Distributable reserves – Change is on the horizon

The requirements surrounding distributable reserves – specifically, what counts as distributable profits and whether companies should be disclosing their levels of distributable profits – are currently under scrutiny by the BEIS Committee, the Competition & Markets Authority and the Investment Association. Consequently, proposed new requirements are expected to be released shortly. Here we consider what the new disclosures requirements may look like, what could provide useful information to stakeholders and who may be affected.

Background

As a consequence of the recent corporate failures, the Business, Energy and Industrial Strategy (“BEIS”) Committee published a report: The Future of Audit (“BEIS Report”), which sets out an array of recommendations to reform the UK audit market. One of these specific recommendations concerned compliance by companies with the capital maintenance regime – requirements set out in the Companies Act 2006 regarding the lawful payment of dividends and the protection of a company’s capital form. The recommendations consider how the existing requirements for distributable profits can, and should be, improved in order to support the prevention of future corporate failures and provide greater transparency to investors and other stakeholders.

To emphasise the point made in the BEIS Report, it included four cases to illustrate the current confusion and poor practice in relation to capital maintenance and the payment of dividends:

• Domino’s Pizza: It emerged in 2017 that Domino’s Pizza had made £85 million of unlawful distributions (dividend payments) over a period of 16 years from 2000.
• Carillion: A £54.4-million dividend was paid on 9 June 2017. A month later, the company announced a £845-million hit to profits. In total, Carillion paid out £333 million more in dividends than it generated in cash from its operations in the five-and-half-year period from January 2012 to June 2017.
• Capita: The company paid £74 million of dividends on 30 November 2017, and £137 million in July 2017. In January 2018, it sought a £700-million rescue from shareholders.
• AssetCo: On 31 January 2019, the High Court ordered the company’s auditor to pay a record £21 million in damages for “negligence of the highest order” and “flagrant breaches of duty” in relation to its audits of AssetCo in 2009 and 2010. One of these breaches concerned capital maintenance. The Judge concluded that the company’s auditor should have identified and told the company that they were not allowed to pay a dividend in 2009, because “there were no distributable reserves, and so there was no possibility of a dividend”.

Additional investigations carried out by the Competition & Markets Authority (“CMA”) and the Investment Association (“IA”) also highlighted the pitfalls in the current requirements and guidance available for determining distributable profits and the weaknesses of how the company law requirements fit in with the accounting requirements (under both UK GAAP and IFRS).

The BEIS Report accused audit firms, regulators and investors of having lost sight of capital maintenance as a central purpose of accounts and audit and that there is little compliance with, or enforcement of, the capital maintenance regime.

The BEIS Committee recommendations, in relation to improving the requirements surrounding distributable profits, are as follows:

• That the FRC urgently reminds directors and auditors of their duties relating to the accounts and impose severe sanctions for breaches. Auditors must be prepared to challenge management on their calculation of realised profits and distributable reserves.
• That the Government and the FRC urgently produce a clear, simple and prudent definition of what counts as realised profits for the purpose of distributions – defining realised profits as realised in cash or near cash.
• That the Government adopts a complementary solvency-based system in which directors must state that dividend payments will not make the company insolvent or create cashflow problems.
• That companies be required to disclose the balance of distributable reserves in the annual accounts and breakdown profits between realised and unrealised.

All of the recommendations will have important and clear implications for companies, however it is the final recommendation that is being considered here: disclosure of the balance of distributable reserves in the annual accounts and the breakdown of profits between realised and unrealised.

There is currently no specific requirement under company law or accounting standards for financial statements to distinguish between realised profits and unrealised profits or between distributable profits and non-distributable profits[1] (albeit this was the subject of a debate between the FRC and the Local Authorities Pension Fund Forum (“LAPFF”) back in 2016). However, the FRC states, in its revised guidance for companies when preparing strategic reports, that disclosures could be made surrounding a company’s capital allocation and dividend policies, as part of the company’s Section 172(1) statement.

So, what could the new proposals require to be disclosed?

What could be most useful for investors and other stakeholders?

It may not sound onerous to require companies to disclose the balance of distributable reserves in the annual accounts, but in reality, this is likely to be a complex (and therefore costly) task for many companies. The requirements and guidance surrounding what constitutes lawful profits available for distribution[2] set out many factors, which need to be considered when declaring a distribution, including:

• complying with the capital maintenance regime (for all companies);
• meeting the net asset test (for public companies);
• ensuring the annual accounts have been properly prepared in accordance with the Companies Act 2006 and an audit opinion has been given (for companies exceeding the audit threshold); and
• determining that the company’s profits are ‘realised’ for distributable purposes (for all companies).

Understanding all of these complex factors will ensure that companies determine the amount that is legally able to be distributed as a dividend. So, will the disclosure of this amount be sufficient for investors and other stakeholders? Putting aside all the complexities of actually determining the amount, in order to address the BEIS report concerns, the disclosure of this balance should provide a valuable and useful figure from which investors and other stakeholders can make informed decisions. For instance, there may be reasons why a company would not choose, or be able to, pay this amount out as a dividend (possibly because the company wishes to hold certain reserves for reinvestment purposes, or the company does not have sufficient cash available, or there may be other commercial reasons for the company not choosing to pay a dividend). As such, the basic disclosure of the balance of distributable reserves in the annual accounts and the breakdown of profits between realised and unrealised (as determined for legal purposes) should, if it is to be useful, consider companies’ expectations and practical ability to declare and pay a dividend in light of other commercial pressures.

Directors must therefore consider their fiduciary and other duties when declaring a dividend and there are disclosure requirements in place (albeit limited) that require some companies to provide certain information about their dividend policy and capital allocation. However, it is this link between management explanations and intentions about current and future dividend policy and the balance as determined for legal purposes, that will make the disclosures most valuable.  

At what level could disclosure be required – Company vs group

From a legal perspective, only a company can have reserves that are available for distribution, a group cannot (i.e. it is the reserves position of an individual company, not the group’s reserve position, which is relevant).

However, in group situations, it will likely be far more useful for investors and other stakeholders to understand a group’s distributable profit situation, rather than solely knowing the top UK parent company’s position. For example, only looking at the top UK parent company in isolation (particularly where the parent company is a holding company) will provide investors with almost no relevant information as it gives no information as to other group entities’ distributable reserves nor the total distributable profits available to the parent. However, to produce a group distributable profits figure is not without complications because factors such as legal, tax and accounting requirements (both local and overseas) may lead to restrictions on the ability of a subsidiary to make a distribution, such restrictions often referred to as a “dividend blockers”.

Understanding the difference between retained profits in the accounts and the reserves available for distribution

The ICAEW Technical Release guidance sets out how to determine whether a company’s accounting profits and losses represent realised profits and losses for distributable purposes. However, will a single amount showing the balance of reserves available for distribution be sufficient for investors and other stakeholders to truly understand a company’s reserves position? If the annual accounts also provided a reconciliation between the accounting profit reserves and distributable reserves, then the answer is maybe.  It is certainly more likely to help investors and other stakeholders understand what elements of the business activities and transactions have resulted in non-distributable profits, which in turn could assist investors and other stakeholders to understand the directors’ rationale behind declaring payments, and indeed, the implications of certain activities and operations being carried out by the company.

Where could the information be disclosed?

The BEIS report recommendation is that companies should be required to disclose the balance of distributable reserves in their annual accounts, however a main implication of this is that the amount will then need to be audited as it is part of the financial statements. This can be viewed as both a positive and negative implication – positive because an audited distributable reserves balance would provide investors and other stakeholders with a higher level of assurance that the balance is not materially misstated, but negative because this will therefore lead to increased costs.

Alternatives for where the information could be disclosed include either within the front-end reporting section of the annual accounts, for example as part of the strategic report, or within a separate report to the annual accounts, for example a report that is published on the company’s website. There are advantages and disadvantages to each alternative; the main ones being that both these options will result in lower costs to companies as the information would not be subject to audit, but on-the-other hand they would both result in a lower level of assurance regarding the validity of the disclosures being provided to investors and other stakeholders. The latter option will also increase the chances that the disclosures may get lost in the already plethora of information that is available on companies’ websites.  

Who will likely be affected by the proposed new requirements?

This is possibly the question with the most uncertainty attached to it. This is because the BEIS Report does not provide any indication as to who the proposed new requirements might be aimed at. Given, however, that the reasons behind the BEIS Report are mainly due to the corporate failures of listed companies, then it is likely that the new proposed requirements will initially become mandatory for those listed on the FTSE 350. Once the requirements become imbedded in these larger listed companies, the requirements might then be considered for mandatory application by smaller listed companies (including companies listed in AIM) or even large private companies. There is, of course, the possibility that the requirements become best practice (albeit voluntarily) for all companies, irrespective of size or complexity. This is because it depends upon what the objective of the proposed new requirements will be: is it (more simply) to provide disclosure about companies’ ability to be able to make current and future distributions, or is it (more holistically) to assist investors and other stakeholders to understand and assess how directors’ are meeting their fiduciary and other duties for ensuring the long-term success of companies.

Conclusions

Recommendations from the BEIS Report are expected to be announced shortly. There are many implications for companies that may be announced in the proposed new requirements, however they are likely to centre around improving the disclosures about a company’s application of the capital maintenance regime and their profits available for distribution. But what exactly will this look like – we will need to wait and see.

[1] Paragraph 2.25 of the ICAEW’s Technical Release: Guidance on realised and distributable profits under the Companies Act 2006 – TECH 02/17BL

[2] Part 23 of the Companies Act 2006, with additional guidance set out in ICAEW’s Technical Release: Guidance on realised and distributable profits under the Companies Act 2006 – TECH 02/17BL