Corporate Update for Listed Companies

2003 has been a busy year so far for corporate governance. January saw the publication of the Higgs Review and the Financial Reporting Council’s new guidance for audit committees, produced by a group chaired by Sir Robert Smith. Together, the recommendations in these reports, which have been reflected in a proposed revised Combined Code, amount to a significant overhaul of best practice in corporate governance and continue to attract a huge amount of interest from many quarters.

Against this backdrop, the 2003 AGM season is currently in full swing and the major institutional shareholder groups have been kept busy analysing the new-style directors’ remuneration reports.

The consultation period for the revised Code closed on 14 April. Over 150 submissions have been made to the Financial Reporting Council (FRC), which had invited "fatal flaw" and drafting comments only.

The government had set a date of 1 July for the revised Code to be put in place but Sir Bryan Nicholson, chairman of the FRC, has recently indicated that there might be a delay if "sufficient consensus" has not been reached by that date. Several commentators, including the London Stock Exchange (LSE), have called for implementation to be delayed.

At a speech at a National Association of Pension Funds (NAPF) conference in March, Ruth Kelly, the Financial Secretary to the Treasury, reiterated that the Higgs Report continues to have the government’s "strong support". In a shift of approach to the FRC’s "fatal flaw" only consultation, she said that the FRC would accept all comments as part of the consultation process and not just comments on points of detail. However, she limited this apparent concession by saying that the FRC is starting from the presumption that the Higgs proposals should be implemented in the absence of a "clear case to the contrary".

The developing consensus among those who are critical of the Higgs proposals, is that most of the problems stem not from the review itself, but from the way that the recommendations have been translated into the draft revised Code. The LSE has suggested that the apparent shift from principles to rules – moving from 13 to 43 – takes corporate governance in an unwelcome direction, encouraging "box-ticking" and creating the mindset that anything is permitted if not expressly forbidden. The Confederation of British Industry (CBI), which has been one of the strongest critics, agrees, sharing the LSE’s concern that too much emphasis is given to compliance with the Code provisions rather than the principles behind them.

The CBI also objects to several of Higgs’ recommendations, particularly in relation to the roles and responsibilities of the chairman and of the senior independent director. The CBI’s response can be found on its website at www.cbi.org.uk.

The FRC is reported to be considering whether some of the Higgs proposals should be introduced as guidance rather than rules. Sir Bryan is quoted as saying "we are looking at what are best left as "comply or explain" provisions and what is better as guidance. It is not a dilution of the Higgs Report but a proper response to the process of consultation in which good points were made".

It was reported in the press that Patricia Hewitt, the UK Trade and Industry Secretary, may give ground over the proposal that senior non-executives should hold regular meetings with shareholders, a development which investors fear could lead to rival boardroom powerbases. Another area on which the government may be prepared to grant some concessions is in respect of the proposal that no one individual could chair more than one FTSE 100 company. It may be prepared to concede that, where a chairman is nearing the end of his appointment with one company, he would be allowed to take up a chairmanship of another.

The Association of British Insurers (ABI) and the NAPF have both said that they have, with immediate effect, adopted the criteria suggested in the Higgs Report for determining whether or not a non-executive director may be regarded as independent.

KPMG carried out a survey of 118 members of FTSE 350 audit committees. The survey found that 65% thought the Smith Report proposals to enhance the responsibilities of audit committees would discourage individuals from serving on them. It also found that 57% thought that companies would struggle to find audit committee members with recent and relevant financial experience.

However, the survey found "strong" support for the proposal that the audit committee should make recommendations to the board on the appointment and remuneration of the auditors, and for the proposal that the audit committee should develop a policy on the provision of non-audit work by the audit firm.

Following the introduction of the Directors’ Remuneration Report Regulations 2002, and against the backdrop of falling equity markets, institutional shareholder groups have tabled a bumper batch of objections and challenges to executive pay so far this year.

The new Regulations require UK quoted companies to produce a directors’ remuneration report for each relevant financial year and to put a resolution on that report to shareholders at each annual general meeting. These new requirements apply with regard to financial years ending on or after 31 December 2002, which means that many listed companies have by now produced their first remuneration reports under the new requirements. The ABI says that the new information being disclosed is the main factor behind the increased number of objections to directors’ pay. More detail on the Regulations can be found later in this article.

The NAPF targeted 21 companies with AGMs during the period from 22 April to 2 May, urging investors to vote against the appointments of directors or remuneration reports at four companies and to abstain on resolutions for a further 17. The ABI, which does not make voting recommendations to its members but highlights issues of concern, says that it, too, is flagging up a record number of executive pay items. The most common objections relate to long-term performance-related schemes, executive bonuses and the length of directors’ contracts.

On 19 February the Pensions Investment Research Consultants (PIRC) published its new shareholder voting guidelines, which it sent to all listed companies, setting out its standard voting positions on major corporate governance issues. These take account of a number of the Higgs and Smith recommendations meaning that, with immediate effect, PIRC will assess listed companies’ annual reports and accounts and AGM notices for aspects of Higgs and Smith compliance, even though the revised Code proposed by these reports is not yet in force. PIRC has said, however, that it is not expecting half of the board (excluding the chairman) to be comprised of independent non-executive directors.

PIRC lists the new issues that it will monitor.

These include:

• whether at least one third of the board is independent;
• whether recruitment practices are transparent;
• disclosure of succession planning processes and of board and director appraisal processes;
• disclosure of induction and ongoing training for directors;
• full disclosure of various elements of directors’ remuneration;
• whether there are rotation requirements for the auditors; and
• composition of the audit committee in terms of financial expertise. PIRC also describes some new or changed areas of voting advice. For example, it will recommend:
• abstaining on the election/re-election of a director holding more than three chairmanships (or more than two within the FTSE 100);
• abstaining on the election/re-election of an executive chairman where there is an unclear division of responsibilities between the chairman and the CEO; and
• opposing the appointment of auditors where "unacceptable" non-audit fees are more than the audit fee over a three year period.

In the light of the proposed revised Combined Code, the Institute of Chartered Secretaries and Administrators (ICSA) has published new guidance notes and updated others, all of which are available on its website at www.icsa.org.uk/news/guidance.php.

According to ICSA, newly appointed directors are often overwhelmed with the volume of documents supplied by the well-meaning company secretary. The guidance note (ref: 030214) recommends that a new director should be provided with certain pieces of key information, together with a comprehensive list of other information that will be made available subsequently.

ICSA worked with the Higgs Review to produce a brief induction checklist, which is incorporated into the guidance note and which was also annexed to the Higgs Report. The checklist is divided into:

• essential material that should be provided immediately;
• material that should be provided over subsequent weeks, as and when deemed most appropriate; and
• items which the company secretary might consider making the director aware of.

This guidance note (ref: 030407) aims to assist company secretaries to ensure that relevant issues are considered before a draft service contract is prepared. It emphasises that full consideration should be given to termination terms and possible mitigation, even though at the time of negotiation the thought of dismissal is inevitably remote. It also recommends that a company's draft service contract be issued on standard terms to a prospective director rather than permitting individual negotiation each time. Our employment group has produced a briefing on the new guidelines on executive remuneration published jointly by the ABI and the NAPF in December 2002.

This guidance note (ref: 030408) summarises the requirements of the Companies Act and the Model Code on directors’ dealings.

ICSA has revised its guidance notes and proforma terms of reference for audit, remuneration and nomination committees (refs: 030211, 030212 and 030213) so that they follow the proposed Code provisions set out in the Higgs Report.

The expected publication by the FSA of detailed consultation papers on its review of the listing regime has been postponed, partly because of the delay in the progress of the EU Prospectus Directive which will impact on the permitted scope of the Listing Rules. As a result, there have been few major developments of note in this area so far this year, but the UKLA has published some helpful letters of guidance and its long-awaited censure of Marconi has given listed companies a useful insight into the approach the UKLA will take to breaches of the Listing Rules.

The FSA is still preparing detailed consultation papers on its review of the Listing Rules. They are expected to be made available this summer and next spring with the final changes to the Listing Rules coming into force in December 2004. In the meantime, the FSA has published a feedback statement on the responses it has received to its July 2002 discussion paper on the Listing Rules.

It is unfortunate that some of the areas where there is a more pressing need for reform, such as in relation to selective disclosure of price sensitive information, will not take place in the immediate future. They will have to await the more radical reforms which will be put in place as part of the implementation of the Prospectus Directive. (See the "What has happened to …?" section of this update for more detail on the status of the Prospectus Directive.)

On 24 March the UKLA published a letter about the disclosure of risk factors in prospectuses and listing particulars.

There is currently no specific requirement in the Listing Rules to include a risk factors section in a prospectus. The UKLA letter says that it has decided not to change the Rules to include such a requirement at this stage but will instead wait to include it as part of the detailed changes that will be required as a result of the implementation of the Prospectus Directive.

The UKLA letter, however, goes on to say that documents to shareholders should give a balanced view of the risks and benefits associated with a proposal and that the UKLA will focus on these statements during the vetting process. As part of that process it will ask issuers and sponsors to consider:

• whether risk factors should be disclosed;
• whether any risk factors are clear, readily understandable and comprehensive – there should be a prominent statement on the front page of the prospectus referring to any separate risk factors section; and
• whether any explanatory statement at the beginning of the document presents the appropriate balance between benefits and associated risk.

In practice this means that, despite the absence of any new provision in the Listing Rules, the UKLA will be looking for risk factor statements in prospectuses and this is best dealt with by way of a separate risk factors section. This has in any event become increasingly common and helps to protect the issuer from any subsequent claims that investors were not adequately advised of the risks. It is important that the risk factors section is tailored to the particular company and its business rather than being a generic list of potential risks.

The FSA has released its long-awaited report into the circumstances surrounding the issue of a profits warning by Marconi in July 2001. It has found that Marconi breached its obligations of disclosure to the market in paragraph 9.2(c) of the Listing Rules by failing to notify the Company Announcements Office "without delay" of a change in its expected performance.

Although criticising the Chairman and Chief Executive's handling of the situation, the FSA found that there was no bad faith on the part of Marconi or its officers. However, it considered it appropriate to draw attention to the contravention by issuing a public statement, the only sanction open to it. (In relation to events since December 2001, the FSA has had additional powers to fine a company or its directors.)

The report contains a detailed examination of the events preceding the profits announcement and provides a useful insight for listed companies into the approach taken by the FSA and its lessons for preventing breaches of Chapter 9 of the Listing Rules. The full report is available on the FSA website at www.fsa.gov.uk.

In January the UKLA wrote to all listed companies to remind them of the requirement that listed companies must announce when certain documents have been submitted to the UKLA. The announcement should say that the document has been submitted to the UKLA and will be available for inspection at the UKLA’s Document Viewing Facility.

The requirement was actually introduced for all listed companies in April of last year but the UKLA has found that a number of companies are not complying with it.

The FSA is proposing to extend the Model Code on directors’ dealings to include spreadbets and other contracts for differences.

This proposed amendment is a result of a number of controversial high-profile cases involving contracts for differences over the last year (e.g. the well-publicised case of "the Spaniard and the Plumber") and will also bring the Code into line with the market abuse regime which already prohibits these types of dealings when a person has price sensitive information.

We have produced a briefing on the interaction between the Directors’ Remuneration Report Regulations 2002 and the Listing Rules and the Combined Code.

In January the UKLA wrote to all listed companies acknowledging that the Listing Rules duplicate many of the provisions in the Regulations. The UKLA says that ultimately it envisages that Rule 12.43A(c) (the rule which requires companies to report on various aspects of directors’ remuneration) will be removed, but that this will only happen as part of the larger review of the Listing Rules which is currently taking place.

The UKLA points out that Rule 12.43A(c)(v) (which requires explanation and justification of any element of remuneration, other than basic salary, which is pensionable) goes further than the Regulations.

The letter also confirms that a resolution to approve the directors’ remuneration report will be regarded as a matter of a routine nature and the circular will not need to be submitted to the UKLA for approval.

Technically, as the resolution will not be "ordinary business" (as defined in the definitions section of the Listing Rules), an explanatory circular will still need to be prepared but this is unlikely to give rise to problems in practice as listed companies will effectively be sending an explanatory circular to shareholders in the annual report and accounts. The UKLA has indicated that it will ultimately amend the definition of "ordinary business" to include a resolution on the directors’ remuneration report.

The long-awaited regulations on treasury shares have finally been published and will come into force at the end of this year. The courts have also been busy with cases which have brought several important company law principles into focus.

Regulations on treasury shares have been laid before parliament and will come into force on 1 December.

Currently, if a company buys any of its own shares it is required to cancel them immediately. Under the new regulations, listed and AIM companies will be able to hold up to 10% of their own shares indefinitely, provided the shares were purchased out of the company’s distributable profits. Shares bought back and held by the company are referred to as treasury shares. Treasury shares can be sold by the company for cash or transferred for the purposes of an employee sharescheme. Statutory pre-emption rights will apply on the sale by a company of its treasury shares in the same way as they apply to an allotment of new shares, although these rights may be disapplied. It is, however, expected that the institutional shareholder committees will apply their pre-emption disapplication guidelines in relation to sales by a company of its treasury shares. Shareholder rights attaching to treasury shares will be suspended for as long as the shares are held in treasury.

The tax position is dealt with in the Finance Bill 2003. For tax purposes, the purchase and holding of shares in treasury, followed by the resale of treasury shares will be treated in the same way as a buyback and cancellation of shares followed by an issue of new shares.

The FSA and the Takeover Panel are consulting on proposed changes to the Listing Rules and the Takeover Code in the context of the introduction of treasury shares.

The Court of Appeal in Chaston v SWP Group Ltd [2002] All ER (D) 345 (Dec) decided that a payment by a subsidiary of accountants’ fees for the preparation of a long form report in connection with the sale of shares in its parent company constituted unlawful financial assistance. Therefore a director of the subsidiary could be sued for the amount of the fees, despite the fact that it was found that the directors had acted in good faith in the best interests of the company and that the payment of the fees had had no impact on the share price. The court suggested that anything that was paid for by the target or its subsidiaries, and which "smoothed the path" of the acquisition, could be financial assistance.

However in the subsequent case, MT Realisations (in liquidation) v Digital Equipment [2003] EWCA Civ 494, the Court of Appeal held that Chaston had been decided on its facts and added that each case on financial assistance involved applying commercial concepts to particular facts.

In this case it was held that a loan restructuring agreement following a share acquisition (which allowed sums owed by the seller to the buyer’s group (including the target) to be off-set against payments due from the buyer to the seller) was not financial assistance.

These cases highlight that financial assistance remains one of the most problematic company law restrictions and must always be carefully considered in any public or private transaction or re-organisation involving the acquisition of shares.

From January of this year companies have been able to offer shareholders who are CREST members the facility of sending back an electronic proxy via the CREST system. The ABI, NAPF and Investment Management Association have written a joint letter to all FTSE 100 companies urging them to allow shareholders to use the new system. CRESTCo Ltd has prepared a note for issuers explaining the new system and some model form wording for a company’s articles of association (and all notices of meetings and proxy forms) where issuers are allowing the CREST proxy system to be used. Further details on this are contained in our briefing on annual report and accounts and preparing for the AGM in 2003

In PNC Telecom plc v Thomas & Another [2003] BCC 202, the court considered whether a notice served by fax had been validly served. PNC was in dispute with one of its shareholders, who held a 17.6% shareholding, and sought under section 368 of the Companies Act to requisition and convene an EGM of PNC.

The requisition was sent to PNC by fax and PNC argued that the shareholder was not entitled to convene a meeting because sending it by fax did not meet the requirement under section 368 that it be "deposited" at PNC’s registered office. The court held that service of a notice by fax was valid service.

PNC had argued that the provisions of the Electronic Communications Order 2000 for service by electronic means specified certain sections of the Act but not section 368. The court held that the Order was primarily concerned with new electronic methods of communication such as emails rather than faxes.

Under the so called "Duomatic principle" (after the case of that name), the English courts have for a long time accepted that informal consent from all shareholders can be treated as binding in the same way as if the matter had been approved at a general meeting of the company pursuant to the company’s articles of association. Two recent cases have focussed on different aspects of this principle.

For the first time, in the case of Euro Brokers Holdings Ltd v Monecor (London) Ltd [2003] ECWA CIV 105, the Duomatic principle has been applied to a failure to comply with the formal corporate procedures set out in a shareholders’ agreement. The Court of Appeal said that a capital call notice under a shareholders' agreement (between two joint venture parties) had been validly given, despite the fact that the procedures set out in the shareholders’ agreement, in particular for a board resolution, were not followed. The court said that the shareholders’ agreement constituted, like the articles, a contract that regulated the relationship between the shareholders in the company. A company could therefore ignore the failure to comply with the formal corporate procedures set out in that shareholders’ agreement if one party was able to show that the shareholders had reached agreement on the matter and the other party had effectively waived the requirement to comply with the relevant procedures.

This has important implications for the way in which issues provided for in shareholders’ agreements are handled. If a party to a shareholders’ agreement puts forward a proposal otherwise than in accordance with the stipulated procedure, the other party should object to the lack of compliance with that process if it wants to preserve its position before deciding what to do. Otherwise, there is a risk that it will be treated as having given its consent to the relevant matter, notwithstanding that the formal procedure had not been complied with.

In EIC Services Ltd v Phipps [2003] All ER (D) 257 (Mar), the company made a bonus issue of shares involving capitalisation of part of its share premium account which, under its articles, required shareholder approval. The requisite approval was not obtained and some shareholders contended that the bonus issue was invalid. The court considered the applicability of the Duomatic principle and held that it was not enough to show that assent would probably have been given if asked. There had to be actual assent. Acceptance of the share certificates for the bonus shares was not sufficient for this purpose.

The disclosure obligations for listed companies continue to increase at the same time as auditors are becoming more sensitive about their liabilities in relation to auditedresults. Another risk area for companies is that of distributable profits, but new guidance from the accountancy institutes may give more certainty in this difficult area.

The European Commission has published its proposed Transparency Directive which will require EU Member States to impose certain minimum disclosure standards on all companies whose securities are admitted to trading on EU regulated markets. It will affect all UK listed and AIM companies when it is implemented, which is currently expected to be in 2005.

The key new requirements for UK companies, if the Directive is adopted in its current form, will be:

• the deadline for issuing annual reports will be three months after the end of each financial year (in contrast to the current Listing Rules time period of 120 days for issue of the preliminary statement and six months for the publication of the annual report and accounts); and
• the publication of quarterly financial information will be made mandatory. This controversial new provision has, however, been watered down by providing that the quarter one and quarter three information requirements will be less onerous than those for half yearly reports. This contrasts with the US position of requiring full financial statements for each of the three quarters of the financial year.

The proposal must be approved by the EU Parliament and Council of Ministers. Technical implementation rules will also need to be prepared.

In The Royal Bank of Scotland Plc v Bannerman Johnstone Maclay [2003] SLT 181, the court held that an auditor was liable to a lending bank which had received audited financial information about a borrower because the auditor had not expressly disclaimed liability to the bank.

The Institute of Chartered Accountants in England & Wales (ICAEW) has issued guidance which, although stressing that auditors’ responsibilities to their clients remain unaltered by the case, recommended that audit reports should contain the following exclusion:

Most UK auditors are now asking UK companies to accept some disclaimer wording. The exclusionary wording is, however, controversial and has been criticised by the Association of Certified Chartered Accountants as being something which could devalue the audit process.

There are additional issues for UK companies required to file reports with the US Securities and Exchange Commission (SEC) because the SEC generally prohibits language excluding liability in this way. The SEC has sent an official response to the ICAEW stating that it will not accept annual reports filed by UK companies containing an audit opinion with such exclusionary wording. The SEC has not made any statement as to its position regarding interim reports which are not technically "filed" with the SEC but are only"furnished" to them.

In March the ICAEW issued new guidance on the determination of realised and distributable profits, which is available from www.icaew.co.uk. The publication of the new Technical Release (7/03) should bring greater certainty to the question of how much of a company’s profits are available for distribution.

The guidance, which has immediate effect, will, however, still require the application of judgement when considering whether realised profits have been created, for example, in circumstances where the profits arise from a linked or related series of transactions designed to achieve a particular outcome. This will be an important issue for intra-group arrangements.

The new rules are also stricter, for example, as regards the form of consideration that must be received in order for a resulting profit to be counted as realised. Again, this will be an issue for groups of companies as it appears that it will no longer be acceptable to leave payments outstanding indefinitely on an inter-company balance.

An immediate task for all companies will be to examine their existing reserves because, although the new rules will not make illegal any distribution made to date, it will be necessary to consider whether any retained reserves need to be reclassified from realised to unrealised (or vice versa).

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