The British Union Jack flag is seen on the desk of a Member of the European Parliament ahead of a debate on the future of Europe, at the European Parliament in Strasbourg, France, March 12, 2019. REUTERS / Vincent Kessler

For years, UK auditors and their regulator seem to have stood on the sidelines as companies ignored crucial capital maintenance and creditor protection law. This has likely contributed to large and damaging bankruptcies and a broader loss of confidence in corporate accounts. It is therefore welcome that the UK government has brought the issue to the fore in its recent proposals to restore confidence in auditing and corporate governance. But rather than reinforcing existing requirements, the proposed solutions are dangerously insufficient.

Preventing unnecessary insolvencies is a critical issue in any economy. This is important for workers, suppliers, customers, investors, creditors and pension funds, as well as for taxpayers who too often foot the bill in corporate bankruptcies. While business inevitably comes and goes in any vibrant economy, recent bankruptcies of UK companies such as outsourcing and construction group Carillion, travel agent Thomas Cook and investment house London Capital & Finance put highlight flaws in the way companies account for profits and capital. This creates hidden and potentially fatal risks.

Reports of private equity investors charging acquired companies with debt and withdrawing large dividends raise similar questions. Are financial accounts a tool for extracting dangerous rents, rather than a means of ensuring the resilience of capital? If so, why are listeners failing to sound the alarm bells?

The UK Department for Business, Energy and Industrial Strategy (BEIS) white paper, released last month, rightly points out the duty of directors to protect capital and legal restrictions on dividend payments. These capital protection requirements are not unique to the UK, although the details vary by jurisdiction.

In Great Britain, directors are prohibited from paying dividends that eat away at a company’s capital, after taking into account expected losses and liabilities. They also cannot distribute profits that have not been made in cash or cash equivalents. This underlies the “going concern” status of a business.

As BEIS notes, recent high-profile corporate bankruptcies raise the question of whether companies and their auditors are following and enforcing the rules. Take Carillion, which went into liquidation in January 2018, causing thousands of job losses. Despite its heavy reliance on long-term contracts, Carillion appears to view the revenues and profits from these deals as certain enough to support cash dividends. In March 2017, the board approved a final dividend of £ 54million a few weeks before the surprise announcement that it would withhold additional payments over concerns over the viability of long-term contracts. Far from signaling solid financial health, Carillion’s uninterrupted flow of dividends since 1999 appears to have eaten away at its capital.

Yet while BEIS has correctly diagnosed a serious problem, its proposals to prevent directors from paying excessive dividends – apparently based on advice from the audit industry – are disconcertingly weak. In fact, they appear to fall outside the current legal standard.

The UK Companies Act 2006 sets out detailed requirements that directors must meet in order to protect capital. The net asset test is essential to this regime, which BEIS and the International Accounting Standards Board recognize is not addressed by international accounting standards. This prevents companies from paying dividends on so-called non-distributable reserves. These reserves include the capital paid in by shareholders, plus accrued but unrealized profits.

In other words, a company can recognize its profits today using International Financial Reporting Standards even though it will only receive the cash in the future. Under UK law these profits should not normally be distributed to shareholders as dividends.

Company law further requires companies to set aside undistributable capital to cover future losses and liabilities, even when the timing or amount is uncertain. A company that knows it faces onerous costs, such as preparing for climate change, shouldn’t ignore this when planning its dividends. Importantly, the law explicitly states that companies must include the amount of non-distributable reserves in their published audited accounts, to show that dividends are both prudent and legal.

Given this legal framework, the proposed reforms seem timid. First, BEIS suggests that directors should declare their distributable reserves “if possible”. If they don’t know the extent of their reserves, they should publish what is known and limit dividends to that amount.

Although this approach seems reasonable, given the existing legal requirement, why don’t the directors know their distributable reserves? Shouldn’t the number of undeliverable reserves already appear in the audited accounts? Do directors properly segregate unrealized gains as required by law? Have they provisioned for probable losses and liabilities? Most importantly, isn’t this information essential in judging whether a business is in operation – an assessment that directors are required to make each year?

This apparent oblivion is not new. UK auditors and the Financial Reporting Council, the industry regulator, have long argued that there is no legal obligation for companies to disclose distributable reserves. In 2015, George Bompas QC unequivocally rejected this view. All existing legislation, he argued, “presupposes that properly prepared accounts will allow the user to determine what is distributable and what is not.”

Second, for companies that combine several subsidiaries into a group, BEIS suggests that directors should “estimate” the total distributable reserves. They can also choose which branch reserves to include. Yet each of these underlying companies is already subject to requirements that directors must know and report their non-distributable reserves. It shouldn’t be a question of estimation. It should be audited.

A third proposal from BEIS is to request a certificate from the directors that any proposed dividend will not threaten the solvency of the company over the next two years. However, company law already requires that foreseeable losses and liabilities be recognized, without a two-year delay.

Finally, BEIS wishes to know whether the newly authorized audit regulator should define the guidelines for the calculation of distributable reserves, rather than leaving them to the auditors themselves. Of course, it should. The current confusion confirms that the audit industry cannot be relied on to draft its own guidelines. The government should write the rules that administrators and auditors must follow.

Confidence in business intrinsically depends on strong capital protection. A regulator should be empowered to ensure that directors and auditors comply with their legal obligations. At one point, this essential function was lost. What is most puzzling about the UK government’s proposals is not only that the suggested reforms are insufficient, but that the legal requirements for capital maintenance have become a matter of consultation rather than enforcement.

NEWS FROM THE CONTEXT

– Natasha Landell-Mills is a partner and responsible for stewardship at Sarasin & Partners.

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