Company distributions have become a controversial subject. The Business, Energy and Industrial Strategy (BEIS) consultation on ‘Restoring Trust in Audit and Corporate Governance’ published in March outlines a number of proposals aimed at protecting investors – but will they achieve their aims?
The BEIS consultation – open for comment until 8 July – is the UK Government’s response to the three independent reviews by Sir John Kingman on the Financial Reporting Council (FRC), Sir Donald Brydon on the quality and effectiveness of audit, and the Competition and Markets Authority on the audit market. Its proposed measures, which aim to enhance the quality of corporate governance, corporate reporting and audit, include proposals to strengthen the law on dividends and capital maintenance and provide more transparency in corporate reporting.
KPMG issued a paper in December 2019 to prompt further thought and discussion around this complex and important topic.
What issues are BEIS seeking to address?
There are three key issues:
- No fixed definition of realised profits and losses: Current guidance on what ‘realised’ means is kept by the accounting bodies, ICAEW and ICAS
- Perceived lack of transparency: Currently, law and accounting standards do not require disclosure of distributable profits
- Backward-looking: The law’s focus on capital maintenance and realised profits and distributable reserves represent a snapshot in time reflecting a company’s past performance and financial position
The proposals aim to address weaknesses in the framework of rules governing dividend payments rather than replacing them with an entirely new system, although views on alternative systems are welcome.
The proposals focus on three key themes:
- Improving disclosure by companies;
- Requiring directors to make a solvency statement on the legality of proposed dividends and the effects on future solvency; and
- Transferring responsibility for rulemaking to the Audit, Reporting and Governance Authority (ARGA).
How could companies improve disclosures?
BEIS proposes that listed and AIM companies should be required to disclose in the audited financial statements:
- Distributable profits of individual companies (or the UK parent company); and
- An estimate of the group’s dividend-paying capacity.
BEIS asks whether Section 172 of the Companies Act 2006 (s172), together with encouragement from investors and ARGA, is enough to ensure companies disclose their distribution and capital allocation policies.
What investors have told us
- Investors want to see clear disclosure of the balance of distributable profits for the parent company and some also strongly support the disclosure of distributable reserves that the parent company could realistically raise from subsidiaries.
- Participants acknowledged the great complexity that preparers of financial reports would need to navigate in applying a group basis and some believed greater narrative disclosure would be more helpful, including where distributable capital is held within a group and what reasons there are for not repatriating the capital to the UK (e.g. local regulatory requirements, local investment necessary to deliver strategy).
- The publication of a company’s dividend policy and approach to share buybacks would be useful and promote better discussions between investors and companies.
- Comparability is key. There is some scepticism over BEIS’ perceived belief that investor pressure will fill the gap on transparency of disclosure around distribution and capital allocation policies; investors believe a specific disclosure requirement is preferable.
How much would a solvency statement help?
For Listed and AIM companies, a new directors’ statement about the legality of proposed dividends and effects on future solvency would be required, covering:
- Confirmation by directors that the dividend is within known distributable reserves and have had regard to their duties arising from s172, wider common law and fiduciary duties; and
- Confirmation that the directors:
- expect that payment of a dividend will not threaten solvency within the next 2 years; and
- believe that the dividend is consistent with the Resilience Statement where one is produced.
What investors have told us
- What matters most is that the company is able to pay the dividends out to shareholders, without risking ‘going bust’ in the near future.
- A solvency statement is welcome but greater consistency on time periods is needed – the period of 2 years does not align with the going concern assessment period and the time frames in the new Resilience Statement.
- Disclosure on sufficiency of reserves might help concentrate minds and reduce administrative errors – but is it enough to change behaviours?
Responsibility for rulemaking: who should own it?
BEIS proposes to transfer responsibility for defining realised profits and losses to the FRC’s successor (ARGA) and enhance legal status and enforceability of that definition, either as:
- Guidance with authoritative status for directors to ‘have regard to’; or
- Binding rules.
What investors have told us
- The most appropriate owner of any reformed regime would be ARGA – provided that they are armed with sufficient resources, skills and knowledge to deliver effective oversight.
- The current model is outdated and a new approach to regulating when companies are or are not allowed to voluntarily pay out dividends is needed.
- Participants felt the proposals fell short and a more robust forward-looking assessment was needed. Other options should be considered such as a prudential or solvency test.