Companies Act

After more than eight years in preparation, the UK’s new Companies Act finally received the Royal Assent on 8 November 2006. The new Act brings together the vast majority of the provisions of the Companies Acts 1985, 1989 and 2004, as well as the many amendments that have been made to those statutes over the years by secondary legislation. John Davies writes

The combined effect of consolidating existing legislation, introducing new reforms and incorporating some elements of non-companies legislation (such as the requirements of the Business Names Act 1985) is that the new Companies Act is, officially, the biggest single statute in UK legal history, with some 1,300 sections, in addition to voluminous schedules.

The new Act sets out to achieve three main objectives: first, to simplify the way that company law is presented, using more accessible language where that can be done without changing meaning; secondly, to create a clearer distinction between the law that applies to small private companies and the rest; and thirdly, to modernise company law by laying the foundations for modern methods of business communication to be used to carry out the various procedures required by the Act.

So what will this mammoth reform actually mean for companies?

Accounting and auditing

One highly visible result of the new Act is that, despite the consolidation, the rules on form and content are to be taken out of the Act itself and will in future be set out in regulations to be made under it. The rationale for this is to help ensure that, when changes in EU law dictate that those rules be amended, this can be done more easily and without causing disruption to the main Act. The consolidation exercise will nonetheless mean that the various legislative changes which have been made in piecemeal fashion over the past few years - the recognition of IFRS, the revised SME accounting and audit thresholds, the requirement for directors to confirm that they have not withheld any relevant information from the auditor - can at last be brought together in one place.

The Act addresses structural issues concerning the application of accounting rules to various classes of company and creates four main categories. The most important ones are the small companies regime, which is formally presented in those terms, and the rules of application to quoted companies (i.e. those companies with a full listing on a regulated stock exchange). The most relaxed rules on preparation and publication will apply to the first category, while the most demanding will apply to the second. In addition to these two categories, the Act makes separate provision for medium-sized companies and groups - for the purpose of determining eligibility to prepare and file group accounts - and for unquoted companies: companies in this latter group will be large companies, either private or public, which are not required to prepare the documents and make the disclosures which are required of quoted companies. The unquoted category will cover AIM-listed companies.

In addition to these four 'regimes', the Act provides for two separate accounting frameworks, namely UK GAAP (referred to as Companies Act individual or group accounts) and IAS accounts. As is currently the case, companies which are not obliged to prepare IAS accounts by the EU IAS regulation will have the option of doing so.

Also, as now, small companies will be subject to modified rules on form and content with respect to their 'full' accounts, and will have the additional option of preparing and filing 'abbreviated accounts' with the registrar. Medium-sized companies, though, will no longer have the option of filing abbreviated accounts.

At the other end of the scale, quoted companies will have to prepare a remuneration report and will be subject to more extensive disclosure requirements in their directors' report; they will also have to prepare and publish interim accounts and post those, and their preliminary results, on their website.

The summary financial statement, currently devised solely for use by listed companies, will in future be an option for all companies, should they choose to use it.

All companies, except for small companies, will have to prepare a 'business review' as part of their directors' report - this is a recent addition which was mandated on member states by the EU's Accounts Modernisation Directive of 2003. The original format of the review, brought into effect in 2005, has been amended and expanded following the abolition of the Operating and Financial Review (OFR) and the ensuing debate on which, if any, elements of the OFR should be salvaged.

The business review requires reporters to give a 'balanced and comprehensive analysis' of the development and performance of the company's business and of its position at the end of the year. Companies must also describe the principal risks and uncertainties facing the business.

The principal burden of the business review will fall on quoted companies. In addition to the matters already mentioned, they must report on the main trends and factors likely to affect the development and performance of the business and disclose information about environmental, employee, social and community matters (albeit only 'to the extent necessary for shareholders to understand the development, performance and position of the business'.) Again, by reference to that standard, the review will have to include financial and non-financial key performance indicators.

Regardless of whether the reporting company is quoted or not, the overriding purpose of the business review will be to help shareholders assess how the company's directors have performed their new fundamental statutory duty to promote the 'success' of their company (see below).

As regards the publication of company accounts, the Act shortens the Companies House accounts filing deadlines - for private companies they will come down from 10 months to nine, and for public companies from seven months to six. This is with the objective of making the accounts on view on the public record (slightly) more up-to-date than they are at present.

There are two very significant reforms relevant to the audit of company accounts.

Liability limitation agreements

The first of these is a matter which has generated considerable debate over the past two or three years, namely liability limitation agreements. By virtue of the new reform, auditors and their clients will be able to enter into agreements to limit the former's liability to the company for any negligence, breach of duty or breach of trust arising during the course of the audit of the company's accounts.

The basis on which the auditor's liability may be limited will be up for negotiation between the two sides: there is no assumption that the limitation of the auditor's liability is to be determined by any particular method. As long as the basis used is 'fair and reasonable', having regard to the auditor's responsibilities and obligations and the professional standards to which he is subject, the limitation can be framed on any basis - it could be stated that the auditor's liability should be in proportion to his share of responsibility for the loss caused, it could be stated to be a multiple of the audit fee or it could refer to a fixed monetary amount.

As befits their status as the ultimate stakeholders in the audit process, a limitation agreement will not be valid unless it has been approved by the company's shareholders. There are three alternative ways in which this can be achieved: first, the members can pass a resolution approving the 'principal terms' of the agreement (leaving the directors to finalise the agreement with the auditor); secondly, the members can pass a resolution to approve the agreement retrospectively, and thirdly, the members can pass a resolution (before the agreement enters into force) waiving their right to approve it (in which case the directors can, if they wish, proceed to negotiate the terms of the agreement with the auditors). Note that this latter method will be available only to private companies.

Wherever a limitation agreement applies to an audit engagement, that fact will have to be disclosed in the company's accounts or directors' report.

A new auditing offence

There is to be a new criminal offence, which will apply where the auditor knowingly or recklessly includes in his audit report any matter which is misleading, false or deceptive in a material particular, or where he omits any required statement within the report - for example, the statement which states that the accounts are not consistent with the accounting records and returns.

Aside from the provisions relating to accounting and audit, other noteworthy reforms which will impact on companies are summarised below.

Directors' duties

The new Act makes important changes to the law governing directors' duties - these will apply universally, to directors of companies of all kinds and sizes. The most obvious change is that, for the first time, the historic common law duties of company directors are set out in statute (albeit with some significant amendments), with the core aim of making the law in this area more accessible to non-specialists. In enshrining these common law duties in statute, the old common law rules are deemed to be abolished - that being said, the Act decrees that the new statutory rules are to be interpreted in accordance with the longstanding legal principles.

Parliament has also made two important substantive changes to the law in this area.

First, directors will be subject to the fundamental duty to make decisions which they believe, in good faith, are most likely to promote the success of the company in the interests of the shareholders as a whole. Note that the common law requirement for directors to act in the best interests of their company has been replaced by the new term 'success', which is not defined but is intended to be of sufficiently broad application to enable 'success' to be construed by reference to the particular aims and objectives of each company, whether it be profit-making or otherwise. As long as they act in good faith, directors' business judgments as to what course of action is most likely to promote the company's success will be a matter for them.

The above notwithstanding, in making their judgments about what is most likely to promote the success of their company, they are to be required to 'have regard' to a non-exhaustive list of 'stakeholder'-related factors listed in the Act - these include the interests of employees, the long-term effects of decisions and the impact of the company's operations on the environment. The Act gives no further guidance as to what exactly the term 'have regard' is intended to mean or to what weight is expected to be placed on the various 'stakeholder' factors. It may well be that the courts will be involved with these matters sooner or later. But taking the terminology used at face value, it is reasonable to suggest that company boards will be expected to consider, at least, the extent to which any conceivable detriment which might be suffered by the 'stakeholder' interests is likely to have a consequential adverse effect on the achievement of 'success' by the company. As a hypothetical example, if a company's directors ignore the effects of its operations on the environment to the extent that it commits criminal offences and incurs substantial civil or criminal penalties, then a court may hold that the directors were not fulfilling their duties to their company.

A second substantive change is made to the standard of skill and care which the law expects of company directors. Traditionally, the law has expected only that a director complies with a 'subjective' test, namely that he or she should bring to the company for its benefit whatever skill and experience he or she actually has. In recent years the courts have tended to expect more than this and, as long ago as 1986, insolvency legislation provided expressly that an objective test be imposed on the assessment of directors' conduct for the purposes of assessing personal responsibility in cases where companies continued to trade while insolvent. The codified statement of duties now says that a new 'objective' standard is to apply to directors' conduct. This new standard will assess an individual director's conduct against the knowledge, skill and experience that may reasonably be expected of a person carrying out the director's functions. Thus, the courts will have a new benchmark against which to assess a director's conduct.

Although all the directors' statutory duties will be owed to the company itself, and not to individual shareholders, much has been made of the possibility that the precise restatement of these duties in legislation will encourage litigation against directors, especially since along with the codification of duties there is to be a new, statutory basis for the longstanding 'derivative action', whereby shareholders can bring legal proceedings in the name of their company. This new basis will allow shareholders to take action against their directors for breach of their duties. However, during the passage of the Bill through Parliament, the Government introduced strong safeguards designed to deter frivolous or vexatious actions by minority shareholders; before being allowed to proceed with an action the shareholder will be required first to establish a prima facie case of breach and, second, to satisfy the court that the alleged conduct was inconsistent with the director's fundamental duty to act in a way which 'promotes the success of his company'. Moreover, the court will be expected to take into account whether the petitioning shareholder is acting in good faith, whether the conduct has been authorised or ratified by the company and any views expressed by 'independent' shareholders. This collection of hurdles will prove a substantial obstacle to overcome.

Other significant reforms are as follows.

• IT - the Act makes some substantial moves in the direction of legitimising the use of e-mail and the internet for company law purposes. Listed companies will all be expected to have websites and to post their annual accounts and other information on them. Companies will be able to choose whether to send their general meeting notices out in paper form, by e-mail or via a notice on their websites. And authority is delegated to the registrar of companies to require any type of company document to be submitted in electronic form. In the medium to long-term, this will allow the registrar to insist that all annual accounts are submitted electronically, although there we are assured that there is no immediate intention to activate this power.
• Administration of private companies - the Act turns on its head the elective regime provisions of the Companies Act 1985 by making all private companies automatically exempt from holding an AGM and laying accounts before members. Private companies which qualify as 'small' will also, of course, be exempt from appointing auditors. Private companies, regardless of size, will also be exempt from the requirement to appoint a company secretary (although they may choose to do so if they wish).

Transitional arrangements

A separate process, to be carried out in early 2007, will determine the timetable for implementation of the new Act. Subject to the results of this exercise, it is likely that most of the provisions will start to come into effect in October 2007. On this basis, the new accounting and reporting provisions may well apply with effect to accounting periods ending 31 December 2008. But a key issue which will need to be resolved is how the new Act will apply to existing companies, particularly small and private companies, which may well have articles of association which either mandate the company to, for example, hold AGMs and appoint/re-appoint directors thereat, or simply assume that AGMs will be held because of the law which applied at the time that the articles were originally drafted.

It seems likely that, in the spirit of respecting the terms of existing agreements, it will be held that the provisions of the new Act will not override any conflicting provisions in current company articles. If this turns out to be so, it would constitute an ideal opportunity for members to encourage all their small company clients to undertake a thorough review of their articles vis-à-vis the new Act during 2007, so as to ensure that their constitutions are up-to-date and enable them to take full advantage of the new flexibility being brought in by the Act.

John Davies is ACCA's head of business law.