provisions that would enable the company to recover and/or withhold sums or share awards from executive directors and specify the circumstances in which it would be appropriate to do so.

The Code leaves it to companies to decide what the appropriate triggers should be for operating malus and clawback. The latest Guidance on Board Effectiveness which accompanies the Code does, however, already suggest that triggers might include payments based on erroneous or misleading data, misconduct, misstatement of accounts, serious reputational damage and corporate failure.

  • What is the Government proposing?

The Government proposes asking the regulator to consult on changes to the Code to include provisions recommending that certain minimum clawback conditions or “trigger points” are included in directors’ remuneration arrangements, which have a minimum period of application of at least two years after an award is made. The following are proposed as minimum conditions within which clawback provisions can be triggered:

  • material misstatement of results or an error in performance calculations;
  • material failure of risk management and internal controls;
  • misconduct;
  • conduct leading to financial loss;
  • reputational damage; and
  • unreasonable failure to protect the interests of employees and customers.

Impact of the proposals

As the Government proposes to implement these changes through amendments to the Code initially, they would only apply to premium listed companies, and would operate on a “comply or explain” basis. The Government will then consider whether there is a need to further extend this to all listed companies, potentially by changes to the Listing Rules. At the moment, it therefore seems that in contrast with other proposals in the White Paper, AIM companies are outside the scope of these changes. They would not apply to larger private companies.

It remains to be seen how much of a practical impact these changes will have if implemented. As many listed companies will have tabled their directors’ remuneration policy at the 2020 AGM, and as malus and clawback provisions were one of the key areas of focus for institutional investors, many listed companies may have already reviewed and expanded their triggers.

What next?

The consultation closes on 8 July 2021. As with all the proposals set out in the White Paper, it is likely to be some time before we see implementation of the measures covered by this briefing.

Changes to the 2006 Act regarding dividends and capital maintenance would be subject to Parliamentary time allowing the necessary legislation to be tabled. Change to the Code around malus and clawback would require a consultation period by the relevant regulator. It could therefore be 2023 before we see these changes being implemented.

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Restoring trust in audit and corporate governance