The U.K. government is joining up the dots on the need for trust to build a strong commercial ecosystem for business. It intends to broaden the remit of audit, introduce new reporting obligations on businesses, and break the dominance of the Big Four accounting firms by requiring the use of smaller “challenger” firms by large companies. It would back up the new accounting regulator ARGA by legislation funded by a mandatory levy on industry with stronger powers of enforcement, in plans announced today.

Under the UK’s Corporate Governance Code, companies could be expected to write into directors’ contracts that their bonuses will be repaid in the event of collapses or serious director failings up to two years after the pay award is made, said the Department of Business, Energy and Industrial strategy (BEIS) as it launched a consultation to last 16 weeks.

“Restoring business confidence, but also people’s confidence in business, is crucial to repairing our economy and building back better from the pandemic. When big companies go bust, the effects are felt far and wide with job losses and the British taxpayer picking up the tab. It’s clear from large-scale collapses like Thomas Cook, Carillion and BHS that Britain’s audit regime needs to be modernised with a package of sensible, proportionate reforms” said, Kwasi Karteng, Business Secretary.

Mr Karteng signalled his determination to tackle audit reform and his thinking on the direction of corporate governance soon after he took on the role of Business Secretary when, in January, he launched legal proceedings “in the public interest” against former directors of Carillion, the U.K.’s second largest construction company which went into liquidation three years ago. This was aimed at banning them from holding senior boardroom positions in the country for a period unto 15 years, and was covered at the time on Board Talk.

Not only Carillion, but large-scale company failures at Thomas Cook and BHS are cited by the government as having contributed to an undermining of investor and public confidence in recent years in how businesses are governed. Post-Brexit, the U.K. government is keen to strengthen the country’s position as a world-class destination for investors. In a speech yesterday to launch the HM Treasury Women in Finance Annual Review, the new Chief Executive of the Financial Conduct Authority (FCA), Nikhil Rathi, stressed the importance of diversity and inclusion in the capital markets.

“In the US, we have seen the Nasdaq take the lead with its listing rules, which will require all companies its listed on its US exchange to have, or explain why they do not have, at least two diverse directors. As part of our regulatory work on diversity and inclusion and the listings framework, we will be exploring whether we should make similar requirements part of our premium listing rules” said Nikhil Rathi.

This is the strongest statement yet that the U.K.’s regulators see diversity and inclusion as a regulatory issue, although we have been inching towards it for some time in the language of voluntary corporate governance standards.

Today’s announcement builds on and consolidates a wide variety of U.K. government initiatives, seemingly aiming to span the broadest range of stakeholders in the conversation on the role of business in society - investors, employees and consumers.

“Robust and rigorous scrutiny of large firms provided by auditors, as well as greater transparency and trustworthy information, is essential to ensuring that investors, employees and consumers have an accurate picture of the health of the company - underpinning a thriving pro-enterprise business environment in the U.K” it said. It aims to unleash competition in the audit market with its reforms, drive up both quality and standards in the market and increase choice by breaking up the Big Four dominance.

Such reform has been much demanded, discussed and awaited. Last year, the Financial Reporting Council (FRC) shockingly reported a third of FTSE 350 audits to be “unacceptable.”

As well as requiring large companies to use smaller firms to conduct a meaningful portion of their annual audit, the government warns that the Big Four could face a cap on their market share of FTSE 350 audits if competition in the sector does not improve. The new regulator ARGA (Audit, Reporting and Governance Authority) could also oversee the largest unlisted companies, and “will have the power to impose an operational split the audit and non-audit functions of accountancy firms to reduce the risk of any conflicts of interest that may affect the standard of audit they provide.”

Conflict of interest is, of course, at the very heart of the structures that can dissolve the glue of corporate governance, and acknowledging it, preventing it, calling it out is essential for the credibility of governance, as mentioned repeatedly in this blog.

Today the U.K. government is also proposing new reporting obligations be introduced on both auditors and directors around detecting and preventing fraud, with boards required to set out what controls they have in place and auditors expected to look for problems.

Coming as this does two days after the Financial Conduct Authority (FCA) announced the first criminal proceedings under the Money Laundering Regulations 2007 (MLR 2007) and the first against a bank, this will lead to a frisson in financial circles around individual accountability . No individuals will be charged as part of these proceedings, said the FCA in the MLR announcement, sparking an immediately sceptical public response on social media. The much-vaunted Senior Managers regime, intended to change culture in financial services, has lost its novelty. Now it looks as if there may be a new conviction towards changing behaviour by pinpointing blame.

Not only could directors of large businesses face fines or suspensions in serious cases of failings - such as significant errors with accounts, hiding crucial information from auditors or leaving the door open to fraud, but they could be hit where it might hurt most - their wallets.

“Under the U.K.’s Corporate Governance Code, companies could be expected to write into directors’ contracts that their bonuses will be repaid in the event of collapses or serious director failings up to two years after the pay award is made, clamping down on “rewards for failure” says today’s announcement.

As part of this overhaul of corporate governance in the U.K., there is a new demand of transparency from large businesses on the state of their finances, “so they do not pay out dividends and bonuses at a time when they could be facing insolvency.” This point is a critical one to re-establish trust with an increasingly cynical public note weary and angry at seeing income inequality grow during the pandemic on top of pension deficits and dividend payouts. Directors would be expected to publish annual ‘resilience statements’ that set out how their organisation is mitigating short and long-term risks, said BEIS.

The messaging from the U.K. government over the past six months, with just over six months to go before the UN climate change conference COP26 has just become clear.

Last November the government announced its intention to lead the G20 in becoming the first member to demand mandatory climate disclosures by large companies and financial institutions across the country, covered here on Board Talk. The Chancellor of the Exchequer, Rishi Sunak, also announced the launch the world’s first sovereign green savings bond, to be used to finance projects tackling climate change, infrastructure and the creation of green jobs.

The need for action on the climate crisis is uniting the general public in a way that nothing else can, because this is a universal threat and its activists and everyday supporters span both generations and socio-economic background. Britain is no different than any other country on that, except that it has a real chance to show leadership at COP26.

Today’s announcement reveals that the U.K. government intends to extend audit beyond a company’s financial result to look at wider performance, including against key climate targets, “to ensure investors and other interested parties are fully informed and can hold companies to account as the U.K. seeks to eliminate its contribution to climate change by 2050.”

This could be a harbinger of real change in the workings, the strategic direction - and the face - of corporate Britain.

Among the dots that link up with today’s announcement is the large pulsating dot of diversity and inclusion. The speech (mentioned earlier ) yesterday by Nikhil Rathi, FCA CEO is recommended reading for an understanding of change. It has been under his leadership that the regulator has made four senior appointments recently, all of whom happen to be women.

He concluded by saying : “ In our recent guidance of vulnerability, we said that firms - all firms - needed to understand the needs of their customers and be able to respond to them through product design, flexible consumer service and communications. I would question if any firm can adequately respond to the needs of these consumers if they do not have diversity of background and experience required to overcome biases and blind spots. Ultimately, improving diversity and inclusion is both a matter of fairness and a crucial way to strengthen consumer outcomes.”

The difference today from past comments on diversity is that the warning from the regulator is unequivocal. “In the years ahead, if we don’t see improvements in diversity at senior levels and better answers, we will also consider how to best use our powers” said Nikhil Rathi.

There is a lot to digest here, and the consultation ends on July 8th, lasting 16 weeks “in light of the current challenges to the UK economy.” It has been welcomed by Sir Donald Brydon and Sir John Kingman, upon whose reviews it is based.

Welcoming the government’s commitment to restoring trust in audit through these reforms, Andrea Costelli, Chief Executive of the Competition and Markets Authority said: “The consultation contains many good proposals, which reflect the CMA’s recommendations and - if they become law - will help improve the health and quality of the audit market.”

As ESG (environmental, social and governance ) issues ascend on the global stage, complete with the values they represent, and the real-life consequences of ignoring them, all eyes will now be on the U.K.

“Audit failure isn’t an abstract problem, it has real life consequences” said Lord Callanan, Minister for Corporate responsibility today.

Useful information : The main proposals today draw upon the Brydon Review, with Sir Donald Brydon’s recommendation for a new audit profession, on the Kingman Review recommending the replacement of the FRC with a new regulator and the Competition and Market Authority (CMA) findings on Big Four dominance of audit and the undermining of market resilience. Sir John Parker’s 2017 Review and its update in 2020 on race and ethnicity in representation in boardrooms is significant in the approach now on diversity and inclusion.

Main Image credit: Department of Business, Energy and Industrial Strategy (BEIS), London, UK.