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Keeping the Owners Informed - Proposals to Improve Corporate Reporting in the UK, Contributed by Frances Le Grys and Nigel Banerjee, Hogan Lovells International LLP

Tuesday, November 15, 2011

The maxim seems to be true that every economic crisis brings its own corporate governance reform. As this crisis is longer than any previous one, it is perhaps not surprising that new governance proposals continue to appear. At the heart of last year's Corporate Governance Code (Governance Code) was the principle that the relationship between shareholders and companies needed to be improved. As part of this, attention has been directed to the quality of corporate reporting. Having consulted on a number of proposals in the first quarter of 2011, the Financial Reporting Council (FRC) has recently published details of the measures it plans to take to encourage a better-informed and more open dialogue between directors and shareholders.1

A Small Piece of the Jigsaw

The stream of initiatives designed to ensure that lessons are learned from the financial crisis shows no signs of abating. From domestic consultations on narrative reporting,2 executive remuneration,3 and liquidity risks,4 to the European Commission's green papers on corporate governance,5 there is an array of efforts to improve a system which, in many people's eyes, failed spectacularly. It is not an easy task to pin down exactly where the FRC's work on corporate reporting fits into this jigsaw, for many of the points upon which it touches are linked to other initiatives. For example, it is impossible to consider the FRC's conclusions on reporting on risks in the narrative report without referring to BIS' plans to re-write substantially the narrative reporting framework. The FRC's proposals do not necessarily have a place of their own in the somewhat haphazard process of reforming the corporate reporting framework, but should be read with an eye on the many other possible changes that are being considered.

The FRC's Initial Proposals

If there does not always seem to be an apparent sense of coherence about the wider efforts to improve the corporate governance regime, transparency was very much the underlying theme of the FRC's January 2011 consultation paper, entitled "Effective Company Stewardship – Enhancing Corporate Reporting and Audit" (Consultation Paper). Ironically, the reference in the paper's title to "stewardship" has the potential to cause a certain amount of confusion. In July 2010, the FRC published the UK Stewardship Code, which, in the words of its preface, "sets out good practice on engagement with investee companies to which the FRC believes institutional investors should aspire." In that context, stewardship relates primarily to the act of ownership and the role of institutional investors in engaging with the companies in which they invest. While the Consultation Paper certainly ties in with this aspect of stewardship (the purpose of increasing transparency in company reporting is to assist shareholders in engaging with their company), it is important to recognise that it also concerns the stewardship role played by directors in their capacity as day-to-day managers of the company. Among the main recommendations in the Consultation Paper were the following:
  • Directors should ensure that the annual report provides a fair and balanced report on their stewardship of the company's business;
  • Directors should describe in more detail their efforts to ensure the reliability of the information on which the management of the company is based;
  • The increasingly important role of the audit committee should be reinforced through fuller reports by audit committees, and by expanded auditor reports that address the completeness and reasonableness of the audit committee's report;
  • Companies should harness technological developments to improve the accessibility of the annual report – in order to release resources to enable companies to explore the possibilities, they could be freed from the obligation to produce hard copy annual reports; and
  • Investors should be more involved in the auditor appointment process – the Consultation Paper suggested that the audit committee could be required to report on the appointment process or even to discuss the matter with key shareholders.
The consultation closed at the end of March 2011. Not surprisingly, given the controversial nature of some of the proposals, it elicited more than 100 responses, and in light of the feedback the FRC published its conclusions in September 2011.6

Feedback: Next Steps

One of the features of the post-financial crisis reform process, at least in the field of corporate governance, has been the extent to which the Government and regulators have refrained from imposing changes without consultation and many of the reforms are attended by discussion papers, stakeholder discussions, consultation papers and feedback statements. Whatever the disadvantages of such a cautious approach to reform, one of its advantages is that there is plenty of scope to mould proposals into an acceptable form or even, if there is sufficient opposition, to drop them altogether. In this case, the FRC has adopted a particularly pragmatic approach to its original proposals. While its September 2011 Feedback Statement contained plans for a number of significant reforms, two of the most eye-catching proposals in the Consultation Paper were abandoned in the face of objections from stakeholders. The FRC's key conclusions are outlined below.

— Audit Committee

The Feedback Statement provided that the audit committee's role should be expanded and its profile as a body charged with overseeing the company's financial affairs should be raised. The FRC proposed that it should consult on amendments to the Governance Code and the Guidance on Audit Committees (formerly entitled the Smith Guidance) to the effect that, in relation to FTSE 350 companies, the:
  • Remit of the audit committee should be extended to include an assessment of: (1) whether the annual report provides the information required in order to allow stakeholders to assess the company's performance and prospects; and (2) whether the annual report is fair and balanced;
  • Audit committee should report to the board on matters including the issues that it considered in relation to the financial statements and the effectiveness of the external audit; and
  • Full audit committee report should be included in the annual report.

— Narrative Reporting

In the FRC's view, narrative reports should focus mainly on strategic risks rather than on purely external risks (e.g., disruption to air travel or natural disasters), and should not consist of an indiscriminate list of every risk which the company faces. Companies' assessment, management and reporting of risk is a particular concern for the FRC, and its work in this area extends beyond this initiative. The latest edition of the Governance Code contains a new principle detailing the board's responsibility for determining the nature and extent of the significant risks it is willing to take,7 and the FRC is planning to review the Turnbull Guidance in 2012 in light of a series of recent discussions with interested parties.8 Meanwhile, Lord Sharman's inquiry for the FRC into going concern and liquidity risks published draft recommendations in November 20119 and is planning to issue its final report in February 2012. The FRC will also work with BIS on the latter's project to introduce substantial reforms to the narrative reporting framework. The core proposal in BIS's September 2011 consultation paper entitled "The Future of Narrative Reporting – Consulting on a New Reporting Framework"10 is to replace the business review and directors' report with:
  • A "strategic report" consisting of a high-level account of the company's strategy and risks; and
  • An "annual directors' statement" containing detailed information set out in a prescribed structure.

— Audit

The FRC also proposes introducing a requirement for companies either to put their audit out to tender at least once every 10 years or to explain why they have not done so. The suggestion in the Consultation Paper that shareholders should be more involved in the auditor appointment process, possibly even through discussions with the audit committee, has been abandoned. The Feedback Statement notes that this was probably the most controversial of the FRC's proposals, and apparently it met with considerable opposition from listed companies. According to the FRC, the role of the auditor in providing independent oversight of the company's financial statements and annual report should be made more transparent. To this end, the FRC will propose revisions to auditing standards on audit reports and reporting by auditors to audit committees.

— Publication of Annual Reports

The suggestion that companies could be freed from the obligation to publish their annual reports in hard copy has been abandoned. This proposal sparked considerable debate, and there is no doubt that it could potentially have resulted in significant cost savings for companies. However, the FRC seems to have been swayed primarily by concerns that some small shareholders would find it difficult to obtain copies of reports if they were not published in hard copy. On balance, the FRC's decision seems sensible. While it is true that companies with a large base of small shareholders might well have opted to continue to produce hard copies on a purely voluntary basis, it seems likely that the change would have disadvantaged at least some investors, and that fact would not have sat well with the FRC's clear and stated efforts to increase shareholder engagement. The Feedback Statement makes the point that companies should, nevertheless, explore options for using technology to make reports more accessible.


In the midst of all the corporate governance changes that are swirling around at the moment, it is important to keep in mind the simple fact that shareholders, rather than directors, own companies. That is why, as the FRC notes in the introduction to the Feedback Statement, the UK's approach to corporate governance is based on shareholder engagement. But, effective engagement is not possible if shareholders do not have to hand all the relevant information about the company, the way in which it is being run and the risks relating to its business, and it is right that the FRC, amongst others, is working to ensure that they have access to that information. Ultimately, however, UK company law already provides shareholders with many of the tools they need in order to ensure that their company is being run broadly in accordance with their wishes. Furthermore, while the reforms which may flow from the Feedback Statement may be sensible, they will amount to very little unless shareholders actually want to be actively engaged in the companies in which they invest. (c) 2011 Hogan Lovells International LLP Frances Le Grys is a partner in the London office of Hogan Lovells International LLP and heads the firm's Corporate Governance Unit. Frances has extensive experience in cross-border and multi-jurisdictional matters, as well as corporate restructurings and reorganisations and shareholder arrangements and joint ventures. Telephone: +44 (0) 20 7296 2781; E-mail: Banerjee is a professional support lawyer in the firm's London office. Telephone: +44 (0) 20 7296 2618; E-mail:
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