New legislation imposes greater accountability on company officers which will increase the need for D&O cover. Simon Goldring and Lorna Sproston report
After the Enron and WorldCom corporate collapses legislation was introduced to to improve the transparency and accountability of companies' financial reporting.
The Companies (Audit, Investigations and Community Enterprise) Act 2004 came into force on 6 April.
The main focus of this Act has been on the relaxation of the prohibition on companies indemnifying their directors.
While the relaxation provisions are important to D&O underwriters, the Act contains a host of other relevant provisions.
It confers wider powers on auditors to gather information, and it also creates new criminal offences for directors and officers who fail to comply.
The consequences for the D&O insurance community are presently uncertain. On the one hand, the new criminal offences could increase the demand for D&O policies and potentially the risk for the insurers.
On the other hand, one objective of the Act is to increase transparency in the accounts process, which if carried through should reduce the risk of major and unexpected corporate collapses in the future.
Auditors have previously been able to require information from a company's officers, and a right of access to company books, accounts and vouchers.
This right remains but is extended by s8 of the Act, so that an auditor can now also require information from the company's employees and from its subsidiaries incorporated in Great Britain.
As a result, there are now wider criminal sanctions, because the offence of knowingly or recklessly providing false or misleading information to an auditor is extended to this wider group of people.
It will also be, for the first time, a criminal offence for a director or other person failing to provide information "without delay".
Where the audited company has a subsidiary incorporated outside Great Britain, an auditor will have no direct power to obtain information, but it can request that the parent company provides information from the subsidiary, and the failure to do so on the part of the parent company could also result in a criminal prosecution.
The flip side of the coin is s9 which imposes more stringent reporting standards on directors with regard to their disclosure statement in the annual directors' report.
The Act requires directors' reports (for financial years beginning on or after 1 April 2005) to contain a statement that so far as each director is aware, there is no "relevant audit information" of which the auditors are unaware, and that the director has taken all the steps he should have taken to make himself aware of such information and to establish that the auditors are aware of it.
"Relevant audit information" is defined as, "information needed by the company's auditors in connection with preparing their report."
This is an onerous obligation, since a director could be guilty even if he did not have direct knowledge of the information, or where he did not realise that the auditors required it.
Making a false statement in the annual directors' report may carry a criminal sanction (with a maximum penalty of up to two years' imprisonment and/or an unlimited fine) if the individual director was aware that the statement was false, or was reckless as to whether it was false, and did not take reasonable steps to prevent the report being approved.
Making no statement is not an alternative, since in those circumstances an offence is still committed under s234(5) of the Companies Act 1985.
In considering the information that a director knew or ought to have known, the court will consider both the knowledge, skill and experience that may reasonably be expected of a person carrying on the same functions as the director concerned, and any additional knowledge, skill and experience that the director in fact possesses.
This mirrors the 'duty of care' applicable in civil cases, so the court's consideration of a director's duty to carry out an investigation of the affairs of the company presently being considered in the Equitable Life case, should be relevant.
The objective of the 2004 Act is to improve the reliability of financial reporting. The additional means by which this objective can be achieved includes:
The 2004 Act should also be considered as part of a package of reforms, including the strengthening of corporate governance, the Operating and Financial Review, IFRS, the Transparency Directive and the Company Law Reform White Paper.
These reforms are intended to improve the transparency of financial reporting and accountability, thereby reducing the likelihood of an 'Enron'-style collapse in the UK. This should theoretically provide increasing stability for the D&O insurance market.
This Act, together with the raft of reforms mentioned above, creates further burdens and duties on directors.
For example, it increases the amount of time and energy directors will need to spend in making inquiries across the company to ensure nothing is hidden.
In an already complex area, the implementation of this Act should increase the demand for the D&O product. IT
' Simon Goldring is a partner, and Lorna Sproston is a solicitor, in the accountants and D&O group at city law firm Reynolds Porter Chamberlain