SMEs get a reprieve from new audit and governance reform

On 31 May, following a long consultation process, the Government published its responses to proposals intended to restore trust in audit and corporate governance. The Government’s responses significantly dilute many of the initial proposals for reform, a move which is likely to provide some welcome relief to the boards of smaller listed and AIM companies battling to cope with regulation and corporate governance compliance. On the other hand, the scope has been broadened to include larger private companies.

The Government’s responses can be found here.

Perhaps the most significant change is to the scope of the reform and the definition of Public Interest Entities (PIEs). These are entities whose transferable securities are admitted to trading on a regulated market, credit institutions, or insurance undertakings. The initial proposal was that all quoted companies having a market capitalisation above a threshold of €200m should be treated as PIEs.

The Government will amend and expand the definition of PIEs to include quoted companies, companies traded on Multilateral Trading Facilities (MTFs) which include AIM, and private companies with more than 750 employees (globally) and annual turnover in excess of £750m (750:750 entities). At a stroke, this takes out of scope large numbers of AIM companies and quoted SMEs. However, LLPs will be included in the definition, if they are 750:750 entities. Public sector bodies, such as local authorities, and Lloyd’s Syndicates are excluded.

This change is a significant move away from the current situation in which all AIM companies having a market capitalisation of over €200m are within scope of the FRC’s Audit Quality Review. It is considered by the Government as being consistent with its stated proportionate approach to regulation. That said, the Government will undertake further work with the FCA, the FRC and the London Stock Exchange to explore whether there is a case for ARGA (the body which is to replace the FRC) to continue certain aspects of scrutiny of all or some companies traded on MTFs, even if they are not PIEs. Companies will not know what this means until after the exploration stage but the Government has indicated companies will have time to adapt.

A point which does not seem to have received much attention is that the UK Corporate Governance Code will be amended to improve transparency about bonus clawback. The Government recognises the need to allow remuneration committees flexibility to adopt tailored malus and clawback policies. It will invite the FRC to consult on the development of existing Code provisions on malus and clawback to improve transparency and to define circumstances, beyond ‘gross misconduct’ or ‘material misstatement’, in which executive remuneration may be withheld or recovered.

A change to the UK Corporate Governance Code is unlikely to affect many AIM companies immediately, as about 80% of them have adopted the QCA Corporate Governance Code.

However, this is an issue of concern to shareholders and AIM companies might consider it worthwhile to watch for governance guidance which, initially applicable to main board listed companies, frequently trickles down to companies traded on MTFs.

And it’s worth bearing in mind that, unless the application of amended UK Corporate Governance Code provisions is limited to companies falling within the new definition of PIEs (i.e., 750:750 entities) many listed SMEs may be caught in the net.

This reform and the Government’s response are interesting insofar as they extend the reach of regulatory scrutiny (to include private companies and LLPs) whilst taking a proportionate approach to focus on those entities (750:750 entities) which, should there be non-compliance or audit failure, are deemed to represent the greater risk to stakeholders.

Taking significant numbers of smaller companies out of scope is sensible and will be welcomed in many boardrooms.

Importantly, being out of scope does not absolve those companies from establishing robust corporate governance frameworks and maintaining high corporate governance standards.  It should, however, enable them to carry-on their businesses without having to cope with additional layers of compliance and regulation.

We would hope that the Governments proportionate approach to audit and corporate governance reform is followed by investors and other stakeholders when engaging with boards and assessing their compliance, or explanations for non-compliance, with governance and regulatory requirements.

To discuss this article, please contact Paul Norris.

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