The Matrix. An overview of corporate governance February 2013 Contents This Matrix gives an overview of the principal current and recent legal and regulatory developments in the UK, EU (and other supra-national) and US arenas as they may affect listed companies in relation to the following: - - - - directors’ duties 1 - shareholder engagement 50 – general duties 1 – statutory and regulatory framework 50 – non-executive directors of listed companies 4 – stewardship 54 – rules applicable to directors of financial institutions 7 – indemnification of directors 10 – recent developments 63 – liability for corporate acts 11 – narrative reporting 65 15 – liability for reports and other statements 71 remuneration - corporate reporting 63 – current regime affecting listed companies 15 - corporate social responsibility 74 – proposals affecting listed companies 18 - accounting standards 80 – remuneration in financial institutions 21 – IFRS 80 27 – domestic accounting standards 83 – enforcement 85 corporate governance codes – general provisions and guidance 27 – board diversity 31 – risk management and control 34 – regulation of auditors and accountants 87 corporate governance committees 36 – audit quality 92 - auditors 87 – remuneration committees 36 – non-audit services 98 – nomination committees 38 – rotation of audit firm/retendering 102 – audit committees - constitution 40 – rotation of audit partner 103 – audit committees - role 43 – liability of auditors 104 – risk committees 47 – other committees 49 This Matrix has been updated to 14 February 2013. i Contents See the Glossary for an explanation of definitions and acronyms used in this Matrix. This Matrix is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on the issues presented here, please contact one of your regular contacts at Linklaters. © Linklaters LLP. All rights reserved 2013. ii Glossary ABI Association of British Insurers Accounts The Large and Medium-sized Directives with a single directive on the Regulations Companies and Groups (Accounts and form and content of annual and 2008 Reports) Regulations 2008 consolidated financial statements AIU Audit Inspection Unit, previously part of Accounting EC proposal for a directive to amend Directive and replace the Fourth and Seventh AIFMD Directive 2011/61/EU on alternative the POB, whose functions were investment funds (known as the transferred in July 2012 to the Audit “Alternative Investment Funds Directive” Quality Review team in the FRC’s or “AIFMD”) Conduct Division Audit Green APB Auditing Practices Board, previously one Paper of the operating bodies of the FRC, Green Paper entitled “Audit Policy: the EC (October 2010) 2012 to the Audit and Assurance team Capital in the FRC’s Codes and Standards Requirements as amended, affecting credit institutions Division Directives Accounting Standards Board, previously CEBS Council of Institutional Investors DGCL Delaware General Corporation Law Dodd-Frank Dodd-Frank Wall Street Reform and Act Consumer Protection Act of 2010 Exchange Act Securities Exchange Act of 1934 emerging As defined in the JOBS Act, issuers with growth less than US$1 billion in total annual company gross revenue in the most recently completed fiscal year Lessons from the Crisis” published by whose functions were transferred in July ASB CII Directives 2006/48/EC and 2006/49/EC, and investment firms Committee of European Banking one of the operating bodies of the FRC, Supervisors (whose responsibilities were whose functions were transferred in July assumed by the EBA on 1 January 2011) FASB Financial Accounting Standards Board FCPA Foreign Corrupt Practices Act foreign As defined in Rule 3b-4(c) of the private issuer Exchange Act (i.e. most non-US, nongovernment issuers) ISS 2012 to the Accounting and Reporting Policy team in the FRC’s Codes and CESR proxy adviser Committee of European Securities Regulators (whose responsibilities were Standards Division JOBS Act assumed by ESMA on 1 January 2011) BIS Institutional Shareholder Services Inc., a Jumpstart Our Business Startups Act of 2012 Department for Business, Innovation & Skills (the government department Company EC Communication entitled responsible for company law and Law Action “Modernising Company Law and corporate governance) Plan Enhancing Corporate Governance in the European Union” (May 2003) iii Model Act Model Business Corporation Act Nasdaq Nasdaq Stock Market LLC Glossary CA 06 Companies Act 2006 CA 85 Companies Act 1985 C(AICE)A Companies (Audit, Investigations and Community Enterprise) Act 2004 CSR Corporate social responsibility DEFRA Department for Environment, Food & Rural Affairs DTR The rules made for the purposes of Part VI of FSMA relating to periodic financial reporting and the disclosure of Company EC Communication entitled “Action Law and Plan: European company law and standards as set out in the Rule 5600 Corporate corporate governance – a modern legal Series of the Nasdaq Listing Rules Governance framework for more engaged Action Plan shareholders and sustainable companies” (December 2012) Reporting Lab 2011 to encourage investors and governance framework” published by and NYSE listing standards Green Paper the EC (April 2011) Council Council of the European Union CRD III Directive 2010/76/EU amending the Capital Requirements Directives as regards capital requirements for the trading book and for re-securitisations, and the supervisory review of remuneration policies, affecting credit institutions and investment firms CRD IV EC proposal for a regulation and a directive to implement the Basel III Financial Reporting Council FRC Guidance “Guidance on Audit Committees”, as Requirements Directives, affecting credit on Audit amended from time to time. The latest institutions and investment firms Committees version (September 2012) applies for 1 October 2012, with early adoption encouraged NYSE corporate governance rules, as set Governance FRC financial years commencing on or after NYSE Rules out in the NYSE Listed Company Manual companies to develop pragmatic solutions to corporate reporting New York Stock Exchange Green Paper entitled “The EU corporate trading on a regulated market The project established by the FRC in NYSE Corporate holdings of securities admitted to Financial Nasdaq Rules Nasdaq corporate governance listing reforms and replace the Capital EBA European Banking Authority. It took over the responsibilities of CEBS on 1 January 2011 iv PCAOB Public Company Accounting Oversight Board SEC Securities and Exchange Commission Securities Act Securities Act of 1933 SOX Sarbanes-Oxley Act of 2002 US GAAP US generally accepted accounting principles Glossary FRC Guidance “Guidance on Board Effectiveness” on Board (March 2011) developed by ICSA on the Effectiveness FRC’s behalf, which replaces the good EC European Commission EFRAG The European Financial Reporting practice guidance (as amended 2006) Advisory Group, a group that assists the from Sir Derek Higgs’ review of the role EC in the endorsement of IFRS pursuant and effectiveness of NEDs (January to the IAS Regulation by providing 2003) advice on the technical quality of IFRS FRC Guidance “Going concern and liquidity risk: Environmenta Directive 2008/99/EC on the protection on Going Guidance for directors of UK l Crime of the environment through criminal Concern companies” updated by the FRC in Directive law ESMA The European Securities and Markets October 2009 FRC Guidance “Internal Control: Revised Guidance for Authority. It took over the on Internal Directors on the Combined Code” responsibilities of CESR on 1 January Control October 2005 (formerly known as the 2011 “Turnbull Guidance”) FRRP ESME European Securities Markets Expert Financial Reporting Review Panel, Group, a group of market practitioners previously one of the operating bodies and participants established by the EC of the FRC, whose functions were in March 2006 to consider how EU transferred to the Conduct Committee securities directives are being applied. of the FRC in July 2012. The FRRP Its remit expired at the end of 2009 continues to exist as an advisory panel of experts appointed by the Conduct Committee FRS Financial Reporting Standard FSA Financial Services Authority EU European Union FEE Fédération des Experts comptables Européens, the representative organisation for the accountancy profession in Europe v Glossary FSA 2010 Financial Services Act 2010 FSMA Financial Services and Markets Act 2000 HMRC HM Revenue & Customs ICAEW Institute of Chartered Accountants in England and Wales ICSA Institute of Chartered Secretaries and Administrators IMA Investment Management Association ISC Institutional Shareholders Committee (renamed the Institutional Investor Committee (May 2010)) Kay Report Financial Green Paper entitled “Corporate Institutions governance in financial institutions and Green Paper remuneration policies” published by the EC (June 2010) Fourth and Directive 2006/46/EC amending, among Seventh others, the Fourth and Seventh Amendment Directives Directive Fourth and Directives 78/660/EEC on the annual Seventh accounts of certain types of company Directives and 83/349/EEC on consolidated accounts FSB Financial Stability Board, the body established in April 2009 as the The Kay Review of UK Equity Markets successor to the Financial Stability and Long-Term Decision Making: Final Forum. The Financial Stability Forum Report (July 2012) was founded in 1999 by G7 finance ministers and central bank governors to Listing Rules The rules made for the purposes of Part enhance co-operation and promote or LR VI of FSMA relating to the admission of stability in the international financial securities to the official list system NAPF National Association of Pension Funds NEDs Non-executive directors OFT Office of Fair Trading IAASB The International Auditing and Assurance Standards Board, an independent standard-setting body under the auspices of IFAC IAS International Accounting Standards vi Glossary POB Professional Oversight Board, previously IASB International Accounting Standards one of the operating bodies of the FRC, Board, an independent standard-setting whose functions were transferred to the body Professional Oversight team in the FRC’s Conduct Division in July 2012 IAS Regulation (EC) No.1606/2002 of the Regulation European Parliament and of the Council Prescribed The Supervision of Accounts and of 19 July 2002 on the application of Body Order Reports (Prescribed Body) and international accounting standards 2012 Companies (Defective Accounts and Directors’ Reports) (Authorised Person) ICGN International Corporate Governance Network, an organisation of about 500 Order 2012 members, mainly institutional investors, quoted UK-incorporated companies that are companies UK, EU or Nasdaq/NYSE listed (but not AIM quoted companies) based in 50 countries IESBA The International Ethics Standards Board for Accountants, an independent Recognised Bodies recognised by the Secretary of standard-setting board under the Supervisory State which maintain and enforce rules auspices of IFAC Bodies regarding the eligibility of persons appointed as statutory auditors and the conduct of statutory audit work Sharman Going Concern and Liquidity Risks: Report Lessons for Companies and Auditors. Final Report and Recommendations of IFAC International Federation of Accountants IFRS International Financial Reporting Standards (also comprising IAS) IOSCO Commissions the Panel of Inquiry led by Lord Sharman (June 2012) International Organization of Securities ISAs International Standards of Auditing vii Glossary UK Corporate UK Corporate Governance Code, as MiFID Directive 2004/39/EC on markets in Governance amended by the FRC from time to time. financial instruments, affecting Code The latest version (September 2012) investment firms applies for financial years commencing on or after 1 October 2012, with early MiFID EC proposal for a directive to revise adoption encouraged Amendment MiFID Directive UK GAAP UK generally accepted accounting principles Modernisatio Directive 2003/51/EC amending, among n Directive UK UK Stewardship Code, setting out good Stewardship practice on engagement between Code institutional investors and investee Directives OECD (September 2012) applies from 1 October 2012 Walker Report Organisation for Economic Cooperation and Development companies, as amended by the FRC from time to time. The latest version others, the Fourth and Seventh public Public interest entities include, for the interest purposes of EU audit legislation, EU- entities incorporated companies listed on an “A review of corporate governance in EU-regulated market, credit institutions UK banks and other financial industry and insurance undertakings entities”, the report by Sir David Walker setting out 39 recommendations to improve corporate governance (November 2009) Shareholder Directive 2007/36/EC on the exercise of Rights certain rights of shareholders in listed Directive companies SMEs Small and medium-sized entities viii Glossary Statutory Directive 2006/43/EC on statutory Audit audits of annual accounts and Directive consolidated accounts, amending the Fourth and Seventh Directives and repealing Council Directive 84/253/EEC TOD Directive 2004/109/EC on the harmonisation of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market (known as the “Transparency Obligations Directive”) TOD EC proposal for a directive to amend Amendment TOD Directive ix Directors’ duties General duties CA 06 contains a statutory statement of duties that The Company Law Action Plan set out a proposal for a Directors’ duties are generally governed by the laws of directors owe to the company in place of the common directive in the medium term to introduce a right for a company’s state of incorporation. No general federal law and equitable rules. There are seven duties set out shareholders to call for a special investigation into the codification of directors’ duties exists. in Sections 171 to 177: company’s affairs and rules on wrongful trading and - to act within powers conferred - to act in the way the directors consider most likely directors’ disqualification. Under the common law of Delaware (where more than 50% of US public companies and more than 60% of the The EC published a consultation on future priorities for Fortune 500 are incorporated), directors owe duties of the Company Law Action Plan (December 2005) and a care, loyalty and good faith to their corporations. By summary report of the results (July 2006). Respondents statute, Delaware corporations are permitted to include generally opposed the adoption of rules on wrongful in their certificate of incorporation provisions limiting or trading and directors’ disqualification, although a slight excluding the liability of directors for breaches of their majority was in favour of a special investigation right. duty of care (but not of loyalty or good faith). community and the environment, the company’s The EC published a Financial Institutions Green Paper In addition, under Delaware case law, directors are reputation for high standards of business conduct on ways to improve corporate governance in financial presumed to have acted on an informed basis, in good and the need to act fairly as between members institutions (June 2010). It sought comments on a faith and without personal interest in a matter. (which the explanatory notes to CA 06 call the number of questions in relation to the duties of principle of “enlightened shareholder value”) directors, including: - to exercise independent judgement - - to exercise reasonable care, skill and diligence - to avoid conflicts of interest - not to accept benefits from third parties - to declare an interest in a proposed transaction or to promote the success of the company for the benefit of its members as a whole. Directors must have regard to the long term and wider factors, namely employees, suppliers, customers and others, the impact of the company’s operations on the arrangement with the company. Other statutory or common law duties, which are not - not second-guess directors by holding them personally should a specific duty be established for a board of liable for any action attributable to a rational business directors to take into account the interests of purpose (the so-called “business judgement rule”). If a depositors and other stakeholders during the plaintiff succeeds in rebutting the presumption, a decision-making procedure? director may have the burden of demonstrating that a is it necessary to increase the accountability of members of boards of directors? - If a plaintiff fails to rebut this presumption, a court will challenged transaction meets the more exacting “entire fairness” standard, requiring a showing that the transaction was both the result of a “fair process” (i.e. should the civil and criminal liability of directors be procedural fairness) and was at a “fair price” (i.e. reinforced? substantial fairness). Note that a breach of the duty of restated in the codified provisions, will also apply in The Financial Institutions Green Paper (June 2010) loyalty may be found if a plaintiff can show that a certain circumstances, e.g. to deal with duties to stated that sanctions may be needed to change director (or director who approved the matter) was 1 Directors’ duties creditors. BIS published a collection of ministers’ statements on directors’ duties to assist interpretation of the codified duties (June 2007). corporate governance behaviour. The summary of responses showed that most respondents were opposed to this on the basis that existing rules imposed sufficient liability on directors. Ways to implement the rules more effectively should be The Walker Report (November 2009) rejected the idea analysed before any harmonisation was decided at EU of extending the duty of directors (of banks and level. the directors’ duty of good faith, particularly in instances where violations of the duty of care were so egregious that they rose to the level of bad faith. This development is made more significant by the fact that terms of a corporation’s certificate of incorporation employees, depositors and taxpayers. It concluded that from liabilities arising out of breaches of the duty of any dilution of the duty of a director to shareholders good faith. A complete abdication of responsibilities is would introduce uncertainty for shareholders and viewed as non-feasance on the part of the director and distract directors from is a breach of the director’s duty. General duties (continued) important strategic concerns. The GC100 (a group representing the general counsel and company secretaries of FTSE 100 companies) published: best practice guidelines for compliance with directors’ duties (February 2007). This recognises the diverse ways in which decisions are taken by directors and argues that the default should not be to provide written records of every decision, but to do so only where circumstances make this particularly necessary or relevant - Recent Delaware cases have shown renewed focus on directors cannot be exculpated or indemnified by the financial institutions) to other stakeholders, such as - interested in the matter. guidance to directors on exercising their powers to approve a conflict (January 2008), including an explanation of changes companies might make to 2 Directors’ duties General duties (continued) their articles and suggested procedures for directors to authorise conflict situations. ICSA published a guidance note on the statutory duties (January 2008) for directors of public companies. Fears that the derivative claim procedure set out in Sections 260 to 264 CA 06 would lead to increased litigation against directors have so far proved unfounded. Only a small number of claims have been given leave to proceed since the procedure took effect in October 2007, e.g. Kiani v Cooper and others [2010] EWHC 577, Robin Stainer v Gerard Alan Lee and others [2010] EWHC 1539, Phillips v Fryer and others [2012] EWHC 1611 and Hughes v Weiss [2012] EWHC 2363. ICSA published a note on specimen board meeting etiquette (September 2009). This provides guidance on modern etiquette for those attending and participating in board meetings to help ensure that the meetings are effective. The Kay Report (July 2012) emphasises that directors are stewards of the assets and operations of their businesses. Their duties are to the company not to the share price. It recommended that directors should adopt “good practice statements” to promote stewardship and long-term decision making. A sample statement is set out in the Report and includes the following principles: 3 Directors’ duties General duties (continued) - directors should understand their duties - long-term value creation is best served by strategies which focus on investing for sustainable performance rather than treating the business as a portfolio of financial interests - corporate reporting should focus on forwardlooking strategy. In its Response to the Kay Report (November 2012), the Government indicates support for the concept of good practice statements and encourages business representative groups and investment industry trade associations to review and endorse the statements and suggest how good practice standards might be further developed. The FSA’s consultation “Enhancing the effectiveness of the Listing Regime” (October 2012) proposes to amend LR 9.8.6(5) to require the company to disclose in its corporate governance statement how the chairman has ensured the directors have a sufficient understanding of the regulatory requirements applicable to a premium listed company and the requirements regarding fiduciary duties that are applicable to directors in the company’s country of incorporation. When making this disclosure, the company should have regard to the listing principle that a listed company must take reasonable steps to enable its directors to understand their responsibilities and obligations as directors. 4 Directors’ duties 5 Directors’ duties Non-executive directors of listed companies In the wake of the 2008 financial crisis, the Walker The EC’s Recommendation on independent directors NYSE/Nasdaq Rules address independence at the board Report and the House of Commons Treasury and board committees (February 2005) sets out a level: Committee Ninth Report, Banking Crisis: reforming general statement of independence (freedom from a corporate governance and pay in the City (May 2009) business, family or other relationship that creates a identified the lack of time spent by NEDs on their role, conflict of interest such as to jeopardise the exercise of the lack of relevant experience and too narrow a talent free judgement). Minimum criteria for independence pool as grounds of concern. and the suggestion that independent directors should meet on a regular basis without management or undertake to maintain their independence of non-independent directors present. The recommendations in the Walker Report were implemented by the UK Corporate Governance Code and FSA Rules. The UK Corporate Governance Code was amended in June 2010 to give greater emphasis to the following: - - - - a majority of the board of directors must consist of independent directors - non-management or independent directors must judgement, remain free of conflicts and clearly express Nasdaq modified (June 2011) its listing rule that their opposition if they believe that a decision of the requires listed companies to disclose in their annual board may harm the company are included as guidance proxies those directors that the board has determined and contained in an annex of the Recommendation. to be independent. The rule now references the The Recommendation is expressed to apply to all disclosure required in Regulation S-K. The disclosure is the responsibility of the chairman for leadership of companies with securities admitted to a regulated substantially similar to the disclosure before the the board and ensuring its effectiveness (Main market, including non-EU companies with a primary modification; however, the modification was made to Principle A3) listing. avoid duplication and confusion. the role of NEDs in constructively challenging The EC published a report on Member States’ Nasdaq requires listed companies to certify that they proposals on strategy (Main Principle A4) application of the Recommendation (July 2007). This have adopted a formal written charter or board the requirement for all directors to allocate noted “a clear trend towards improving corporate resolution addressing the nomination process. NYSE sufficient time to the company to discharge their governance standards in the EU” and that most requires listed companies to adopt and disclose formal duties effectively (Main Principle B3). Member States had complied with the corporate governance guidelines which address director Recommendation “almost fully or to a large extent”. qualification standards, director responsibilities, access The main areas of non-compliance were the failure by to management and independent advisers, director some Member States to: orientation and continuing education as well as board In addition, the preface to the UK Corporate Governance Code was amended to encourage chairmen to include a personal statement on the role and effectiveness of the board. The FRC Guidance on Board Effectiveness (March 2011) includes guidance on the role of NEDs taking into - recommend a sufficient number of independent evaluation. board members in remuneration and audit Accommodations/exemptions to the corporate committees governance requirements of the NYSE/Nasdaq Rules are 6 Directors’ duties account the 2010 changes made in the UK Corporate - Governance Code. set a cooling-off period before a former CEO of a available to non-US issuers – see Corporate governance company could become its chairman. codes – general provisions and guidance below. ICSA published guidance on the liability of NEDs IOSCO published a report (March 2007) on the The SEC’s Form 20-F requires that any issuer with (January 2013). It suggests ways in which NEDs can definition and role of independent directors of listed securities listed on a US exchange must disclose, in approach their work in a way that demonstrates to companies in 18 jurisdictions. This identified the summary form, any significant differences between its regulators and the courts that they have taken dominant trends with respect to the independence of corporate governance practices and those followed by appropriate steps to exercise care, skill and diligence. It boards and described how each jurisdiction addressed US domestic companies under the listing standards of considers steps NEDs should take before and on joining the OECD principle that boards should be able to the same exchange. a board and cross-refers to previous ICSA guidance on exercise objective and independent judgement on due diligence for prospective directors (May 2011) and corporate affairs. guidance on the induction of directors (June 2012). ISS’s 2012 U.S. Proxy Voting Summary Guidelines sets forth a narrower definition of “independent director” The OECD’s report “Corporate Governance and the than the NYSE/Nasdaq Rules. ISS generally recommends Financial Crisis: Key Findings and Main Messages” (June voting for shareholder proposals requiring an 2009) stressed the importance of a competent board independent that is capable of objective and independent judgement. It made the following observations: Non-executive directors of listed companies (continued) NAPF’s Corporate Governance Policy and Voting - Guidelines (November 2012) state that, where a nonindependent NED upsets board balance, shareholders might vote against the re-election of that director. The FSA published a consultation “Enhancing the effectiveness of the Listing Regime” (October 2012). It - - proposes new rules principally addressed to premium listed companies with a controlling shareholder, but some proposals are expressed to apply to all companies with a premium listing of shares. In relation to directors: - companies with controlling shareholders will need - board evaluation should be conducted by chairman unless there is a counterbalancing governance independent experts on a regular basis structure. it is good practice for the role of the chairman and The SEC adopted rules (December 2009) amending its CEO to be split proxy rules to require, among other things: it is good practice for the board to develop a - additional disclosures in a company’s proxy specific policy for the identification of the best skill statement regarding director qualifications, composition of the board including whether the company uses diversity as a factor in selecting directors some form of continuing training is required, especially in banks. - The OECD published its conclusions and emerging 7 disclosures about board structure and risk oversight, including the reasons for separating or combining the positions of CEO and chair of the Directors’ duties Non-executive directors of listed companies (continued) - to have a majority of independent directors and the good practices (February 2010). This concluded that shareholders other than the controlling there was no urgent need to revise the OECD Principles shareholders will be given a separate vote on the of Corporate Governance (2004) but that they needed election of independent directors to be implemented more effectively. LR 9.8.6(5) will be amended to require the company The Corporate Governance Green Paper (April 2011) instructions by shareholders) in all elections for to disclose in its corporate governance statement sought views on whether there should be a limit on the directors, on executive compensation or on “any how the chairman has ensured the directors have a number of mandates a NED should hold and whether significant matter” as determined by the SEC. sufficient understanding of the regulatory listed companies should be encouraged to conduct Previously, NYSE Rule 452 permitted a broker to vote requirements applicable to a premium listed external evaluations regularly and how this should be on behalf of beneficial owner customers in uncontested company and the requirements regarding fiduciary done. elections of directors if the customers had not returned duties that are applicable to directors in the board of directors. Pursuant to the Dodd-Frank Act, the SEC approved an amendment to NYSE Rule 452 (September 2010) to prohibit broker discretionary voting (i.e. voting without their voting instructions. company’s country of incorporation. The NYSE published an information memo (January 2012) clarifying the application of NYSE Rule 452 to certain types of corporate governance proxy proposals. The NYSE has determined that certain proxy proposals that it previously ruled as “Broker May Vote” will now be treated as “Broker May Not Vote” matters, including: - de-staggering the board of directors - majority voting in the election of directors - eliminating supermajority voting requirements - providing for the use of consents - providing rights to call a special meeting - certain types of anti-takeover provision overrides. The SEC adopted rules (August 2010) requiring companies to allow a qualifying shareholder (or group 8 Directors’ duties Non-executive directors of listed companies (continued) of shareholders) to include its nominee(s) for the board of directors on the company’s proxy statement, but the rules were struck down by the Court of Appeals for the D.C. Circuit (July 2011) and the SEC has stated that it will not appeal the decision. 9 Directors’ duties Rules applicable to directors of financial institutions The FSA extended the scope of its approved persons The EC published a Financial Institutions Green Paper regime in August 2009 to cover individuals with on ways to improve corporate governance in financial significant influence over FSA-authorised firms. See FSA institutions (June 2010). It sought comments on a policy statement 09/14 setting out the FSA’s final rules number of questions in relation to directors, including: (July 2009). - The FSA wrote to the CEOs of 5,000 regulated firms to reinforce how its approach applies to approving and supervising individuals performing significant influence which a director may sit? - should combining the functions of chairman and chief executive be prohibited in financial functions (October 2009). It stressed that responsibility institutions? for assessing whether a candidate is fit and proper rests with the firm and that firms should have robust should there be a limit on the number of boards on - should recruitment policies specify the duties and recruitment, referencing and due diligence processes in profile of directors (including the chairman), ensure place. that directors have adequate skills and ensure that the composition of the board of directors is The FSA appointed (November 2009) a panel of senior suitably diverse? If so, how? advisers to support its senior influence function assessments for NEDs proposed for FTSE 100-listed - would including more women and individuals from banks and life assurance company boards (November different backgrounds improve the functioning of 2009). This follows a recommendation in the Walker boards of directors? Report. - should a compulsory evaluation of the functioning The FSA published Policy Statement 10/15 (September of the boards of directors, carried out by an 2010) setting out final rules to implement FSA-specific external evaluator, be put in place? Should the aspects of the Walker Report. The rules amend the result of this evaluation be made available to approved persons regime by introducing a more supervisory authorities and shareholders? detailed framework of controlled functions to make clearer the exact role an individual performs within a - should the role of supervisory authorities in the internal governance of financial institutions be firm and increase the FSA’s ability to vet and track 10 Directors’ duties individuals as they move role. The rules took effect on 1 May 2011. The FSA also proposed to extend the regime to capture more individuals from parent companies redefined and strengthened? - power and duty to check the correct functioning of who exert significant influence upon a UK-regulated the board of directors and the risk management firm (including overseas parent companies, but not function? How can this be put into practice? including EEA-based parent companies), although the implementation of the final rules regarding this should the supervisory authorities be given the - should the eligibility criteria be extended to cover requirement has been postponed pending certain the technical and professional skills, as well as the required changes to the FSA’s online notification and individual qualities, of future directors? How can application system. this be put into practice? The FSA published a consultation (December 2011) on The directive forming part of CRD IV (July 2011) and guidance to assist NEDs understand their role in the MiFID Amendment Directive (October 2011) set out ensuring the fair treatment of customers by their firms. proposals to address many of the above. For example: The FSA expects NEDs to play a pivotal part within the firm’s governance by ensuring that the firm is meeting its Rules applicable to directors of financial institutions (continued) responsibilities to retail customers. The guidance - directors must commit sufficient time to perform proposes that amongst the issues that NEDs should their functions. In particular, executive directors consider are: must not hold, at the same time, more than one - executive directorship with two non-executive taking a strategic view to treatment of their directorships. NEDs must not hold more than four customers; being confident that the firm is non-executive directorships identifying, monitoring and mitigating risk to its customers - - periodically assess its governance arrangements having the right mix of skills on the board and the right information to be able to constructively challenge the executive the management body should monitor and - competent authorities should require institutions to take diversity into account. In particular, institutions 11 Directors’ duties Rules applicable to directors of financial institutions (continued) - supporting a culture within the firm that takes into should put in place a policy promoting gender, account fair treatment of customers. geographical, educational and professional diversity (see also Board diversity below). The role of the FSA in delivering effective corporate governance was discussed by Hector Sants in his final In addition, the directive forming part of CRD IV (July speech as CEO of the FSA (April 2012). Among other 2011) provides that: things, he stressed the need for enforcement to be credible and suggested that penalties should be raised - the CEO unless justified and authorised by the to provide effective deterrence. Also, there should be a competent authorities presumption that if a person is on the board of a bank that fails, that person should not be allowed to carry on that role in the future. Following the recommendations of The Joint Committee on the draft Financial Services Bill on introducing a concept of strict liability for executives and board members for the adverse consequences of poor decisions, (December 2011), HM Treasury published a consultation paper (July 2012) seeking views on proposals: - to introduce a rebuttable presumption that a director of a failed bank is not suitable to be approved by a regulator to hold the position of senior executive in a bank - to strengthen sanctions for serious misconduct in the management of a bank. the chairman should not exercise the functions of - competent authorities should carry out a review and evaluation to check compliance with the directive, including in relation to governance arrangements, corporate culture and values and the ability of the board to carry out its duties. Among other things, competent authorities should review agendas and supporting documents from board and committee meetings and the results of external evaluation. The Basel Committee on Banking Supervision issued (October 2010) its Principles for Enhancing Corporate Governance. The Principles are intended to provide guidance for bank supervisors on the corporate governance principles that should be adopted by the banking organisations they supervise. They emphasise the importance of supervisors regularly evaluating a The Treasury Select Committee published terms of banking organisation’s corporate governance policies reference for an inquiry into corporate governance and and practices as well as its implementation of the remuneration in systemically important financial Principles. 12 Directors’ duties Rules applicable to directors of financial institutions (continued) institutions (April 2012). The terms of reference cover The Group of Thirty, a non-profit, international body matters such as: composed of senior representatives of the private and - whether NEDs should bear greater liabilities than under current law - public sectors and academia, published a report (April 2012) on effective governance of financial institutions. Based on an examination of governance arrangements whether executives in FTSE 100 companies should at 36 of the world’s largest financial services firms, it be able to hold non-executive positions in other calls on directors, managers, supervisors and long-term firms shareholders to reassess their approach to governance - the effectiveness of the FSA approval process and includes recommendations for what each needs to - the effectiveness of board structures and whether UK financial institutions should consider adopting alternatives to the unitary board structure - the impact of the Walker Report on corporate governance and corporate behaviour in financial services. do to make the governance of financial institutions function more effectively. The EBA published guidelines for assessing the suitability of members of the management body and key function holders of a credit institution (November 2012). The guidelines set out the process, criteria and minimum requirements for assessing suitability and The Treasury Select Committee published written should be applied by competent authorities and credit evidence submitted to the inquiry (June 2012). institutions by 22 May 2013. The Parliamentary Commission on Banking Standards (a Consistent with the EC’s Communication (December joint committee appointed by the House of Commons 2010), which called for more dissuasive sanctions for and House of Lords) is considering the professional breach of EU financial services rules, the TOD standards and culture of the UK banking sector and Amendment Directive also seeks to ensure that lessons to be learned about corporate governance, competent authorities have uniformly tough sanctioning transparency and conflicts of interest, and their powers, providing for sanctions of up to 10% of implications for regulation and for government policy. It consolidated annual turnover for companies and up to published a call for evidence (July 2012) seeking views €5 million for individuals for breach of the periodic on a broad range of issues, including the role of NEDs, reporting and certain other obligations of TOD. There is and has established panels to consider corporate also a new provision requiring competent authorities to 13 Directors’ duties Rules applicable to directors of financial institutions (continued) governance at and below board level. It published its publish the sanctions that are applied. A similar first report (December 2012) which focuses on the ring- sanctions framework is proposed in CRD IV and the fencing of retail and investment banking in the MiFID Amendment Directive. Financial Services (Banking Reform) Bill. Its final report (expected in 2013) will consider the broader questions of standards, culture and corporate governance in greater detail. 14 Directors’ duties Indemnification of directors Sections 232 to 238 CA 06 permit companies to Delaware companies are permitted to indemnify indemnify directors in relation to liabilities owed to directors who are subject to civil, criminal, third parties (i.e. persons other than the company or an administrative or investigative proceedings and for associated company). Also, companies may indemnify a expenses incurred (including legal fees), as well as for director of a company that is a trustee of an amounts paid or incurred in satisfaction of settlements, occupational pension scheme against liability incurred judgments and fines. A corporation may only indemnify, in connection with the company’s activities as trustee of however, in those cases in which it has been the scheme. determined that the director to be indemnified acted in good faith, for a purpose that he reasonably believed Sections 205 and 206 CA 06 provide that funding for was in, or not opposed to, the corporation’s best the purpose of enabling a director to defend himself in interests, and, in the case of any criminal proceeding, civil or criminal proceedings or regulatory actions is an had no reasonable cause to believe that his conduct exception to the prohibition on loans, quasi-loans and was unlawful. credit to directors in Sections 197 to 201 CA 06. To fall within the exception, the proceedings must be brought In a third-party action, the corporation may indemnify in connection with any alleged negligence, default, for all losses, expenses, judgments, fines and amounts breach of duty or breach of trust by a director in paid in settlement. relation to the company or an associated company. If a claim is brought as a derivative action (i.e. on behalf The Listing Rules were amended (October 2012) to of the corporation by its shareholders), the corporation extend the list of transactions to which Chapter 11 may indemnify only for expenses. The Delaware statute (Related Party Transactions) does not apply to loans to does not authorise reimbursement of settlements paid directors in relation to the defence of a regulatory or judgments in derivative actions, which reflects a investigation under Section 206 CA 06. Before 1 public policy concern with circular recovery – i.e. a October 2012, only loans granted to directors in corporation would be paying the settlement or relation to business expenses and expenditure to judgment on behalf of the indemnified party to itself defend civil and criminal claims under Sections 204 and since the corporation is the nominal plaintiff in a 205 CA 06 were exempt. derivative action. In addition, if a director is judged to be liable to the corporation in a derivative action, The UK Corporate Governance Code refers to the need 15 Directors’ duties for companies to arrange appropriate insurance cover indemnification for expenses is subject to court in respect of legal action against directors (Provision approval. This lack of indemnification in derivative A1.3). ICSA published a guidance note on directors’ and actions has traditionally been mitigated for directors by officers’ insurance (November 2008) relating to this the “exculpation provision” in corporate charters and provision. directors’ and officers’ insurance. 16 Directors’ duties Liability for corporate acts Bribery Bribery Bribery The Bribery Act 2010 came into force in July 2011. It is The OECD Convention on Combating Bribery of Foreign The FCPA prohibits bribery of foreign officials and largely based on the Law Commission’s report on Public Officials in International Business Transactions imposes on companies accounting requirements reforming bribery (November 2008) and replaced the and related OECD anti-bribery instruments (adopted designed to provide reasonable assurances that bribery previous patchwork of law with two general offences of November 1997) establishes legally binding standards payments come to the attention of management. bribery (one for paying and one for receiving bribes), a to criminalise the bribery of foreign public officials in specific offence of bribing a foreign public official and a international business transactions. 34 OECD members new corporate offence of negligently failing to prevent and six non-member countries have adopted the bribery by an employee or agent. The corporate offence Convention. is punishable with an unlimited fine; the other offences are punishable with a fine and/or up to 10 years’ imprisonment. the non-corporate offences can also be liable for such offence, along with the company. The corporate offence applies if a person “associated with” a “relevant commercial organisation” bribes - a Recommendation on the non-tax deductibility of a Recommendation for further combating bribery of foreign public officials (November 2009). This includes good practice guidance on internal controls, ethics and compliance (Annex II). another person and the organisation has no adequate These recommendations now form part of the procedures to prevent bribery. “Relevant commercial Convention on Combating Bribery. organisations” include UK companies and partnerships The OECD’s 2011 annual report gives an overview of wherever they carry on business or non-UK companies the working of the Convention on Combating Bribery and partnerships carrying on business in the UK. and includes detailed enforcement data. “Associated persons” include people who perform services for or on behalf of a “relevant commercial organisation” and may include employees, agents, subsidiaries or joint venture vehicles and/or partners. commit an act in furtherance of a foreign bribe while in apply to issuers that have US-registered securities or bribes (May 2009) A senior officer who consents or connives with any of to all US “domestic concerns” and foreign persons who the United States. The accounting requirements only The OECD adopted: - In general, the anti-bribery provisions of the FCPA apply are subject to the ongoing reporting requirements of the Exchange Act. In recent years, the US Government has become more aggressive in prosecuting FCPA violations and has increasingly pursued individuals. The SEC and DOJ issued (November 2012) A Resource Guide to the U.S. Foreign Corrupt Practices Act, outlining their approach to FCPA enforcement. Whistleblowing The SEC enacted a new whistleblower programme (August 2011). The programme was created to provide monetary incentives for individuals to come forward The ICGN published guidance on anti-corruption and report possible violations of the federal securities practices (March 2009). This places the responsibility on laws to the SEC. Under the programme, eligible shareholders to ensure the companies in which they whistleblowers are entitled to an award of between 10% invest have appropriate preventative and enforcement and 30% of the monetary sanctions collected in actions “Adequate procedures” is not defined but the Act 17 Directors’ duties contains an obligation on the Secretary of State to measures to deal with corrupt activities. publish guidance about the types of procedures brought by the SEC and related actions brought by other regulatory and law enforcement authorities. organisations are expected to put in place. The Ministry The programme also prohibits retaliation by employers of Justice published guidance (March 2011) setting out against employees who provide the SEC with six principles that, in the Government’s view, should information about possible securities violations. inform the procedures companies should put in place. The guidance also seeks to clarify the scope of the corporate offence. The personal consent of the Director of the Serious Fraud Office or the Director of Public Prosecutions is required before proceedings for bribery can be brought. Their approach to prosecution decisions is set out in joint guidance (updated October 2012). The guidance Liability for corporate acts (continued) emphasises that a prosecution will only be brought if there is both sufficient evidence and that prosecution is in the public interest. The guidance includes nonexhaustive lists of factors both for and against prosecution, with specific references to facilitation payments and hospitality and promotional expenditure. Following the appointment of a new director, David Green QC, the SFO revised its approach to facilitation payments, business expenditure (hospitality) and corporate self-reporting (October 2012). In particular, whether it will prosecute in respect of a bribe presented as hospitality or other business expenditure, or in relation to facilitation payments, will be governed by 18 Directors’ duties Liability for corporate acts (continued) the existing tests contained in the joint guidance and the Code for Crown Prosecutors (and, where relevant, the Joint Guidance on Corporate Prosecutions). Assurances given by former director Richard Alderman that the SFO would not always seek to prosecute, particularly where companies self-report wrongdoing and demonstrate their willingness to reform, have not been restated and references the SFO’s policy of dealing with overseas corruption, which included guidance on self-reporting, have been removed from the joint guidance. Transparency International has published the following: - a report on avoiding corruption risks in the City (May 2010). This provides an overview of the Bribery Act 2010 and highlights the types of business activity which put City businesses at greatest risk in relation to bribery and prosecution - guidance (July 2010) on adequate procedures - guidance (May 2012) on anti-bribery due diligence in mergers, acquisitions and investments - a report (July 2012) ranking reporting by listed companies on matters such as anti-corruption, organisational transparency and country-by-country reporting. The report concluded that multinationals have a long way to go to improve transparency, especially in the financial sector. 19 Directors’ duties Liability for corporate acts (continued) The SFO published “Serious economic crime: a boardroom guide to prevention and compliance” (September 2011). The intention is to give board-level readers in the UK and international businesses informed commentary on the impact of anti-fraud and anticorruption legislation. The British Standards Institution published a standard “BSI 10500 – Specification for an anti-bribery management system” (December 2011). This is intended to provide an agreed benchmark against which organisations can measure that their anti-bribery systems are adequate. The British Bankers’ Association published guidance for the UK banking sector to consider regarding the implementation of the UK Bribery Act 2010 (December 2011). The FSA published (March 2012) the findings of its thematic review of the anti-bribery and corruption systems of 15 investment banks. While some of the banks had taken steps to implement effective controls, most had more work to do. In light of the review, the Liability for “environmental crimes” Liability for “environmental violations” Federal environmental statutes do not define “person” FSA consulted (March 2012) on updating its regulatory The EC adopted the Environmental Crime Directive to expressly include corporate officers or directors in guidance, “Financial crime: a guide for firms” (December (November 2008). Under the Directive, Member States evaluating liability for either civil or criminal violations, 2011). are required to apply effective criminal sanctions for the although some laws do include an “individual” within commission of serious environmental offences when the meaning of the term. Personal liability for corporate committed intentionally or with serious negligence. The officers and directors is therefore very rare under US criminal penalties to be imposed are left to Member environmental law, absent certain specific facts such as Liability for manslaughter Although only companies can be liable under the 20 Directors’ duties Liability for corporate acts (continued) Corporate Manslaughter and Corporate Homicide Act States’ discretion but should be effective, proportionate (i) personal participation in an environmental violation; 2007, a director may still be open to prosecution under and dissuasive. (ii) authority, and failure, to control wrongful conduct the general criminal law. giving rise to the violation (as in the case of a director responsible for the environment, health and safety); (iii) Liability for “environmental crimes” participation in decision making at the facility level that Most health and safety legislation in the UK already creates the violation; or (iv) serving as both an officer allows for secondary individual liability in that a and a shareholder in a closely held corporation in a “director, manager, secretary or other similar officer” case where the US Government pierces the corporate may also be liable where an offence by the company veil to impose personal liability. was committed with such person’s “consent, connivance, or [was] attributable to his/her neglect”. It is also possible for civil penalties to be imposed on businesses as an alternative to prosecution in some cases. Disqualification for breach of competition law The OFT published (June 2010) guidance on director disqualification orders in competition law cases. The guidance sets out how and when the OFT will take action to disqualify directors where they uncover evidence that a director was responsible for, or ought to have known of, competition law breaches at a company. The guidance makes clear that the OFT will be just as concerned with directors who ought to have known of competition law breaches at a company as those who were personally involved in an infringement. Cases will 21 Directors’ duties Liability for corporate acts (continued) be chosen based on the evidence available and the seriousness of the conduct. Further guidance on how the OFT will assess the extent of a director’s responsibility for infringements of competition law was published (June 2011). This is intended to provide guidance on the knowledge the OFT expects directors to have and the steps it believes are reasonable for directors to take to detect and prevent infringements of competition law. Criminal liability in regulatory contexts The Law Commission published a consultation paper (August 2010) on issues connected with criminal liability in regulatory contexts. Among other things, this considers the basis on which directors can be made liable for offences committed by their companies. In general terms, it considers that, where it is appropriate for directors to be liable for an offence committed by their company on the basis that they consented or connived with the company’s commission of the offence, the provision should not be extended to include instances where the company’s offence is attributable to neglect on the part of the directors. However, it does seek views on whether it might be appropriate in some circumstances to provide that directors can be liable for a separate offence of negligently failing to prevent an offence. The Law Commission published a summary of 22 Directors’ duties Liability for corporate acts (continued) responses received (November 2011). 23 Remuneration Current regime affecting listed companies Section 420 CA 06 and Schedule 8 of the Accounts The EC’s Recommendation on remuneration for Item 402 of SEC Regulation S-K requires the following Regulations 2008 require quoted companies (see directors of listed companies (December 2004) advised disclosure about the principal executive officer, principal Glossary) to publish, as part of the annual reporting that shareholders be kept informed about the financial officer, the three other highest-paid executive cycle, a report on directors’ pay on which shareholders company’s policy on directors’ remuneration as well as officers and the directors: will vote at each annual general meeting. The vote of how much individual directors are earning and in what shareholders is advisory only. The content requirements form, and that they should have adequate control over for the report are set out in the Accounts Regulations these matters and over share-based remuneration 2008. These overlap with disclosure requirements in the schemes. It invited Member States to adopt the Listing Rules and UK Corporate Governance Code. following measures: BIS has proposed significant changes to this disclosure - - a compensation discussion and analysis or “CD&A” addressing the objectives and implementation of executive compensation programmes and focusing on the most important factors underlying each company’s compensation policies and decisions. an annual statement in relation to remuneration The CD&A must be filed with the SEC and will form framework which are intended to take effect in 2013. policy should be released by all listed companies part of the disclosure subject to certification by the For more information, see Proposals affecting listed containing information about the breakdown of CEO and CFO companies below. remuneration (fixed and variable), performance criteria and the parameters for bonus schemes ICSA updated its guidance on the remuneration report compensation) for each named executive officer information need not be disclosed practice guidelines on executive contracts and over the last three years, accompanied by narrative directors’ remuneration should be on the agenda at disclosure and details on the grant of plan-based these require companies to disclose fully in the the shareholders’ general meeting and, to increase awards showing non-equity and equity-based remuneration report the constituent parts of any accountability, should be the subject of a vote awards and other equity compensation severance payment with a justification of the total value (either binding or advisory) and the elements paid and encourage boards to - a summary compensation table or “SCT” showing compensation (including a column reporting total and/or non-cash benefits. Commercially sensitive (October 2008). The ABI and NAPF published joint best severance pay (February 2008). Among other things, - a pensions benefit table and a non-qualified disclosure of the remuneration of individual deferred compensation table as well as a directors should include detailed information such description and quantification of termination and as remuneration and/or emoluments, shares or change-of-control payments to named executive For non-banks, remuneration changes following the rights to share options, contributions to officers 2008 financial crisis were limited to the following supplementary pension schemes and any loans, clarifications to Section D and Schedule A of the UK advances or guarantees to each director consider making directors’ contracts with a shorter - - notice period than 12 months. Corporate Governance Code: - shares and share option schemes for directors 24 - two additional tables showing outstanding equity awards at fiscal year-end and amounts realised on Remuneration - performance-related elements of executive should be subject to prior approval of shareholders the exercise of stock options and the vesting of directors’ remuneration should be stretching and at the annual general meeting. restricted stock during the last fiscal year designed to promote the best interests of the company - companies with securities admitted to a regulated remuneration for NEDs should not include any market, including non-EU companies with a primary performance-related elements (options or other listing. awards). These can only be granted with - a table showing director compensation in the last fiscal year comparable to the SCT. The rules do not change the disclosure requirements for foreign private issuers (see Glossary) whereby such The EC reported on Member States’ application of the an issuer is deemed to comply with Item 402 of Recommendation (July 2007). It found that transparency Regulation S-K if it provides certain base information standards were widely followed but was disappointed with respect to compensation and employee share executive options should not be offered at a with the application of the recommendation for options, unless more detailed information is made discount, save as permitted by the Listing Rules shareholders to vote on remuneration policy. publicly available elsewhere. Following a recommendation by the European Issuers that qualify as emerging growth companies (see Corporate Glossary) do not have to provide the CD&A disclosure. shareholder approval and any shares acquired must be held until at least a year after the NED leaves - The Recommendation is expressed to apply to all Current regime affecting listed companies (continued) - - payouts or grants under incentive schemes should be Governance Forum (March 2009), the EC published SEC guidance has continued to emphasise the subject to non-financial performance metrics, if (April 2009) a Recommendation on the remuneration of importance of clear and concise disclosure and analysis appropriate (as well as or instead of financial directors of listed companies to complement the 2004 about executive compensation practices. The SEC also performance measures), and remuneration incentives Recommendation. It is not binding, but Member States issued Compliance and Disclosure Interpretations (May should be compatible with risk policies and systems were invited to implement the necessary measures by 2009) providing guidance on the disclosure of tax 31 December 2009 and to notify the EC of the gross-ups, stock/options grant dates and life insurance measures taken. Key measures: premiums. - awards of variable components of remuneration Separate from the listing rules, SEC Regulation S-K (e.g. bonuses) should be subject to limits and to requires Exchange Act registrants subject to the proxy predetermined and measurable performance rules (i.e. not foreign private issuers (see Glossary), as criteria, which should promote the “long-term they are not subject to the proxy rules) to disclose, with sustainability” of the company. Payment of a major respect to any compensation consultant whose work provisions that permit the company to reclaim variable elements in exceptional circumstances of misstatement or misconduct should be considered. The Remuneration Consultants’ Group, a body established in 2009 and which represents executive remuneration consultancy firms advising UK listed companies, published a Code of Conduct (November 2009) in response to the 25 Remuneration Current regime affecting listed companies (continued) recommendation in the Walker Report. It published an proportion of variable components should be has raised any conflict of interest, the nature of the updated version of the Code (December 2011) containing deferred and the company should be entitled to conflict and how the conflict is being addressed. more emphasis on managing conflicts of interest and reclaim any payment made on the basis of compliance. information that is “manifestly misstated” The ABI publishes guidelines on executive remuneration involvement. Equity compensation plans, with minor companies should limit directors’ termination exemptions, are subject to a shareholder approval (latest version November 2012). The ABI has not made any payments so that they are no greater than the requirement. Accommodations/exemptions are available major changes in view of the changes proposed by BIS to equivalent of two years of the fixed component of to non-US issuers. See Corporate governance codes - remuneration reports and shareholder votes (see Proposals a director’s pay general provisions and guidance below. termination payments should not be paid if The CII’s executive compensation policy (updated termination is due to inadequate performance October 2012) emphasises compensation for affecting listed companies below) but highlights the following messages: - the variable element of remuneration should be kept as simple as possible and limited to an annual bonus - NYSE/Nasdaq Rules call for additional shareholder - - three-year vesting period and vesting should be and one long-term incentive - - subject to predetermined and measurable shareholders expect the remuneration committee to performance criteria. After vesting, directors should protect and promote their interests in setting hold shares in the company until the end of their executive remuneration employment. NEDs should not be remunerated with share options performance measures should be linked to the timing of the implementation of the strategy of the company - the remuneration committee should have at least one person experienced in the field of executive take undue financial operational risks or adopt an remuneration policy. The EC published a report (May 2010) on the disappointing implementation of its April 2009 employee pay costs on the finances of the company. Recommendation on the remuneration of directors of expectations for companies considering early compliance on benchmarking, executive salaries, disclosure of annual as well as long-term incentive compensation, dilution, stock options, perquisites, employment contracts, retirement arrangements and stock ownership requirements. pay proposals if: - there is a misalignment between CEO pay and company performance companies should consider the impact of total An appendix to the guidelines sets out the ABI’s general performance over the long term and provides guidance ISS will recommend a vote against management say on and should avoid providing an implicit incentive to unduly risky capital structure - share options should not be exercisable until after a listed companies. Only 10 Member States had implemented at least half the Recommendation. - the company maintains problematic pay practices or - the board exhibits poor communication and responsiveness to shareholders. In its 2013 updates to its proxy voting guidelines 26 Remuneration Current regime affecting listed companies (continued) with BIS new reporting requirements. NAPF’s Corporate Governance Policy and Voting Guidelines (latest version November 2012) endorse the UK Corporate Governance Code, whilst stressing that companies should tailor policies to their particular circumstances and structure remuneration to reflect the The ICGN published its Non-executive Director (November 2012), ISS announced that it would Remuneration Guidelines and Policies (March 2010). recommend a vote “against” or “withhold” from They are primarily addressed to companies and their directors (aside from new nominees) if the “board” non-executive board members and set out key failed to act on a shareholder proposal that received remuneration principles which are recommended to be the support of a majority of votes cast (as opposed to applied by companies regardless of their domicile. shares outstanding) during the 2013 proxy season or subsequent years. ambitions and risks inherent in the business. There are also guidelines requiring the remuneration committee to NYSE Rule 452 prohibits brokers from voting, absent disclose whether the Remuneration Consultants Group’s specific instructions from their clients, in relation to the Code of Conduct (December 2011) has been taken into election of directors, executive compensation or “any account when selecting consultants. Companies are other significant matter”. The NYSE clarified in an encouraged to submit the recruitment function to periodic information memo (January 2012) that the following tender and disclose their policies on it. proposals the NYSE had previously deemed as “Broker May Vote” will be treated as “Broker May Not Vote” The Remuneration Consultants Group published a review matters: (December 2012) of the effectiveness of its Code of Conduct. This set out a number of steps for its members to take to increase the awareness of the Code of Conduct. - de-staggering the board of directors - majority voting in the election of directors - eliminating supermajority voting requirements - providing for the use of consents - providing rights to call a special meeting - certain types of anti-takeover provision overrides. The SEC has approved listing rule amendments proposed by the NYSE (January 2013) and Nasdaq (January 2013) to require listed companies to comply 27 Remuneration Current regime affecting listed companies (continued) with new compensation committee requirements mandated by the Dodd-Frank Act. See Remuneration committees below. 28 Remuneration Proposals affecting listed companies The BIS call for evidence “A Long-Term Focus for In a non-legislative resolution (July 2010), the European The SEC is expected to propose and adopt further rules Corporate Britain” (October 2010) highlighted Parliament called for remuneration policy principles to in 2013 pursuant to the Dodd-Frank Act that would considerable increases in executive pay at a time when be extended to cover all listed companies. This followed impose the following executive compensation returns to shareholders and general salaries had been a European Parliament resolution on questions related provisions on public companies: relatively flat. to companies’ management (May 2010) which urged Following a discussion paper on executive remuneration (September 2011) and a consultation on shareholder voting rights on executive pay (March 2012), BIS the EC to propose amendments to financial services - disclosure of the relationship between executive compensation and the company’s financial legislation to ensure consistency between banking and performance non-banking institutions in remuneration policy. - disclosure of the ratio between median employee published a consultation (June 2012) on draft In the Corporate Governance Green Paper (April 2011), regulations to replace the existing rules on reports on the EC expressed concerns about the mismatch directors’ remuneration. The report will be divided into between performance and executive directors’ two parts: remuneration. It also suggested that a focus on short- based compensation during the three-year period term performance could have a negative influence on prior to a restatement (which do not require a long-term sustainability of the company. It sought views showing of misconduct and apply to current and on whether the disclosure of remuneration policy, the former executive officers) - a largely forward-looking statement of the company’s remuneration policy from the date of the AGM (the policy report) - remuneration report and individual remuneration of a report on the implementation of the company’s executive and non-executive directors should be existing policy in the year under review, including mandatory and whether the remuneration policy and actual sums paid (the implementation report). This remuneration report should be put to a vote by will include a requirement for a single figure for shareholders. each director and a chart comparing CEO pay against company performance. Details of termination payments must also be included. compensation and CEO compensation - - mandatory clawback policies to recover incentive- disclosure of whether employees may hedge the company’s stock. It is likely but not certain (until the SEC and/or the exchanges issue their rules) that non-US issuers will be exempt from such requirements, as long as they comply In the Company Law and Corporate Governance Action with their home jurisdiction requirements and make Plan (December 2012), the EC indicates that it will certain disclosures. propose an amendment to the Shareholder Rights The regulations are expected to take effect for AGMs Directive in 2013 to improve the transparency of held in financial years beginning on or after 1 October remuneration policies and individual remuneration of 2013. directors and give shareholders the right to vote on the Alongside these disclosure changes, BIS published draft remuneration report. 29 Remuneration legislation (June 2012) which will amend CA 06 to require quoted companies (see Glossary) to seek shareholder approval on the implementation report every year and on the policy report at least every three years (or sooner if changes are made to a policy previously approved or if shareholders voted against the implementation report the previous year). An ordinary resolution is required in each case. The vote on the implementation report is advisory but the vote on the policy report is binding. If a payment is promised or made and is not consistent with the previously approved policy report, it will have no effect and the director will be required to repay the Proposals affecting listed companies (continued) money or other assets, holding them in trust for the company in the meantime. Any director who authorises a payment must indemnify the company for any loss which results from the payment. The draft legislation is contained in amendments to the Enterprise and Regulatory Reform Bill. The Bill is expected to get royal assent in April 2013 and is likely to take effect in October 2013. The FRC has indicated (September 2012) that it will consult on further changes to the UK Corporate Governance Code once the Government’s legislation has been finalised. The amendments will relate to clawback arrangements; the practice of executive 30 Remuneration Proposals affecting listed companies (continued) directors sitting on the remuneration committees of other companies; and whether companies should engage with shareholders and report to the market in the event that they fail to obtain at least a substantial majority in support of a resolution on remuneration. The Financial Reporting Lab published a report (June 2012) on the practicalities of disclosing a single figure for remuneration. It launched a second project (November 2012) on BIS’ proposals to require the disclosure of (i) scenarios for directors’ pay for performance above, on and below target and (ii) a chart comparing company performance and CEO pay. The Kay Report (July 2012) recommended that companies should structure directors’ remuneration to relate incentives to sustainable long-term business performance. Long-term performance incentives should be provided only in the form of company shares to be held at least until the executive has retired from the business. The GC 100 has established a working group to develop best practice guidance on the practical implications of BIS proposed regulations on directors’ remuneration reports. The working group aims to publish guidance by the end of June 2013. The ABI envisages that it will issue revised guidelines on executive remuneration once the legislation and regulations on executive remuneration have been 31 Remuneration Proposals affecting listed companies (continued) finalised (so after April 2013). A group of pension investment bodies, including NAPF, published (February 2013) a discussion document setting out four remuneration principles for building and reinforcing long-term business success. These provide that: - management should make a long-term investment in the success of the businesses they manage - pay should be aligned to the long-term success and desired corporate culture throughout the organisation - pay schemes should be simple, understandable for both investors and executives and ensure that rewards reflect long-term returns to shareholders - remuneration committees should fully explain and justify how their decisions operate to deliver longterm business success. The authors plan to meet with remuneration committee chairs and shareholder representatives over the coming months to discuss the principles and refine the document as a guide to help shareholders assess companies’ pay practices. 32 Remuneration Remuneration in financial institutions The FSA 2010 (effective 8 June 2010): - gave power to HM Treasury to make regulations for certain authorised firms to prepare, approve and disclose remuneration reports covering their executive officers, employees and consultants - imposed a duty on the FSA to make rules requiring certain authorised persons to establish, implement and maintain a remuneration policy which is consistent with the effective management of risks and the implementation standards for Principles for Sound Compensation Practices issued by the FSB - gave power to the FSA to provide that provisions of a service contract contrary to FSA rules on The Financial Stability Board published Principles for As mandated by the Dodd-Frank Act, the SEC and six Sound Compensation Practices which were endorsed by other US federal regulators jointly approved the the G20 Leaders (April 2009). The Principles require issuance of a proposed rule (March 2011) imposing the financial institutions to ensure that their compensation following on “covered financial institutions” (i.e. banks, policies are consistent with their long-term profitability bank holding companies, broker-dealers and investment and prudent risk-taking. advisers with US$1 billion or more in assets, including The OECD’s report, “Corporate Governance and the Financial Crisis: Key Findings and Main Messages” (June FSB’s Principles for Sound Compensation Practices. The OECD also identifies a number of failings by financial - setting out the bands for disclosure of executive were not taken forward on the grounds that they went beyond CRD III. However, these are replicated in the draft regulation within CRD IV (which proposes that firms disclose the number of individuals being paid €1 million or more per financial year, broken down into pay bands of €500,000), so may yet be implemented. The FSA published the Remuneration Code to implement the powers given to it by FSA 2010 and to - - compensation arrangement that encourages managers and others had too much influence on with excessive compensation, or that could lead to the level and conditions for performance-based material financial loss - a requirement for incentive-based compensation the link between performance and remuneration arrangements to be adopted under policies and was often weak or difficult to establish procedures developed and maintained by a covered remuneration schemes were often overcomplicated. The FSB published Implementation Standards (September 2009) for its Principles for Sound Compensation Practices. The Implementation Standards provide that: - prohibitions on maintaining any incentive-based inappropriate risks by providing covered persons remuneration - disclosure of incentive-based compensation arrangements to their regulators institutions in its report: of assets paid or money transferred. remuneration, beginning at £500,000. These proposals - 2009), recommends that financial institutions follow the remuneration are void and provide for the recovery HM Treasury published draft regulations (March 2010) foreign private issuers (see Glossary)): financial institution and approved by its board. Under the proposed rule, further restrictions, including mandatory deferral of at least 50% of executive officers’ incentive-based compensation over a period of at least three years and board approval of the compensation of non-executive officers who could expose the financial significant financial institutions should ensure that institution to substantial losses, would also be imposed total variable compensation does not limit their on covered financial institutions with total consolidated ability to strengthen their capital base and national assets of US$50 billion or more. supervisors should limit variable compensation as a 33 Remuneration implement CRD III and the Walker Report. The percentage of total net revenues when it is The SEC has not indicated when it will adopt the Remuneration Code amended the FSA’s previous Code inconsistent with the maintenance of a sound proposed rule. of Practice on remuneration (which applied from 1 capital base January 2010) and reflected the CEBS Guidelines (December 2010). The Remuneration Code applies from - a substantial proportion of compensation for senior executives and employees whose actions have a 1 January 2011 and: - material impact on the risk exposures of the firm extended the scope of the old Code from 26 financial institutions to all banks, building societies and investment firms (including asset managers) – should be variable and performance-based - a substantial proportion of such variable compensation – 40 to 60% – should be payable approximately 2,700 firms - under deferral arrangements over a period of at recast certain evidential provisions and guidance least three years. For senior management and the into rules to reflect the binding nature of CRD III most highly paid employees, the percentage should be above 60% Remuneration in financial institutions (continued) - introduced rules that require firms to ensure that total be awarded in shares or share-linked strengthen their capital base and that total variable instruments, subject to an appropriate share remuneration must be significantly reduced where the retention policy performance introduced a rule to implement the voiding provisions of FSA 2010. The rule defines instances where breaches of the Code may render a contract void and require recovery of payments to be made - more than 50% of variable compensation should variable remuneration does not limit their ability to firm produces subdued or negative financial - - introduced rules on remuneration structures, covering the deferral of variable remuneration, ex-post performance adjustment and guaranteed minimum - the remaining proportion of deferred compensation can be paid in cash, vesting gradually and subject to clawback. G20 leaders endorsed the Implementation Standards at the Pittsburgh summit (September 2009). The FSB launched (March 2012) a bilateral complaints handling process to address complaints made by individual firms to their regulators concerning inconsistent implementation of the FSB’s principles 34 Remuneration Remuneration in financial institutions (continued) bonuses - extended the group of employees to which the Code and standards by firms headquartered in other jurisdictions. applies to include senior management and anyone The FSB published a progress report on whose professional activities could have a material implementing the Principles for Sound Compensation impact on a firm’s risk profile. Practices and the Implementation Standards (June The FSA adopted a proportional approach in applying the changes, as permitted by CRD III. There were originally four tiers of firms but this was reduced to three in December 2011 (see below). Firms in tiers three and four could disapply certain rules. 2012) since its peer review (October 2011). It noted that almost all member jurisdictions had completed implementation of the principles and standards and progress had been made in implementing the Basel Committee’s Pillar 3 disclosure requirements for remuneration. However, more needed to be done to The FSA published Remuneration Disclosure Rules fully embed them in regulation or supervisory (December 2010). They form part of the Prudential guidance across all jurisdictions. Notwithstanding Sourcebook for Banks, Building Societies and Investment reported progress, some jurisdictions elected not to Firms (BIPRU 11.5.18) and implement the disclosure implement one or more of the standards related to requirements of CRD III. They also took effect on 1 January the alignment of compensation with prudent risk 2011 and require firms to disclose on an annual basis both taking. The findings confirm the conclusion of the remuneration policy and details in respect of senior peer review that national authorities must sustain management and members of staff whose actions have a their implementation efforts to achieve lasting material impact on the risk profile of the firm, subject to improvements in compensation structures and proportionality. practices. The FSB will continue to monitor actions The FSA published guidance and templates relating to the taken. Remuneration Code (August 2011). The package includes The Basel Committee on Banking Supervision guidance on how to apply to vary a firm’s proportionality published (January 2010) an assessment tiers, templates for self-assessment of compliance, methodology to help supervisors assess individual guidance on retention periods and guaranteed variable firms’ compliance with the FSB’s Principles for Sound remuneration and a set of frequently asked questions on Compensation Practices and Implementation the Remuneration Code. 35 Remuneration Remuneration in financial institutions (continued) The FSA published two Dear CEO letters (October 2011) setting out its plans for monitoring implementation of the Remuneration Code during 2012, guidance on the definition of “Code staff”, what the FSA expected to see in a long-term incentive plan that was used to pay part of variable remuneration and the structure of instruments used as an alternative to shares in paying variable remuneration. The FSA published finalised guidance on buy-out awards to new staff (October 2011). This confirms that, although the FSA does not encourage the use of buy-out awards, such awards may normally be made without contravening the Remuneration Code if (i) the firm has taken reasonable steps to ensure that the buy-out is not more generous in Standards. The Basel Committee published guidance on aligning remuneration policies with risk and performance outcomes (May 2011). It asserts that appropriate compensation structures are integral to effective risk management and corporate governance, and requires banks to fully implement the FSB Principles or equivalent national standards. The Basel Committee published Pillar 3 disclosure requirements for remuneration (July 2011). They take full account of FSB Principles and Implementation Standards and aim to promote greater convergence and consistency of disclosure. amount or terms than the award from the previous The EC published a Recommendation on employer and (ii) the buy-out is subject to appropriate remuneration policies in the financial services sector performance adjustment conditions. (April 2009). It was not binding but Member States The FSA amended (November 2011) the application of its rules on voiding and recovery so that they apply to the largest banks and broker dealers. These took effect on 1 January 2012. The FSA updated its guidance on proportionality (December 2011). This changed the boundary between tiers 2 and 3 for banks and building societies. The FSA amended its proportionality guidance (September 2012) to replace the four-tier division of Remuneration Code firms (based on capital resources) with three new levels (based were invited to implement the suggested measures by 31 December 2009. Member States were to ensure that financial institutions had remuneration policies for risk-taking staff that were consistent with, and promoted, sound and effective risk management. The EC published a report (June 2010) noting the disappointing implementation of its April 2009 Recommendation on remuneration policies in the financial services sector. According to the report, only 16 Member States had fully implemented the Recommendation. 36 Remuneration Remuneration in financial institutions (continued) on total assets). This approach is intended to allow the CRD III (effective 1 January 2011) requires EU credit FSA to focus its resources on the most significant firms institutions and investment firms to have sound who pose risks to financial stability. remuneration policies that do not encourage or The FSA published (August 2012) a statement on the implementation of CRD IV. It noted that the plenary vote reward excessive risk-taking. Key provisions: - upfront cash bonuses must be capped at 30% of in the European Parliament had been delayed and that the total bonus and at 20% for particularly large CRD IV would not take effect in January 2013 as originally bonuses and at least 50% of the total bonus indicated. No alternative date has been set for must be paid broadly as shares, ownership implementation but the FSA indicated that it would keep interests or, as appropriate, capital instruments the situation under review. (which will bear losses first in case of bank difficulties), in each case subject to retention Following the publication (July 2012) by the EBA of final arrangements guidelines on the data collection exercises regarding high earners and remuneration benchmarking, the FSA - between 40% and 60% of any bonus must be published guidance (November 2012) on data collection deferred for at least three years and be on remuneration practices. recoverable if investments do not perform as expected HM Treasury published a consultation (December 2011) setting out draft regulations that require large banks - operating in the UK (excluding the UK operations of EEA firms) to publish the pay details of their eight most highly remunerated individuals by 31 December 2012, covering the capital and liquidity costs of bonuses - February 2011 between the Government and the UK’s five appropriate, specified capital instruments - to all large banks. The Treasury Select Committee published terms of harsher rules will apply to banks which received government support biggest banks which envisaged that the Government would be consulting on extending remuneration disclosure discretionary pension payments must be held in shares, equivalent ownership interests or, as the financial year beginning after 1 January 2011. The consultation follows the Project Merlin agreement in performance measures for bonuses must reflect - supervisors will be given powers to impose financial and non-financial penalties for noncompliance. 37 Remuneration Remuneration in financial institutions (continued) reference for an inquiry into corporate governance and remuneration in systemically important financial institutions (April 2012). On remuneration, the terms of reference include: - the role of institutional investors, remuneration consultants, employees and others with respect to remuneration - - and practices to help regulators implement CRD III (December 2010). The EBA published the results of its survey (March 2012) on the implementation of the CEBS guidelines. The survey findings indicated that in most countries the guidelines came into force on 1 January 2011 the case for introducing greater transparency for and that supervisors had actively assessed senior executives with respect to remuneration remuneration policies requiring, where needed, whether there should be further reform of the remuneration arrangements of senior executives and whether this should extend to those highly paid individuals who sit below executive level - CEBS published guidelines on remuneration policies interventions in the remuneration structures and payouts of the variable component. While considerable progress had been reported with respect to the governance of remuneration, some areas of concern remained. Further supervisory the merits and drawbacks of strict liability for bank guidance was needed in setting up the criteria for executives or an automatic incentives-based approach, identifying risk takers as well as in the application of as suggested by the FSA. the proportionality principle and of the risk alignment The Treasury Select Committee published written evidence practices. submitted to the inquiry (June 2012). The EBA published final guidelines (July 2012) on the The FSA published a consultation (November 2012) on data collection exercise regarding high earners and implementation of the AIFMD. This requires the disclosure on the remuneration benchmarking exercise, as of the following information on remuneration: mandated by CRD III. The objective of the guidelines - the total amount of remuneration for the financial year paid by the alternative investment fund manager to its staff, split into fixed and variable remuneration; is to streamline the data collection and increase the consistency and comparability of the information collected by national competent authorities. the number of beneficiaries and carried interest paid The EC published a draft of CRD IV (July 2011). The by the alternative investment fund draft regulation forming part of CRD IV includes the 38 Remuneration Remuneration in financial institutions (continued) - the aggregate amount of remuneration broken down following provisions in relation to remuneration by senior management and members of staff of the (which would be directly applicable in Member States alternative investment fund manager whose actions without the need for further legislative action): have a material impact on the risk profile of the alternative investment fund. - national authorities should collect information on the number of individuals per institution earning HM Treasury published a consultation (January 2013) on more than €1 million, to be published by the EBA the transposition of the AIFMD. Among other things, this on an aggregate country basis seeks views on the proportionate implementation of the AIFMD’s remuneration provisions. - significant institutions should publicly disclose the number of staff whose professional activities For further information on the governance of have a material impact on the institution's risk remuneration, see Remuneration committees below. profile, who are being paid €1 million or more per financial year, broken down into pay bands of €500,000 - institutions whose capital falls below the capital buffers set pursuant to CRD IV will be subject to restrictions on the award of variable remuneration and discretionary pension benefits, and will not be able to pay, or create an obligation to pay, variable remuneration or discretionary pension benefits if the obligation to pay was created at a time when the institution failed to meet the combined buffer requirements. It has been proposed that CRD IV should include a cap on variable pay. The Economic and Monetary Affairs Committee of the European Parliament voted to cap bankers’ bonuses at 1x fixed pay (May 2012). Following a compromise (December 2012) with the 39 Remuneration Remuneration in financial institutions (continued) Council, the default position remains at 1x salary unless a supermajority of the firm's shareholders approve an increase to 2x salary. The plenary vote of the European Parliament on CRD IV (including the proposed bonus cap) has been postponed to April 2013. ESMA published a consultation (September 2012) on proposed guidelines on remuneration policies and practices under MiFID. These aim to foster a consistent application and improved implementation of the existing MiFID conflicts of interest and conduct of business requirements in the area of remuneration across Member States. ESMA published final guidelines (February 2013) on remuneration guidelines on remuneration policies and practices under the Alternative Investment Fund Managers Directive. These are similar to the guidelines which CEBS issued (December 2010) for firms caught by CRD III, although the requirements are tailored to asset management firms. 40 Corporate governance codes General provisions and guidance The UK Corporate Governance Code sets out standards In the Company Law Action Plan, the EC rejected the There is no unitary corporate governance code. of good practice in relation to directors, remuneration, creation of a single European code of corporate Corporate governance is covered by state law, federal accountability and audit. governance but proposed that the EU should adopt a law and regulation and exchange listing requirements. Listing Rule 9.8.6R(5) requires companies with a premium listing (wherever incorporated) to report on how they have applied the Main Principles of the UK Corporate Governance Code. LR 9.8.6R(6) requires such companies to confirm that they have complied with its common approach covering a few essential rules and ensure adequate co-ordination and convergence of national corporate governance codes. It established the NYSE Rules require companies to: - ethics (see Corporate social responsibility below) European Corporate Governance Forum (October 2004), comprising 15 experts, to take this forward. adopt and disclose a code of business conduct and - adopt and disclose formal corporate governance Provisions or provide an explanation where they have The European Corporate Governance Forum published guidelines that include, inter alia, director not. This is known as the “comply or explain” principle. a statement on the comply or explain principle qualification standards, director responsibilities, (February 2006) which it believes is a better and more director access to management and outside efficient approach than detailed regulation. It advisers, director compensation and management encouraged Member States that had not yet adopted a succession The FRC published a paper (October 2010) explaining the UK approach to corporate governance and the comply or explain principle. Before 6 April 2010, non-UK companies only had to disclose whether they complied with the corporate governance regime of their country of incorporation and the significant ways in which their corporate governance practices differed from those set out in the code to do so. - establish an internal audit function The EC’s Recommendation on independent directors - certify annually as to compliance with NYSE and board committees (February 2005) is generally similar to, or slightly less onerous than, the UK Corporate Governance Code. corporate governance listing standards. Nasdaq Rules also require the adoption and disclosure of a code of conduct, which must be applicable to all Code. This changed (effective for financial years The Fourth and Seventh Amendment Directive requires directors, officers and employees and must comply with commencing on or after 31 December 2009) and non- EU-incorporated listed companies to include a the definition of a “code of ethics” under SOX § 406. UK companies must now include the same information statement in their annual report which must: as UK companies (i.e. state how they apply the Main Principles of the Code and comply or explain relative to - the Provisions). More than 300 companies were non-US issuers listed on NYSE/Nasdaq from corporate to the company governance requirements. However, NYSE/Nasdaq Rules as well as SEC Rules (as amended in September 2008) affected. - describe its corporate governance practices The FRC published amendments (September 2012) to - include a description of the main features of the the UK Corporate Governance Code. These take effect Current rules permit the NYSE and Nasdaq to exempt refer to the corporate governance code applicable company’s internal control and risk management 41 require annual disclosure of any significant ways in which a non-US issuer’s corporate governance practices differ from NYSE/Nasdaq listing standards. Under SEC Corporate governance codes for financial years commencing on or after 1 October 2012. The changes include: - system in relation to the financial reporting process. The Fourth and Seventh Amendment Directive also Rules, such disclosure must be made in a registrant’s annual report. NYSE/Nasdaq Rules impose the following additional requirements: additional guidance has been included on the requires disclosure by unlisted companies of meaning of a good explanation of non-compliance. transactions with related parties and requires all This involves providing a clear rationale for the companies to provide information about off-balance of SOX (see Audit committees - constitution below) action taken and a description of any action taken sheet arrangements. (NYSE/Nasdaq) to address any additional risk and to maintain conformity with the relevant principle of the Code. Where deviation from a particular provision is intended to be limited in time, the explanation should indicate when the company expects to conform with the provision The European Corporate Governance Forum published - - an audit committee that satisfies the requirements prompt notification if the company becomes aware a statement (March 2009) calling for the following new of any non-compliance (both the NYSE (November rules so that EU companies should not have to apply 2009) and Nasdaq (May 2010) changed their rules more than one code: to require notification of any non-compliance, - material or not) with relevant NYSE/Nasdaq a company incorporated in the EU with shares corporate traded on a regulated market should apply a corporate General provisions and guidance (continued) - governance code from the Member State of its the annual report and accounts taken as a whole is registered seat or the Member State of its primary fair, balanced and understandable and to provide share listing respect to the company’s corporate governance Member States should require no more than that a practices (primarily with respect to the audit company which is registered in that Member State committee) and an Interim Written Affirmation or the shares of which are admitted to trading in within five business days each time a change occurs that Member State explains in what significant ways to the audit committee or the company determines the actual corporate practices of that company it is no longer a foreign private issuer (see Glossary) deviate from those set out in the Member State’s (NYSE) the information necessary for shareholders to assess the company’s performance, business model and strategy. There is also a new supporting principle requiring the board to establish arrangements to enable it to be in a position to provide this confirmation - governance standards (NYSE/Nasdaq) a new provision requiring the board to confirm that companies are required to identify the external facilitator of the board evaluation, as well as any external search consultants and remuneration consultants used, in the annual report. Also, - corporate governance code. - - published “Corporate Governance and the Financial 42 disclosure of receipt of a going concern opinion (Nasdaq) Following a fact finding study (February 2009) and feedback from a consultation (March 2009), the OECD submission of an Annual Written Affirmation with - provision of an interim balance sheet and income statement within six months of the end of the Corporate governance codes General provisions and guidance (continued) companies that use external consultants must Crisis: Key Findings and Main Messages” (June 2009) disclose whether they have any other connection and “Conclusions and emerging good practices” with the company. (February 2010). The second paper concluded that the The guidance on a good explanation follows a paper (February 2012) on what constitutes a good explanation under the comply or explain regime. For other 2012 amendments to the UK Corporate Governance Code, see Board diversity, Audit committees - role, Stewardship, Narrative reporting and Rotation of audit firm/retendering below. Further guidance on the UK Corporate Governance Code is given in the FRC Guidance on Audit Committees, FRC Guidance on Internal Control, the FRC Guidance on Board Effectiveness (covering the role of the chairman, directors and the behaviour of boards) and the FRC Guidance on Going Concern. For further information, see Audit committees - role, Risk management and control and Narrative reporting below. All UK companies with a premium listing and all UK and non-UK companies with a standard listing, unless they are required to comply with equivalent rules in another challenge was to encourage and support the effective implementation of agreed standards rather than to revise the OECD Principles (updated in 2004). The FEE published a discussion paper on the auditor’s role in providing assurance on the corporate governance statement (November 2009). The EC commissioned a study (December 2008) on the monitoring and enforcement systems concerning Member States’ corporate governance codes. The EC’s final study (September 2009) revealed widespread support for the comply or explain principle but also shortcomings in implementation. The level of meaningful disclosure by companies was low, especially in risk management and remuneration, and investors were too inactive. A resolution of the European Parliament on questions related to companies’ management called for legislative action in relation to corporate governance and remuneration (May 2010). EEA State, are required to publish a corporate The EC published a Financial Institutions Green Paper governance statement in accordance with DTR 7.2 and on corporate governance in financial institutions and an make disclosures about board and committee structures accompanying Staff Working Paper (June 2010). This and the main features of the company’s internal control covered similar themes to the Walker Report but some and risk management systems in relation to the of the questions posed by the EC suggested a policy 43 second quarter (Nasdaq). Corporate governance codes General provisions and guidance (continued) financial reporting process. In most cases, the provisions of the UK Corporate Governance Code are more detailed than DTR 7.2. In these cases, companies with a premium listing will response that would go further than Walker’s recommendations. The EC’s questions include the following: - remain free to choose whether to comply with the relevant provision of the UK Corporate Governance Code but, if they choose to explain rather than comply, may sit be limited? - - directors improve the functioning and efficiency of (April 2011). This revealed that only 33 of the top 200 boards? listed companies undertook external board evaluation ICSA published a note on directors’ induction (July 2012). This includes a checklist of possible topics and could the inclusion of more women and individuals with different backgrounds on the board of ICSA published a board evaluation survey for 2010 in 2010 (compared with 30 in 2009). should recruitment policies ensure that directors have adequate skills? they must at least ensure that they comply with the minimum requirements in DTR 7.2. should the number of boards on which a director - should a compulsory evaluation of the functioning of the board, carried out by an external evaluator, be put in place? documents to consider covering in an induction An EC communication sets out financial reform programme and makes suggestions for programme proposals needed to implement fully the EC’s G20 design. commitments (June 2010). The ABI published a report on board effectiveness The Corporate Governance Green Paper (April 2011) (December 2012) following a review of the annual referred to the possible need to reinforce certain reports of FTSE 350 companies. The report highlights requirements at EU level by introducing them in best practice examples of disclosures on diversity, legislation rather than recommendations but said it did succession planning and board evaluation by FTSE 350 not want to change the fundamentals of the comply or companies. It noted that boards were making progress explain approach. It also sought comments on whether on diversity and external evaluation but could do more monitoring bodies should be authorised to check the to clarify their approach to succession planning. The quality of the explanations in corporate governance report also includes a new section on the role of the statements. 44 Corporate governance codes General provisions and guidance (continued) chairman, drawing together the perspectives of The mandate of the European Corporate Governance chairmen of FTSE 350 companies on the skills they Forum expired in July 2011 and the EC is considering consider to be most important in creating an effective how best to involve experts in future developments in board. EU corporate governance, in the light of responses to The FRC published (December 2012) Developments in the Corporate Governance Green Paper. Corporate Governance 2012. It notes that over half of The EC published a summary of the response to the FTSE 350 companies comply fully with the UK Corporate Governance Green Paper (November 2011): Corporate Governance Code and the aggregate compliance rate among such companies is 97%. In - companies who departed from corporate cases of non-compliance, the FRC found the standard governance codes to provide better explanations of explanation to be variable. Companies are generally better at setting out the background and actions taken most of the respondents were in favour of requiring - 75% of respondents did, however, support carving to mitigate any governance concerns than they are at out remuneration from the comply or explain explaining the reasons for their decisions. In the approach so that certain disclosures would be absence of improvement in 2013, the FRC will consider mandatory what further action is needed to ensure the criteria set - most of the respondents to the Green Paper out in the UK Corporate Governance Code are opposed use of monitoring bodies to check the consistently applied. quality of the explanations in the corporate The ABI published (December 2012) a report following governance statements. a review of the explanations made by 128 companies The European Parliament passed a resolution (March that had departed from the UK Corporate Governance 2012) welcoming the Corporate Governance Green Code. It identifies six criteria (which reflect the guidance Paper, but regretting that issues such as directors’ in the UK Corporate Governance Code) to assist responsibility, directors’ independence, conflicts of companies in preparing their explanations of non- interest or stakeholder involvement were left out. In compliance and gives examples of good and bad particular: practice. According to the report, only 27% of companies provided a convincing and understandable rationale for non-compliance and only 20% provided - a more accountable corporate sector should be created in the EU. The corporate sector should take 45 Corporate governance codes General provisions and guidance (continued) any description of mitigating action. 16% of companies social, ethical and environmental concerns into met none of the criteria. The ABI found that disclosure account in its operations and demonstrate its was better where the chairman provided an responsibility to employees, shareholders and introduction to the corporate governance statement society as a whole and encourages all chairmen to do this. - Member States should be encouraged to set limits to the number of boards on which a director can serve - the EC should strengthen the regulation of proxy advisers - the comply or explain system is a useful tool in corporate governance - any deviation from national codes should be explained in a meaningful way and alternative corporate governance measures should be identified and explained. The OECD published “Corporate Governance, Value Creation and Growth: The Bridge between Finance and Enterprise” (May 2012). This examined the role of corporate governance arrangements in providing the right incentives to contribute the value creation process within private enterprises and the implications of the differences in ownership structures on corporate governance practices and frameworks. In the Company Law and Corporate Governance Action Plan (December 2012), the EC indicated that it proposed to launch an initiative in 2013, possibly by 46 Corporate governance codes General provisions and guidance (continued) means of a recommendation, to improve the quality of explanations by companies that depart from corporate governance codes. 47 Corporate governance codes Board diversity Following the Government’s commitment in the The EC’s Strategy for equality between women and men The SEC adopted rules (December 2009) amending its coalition agreement (May 2010) to improve gender (September 2010) sets out the EC’s work programme proxy rules to require, among other things, additional equality, it appointed Lord Davies to develop a business on gender equality for the period 2010-2015. Progress disclosures in a company’s proxy statement regarding strategy (August 2010), building on the Tyson report is to be reported annually. So far two reports have director qualifications, including whether and how the (June 2003). Lord Davies published a call for evidence been published (March 2011) and (April 2012). company uses diversity as a factor in selecting directors. on women on boards (October 2010). EC commissioner Viviane Reding called on listed The Davies report (February 2011) recommended that companies (March 2011) to pledge 30% of female all chairmen of FTSE 350 companies should announce board members by 2015 and 40% by 2020. by September 2011 the percentage of women they hoped to have on their boards by 2013 and by 2015. For FTSE 100 companies, this figure was to be at least 25% in 2015. The Corporate Governance Green Paper (April 2011) sought views on whether listed companies should disclose diversity policy and report on progress. Diversity is not just a gender issue; the Corporate As recommended by the Davies report, executive search Governance Green Paper suggests that there needs to firms published a code of conduct (July 2011) to be more international diversity on boards as well. encourage headhunters to assist boards in ensuring diversity and maximising effectiveness. BIS published a press release (July 2012) noting that 34 executive search firms had signed up to the code of conduct. BIS also encouraged companies to adopt the voluntary “Think, Act, Report” approach of gender equality reporting. This was produced by the Government Equalities Office and launched by the Home Secretary (September 2011). The FRC consulted (May 2011) on ways to implement the recommendations in the Davies report in relation to the UK Corporate Governance Code. It published a feedback statement (October 2011) confirming the A resolution of the European Parliament called for legislative measures if voluntary ones do not increase the proportion of women on boards (July 2011). Both the directive forming part of CRD IV and the MiFID Amendment Directive propose that financial institutions should have a policy promoting gender, age, geography, educational and professional diversity when selecting board members. However, neither proposes quotas as this stage. The EC published a consultation (May 2012) on possible action at EU level, including legislative measures such as quotas, to redress the gender imbalance on boards. 48 The term diversity is not defined, but the SEC has indicated that the term is meant to be interpreted broadly to include differences in viewpoint, professional experience, education, and skill as well as race, gender, and national origin. Corporate governance codes following changes to the UK Corporate Governance The EC published a draft directive (November 2012) Code: that will set an objective for listed companies to achieve - the introduction of a new requirement for listed companies to report annually on their boardroom diversity policy, including gender, any measurable objectives that the board has set for implementing the policy and the progress it has made in achieving the objectives - 40% representation for the “under-represented sex” among NEDs by 2020. Companies that don’t meet the target must ensure that their recruitment processes are transparent and unbiased, and give preference to equally qualified female candidates. If they fail to meet the target, notwithstanding such processes, they must provide an explanation. Companies must also set a the inclusion of a new supporting principle voluntary target for the number of executive directors. confirming that diversity, including gender, should Companies will be required annually to provide to be addressed in the board effectiveness review, national competent alongside the balance of skills, experience, independence and knowledge of the company on the board. Board diversity (continued) The changes apply to financial years commencing on or authorities, and publish on their website, information after 1 October 2012 but the FRC strongly encouraged about the gender representation of both executive companies voluntarily to apply and report on the directors and NEDs and the measures they have taken changes with immediate effect. to achieve the relevant targets. Grant Thornton’s corporate governance review 2012 No sanctions apply if the targets are not met. Sanctions (December 2012) indicated that 78% of companies in will only apply if: the FTSE 350 provided a basic outline of their policy on diversity in 2012, with 16% providing detailed - NEDs fails to put in place the recruitment measures disclosure. The ABI published a report on board effectiveness (December 2012). Whilst noting examples of good disclosure by FTSE 350 companies, it concluded that a company which does not meet the target for required by the draft directive - a company fails to publish a target for the number of executive directors or 49 Corporate governance codes Board diversity (continued) most disclosures were boilerplate and recommends ways they can be improved. - a company fails to comply with the reporting measures required by the draft directive. Lord Davies published the first annual progress report It is for each Member State to lay down the sanctions (March 2012) on the Davies report. It was accompanied which will apply. These may include fines and/or the by Cranfield School of Management’s report, “The appointment of a NED being declared void if the rules Female FTSE Board Report 2012”. The reports showed on recruitment process and positive discrimination have that: not been complied with. - within the FTSE 100, women held 15.6% of all In the Company Law and Corporate Governance Action directorships (up from 12.5%) and there were only Plan (December 2012), the EC indicates that it plans to 11 all-male boards (down from 21) make a proposal in 2013 to require companies to - within the FTSE 250, women held 9.6% of all directorships (up from 7.8%) and all-male boards disclose their board diversity policy through an amendment of the Fourth and Seventh Directives. were in a minority for the first time (44.8% down from 52.5%). The Equality and Human Rights Commission published a further report by Cranfield School of Management (May 2012) on the process of recruiting and appointing women onto the boards of the FTSE 350 listed companies. The report reveals that executive search firms had had some success in getting more women on long lists but when it came to short-listing and appointing, successful candidates tended to be those who were perceived as “fitting in” with the values, norms and behaviours of existing male board members. A House of Lords EU Committee sub-committee published an inquiry (June 2012) into gender imbalance in boardrooms and a report (November 2012). The 50 Corporate governance codes Board diversity (continued) report concluded that the EC had not made a convincing case in support of board quotas and that a voluntary business-led approach was preferable. The Government published a response (January 2013) welcoming the report. A Commons Select Committee for Business, Innovation and Skills announced a new inquiry into women in the workplace (September 2012). This sought comments on: - the success of the Davies report - the extent to which investors should take into account the percentage of women on boards when considering company reporting and appointments to the board - the reasons why there were so few women in senior positions on boards. Following two consultations (August 2010 and September 2011) on ways to improve the quality of narrative reporting and a response statement (March 2012), BIS consulted (October 2012) on regulations to amend CA 06 to require quoted companies (see Glossary) to include, in a strategic report, a breakdown of the number of persons of each sex who are directors, managers and employees of the company. Managers are defined as persons (other than directors) who are employees and have responsibility for planning, directing or controlling the activities of the company. The additional disclosures will apply for 51 Corporate governance codes Board diversity (continued) financial years ending on or after 1 October 2013. See Narrative reporting below. 52 Corporate governance codes Risk management and control The FRC Guidance on Internal Control (October 2005) The European Corporate Governance Forum issued a There are additional disclosure requirements under SOX includes a requirement on boards to confirm in the statement on risk management and internal control for financial statements of all companies filing or about annual report where action has been or is being taken (June 2006). It considered that there was no need to to file reports with the SEC: to remedy significant failings or weaknesses identified impose an EU obligation on boards to certify the from their review of the effectiveness of internal control effectiveness of internal controls as required in the US systems. However, there is no requirement for directors by SOX. to make a statement in the annual report and accounts on the effectiveness of the company’s internal control systems, similar to SOX § 404. The FRC is expected to consult on amendments to the FRC Guidance on Internal Control in 2013. - material off-balance sheet arrangements and known contractual commitments must be disclosed (SOX § 401(a)) (SEC Rules adopted January 2003) Weaknesses in risk management were identified by the OECD in Corporate Governance and the Financial Crisis: - management must report on internal controls over financial reporting, including the effectiveness of Key Findings and Main Messages (June 2009). The those controls, and auditors must issue an OECD’s paper on conclusions and emerging good attestation report on the effectiveness of internal practices (February 2010) found that the board’s controls over financial reporting (SOX § 404) (SEC The FRC published a guide (December 2004) for UK and responsibility for defining strategy and risk appetite Irish companies registered with the SEC on the use of needed to be extended to establishing and overseeing the FRC Guidance on Internal Control (then referred to enterprise-wide risk management systems. The paper as the “Turnbull Guidance”) to comply with the SEC argued that it was good practice for the risk The SEC provided the following relief (December 2006) requirements to report on internal controls over management function to report directly to the board. with respect to compliance with the internal controls financial reporting under SOX § 404. The ICGN revised its Global Corporate Governance Rules adopted June 2003, February 2004 and June 2007). rules of SOX: - newly public companies will not be obliged to The Walker Report (November 2009) recommended Principles (November 2009) to include greater that banks and financial institutions should establish consideration of the behavioural aspects of governance provide either management’s assessments or risk committees comprising NEDs and supported by a as well as new sections on corporate culture and risk independent auditors’ attestations until their chief risk officer. See Risk committees below. management. The ICGN also published Corporate Risk second annual report after becoming a public Oversight Guidelines (October 2010) to help investors company Although risk committees are not mandated for listed companies in general, there is greater emphasis on risk assess how well a portfolio company’s board is - non-US issuers and non-accelerated filers, when overseeing risk. providing management’s assessments without Main Principle on internal control was extended in 2010 The EC’s Financial Institutions Green Paper (June 2010) independent auditors’ attestations pursuant to SEC to confirm that the board is responsible for determining noted the absence of a healthy risk management Rules, may “furnish” rather than “file” those the nature and extent of the significant risks it is willing culture in financial institutions and the failure of assessments, reducing liability with respect to those in the UK Corporate Governance Code. In particular, the 53 Corporate governance codes to take to achieve its strategic objectives. Also, the UK financial institutions to take a holistic approach to risk assessments and eliminating mandatory Corporate Governance Code provides that the annual management. It included a number of questions on incorporation by reference to such assessments. report should explain the company’s business model to ways to enhance the status of the Chief Risk Officer and Non-US issuers that are not large accelerated filers enable investors to understand better the risks and how to improve the communications between the risk (generally, large accelerated filers are filers with a uncertainties that the company faces. management function and the board. It also asked market capitalisation of more than US$750 million), whether executives should be required to approve a pursuant to a rule adopted by the SEC in August report on the adequacy of internal control. 2006, are not obliged to provide the independent The Institute of Risk Management published (September 2011) guidance for directors and senior auditor’s attestation until the year after they first executives on the UK Corporate Governance Code’s The Corporate Governance Green Paper (April 2011) disclosure on board responsibility on risk. The guidance confirmed that boards of listed companies in general aims to provide practical advice on how to approach should take responsibility for risk appetite and the development and implementation of a risk appetite reporting. It suggests that disclosures in the risk report The SEC adopted guidance to management on framework. should include key societal risks, such as risks relating compliance with SOX § 404 (June 2007). The guidance to climate change, the environment, health and safety is intended to help management make its evaluation and human rights. process more efficient and cost-effective. The FRC met with companies, investors and advisers in The Basel Committee on Banking Supervision published The PCAOB adopted (June 2007) an auditing standard early 2011 to discuss how boards were approaching the (January 2013) its principles for effective risk data for the audits of registrants’ internal control over disclosures on risk in the UK Corporate Governance aggregation and risk reporting to strengthen banks’ risk financial reporting under SOX § 404. Code. In a summary of its discussions (September management capabilities. begin complying with the management’s assessment requirement. Risk management and control (continued) 2011), the FRC notes that there had been a “step change” in efforts made by directors to manage risks although reports on risk did not always get to the “heart of the matter”. For more information, see Corporate reporting - recent In the Company Law and Corporate Governance Action Plan (December 2012), the EC indicates that it plans to make a proposal in 2013 to strengthen disclosure requirements with regard to risk management through In view of developments in the eurozone, the FRC an amendment of the Fourth and Seventh Directives. published a note on reporting on country and currency Extending reporting to cover non-financial risks is risk in annual financial reports (January 2012) and in intended to establish a more comprehensive risk profile interim financial reports (June 2012). Both notes stress of the company, improve risk management and the importance of: encourage companies to adopt a sustainable and long54 developments below. Corporate governance codes - conveying a balanced and understandable term strategic approach to their business. assessment of the company’s position and prospects - explaining the nature and scope of direct and, if practicable, indirect exposures to country and currency risks and how they are being mitigated. In some circumstances it may be helpful to indicate that certain risks are absent or not significant. The FRC encourages companies to make disclosures of country and currency risk in one section of their financial reports. Companies are also required to disclose the principal risks and uncertainties facing them as part of their business review. The FRC expressed concerns about the quality of the disclosures in a statement (February 2011) but noted a significant improvement in the reporting of risks and of mitigating actions in its annual report (September 2012). Risk mitigation is a difficult area because of the tension between the FRRP’s approach and the SEC’s practice of not allowing companies to use mitigating language in their risk factor disclosure in the Form 20-F and other SEC filings. The FRC’s Developments in Corporate Governance 2012 (December 2012) noted that reporting on internal control needed to improve. It plans to consult on amendments to the FRC Guidance on Internal Control later in the year. 55 Corporate governance committees Remuneration committees Provisions of the UK Corporate Governance Code The EC’s Recommendation on independent directors The SEC requires the following disclosures with respect relevant to remuneration committees include: and board committees (February 2005) recommended to compensation committees (and further rules have that listed companies should establish a remuneration been adopted by the NYSE/Nasdaq) with respect to committee to ensure that remuneration was set in an compensation committees and advisers pursuant to the objective way. An annex to the Recommendation set Dodd-Frank Act, as discussed below): - the board should establish a remuneration committee of at least three (or, in the case of smaller companies outside the FTSE 350 throughout the previous reporting year, two) members who should all be independent NEDs (D2.1). The chairman may sit on the remuneration committee if considered independent at the time of appointment - the remuneration committee should recommend and monitor the level and structure of remuneration for senior management in addition to the remuneration committee. These are generally similar to, or less onerous than, the UK Corporate - the authority of the compensation committee - the extent to which the compensation committee may delegate its authority to other persons Governance Code. The Recommendation on the remuneration of directors - any role of executive officers in determining or of listed companies (April 2009) recommended that one recommending the amount or form of executive person on the remuneration committee should have and director compensation experience in the field of executive remuneration. - any role of compensation consultants in the remuneration for all executive directors and the This has not been implemented in the UK, partly determining or recommending the amount or form chairman. “Senior management” should be because the meaning of experience was not sufficiently of executive and director compensation determined by the board but should normally clear. include the first layer of management below board level (D2.2) - out criteria for the composition, role and operation of the remuneration committee should carefully consider what compensation commitments their directors’ terms of appointment would entail in the event of early termination, to avoid rewarding poor performance. They should also take a robust line on reducing compensation to reflect the departing directors’ obligations to mitigate loss (D1.4). The Walker Report (November 2009) made a number of recommendations in relation to the remuneration - with respect to any such compensation consultant The EC’s report (May 2010) on implementation of the whose work has raised any conflict of interest, the Recommendation notes that only 10 Member States nature of the conflict and how the conflict is being had implemented at least half of it. addressed. The FSB published implementation standards for its The SEC has approved listing rule amendments Principles for Sound Compensation Practices proposed by the NYSE (January 2013) and Nasdaq (September 2009). It recommended that significant (January 2013) to require listed companies to comply financial institutions should have a remuneration with new compensation committee requirements committee as an integral part of their governance mandated by the Dodd-Frank Act. structure. The remuneration committee should: The NYSE and Nasdaq rules differ in a few aspects, but - they both impose the following requirements on listed be constituted in a way that enables it to exercise 56 Corporate governance committees committees of banks and financial institutions, competent and independent judgement on including: compensation policies and practices and the - incentives created for managing risk, capital and the terms of reference should include responsibility - basis - remuneration committee report should confirm that the committee is satisfied with the way performance objectives and risk adjustments are - independent legal counsel and other compensation advisers (“compensation advisers”) and be directly with an assessment of the firm’s financial condition responsible for oversight of their work and future prospects - work closely with the firm’s risk committee in the evaluation of the incentives created by the compensation system reflected in their compensation structures and explain the principles underlying such 57 the compensation committee must have the sole authority to engage compensation consultants, should demonstrate that its decisions are consistent respect of all high-end employees in relation to high-end employees, the be independent, and certain additional factors must and likelihood remain uncertain. In so doing, it the terms of reference should be extended to cover all members of the compensation committee must be considered in assessing independence carefully evaluate practices by which compensation is paid for potential future revenues whose timing oversight of remuneration policy and outcomes in - - liquidity for setting the over-arching principles and parameters of remuneration policy on a firm-wide companies: - listed companies must provide appropriate funding Corporate governance committees Remuneration committees (continued) objectives and adjustments if they differ from those - of executive board members - - for payment of reasonable compensation to a compliance with the FSB Principles for Sound compensation adviser Compensation Practices for FTSE 100-listed banks and comparable unlisted entities such as the largest building societies, the ensure that the firm’s compensation policy is in - compensation committees must consider six ensure that an annual compensation review, independence factors when selecting a remuneration committee report should disclose externally commissioned if appropriate, is compensation adviser, although a compensation features of high-end employees’ remuneration (in conducted independently of management and adviser is not required to be independent. bands rather than individually) submitted to the relevant national supervisory the remuneration committee should seek advice - authorities or disclosed publicly. As with most of the corporate governance requirements imposed by the exchanges, foreign private issuers (see from the board risk committee on specific risk Both CRD III and the directive forming part of CRD IV Glossary) may follow home country practice instead of adjustments to be applied to performance require competent authorities to ensure that significant the new compensation committee requirements, objectives; in the event of any difference in view, credit institutions and investment firms establish a although Nasdaq specifically requires a foreign private risk adjustments should be decided by the remuneration committee. The chair and members must issuer (see Glossary) to disclose in its annual report the chairman and NEDs on the board. be board members that do not perform any executive reason it does not have a fully independent function. They must take into account the long-term compensation committee. These recommendations have largely been implemented through amendments to the FSA’s Remuneration Code and through powers given to the interests of shareholders, investors and other stakeholders. The requirements relating to compensation committee responsibilities and authority are effective beginning 1 FSA and HM Treasury in FSA 2010. July 2013. Listed companies will have until the earlier of their first annual meeting after 15 January 2014 and 31 ICSA updated its terms of reference for remuneration October 2014, to comply with the compensation committees (October 2010) to reflect the UK Corporate committee independence requirements. Governance Code. The FRC published (September 2012) amendments to the UK Corporate Governance Code which take effect for financial years commencing on or after 1 October 2012. Companies are required to identify any external remuneration consultants used and disclose whether they have any other connection with the company. 58 Corporate governance committees Remuneration committees (continued) The FRC has indicated (September 2012) that it plans to consult on further amendments to the UK Corporate Governance Code in relation to: clawback; the practice of executive directors sitting on the remuneration committees of other companies; and whether companies should engage with shareholders and report to the market in the event that they fail to obtain at least a substantial majority in support of a resolution on remuneration. The consultation will take place once the Government’s legislation on voting and executive remuneration has been finalised. 59 Corporate governance committees Nomination committees Provisions of the UK Corporate Governance Code The EC’s Recommendation on independent directors Although foreign private issuers (see Glossary) are relevant to nomination committees include: and board committees (February 2005) recommends exempt, SEC Rules require US listed companies to that listed companies should establish a nomination provide more robust disclosure of nominating committee to ensure that the process for the committee processes in their annual proxy statements appointment and removal of directors is carried out in to shareholders, including: - the nomination committee should consist of a majority of independent NEDs (B2.1) - the chairman should be allowed to chair the an objective and professional way. An annex to the nomination committee except when the committee Recommendation sets out criteria for the composition, discusses the appointment of a new chairman (B2.1) role and operation of the nomination committee. These the nomination committee should evaluate the are generally similar to, or less onerous than, the UK balance of skills, experience, independence and Corporate Governance Code. knowledge on the board and prepare a description The Financial Institutions Green Paper (June 2010) on of the role and capabilities required for a particular corporate governance in financial institutions did not evaluating candidates to be nominated as directors appointment in light of this (B2.2). mention nomination committees directly but noted that (including the involvement of third parties and Also, there is a Supporting Principle that requires the the failure of directors in financial institutions to identify minimum qualifications and standards for director search for board candidates to be conducted and and manage risk was at the heart of the origins of the nominees) appointments made on merit and against objective financial crisis and that this raised important questions criteria and with due regard to the benefits of diversity about the quality of appointment procedures. on the board, including gender diversity. The directive forming part of CRD IV proposes that ICSA updated its terms of reference for nomination boards of credit institutions and investment firms forward by large, long-term shareholders or groups committees (October 2010) to reflect the UK Corporate should establish a nomination committee, responsible of shareholders. Governance Code. for defining the roles and capabilities required for - The FRC published (September 2012) amendments to the UK Corporate Governance Code which take effect for financial years commencing on or after 1 October 2012. Companies are required to identify the external facilitator of the board evaluation, as well as any external search consultants and remuneration particular appointments. Directors will also be subject to an enhanced “fit and proper” test and should receive appropriate induction and continuous training. The MiFID Amendment Directive also proposes that investment firms should establish a nomination committee, where appropriate and proportionate in 60 - whether the company has a separate nominating committee and, if not, why not - whether members of the nominating committee satisfy independence requirements - - the company’s process for identifying and whether a company considers director nominees put forward by shareholders and, if so, its process - whether the company has rejected candidates put Corporate governance committees consultants used, in the annual report. Also, companies view of the nature, scale and complexity of their that use external consultants must disclose whether business. they have any other connection with the company. NAPF’s Corporate Governance Policy and Voting Guidelines (November 2012) state that shareholders may abstain or oppose the re-election of the chairman of the nominations committee or the chairman of the board in the absence of a full explanation of noncompliance with the UK Corporate Governance Code in relation to board appointments, succession or evaluation. 61 Corporate governance committees Nomination committees (continued) The Kay Report recommended that companies should consult their shareholders in advance of making major appointments to the board. This has been added to the good practice statement for directors (see BIS’ response (November 2012) to the Kay Report). 62 Corporate governance committees Audit committees - constitution Provisions of the Statutory Audit Directive relating to The EC’s Recommendation on independent directors Rules promulgated under SOX § 301 prohibit the listing audit committees were implemented by DTR 7.1. This and board committees (February 2005) recommended of companies not meeting the following requirements: requires UK companies with transferable securities that listed companies should establish an audit admitted to trading on a regulated market to have a committee. An annex to the Recommendation set out body responsible for carrying out the audit functions criteria for the committee’s composition. These are set out in the Statutory Audit Directive. The body generally similar to, or less onerous than, the UK should have at least one independent member and a Corporate Governance Code. (SEC Rules adopted April 2003 and NYSE/Nasdaq Rules The Statutory Audit Directive contains a requirement for approved November 2003.) all public interest entities (see Glossary) to have an SEC Rules make significant accommodations for non-US audit committee. The audit committee should be issuers: member who has competence in accounting and/or auditing. Companies are also required to issue a statement which identifies the body which carries out the audit functions and describes how that body is composed. composed of non-executive members of the administrative body and/or members of the supervisory Provision C3.1 of the UK Corporate Governance Code body, i.e. NEDs, and/or members appointed by the states that the board must establish an audit shareholders in general meeting, with at least one committee. independent member with competence in accounting To deal with the overlap between the DTR and the UK Member States may exempt from the audit committee the FSA’s view, compliance with certain provisions of requirement: to ensure full compliance with DTR 7.1.1 to 7.1.5. Under the UK Corporate Governance Code: - each company must have an audit committee - each member of the audit committee must be “independent”. - - board of directors exercise certain statutory responsibilities relating to the appointment and oversight of audit committees - allowing non-management employees to sit on audit committees in accordance with home country legal or listing requirements without violating the unlisted credit institutions and insurance undertakings independence criteria - clarifying that, solely for the purposes of these public interest entities (see Glossary) that have a rules, the term “board of directors” means the the audit committee should have a minimum of “body performing equivalent functions to an audit supervisory, or non-management, board for issuers three (or, in the case of smaller companies outside committee, established and functioning according from jurisdictions with two-tier board structures the FTSE 350 throughout the previous reporting to provisions in place in the Member State where year, two) members, all of whom should be the entity to be audited is registered”. independent NEDs (C3.1) - clarifying that the rules do not conflict with home country requirements that shareholders or the full and/or auditing. Corporate Governance Code, DTR 7.1.7 confirms that, in the UK Corporate Governance Code should be enough - The European Confederation of Directors’ Associations 63 - allowing representatives of controlling shareholders and foreign government shareholders to sit on audit committees in certain circumstances Corporate governance committees - the chairman of a company outside the FTSE 350 published (September 2011) guidance on the may be a member of (though may not chair) the requirements of the Statutory Audit Directive in relation audit committee, provided he or she was to audit committees. considered independent on appointment (C3.1) - - exempting listed foreign governments from the requirements of these rules - allowing alternative structures such as statutory The EC’s Financial Institutions Green Paper considers auditors and boards of auditors to oversee audit the board should satisfy itself that at least one whether one of more members of the audit committee firms. member should have recent and relevant financial should participate in the risk committee and vice versa experience (C3.1) (there is no detailed definition to strengthen the oversight of risk. This is not equivalent to “audit committee financial expert” in specifically addressed in CRD IV. the US). If non-US issuers avail themselves of one of the exemptions, they must disclose that choice in their annual report on Form 20-F. In addition, non-US issuers The EC published (November 2011) a draft regulation that rely on any of the exemptions will be required to The FRC Guidance on Audit Committees (September on requirements for audits of public interest entities disclose their assessment as to whether and, if so, how 2012) provides guidance on how to comply with the (see Glossary) and a draft directive amending the that reliance provisions relating to the establishment of the audit Statutory Audit Directive. Among other things, the draft committee in the UK Corporate Governance Code. regulation includes more detailed rules on the membership of audit 64 Corporate governance committees Audit committees - constitution (continued) NAPF’s Corporate Governance Policy and Voting committees. In particular, at least one member must would materially adversely affect the ability of their Guidelines (November 2012) state that shareholders have competence in auditing and another member in audit committee to act independently and satisfy the may choose to vote against the re-election of the accounting and/or auditing. This goes further than the other audit committee requirements of SOX. chairman of the audit committee, or another member existing provisions which only require one member to of the audit committee, or, in exceptional have competence in accounting and/or auditing. circumstances, the reappointment of the auditor, where Each audit committee must either designate an “audit committee financial expert” or explain why such an expert has not been appointed. issues relating to auditor and/or non-audit fees are not To qualify as an “audit committee financial expert”, an resolved to their satisfaction. individual must have all of the following attributes: - an understanding of GAAP and financial statements - an ability to assess the general application of GAAP in connection with the accounting for estimates, accruals and reserves - experience in preparing, auditing, analysing or evaluating financial statements that present a breadth and level of complexity of accounting issues that are generally comparable to the breadth and complexity of issues that can reasonably be expected to be raised by the company’s financial statements, or experience in actively supervising one or more persons engaged in such activities - an understanding of internal controls and procedures for financial reporting - an understanding of audit committee functions. A person can acquire such attributes through any one or more of the following means: 65 Corporate governance committees Audit committees - constitution (continued) - education and experience as a principal financial officer, principal accounting officer, controller, public accountant or auditor or experience in one or more positions that involve the performance of similar functions - experience in actively supervising a principal financial officer, principal accounting officer, controller, public accountant, auditor or person performing similar functions - experience in overseeing or assessing the performance of companies or public accountants with respect to the preparation, auditing or evaluation of financial statements or - other relevant experience. Note that, for non-US issuers, the SEC has clarified that the audit committee financial expert’s understanding must be of the GAAP used by the non-US issuer in preparing its primary financial statements filed with the SEC. (SOX § 407) (SEC Rules adopted January 2003.) The NYSE amended its rules (November 2009) to clarify that if an audit committee member simultaneously serves on the audit committees of more than three public companies, then the board must determine that such service would not impair such member’s ability to serve on the audit committee and must disclose such 66 Corporate governance committees Audit committees - constitution (continued) determination. 67 Corporate governance committees Audit committees - role Provision C3.2 of the UK Corporate Governance Code IOSCO published “Principles of Auditor Independence SOX specifies certain audit committee responsibilities, sets out the main role and responsibilities of the audit and the Role of Corporate Governance in Monitoring an including (SOX §§ 202, 204 and 301): committee. The audit committee should, among other Auditor’s Independence” (October 2002). things: - - monitor the integrity of the financial statements of (May 2002) proposed that auditors should consider the company and any formal announcements whether the governance structure of the audited entity relating to the company’s financial performance, provides safeguards to mitigate threats to reviewing significant financial reporting judgements independence. The involvement of the governance contained in them body of listed entities in an auditor’s appointment or in review the company’s internal financial controls and, unless expressly addressed by a separate risk committee of independent directors or by the - to independence (para. A 4.1.1 and Annex para. 4.1.1). - receiving reports of critical accounting policies and practices as well as alternative accounting treatments - oversight of accounting firms (including payment of compensation) - whistleblowing procedures - authority and funding to engage outside advisers. (SEC Rules adopted January and April 2003.) and risk management systems and board committees (February 2005) recommended Also, pursuant to SOX § 307 and SEC Rules, audit that listed companies should establish an audit committees may receive and take action on attorneys’ committee. An annex to the Recommendation set out reports of “evidence of material violations of securities criteria for the committee’s role and operation. These law…”. monitor and review the effectiveness of the make recommendations to the board in relation to are generally similar to, or less onerous than, the UK the appointment, reappointment and removal of Corporate Governance Code. and terms of engagement of the external auditor review and monitor the external auditor’s independence and objectivity and the effectiveness of the audit process, taking into consideration - considered in determining the significance of a threat pre-approval of non-prohibited non-audit services The EC’s Recommendation on independent directors the external auditor and approve the remuneration - commissioning non-audit services was a factor to be - board itself, review the company’s internal control company’s internal audit function - The EC’s Recommendation on Auditor Independence The Statutory Audit Directive provides that the audit committee should, inter alia: - monitor the financial reporting process - monitor the effectiveness of the company’s internal relevant UK professional and regulatory control, internal audit and risk management requirements systems develop and implement a policy on the - NYSE/Nasdaq Rules require/authorise audit committees, amongst other things, to: - hire and fire independent auditors; approve nonaudit services; review their work; and obtain advice from outside legal or accounting advisers if necessary (NYSE and Nasdaq) - consider annual/quarterly financial statements and MD&A; discuss earnings press releases, guidance monitor the statutory audit of the annual and 68 provided to analysts and rating agencies and risk Corporate governance committees engagement of the external auditor to supply nonaudit services, taking into account relevant ethical guidance, and report to the board, identifying any matters in which it considers that action or improvement is needed and making recommendations as to the steps to be taken - report to the board on how it has discharged its responsibilities. Other provisions of the UK Corporate Governance Code relating to the role of audit committees include provisions that: - the audit committee should review arrangements consolidated accounts - management policies; and meet regularly with management, internal auditors and independent review and monitor the independence of the auditors (NYSE) statutory auditor or audit firm and in particular the provision of additional services to the audited entity. - review and approve all related party transactions (Nasdaq). Also, the appointment of the statutory auditor of a NYSE/Nasdaq Rules are largely consistent with SOX, public interest entity (see Glossary) must be based on a although they allow for the exemption of non-US recommendation of the audit committee. issuers where such exemptions would not be contrary In the Audit Green Paper (October 2010), the EC sought views on how the dialogue between the external auditors, internal auditors and the audit committee could be improved. by 69 to US securities laws. However, audit committee rules under SOX § 301 apply to non-US issuers, albeit with significant accommodations. See Audit committees constitution above. Corporate governance committees Audit committees - role (continued) which staff of the company may, in confidence, The EC published (November 2011) a draft regulation The PCAOB adopted Auditing Standard No. 16, raise concerns about possible improprieties in on requirements for audits of public interest entities Communications with Audit Committees (August 2012) financial reporting or other matters, to ensure that (see Glossary) and a draft directive amending the which the SEC approved (December 2012). The new arrangements are in place for the proportionate Statutory Audit Directive. The draft regulation provides standard primarily retains or enhances existing audit and independent investigation of such matters and that: committee communication requirements and is effective for appropriate follow-up action (C3.5) - the audit committee is to be responsible for if the board does not accept the audit committee’s conducting an auditor selection procedure based recommendation on the appointment, on detailed criteria set out in the draft regulation. reappointment or removal of the external auditors, In order to give mid-tier firms more opportunities it should include in the annual report, and in any to bid for audit mandates, at least one of the firms papers recommending appointment or invited to tender must be a firm that received less reappointment, a statement from the audit than 15% of its total audit fees from large public committee explaining its recommendation and the interest entities in the Member State the previous reasons why the board has taken a different year position (C3.7) - - - unless an auditor’s appointment is being renewed the annual report should explain to shareholders (this is permitted only once), the recommendation how, if the auditor provides non-audit services, of the audit committee to the board must include auditor objectivity and independence are at least two possible choices for the audit safeguarded (C3.8). engagement and a justified preference for one of The FRC Guidance on Audit Committees provides additional guidance on Section C3 of the UK Corporate Governance Code. them. The proposal for the appointment of statutory auditors made by the board to the general meeting of shareholders must include the recommendation of the audit committee and, if the ICSA’s terms of reference for audit committees were proposal of the board departs from the audit updated (October 2010) to reflect amendments to the committee’s recommendation, it must justify the UK Corporate Governance Code in June 2010. A further departure. update will be required to reflect the 2012 amendments FEE published (June 2012) a discussion paper on the 70 for audits of financial statements with fiscal years beginning on or after 15 December 2012. The standard also applies to audits of emerging growth companies and foreign private issuers (see Glossary). See Regulation of auditors and accountants below. Corporate governance committees Audit committees - role (continued) to the UK Corporate Governance Code. The House of Lords Economic Affairs Committee’s report “Auditors: Market concentration and their role” (March 2011) recommended that audit committees should hold discussions with principal shareholders every five years, that the published report of the audit committee should detail significant financial reporting functioning of audit committees following a survey in a number of EU countries. The discussion paper recommends various improvements in relation to establishment, composition, competences and responsibilities as well as reporting to and from the audit committee with the overall aim of improving the quality of financial information provided by companies. issues raised during the course of the audit and that they should explain the basis of the decision on audit tendering and auditor choice. The FRC published (February 2012) jointly with the Institute of Chartered Accountants of Scotland and the Institute of Chartered Accountants in Australia, a report summarising discussions with audit committee chairmen in the UK, Australian and other markets. The report covers issues such as the role and composition of the audit committee and its relationship with the board, management and the external auditor. The AIU includes a section for audit committees in its 2011/12 Annual Report (June 2012). It warns audit committees to consider carefully the scope of the audit where significant fee reductions are contemplated, suggests ways audit committees can encourage auditor scepticism and recommends that audit committees seek additional information if auditors do not provide a good standard of independence reporting in the context of non-audit services. 71 Corporate governance committees Audit committees - role (continued) The FRC published amendments (September 2012) to the UK Corporate Governance Code and the FRC Guidance on Audit Committees which take effect for financial years commencing on or after 1 October 2012 with earlier adoption encouraged. The amendments in relation to audit committees implement the FRC’s effective stewardship project and address concerns about uninformative audit committee reports expressed in the FRC’s Developments in Corporate Governance 2011 (December 2011) and the FRC’s Developments in Corporate Governance 2012 (December 2012). Main changes: - the audit committee must include additional information in its report to shareholders, including information on the significant issues that it considered in relation to the financial statements and how these issues were addressed, details on how it assessed the effectiveness of the external audit process, the approach taken to the appointment or reappointment of the external auditor and information on the length of tenure of the current audit firm and when the tender was last conducted - the audit committee must report to the board on how it has discharged its responsibilities - the board must confirm that the annual report and accounts taken as a whole are fair, balanced and 72 Corporate governance committees Audit committees - role (continued) understandable and provide the information necessary for shareholders to assess the company’s performance, business model and strategy. The board should establish arrangements to enable it to be in a position to provide this confirmation. In this context, the board may request input from the audit committee, as appropriate. In relation to reporting on significant issues, the FRC Guidance on Audit Committees suggests that this should include matters that informed the board’s assessment of whether the company is a going concern. There is a greater stress in the FRC Guidance on Audit Committees on formal reporting by the audit committee to the board. The FRC also published updated guidance for audit committees on the use of audit firms from more than one network (September 2012). Originally published in 2008, the guidance provides audit committees of growing companies using non-Big Four audit firms with factors they may wish to consider when their activities expand geographically beyond the perceived capacity of their existing firm. 73 Corporate governance committees Risk committees The Walker Report (November 2009) recommended The EC’s Financial Institutions Green Paper on corporate The Dodd-Frank Act requires the Board of Governors of that banks and financial institutions should establish governance in financial institutions and accompanying the Federal Reserve to issue rules requiring all public risk committees comprising NEDs and supported by a Staff Working Paper (June 2010) considers whether non-bank financial companies supervised by the Federal chief risk officer. board risk committees should be compulsory and seeks Reserve and all public bank holding companies with comments on ways to enhance the status of the chief assets exceeding US$10 billion to have risk committees. risk officer. The Federal Reserve may also require public bank The FSA added guidance to the FSA Handbook (the Senior Management Arrangements, Systems and Controls (SYSC) Sourcebook) with effect from 1 May The directive forming part of CRD IV proposes that 2011 to implement Walker’s recommendations on risk. boards of credit institutions and investment firms The guidance encourages regulated firms to consider should set up a separate risk committee, made up of appointing a chief risk officer and establish a board risk NEDs. Credit institutions and investment firms should committee, taking account of their size, nature and also have an independent risk management function complexity. The FSA also states in the guidance that it with sufficient authority and resources and the ability to considers FTSE 100 banks and insurers to be examples report directly to the board, when necessary. of the type of firm that should structure their risk holding companies with assets of less than US$10 billion to have risk committees if deemed necessary or appropriate to promote sound risk management. The risk committees would be responsible for the oversight of the company’s enterprise-wide risk management practices and must include at least one risk management expert with experience in identifying, assessing and managing risk exposures of large, complex firms. The Federal Reserve will determine the control arrangements in this way. The FSA’s reasons for number of independent committee members that are introducing the new rules are set out in a Policy required, based on the nature of the company’s Statement 10/15 (September 2010). operations, size of assets and other appropriate criteria. According to the FRC’s final report (December 2009) of Otherwise, risk committees are rare in the US and the its review of the Combined Code (the predecessor to audit committee generally supervises risk issues. the UK Corporate Governance Code), few respondents supported mandatory risk committees for listed companies in general. A report (October 2009) carried out by Independent Audit Limited for the ICAEW on risk governance in 70 non-financial services companies in the FTSE 350 suggested that there was no case for major change in the UK’s risk governance rules for nonfinancial companies and that the focus should be on 74 Corporate governance committees making the existing rules work better, for example by encouraging the right behaviour and attitudes to risk management. Although risk committees are not mandatory for nonfinancial companies, there is more emphasis on risk management in the UK Corporate Governance Code (see also Risk management and control above). ICSA published terms of reference for risk committees for the first time (October 2010) reflecting the greater emphasis given to risk in the UK Corporate Governance Code. 75 Corporate governance committees Risk committees (continued) The FRC met with companies, investors and advisers in early 2011 to discuss how boards were approaching their responsibilities on risk. In the summary of its discussions (September 2011), it noted that different board committee structures were appropriate to different industries and companies and that the decision whether to establish a risk committee should be left to individual boards. Grant Thornton’s corporate governance review 2012 (December 2012) noted that increasing numbers of non-financial companies in the FTSE 350 have risk committees – 40% in 2012 compared to 33% in 2011. 76 Corporate governance committees Other committees Disclosure committees Disclosure committees UK companies generally do not have US-style SEC Rules addressing SOX certification requirements disclosure committees although Listing Principle 2 set extend to “disclosure controls and procedures”, i.e. out in 7.2.1R supplemented by 7.2.2G of the Listing procedures to ensure that required information is Rules requires a listed company to take reasonable recorded, processed, summarised and reported on a steps to establish and maintain adequate procedures, timely basis. CEOs/CFOs must certify as to their systems and controls to enable it to comply with its evaluation of disclosure controls and procedures and obligations, in particular in relation to the timely and the inclusion in the filing of their conclusions about the accurate disclosure of information to the market. In effectiveness of such controls. practice, the audit committee may fulfil the role of a The SEC recommended (August 2002) that SEC- disclosure committee. Provision C3.2 of the UK registered companies should have a disclosure Corporate Governance Code provides that the audit committee to assist in establishing controls and committee should monitor the integrity of a company’s procedures as well as to oversee the preparation of financial statements and any formal announcements disclosure. Members might include the general counsel, relating to financial performance, reviewing significant heads of major subsidiaries, the head of investor financial reporting judgements contained in them. relations and risk management staff. Provision 3.4 of the UK Corporate Governance Code Qualified legal compliance committees also provides that, where requested by the board, the audit committee should provide advice on whether the The SEC provides that issuers may establish qualified annual report and accounts, taken as a whole, is fair, legal compliance committees (“QLCCs”) as an alternative balanced and understandable and provides the means of addressing the “reporting requirements” for information necessary for shareholders to assess the attorneys which are mandated by SOX. Attorneys company’s performance, business model and strategy. obliged to report evidence of a material violation of US securities laws or a breach of fiduciary duty or similar CSR committees violation by a client, or by any officer, director, The UK Corporate Governance Code does not refer to employee or agent of that client, may report to the CSR committees and they are not a requirement of UK QLCC. A QLCC would be composed of at least one company law. However, there is a growing trend for 77 Corporate governance committees companies to set up such committees, which reflects member of the audit committee and two or more growing pressure on companies to promote sustainable additional independent board members. However, businesses. QLCCs have not been widely adopted. Executive committees ICSA provided guidance (September 2004) on terms of reference for an executive committee, intended as a forum where the chief executive can consider major operational decisions. 78 Shareholder engagement Statutory and regulatory framework Shareholders have the right to appoint and remove The Shareholder Rights Directive was intended to The current default standard in most states for the directors by a resolution passed by a majority of those facilitate shareholder engagement by establishing election of directors is plurality voting, under which a voting. Under the articles of association, the board requirements for the exercise of certain shareholder director is elected if s/he receives the most votes, rather usually has the right to appoint directors to fill rights that are attached to voting shares of companies than having to win at least 50% of the votes. Thus, if an vacancies and appoint additional directors, subject to with a registered office in a Member State where the election is uncontested, it would be possible for a the approval at the annual general meeting of a shares are admitted to trading on a regulated market. nominee to win a board seat simply by receiving one majority of the shareholders who vote. Under the UK Main provisions: “for” vote. Because high costs and the judicial rejection Corporate Governance Code, all directors of FTSE 350 companies are subject to annual election by the - meeting. This can be reduced to 14 days for a shareholders and must step down if they fail to secure meeting (other than the annual general meeting) the approval of a majority of the shareholders who with shareholder consent where the company offers vote. CA 06 contains a number of measures designed to promote shareholder engagement by facilitating involvement, and increasing confidence, in the voting - a registered shareholder in a company traded on a regulated market has the right to nominate a person on whose behalf it holds shares to receive information that is sent to the registered shareholder (Sections 146 to 153) - subject to provisions to that effect in the company’s articles, a registered shareholder may nominate another person to exercise or enjoy all or any of the shareholder’s rights (including voting rights) to the extent specified by the shareholder (Section 145) - shareholders to nominate their own candidates for the board, plurality voting has been criticised as a “rubber stamp” for the corporation’s nominee. Activists continue to push for corporations to adopt means majority voting for the election of directors, but an the notice of meeting must also be published on (or 14 days where the notice of meeting is reduced) - of the SEC’s proxy access rule make it difficult for the facility for all shareholders to vote by electronic the company’s website 21 days before the meeting process: - a company must give 21 days’ notice of a general each Member State must fix a single record date attempt to insert a majority voting requirement in the Dodd-Frank Act was ultimately rejected. The CII considers plurality voting to be flawed and endorses majority voting. for all companies to determine the eligibility of a The DGCL, the Model Act (the foundation of corporate shareholder to vote. Share blocking, the practice of statutes in many states excluding Delaware) and the preventing shareholders from trading their shares California Corporations Code were amended in 2006 to during a certain period before the meeting, is facilitate majority voting. Under the DGCL, shareholders prohibited can propose and adopt changes to bylaws, including Member States must permit companies to offer participation in the general meeting by electronic means. Unjustified obstacles to electronic voting are prohibited changes establishing majority voting. Whilst these changes can be overruled by the board of directors if the certificate of incorporation permits the board of directors to amend the bylaws, Section 216 of the DGCL prohibits repeal by the board through unilateral action 79 Shareholder engagement - quoted companies (see Glossary) must disclose on - their websites the results of polls at meetings (Section 341) (Provision E2.2 of the UK Corporate Governance Code recommends that companies publish on their website details of proxies lodged - of any shareholder-adopted bylaw that addresses the exercise rights by proxy requisite vote for election of directors. To accommodate a company must publish voting results on its website within 15 days of the meeting. majority voting proposals which require nominees who are not elected by a majority to tender their resignation, Section 141(b) of the DGCL allows a at any general meeting where votes are taken on a The EC published a consultation document (April 2007) resignation of a director to be conditional upon a show of hands as well as votes for and against a to assess the need for further measures to facilitate future event, such as a director failing to receive a resolution) shareholder rights and a summary of responses specified vote for re-election, and further allows such (September 2007). The responses showed support for resignations to be irrevocable. shareholders of quoted companies (see Glossary) have the right to require independent scrutiny of any poll (Sections 342 to 351) - - shareholders should have a general right to registered shareholders may nominate proxy/ies to provisions on stock lending, giving depositary holders the right to direct how votes on underlying shares should be cast and provisions requiring intermediaries to pass on and execute voting instructions. The EC originally indicated 80 The DGCL authorises but does not require the adoption by the company of: Shareholder engagement Statutory and regulatory framework (continued) speak at meetings, demand a poll, and vote on a that it would publish a recommendation in 2008, but show of hands or on a poll (Section 324). has not taken any further action. - a bylaw setting forth requirements for shareholder access to the company’s proxy materials (DGCL Section 112) The Shareholder Rights Directive was implemented by For an analysis of the problems with cross-border The Companies (Shareholders’ Rights) Regulations 2009 voting, caused by shares being held through chains of on 3 August 2009. The regulations made the following intermediaries, see the statement and memorandum reimbursement of shareholder proxy expenses amendments to CA 06 and give shareholders a number (June 2006) by the European Corporate Governance (DGCL Section 113). of additional rights to be heard: Forum. - 5% (reduced from 10%) of members can requisition The Company Law Action Plan considered that there a general meeting (Section 303) was a medium- to long-term case for introducing a - every member has the right to have questions answered at a general meeting, unless an exception applies (Section 319A) - - a bylaw setting forth requirements for the The DGCL also: - separate the date by which shareholders must “one share, one vote” principle in the EU and doing register in order to be entitled to notice of a away with the multiplicity of voting rights, voting right shareholder meeting from the date by which ceilings, priority (or preference) shares, depositary shareholders must register in order to be entitled receipts and non-voting shares. The EC published an 5% of members can require “other matters of independent research report (June 2007) and the business” which are not resolutions to be included European Corporate Governance Forum published a in the annual general meeting agenda (Section paper (June 2007). Neither showed conclusive evidence 338A). of a causal link between one-share-one-vote and the authorises, but does not require, a board to to vote at the meeting (DGCL Section 213(a)) - allows judicial removal of directors under certain circumstances (DGCL Section 225(c)) - provides a statutory default rule confirming a In addition, the regulations required companies to economic performance of companies. The EC covered person’s right to indemnification for certain provide additional information in notices of meetings announced (October 2007) that it would be taking no expenses accrued while an indemnification bylaw and on company websites. further action on this issue. was in force where such bylaw is subsequently ICSA has published the following guidance notes: The OECD Steering Group on Corporate Governance amended to limit or eliminate the right (DGCL agreed (November 2007) a common position on Section 145(f)). - Indirect Investors – Information Rights and Voting (October 2007). This seeks to explain Sections 145 and Sections 146 to 153 of CA 06 and offers guidance and best practice recommendations to indirect and registered shareholders, companies whether there should be proportionality between The Model Act permits the adoption of bylaws ownership and control (also known as one-share-one- mandating majority voting. Specifically, the Model Act vote) in listed companies. Among other things, it provides for election by a plurality vote, but with the concluded that: qualification that a nominee who is so elected but fails - to receive a majority of the votes cast in the director’s the cost of regulating proportionality would be 81 Shareholder engagement Statutory and regulatory framework (continued) and registrars - Implementation of the Shareholder Rights Directive considerable - (July 2009). This summarises and gives guidance to companies on corporate representatives, proxies voting on a show of hands, advance voting on a poll, website requirements for poll results and the - election would serve as a director only for a term strengthening corporate governance frameworks was a better alternative - on which the board otherwise fills the office. The Model specific problems could be dealt with through Act also allows corporations to adopt resignation carefully targeted regulation. policies tied to the occurrence of a future event, similar The ICGN published a code of best practice on stock to the DGCL. general meetings lending (September 2007). This was intended to clarify California law provides that certain California-based the responsibilities of all parties engaged in stock corporations that are also listed corporations may lending, increase transparency and ensure that the amend their bylaws or charters to require directors to governance consequences of lending shares (such as a be elected by “approval of the shareholders” in possible loss of shareholder votes) were taken into uncontested elections. Practical issues relating to shareholder voting at the notice of meeting, proxy deadline and record date, the voting period and what should happen after the proxy deadline has passed. account. It included a principle that companies should know who controlled the votes at their general Section E of the UK Corporate Governance Code deals meetings. The relevant market authorities were invited with relations between companies and shareholders. to consider amending their disclosure regimes to Among other things: include the transfer of actual or contingent voting the chairman should discuss governance and strategy with major shareholders (Provision E1.1) - - rights executed through the use of securities lending and derivatives. Shareholders can require a US public company to include shareholder proposals on the company proxy statement under Rule 14a-8 of the Exchange Act. If a company is able to exclude such proposal under the various bases provided under Rule 14a-8, the shareholder would have to undertake the expensive and difficult project of creating its own proxy materials and the senior independent director should attend ESME published a report on the implementation of TOD conducting its own proxy solicitation, if it wants to sufficient meetings with a range of major in the EU (December 2007). Among other things, it disseminate its proposal. If a shareholder is successful shareholders to help develop a balanced flagged the variation in the understanding and the under Rule 14a-8, the shareholder proposal is included understanding of their concerns (Provision E1.1) consequences of securities lending across Member in the company’s proxy statement along with States and noted concerns, such as where securities are management’s proposals. Foreign private issuers (see borrowed for the purpose of influencing a shareholder Glossary) are not subject to Rule 14a-8 and the SEC’s meeting. The report set out what ESME considered to proxy rules in general. the chairman should ensure the views of shareholders are communicated to the board as a whole (Provision E1.1) - which the voting results are determined or (ii) the date right of shareholders to have questions answered at company general meetings (April 2012). It covers - ending on the earlier of (i) 90 days from the date on the board should state in the annual report the be elements of good practice in the lending market. IOSCO published a report (June 2009) on minority 82 The SEC adopted rules (August 2010) requiring Shareholder engagement Statutory and regulatory framework (continued) steps taken to ensure that members of the board, shareholders in listed issuers and summarised the companies to allow a qualifying shareholder (or group especially NEDs, develop an understanding of the protections and standards in 18 jurisdictions. of shareholders) to include its nominee(s) for the board views of major shareholders e.g. through face-toface contact, analysts’ or brokers’ briefings and surveys of shareholder opinion (Provision E1.2). The European Parliament’s Committee on Economic and Monetary Affairs published a study (December 2009) on the questionable use of shareholder voting rights, such Also, new directors should avail themselves of as where an investor can direct voting without being a opportunities to meet major shareholders as part of shareholder (hidden voting) or where a shareholder their induction (Provision B4.1). votes without a corresponding financial interest in the The Bank of England’s Securities Lending and Repo Committee’s Securities Borrowing and Lending Code of Guidance (July 2009) applies to securities lending by UK the company’s remuneration policy every three years and an advisory vote (ordinary resolution) on the implementation of its policy in the year under review. See Remuneration - proposals affecting listed companies above for more information. The FSA published a consultation “Enhancing the effectiveness of the Listing Regime” (October 2012). It proposes new rules principally addressed to premium listed companies with a controlling shareholder (on the basis that engagement by institutional shareholders that it will not appeal the decision. See also Nonexecutive directors of listed companies above. proxy solicitation and proxy voting. It has issued a limitation of voting rights to avoid such uses. concept release (July 2010) for public comment on statement on empty voting and transparency of CA 06 to require a binding vote (ordinary resolution) on of Columbia Circuit (July 2011), and the SEC has stated voting). The study proposes compulsory disclosure and stock loans when corporate activities are concerned. published draft legislation (June 2012) which will amend struck down by the US Court of Appeals for the District The SEC is also exploring reform of the mechanics of The European Corporate Governance Forum adopted a voting rights on executive pay (March 2012), BIS rules were stayed (September 2010) and were ultimately company, e.g. if shares are lent or swapped (empty participants. It states that shareholders should recall Following a consultation to give shareholders greater of directors on the company’s proxy statement, but the shareholder positions (February 2010). It also recommended mandatory disclosure of voting rights held within empty voting arrangements (e.g. through an certain aspects of the proxy system, including the accuracy and transparency of the voting process; communications and shareholder participation; and the relationship between voting power and economic interest. amendment of TOD), the right of lenders to recall The SEC approved the amendment to NYSE Rule 452 securities at any time and the introduction of a rule (September 2010) to prohibit broker discretionary that a company and its subsidiaries should only lend voting (i.e. voting without instructions by shareholders) the company’s shares if the lending contract stipulated in all elections for directors, on executive compensation that the borrower would not vote the shares. or on “any significant matter” as determined by the The EC’s report on TOD (May 2010) concluded that TOD’s disclosure obligations needed to be adapted to take account of innovative financial products. In particular, the insufficient disclosure of stock lending SEC. Previously, NYSE Rule 452 permitted a broker to vote on behalf of beneficial owner customers in uncontested elections of directors if the customers had not returned their voting instructions. practices had increased the risk of empty voting and The NYSE published an information memo (January lack of disclosure regarding cash-settled derivatives had 2012) clarifying the application of NYSE Rule 452 to 83 Shareholder engagement Statutory and regulatory framework (continued) may have little influence on such companies), but some proposals are expressed to apply to all companies with a premium listing of shares. For example: - controlling shareholders will have to enter into relationship agreements with listed companies to led to increased problems of hidden ownership. The TOD Amendment Directive (October 2011) contains proposals to: - from the shareholders companies with controlling shareholders will need to have a majority of independent directors and the shareholders other than the controlling - - majority voting in the election of directors holding of shares, including cash-settled derivatives - eliminating supermajority voting requirements require the aggregation of holdings of shares with - providing for the use of consents - providing rights to call a special meeting - certain types of anti-takeover provision overrides. those of financial instruments giving access to shares (including cash-settled derivatives). election of independent directors the UK disclosure provisions in DTR 5 (which are currently super-equivalent). into the listing principles for premium listed ESMA published a call for evidence (September 2011) in companies relation to the issues and potential problems relating to the rules on control of business and independence LR 9.8.6(5) will be amended to require the company to disclose in its corporate governance statement how the chairman has ensured the directors have a sufficient understanding of the regulatory requirements applicable to a premium listed company and the requirements regarding fiduciary duties that are applicable to directors in the company’s country of incorporation. be treated as “Broker May Not Vote” matters, including: - These will align the TOD provisions more closely with a “one share, one vote” principle will be introduced that it previously ruled as “Broker May Vote” will now de-staggering the board of directors shareholders will be given a separate vote on the from controlling shareholders will be tightened - - The NYSE has determined that certain proxy proposals - extend the current disclosure regime to cover all instruments with a similar economic effect to the ensure independence of the company’s business - certain types of corporate governance proxy proposals. empty voting. It published a feedback statement (June 2012) which concluded that there was insufficient evidence to justify any regulatory action at European level. ESMA published a discussion paper on proxy advisers and how to regulate them (March 2012). This considers the factors influencing the accuracy, independence and reliability of proxy advice, such as the potential for conflicts, proxy advisers’ methodology and their dialogue with issuers, the degree of transparency on the management of conflicts, the dialogue with issuers, 84 Shareholder engagement Statutory and regulatory framework (continued) The consultation also proposes that all disclosures voting policies and guidelines, voting recommendations required by the Listing Rules should be placed in a and procedures for drawing up a voting separate section of the annual report. recommendations report. ESMA seeks views on a number of policy options, ranging from encouraging the development of improved investor codes and developing ESMA recommendations to more formal legislative measures. 85 Shareholder engagement Stewardship The drive to ensure that institutional investors engage The Company Law Action Plan rejected a requirement Regulations under the Employment Retirement Income with the companies in which they invest has a long for institutional investors to exercise voting rights, but Security Act of 1974 state that the fiduciary history. The Myners Report, “Institutional Investment in set out a proposal for the medium term to require responsibility of managing employee benefit plan assets the UK: A Review” (March 2001), recommended that institutional investors to disclose their investment and consisting of equity securities extends to the exercise of those responsible for pension scheme investment voting policies and, at the request of beneficiaries, their voting rights attaching to those securities. should adopt on a “comply or explain” basis a series of voting records in individual cases. principles codifying best practice for investment decision making, actively monitor and communicate with the management of investee companies and exercise shareholder votes where these would enhance the value of an investment. Lord Myners published a review (January 2004) on the impediments to voting UK shares, followed by three progress reports (March 2005, November 2005 and July 2007) for the Shareholder Voting Working Group. The July 2007 report showed that voting levels and electronic voting were increasing, but that some votes continued to be lost in the chain of instructions. Section 1277 CA 06 includes a reserve power for the Secretary of State and the Treasury to make regulations requiring institutional investors to disclose how they have voted the shares in which they have an interest. investment advisers with authority over client proxies institutional shareholder responsibilities (July 2007). This to: set out the responsibilities of institutional shareholders both in relation to their role as owners of a company’s The OECD published “Corporate Governance and the Financial Crisis: Key Findings and Main Messages” (June adopt voting policies and procedures designed to ensure that the adviser votes in the best interest of clients - disclose voting policies and procedures to clients. 2009). This called on companies to do more to support SEC-registered management investment companies are constructive engagement with shareholders and on also required to disclose proxy voting policies and shareholders to play a more active, informed role. procedures, as well as voting records (SEC Rules The EC published a Financial Institutions Green Paper (June 2010). In relation to shareholder engagement, and in view of the emergence of new categories of shareholder with little interest in long-term governance, it questioned the effectiveness of corporate governance rules based on the presumption of effective control by shareholders. It sought views on whether shareholder published a comply or explain code on voting control of financial institutions was still realistic and on disclosure (June 2007) and an updated version of the ways to improve shareholder engagement in practice. policy on voting and voting disclosure to be included in - equity and in relation to their internal governance. To pre-empt use of the reserve power, the ISC “Statement of Principles” (June 2007) to require the SEC Rules (January 2003) require SEC-registered The ICGN published a statement of principles on The EC’s Corporate Governance Green Paper (April 2011) considered how to encourage shareholders to be 86 adopted January 2003). The SEC also proposed rules (October 2010) pursuant to the Dodd-Frank Act, that would require institutional investment managers with investment discretion over at least US$100 million in US public company equity and certain other securities to disclose at least once a year how they voted in the now required “say on pay” votes. The rules have not yet been adopted. SEC Rules (November 2003) require enhanced disclosure regarding shareholder communications with directors, including whether a company has a process Shareholder engagement the terms of engagement between institutional more active on corporate governance issues and to for communications by shareholders to directors and, if investors and their agents. ISC reclassified the take an interest in sustainable returns and longer-term not, why not, and disclosure of director attendance at Statement of Principles as a comply or explain Code performance. In particular, the EC indicated that it was annual meetings. Foreign private issuers (see Glossary) (November 2009). considering a framework requiring institutional investors are exempt from these rules. The principles set out in the Myners Report were reviewed by NAPF in 2007. NAPF’s recommendations (including that trustees should adopt or ensure their investment manager adopted the ISC Code) were endorsed by HM Treasury (October 2008). to publish their voting policies and records following widespread support for this in the responses to the Financial Institutions Green Paper. In addition, the EC sought comments on the following: - whether EU rules (e.g. on pension fund accounting) The FRC commissioned a review of shareholder contributed to inappropriate short-termism among engagement by the JCA Group. The review was carried investors out between January and March 2009 and suggested actions for companies and shareholders to take to improve 87 The SEC has adopted rules (January 2008) which promote the use of electronic shareholder forums by exempting solicitations in these forums from the proxy rules in certain circumstances (January 2008). Shareholder engagement Stewardship (continued) engagement. - incentive structures for, and performance evaluation The ISC published a statement (June 2009) on ways to of, asset managers improve institutional shareholders’ role in governance. Among other things, it called on the authorities to whether there should be greater disclosure of - whether there should be rules to prevent conflicts make it clear that there are no regulatory impediments of interest arising within asset managers or to to collective engagement. In response to this: enhance disclosure and management of conflicts of - interest the FSA confirmed (August 2009) that ad hoc discussions and understandings between - institutional shareholders do not contravene its rules. In particular, engaging collectively with the management of an investee company is not market through reform of EU laws on acting in concert) - - whether other legislative measures were necessary avoid disclosure of shareholdings could be market (e.g. restrictions on the ability of proxy advisers to abuse). Furthermore, ad hoc discussions between provide consulting services to investee companies) investors regarding particular issues will not trigger - whether there was a need for a European a requirement to aggregate shareholdings for the mechanism to help issuers identify their purposes of determining whether a disclosure shareholders in order to facilitate dialogue on threshold has been reached under DTR 5 or corporate governance issues. whether there has been a change of control of an FSA-authorised institution under FSMA - the role of proxy advisers and whether this needed to be made more transparent abuse (although dealing on the basis of knowledge of another party’s intentions or working jointly to ways to facilitate shareholder co-operation (e.g. In relation to companies with controlling or dominant shareholders, the EC sought comments on whether the Takeover Panel published a practice statement minority shareholders needed more protection against (September 2009) setting out the circumstances in related party transactions and referred to the statement which a mandatory offer may be triggered by by the European Corporate Governance Forum (March activist shareholders. It also explains why the 2011). The statement is similar in principle to the Takeover Code’s acting in concert provisions and related party provisions that apply to premium listed mandatory offer requirements should not constrain 88 Shareholder engagement Stewardship (continued) normal collective shareholder action. companies under the UK Listing Rules. Following the 2008 financial crisis, the Walker Report To help align the interests of shareholders and recommended that the FRC should assume companies in significant corporate transactions, the responsibility for stewardship from the ISC. The FRC European Corporate Governance Forum also published consulted on the form of a code (January 2010) and a statement (April 2011) recommending that all published the UK Stewardship Code and a note on acquisitions or disposals of businesses by a listed implementation (July 2010). The principles of the UK company representing 25% or more of assets or profits Stewardship Code are based on the ISC Code and state of that listed company should be submitted to that institutional investors should: shareholders for their prior approval before becoming - publicly disclose their policy on how they will discharge their stewardship responsibilities - have a robust policy on managing conflicts of interest in relation to stewardship which should be publicly disclosed - monitor their investee companies - establish clear guidelines on when and how they will escalate their activities as a method of protecting and enhancing shareholder value - - - effective. Alternatively, listed companies could obtain a blanket authority from their shareholders, provided this authority was renewed at least once every 12 months. The OECD published the following: - a report on the role of institutional investors in promoting good corporate governance. It included a detailed review of institutional investors in Australia, Chile and Germany (January 2012) - a report (April 2012) on related party transactions and the protection of minority shareholder rights in be willing to act collectively with other investors 31 jurisdictions. It also includes a detailed analysis where appropriate of the regulatory and legal systems in Belgium, have a clear policy on voting and disclosure of France, Italy, Israel and India. voting activity IOSCO published a report (June 2012) on the report periodically on their stewardship and voting development and regulation of institutional investors in activities. emerging markets. Also, as recommended by the Walker Report, the UK In the Company Law and Corporate Governance Action 89 Shareholder engagement Stewardship (continued) Stewardship Code is applied on a comply or explain Plan (December 2012), the EC indicates that it will basis. UK-authorised asset managers are required by propose an initiative in 2013 to improve the visibility of Rule 2.2.3 of the FSA’s Conduct of Business sourcebook shareholdings in Europe as part of its legislative work (effective from December 2010) to disclose on their programme in the field of securities law. It also website, or in other accessible form, the nature of their proposes to amend the Shareholder Rights Directive to: commitment to the UK Stewardship Code or, where they do not commit, to explain their alternative - engagement policies and voting records investment strategy. Details of all signatories to the UK Stewardship Code, - application and monitoring of the UK Stewardship Code improve shareholder control over related party transactions with links to their statements, are available on the FRC website. Additional information on the background, require institutional investors to disclose voting and - improve the transparency and the conflict of interest frameworks applicable to proxy advisers. is also available on the FRC website. By December 2012, Also, the EC plans to work closely with competent 259 asset managers, owners and service providers had national authorities and ESMA to develop guidance to signed up to the UK Stewardship Code. increase legal certainty as regards the relationship NAPF published guidance on how investors can apply between investor co-operation on corporate the UK Stewardship Code (November 2010). It also governance issues and the rules on acting in concert. published a guide (March 2011) to help pension funds develop and implement a stewardship policy based on the UK Stewardship Code. NAPF published its first Stewardship Policy (November 2012) setting out best practice for pension fund trustees and explaining how pension funds should fulfil their stewardship responsibilities. Shareholder engagement has also been considered by the Takeover Panel following concerns about institutional shareholders selling shares to short-term 90 Shareholder engagement Stewardship (continued) speculative investors during the Kraft bid for Cadbury in 2010. As part of its review of the UK takeovers regime, the Takeover Panel published a paper (June 2010) seeking comments on measures to give more say to long-term shareholders. These included withdrawing voting rights from offeree shares acquired during an offer period or giving enhanced voting rights on shares held for a specified period. None of these changes were included in the amendments to the City Code on Takeovers and Mergers that took effect in September 2011. Instead, to redress the balance between bidders and target companies, the Takeover Panel introduced rules that affect virtual bids (such as requiring potential offerors to be identified at the start of an offer period and fixing “put up and shut up” deadlines), prohibit deal protection measures, increase the quality of disclosure of certain information and provide greater recognition of the offeree company employees. The ICAEW published a report on activist shareholders (November 2011) and the implications for corporate governance. In response to concerns about the short-term focus of investors and directors, BIS commissioned (June 2011) Professor John Kay to conduct a review into investment in the UK equity markets. Following a call for evidence (September 2011) and an interim report (February 91 Shareholder engagement Stewardship (continued) 2012), Professor Kay published the Kay Report (July 2012). The Kay Report set out 10 principles for equity market participants, including institutional investors, and recommended: - the extension of the UK Stewardship Code to cover strategic issues as well as questions of corporate governance - the adoption by directors, asset managers and asset holders of good practice statements to promote stewardship and long-term decision making. However, no changes were recommended to directors’ duties under CA 06 - the establishment of an investors’ forum to facilitate collective engagement by investors in UK companies - that companies consult their major long-term investors over key board appointments - that the scale and effectiveness of merger activity of and by UK companies be kept “under careful review” by BIS and by companies themselves. However, the report did not recommend any formal national interest test or additional regulation of takeovers - the application by UK and EU regulatory authorities of fiduciary standards to all relationships in the investment chain which involve discretion over the 92 Shareholder engagement Stewardship (continued) investments of others, or advice on investment decisions - an investigation by the Law Commission into the legal concept of fiduciary duty as applied to investment to address uncertainties and misunderstandings on the part of trustees and their advisers - full disclosure by asset managers of all costs and performance fees charged to the fund - disclosure of all income from stock lending and the rebating of such income to investors - structuring asset managers’ remuneration to align the interests of asset managers with the interests and timescales of their clients. A long-term performance incentive should be provided in the form of an interest in the fund (either directly or via the firm) to be held at least until the manager is no longer responsible for that fund - exploration by the Government of ways individuals can hold shares directly in CREST. BIS published its response (November 2012) to the Kay Report. It endorsed the 10 principles for equity market participants set out in the Kay Report but recast the meaning of fiduciary standards to require equity participants to act in good faith, in the best long-term interests of their clients or beneficiaries and in line with 93 Shareholder engagement Stewardship (continued) generally prevailing standards of decent behaviour. It has asked the FSA and FRC to consider to what extent current regulatory rules align with this principle. Also, BIS has asked the Law Commission to conduct the investigation (as recommended by the Kay Report) into the fiduciary and other duties applicable to trustees and other investment intermediaries. BIS has added two of the Kay Report recommendations to the good practice statement for directors to give them greater emphasis: - companies should consult their shareholders in advance of making major appointments to the board - whilst not detracting from the obligation of companies to meet their obligations to disclose regulated information, companies should seek to disengage from the process of managing shortterm earnings expectations and announcements. This is intended to help shift the focus of investors onto the fundamentals of the company and its long-term strategy. BIS intends to publish a progress report in summer 2014 setting out whether Professor Kay’s recommendations have been achieved and what further action may be necessary. The Ownership Commission, an independent body endorsed by the former Labour Government and 94 Shareholder engagement Stewardship (continued) supported by the Co-operative Group, published a report (March 2012) on ways to deliver better longterm “stewardship-orientated” ownership. It made a number of detailed recommendations, including: - giving tax relief to equity finance to even out the tax advantages given to debt - widening directors’ fiduciary duties so that directors owe a “duty of stewardship”. The fiduciary duties of institutional investors should also include stewardship responsibilities - greater transparency in the behaviour of institutional shareholders in an offer period. Also, directors should be able legally to act with discretion as to the interests of the company, and their judgements and recommendations protected by a safe harbour provision. Fair Pensions, a charity which campaigns for responsible investment, published a report on the enlightened shareholder (March 2012). This called for a clarification of investors’ duties to the people whose money they manage in order to overcome narrow interpretations of the law based on maximising short-term returns and refocus it on sustainable wealth creation. The 2020 Investor Stewardship Working Party (a group of six institutional investors supported by Tomorrow’s Company, a think tank) published 2020 Stewardship Improving the Quality of Investor Stewardship (March 95 Shareholder engagement Stewardship (continued) 2012), containing recommendations for improving engagement practices. This followed a number of discussions with company chairmen who spoke about the shortcomings in investor engagement. In response to a request from the 2020 Investor Stewardship Working Party, ICSA published a consultation paper on improving engagement practices between companies and institutional investors (October 2012). The consultation paper sought views on a list of practical measures designed to make meetings more productive, including: - whether the nature of the discussion between a company and its institutional investors needed to change, with more emphasis on dialogue which builds and encourages a long-term relationship with the company - the improvements that could be made to the process of conducting engagement meetings - whether companies and institutional investors should seek feedback on the quality of engagement meetings and how that might achieved. The FRC published (September 2012) amendments to the UK Stewardship Code. The amendments: - clarify the meaning of stewardship and the respective responsibilities of asset owners and asset 96 Shareholder engagement Stewardship (continued) managers - require signatories to review their policy statements annually, update them as necessary and indicate the date of their last review - encourage more informative disclosure on conflicts of interest - remove the inference that institutions should not become insiders by stating that institutional investors “may or may not want to be made insiders”. Institutional investors that wish to become insiders should indicate their willingness to do this and the mechanism by which this could be done in their stewardship statement - encourage more informative disclosure about when an investor might participate in collective engagement - require institutional investors to disclose the use they make of proxy voting or other voting advisory services, describing the scope of such activities and identifying the providers. They should also disclose the extent to which they use, rely on and follow the recommendations of proxy advisers - require signatories to disclose their stock lending policy and whether they recall lent stock for voting purposes - require asset managers to obtain an assurance 97 Shareholder engagement Stewardship (continued) report. The FRC’s Developments in Corporate Governance 2012 (December 2012) confirms that the FRC will monitor the impact of changes to the UK Stewardship Code on the quality of engagement. It identifies four factors that could lead to improvements in stewardship: - a more pro-active approach by asset holders in setting investment mandates - more involvement from overseas long-term holders of UK shares e.g. by means of an investor forum - the development of investors’ engagement skills - increasing the reliability of the voting chain. In relation to the latter, the FRC plans to meet with market participants in the first quarter of 2013 to debate voting by investors in pooled funds and will consider whether to address the issue in a future edition of the UK Stewardship Code. The FRC also hopes action by the EC to improve visibility of shareholdings of listed companies and revisit shareholder identification more generally will improve the operation of the voting chain. 98 Corporate reporting Recent developments The DTR require UK-incorporated issuers of shares (and TOD requires issuers with securities traded on a The Dodd-Frank Act exempts issuers with a market other issuers where the UK is the “home state”) to regulated market to publish annual and half-yearly capitalisation of less than US$75 million from the publish annual and half-yearly reports and an interim reports and an interim management statement within internal control reporting requirements of SOX § 404. management statement within each half-year period. each half-year period. Pursuant to the Dodd-Frank Act, the SEC also issued a The Companies and Limited Liability Partnerships ESMA published (April 2012) Frequently Asked (Accounts and Audit Exemptions and Change of Questions on TOD. They confirm that additional Accounting Framework) Regulations 2012 exempt a information in annual and half-yearly financial reports subsidiary from statutory audit if its parent company (beyond the minimum requirements) is permitted and guarantees its debt and the shareholders unanimously discuss the requirement to make regulated information declare each year to dispense with the audit. The public. subsidiary must be unlisted and may not be in the banking or insurance sectors and the parent company must be incorporated in the EU. The subsidiary must still be included in the consolidated accounts of the parent company. The exemption takes effect for accounting years ending on or after 1 October 2012. CESR published a consultation on pan-European access to financial information (July 2010). This addresses the requirements of SOX § 404, see Risk management and control above. Glossary) to present just two years (rather than three) of information as mandated by TOD. audited financial statements and just two years (rather same date if the same conditions are met. particularly annual reports (February 2010). The principles also cover the timeliness of disclosures, disclosure criteria and the storage of information. (July 2012) recommended that: Following a review of TOD, the EC published: - - a report (December 2008) on the measures being process of managing short-term earnings adopted by Member States that are more stringent expectations and announcements than TOD (a minimum harmonisation directive) interim management statements should be SOX § 404(b) requirements for such companies. mechanisms for the central storage of regulated periodic disclosure by listed entities in periodic reports, - million, which recommends maintaining the existing The JOBS Act allows an emerging growth company (see the requirement to file accounts with effect from the companies should seek to disengage from the market capitalisation is between US$75 and US$250 development of the network of officially appointed IOSCO published a final report on the principles for focusing on short-term information, the Kay Report of complying with SOX § 404(b) for companies whose For further information on the internal control reporting The Regulations also exempt dormant companies from As part of the effort to stop companies and investors study (April 2011) regarding how to reduce the burden - an external study on the application of TOD 99 than five) of selected financial information in its IPO registration statement and exempts such companies from the SOX § 404(b) auditor attestation report requirement for up to five years after IPO. Corporate reporting abolished. Under BIS’ narrative reporting proposals (October 2012), (December 2009) - a consultation and report on the operation of TOD the strategic report will replace the summary financial together with a staff working document on issues statement that companies may provide to shareholders emerging from the review (May 2010). under certain conditions instead of the annual report and accounts. See Narrative reporting below. The FRRP’s annual report (September 2012) notes that the issues raised in half-yearly reports were not of such In the TOD Amendment Directive (October 2011) the EC proposes: - reduce the administrative burden of publishing substance to justify an approach to the companies quarterly information, especially for smaller listed concerned. It does, however, recommend a number of companies actions for companies to consider in their next halfyearly to abolish interim management statements to - additional disclosure requirements for listed 100 Corporate reporting Recent developments (continued) reports, given prevailing economic uncertainty: - undertakings active in the extractive and logging of primary forest industries (and, if amended as boards should review assets and liabilities for proposed by the European Parliament’s Legal indications of significant impairment since the end Affairs Committee, the banking, telecoms and of the previous financial year. One possible trigger construction industries) - see Corporate social is a reduction in the company’s market responsibility below capitalisation to a level significantly below the amounts at which its assets and liabilities are stated - in its accounts - including standard forms or templates in relation to management reports, to reduce the administrative companies for whom funding is a challenge should burden and to ensure the comparability of reconsider the disclosures provided in their year- information end accounts and update them where appropriate to reflect the current position at the half-year stage - to require ESMA to issue non-binding guidelines, - to take powers to specify minimum standards for the dissemination of regulated information, access boards should refer to the FRC’s Update for to regulated information at EU level and central Directors, Country and Currency Risk – Interim storage mechanisms (since the network of national Reports (June 2012) for points to consider in storage mechanisms mandated by TOD does not respect of heightened country and currency risk. allow easy access to information). The EC published the Accounting Directive (October 2011). The main purpose of the Accounting Directive is to simplify the preparation of financial statements for smaller companies but it also proposes: - additional disclosure requirements for large unlisted undertakings active in the extractive or logging of primary forest industries (and, if amended as proposed by the European Parliament’s Legal Affairs Committee, the banking, telecoms and construction industries) - see Corporate social 101 Corporate reporting Recent developments (continued) responsibility below - measures to make the rules on financial statements clearer for all companies (e.g. by merging the Fourth and Seventh Directives, updating the language and removing the overlap between the two Directives). The Council of the European Union agreed (July 2012) the general approach of the Accounting Directive. Under the Company Law and Corporate Governance Action Plan, the EC plans to publish proposals in 2013 to require companies to disclose additional nonfinancial information. 102 Corporate reporting Narrative reporting Section 417 CA 06 requires companies to include a The Modernisation Directive requires large and Registration statements and annual reports (Form 20-F business review in the directors’ report. This is a medium-sized companies to provide an analysis of the for most non-US companies) are required to include a requirement of the Modernisation Directive. The development and performance of their business in “Management’s Discussion and Analysis of Financial business review must, to the extent necessary for an their annual reports, describing the principal risks and Condition and Results of Operations” (“MD&A”) or understanding of the development, performance or uncertainties they face and providing financial and “Operating and Financial Review and Prospects” (“OFR”). position of the business of the company, include an non-financial performance indicators such as Management discusses the company’s “financial analysis using financial and, where appropriate, other environmental and employee information. Member condition, changes in financial condition and results of key performance indicators, including information States may exempt medium-sized companies from operations” for the historical period covered by the relating to environmental and employee matters, with certain non-financial requirements. financial statements and gives its assessment of factors, the depth of analysis required being proportionate to the size and complexity of the business. IOSCO published a report (February 2003), “General Principles Regarding Disclosure of Management’s trends and uncertainties which are anticipated to have a material effect. BIS published guidance (December 2005) on the Discussion and Analysis of Financial Condition and Additional disclosure regarding liquidity and capital requirements for the directors’ report. This endorses Results of Operations”. resources and critical accounting policies and estimates guidance on non-financial matters, including: - - - CESR published (October 2005) a recommendation on is typically included (SEC Rules proposed May 2002 and interpretive guidance issued December 2003). the report of the Accounting for People Task Force the best way to use and present alternative on measuring and evaluating the workforce performance measures, i.e. financial data which is not Rules promulgated under SOX require disclosure of non- (October 2003) extracted or cannot be derived from the statutory GAAP financial information (SEC Rules adopted January audited financial statements. 2003) and off-balance sheet arrangements (SOX § 401) Environmental Reporting Guidelines – Key (SEC Rules adopted January 2003). Performance Indicators published by DEFRA and The ICGN published guidance on non-financial Trucost (January 2006) but currently being updated. business reporting (December 2008). This sets out The SEC adopted rules (July 2006) requiring companies See DEFRA’s consultation (July 2012) disclosure criteria that will assist companies in meeting to provide a narrative explanation of the objectives and the expectations of investors. It also aims to generate implementation of an issuer’s executive compensation substantive dialogue between investors and company programme. See Regulation S-K under Remuneration - boards about the content and timing of non-financial current regime affecting listed companies above. the ASB’s Reporting Statement setting out best practice for a voluntary operating and financial review (January 2006). Section 417(5) of CA 06 contains an additional requirement for directors of quoted companies (see business reporting. The SEC proposed amendments (September 2010) (not The Climate Disclosure Standards Board published a yet adopted) to require SEC-registered companies, framework on how companies can report climate including non-US companies, to make more extensive 103 Corporate reporting Glossary) to include an “enhanced” business review in the directors’ report. They must disclose, to the extent necessary for an understanding of the development, performance or position of the company’s business, information covering: change in their annual reports (September 2010). The IASB published (December 2010) a practice statement setting out a broad, non-binding framework for the presentation of narrative reporting to accompany financial statements prepared in disclosures regarding their short-term borrowings in order to provide investors with a more accurate picture of their financing activities. The SEC’s current MD&A rules already require companies to disclose their use of short-term borrowing arrangements and their exposure to related risks and uncertainties, but do not specifically - future developments accordance with IFRS. - environmental, employee and social policies Following its questionnaire on country-by-country to disclose information about intra-period short-term reporting by multinational enterprises (October 2010), borrowings. The proposed amendments would require the EC published (October 2011) the TOD Amendment To prevent defensive disclosures and encourage useful disclosure of, among other things, the maximum daily Directive and the Accounting Directive. These contain narrative reporting, CA 06 introduced a new regime amount of each specified category of short-term proposals to require listed and large unlisted borrowings during the reporting period (financial undertakings active in the extractive or logging of companies only) or the maximum month- - essential contractual arrangements. require companies other than bank holding companies primary forest 104 Corporate reporting Narrative reporting (continued) defining the extent of liability for financial reporting industries (and, if amended as proposed by the end amount of each specified category of short-term disclosures, including the “enhanced” business review. European Parliament’s Legal Affairs Committee, the borrowings during the reporting period (all other See Liability for reports and other statements below. banking, telecoms and construction industries) to report companies). At the same time, the SEC also issued annually on all material payments to governments on a interpretive guidance intended to make clear that country-by-country basis and by project - see companies may not use financing structures to mask Corporate social responsibility below. their financial condition. 2012), BIS published (October 2012) draft regulations to The TOD Amendment Directive (October 2011) also Pursuant to the Dodd-Frank Act, the SEC has adopted amend CA 06 to require companies to prepare a contains proposals to require ESMA to issue non- rules that would require SEC-reporting companies to strategic report instead of a business review. binding guidelines, including standard forms or make certain disclosures relating to the use of certain templates in relation to management reports to reduce minerals financing conflict in the Democratic Republic the administrative burden for listed SMEs and ensure of the Congo and adjoining countries (August 2012), the comparability of information. mine safety (December 2011) and payments made by Following two consultations (August 2010 and September 2011) on ways to improve the quality of narrative reporting and a response statement (March The requirements applicable to the strategic report largely replicate the business review except that quoted companies (see Glossary) will also have to include, to the extent necessary for an understanding of the The EC published a questionnaire (November 2010) development, performance or position of their business: seeking comments on whether changes were needed to - information about human rights alongside social and community issues - a breakdown of the number of persons of each sex who are directors, managers and employees of the company. Managers are defined as persons (other than directors) who are employees and have responsibility for planning, directing or controlling the activities of the company. There is also a requirement for quoted companies (see Glossary) to describe their business model and strategy. This makes mandatory the UK Corporate Governance Code provision that applies to premium listed resource extraction issuers to governments (August 2012). See Corporate social responsibility below. the EU’s rules on companies’ disclosure of non-financial The SEC has also issued guidance (October 2011) on information. It published a summary of the responses disclosure obligations relating to cybersecurity risks and (April 2011). incidents. The purpose of the guidance is to assist The Corporate Governance Green Paper (April 2011) sought views on whether the board should be required to report the company’s risk appetite “meaningfully” for shareholders. It also asked whether risk disclosure should extend to “societal risks”, meaning risks that affect society as a whole. registrants in assessing what disclosures, if any, they should provide about cybersecurity matters in light of each issuer’s specific facts and circumstances. According to the guidance, although no existing disclosure requirement explicitly refers to cybersecurity risks and cyber incidents, a number of disclosure requirements (including the risk factors, MD&A, description of Disclosure of non-financial information is part of the business, legal proceedings, financial statements and EC’s agenda for a renewed CSR strategy as set out in its disclosure controls and procedures sections) may Communication on CSR (October 2011). See Corporate impose an obligation on registrants to disclose such 105 Corporate reporting Narrative reporting (continued) companies on a comply or explain basis. social responsibility below. risks and incidents. The strategic report will replace the summary financial The Company Law and Corporate Governance Action The SEC has also issued guidance (January 2012) statement that companies may provide to shareholders Plan (December 2012) states that the EC will make a regarding disclosure relating to registrants’ exposures under certain conditions instead of the annual report proposal in 2013 to strengthen disclosure requirements to European sovereign debt. The guidance states that and accounts. in relation to risk management, diversity and other non- registrants should consider the following in drafting financial information by means of an amendment to the their disclosure: To offset the additional disclosures in the strategic report, the requirement for quoted companies (see Glossary) to report on their essential contractual arrangements in the strategic report and for companies to include information in relation to asset values, charitable donations, creditor payment policies and information on purchases by private companies of own Fourth and Seventh Directives. The disclosure requirements in relation to non-financial information - counterparty, categories of financial instruments are expected to cover similar ground to the BIS proposals for the strategic report (environment, - - - The following proposals contained in BIS’ earlier - requiring companies to publish an annual directors’ other risk management disclosure – how management is monitoring and/or mitigating statement in a prescribed format exposures, impact of current developments in splitting information on remuneration between the identified countries strategic report and annual directors’ statement. BIS - effects of credit default protection to arrive at net exposure – by counterparty and country consultation (September 2011) have been dropped: - total gross exposure (funded and unfunded) – by counterparty and country shares in the directors’ report, will be removed. - unfunded exposure – by counterparty and country, key terms employees, human rights) but with additional disclosures on anti-bribery procedures. gross funded exposure – by country, type of has now decided to keep the remuneration report - as a separate document because of its shareholder In determining which countries are covered by this voting proposals (see Remuneration – proposals guidance, registrants should focus on those affecting listed companies above) experiencing significant economic, fiscal and/or political the auditors’ confirmation that nothing had come strains such that the likelihood of default would be to their attention that was inconsistent with the higher than would be anticipated when such factors do report. Instead, the strategic report will be reviewed not exist. The guidance states that disclosures should 106 post-reporting date events. Corporate reporting Narrative reporting (continued) - - by auditors for consistency in the same way that be provided separately by country, segregated between the directors’ report is reviewed for consistency sovereign and non-sovereign exposures, and by with financial statements financial statement category, to arrive at gross funded exposure, as appropriate. the introduction of a statutory standard or independent assurance on narrative information. The JOBS Act allows an emerging growth company (see Instead, BIS has asked the FRC to provide guidance Glossary) to present just two years (rather than three) of on the strategic report to replace the ASB reporting audited financial statements and just two years (rather statement on the operating and financial review than five) of selected financial information in its IPO (January 2006) registration statement. The MD&A only needs to cover the audited financial statements presented. the proposal for the strategic report to be signed by each individual director. President Obama signed into law the Iran Threat Reduction and Syria Human Rights Act of 2012 (August BIS proposes to bring the changes into force for 2012). Among other things, this makes US firms liable financial years ending on or after 1 October 2013. for their foreign subsidiaries’ involvement in DEFRA published a consultation (July 2012) on draft sanctionable activity in Iran and subjects corporate regulations to require quoted companies (see Glossary) officers to liability as well. It also imposes requirements to report on greenhouse gas emissions. These are for the reporting of certain Iran-related dealings on expected to take effect for financial years ending on or companies that filed periodic reports under Section after 1 October 2013 in line with BIS’ proposals. See 13(a) of the Exchange Act, including with respect to the Corporate social responsibility below for more detail. Iran-related dealings of US parents’ foreign subsidiaries. The FRC has also been considering how companies can improve the way they report to shareholders. It launched a project (July 2010) to examine the lessons to be learned from the credit crisis and other market developments as they affect corporate reporting, accounting and auditing of non-financial services companies. This was followed by its effective company stewardship project (January 2011) to improve 107 Corporate reporting Narrative reporting (continued) corporate reporting and audit, its cutting clutter initiative, Lord Sharman’s inquiry into going concern assessments (March 2011) and the launch of the Financial Reporting Lab (October 2011). In light of findings from the effective company stewardship project (January 2011), the FRC published changes to the UK Corporate Governance Code and its Guidance for Audit Committees (September 2012). The changes include a new provision requiring the board to confirm that the annual report and accounts taken as a whole is fair, balanced and understandable and provide the information necessary for shareholders to assess the company’s performance, business model and strategy. There is also a new supporting principle requiring the board to establish arrangements to enable it to be in a position to provide this confirmation. Other changes to the UK Corporate Governance Code are discussed in Corporate governance codes - general provisions and guidance and in Audit committees – role above and in Audit quality below. In relation to cutting clutter, the FRC published (October 2011) a discussion paper, “Thinking about disclosures in a broader context: a road map for a disclosure framework”. This aims to improve the quality of information disclosed in annual reports as a whole, not just in financial statements, and to curtail a piecemeal approach to reporting. Among other things, 108 Corporate reporting Narrative reporting (continued) the FRC seeks views on common themes for the information users may need and principles for good communication and calls for the development of placement criteria and guidance on materiality to reduce duplication and cut clutter. In relation to going concern assessments, Lord Sharman’s panel of inquiry published a final report (June 2012) recommending that the FRC should: - review the FRC Guidance on Going Concern (October 2009) to ensure that the going concern assessment is integrated within directors’ business planning and risk management processes - ensure that the directors’ discussion of strategy and principal risks always includes the directors’ going concern statement - work with international standard setters to harmonise the different descriptions of going concern in international accounting and auditing standards and to agree a common international understanding of the purposes of the going concern assessment - liaise with the UKLA to ensure consistency between the going concern disclosures in the UK Corporate Governance Code and the Listing Rules - take a more systematic approach to learning lessons when significant companies fail or suffer 109 Corporate reporting Narrative reporting (continued) significant financial or economic distress but nonetheless survive. The FRC published a consultation paper (January 2013) proposing new guidance for directors on going concern assessments to implement Lord Sharman’s recommendations. According to the guidance: - the directors’ going concern assessment should be integrated into the company’s processes for setting strategy, risk management and business planning - the directors should cover not just liquidity and solvency over the next 12 months but also the sustainability of the business model over both the economic cycle and the company’s own business cycle - the directors should confirm in the annual report that they undertook a robust going concern assessment and should refer to the significant solvency and liquidity risks that they considered and indicate how they are being addressed. This should form part of the discussion of the company’s principal risks in the business review. In addition to these revisions, the FRC proposes to issue supplementary guidance to address going concern risks for banks and amendments to audit standards to provide for an enhanced role for the auditor in relation to going concern assessments. 110 Corporate reporting Narrative reporting (continued) For more information in relation to audit standards, see Audit quality below. These amendments are expected to take effect for financial years commencing on or after 1 October 2012. For other developments in relation to the reporting of risk, including the FRC’s recommendations in relation to the reporting of country and currency risk, see Risk management and control above. 111 Corporate reporting Liability for reports and other statements DTR 4.1 and 4.2 implement TOD and require the annual TOD requires issuers to publish annual reports, half- Under US law, directors can be held liable to purchasers and half-yearly financial report to contain responsibility yearly reports and interim management statements with of securities based on allegations of material statements by persons responsible within the issuer. the objective of allowing investors to make an informed misstatements in, or material omissions from, assessment of an issuer’s position and to increase information provided to investors (including, but not investor protection in the EU. Such reports and limited to, a prospectus). Concerns that responsibility statements and the implementation of TOD would overturn existing principles of English law and make directors liable not just to shareholders but also to investors led to the inclusion of a new liability regime for financial reporting disclosures in CA 06 and FSMA: statements must be made generally available throughout the EU and a statement of responsibility must be given by persons responsible in the annual and half-yearly reports. Member States must impose liability on at least the issuer or the directors but they may Section 463 CA 06 provides that directors are liable, but determine the extent of the liability. TOD has been only to their company, in respect of an untrue or implemented in the UK by CA 06, FSMA and the DTR. misleading statement in, or omission from, the annual directors’ report if they knew or were reckless as to whether the statement was misleading or knew the omission to be a dishonest concealment of a material fact. An issuer of securities is strictly liable for material misstatements or omissions in a registration statement (which includes the prospectus) declared effective by the SEC. In such filings, directors can assert a “due diligence” defence based on the directors’ reasonable investigation and care with respect to the relevant statements. In a leading case on the availability of the The Fourth and Seventh Amendment Directive confirms due diligence defence, the court held that, although the collective duty and liability of board members directors are not required to conduct an independent towards the company for the financial and other key audit, they must read the registration statement and information that they publish in their annual report and make an independent investigation of the material facts accounts. It also requires Member States to have contained in it. Section 90A and Schedule 10A FSMA (as amended appropriate sanctions and liability rules for failure to following a review and report by Professor Paul Davies comply with accounting rules. The Directive applies to (March and June 2007, respectively) and a consultation all types of companies incorporated in the EU, not just by HM Treasury (July 2008)) impose statutory liability listed ones. Projections and other forward-looking information that are within a securities law “safe harbour” will not subject a director to liability if a prediction of financial results or future conditions fails to materialise, so long on listed issuers to compensate buyers, sellers or as the projections are accompanied by meaningful holders of their securities who suffer loss as a result of cautionary language. (i) misleading statements or dishonest omissions in information published via a Regulatory Information Service or (ii) dishonest delay in publishing such information. However, issuers are only liable for misleading statements or omissions if a director knew 112 Corporate reporting Narrative reporting (continued) or was reckless as to whether the statement was untrue or misleading or knew the omission to be a dishonest concealment of a material fact. The regime exempts issuers and their directors from any other liability relating to such information (but without prejudice to the regulatory powers of the FSA or any criminal sanctions which may be imposed). The liability regime is designed to protect directors and issuers from liability unless the directors are reckless or fraudulent, in order to ensure that directors are not necessarily deterred by fears of liability from making useful and, in particular, forward-looking disclosures. In its consultation on narrative reporting (September 2011), 113 Corporate reporting Liability for reports and other statements (continued) BIS noted the reluctance of directors to make forwardlooking statements and sought views on what could be done to encourage fuller and more meaningful disclosure and on how best to promote understanding of the protection provided by the UK’s liability regime. The requirements of the Fourth and Seventh Amendment Directive in relation to the collective responsibility of the directors for reports and accounts are reflected in CA 06. The UK Corporate Governance Code contains a new provision requiring the board to confirm that the annual report and accounts taken as a whole are fair, balanced and understandable and provide the information necessary for shareholders to assess the company’s performance, business model and strategy. There is also a new supporting principle requiring the board to establish arrangements to enable it to be in a position to provide this confirmation. The LR and DTR already require issuers to take reasonable care to ensure that information notified to a Regulatory Information Service is not misleading and omits nothing that would affect the import of the information. As such, the board’s confirmation arguably does not place additional obligations on boards, but boards may wish to review their processes for reviewing and approving the annual report and accounts. 114 Corporate reporting Liability for reports and other statements (continued) Confirmation as to adequacy of accounting systems For financial years commencing on or after 21 July 2009, Section 93 and Schedule 46 of the Finance Act 2009 require “senior accounting officers” of “qualifying companies” to take reasonable steps to establish and monitor accounting systems that are adequate for the purposes of accurate tax reporting. The senior accounting officer must also certify this annually to HMRC or alternatively specify any inadequacies in the system. The “senior accounting officer” is the director or officer of the company who has overall responsibility for the company’s financial accounting arrangements, and a “qualifying company” means a UK company that individually or when its results are aggregated with UK companies in the same group had a turnover of more than £200 million or a balance sheet total of £2 billion in the previous financial year. In the event of failure to take reasonable steps or to provide a certificate, the senior accounting officer is liable to a penalty of £5,000. The company is also liable to a penalty of £5,000 if it fails to notify HMRC of the identity of the senior accounting officer. HMRC updated its guidance in relation to the new duties of senior accounting officers (June 2012). 115 Corporate social responsibility Corporate social responsibility CA 06 introduced CSR into the statutory framework: - directors are required to have regard to factors such as employees, suppliers, customers and the impact of the company’s operations on the community and the environment (Section 172 CA 06) - The EC Communication (July 2002) sets out key Both the NYSE Rules and the Nasdaq Rules require principles and a strategy for the promotion of CSR in companies to adopt codes of business conduct and the EU. The EC launched the European Multi- ethics. The NYSE amended its rules (January 2010) to stakeholder Forum on CSR in October 2002 to bring require a listed company to disclose any waiver of its together companies and other stakeholders to business code of ethics granted to executive officers or exchange good practice and assess the appropriateness directors within four business days. Nasdaq amended of establishing common guiding principles. The EC its rules (July 2010) to permit the disclosure of waivers business reviews of quoted companies (see hosts plenary meetings of the European Multi- of a company’s code of conduct to be made on or Glossary) must include details of policies on stakeholder Forum on CSR periodically. The last through a listed company’s website or, in certain employees, the environment and social and meeting was in November 2010. circumstances, through a press release. The Modernisation Directive (June 2003) requires large The SEC published an interpretive release (February community issues and report on their effectiveness (Section 417(5) CA 06) and medium-sized companies to provide an analysis of 2010) which, while not amending existing disclosure the stated purpose of the business review (for all the development and performance of their business in rules, is clearly intended to encourage greater climate companies) is to help members assess how the their annual reports, describing the principal risks and change-related disclosure. The guidance describes four directors have performed their duty under Section uncertainties they face and providing financial and non- topics as examples of climate change-related issues that 172 of CA 06 (Section 417(5) CA 06). financial performance indicators, such as environmental an issuer, including a foreign private issuer (see These requirements provide the directors with an and employee information. Member States may exempt Glossary), may need to consider under existing SEC annual opportunity to demonstrate that they are medium-sized companies from certain non-financial disclosure rules: performing their duties. Whilst the review may be requirements. scrutinised by non-governmental organisations, activist The EC’s Communication (March 2006) announced the shareholders and others with an interest in looking for launch of a “European Alliance” to encourage the failings in directors’ strategy or policies and, potentially, European business community to increase its evidence to make a derivative claim, no derivative commitment to CSR. The European Alliance published a claims based on CSR issues have been made to date. toolbox for a competitive and responsible Europe Instead, activist shareholders have sought to highlight (December 2008). - concerns by tabling resolutions at general meetings and have referred two listed companies to the FRRP for the - the impact of legislation and regulation - international accords - indirect consequences of regulation or business trends - the physical impacts of climate change. Recently, public companies have also seen a In the Europe 2020 Strategy (adopted March 2010), the significantly higher number of activist shareholder EC made a commitment to “renew the EU strategy to resolutions seeking greater disclosure regarding 116 Corporate social responsibility environmental disclosures in their business reviews. promote CSR as a key element in ensuring long-term companies’ financial exposure and response strategies Both cases have now been concluded. employee and consumer trust”. to climate-related business trends. The Corporate Responsibility Coalition, a group of more The EC’s communication, “Towards a Single Market Act. Pursuant to the Dodd-Frank Act, the SEC has adopted than 130 civil rights charities and campaigning For a highly competitive social market economy” rules that require SEC-reporting companies to make organisations, published a campaigner’s guide to CA 06 (October 2010), also stresses the importance of building certain disclosures relating to the use of certain (September 2007) and guidance for directors on CA 06 consumer trust and confidence and achieving a minerals financing conflict in the Democratic Republic (October 2007). competitive social market economy with sustainable of the Congo and adjoining countries (August 2012), economic growth. Improved disclosure, particularly in mine safety (December 2011) and payments made by the areas of the environment, human rights and resource extraction issuers to governments (August sustainable development, has a role to play in achieving 2012). BIS published a corporate responsibility report (February 2009). This considers developments since 2004 and highlights relevant activity across government departments. A note was added to Rule 25.2 of the Takeover Code (September 2011) to clarify that board of an offeree company is not required to consider the offer price as the these aims. The first reporting period for the conflicts minerals rules The Corporate Governance Green Paper (April 2011) covers 1 January 2013 to 31 December 2013. The first sought views on whether to require directors to report must be filed on or before 31 May 2014. The disclose societal risks, meaning risks that affect society mine safety regulations took effect on 27 January 2012. as a whole, The 117 Corporate social responsibility Corporate social responsibility (continued) determining factor when recommending or opining on such as risks relating to climate change, environment, resource extraction rules take effect for fiscal years an offer and is not precluded from taking into account health and safety and human rights. ending after 30 September 2013, with a partial report any other factors which it considers relevant. G8 governments at the Deauville summit (May 2011) permitted if the company’s fiscal year began before 30 September 2013. Following two consultations (August 2010 and pledged “to setting in place transparency laws and September 2011) on ways to improve the quality of regulations or to promoting voluntary standards that The disclosure requirements relating to mine safety and narrative reporting and a response statement (March require or encourage oil, gas, and mining companies to payments by resource extraction issuers are limited, 2012), BIS published (October 2012) draft regulations to disclose the payments they make to governments”. respectively, to companies that operate or have amend CA 06 to require companies to prepare a strategic report instead of a business review. The requirements applicable to the strategic report are largely the same as the business review except that Following its questionnaire on country-by-country reporting by multinational enterprises (October 2010) and in light of the Deauville pledge, the EC published subsidiaries that operate coal or other mines, and to companies engaged in the commercial development of oil, natural gas, or minerals. (October 2011) the TOD Amendment Directive and the The disclosure rules relating to conflict minerals, Accounting Directive. These contain proposals to however, have potentially far wider effect, as the require listed and large unlisted undertakings active in conflict minerals at issue are used in many common the extractive or logging of primary forest industries to products, such as mobile telephones, computers, digital report annually on all material payments to cameras, jewellery, jet engine components and a governments on a country-by-country basis and by number of electronic components, and the proposed Disclosure requirements have also been imposed on project (to the extent payments are allocated to specific conflict minerals rules do not contain any materiality investors. The Occupational Pension Schemes projects). The intention is to capture payments threshold. The rule requires any SEC-reporting issuer for (Investment) Regulations 2005 require trustees of comparable to those disclosed in an undertaking whom conflict minerals are necessary to the pension schemes to disclose in their Statement of participating in the Extractive Industries Transparency functionality or production of a product manufactured Investment Principles the extent to which they take Initiative and to improve accountability and governance or contracted to be manufactured by the issuer to social, ethical or environmental issues into account in in resource-rich countries. The EC’s proposals are similar conduct a reasonable country of origin inquiry and their investment decisions. to those contained in the Dodd-Frank Act except that make certain disclosures regarding the conflict minerals. (i) they also apply to large unlisted companies and to If the conflict minerals originated in the Democratic companies in the forestry sector and (ii) there are no Republic of the Congo or an adjoining country, then requirements to disclose conflict minerals. the issuer must conduct due diligence in accordance quoted companies (see Glossary) will also be required to include information on human rights, to the extent necessary for an understanding of the development, performance or position of their business. See Narrative reporting above for details of BIS’ proposals. The NAPF’s Responsible Investment Guide (March 2009) is designed to assist investors, especially pension funds, in developing policies. It recommends that funds should give careful consideration to the extent to which they The Legal Affairs Committee of the European 118 with a nationally or internationally recognised due Corporate social responsibility Corporate social responsibility (continued) wish managers to take responsible investment issues Parliament voted (September 2012) to extend these diligence framework (such as the OECD’s due diligence into account when implementing their investment reporting requirements to the banking, telecoms and guidance for responsible supply chains of minerals from policies and reporting on them. construction sectors. conflict-affected and high-risk areas) and submit an Companies have published CSR reports on a voluntary The EC also published a study on sustainability basis for a number of years, encouraged by guidelines reporting in the EU (January 2011). The study looked at such as: how companies report the challenges they face, Lawsuits have been filed to overturn the conflict whether their reporting met investors’ needs and what minerals and resource extraction payments disclosure public policy instruments are available to stimulate rules, but no substantive rulings have been made in the reporting. cases yet, and the SEC has rejected a motion to delay - Business in the Community’s “Indicators that count”, a report on indicators found useful and measurable as a starting point for measuring and reporting - - social and environmental impact (July 2003) and a The EC published a Call for Proposals (spring 2011) to Guidance Note on Corporate Responsibility build the capacity of investors to integrate Reporting (updated May 2009) environmental, social and governance information in Environmental Reporting Guidelines – Key Performance Indicators published by DEFRA and The EC published a Communication on CSR (October Trucost (January 2006). These are currently being 2011) which sets out the EC’s agenda for the period updated - see DEFRA’s consultation (July 2012) 2011-2014. In particular, the EC intends to: PIRC (an independent consultant to institutional - monitor the commitments made by large European investors) includes guidelines on sustainability and enterprises (with over 1,000 employees) to take non-financial reporting in its annual Shareowner account of internationally recognised guidelines. Voting Guidelines. Disclosure of environmental and This is part of the EC’s plan to improve the social performance is a key element of PIRC’s alignment of European and global approaches to voting recommendations and PIRC expects up-to- CSR date environmental, social and governance disclosure for all FTSE 350 companies - their valuation of enterprises. - introduce a legislative proposal to improve company disclosure of social and environmental the ABI’s Guidelines on Responsible Investment information following its questionnaire on non- Disclosure (January 2007). The guidelines call on financial reporting (November 2010). boards to confirm they have reviewed and are 119 audited report to the SEC describing, among other things, the due diligence measures taken. the effective date of the resource extraction payments disclosure rule. Corporate social responsibility Corporate social responsibility (continued) managing risks and opportunities and encourage The Communication on CSR marks a more assertive boards to take a more integrated approach to risks approach to CSR by the EC. It includes a new, clearer, and opportunities and to move away from an definition, defining CSR as “the responsibility of emphasis on purely social, environmental and enterprises for their impacts on society”. The previous ethical issues. definition referred to CSR as “a concept whereby Various guidelines and reports have been published to encourage companies to report on their greenhouse gas emissions, e.g.: companies integrate social and environmental concerns in their business operations and in their interaction with their stakeholders on a voluntary basis”. The Communication on CSR suggests that European - DEFRA and the Department of Energy and Climate policy to promote CSR should be consistent with the Change published guidance (September 2009) on following internationally recognised guidelines: how UK organisations should measure and report their greenhouse gas emissions - - the OECD Guidelines for Multinational Enterprises (revised May 2011). These provide voluntary the ICAEW and the Environment Agency published principles and standards for responsible business guidance on environmental issues and annual conduct in areas such as employment and industrial financial reporting (September 2009) to help relations, human rights, the environment, preparers, users and auditors of annual financial information disclosure and the combating of statements to identify environmental issues of bribery sufficient relevance to warrant disclosure. - the 10 principles of the UN Global Compact The Climate Change Act 2008 required the Secretary of (launched July 2000), covering areas such as human State to make regulations requiring the disclosure of rights, labour, the environment and anti-corruption greenhouse gas emissions or lay a report before Parliament explaining why no such regulations were required. DEFRA published a consultation (July 2012) on the form of regulations requiring quoted companies (see Glossary) to report on greenhouse gas emissions from the operations worldwide which their group controls, using the IFRS 10 control test. Emissions for - the UN Guiding Principles on Business and Human Rights (endorsed by the UN Human Rights Council June 2011). The Guiding Principles, developed by UN Special Representative Professor John Ruggie, stress the need for businesses to conduct due diligence to identify, prevent and mitigate their 120 Corporate social responsibility Corporate social responsibility (continued) these purposes covers emissions created directly by the impact on human rights and for businesses that group and emissions associated with power brought in pose a risk of severe human rights impacts to by the group. The regulations are expected to take report formally how they address such impacts. The effect for financial years ending on or after 1 October Guiding Principles implement the Protect, Respect 2013. Guidance on the new requirements is currently and Remedy Framework (also developed by being drafted. Professor Ruggie) (June 2008) The Department of Energy and Climate Change - the ISO Guidance Standard on Social Responsibility, published a consultation (March 2012) on a ISO 26000 (November 2010). This contains simplification of the CRC Energy Efficiency Scheme. The voluntary guidance for reporting on social Department published a response (December 2012) and responsibility and is intended for use by confirmed its intention to implement most of the organisations of all types, in both the public and proposals as set out in the consultation. An order will private sectors be laid before Parliament and is expected to come into effect on 1 June 2013. - the ILO Tripartite Declaration of Principles Concerning Multinational Enterprises and Social Anti-corruption campaigner, Transparency International, Policy (adopted March 2006). This sets out published a report (July 2012) which ranks 105 of the guidelines to multinational enterprises, biggest publicly traded companies worldwide based on governments, and employers’ and workers’ their public commitment to transparency. It considers organisations in such areas as employment, public reporting on matters such as anti-corruption, training, conditions of work and life, and industrial organisational transparency and country-by-country relations. reporting. The report concluded that multinationals have a long way to go to improve transparency, especially in the financial sector. Other guidelines not specifically mentioned in the Communication on CSR include: - the Equator Principles, a set of voluntary guidelines for lenders for assessing the economic and social impact of projects (July 2006). A process to update the guidelines was launched in July 2011 - IFC’s Sustainability Framework (updated January 121 Corporate social responsibility Corporate social responsibility (continued) 2012) consisting of a policy on environmental and social sustainability, performance standards and access to information - the Climate Disclosure Standards Board’s Reporting Framework (October 2012). The Framework provides guidance on the climate change data that should be included in mainstream reports - the Sustainability Reporting Guidelines developed by the Global Reporting Initiative, a network-based organisation that is a collaborating centre of the United Nations Environment Programme. The Guidelines are for voluntary use by organisations reporting on the economic, environmental and social dimensions of their activities, products and services. The Guidelines were updated in March 2011 to include expanded guidance for reporting on human rights, local community impacts and gender - the UN Principles for Responsible Investment. Investors who adopt the principles commit, among other things, to incorporate environmental, social and corporate governance issues into their investment analysis and decision-making processes and to seek appropriate disclosure of such issues by the companies in which they invest - guidance notes published by the Human Rights Working Group of the UN Global Compact 122 Corporate social responsibility Corporate social responsibility (continued) - the public exposure draft of the CEO Water Mandate’s Corporate Water Disclosure Guidelines (August 2012). The guidelines seek to advance a common approach to corporate water disclosure that addresses the complexity of water resources in a comprehensive yet concise manner. The guidelines are expected to be finalised in 2013. The Global Reporting Initiative and the Prince of Wales’ Accounting for Sustainability Project announced (August 2010) the formation of the International Integrated Reporting Committee. Its remit is to create a globally accepted framework for accounting for sustainability which brings together financial, environmental, social and governance information in a clear, concise, consistent and comparable format. Its members include representatives from a number of FTSE 100 companies, the Big Four firms of accountants and the IASB and FASB. The Committee invited (July 2011) companies and investors to participate in a pilot project to test the principles of integrated reporting. The pilot project began in October 2011. The Committee also published a discussion paper (September 2011) which considers the rationale for integrated reporting and the development of an international integrated reporting framework. The Committee published a draft outline of an integrated reporting framework (July 2012), followed by a prototype framework for integrated reporting 123 Corporate social responsibility Corporate social responsibility (continued) (October 2012). It intends to publish a consultation draft of the framework in April 2013 and a final version in December 2013. The OECD Due Diligence Guidance for Responsible Supply Chains of Minerals from Conflict-Affected and High-Risk Areas (May 2012) provides step-by-step management recommendations endorsed by governments for global responsible supply chains of minerals in order to encourage companies to respect human rights and avoid contributing to conflict through their mineral or metal purchasing decisions and practices. A supplement on gold was published in July 2012. The EC announced (February 2012) that human rights guidance will be developed for the sectors of employment and recruitment agencies, information and communication technology, and oil and gas. The guidance will be based on the UN Guiding Principles on Business and Human Rights and is expected to be completed by April 2013. Further information about this process is available on the website of the Institute for Human Rights and Business. The EC published a guide to human rights for SMEs (December 2012), based on the UN Guiding Principles on Business and Human Rights. This may be of interest to all companies, as it identifies a number of business situations that may have a negative impact on human 124 Corporate social responsibility Corporate social responsibility (continued) rights. Following on from its resolution on CSR (March 2007), the European Parliament adopted two further resolutions (February 2013) urging the EC to take a wide range of actions to promote corporate social responsibility in business. 125 Accounting standards IFRS The IAS Regulation (July 2002) requires UK publicly The IAS Regulation (July 2002) requires “publicly traded Domestic public companies must prepare their accounts traded companies to prepare consolidated accounts on companies” (i.e. companies governed by the law of a on the basis of US GAAP, while non-US public the basis of IFRS adopted by the EU for financial years Member State whose securities are admitted to trading companies may prepare their financial statements in commencing on or after 1 January 2005. on an EU-regulated market) to prepare their accordance with US GAAP, IFRS as adopted by the IASB consolidated accounts on the basis of IFRS adopted by or local GAAP with a reconciliation to US GAAP. CA 06 implements certain options in the IAS Regulation and permits (i) UK publicly traded companies to use IFRS in their individual accounts and (ii) other UK the EU for financial years commencing on or after 1 January 2005. Since 2002, the FASB and the IASB have undertaken a formal process to converge US GAAP and IFRS. A joint companies and limited liability partnerships to use IFRS To apply for the purposes of the IAS Regulation, memorandum of understanding (September 2002) in their individual and consolidated accounts. individual standards must be endorsed by the announced the FASB’s and IASB’s intention to Accounting Regulatory Committee and adopted by the collaborate on the development of common, high- EC. A consolidated text of IFRS adopted and applicable quality standards with the ultimate goal of a single set BIS updated (June 2008) its guidance on CA 06 and the IAS Regulation. in the EU (December 2008) is set out in Regulation of high-quality global accounting standards. This was The ICAEW published a report for the EC on the first 1126/2008. Details of IFRS adopted since that date or followed by an updated MOU (February 2006) and a year of implementation across the EU of IFRS (October which are in the process of adoption are set out on the progress report (September 2008). 2007) and an assessment for the United Nations of the EC website. UK’s experience in implementing IFRS (November 2008). The SEC adopted rules (December 2007) that allow The EC and the Accounting Regulatory Committee foreign private issuers (see Glossary) to make filings Financial statements prepared in accordance with IFRS approved (November 2005) standard wording for with the SEC using financial statements prepared in must achieve a “fair presentation” rather than give a compliance with IFRS to be used in notes to the accordance with IFRS, as issued by the IASB, and true and fair view. However, the true and fair view is accounts and in the audit report: “in accordance with without reconciliation to US GAAP. still considered central to the preparation of financial International Financial Reporting Standards as adopted statements in the UK, whether prepared under IFRS or by the EU” or “in accordance with IFRSs as adopted by UK GAAP, and the requirement to present fairly is not a the EU”. different requirement from that of showing a true and fair view but is a different articulation of the same concept. See the opinion of Martin Moore QC (April 2008), commissioned by the FRC. Section 393 CA 06 prohibits directors from approving Following calls from the leaders of the G20, the FASB and IASB committed (November 2009) to meet a June 2011 target date for convergence. However, this target Of the standards adopted to date, only IAS 39 was not met. Since then, the IASB and FASB have “Financial Instruments: Recognition and Measurement” published (April 2012) a joint progress report describing has not been adopted in full, because the EC declined the progress made on outstanding projects, e.g. in to adopt certain provisions relating to hedge relation to financial instruments, impairment and hedge accounting. This means that there is a small difference accounting. 126 Accounting standards accounts (including accounts prepared in accordance between IAS 39 as issued by the IASB and the version Following a concept release (2007), the SEC published a with IFRS) unless they are satisfied that they give a true which publicly traded companies are required by the roadmap (November 2008) setting a target date of and fair view of the assets, liabilities, financial position IAS Regulation to use in their consolidated accounts. 2011 for the SEC to decide whether to require US and profit or loss of the company. The EC issued a statement (November 2005) clarifying The FRC published a statement confirming that the true that any IFRS adopted and published in the Official and fair view remains of fundamental importance in Journal by the date the accounts are signed (rather both UK GAAP and IFRS (July 2011). This follows than the end of the financial year) can be used in the concerns raised in evidence to the House of Lords preparation of the accounts for that financial year (as Economic Affairs Committee enquiry into audit market long as the standard does not prohibit early adoption). concentration that IFRS leads auditors to place conformity with IFRS before reliance on the true and fair view. The FRC statement confirms that: Third country (non-EU) issuers of securities admitted to trading on an EU-regulated market are exempted from preparing their financial statements, and from including historical financial information in prospectuses, in accordance with IFRS if the third country GAAP used is 127 issuers to adopt IFRS. However, in a statement (February 2010), the SEC stepped back from a commitment to make IFRS mandatory. Instead it stated that its decision would be about “incorporating IFRS into the financial reporting system for US issuers”. It also stated that the earliest date that US issuers would report under any new system would be 2015 or 2016. The SEC issued (August 2010) two releases for public comment on topics related to its consideration of Accounting standards IFRS (continued) - the introduction of IFRS did not change the requirement for accounts to show a true and fair view - Regulation (EC) No 1569/2007 as amended by Commission Delegated Regulation EU 310/2012 incorporating IFRS into the financial reporting system for US issuers. The first release focused on matters concerning issuers and the second release considered the preparedness of investors. prudence continues to underlie the preparation of established a mechanism for the determination of accounts under both UK GAAP and IFRS even equivalence. Among other things, the EC must consult The SEC hosted a roundtable (July 2011) involving though the IFRS conceptual framework replaced ESMA (formerly CESR) before making a determination. investors, smaller public companies and regulators. prudence with neutrality - considered by the EC to be equivalent to IFRS. ESMA provided advice to the EC on the equivalence of the true and fair override still applies where US, Japanese and Chinese GAAP (March 2008), directors and auditors do not believe that following Canadian and South Korean GAAP (May 2008) and a particular accounting policy will give a true and Indian GAAP (November 2008). It also published two fair view. In such circumstances, the directors are supplementary reports on the programmes of Canada, legally required to adopt a more appropriate policy, India and South Korea to converge with or adopt IFRS, even if this requires a departure from the standard. on the level of application of Chinese accounting The FRC updated its bulletin on auditors’ reports (October 2012) containing updated examples of auditors’ reports for audits of financial statements, including for companies that prepare accounts in accordance with IFRS. The wording reflects the formulation for IFRS compliance approved by the EC and the Accounting Regulatory Committee. The Companies and Limited Liability Partnerships (Accounts and Audit Exemptions and Change of Accounting Framework) Regulations 2012 permit companies that prepare their individual accounts under EU-adopted IFRS to change their accounting framework to UK GAAP. Companies are permitted to make the change once every five years. The Regulations apply for standards by Chinese issuers and on the use of third Some criticised the change to IFRS as too costly, particularly with regard to smaller companies. It was also suggested that implementation of IFRS, which, unlike US GAAP, favours broad principles over detailed rules, could possibly be too confusing and difficult for US accountants, who previously have had detailed interpretive guidance regarding the enactment of new rules. country GAAP on EU markets (June 2009 and The SEC’s Office of the Chief Accountant published (July November 2010). ESMA’s advice and reports are 2012) its final staff report on the work plan related to available from the Equivalence/IFRS and GAAP section global accounting standards. This did not make any of its website (under the Co-operation and recommendations to the SEC regarding the Convergence tab). incorporation of IFRS into the US financial reporting The EC adopted a Decision (December 2008) which determined that the GAAPs of the US and Japan were equivalent to IFRS. It also accepted financial statements using the GAAPs of China, Canada, South Korea and India on a transitional basis. The EC adopted a further Decision (April 2012) declaring the GAAPs of China, Canada and South Korea as equivalent and prolonging the transitional period during which Indian issuers may 128 system or how this could be done but merely summarised the work plan so far. Former SEC Chairman Mary Schapiro also stated (July 2012) that the SEC did not have a timeline for deciding whether to require US issuers to adopt IFRS. Accounting standards IFRS (continued) accounting years ending on or after 1 October 2012. The FRC, the European Financial Reporting Advisory Group and the Autorité des Normes Comptables continue to prepare their financial statements and provide historical financial information in third country GAAP to 31 December 2014. published a discussion paper (July 2012) on the key The IASB published an IFRS designed for use by SMEs principles for a disclosure framework for notes to (July 2009). Many of the principles in full IFRS have financial statements. These include objectives-based been simplified, topics not relevant to SMEs have been requirements that require greater judgement and omitted, and the number of required disclosures has consideration of an entity’s circumstances rather than been significantly reduced. Revisions to the IFRS for lengthy boilerplate disclosures and strengthening the SMEs will be limited to once every three years. The IFRS application of materiality. The discussion paper is for SMEs is separate from full IFRS and available for any intended to support the work of the IASB in developing jurisdiction to adopt, whether or not it has adopted full a disclosure framework. It follows concerns that the IFRS. It is also for each jurisdiction to determine which ever-increasing length of notes to the financial entities should use the standard. statements mean that they no longer serve their purpose of helping investors and creditors understand the numbers in the financial statements. The FRC published a discussion paper, “Thinking about disclosures in a broader context: a road map for a disclosure framework” (October 2012). This aims to improve the quality of information disclosed in annual reports as a whole, not just in the financial statements, and to curtail a piecemeal approach to reporting. Among other things, the FRC seeks views on common Question and answer guidance on IFRS for SMEs (June 2011) is available from the IFRS for SMEs page on the IASB website. The EC indicated (October 2011) that it will not require the use of IFRS for SMEs at EU level. However, Member States may still adopt IFRS for SMEs for some or all of their unlisted companies, provided that they comply with European legal requirements and modify IFRS for SMEs where it departs from those requirements. themes for the information users may need and The IASB published a consultation (July 2011) on its principles for good communication and calls for the work plan for the next three years, followed by a development of placement criteria and guidance on feedback statement (December 2012). There was almost materiality to reduce duplication and cut clutter. unanimous support for the IASB to prioritise work on the conceptual framework underlying the preparation 129 Accounting standards IFRS (continued) The Financial Reporting Lab is considering a project on and presentation of IFRS-compliant reports. A accounting policy disclosure, integrating accounting discussion paper is expected in the second quarter of policies with the notes to which they relate. 2013. The ICAEW published (January 2013) a report on the The ICGN published (2010) a position paper setting out future of IFRS. This summarises the benefits of a global what investors want from financial reporting. set of standards, assesses what has been achieved to date and seeks to encourage a debate on the steps required to safeguard the success of international accounting standards. The FRC, along with EFRAG and the national standard setters of France, Germany and Italy, published (February 2013) a strategy on the IASB’s revision of its conceptual framework. The collaboration between standard setters is intended to ensure that the revised conceptual framework is conducive to robust and effective accounting standards in Europe. The document illustrates some of the major issues that may arise, such as whether adequate emphasis is given to prudence and reliability, explains the strategy for engaging with the IASB and encourages others within Europe to engage with the development of the new framework. The Institute of Chartered Accountants in Scotland and the New Zealand Institute of Chartered Accountants published (July 2011) recommendations to reduce disclosures in financial statements following a study commissioned by IASB. ESMA published a consultation (November 2011) on the application of materiality in financial reports produced using IFRS, followed by a summary of responses (August 2012) and a feedback statement (February 2013). ESMA intends to provide the IASB and IAASB with the outcome of the consultation and encourage them to address aspects of materiality that are seen to be problematic in practice, e.g. the diverse application of the concept of materiality and the length of disclosures. The IFRS Foundation published proposals (November 2012) to create an advisory group to the IASB consisting of national accounting standard setters and regional bodies. The aim is to create a more effective dialogue between the IASB and standard setters now that more than 100 countries permit or require the use of IFRS. 130 Accounting standards Domestic accounting standards Companies not required to prepare their accounts on Domestic public companies must prepare their accounts the basis of IFRS, or which choose not to do so (see on the basis of US GAAP, while non-US public IFRS above), continue for now to prepare their accounts companies may prepare their financial statements in US in accordance with UK GAAP. GAAP, IFRS as adopted by the IASB or local GAAP with a reconciliation to US GAAP. The Statutory Auditors (Amendment of Companies Act 2006 and Delegation of Functions etc) Order 2012 The process for incorporating IFRS into the US financial prescribes the FRC as the body responsible for issuing reporting system appears to have stalled. The target accounting standards for the purposes of Section 464 date for the SEC to decide whether to require US of CA 06 with effect from 2 July 2012. The FRC took issuers to adopt IFRS (as set out in the SEC’s roadmap over the role from the ASB, following the restructuring (November 2008)) was not met and the SEC does not of the FRC. currently have a timeline for making the decision. See IFRS above. The FRC is in the process of finalising proposals for the replacement of UK GAAP. It published (November 2012) FRS 100 and 101 and is expected to publish FRS 102 in early 2013. The standards will apply from 1 January 2015, with earlier adoption permitted. FRS 100 sets out the overall financial reporting framework and FRS 101 sets out reduced disclosures for subsidiaries and other qualifying entities, allowing them to apply the measurement and recognition requirements of EU-adopted IFRS, without complying with the full disclosure framework. FRS 102 is expected to set out substantive rules based on the IFRS for SMEs, but with certain accounting treatments currently permitted under UK accounting standards being retained. 131 Accounting standards Companies that are not eligible to apply the Financial Reporting Statement for Smaller Entities (FRSSE) (or that are eligible but choose not to apply it) may prepare their accounts using FRS 102, EU-adopted IFRS or, if they are a subsidiary or other qualifying entity, the reduced disclosure framework set out in FRS 101. The newly published FRSs have been developed from the exposure drafts (FREDs 46, 47 and 48) on which the FRC consulted in January 2012. The Accounting Standards (Prescribed Bodies) (United States of America and Japan) Regulations 2012 permit 132 Accounting standards Domestic accounting standards (continued) companies listed on stock exchanges in the US and Japan but not in an EU Member State to continue using their local GAAP for a transitional period if they relocate to the UK. This applies until 31 December 2015. 133 Accounting standards Enforcement CA 06 provides for a system of administrative CESR issued Standard No. 1 on Financial Information, Federal securities laws authorise the SEC to investigate enforcement where the Secretary of State can apply to “Enforcement of standards on financial information in any person or entity suspected of violating federal the court for a declaration that the report and accounts Europe” (March 2003). It is based on general principles securities laws or SEC Rules. In addition, the federal do not comply with statutory requirements or for an with a view to harmonising institutional oversight securities laws grant express private rights of action for order requiring directors to produce revised accounts. systems in Europe. It issued Standard No. 2 on Financial some specific types of violations. The SEC has authority The Secretary of State has power to authorise others to Information, “Co-ordination of enforcement activities” to issue cease-and-desist orders and to seek injunctive apply to the court. (April 2004), setting out key principles for a co- orders in a federal district court against persons for ordination mechanism for enforcement, followed by violations of the securities laws, including violations of implementation guidance (October 2004). These the fraud provisions. In addition, the SEC may seek documents are available from the IFRS Enforcement monetary penalties in federal district court from section of the ESMA website (under the Investment and persons who have violated a cease-and-desist order or Reporting tab). federal securities laws. The court decides the penalty The Prescribed Body Order 2012 authorises the Conduct Committee of the FRC for these purposes. The Conduct Committee assumed this role from the FRRP (July 2012), following the restructuring of the FRC. C(AICE)A enables the Secretary of State to make an order appointing a body to keep under review periodic accounts and reports that are produced by issuers of listed securities and inform the FSA of any conclusions. The Prescribed Body Order 2012 appoints the Conduct Committee for these purposes in relation to annual and As proposed in Standard No. 2 (April 2004), ESMA has developed a database of enforcement decisions. In Under SOX, the SEC has the power to enforce the response to public comment on the standard, ESMA following: publishes extracts of the database from time to time on the IFRS Enforcement section of its website. half-yearly reports published under DTR 4. The Conduct IOSCO announced (October 2005) that it was Committee’s jurisdiction under the Order extends to establishing arrangements for regulators to share companies that are not UK-incorporated if the UK is decisions on the application of IFRS. IOSCO catalogues their “home state” for the purposes of TOD. the decisions on a database in order to maximise co- The FRC published the FRRP’s 2012 annual report based on the facts and circumstances of each case. ordination and convergence. (September 2012). The FRRP noted a significant The Fourth and Seventh Amendment Directive confirms improvement in the reporting of principal risks and the collective responsibility of board members towards uncertainties and considered that the reporting of the company for the financial and other key information mitigating actions had been done well. See Risk that they publish in their annual report and accounts. management and control above. It also welcomed signs The Directive applies to all EU-incorporated companies. 134 - periodic reports, including financial statements, for SEC-reporting companies every three years (SOX § 408) - SEC enforcement initiatives for the five years preceding SOX (SOX § 704) - the requirement for CEOs and CFOs to certify that the financial information included in periodic reports fairly presents in all material respects the financial condition and results of operations of the company. There are two overlapping certification requirements with civil and criminal penalties (SOX Accounting standards of a greater focus on key messages and material TOD requires directors of issuers of securities traded on disclosures, with some companies eliminating an EU-regulated market to give a responsibility unnecessary content and making changes to the order statement for information contained in the annual and of content of the annual reports. half-yearly reports they publish in the EU. Following the restructuring of the FRC, the Conduct For both the Fourth and Seventh Amendment Directive Committee published (July 2012) operating procedures and TOD, Member States are required to apply their setting out its policy on reviewing reports and accounts. liability regimes to the givers of such statements. These are substantially similar to those of the FRRP and include the following changes made by the FRRP in April 2012: - §§ 302 and 906) (SEC Rules adopted August 2002) - public company and tampering with records (SOX §§ 802, 807 and 1102) - breach of EU financial services rules, the TOD to allow the FRC to make an announcement where Amendment Directive also seeks to ensure that a company makes a significant change to its competent authorities have uniformly tough sanctioning corporate powers, providing for 135 the prohibition on officers and directors taking any action that improperly or fraudulently influences or misleads auditors (SOX § 303) (SEC Rules adopted Consistent with the EC’s Communication (December 2010), which called for more dissuasive sanctions for criminal sanctions for securities fraud involving a May 2003) - the requirement for CEOs and CFOs to forfeit equity-based compensation and trading profits if their company has had to restate financial statements as a Accounting standards Enforcement (continued) reporting following an FRC intervention - to allow the FRC to release an announcement where the existence of an FRC enquiry has become public other than as a result of an FRC press notice (e.g. where a complainant has published an approach made to the FRC). There is currently no formal regulatory monitoring of the quality of the explanations companies provide when explaining departures from the UK Corporate Governance Code and the FRC believes that it is for shareholders to judge whether corporate governance in a particular company is satisfactory. sanctions of up to 10% of consolidated annual turnover result of misconduct (SOX § 304). In several cases, for companies and up to €5 million for individuals for the SEC has successfully pursued compensation breach of the periodic reporting and certain other clawbacks under § 304 despite the lack of any obligations of TOD. Competent authorities will be allegation of wrongdoing on the part of the CFO or required to publish the sanctions that are applied. A CEO. The SEC has indicated that it believes that similar sanctions framework is proposed in CRD IV and misconduct by anyone at the company resulting in the MiFID Amendment Directive. a restatement is a sufficient basis to pursue regulatory framework applicable to auditors and The SEC issued (January 2006) a statement concerning enforcement matters. It included common criteria for financial penalties in which it articulated the points it public oversight systems, proposed a model of co- considers in assessing penalties against issuers: operation between Member States and established procedures for the exchange of information between The FRC announced (January 2013) that its monitoring oversight bodies of Member States in investigations. It activity in 2013/14 will focus on the support services, also allowed for reciprocal co-operation with third retail, natural resources/extractive industries and countries. construction sectors. clawbacks from the CEO and CFO under § 304. The Statutory Audit Directive sought to strengthen the - the presence or absence of a benefit to the corporation - the degree to which the penalty will recompense or harm the shareholders. Article 63 of the directive forming part of CRD IV (July Other factors include deterrence, level of injury to 2011) proposes a duty for the statutory auditor to innocent parties, pervasiveness of the violation, the report to the competent authorities any fact or decision level of intent and the difficulty of detection. which is liable to constitute a material breach of law, Although the Dodd-Frank Act (July 2010) did little to regulation or administrative provision relating to the affect private rights of action, it does expand SEC authorisation of a financial institution it audits or which enforcement authority in several areas, including the could affect the continuous functioning of the liability of control persons (e.g. whereby a “controlling” institution or lead to a refusal to certify the accounts or director or officer could be held liable for the acts of to the expression of a reservation. the “controlled” company) and aiding and abetting ESMA published (June 2012) an activity report on IFRS liability. The SEC will be provided with increasingly enforcement in the European Economic Area in 2011. larger budgets over the next few years and is 136 Accounting standards Enforcement (continued) Whilst the quality of IFRS financial statements is improving, more needs to be done by some issuers in areas such as disclosures related to fair value, the hierarchy of financial instruments, disclosures of assumptions used as part of impairment tests, presentation of risk factors and uncertainties with an impact on going concern assumptions and issues related to consolidation. ESMA published a list of enforcement priorities (November 2012) to be used by EU national competent authorities in their assessment of listed companies’ 2012 financial statements. These relate to financial assets, impairment of financial assets, defined benefit obligations and provisions, contingent liabilities and contingent assets. 137 expanding its enforcement resources. Auditors Regulation of auditors and accountants The powers of the Secretary of State in Part 42 of CA 06 IOSCO published “Principles for Auditor Oversight” As mandated by SOX, the PCAOB was established by to oversee the regulation of statutory auditors by (October 2002), setting out principles of oversight for the SEC (April 2003) to register, inspect, investigate and professional accountancy bodies were delegated to the auditors of listed companies. It published a survey on discipline public accounting firms that prepare audit FRC by the Statutory Auditors (Amendment of the regulation and oversight of auditors in 59 reports for companies. The PCAOB is responsible for Companies Act 2006 and Delegation of Functions etc) jurisdictions (April 2005). establishing audit, quality control and ethics standards Order 2012 (SI 2012/1741). Before the restructuring of the FRC in July 2012, the powers of the Secretary of State were exercised by the POB. The Order provides The Statutory Audit Directive: - systems at Member State level that directions issued by the POB remain in force as if issued by the FRC. established common criteria for public oversight - established an audit regulatory committee of The professional accountancy bodies have the primary Member State representatives at EU level to direct responsibility for the supervision of their implement the detailed measures of the Directive members acting in their professional capacity. However, and allow for continuous monitoring Part 42 of CA 06 requires the audits of major public - created a co-operative model between regulatory for registered accounting firms (SOX §§ 101 et seq.). Only accounting firms that are registered with the PCAOB can participate in audits of, or issue audit reports on, companies (whether US or non-US companies) that are registered with the SEC. The PCAOB has promulgated a number of standards, including: - Auditing Standard No. 3 Audit Documentation - Auditing Standard No. 4 Reporting on Whether a interest entities (see Glossary) and the disciplining of authorities of Member States on the basis of “home statutory auditors in relation to major public interest country control” (i.e. audit firms are principally Previously Reported Material Weakness Continues cases to be carried out independently. The FRC’s Audit regulated by authorities in the Member State where to Exist Quality Team carries out the monitoring role (see Audit they are established). This model of co-operation quality below) and the Conduct Committee of the FRC was also extended to third countries on the basis of carries out the disciplinary role. reciprocity The FRC published a consultation (June 2012) proposing - required audit firms that audit public interest entities (see Glossary) to publish annual The aim was to enable the FRC to make its own rules transparency reports on their websites within three for disciplinary arrangements in relation to accountants, months of financial year-end professional accountancy bodies. The proposals were finalised and the Accountancy Scheme became effective - Auditing Standard No. 5 An Audit of Internal Control Over Financial Reporting that is Integrated with an Audit of Financial Statements changes to the disciplinary schemes for accountants. without needing to obtain the agreement of the - contained rules on the registration and oversight of auditors and audit firms from non-EU countries who issue audit reports in relation to the accounts of 138 - Rules 3501, 3502, and 3520 to 3524: Ethics and Independence Rules. The Dodd-Frank Act allowed the PCAOB to share information with foreign auditors’ oversight authorities. This removed an obstacle to the exchange of audit working papers between EU and US competent Auditors (October 2012). Amendments to CA 06 took effect on 2 July 2012 and require supervisory bodies to participate in on the adequacy of US supervisory authorities auditors”). There is an exemption if the country (September 2010). equivalent systems of registration and oversight failing to comply with the relevant supervisory body’s procedure to implement these changes. regulated market in the EU (“third country the audit firms from third countries are subject to against audit firms and/or independent auditors for consultation (December 2012) on the sanctions authorities and enabled the EC to publish its decision concerned offers reciprocity to EU auditors and if arrangements enabling the FRC to determine sanctions rules relevant to statutory audit. The FRC published a non-EU companies whose securities are traded on a - The PCAOB has published (October 2011) proposed changes to its standards which would require the name of the engagement partner to be disclosed in the audit permitted the use of ISAs as adopted by the EC for report. It would also require disclosure of other EU statutory audits. accounting firms and other persons not employed by The EC established (December 2005) the European the auditor that took part in the audit. The POB’s last annual report to the Secretary of State Group of Auditors’ Oversight Bodies to ensure the The PCAOB adopted Auditing Standard No. 16, (June 2012) related to the year to 31 March 2012. It efficient co-ordination of new public oversight systems Communications with Audit Committees (August 2012), suggested that some aspects of the monitoring process of statutory which the SEC approved (December 2012). The new secure improvements in audit quality. Following the auditors and audit firms within the EU. The Group also standard primarily retains or enhances existing audit restructuring of the FRC, next year’s report will be provides technical input into the preparation of committee communication requirements and is effective issued by the FRC’s Conduct Committee. measures to implement the Statutory Audit Directive, for audits of financial statements with fiscal years such as endorsement of ISAs or assessment of third beginning on or after 15 December 2012. The standard countries’ public oversight systems. also applies to audits of emerging growth companies by professional accountancy bodies should be modified to Regulation of auditors and accountants (continued) The Statutory Auditors and Third Country Auditors Regulations 2007 amended Part 42 of CA 06 to put in and foreign private issuers (see Glossary). place, as required by the Statutory Audit Directive, a The EC published a consultation (January 2007) on system of registration and regulation of third country measures to implement the provisions of the Statutory Auditing Standard No. 16 requires the communications auditors of non-EU companies listed in the UK. Audit Directive regarding the regulation and oversight with the audit committee to occur before the issuance of third country auditors. of the audit report. The standard requires auditors to The powers of the Secretary of State to regulate third country auditors have been delegated to the FRC by The EC adopted a decision (January 2011) declaring the The Statutory Auditors (Amendment of Companies Act audit oversight regimes of 10 non-EU countries 139 communicate, among other matters, the following to audit committees: Auditors Regulation of auditors and accountants (continued) 2006 and Delegation of Functions etc) Order 2012 (SI equivalent to those of the EU. This allows EU national 2012/1741) (effective July 2012). Before that time, the audit oversight bodies to rely on the inspections of third management in connection with the appointment or powers were exercised by the POB. country auditors carried out in Australia, Canada, China, retention of the auditor, including significant Croatia, Japan, Singapore, South Africa, South Korea, discussions regarding the application of accounting Switzerland and the US. In addition, auditors from 20 principles and auditing standards The POB published (November 2008) detailed arrangements implementing the requirements of the Statutory Audit Directive in relation to regulation of third country auditors in the UK. other non-EU jurisdictions were granted transitional relief for financial years commencing in the period from - - any significant issues that the auditor discussed with certain matters regarding the company’s accounting policies, practices and estimates (consistent with 2 July 2010 to 31 July 2012. During this period, auditors Rule 2-07 of Regulation S-X) POB published a consultation (March 2012) Monitoring of those jurisdictions are allowed to perform audit the work of third country auditors in which it sought activities in the EU without EU oversight and without views on the system of external monitoring that should registering with EU competent authorities, provided that apply to third country auditors. The aim was to carry they comply with minimum information requirements out reviews of third country audits and audit firms in a necessary for maintaining adequate investor protection way that was effective but did not impose transactions, including the business rationale for levels in Europe. such transactions - the auditor’s evaluation of the quality of the company’s financial reporting - disproportionate costs and regulatory burdens. The POB - information related to significant unusual an overview of the overall audit strategy, including concluded that this was difficult to achieve under The Statutory Audit Directive only allows third countries current EU requirements and called for a simplification access to EU auditors’ working papers if the competent timing of the audit, significant risks the auditor of the relevant provisions. authorities in those countries meet requirements which identified, and significant changes to the planned the EC has declared adequate and there is a reciprocal audit strategy or identified risks The EC decisions (February 2010 and September 2010) which permit the transfer of audit working papers to agreement in place regarding the exchange of papers. - information about the nature and extent of certain countries outside the EU were implemented by The EC adopted (February 2010) a decision recognising specialised skill or knowledge needed in the audit, The Companies Act 2006 (Transfer of Audit Working the adequacy of the auditor supervisory authorities in the extent of the planned use of internal auditors, Papers to Third Countries) Regulations 2010. Canada, Japan and Switzerland. The EC adopted a company personnel or other third parties, and other further decision (September 2010) recognising the independent public accounting firms, or other adequacy of the auditor supervisory authorities of persons not employed by the auditor that are Australia and the US. This will enable the exchange of involved in the audit The Statutory Audit Directive requires, that in certain circumstances, Member States should apply their system for the external monitoring of audit work to third country auditors and the relevant audit engagements. audit working papers between the Member States’ 140 - difficult or contentious matters for which the Auditors Regulation of auditors and accountants (continued) This requirement applies for the most part where there oversight authorities and their counterparts in the is no equivalent system of audit regulation and external jurisdictions covered by the decisions. monitoring in the third country, and no plans to introduce such a system. The EC published an independent study on the ownership rules that apply to audit firms and their auditor consulted outside the engagement team - the auditor’s evaluation of going concern - expected departures from the auditor’s standard report The EC decision (January 2011) on the equivalence of consequences on audit market concentration (October the audit oversight regimes of 10 non-EU countries has 2007). The study noted that restrictions on access to been implemented by The Statutory Auditors and Third capital were one of the barriers into the market for significant to the oversight of the company’s Country Auditors (Amendment) Regulations 2011. This large audits and suggested that a relaxation of financial reporting process, including complaints or allows the POB to disapply the requirement to monitor ownership restrictions in the audit profession could help concerns regarding accounting or auditing matters the audits of issuers in equivalent countries on the basis reduce market concentration. The EC published a that have come to the auditor’s attention during the of reciprocity. consultation on ownership structures in audit firms audit. The AIU agreed a statement of protocol with the PCAOB (January 2011). This was intended to facilitate effective co-operation between the two organisations and pave the way for joint work on inspections, including exchanges of information and interviewing firm personnel. However, in its consultation on the monitoring of third country auditors (March 2012), the POB noted that reciprocity had not yet fully been met in relation to the US. The FRC published (jointly with BIS) a study and a discussion paper on choice in the UK audit market (April and May 2006, respectively). It appointed a market (November 2008) and a summary report of the responses (July 2009). Lack of harmonisation of regulatory requirements, especially independence rules for auditors, professional qualification requirements and the impossibility of providing cross-border services without multiple registrations, were also seen as important barriers. There was a need for action at EU level but this would also need to take into account the position outside the EU. IOSCO published consultation papers (September 2009) on: - the transparency of firms that audit public participants’ group (October 2006) to provide advice companies. This explores the potential effects of the and identify and assess possible actions to mitigate the enhanced transparency of audit firms and whether risks arising from the concentrated nature of the UK this will improve audit quality and the availability 141 - other matters arising from the audit that are Auditors Regulation of auditors and accountants (continued) audit market. The group published a final report in October 2007. and delivery of audit services - the content of auditors’ reports. This outlines the In response to the recommendations of the Market history and shortcomings of auditors’ reports and Participants’ Group: suggests possible solutions - - - the Joint Audit Committee of the Institute of - non-professional ownership structures for audit Chartered Accountants published new audit firms. This examines the impact of audit firm regulations and guidance on mechanisms to allow ownership restrictions on the concentration in the incoming auditors access to information held by market for auditing large issuers and explores the outgoing auditors (March 2008) pros and cons of authorising other audit firm ownership and governance models. the Consultative Committee of Accountancy Bodies published a voluntary code of practice on disclosure The European Group of Auditors’ Oversight Bodies of audit profitability which applies to audit periods published a guidance paper (December 2009) setting beginning on or after 6 April 2009 (March 2009) out a common approach for co-operation between the an ICAEW working group published an audit firm governance code (January 2010) aimed at the eight firms which audit more than 20 UK companies listed competent authorities of Member States with respect to audit firm and auditor oversight within the EU, as required by the Statutory Audit Directive. on the main market of the London Stock Exchange. The Financial Institutions Green Paper on corporate Firms are expected to state in their transparency governance in financial institutions (June 2010) reports how they apply the Code’s provisions and considered the role of auditors of financial institutions include a comply or explain statement. and sought comments on the following questions: On its website, the FRC notes that all but one of the - Market Participants’ Group’s recommendations had been implemented by 2010 without any discernible change to levels of market concentration. It concluded that audit regulators did not have sufficient tools to effect changes to market structure, and so welcomed should co-operation between external auditors and supervisory authorities be deepened? - should auditors be required to alert the board of directors and the supervisory authorities of any substantial risks they discover in the performance of 142 Auditors Regulation of auditors and accountants (continued) the OFT’s decision to refer the audit market to the Competition Commission. In the meantime, it is working with the major audit firms to develop contingency plans their duties? - financial information? which can be activated in the event of a firm finding itself in serious difficulty. should auditors’ control be extended to risk-related - should auditors validate a greater range of information which is relevant to shareholders than The House of Lords Economic Affairs Committee they do at present? published a report, “Auditors: Market concentration and their role” (March 2011), following an inquiry. This made Following the Audit Green Paper (October 2010), the EC a number of recommendations in relation to the published (November 2011) a draft regulation on regulation of auditors: requirements for audits of public interest entities (see - the regulation of accounting and auditing should be rationalised and reformed - the Government and regulators should promote the introduction of living wills by auditors - Glossary) and a draft directive amending the Statutory Audit Directive. Proposals affecting the regulation of auditors include: - the elimination of the rule that requires the majority of the capital of audit firms to be held by auditors the Government should encourage the emergence to encourage more entrants to join the audit of a competitor to the Big Four if the Audit market. However, the majority of members of the Commission is abolished and make greater efforts administrative or management body must be audit to enable non-Big Four Firms to win public sector firms or statutory auditors work - the OFT should investigate the audit market - the OFT should conduct a market study of restrictive bank covenants. The OFT announced (October 2011) that it had formed the view that competition might not be working well in the market for statutory audit services to large - a requirement for competent authorities responsible for the supervision of auditors to be independent of audit firms - the assumption by ESMA of the supervisory functions of the European Group of Auditor Oversight Bodies. However, national auditor supervision by competent authorities will continue 143 Auditors Regulation of auditors and accountants (continued) companies in the UK and had referred the matter to the - the creation of a single market for statutory audits Competition Commission for further investigation. This by introducing a European passport for the audit followed a round of public consultation, including profession. This would allow an audit firm approved meetings with interested parties to determine, among in one Member State to provide services across the other things, the potential overlap with parallel work EU ongoing at EU level. Although there is potential overlap with parallel work going on at EU level, the OFT decided - recognising the aptitude of an audit firm to perform to proceed with a referral because the nature, content high-quality audits of listed companies and timing of EU legislation was not settled and because it believed that the Competition Commission the introduction of a European certificate - mandating the use of ISAs. could provide important inputs during the legislative process and could address UK-specific competition concerns that may not be within the scope of the EC’s work. The Competition Commission published a statement (October 2011) inviting initial submissions by 11 November 2011. It published an issues statement and a timetable (December 2011). The issues statement set out some initial theories of what might be adversely affecting competition in the market and what might be adverse outcomes. Since that time, it has published a framework for assessment and revised theories of harm and a number of working papers to invite comments and assist the inquiry group in developing its thinking on key areas. Among these published working papers was a paper (September 2012) on auditor clauses in loan agreements (requiring borrowers to have their 144 Auditors Regulation of auditors and accountants (continued) accounts audited by one of the Big Four). The Competition Commission is required to report by October 2013 and is expected to produce provisional findings in February 2013 according to its revised administrative timetable (January 2013). 145 Auditors Audit quality CA 06 contains a number of measures to improve the The Statutory Audit Directive requires Member States to Section 104 of SOX requires the PCAOB to conduct a quality of audits: ensure that statutory auditors and audit firms are continuing programme of inspections of registered subject to a system of quality assurance that is public accounting firms. In those inspections, the PCAOB independent from the statutory auditors and audit firms. assesses compliance with SOX, the rules of the PCAOB, The EC published (May 2008) a recommendation the rules of the SEC and professional standards in providing guidance on establishing an independent connection with the firm’s performance of audits, system as mandated by the Directive. issuance of audit reports and related matters involving - the Secretary of State has the power to publish regulations requiring publication of auditors’ engagement letters (Section 494) - the senior statutory partner on an audit is required to sign the audit report (Section 504) - auditors of quoted companies (see Glossary) are required to make a statement when they leave office explaining the circumstances surrounding their departure (Section 519) - The Statutory Audit Directive permitted the use of ISAs as adopted by the EC for EU statutory audits. The EC published a consultation on the adoption of ISAs and a study on the potential costs and benefits (June 2009). It published a summary of the results of the shareholders of quoted companies (see Glossary) consultation (March 2010). The overwhelming majority may require website publication of matters relating of respondents were in favour of the adoption of ISAs. to the audit or in connection with an auditor issuers. SOX requires the PCAOB to conduct inspections annually for firms that provide audit reports for more than 100 issuers, and at least triennially for firms that provide audit reports for fewer issuers. SOX requires the PCAOB to prepare a written report concerning each inspection. Pursuant to SOX and the rules of the PCAOB, the PCAOB provides a copy of each report, in appropriate detail, to the SEC and to certain IOSCO published a consultation paper (September 2009) state regulatory authorities. The PCAOB also makes on the content of auditors’ reports. This outlines the The FRC’s Audit Quality Review team monitors the portions of those reports available to the public, subject history and shortcomings of auditors’ reports and quality of the audits of listed and other major public to restrictions in SOX that prohibit, or require a delay in, suggests possible solutions. the public disclosure of certain information. The IAASB published a discussion paper, “The Evolving In July 2009, the PCAOB issued a concept release to Nature of Financial Reporting: Disclosure and Its Audit consider the effects of a potential requirement for the Implications” (January 2011). This highlights trends in engagement partner (in addition to the audit firm) to financial reports, and explores issues and practical sign the audit report. ceasing to hold office (Section 527). interest entities (see Glossary) pursuant to powers set out in Schedule 10 of CA 06. Before the restructuring of the FRC (July 2012), the role was carried out by the POB. A list of such entities is published annually and is available on the FRC website. The POB published the Audit Quality Framework (February 2008), to assist audit committees, companies and auditors to recognise the critical elements of highquality audits. challenges in preparing, auditing and using them. The PCAOB issued a concept release (June 2011) The IAASB published a consultation paper, “Enhancing detailing alternatives for changing the auditor’s the Value of Auditor Reporting: Exploring Options for reporting model. The alternatives include: Change” (May 2011). It seeks views on the usefulness of 146 Auditors The POB published (April 2008) the Statutory Auditors auditor reporting, describes issues such as the gap (Transparency) Instrument 2008, requiring auditors of between what an audit is and what users expect it to be public interest entities (see Glossary) to publish on their and sets out possible changes to the way auditors websites annual transparency reports. Among other report on financial statements. things, auditors of such entities must provide information about themselves, their quality control systems and their independence procedures and practices. In its report to the Secretary of State for the year to March 2012 (June 2012), POB states that the quality of transparency reports produced by the largest audit firms has continued to improve. Those of the smaller audit - an auditor’s discussion and analysis - required and expanded use of emphasis paragraphs - auditor assurance on other information outside the financial statements Following the Audit Green Paper (October 2010), the EC published (November 2011) a draft regulation on requirements for audits of public interest entities (see - clarification of language in the standard auditor's report. Glossary) and a draft directive amending the Statutory The concept release also seeks comments on Audit Directive. alternatives for amendments to, or the development of Key proposals: new, auditing standards that would supersede the - mandatory tendering of audit mandates for public firms generally meet the statutory requirements but tend to 147 PCAOB’s current standards on the auditors’ report. Auditors Audit quality (continued) provide boilerplate disclosures. In its 2011/12 annual report (June 2012), the AIU reported a further reduction in the proportion of audits requiring significant improvements. However, it noted The PCAOB issued a practice alert (December 2012) on tier firms more opportunities to bid for audit maintaining and applying professional scepticism in mandates, at least one of the firms invited to tender audits to remind auditors of the importance of must be a firm that received less than 15% of its professional scepticism. total audit fees from large public interest entities in pressure on firms to increase audit efficiency and the Member State the previous year recommended that audit firms establish safeguards to ensure audit quality, especially where significant fee interest entities (see Glossary). In order to give mid- - the draft regulation sets out detailed procedures reductions have been agreed. Also, it considered that and selection criteria to be used in the tendering the effect of changes in behaviour promoted by firms to process reinforce professional scepticism in their audit work had yet to be reflected. - any contractual clause entered into between a public interest entity (see Glossary) and a third party The APB issued new ISAs to replace the versions issued restricting the choice of auditor (e.g. to a Big Four in 2004 and a paper summarising the main changes firm) will be void (October 2009). The new standards incorporate the clarified ISAs issued by the IAASB, where necessary - to provide more information to all stakeholders, augmented to address specific UK legal and regulatory including more detail on going concern. Auditors requirements. Compliance with the standards issued by will also be required to provide a more detailed the APB nevertheless enables the auditor to assert full report on the audit to the audit committee and compliance with the ISAs issued by the IAASB. The new management standards became effective for audits of financial statements for periods ending on or after 15 December 2010. the content of the audit report should be expanded - the rule that the majority of capital of audit firms must be held by auditors is to be eliminated to encourage more entrants to join the audit market. The ICAEW Financial Services Faculty published a report, However, the majority of members of the “Audit of banks: lessons from the crisis” (June 2010) administrative or management body must be audit following a six-month research project. Among other firms or statutory auditors. things, it concluded that the audit report had become too standardised and considered that more work FEE published a policy statement (July 2012) on 148 Auditors Audit quality (continued) needed to be done to explain how auditing improves improvements to audit reports. It called for ISAs to be the quality of reported financial information. It amended to require more information to be included in recommended that: the audit report on the auditor’s view on the use of the - auditors should have more involvement in reporting on the front sections of the annual report, e.g. in reporting on whether there are any material omissions in the information provided there - the ICAEW should produce guidance for bank auditors on good practice for reporting to audit committees - going concern assumption by management and on the entity’s audit approach used in relation to the audited entity’s significant audit risks. The IAASB published a consultation paper (January 2013) on an audit quality framework. Among other things, it sought comments on the key factors that contribute to audit quality. banks should develop summary risk statements to explain the big picture on risk and auditors should develop assurance reports to accompany such statements. The FSA and the FRC published a discussion paper (June 2010) which considered ways of enhancing auditors’ contributions to prudential regulation. This followed a review by the FSA into how effective auditors had been in providing the FSA with comfort that the firms they audited had complied with the FSA’s client assets regime. This found certain weaknesses in some of the client assets auditor reports received by the FSA and a lack of understanding by some auditors of the relevant FSA rules. The FSA and FRC published a feedback statement (March 2011) summarising the responses to their joint discussion paper (June 2010) on enhancing the auditor’s 149 Auditors Audit quality (continued) contribution to prudential regulation. The feedback statement notes recent actions, including: - the development by the FSA of a code of practice providing guidance on the relationship between auditors and supervisors of regulated firms. It recognised that timely, relevant information sharing was an essential part of an effective working relationship, and it indicated a minimum level of bilateral and trilateral meetings that should take place for high impact firms. A final version of the code of practice was published (May 2011) - increased dialogue between the FSA and auditors, individually and collectively, to discuss key financial reporting issues - increased use by the FSA of its powers to commission reports from skilled persons under Section 166 of FSMA - publication of a memorandum of understanding relating to information sharing between the AIU and the FSA (January 2011), which included a commitment to meet at least four times a year. The FSA confirmed in the feedback statement that it would not be seeking enforcement powers, as originally suggested, in light of improved co-ordination between the AIU and FSA. The FSA also published (March 2011) a policy statement 150 Auditors Audit quality (continued) setting out new requirements for firms holding client assets and their auditors. This follows a consultation paper (September 2010). The new rules: - confirm and clarify the standards required for auditors’ client assets reports in order to provide clear focus of accountability - increase the quality and consistency of information provided in the report so the FSA can better use it to undertake both firm and thematic reviews - improve firms’ governance oversight of their auditors and their compliance with the client assets rules. The APB published (October 2011) guidance for auditors providing client asset reports, in light of the FSA’s new rules. The APB published (August 2010) a discussion paper on auditor scepticism and a feedback statement (March 2011). Responses suggested a wide range of views about what the initial mindset should be. The APB published a further paper (March 2012), “Professional Scepticism: Establishing a common understanding and reaffirming its central role in delivering audit quality”. This concluded that the immediate emphasis should be on encouraging auditors and others to deliver a step change in behaviours that will achieve consistency in the manner in which 151 Auditors Audit quality (continued) professional scepticism is exercised in the conduct of their audits. The APB also intends to seek to influence the IAASB to enhance the relevant international auditing standards. The Companies and Limited Liability Partnerships (Accounts and Audit Exemptions and Change of Accounting Framework) Regulations 2012 exempt unlisted subsidiary companies outside the banking and insurance sectors from mandatory audit if they fulfil certain conditions with effect for accounting years ending on or after 1 October 2012. The Regulations also align mandatory audit thresholds for small companies with the accounting thresholds for small companies with effect from the same date. The FRC published revisions to ISAs (September 2012) to give effect to its effective company stewardship project and to support changes (September 2012) to the UK Corporate Governance Code and the FRC Guidance on Audit Committees. The FRC consulted (January 2013) on further revisions to ISAs to implement Lord Sharman’s recommendations on going concern assessments. It also consulted (February 2013) on revisions to the standard on audit reports (ISA 700) to make such reports more informative and less of a binary pass/fail opinion. The combined effect of these revisions is to require the auditor to: 152 Auditors Audit quality (continued) - communicate to the audit committee information that the auditor believes the audit committee will need to understand the significant professional judgements made in the audit - report, by exception, if the board’s statement that the annual report is fair, balanced and understandable is inconsistent with the knowledge acquired by the auditor in the course of performing the audit, or if the matters disclosed in the report from the audit committee do not appropriately address matters communicated by the auditor to the committee - consider the directors’ going concern statement and the related disclosures by the audit committee about the directors’ going concern assessment and state in the audit report whether or not there is anything it should add or draw attention to - describe in the audit report the risks of material misstatement that the auditor identified and which had the greatest effect on audit strategy and the allocation of resources in the audit - explain how the auditor applied the concept of materiality in planning and performing the audit - provide a summary of the audit scope, including an explanation of how the scope was adapted to take account of the risks of material misstatement, and the auditor’s application of the concept of 153 Auditors Audit quality (continued) materiality. The revisions will be effective for audits of financial statements for periods commencing on or after 1 October 2012. The FRC and the Institute of Chartered Accountants of Scotland announced (November 2012) that they have commissioned a project to investigate the competencies and professional skills of auditors. This will explore the mix of attributes, competencies, professional skills and qualities that need to be combined in an audit team and consider whether there is a need to reconsider the staffing model for the audit of complex businesses. A report is to be delivered by 30 September 2013. 154 Auditors Non-audit services The UK Corporate Governance Code contains a The EC Recommendation on Auditor Independence Pursuant to SOX § 201, eight specified types of non- Provision (C3.8) that the annual report should explain to (May 2002) adopted a principles-based approach audit services are completely prohibited: shareholders how, if the auditor provides non-audit (whereby auditors cannot provide non-audit services services, auditor objectivity and independence are that would compromise their independence or be safeguarded. Further guidance is given in the FRC involved in management decisions) and set out specific Guidance on Audit Committees. instances where provision of non-audit services caused Auditors’ ethical guidance in relation to non-audit services is set out in ES/5, one of five Ethical Standards for auditors published by the Audit and Assurance team too high a risk to an auditor’s independence. It also recommended full disclosure, at least annually, of fees for audit and non-audit services. within the Codes and Standards Division of the FRC The Statutory Audit Directive followed the basic (which assumed the functions of the APB following the principles laid down in the EC Recommendation but set restructuring of the FRC). It is based on a threats and out additional measures, such as requiring the auditor safeguards approach and provides guidance on non- to document in the audit working papers significant audit services which may create threats to an auditor’s threats to its independence and safeguards to mitigate objectivity or perceived loss of independence. The non- those threats. audit services covered include internal audit, IT services, valuation, tax, litigation support, remuneration and recruitment and corporate finance services. ES/5 also sets out a number of situations where safeguards are insufficient and where audit firms should not provide non-audit services. Following the Audit Green Paper (October 2010), the EC published (November 2011) a draft regulation on requirements for audits of public interest entities (see - bookkeeping - financial information systems design and implementation - appraisal or valuation services or fairness opinions - actuarial services - internal audit outsourcing services - management functions or human resources - broker, dealer, investment adviser, or investment banking services - legal and expert services unrelated to the audit Non-audit services that are not prohibited must be preapproved by the audit committee pursuant to SOX § 301. Glossary) and a draft directive amending the Statutory The above rules have been implemented by SEC Rules Audit Directive. The draft regulation includes a ban on adopted January 2003. large audit firms (essentially, the Big Four) providing The ICAEW has adopted the Ethical Standards and non-audit services and a requirement for them to cross-refers to them in its Code of Ethics (updated separate their audit activities into pure audit firms January 2011). The latest update also reflects (which must be outside a network which provides non- amendments to the IESBA Code of Ethics for audit services within the EU), in order to avoid conflicts Professional Accountants. of interest. The APB published an Ethical Standard for Reporting IOSCO published a statement, “Principles of Auditor 155 Auditors Accountants (October 2006). Many of the requirements of the Statutory Audit Directive in relation to ethics, independence and audit fees were substantially covered by the Ethical Standards and audit regulations issued by Recognised Supervisory Bodies, but required statutory underpinning. This was Independence and the Role of Corporate Governance in Monitoring an Auditor’s Independence” (October 2002), recommending that the audit committee should oversee policies governing circumstances in which contracts for non-audit services could be entered into with the company’s external auditors. achieved by The Statutory Auditors and Third Country IOSCO published a study of the regulation of non-audit Auditors Regulations 2007 which amended Schedule 10 services in 40 countries (March 2007). of CA 06. The IESBA Code of Ethics for Professional Accountants The APB published (December 2011) two amendments (2012 edition) requires accountants to comply with a to its Ethical Standards. These involve: number of fundamental principles, including integrity, - amending the appendix in ES/1 to provide a objectivity, professional competence and due care, simplified illustrative template for communicating 156 Auditors Non-audit services (continued) - information on audit and non-audit services to confidentiality and professional behaviour. It analyses those charged with governance which reflects potential threats to the principles under five headings: amended UK regulations on auditor remuneration self-interest, self-review, advocacy, familiarity and disclosures intimidation and requires auditors to apply safeguards amending ES/5 to extend until 31 December 2014 the transitional arrangement for tax services provided on a contingency fee basis where contracts were entered into prior to 31 December 2010. where a threat has been identified. For listed and certain other public interest entities (meaning those defined by regulation or legislation as such or for which the audit is required by regulation or legislation to be conducted in compliance with the same independence requirements that apply to the audit of listed entities) NAPF’s update of its Corporate Governance Policy and there are new prohibitions on firms providing non-audit Voting Guidelines (November 2012) states that non- services, e.g. certain internal audit services, valuation audit fees should be capped at 100% of audit fees. services, tax calculations, design or implementation of The House of Commons Treasury Committee Ninth certain IT systems and recruiting services. Report, Banking Crisis: reforming corporate governance FEE published a policy statement (July 2012) on the and pay in the City (May 2009) called for a ban on provision of non-audit services to audit clients. It argues auditors providing non-audit services to enhance that non-audit services are not a monolithic bloc which investor confidence and trust. endanger auditor independence and have to be In response to this, ES/5 and the FRC Guidance on prohibited as a whole. It considers that further Audit Committees were reviewed. The call for a ban on harmonisation at EU level could be achieved with the non-audit services was rejected but additional guidance application of the principles and requirements of the was provided. ES/5 as updated (December 2010): IESBA Code of Ethics for Professional Accountants. - provides additional guidance in relation to conflicts of interest and requires auditors to consider the consequential implications for their independence - provides that outsourcing substantially all of the internal audit activity to an audit firm is Certain services should generally be prohibited as provided in the Code but others should generally be permitted with an overall requirement to address specific threats to independence. FEE published a comparison (January 2013) of auditor 157 Auditors Non-audit services (continued) - unacceptable where the work undertaken is independence provisions in the Statutory Audit significant to the audited entity Directive and the EC Recommendation on Auditor prohibits the provision of restructuring services in certain circumstances. Independence and the IESBA Code of Ethics for Professional Accountants. Although they use essentially the same conceptual approach, it notes that the IESBA In addition, the FRC Guidance on Audit Committees Code of Ethics for Professional Accountants contains was amended to clarify how the audit committee stricter provisions for those non-audit services that are should approve non-audit services. This: incompatible with audit services. - requires the audit committee to consider whether the audit firm is the most suitable supplier of the non-audit service and the fees incurred for nonaudit services, both for individual services and in aggregate relative to the audit fee - requires the audit committee to establish a list of non-audit services for which specific audit committee approval is required before they are contracted - provides additional guidance on the explanation to be provided in the annual report as to how auditor objectivity and independence is safeguarded where an auditor provides non-audit services. In its 2011/12 Annual Report (June 2012), the AIU noted that any threat to auditor independence from the provision of non-audit services should be reported to audit committees while there was still time to mitigate the risk. Sufficient detail should be provided to enable an informed assessment as to whether auditor 158 Auditors Non-audit services (continued) independence had been maintained. It considers that auditors are sometimes too ready to underestimate the threats and argue without proper consideration that current arrangements are sufficient safeguards against the threats. Audit committees are entitled to expect a good standard of independence on reporting from auditors and should seek additional information if not initially provided. The Companies (Disclosure of Auditor Remuneration and Liability Limitation Agreements) (Amendment) Regulations 2011 came into force on 1 October 2011 and replaced the previous classification of audit and non-audit services, which large companies and groups must use to disclose the fees they have paid their auditor or associates of their auditor. The new classification is intended to link more clearly to the Fourth and Seventh Directives and the APB’s Ethical Standards. The House of Lords Economic Affairs Committee’s report “Auditors: Market concentration and their role” (March 2011) recommended that external auditors should be banned from providing internal audit services, tax advisory services and advice to the risk committee for the audit client. It also recommended that the OFT examine whether any other services should be banned from being carried out by a firm's external auditors. 159 Auditors Non-audit services (continued) In its response to the House of Lords Economic Affairs Committee’s report (May 2011), the Government asserted that the APB’s Ethical Standard 5, as updated in December 2010, was sufficient to ensure the independence of the auditor. The POB published (June 2012) “Key Facts and Trends in the Accountancy Profession”. It noted that, since 2006, the income of the Big Four from non-audit work for non-audit clients had increased whilst the fee income from non-audit services from audit clients had decreased. 160 Auditors Rotation of audit firm/retendering The House of Lords Economic Affairs Committee’s report The Statutory Audit Directive does not require the A study of mandatory audit firm rotation was required “Auditors: Market concentration and their role” (March rotation of an audit firm, only the key audit partner by SOX § 207. In its report (November 2003), the 2011) recommended that FTSE 350 companies should (see Rotation of audit partner below). However, Recital General Accounting Office concluded that the most carry out a mandatory tender of their audit contract 26 allows Member States to require the change of prudent course of action was for the SEC and the every five years and that audit committees should hold audit firm if appropriate to attain the objectives of the PCAOB to monitor and evaluate the effectiveness of discussions with principal shareholders every five years. Directive. SOX’s requirements for enhancing auditor The FRC published (September 2012) amendments to The EC published (November 2011) a draft regulation the UK Corporate Governance Code. Among other which provides for mandatory rotation of audit firms The NYSE has asked audit committees to consider, things, a separate section of the audit report should of public interest entities (see Glossary) after six years where appropriate, audit firm rotation. describe the work of the audit committee and include an with a cooling-off period of four years before the audit explanation of how it assessed the effectiveness of the firm can be engaged again by the same client. The six- audit process and the approach taken to the year period can be extended to eight years in appointment or reappointment of the external auditor, exceptional circumstances but these are not defined. together with information on the length of tenure of the Although the EC has not mandated joint audits (i.e. current audit firm and when the tender was last audits to be carried out by more than one firm) as conducted. There is also a new provision requiring FTSE originally rumoured, it is seeking to encourage them 350 companies to put the external audit contract out to by extending the period for mandatory rotation from tender at least every 10 years. Transitional arrangements six to nine years where joint audits are conducted have been posted on the FRC website (see under “Audit (extendible to 12 years in exceptional circumstances). tendering”) to avoid all companies putting their audit contracts out to tender at the same time. For details on the tendering procedures set out in the draft regulation, see Audit quality above. In its Developments in Corporate Governance 2012 (December 2012), the FRC states that it is holding meetings with market participants on the conduct of audit tenders, focusing on how to assess the quality of current/prospective auditors. This may result in guidance to assist companies on future tender processes. 161 independence and audit quality. The PCAOB published a concept release (August 2011) seeking views on how to enhance auditor independence, objectivity and professional scepticism. It also discussed mandatory audit firm rotation. Auditors Rotation of audit partner The APB’s Ethical Standard 3 on long-term association The EC Recommendation on Auditor Independence Mandatory audit partner rotation applies to auditors of with the audit engagement provides that, in the case of (May 2002) states that “key audit partners” (broadly SEC-registered companies every five fiscal years (lead listed companies: those responsible for reporting on significant matters) and concurring audit partners) or seven years (other key should rotate within seven years. audit partners) (SOX § 203) (SEC Rules adopted January - no one should act as an audit engagement partner for more than five years - anyone who has acted as the audit engagement partner for a particular audited entity for a period of five years should not subsequently participate in the audit engagement until a further period of five years has elapsed. Ethical Standard 3 permits the extension of the rotation period for the audit engagement partner of a listed company from five to seven years if the audit committee of the audited entity and the audit firm decide that a The Statutory Audit Directive requires key audit partner(s) to rotate within a maximum period of seven years. Key audit partner(s) should not participate in the audit again for at least another two years. The EC’s (November 2011) draft regulation extends this twoyear period to three years. In relation to the audit of listed entities, the IESBA Code of Ethics for Professional Accountants (2012 edition) provides that: - key audit partners should be rotated after serving degree of flexibility over the timing of the rotation is for a pre-defined period, normally no more than necessary to safeguard the quality of the audit. seven years According to Ethical Standard 3, the audit committee and audit firm may decide a degree of flexibility is necessary where a substantial change has recently been made or will soon be made to the nature or structure of the audited entity’s business or where there are - such individuals rotating after a pre-defined period should not participate in the audit engagement until a further period of time, normally two years, has elapsed. unexpected changes in the senior management of the The definition of “key audit partners” was extended in audited entity. Any extension and the reasons for it must 2009 to cover not just the engagement partner and be disclosed to the audited entity’s shareholders as soon the individual responsible for the engagement quality as practicable. control review, but also audit partners on the The FRC updated the FRC Guidance for Audit Committees (December 2010) to reflect the extension of engagement team who make key decisions (e.g. where they are responsible for substantial subsidiaries or 162 2003). Auditors the rotation period as set out in Ethical Standard 3. divisions). The Government implemented the rotation requirements in the Statutory Audit Directive by giving statutory underpinning to the existing Ethical Standards. This was achieved by The Statutory Auditors and Third Country Auditors Regulations 2007 which amended Schedule 10 of CA 06. 163 Auditors Liability of auditors Section 507 of CA 06 provides that it is a criminal The EC established (November 2005) a forum of 20 Current Exchange Act rules regarding independence of offence (punishable by a fine) for an auditor knowingly market experts from various professional backgrounds accounting firms that audit and review financial or recklessly to cause a misleading, false or deceptive to look at issues surrounding the liability of auditors statements and prepare attestation reports filed with the audit report to be made or omit a statement required and consider market-led solutions to mitigate litigation SEC do not explicitly address how auditors may manage under CA 06. risks. their liability to their clients and their clients’ Sections 534 to 538 CA 06 allow shareholders to agree The EC also published a consultation (January 2007) on a limit on the liability of auditors in respect of any whether there was a need to reform rules on auditors’ negligence, default, breach of duty or breach of trust, liability for negligence in the EU. It invited views on four occurring in the course of an audit, by means of a options: a single cap; a cap linked to the firm’s size; a limitation liability agreement or “LLA”. The limit cannot cap linked to audit fees; or proportionate liability. It also reduce the auditors’ liability to less than is fair and published an overview and an update of the civil liability reasonable, and must be subject to shareholder of statutory auditors in Member States (January 2007). approval, to be given on an annual basis before or after shareholders in respect of their work. Rather, the SEC has provided guidance (see Codification of Financial Reporting Policies, Section 602.02.f.i) which provides that “[w]hen an accountant and his client, directly or through an affiliate, have entered into an agreement of indemnity which seeks to assure to the accountant immunity from liability for his own negligent acts, whether of omission or commission….the accountant The EC published a summary report on the responses cannot be recognized as independent.” Further, the (June 2007). The audit profession and respondents from SEC’s Office of the Chief Accountant stated (December An LLA must be disclosed in the annual accounts or countries where a limitation already existed supported 2004) that including clauses in engagement letters directors’ report pursuant to The Companies (Disclosure an EC initiative but the majority of the respondents whereby a company indemnifies or holds the auditor of Auditor Remuneration and Liability Limitation from countries without a limitation rejected any EC harmless from liabilities arising from knowing Agreements) (Amendment) Regulations 2011. action. Generally, the audit profession preferred a misrepresentations by management would also impair limitation based on capping, whereas the other the auditor’s independence (see question 4 under respondents preferred a solution based on “Other Matters”). the company enters into the LLA. The Government took a reserve power (Section 535(2) of CA 06) to make regulations about the kinds of provisions that LLAs should (or should not) contain, proportionate liability. Numerous committees, such as the Advisory Committee particularly with a view to preventing adverse effects on The EC published a recommendation inviting Member on the Auditing Profession, formed by the US Treasury competition. This is a reserve power and the States to limit auditor liability (June 2008) by one or Secretary in May 2007, as well as the Committee on Government stated that it had no plans to use it (see more of the following three methods: Capital Markets Regulation, formed in 2006, - establishing a maximum financial amount (or a recommended that Congress explore protecting audit formula for the calculation of such an amount) firms against catastrophic loss through the provision of paragraph 2.7 of BIS’ consultation paper on implementation of CA 06 (February 2007)). caps or safe harbours, provided that any use of such An FRC working group published guidance on LLAs 164 Auditors (June 2008). The guidance: - - explains what is and what is not permitted under CA 06 - sets out factors for directors to consider when assessing the case for an LLA - - - establishing a set of principles to prevent auditors protection was balanced by stiff action against those being liable beyond the actual contribution to the responsible for misconduct. A report by the Mayor of loss suffered (so that the auditors are not jointly New York and Senator Schumer similarly recommended and severally liable with other wrongdoers) capping auditor liability. However, no action has been allowing the company and auditor to determine taken by Congress or the SEC. liability by agreement. Any agreement must be The Advisory Committee published its final report provides specimen clauses providing for subject to judicial review, the limitation must be (October 2008), but was unable to reach a consensus as proportionate liability, liability based on a fair and decided by the administrative body of the company to whether limits on auditor liability would be beneficial reasonable test and a monetary cap (i.e. the board in the case of a UK company) and or harmful to the capital markets and to investors or, for explains the process for obtaining shareholder must be subject to shareholder approval. The that matter, whether such limits were necessary to approval for public and private companies and sets limitation and any modification to it must be sustain the auditing profession. out specimen resolutions. published in the notes to the accounts of the company. 165 Auditors Liability of auditors (continued) The ISC published a statement on LLAs (June 2008) to Member States were asked to inform the EC of any coincide with the FRC guidance. The statement explains measures taken by 5 June 2010. what institutional investors will expect from companies seeking shareholder approval for LLAs and provides guidance on the disclosures that institutional investors will require. Fixed caps are not acceptable and a key concern is audit quality. NAPF supports proportionate liability and also opposes a cap. Its Corporate Governance Policy and Voting Guidelines (November 2012) state that investors should consider voting against resolutions which propose any form of liability limitation other than proportionate liability unless there are compelling reasons why that is not appropriate. The GC100 has published a note on LLAs (July 2009). This sets out the main issues for boards to take into account when deciding whether or not to enter into an LLA and gives guidance on what is meant by proportionate liability and how to explain the impact of proportionate liability to shareholders. In practice, in part because of the SEC’s views for USregistered companies, LLA provisions have not been entered into by listed companies. The House of Lords Economic Affairs Committee’s report “Auditors: Market concentration and their role” (March 2011) recommended that auditors’ unlimited liability be investigated by the OFT to determine 166 Auditors Liability of auditors (continued) whether it deterred non-Big Four auditors from taking on large listed clients. In its response to the House of Lords Economic Affairs Committee (June 2011), the Government indicated that it has no current plans to further limit liability for auditors. 167 Linklaters LLP One Silk Street London EC2Y 8HQ Telephone: (44-20) 7456 2000 Facsimile: (44-20) 7456 2222 http://www.linklaters.com/