Directors & officers and their insurers await detail of UK audit reforms

The government is set to publish a white paper with proposals for the reform of UK corporate governance and audit oversight. Accountancy firms are already splitting out their audit and consultancy arms and a new regulator, the Audit Reporting and Governance Authority (ARGA), will replace the Financial Reporting Council. If press reports are correct, the proposed changes also have the potential to dramatically impact the exposure of D&Os and their insurers to new risks relating to the accuracy of a company’s financial statements.

Proposed reforms – personal responsibility

At present, responsibility for the accuracy of financial accounts rests with a company’s board. In what would represent a major change, the Department for Business, Energy and Industrial Strategy is believed to favour making D&Os personally responsible for the accuracy of those financial statements, with the possibility of fines or disqualification for failure to uphold corporate reporting and audit standards.

The government has yet to publish its proposals and it remains to be seen how far-reaching any reforms will be. A change of the type reported could mean a similar legislative regime in the UK to that which exists in the US under the Sarbanes-Oxley Act of 2002, where D&Os are required to report on the adequacy of the company’s internal controls on financial reporting. A key driver for the introduction of the Sarbanes-Oxley Act was to combat accounting fraud following the collapse of Enron in 2001 and the focus on audit reform in the UK follows several high profile corporate failures including Carillion, Patisserie Valerie and BHS.

Concerns for business and insurers

Whilst requiring accurate financial results and combatting fraud are likely to generate wide spread support in principle, the changes being mooted may be controversial. Business figures including the director-general of the Institute of Directors have already raised concerns, especially at the possibility of increasing compliance costs for businesses (particularly SMEs) at a time when challenges are being posed by the COVID-19 pandemic and Brexit. Some business leaders have expressed concern that innovation will be stifled as directors may become overly risk-averse.

In terms of the impact on D&O insurance, the devil will be in the detail. In what is already a hard market, a personal exposure arising from audit reforms would prompt an increase in premiums, in all probability. Even if spurious claims or investigations were brought on the basis of legislative changes in this area, the cost of defending such actions could be very significant, especially where a D&O is seeking to avoid a personal exposure for a fine falling outside the scope of cover.

Comment

Looking ahead, D&O insurers are likely to assess the commercial viability of what cover can be provided. There are a myriad of potential responses, ranging from the status quo to the imposition of a specific exclusion of the kind sometimes seen in relation to Sarbanes-Oxley. Compromise measures could include the imposition of sub limits, a tightening to the definition of “Defence Costs” (or similar) and/or insurers having greater rights over the conduct of the defence of claims, for example by having the choice over which firm acts in defence of the D&O.

We shall comment further on the government’s white paper following publication.

Related items: