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Companies Act 1985 (Operating And Financial Review And Directors' Report Etc) Regulations 2005

Volume 670: debated on Wednesday 16 March 2005

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8.16 p.m.

rose to move, That the draft regulations laid before the House on 12 January be approved [5th Report from the Joint Committee].

The noble Lord said: My Lords, I probably ought to preface my comments by saying that we had a good go at debating this Motion in the Moses Room, but unfortunately we were unable to do so. I shall detain noble Lords for as short a time as I can.

This statutory instrument amends the Companies Act 1985 in four main ways. First, it introduces a requirement for quoted companies to prepare an operating and financial review, or OFR. Secondly, it extends the "fair review" of companies' business in directors' reports, as required by Directive 2003/51/EC of the European Parliament and of the Council of 18 June 2003, generally referred to as the "modernisation directive".

Thirdly, it provides for a review of the OFR by the companies' auditors and amends the existing requirement for auditors' review of directors' reports. Fourthly, it establishes a parallel criminal and administrative enforcement regime for the OFR and directors' reports.

The regulations require the directors of a quoted company to prepare an OFR for each financial year. An OFR is a balanced and comprehensive analysis of the development and performance of a company's business, including the main trends and factors underlying its performance and financial position during the year, together with those trends and factors likely to affect its performance in future years. Its aim is to focus on more qualitative and forward-looking information than was traditionally included in annual reports in the past. In order for an OFR to comply with the regulations, it may be necessary for it to include information on a range of factors relevant to understanding the business—for example, information about environmental matters, about the company's employees and about social and community issues. However, if the nature of the company's business means that it is not necessary to disclose information about one or more of these issues in the OFR, directors must make a statement to this effect in the OFR. Shareholders will therefore know that the directors have considered the matter.

The regulations also implement the parts of the accounts modernisation directive that extend the current requirement for the director's report to contain a "fair review" of the business. In future, the director's report will have to contain a "balanced and comprehensive analysis" of the business's performance and development during the year and the position of the company at the end of the year. The objective is similar to that of the OFR: greater transparency and precision of company reporting on performance on financial and non-financial matters.

All quoted companies, regardless of size, will have to prepare an OFR. However, information already contained in the OFR does not have to be duplicated in the directors' report. While all companies will have to prepare a directors' report, small companies will not have to prepare the extended fair review; and we have taken advantage of the exemptions in the directive to exempt medium-sized companies from the requirement to include certain non-financial information.

We have also provided safeguards to ensure that information provided by the OFR and directors' report is meaningful and relevant. The legislative requirements for the OFR will be supported by an OFR standard prepared by the Accounting Standards Board. The ASB is currently consulting on a draft standard.

The regulations also provide for a review of the OFR and directors' report by the company's auditors, and for a parallel criminal and administrative enforcement regime for the OFR and directors' report. The Financial Reporting Review Panel will review the OFR in relation to possible omissions and mis-statements. The panel's administrative enforcement role will begin one year after the regulations come into effect, applying to OFRs for financial years beginning on or after 1 April 2006. This will give all parties the opportunity to become familiar with new requirements and relevant standards, and to share good practice.

The purpose of the OFR is explicitly to assist shareholders assess the company's strategies and the potential for them to succeed. It is a real step change in the way directors report to their shareholders on the performance and prospects of the business. The information that will be disclosed in the OFR is the type of information not often well captured in traditional financial statements. For example, information about the company's strategy, prospects, opportunities and risks; intangible and so-called "soft" assets; and key stakeholder relationships. That is very much the sort of information which I can say from experience merchant and company bankers need to know when they make assessments about investment prospects. But this is now to be extended to shareholders more generally.

More individuals and families own shares than ever before, either directly or indirectly, for example through holdings in pension funds, and employees often receive share options. It is increasingly important that shareholders should be able to understand how well the business they own is prepared for the future. The OFR will improve the quality, usefulness and relevance of information, which will help enable shareholders to achieve a better understanding of the company's business and future prospects. It will also encourage an open dialogue between shareholders and business to stimulate long-term wealth creation.

In developing the regulations, we have been guided by several principles: that we should not impose unnecessary burdens on business; that we should promote relevant and open reporting, where companies have the confidence to produce high-quality information rather than boilerplate reporting; and that we should listen to what stakeholders say and, where necessary, make changes.

In response to issues raised by respondents to the consultation we carried out last year, we have simplified the audit requirements, addressed duplication of reporting requirements, avoided unnecessary publishing costs and given companies more time to manage the transition we are asking them to make. We believe that these changes have strengthened the proposals and will enhance the usefulness of the OFR for both shareholders and other stakeholders. Indeed, we are grateful to all those who took part in the consultation for guiding us in that direction.

We are not alone in taking that view. As the CBI said following the Government's response to the consultation:
"The changes enable firms to explain activities to stakeholders in plain language without checking every comma for exposure to legal challenge. There is now a real possibility that the OFR will improve dialogue between companies and constituencies, something we all want".

These regulations build on the existing company law reporting framework by requiring companies to report on their main qualitative factors. They will help shareholders exercise responsible control, improve the quality of investment decisions and, ultimately, the working of capital markets. I beg to move.

Moved, That the draft regulations laid before the House on 12 January be approved [5th Report from he Joint Committee].(Lord Triesman.)

My Lords, perhaps I may reassure the Minister that I support the regulations. The only interest I declare is one I share with the noble Lord, Lord Gordon, in that I belong to the most excellent initiative of some Members of your Lordships' House in the formation of the All-Party Parliamentary Corporate Governance Group. It held an excellent meeting this morning.

I welcome the regulations, which have come as a result of almost five years of hard work and a lot of consultation, born originally out of the Company LawReview. I pay particular tribute to a former colleague of mine, Rosemary Radcliffe, who chaired the working group on guidance for company directors in preparing the OFRs. My contribution this evening will be brief; I just want to sound three cautionary notes.

If applied sensibly, the transparency of information about the risks inherent in running a particular business will especially benefit listed companies, which will be subject to the full responsibility of these regulations. However, it is right to limit the full impact of the OFR to listed companies at this stage, and not extend that to all companies. That may arise in future, but it is the right decision to limit it at present. I am pleased that we are not following the American example of prescriptive regulations—for example, their Sarbanes-Oxley Act—about what should go in an annual report. The regulations before your Lordships tonight strike the right balance in setting out principles. The guidance coming from the Accounting Standards Board, and indeed from the department, will encourage companies to do what is in their interests—and not to react to a perceived burden being placed on them by government.

My three cautionary comments are born of experience; like the noble Lord, Lord Gordon, I would be subject to these regulations as a director of a number of companies. My first is that annual reports are becoming like telephone directories. Each year they seem to be longer and longer. It is important that the Financial Reporting Review Panel encourages companies to be crisp, clear, transparent, fair and balanced in their reports. As Alastair Ross Goobey said to the all-party group this morning, we do not need lots of woolly phrases such as: "your company is well positioned to benefit from an upturn in the economy". What we want is a frank report of what is said around the directors' table about the risks facing the companies. The FRRP has a real responsibility to encourage best practice. The Minister referred to stakeholders other than shareholders; employees, customers and, indeed, regulators. People will read annual reports if they are short, sharp and crisp.

Secondly, I think that the Better Regulation Task Force under David Arculus reported today. I have not seen the report, but in the newspapers there was some indication that one of the key messages his committee was delivering is: "one new regulation in, one old regulation out". Perhaps I am addressing the department through the Minister here, but I hope that at some stage we should consider whether we need an OFR, a directors' report, and—who knows what legislation will bring in the future?—a corporate social responsibility report. That really would be very controversial. If we can simplify the reporting requirements upon companies—perhaps, ideally, in having only one report encompassing some of the statutory information which directors have to disclose in the directors' report—so much the better.

Finally, the Minister referred to the category of smaller, unlisted companies. They will need the most help. It is not likely to be appropriate or effective to rely on Companies House to read—and, if you like, police—what these companies put in their directors' report. However, they must now expand the directors' report to include some of the points that the OFR requires of listed companies. That is just unrealistic. We must look to the accounting and legal professions—and indeed, to financial journalists—to provide some guidance on best practice. So, I welcome these regulations. All of us would wish companies to follow good practice, and not regard these regulations as a statutory burden.

8.30 p.m.

My Lords, I shall be extremely brief but it is appropriate to congratulate the Government on having listened to the concerns of the business community and, more importantly, on having heeded them.

It is fair to say that when the DTI published the draft regulations on 5 April last year, they were met with a considerable degree of apprehension not only by people in business but also by the auditing community. Auditors, after all, have honed to perfection their skills in ensuring that a company's statement of its financial performance over a year is entirely accurate. However, it is a wholly different task to ask them to apply the same degree of precision to a piece of crystal ball gazing, which is what the operating and financial review will be in part. As someone said at a talk I attended on this subject, it is rather like asking a marine cartographer to produce a Turner seascape—the skills are just not there. That is why everyone was concerned about the draft regulations. The Government have now changed them. I share the general welcome of the noble Lord, Lord Freeman, for the regulations that have now been produced. They are a step change for the business community and will involve much work, but if the measure is dealt with sensibly it can be useful to the company as well as to shareholders.

Directors will be required to show only the degree of care they would be required to show under common law—so there is no extra burden there—and auditors are required to ensure that there is nothing inconsistent with the company's accounts as they have seen them. That makes a lot of sense. Let us hope that the Accountancy Standards Board in drawing up the framework and the guidance does not end up being over-prescriptive, thus undoing the Government's good work so far. However, for the moment, I congratulate the Government.

My Lords, we on the Liberal Democrat Benches welcome the introduction of the OFR. In doing so I ought to declare an interest as a chairman of a company that advises others on corporate social responsibility.

Unlike the order on trading stamps, which we have just discussed, these regulations really are of fundamental significance both for the future of accounting and, I hope, for standards of business behaviour across the board. As the noble Lord, Lord Gordon, said, the regulations have been the subject of very intensive consultation. I, too, congratulate the Department of Trade and Industry on taking account of many of the different objections that were made on various sides and on producing something which strikes a balance between placing additional requirements on companies but not doing it in a way that overburdens them.

As noble Lords will know, there remain a number of questions and concerns about the regulations, which I suspect will be dealt with over time in various ways. First, they relate just to quoted companies and not to private companies or to companies that are owned outside the UK and quoted elsewhere. I suspect, however, that as the practice of producing OFRs develops, and particularly as companies move towards what the noble Lord, Lord Freeman, mentioned—namely, a single report that encompasses the existing report and the OFR—a large number of companies that are not formally required to produce an OFR will find it in their interests to do so as investors will compare them with other companies in their sector. If they do not produce OFRs on the same basis as their competitors, they may feel that they are at a competitive disadvantage.

Another objection that has been raised from the NGO side is that the OFR is directed exclusively at shareholders rather than other stakeholders. There was much argument about whether it should be directed equally at all stakeholders. My view on that is rather like that of the Bank of England in having one primary aim in setting interest rates; namely, that if you have one target, it is a lot easier to hit it.

I also think that, although the OFR is directed primarily at shareholders, other stakeholders will be able use it. I am sure that NGOs that have environmental, social or supply chain concerns will use them. The fact that, not technically, OFRs are not addressed to NGOs will not constrain the information that is included in them or the ability of NGOs to scrutinise them.

There is still a lot of scepticism and doubt in the business community about whether the OFR will make the kind of change that those of us who support them wish. I attended a lunch in your Lordships' House earlier this week that was organised by the Good Corporation, which is at the forefront of promoting best practice. A number of representatives of companies with good track records on corporate and CSR policy questioned whether the OFR would effect the change in behaviour that we want.

There is still a lot of cynicism, not in the CBI or the representative bodies, but in individual businesses that, in some cases, will have to start doing things that they have never done before, such as setting KPIs on non-financial issues. We shall see whether they do something that will affect their behaviour, or simply the minimum necessary to get over the regulatory hurdle. I hope that in the months ahead the Government will be more proactive than they have been recently in making the business case for embracing the OFR and for the policies that companies need to adopt in order to satisfy its requirements.

Looking at two or three areas that the OFR will cover for the first time, if businesses adopt best practice it will drive up their performance. Let us take employee policy. If businesses improve training and consultation and apply equal opportunities policies more rigorously, the likelihood is that they will have a more motivated staff with higher morale and lower turnover. They will therefore have higher productivity. Doing those things is not a burden; it is a potential business benefit. Equally, treating suppliers and customers well must be in a company's best interest. If we look at the proposals made a while ago by Barclays to close branches and introduce ATM charges, not adopting customer-sensitive policies did real damage to its brand. Finally in this category, adopting good practice on environmental standards has broad public policy benefit, but it can also save costs for the company concerned.

It is interesting that a recent report by the Economist Intelligence Unit on senior executives worldwide found that four out of five of them thought that good corporate governance would enhance their company's brand value. Doing things well should not be seen as a burden; it should be seen as what all good companies do. Therefore, in the short term companies that adopt the good practice that the OFR promotes will gain business advantage. In the medium term, I hope that OFRs will drive up standards and produce greater transparency and accountability across the business world as a whole.

My Lords, I am grateful to the Minister for his explanation of this rather complex set of regulations. They are complex because of their length. Although the regulations are only 14 pages long, they need 48 pages of explanatory notes from the DTI. However, the Minister explained the regulations so well that I did not need to read the notes.

In essence, these regulations introduce a requirement for quoted companies to prepare an operating and financial review in addition to their annual accounts and directors' reports. They extend the obligation to provide a fair review of the company's business in the directors' report that is required by a recent EC directive.

Although—as the noble Lord, Lord Gordon of Strathblane, and my noble friend Lord Freeman commented—the Government have on this occasion listened to business and taken on board some of the comments; and they have certainly resisted the temptation to go over the top and gold plate the directive—which is often the case—the regulations go further than the directive requires, as my honourable friend pointed out in the other place.

In such cases a recognition of the unique status and reputation of the City in the financial world is always required: a status that results in enormous economic benefits to the United Kingdom plc, which we should not allow to be eroded by overregulation or to be hampered by unnecessary red tape.

I need not take up much of your Lordships' time in discussing the regulations because they received detailed comment before the Second Standing Committee on Delegated Legislation in the other place. However, I would like to make one or two comments. First and foremost, I note that these regulations apply only to quoted companies. Of course they do not apply to private companies which, quite rightly, have a very relaxed reporting regime.

However, neither do they apply to the markets that operate as an alternative to what I may call the regular stock exchanges. I refer to AIM and OFEX. Although these two markets are designed to enable a more lightly regulated regime, and hence to provide easier access to capital investment, it should be noted that investors will be less well informed than those who buy shares on the ordinary stock exchanges.

If I may digress for a moment, I am sorry if, in referring to the "ordinary" or "regular" stock exchanges, it sounds as though I am in any way suggesting that AIM or OFEX are in any way less than regular or somehow inferior. A hunt through my thesaurus failed to produce a better adjective, so I left it as it was.

Of course I am happy to acknowledge, before I hear from their respective PR departments, that they both serve an important part in providing capital to the market, especially to new enterprises, and it is true that some do eventually become quoted on the stock exchanges, and it is probably true that they all aspire to do so.

Let me also hasten to add that I am not complaining that companies quoted on AIM and OFEX are excluded from the new regulations. I am certainly not suggesting that they should be included. I am merely pointing out the discrepancy, in the commendable interest of a light regulatory hand, between investors in one type of public company and another.

As your Lordships know, my party is in favour of minimal regulatory burden. It has been suggested that the new OFRs will variously blind investors with science, or alternatively will not be read by the majority of them in any case. My noble friend Lord Freeman made the point that they should be short and simple. It is probably true that many individual investors—as distinct from institutional investors—do not read the material they receive from their plcs until something goes wrong; and then they read everything.

The directors can do no more than provide the information to the shareholders, whether they read it or not. I would however like to hope—forlornly, I fear—that all companies, but particularly property companies, will use the new regime to cease the practice of constantly revaluing their freehold and leasehold properties to create paper profits, on which corporation tax is levied, with which to dress up their balance sheets and profit and loss accounts.

The trouble is that if property values fall for some reason, the artificial profit turns into an artificial loss. In my personal view a profit or loss occurs only when an asset is sold. Of course shareholders and potential shareholders must be told the current market value of the company's assets, and perhaps the new OFRs will be a good place to provide this information, and at the same time avoid the situation whereby the company has to pay real money to the Treasury as tax on theoretical paper profits.

The second point arising from these new regulations is the cost of implementing them. The Minister for Industry and the Regions admitted to the Scrutiny Committee of the other place that the total cost shown in the regulatory impact assessment is £137.2 million. She dismissed that figure by breaking it down to £31,500 per company for OFR compliance and £2,700 for enhanced directors' reports.

8.45 p.m.

However, I do not think that that is just a one-off cost. It applies each and every year, and with the passage of time it will undoubtedly increase. Whichever way you look at it, almost £137.25 million of extra annual expense, piled on top of all of the additional regulatory burden endured by industrial and commercial companies, could by no means be described as "peanuts". Some £30,000-odd per company, when compared with the amount spent by Whitehall on paperclips, may be considered completely trivial. However it makes a difference to individual shareholders and to the pension plans in which they have invested.

It is undoubtedly the case, as my honourable friend the Member for North-West Norfolk pointed out to the committee, that a whole new industry will be created consisting of consultants and advisers to assist in the preparation of the operating of financial reviews. My noble friend Lord Freeman said that it would be necessary to have people who could do those things, otherwise they would not understand it all. There is still a gap in the information regime that the Government may need to examine, if not redress. I refer to the information provided, or rather not provided, to investors in ISAs, pension plans, investment trusts and similar saving instruments. They still do not get the financial data that investment managers do, and perhaps they should.

Other speakers this evening have welcomed what the Government have done. I certainly welcomed the part where they listened and took note of some of the problems that people had. As noble Lords will know, and as I stated earlier, we like a light regulatory hand. Nevertheless, we do not oppose the making of this order.

My Lords, I am again grateful to all four noble Lords who have contributed to the debate. I must declare my hand from the outset; I am temperamentally a deregulator as well, so I wholly share the view that we badly need a regulatory light touch.

I will briefly dwell on a few of the points that have been made. The noble Lord, Lord Freeman, made three important points, and I will comment on each of them. I wholly agree that annual reports are getting very long; and they are getting harder to follow not just because of their length but because of their intricacy. It is important that they become clearer and more transparent and that they are written in plain English. We should all share that objective, as I certainly do.

Secondly, he mentioned the BETTA regulation task force. I declare a past interest as having been a member of the BETTA regulation task force. It was always an objective that where regulations came in some other regulations of a matching number, or preferably even more in number, should go out. That understanding is beginning to take hold. I welcome the fact that it has been said again this evening and that we have been reminded of it.

I want to say a few things about the smaller, unlisted companies, and companies in AIM and OFEX as well, which the noble Baroness, Lady Miller, mentioned. Those have also come up in the comments made by my noble friend Lord Gordon of Strathblane and the noble Lord, Lord Newby. It is of fundamental importance that the companies that make those reports should start off in clear and approachable language. It is absolutely true that we have used our get-out not to insist on the same requirements of other companies.

I share the view that has been expressed by all noble Lords in this debate that it is likely that the requirements on listed companies will spill over in terms of the encouragement that is provided to other companies. It may well be that some of them will then feel that they must hire more consultants than they had originally planned to. As the noble Lord, Lord Newby, said, it is fundamentally important that the encouragement overcomes the anxieties, and the Government should be proactive in that. It is important that companies of all sizes think about what they have to say about environmental standards, employee standards and so on. I hope that encouragement from the quoted stock market companies is transferred. My reason is straightforward. Even if it costs just under £140 million a year, if we are to have knowledgeable markets—markets in which investors and stakeholders, including employees, have a really good grasp and therefore operate with the greatest possible precision in the way they make their investments and judge the value of those investments and make their assessments of future prospects for their investments—it must be right to go in this direction.

We do not want a casino in the markets, we want knowledgeable investment. That is what companies have said in response to the consultation, as has been said here this evening. I will not labour the point, but it was a point very well made by noble Lords with which I certainly agree.

I make the point to the noble Baroness, Lady Miller, that it seems very likely that those investing in saving instruments of one kind or another will, quite rightly, in due course, want to know more, and along the same lines. That itself will help. There is no compulsion in that area, but it must help that people know what they are investing in, where those investments are likely to go, and whether competing investments may be better and serve their interest to a greater extent. All of those make for a knowledgeable investment world, and we have to operate in the future in a knowledgeable investment world.

I hope that noble Lords do not mind that I have already replied to that point; it is the style and standards that we are trying to set alongside this regulatory change.

On Question, Motion agreed to.

House adjourned at eight minutes before nine o'clock.