What sanctions are necessary?

Sanctions under the Companies Acts

Centre stage in this segment of the Virtuous Circle are the Companies Acts. A traditional view of sanctions for breaches of the Companies Acts would categorise them, in general terms, as follows:

imprisonment of officers: for example, should a company wish to disapply rights of pre-emption in relation to a further issue of shares, it must seek the consent of shareholders and, in doing so, the directors must provide a statement setting out certain matters, including the reason for recommending the resolution be passed. To the extent that a director knowingly or recklessly permits the inclusion of any matter that is false or deceptive in that statement, he commits a criminal offence punishable by a twelve-month term of imprisonment if convicted on indictment;

fines for companies and/or directors: for example, a director failing to disclose to the board a personal interest in a transaction or arrangement to which the company is already a party is liable to an unlimited fine if convicted on indictment;

civil remedies and restitution: for example, a loan entered into between a company and a director which breaches the Companies Acts is voidable at the option of the company; as such the company will be able to rescind the transaction and recover any money or other asset with which it has parted; furthermore, the director involved is liable to account for any direct or indirect gain he has made from the transaction as well as being liable to indemnify the company for any loss it has suffered.

Sanctions and corporate reporting

Fundamental to an effective system of corporate governance are disclosure and transparency – hence their prominence in the Virtuous Circle. Directors of companies failing to keep ‘sufficient’ accounting records can be sentenced to up to two years’ imprisonment if convicted on indictment. If annual accounts are approved which do not comply with the Companies Acts or, in the case of the consolidated accounts of listed companies, IFRS, then every director who is party to their approval and who knows they do not comply or is reckless as to whether they comply is liable to a fine.

Key disclosures in annual accounts, aside from the financial statements themselves, are contained in the directors’ report (the requirements of which are also prescribed by the Companies Acts) and directors can be fined if directors’ reports are non-compliant.

Ultimately, failure to deliver accounts to the Registrar of Companies within the permitted time limits renders directors liable to a fine, and in 2004/5 there were more than 2600 convictions for this offence.16 Thus, the boundaries of

16 DTI Report, Companies in 2004–5, published October 2005.

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the corporate reporting regime seem to be secure – with strong sanctions based on the criminal law. However, more sophistication is required for the system of corporate reporting to work effectively.

The role of auditors

Arguably, a more sophisticated sanction securing compliance lies in the role of auditors. As the steering group which undertook the Company Law Review emphasised in its 2001 report: ‘The auditor’s role is fundamental in ensuring truth and comprehensiveness in reporting, and that management is properly accountable to shareholders and to external constituencies. The audit process also benefits these interests indirectly, by encouraging good corporate governance.’17 The Hampel Report stated: ‘The statutory role of the auditors is to provide the shareholders with independent and objective assurance on the reliability of the financial statements and of certain other information provided by the company. This is a vital role; it justifies the special position of the auditors under the Companies Act.’18

Audit reports must state whether accounts have been properly prepared in accordance with the requirements of the Companies Acts or IFRS and whether the information in directors’ reports is consistent with those accounts. Auditors must also report to shareholders on the auditable part of the directors’ remuneration report and state whether it has been properly prepared.

Auditors must investigate and then state whether the accounts give a true and fair view of the financial position of the company. No board wishes to have a qualified audit report and the compelling effect that the threat of such a qualification would have on conditioning board behaviour is obvious.

The presentation of the true and fair view means that an auditor’s opinion is given on the substance of accounts, rather than their strict legal form, and that should make UK companies less susceptible to the problems unearthed in the Enron case. That said, the Government has heeded arguments that the introduction of IFRS has weakened this position such that, under the 2006 Act, directors will also be required to stand behind this statement.

This system of checks, balances and accountability is strengthened by the regulation of the audit profession through professional standards set by the APB, and scrutiny of individual audits through the POB, the AIDB and the individual Accountancy Bodies. Moreover, the FRRP has been given authority to review accounts of public and large private companies for compliance with the law and accounting standards and keep under review interim and final reports of listed issuers. By way of sanction, the FRRP may apply to the court to compel a company to revise defective accounts and the FRRP’s remit now extends to the business review elements of directors’ reports.

17Para 5.129, Company Law Review.

18Para 6.2, Report of the Committee on Corporate Governance, January 1998.

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What sanctions are necessary?

If one adds to this regime the changes made to address auditor conflicts of interest – namely the controls over provision of non-audit services and the requirement for audit partner rotation – one might conclude that the boundaries of the UK corporate reporting regime were effectively policed. Yet legislation has gone further still.

Plugging the ‘expectations gap’

The Company Law Reform steering group stated in 2000 that, in relation to corporate reporting and the audit process, there was an ‘expectations gap – that is the gap between what auditors can achieve and what users think they can achieve’. The group said that

The general public . . . often assumes that a primary task of the statutory audit is to expose fraud and other criminality. Governments and regulators also expect an increased contribution towards the detection of fraud. In reality auditors cannot be expected to detect a carefully planned and executed fraud’ [and] Even among informed commentators there can be a reluctance to accept that corporate failure is an inevitable feature of the capitalist system and that the collapse of large companies will tend to expose accounting weakness and financial malpractice.19

A year later, the collapse of Enron precipitated UK legislation (the C(A,ICE) Act) aiming to plug this expectations gap, avert similar disasters in the UK and increase the reliability of, and confidence in, company accounts. First, auditors were given extended powers to require information and explanations from a wider group of people, including employees, and a criminal offence for failing to provide that information was introduced. Second, directors were obliged to include in accounts a statement that, so far as each of them was aware, there was no ‘relevant information’ of which the auditors were unaware, and that they had taken all the steps they should have to avail themselves of such information and ensure that the auditors knew of it as well. A director failing to do so risks possible imprisonment or a fine. This second limb is a potentially onerous obligation, and immediately begs the question of how far each director needs to go to satisfy himself that he has investigated and passed on all relevant information and the extent of the audit trail required to prove it.

The 2006 Act goes further still. Two new criminal offences are to be introduced for auditors where they knowingly or recklessly cause an audit report to include ‘any matter that is misleading, false or deceptive’ or knowingly or recklessly cause a report to omit a statement that is required by the Act. Each offence is punishable by a fine – the original proposal had been to allow a custodial sentence.

19Para 5.129, Modern Company Law for a Competitive Economy – Developing the Framework – March 2000, Company Law Reform Steering Group.

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