Select Committee on Treasury Minutes of Evidence

Letter to the Chairman from Lord Sharman of Redlynch

  I was interested to read the announcement of the Treasury Committee inquiry into the financial regulation of the public limited companies. As a former Chairman of KPMG International (I retired in September 1999) I do have some considerable experience of the issues which you will be addressing both in terms of this country and overseas. The purpose of this letter is to let you know that I am prepared to give evidence to your inquiry should you deem it desirable.

  By way of background I enclose a copy of the full text of my intended speech (it was cut short due to time limits) in the recent House of Lords Debate on the Corporate failures.

27 March 2002


  My Lords

  Before I begin I must first declare an interest. My interests are set out in the register of members' interests but that which is most relevant to the issue we are debating today is that I am the former Chairman of KPMG and one of the so called big five accounting firms. I continue as a paid advisor to that firm.

  It is with a great deal of sadness that I approach the motion for debate today. When I joined the accountancy profession some 40 years ago, it was a profession held in high esteem. Indeed in those days girlfriends' mothers were quite keen at having prospective chartered accountants as sons-in-law.

  Today we have the greatest crises which the accountancy profession has faced in its history. The reputation of Arthur Andersen which took some 90 years to build, lies in tatters, destroyed in 90 days. The indictment of that firm for obstructing the course of justice in the USA, will if sustained leave a stain on the whole of the global accounting profession which will take many years to remove.

What has caused this?

  Clearly the trigger has been the collapse of Enron, the largest corporate failure in the history of the USA (if not the world) causing the loss of livelihood and pensions of many thousands of people.

How did it come about?

  Essentially Enron built a house of cards, which collapsed at the first breath of wind. The collapse, which happened after it admitted it had overstated profits by $586 million, understated debt by $2.6 billion left $63 billion in liabilities. The share price which had traded at $90 in August 2000, closed at $1 when trading was suspended on 15 January 2002.

  Throughout the 1990s Enron experienced phenomenal growth. Annual turnover grew from $7.9 billion in 1993 to $100 billion in 2000. This was accompanied by steady positive earnings and a share price rise that ultimately stood at 70 times earnings.

  Between 1997 and 2001, it created a series of special purpose vehicles which removed assets and liabilities from the Enron balance sheet, in some cases this involved the purchase of assets from Enron on which it recognised a gain. These schemes were constructed with the benefit of advice from the auditors, lawyers and investment bankers. The schemes were guaranteed by Enron and secured with its own shares.

  What was unusual about these schemes was the scale, they were very large in relation to Enron and the involvement of both Enron insiders and other related parties as limited partners in these schemes.

  The obvious questions that arise are:

      (a) were the schemes legal—well it appears that they were;

      (b) were they disclosed in the financial statements—again the answer is yes. If one attempts to understand Notes 1, 7, 8, 9, 10 and 16 to the 2000 financial statements there was enough there to alert the reader.

  The rot started in March 2001 when Fortune Magazine began an article:

    "Its in a bunch of complex businesses. Its financial statements are nearly impenetrable. So why is Enron trading at such a huge multiple?"

  Things got worse for the rest of the year, including a third quarter restatement of earnings and falls in the share price (exacerbated by Hedge funds shorting the stock heavily, which triggered the calling of debt resulting in a rapid downward spiral to collapse.

  In my view what we have is:

  First a failure in corporate management—a house built on sand won't survive once the foundations start to move.

  Compounded by a failure in corporate governance. Clearly the Enron board did not exercise enough control on the actvity of management.

  Enabled by auditing failure, at a minimum the reasons for the earnings restatements should have been identified and prevented.

  All made possible by inadequate regulation and accounting rules.

  This series of failures was then compounded by what is alleged to be the wholesale destruction of evidence—"the shredding" by the very people—auditors—who are supposed to be the "watchdog"—the people who are supposed to exemplify independence, objectivity and probity. Little wonder then public confidence in them has taken a huge knock!

  It is very important to remind ourselves that this all took place in the USA—could it happen here? Well I can do no better than quote Sir Howard Davis, chairman of the FSA who in a speech to the World Economic Forum in New York at the end of January 2002 said "the wholly honest answer to that question if one means—could there be a large and unpredicted corporate failure in the UK—is Yes". He went on to explain the key differences between practice in the UK and USA.

  So far as the key issues in the Enron affair itself are concerned:

    (1) The off balance sheet activities would not have been acceptable in the UK—here there is a key difference—the USA has a detailed rules' based system of accounting. In the UK and internationally we proceed on the basis of principles based accounting—which requires the exercise of judgement as to substance over form. The SPV's would not have been "off balance sheet" in the UK.

    (2) The use of own shares as security and to fund retirement plans. The use of own shares as debt security is not that common in the USA and unknown in the UK. The use of own shares to fund retirement plans in the UK is controlled by the MFR and limited to 5 per cent of such plans.

  As regards the activities of the investment banks and the hedge funds I take little comfort, indeed I understand that as much as 30 per cent of the daily turnover of the LSE may be due to hedge funds.

The motion before us calls attention to recent corporate failures and to the case for regulation and other action to maintain public confidence in business and accountancy.

  As I said earlier let's make no mistake—when the Financial Times leader calls as it did on 13 March 2002 for the potential "Fat Four" to spin off their consultancy businesses and be banned from doing non-audit work for audit clients, we have a deep crisis in public confidence.

What should we be doing about this?

  First, Management: There is no process that I know that can make incompetent management competent. The purpose of corporate governance is to provide a system of checks and balance to militate the effect of poor or corrupt management.

  Second, Governance: There are many who have said the system of corporate governance in the UK is different and generally regarded as more thorough and a role model for the rest of the world. We seem to have overdosed all thoughts on corporate governance from Cadbury through Hampel and Greenbury to Turnbull. However I do agree that an examination of the role of non-executive directors recently announced by the Government will be a welcome addition to this batch. We should look at how many non-executive appointments an individual can handle sensibly and also at the desirability of full-time executives taking on more than say one non-executive appointment in another company. It will also be useful to see whether the real role and responsibilities for non-executives can at least be somewhat better defined than it is at present.

  Third we need to look at auditor independence and regulation. I hope that the major firms and their professional bodies realise how deep the crisis of public confidence is. It is shot—they can no longer go on behaving as if they are some sort of private club. More transparency in their affairs is desperately needed. I am deeply disappointed that other major firms did not follow the example of KPMG and Ernst & Young in publishing financial statements. Transparency is what generates public confidence and the affairs of some of these firms are remarkably opaque. I believe this is a strong case, after all these firms are very large enterprises. They employ upwards of 10,000 people each and have a significant role in the economy of this country. Why should they not have their financial statements auditied to the same standards of public companies and publish them in the same way. Proper financial disclosure and segmental reporting would once and for all resolve the issue of whether auditing is used as a loss leader.

  Progress has been made on regulation in recent past and although again I find the arrangements for it somewhat opaque there seem to be a large number of bodies all involved in this from the Investigation and Disciplinary Board through the Ethics Standard Board, the Auditing Practices Board, the Review Board and the Accountancy Foundation. Whilst all of this has the appearance of independence all the appointments are made independently of the accountants. It falls short in one key aspect, namely that the funding of the Foundation is by the accountants—he who pays the piper calls the tune. It seems to me a further step should be considered, that of the Government taking over funding of the Foundation and responsibility for the appointments of the members of the Board. This I feel would go someway towards demonstrating strong independence of regulation.

  A further step also in terms of transparency would be for the JMU, the body which conducts reviews of audit quality, to publish the individual reports on firms that have responsibility for auditing public companies. I recommended this in the case of the C&AG in my report Holding to Account last year.

I can see no valid reason for these reports not being made public. Again transparency will help in restoring public confidence.

  I turn now to other issues regarding auditors. Sir Howard Davis in his speech which I referred to previously in New York raised three possible steps. First, the mandatory rotation of auditors perhaps every five years. He uses the example of the audit committee as a support for this motion. I have to say that I do not believe that mandatory rotation would be helpful. In the countries where it has been tried, Brazil and Italy, it has been abandoned as a failure. The Cadbury committee looked at it and concluded that it would not work in this country as have the Irish Government recently. The Audit Commission does rotate the audit responsibilities after a fashion but it must be remembered that the Audit Commission is responsible for the appointment of auditors to local authority and health service entities which are a largely homogeneous group of entities. It is a very different thing to be dealing with very disparate businesses and rotating auditors. However, I do think we should look again at the issues of audit staff rotation and see if a more frequent rotation of say five years rather than seven is appropriate. Also the issue of audit partners joining their clients needs examination to see if there is a case for a moratorium period of say two years before such a partner could join a client.

  The second possibility he mentions is to require regular retendering of audit work. But not rule out the possibility that the current auditor be reappointed. Again I think this would have a limited benefit. Audit committees, if they are worth their salt should be looking at the appointment of auditors on a regular annual basis. I can see nothing that this suggestion would add to that.

  The third option mentioned both by the Financial Times and Sir Howard Davis is limits on the amount of non audit work. Here again I think this falls rightly into the remit of the audit committee. The audit committee should be monitoring all of the activity and relationships between the auditors and the company. Artificial limits either by percentage or absolute amounts will not in my judgement help. In many cases the additional work undertaken by auditors is as a result of competitive tendering, or in the case of many regulated industries a natural extension of audit work eg Reports for regulators etc. Competitive tendering in itself is a sensible test of the water and I don't believe that artificial limits will help.

  Those who like myself sit on audit committees will be well aware of all fees paid to auditors by shareholder groups such as the ABI and PIRCS which keeps such audit committees on their toes.

  My Lords, in concluding it is clear that the accounting profession and business needs to take a very close look at itself in the light of the Enron Affair. But let us not forget it was not only the board of directors, management and the auditors that were involved in this shambles. Investment bankers, lawyers and other advisors were clearly involved as well. We must not over-concentrate on one of the villains in the piece. There is quite a large cast to look at.

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