Corporate Law Update

A round-up of developments in corporate law for the week ending 15 June 2018.

This week:

Government proposes legislation for governance reforms

The Government has published draft legislation designed to implement many of the proposed reforms coming out of its recent white paper on corporate governance reform.

If approved by Parliament, the Companies (Miscellaneous Reporting) Regulations 2018  will make certain changes to the information companies must disclose in their annual reports. The changes would apply to financial years beginning on or after 1 January 2019.

The Government has also published guidance on the new regulations.

The proposed changes include the following.

Statement on directors’ duties

Large companies would need to include a "section 172(1) statement" in their strategic report, describing how their directors have considered the factors in section 172(1)(a) to (f) of the Companies Act 2006 when carrying out their duty to promote the company’s success.

These include the likely consequences of decisions in the long term, the interests of employees, the need to foster relations with suppliers and customers and maintain a reputation for high standards of business, impact on the environment and community, and the need to act fairly between shareholders.

This would apply to all large companies, whether publicly traded or private. Unquoted companies (including AIM and NEX Growth companies) would also have to publish the statement on their website, or on a website that identifies the company (such as a holding company’s website).

Corporate governance statement

A significant change is the proposed introduction of a corporate governance statement. A company’s director’s report would need to identify a “corporate governance code” and set out how the company applied or departed from that code.

Broadly speaking:

  • a company will “enter” the regime if it has either more than 2,000 employees, or both turnover over £200 million and a balance sheet total over £2 billion, in its first financial year or in two subsequent consecutive financial years; and
  • it will “leave” the regime if it no longer satisfies either of those criteria for two consecutive financial years.

Main Market and NEX Main Board companies would be exempt, as they already produce a corporate governance statement under the Financial Conduct Authority’s Transparency Rules (DTR 7.2).

Few (if any) AIM companies and NEX Growth companies will meet the thresholds above for the proposed new statutory reporting requirement, although, following changes to the AIM Rules for Companies, AIM companies of all sizes are now required to identify a “recognised corporate governance code” and (from September 2018) to report on departures from it.

The real effect of the proposed change, therefore, would be to bring the comply-or-explain requirement to the very largest privately owned companies. There is currently no corporate governance code for private companies, but the Financial Reporting Council has convened a Coalition Group to draft one.

CEO pay

Companies that produce a directors’ remuneration report would need to include a ratio of CEO to average employee pay. This would affect Main Market companies and other companies admitted to an EEA regulated market, the NYSE or Nasdaq (so-called “quoted companies”).

Broadly speaking:

  • a company will “enter” the regime if it has either more than 250 employees in its first financial year or in two subsequent consecutive financial years; and
  • it will “leave” the regime if it no longer satisfies that criterion for two consecutive financial years.

The remuneration report would need to state the ratio of CEO pay against average employee pay on the 25th, 50th and 75th percentiles. Companies would have three options for calculating the ratio:

  • Aggregate total workforce pay and benefits
  • Use "hourly rate gender pay gap information" and identify "best equivalents" for the three quartiles
  • Use other information (instead of or alongside pay gap information) to identify best equivalents for the three quartiles

The report would also need to:

  • explain the company’s choice of methodology and why any best equivalents reasonably represent the three quartiles
  • explain any changes to the CEO pay ratio year on year, including whether they arise because the CEO's pay, average workforce pay, the company's employment models or the ratio calculation methodology has changed since the previous year
  • report on trends in the median (50th) percentile and explain why that ratio is consistent with the company’s employee pay, reward and progression policies

Other changes

These include the following:

  • When reporting on awards to directors, quoted companies would need to state the amount of each award attributable to "share price appreciation", and whether any discretion to make the award resulted from share price appreciation or depreciation.

    They would also need to set out any executive director performance measures applicable across multiple years and the maximum amount receivable under them on a 50% increase in share price.

  • Companies with more than 250 employees in their first financial year or two consecutive financial years would be required to include more detail on engagement with employees, including how the directors engaged with employees and had regard to employees’ interests. This would apply to both quoted and unquoted companies.
  • Companies would be required to explain how the directors have had regard to the need to foster business relationships with suppliers, customers and others during the financial year. Again, this would apply to both quoted and unquoted companies, provided they meet certain financial and headcount thresholds during their first financial year or two consecutive financial years.

The regulations apply only to companies, and not to limited liability partnerships (LLPs). The Government’s guidance confirms that this is intentional. This makes sense, as LLPs do not have directors and their members are not subject to duties such as that in section 172 of the Companies Act 2006.

New listing category for sovereign-controlled companies

The Financial Conduct Authority (FCA) has confirmed that it will be introducing a new premium listing category for sovereign-controlled companies (“SCCs”) with effect from 1 July 2018.

The decision follows the FCA’s consultation on the proposal in July 2017. The final rules, which are available in the FCA’s policy statement, differ slightly from the consultation draft.

The key points to note on the new listing category are as follows:

  • An SCC is a company with a shareholder that is a sovereign country and which controls 30% or more of the company’s voting rights.
  • SCCs will be subject to most premium listing requirements, including running an independent business, reporting against the UK Corporate Governance Code, employing a sponsor and applying pre-emption rights.
  • However, unlike other premium-listed issuers, an SCC will not need to put an agreement in place with its controlling shareholder.
  • An SCC will also not need to obtain a sponsor’s opinion or independent shareholder approval before entering into a transaction with its sovereign shareholder. However, in a change from the consultation, SCCs will need to announce transactions with their sovereign shareholders as soon as they have entered into them.
  • A company with an existing premium listing will be able to move to the new category with the approval of its independent shareholders.
  • Finally, SCCs will be able to list depositary receipts (DRs) in the new premium category, as well as equity shares. (Apart from this, DRs will remain ineligible for premium listing.)

In essence, this means that SCCs will be subject to the full premium listing regime, subject to the two modifications described above. The FCA believes these modifications are proportionate and appropriate, and that it will be fully transparent to investors that these modifications apply to an SCC.

SCCs will still be able to apply for a premium listing as a commercial company or a standard listing if they wish to do so.

New guidance on whether guarantees and loans are distributions

The Law Society and the City of London Law Society (CLLS) have published two joint notes on whether certain transactions would qualify as “distributions” under English company law.

The first note discusses whether a subsidiary makes a distribution when it guarantees its parent’s or sister company’s obligations to a third party (such as a bank).

The second note discusses whether a normal on-demand intra-group loan from a subsidiary to its parent or sister company is a distribution.


The two notes have been prompted by recent guidance issued by the Institute of Chartered Accountants of England and Wales (ICAEW).

In June 2017, the ICAEW published Technical Release 02/17BL (“Tech 02/17”). Tech 02/17 is non-binding guidance that assists with deciding whether a company has “realised” or “distributable” profits, which in turn helps directors to decide whether they can pay a dividend or distribution. It replaced the ICAEW’s previous guidance on this subject (Tech 02/10).

The ICAEW published Tech 02/17 following a consultation. However, the final form of Tech 02/17 contained certain views that were not in the exposure draft. In particular, it said the following:

  • If a subsidiary guarantees a liability of its parent or a sister company (an “upstream guarantee”) without receiving a market fee in return, this can amount to a distribution.
  • If a company provides an interest-free loan, repayable on demand, to its parent or a sister company (an “intra-group loan”), this can amount to a distribution if it is “at undervalue”.

This would mean that a subsidiary would need to have an appropriate level of distributable profits before it could enter into an intra-group loan or an upstream guarantee, or it would need to receive some kind of compensation in return. In each case, this could cause significant problems (see below).

What is a “distribution”?

Broadly speaking, a “distribution” is when a company transfers an asset to one or more of its members (for most companies, their shareholders) without receiving the full market value in return.

Most commonly, this happens when a company makes a cash payment to its shareholders in order to distribute the profits it has earned. This is known as a “dividend”.

However, distributions can also happen where a company transfers non-cash assets to its members and receives nothing in return (a “distribution in kind”), or where it sells an asset to a member for less than its market value. This is so even if the sale is not formally described as a “distribution”.

English case law also states that an asset does not need to be transferred directly to a company’s member(s) to be a distribution. A company may also make a distribution if it gifts an asset, or sells an asset at an undervalue, to a company under common control with it (such as an indirect holding company or a sister company).

In order to justify making a distribution, a company must have distributable profits available to cover the entire amount of the distribution. If a company makes a distribution with insufficient profits, the portion of the distribution that exceeds those profits is “unlawful”. This has several consequences, the most important of which are as follows:

  • The company’s directors may be in breach of their duties and may be personally liable.
  • The person receiving the distribution may be required to hold it on trust and pay it back.
  • If the company goes into liquidation or administration, the liquidator or administrator may be able to challenge the distribution (and claw it back) as a transaction at an undervalue.
  • If the company or its holding company has prepared individual or group accounts on the basis of the dividend, those accounts may be wrong and may need to be restated. This is important for publicly traded companies, which may be liable to compensate anyone who buys their shares on the basis of inaccurate financial statements and suffers a loss as a result.

Why is this important?

Upstream guarantees commonly form part of financing packages provided by external lenders, often in context of an acquisition or other leveraged financing. They can be secured or unsecured but either way are designed to support the repayment of a loan by the principal borrower. There is currently no practice of paying fees for giving upstream guarantees.

If an upstream guarantee were to amount to a “distribution”, the implications for debt financing could be severe. Lenders would need to undertake financial due diligence on subsidiaries’ distributable reserves, and fees may need to be put in place to ensure that the guarantees could not be invalidated.

Intra-group loans are a common way of moving funds efficiently and easily around groups of companies. If an intra-group loan were to amount to a “distribution”, businesses would need to spend considerable time and money obtaining advice on their subsidiaries’ distributable reserves and what rates of interest would be appropriate to compensate the subsidiary for the risk of non-repayment.

Upstream guarantees

As mentioned above, Tech 02/17 says that, if a subsidiary guarantees its parent’s or sister company’s obligations towards a third party and doesn’t receive a market fee in return, the guarantee can be a distribution.

The Societies’ view, however, is that an upstream guarantee will be a distribution only if:

  • the subsidiary’s directors believe the guarantee will be called (or it is likely the guarantee will be called); and
  • the subsidiary does not receive any value in return for paying out under the guarantee.

This is because only in these circumstances has the subsidiary effectively transferred an asset to its parent or sister company (by agreeing to pay its liability and receive nothing in return). Otherwise, the subsidiary has not actually parted with any assets.

According to the note, a subsidiary’s directors must judge this when giving a guarantee, not when it is called. On this basis, the note says that an upstream guarantee given on a “normal financing transaction” will not be a distribution. It does not matter whether the subsidiary receives a fee.

This goes a long way towards alleviating the concerns above. However, it is important to remember that, outside a “normal financing transaction”, an upstream guarantee could be a distribution. If the subsidiary’s directors know that its parent will never be able to satisfy the liability in question or reimburse the subsidiary, it will be much harder to conclude that the guarantee is not a distribution.

Intra-group loans

As mentioned above, Tech 02/17 says that, if a company provides an interest-free loan to its parent or a sister company which is repayable on demand, this can be a distribution if it is “at undervalue”.

The Societies’ view, however, is that merely making an on-demand loan to a parent or sister company without charging interest (or charging interest at a sub-market rate) is not a distribution, because the subsidiary can always demand repayment at any time.

The note says that an intra-group loan could be a distribution only if:

  • it is likely that the parent or sister company will not be able to repay the loan; and
  • the subsidiary does not receive any value in return for assuming that risk.

In essence, the test is the same as for an upstream guarantee: is there a risk that making the loan could result in the subsidiary being out of pocket? For example, a loan may well be a distribution if the subsidiary never intends to demand repayment from its parent or sister company.

The subsidiary’s directors need to judge this when making the loan, not when it is repaid. On this basis, the note says that a normal on-demand intra-group loan will not be a distribution.

Again, this view helps to address the concerns above. However, as with upstream guarantees, the note does not give carte blanche to make loans to parent and sister companies. A subsidiary’s directors must still consider carefully and assess the likelihood that the parent or sister company might default on the loan. If that likelihood is material, the subsidiary should refrain from making the loan, or at least fix an appropriate interest rate to reflect the risk of non-repayment.

Review into the role and effectiveness of the FRC

The Department for Business, Energy and Industrial Strategy (BEIS) has published an independent call for evidence on the role and effectiveness of the Financial Reporting Council (FRC).

The FRC is the UK’s central authority for accounting and audit regulation. It is also responsible for publishing codes of good practice for corporate governance and investor engagement (stewardship).

The call for evidence focusses principally on the FRC’s structure, culture, accountability and powers, and how it is governed and resourced. In addition, the paper raises the following questions:

  • What should the FRC’s objectives be? Does the FRC need structural change? Should any of its functions be moved to other regulators?
  • How effectively does the FRC improve audit? Is it “too close to the big 4” accounting firms? How effectively has it influenced UK and international accounting standards and how else can it improve the quality of financial reporting?
  • Has the FRC’s Stewardship Code improved engagement by institutional investors?
  • How could the FRC better take swift, effective and appropriate enforcement action? Are there any gaps in its powers? Could the FRC do more to help reduce the risk of major corporate failure?
  • How could the longer-term viability statement be made more effective?
  • Should the FRC be put on a more conventional statutory footing?
  • Who should fund the FRC, and how?

The review has asked for responses by 6 August 2018.