Examination of Witnesses (Questions 400-416)|
DAVIES, KCB, AND
TUESDAY 2 JULY 2002
400. I always mean what I say and I hope you
do as well.
(Sir Howard Davies) The listing authority of the Stock
Exchange came over to the FSA in the year 2000 and the listing
rules are a combination of things which are absolutely required
in order to be a listed and traded company in terms of presentation
of timely accounts and disclosure of price sensitive information.
They also include a series of other corporate governance related
requirements, largely disclosure based requirements which have
been built up over a number of years and in some cases in a voluntary
way. For example, the Cadbury Code has now been turned into the
Combined Code and is tacked onto the listing rules. The rules
on disclosure of executive remuneration which were largely articulated
by the Greenbury Committee a few years back have also been included
in the listing rules so that it is part of the listing rules that
you need to disclose your compliance with these codes or, if not
why not? When we took these over and we agreed with the Treasury
that we would review the listing rules, beginning this year, we
assumed that we would be reviewing the appropriateness of those
disclosure requirements whether they needed to be amended, whether
more corporate governance features should be added to them, etcetera.
Included in there are some elements about auditor independence.
However, in the period since we began to look at the listing rules,
a new Prospectus Directive has appeared in Brussels which really
alters the legal framework for listing rules and for admission
to trading, indeed does away with the concept of listing as we
have traditionally understood it in this country, in favour effectively
of a more limited concept of admission to trading on a regulated
market. It is difficult to give a completely categorical answer
to your question at this point because the directive is still
under discussion in Brussels. It has not yet been agreed, it is
in Council working groups of one sort or another. Our current
reading of it suggests that a number of the existing provisions
in the listing rules, particularly related to corporate governance,
would no longer be possible for us to implement using that legal
basis. They would therefore fall away from the listing rules.
401. Could you just give a quick example of
what those might be?
(Sir Howard Davies) The Combined Code, for example,
or the rules on disclosure of executive remuneration. In those
circumstances there would need to be some different legal backing
for those requirements, if you wanted to keep them. That could
be done under company law, it could conceivably be done as part
of the admissions and trading requirement by the exchange, but
since exchanges are now tending to be commercial entities competing
with each other, whether they would wish to impose additional
requirements when they are competing for listings is a moot point.
Whether that would be adequate to satisfy the public interest,
I am not sure. The interaction between the Prospectus Directive
and the Companies Bill is an interesting one and one which the
Government are currently thinking about. It is hard for me to
give you a more categorical answer to that in this current rather
uncertain set of circumstances.
402. A timing point. When do you think this
issue will be resolved from your point of view, because you will
obviously have to come to some end point where you say these are
listing requirements in the UK? What is the timescale? I entirely
appreciate that this is ongoing at the moment, but clearly the
sooner the better. When do you think we are going to have an answer
(Sir Howard Davies) We propose to kick off the listing
review with a discussion paper fairly shortly. That discussion
paper will have to be somewhat conditional. It will give a taxonomy
of existing rules, explain which of them can remain and which
of them are likely to fall away. Certainty will occur when the
Prospectus Directive has finally been agreed and my understanding
is that it is a high priority of the Danish Presidency to agree
a Prospectus Directive in the second half of this year. I would
have thought that some time in the autumn we would know the final
shape of the Prospectus Directive, therefore what is in and what
is out of the listing rules, therefore what needs to be picked
up elsewhere if people think that it remains a valuable set of
403. Your document will come out when? It sounds
a helpful document.
(Sir Howard Davies) Probably around the end of this
(Mr Foot) It is the intention at the moment that the
Prospectus Directive would be applied from December 2003. That
date could slip but that is what we have to assume is the earliest
practical point at which these issues might crystallise in the
(Sir Howard Davies) There would be time to pick this
404. Are you doing these negotiations as the
FSA or are you doing them in tandem with the Government?
(Sir Howard Davies) It is a directive, so it is a
405. They are in charge.
(Sir Howard Davies) Yes. This is in the European Council
working group. We are asked for our technical advice.
406. I am not being funny, but are you running
happily in tandem with Government on this? In terms of public
regulation of companies these are very important negotiations
and if the end result weakened the regulation here, you are suggesting
that it would probably need quick legislation. Is that a view
you think is shared by the negotiators?
(Sir Howard Davies) Yes. I think I would probably
say running unhappily in tandem with Government, but that is not
to say there is any difference between us. Neither of us is particularly
pleased about the shape of this directive as it currently stands.
We understand the logic of it in relation to the way things are
done in the rest of Europe, but we think, and believe the Government
think, that the way in which corporate governance has been enforced
in this country is actually quite a sensible way of doing it.
I have been on both sides of this because when I was at the CBI
we negotiated codes of conduct which we were then happy to see
enforced in the listing rules. It is a rather more flexible way
of doing it than through company law. It does mean that if you
have a code it is essentially a disclosure based regime but you
can amend the code without too much fuss. Obviously the more you
put in primary legislation the more cumbersome the way of devising
corporate governance which you need to change in response to market
circumstances. We both feel that it is a pity that our existing
approach does not look as though it is going to be viable any
longer. I hope you would not find any disagreement between us
and the Government on this point.
407. May I just follow up the speech Sir Howard
made in January 2002 when he touched on some of the implications
of the Enron crisis. One of the proposals you floated in that
speech, was the idea of having a mandatory rotation of the auditors
every five or seven years, which seems to be something which we
read in the newspapers this week the Government may be picking
up on. Could you explain to us whether you believe the proposal
for mandatory rotation is something the Government should be putting
(Sir Howard Davies) I have to say that I have an open
mind on this. I must say that some of the arguments which have
been advanced against this strike me as being less than wholly
persuasive in that the problems which have emerged, and people
say the problems emerge in the first year or two of audits rather
than at the end, have been in a regime without audit rotation,
typically where the previous auditor has probably resigned or
been kicked out by the firm because they have fallen out or whatever.
In a way it is not surprising in a regime without auditor rotation
that you typically find problems in the first year or two of a
new auditor. That does not seem to me to be a knock-down argument
against auditor rotation because I do not know whether you would
have the same circumstance if you actually had a regular rotation
point of view. I suppose that if I were forced to offer a preference
on it at this pointand in a way I am relieved that this
is ultimately not my decisionI would favour going for something
where the audit committee needed to make a positive decision on
reappointing the auditors and explaining why they were doing so.
We could have perhaps more frequent rotation of audit partnersseven
years is quite a long time and I would favour shortening that
to fiveand then maybe some backstop provision for auditor
rotation at 15 years or something. It strikes me that a century,
which is how long some of these auditors have been there, does
seem to be quite a long time. If I were put on the spot at the
moment, I would go for something along those lines, but it is
right that the review board is having a look at the arguments
because some of the so-called evidence which is presented one
way or the other does not seem to me to be evidence which is directly
relevant to this particular case. May I add one further point?
I do think that there is a kind of culture issue here as much
as a rules issue. If you look at what has been said around Enron
and the relationship with Andersen, Andersen partners quoted as
saying, "We do not call audit audit around here in Enron",
more generally the American Institute of Chartered Public Accountants
published a book only in 1999 called "Leveraging the audit
into a profitable relationship", the sort of culture of audit
in the service of management, part of the management team, is
the thing we have to get away from, and that auditors are merely
in the service of shareholders and are also operating in a public
interest, in the interest of making markets work effectively,
that proper information is out there. It is that cultural shift
which is important and how you can achieve that. I am not sure
you achieve that just by some five-year rule.
408. I want to come to that in just a second.
Just to clarify, your general inclination in this area is not
to go for mandatory rotation of auditing firms, but perhaps to
rotate the partners more frequently and to have what you also
touched on in your speech in New York which would be to have a
(Sir Howard Davies) A regular positive decision and
reassessment of the auditor, perhaps with mandatory rotation after
15 or 20 years or something like that as a backstop function.
This is what I think I would do if I were pressed to make this
409. Before we look at the issue of audit versus
non-audit work, this question of rotation is really an issue about
whether or not the experience of auditing a company for a long
period of time and understanding it is more important and more
useful than the fresh pair of eyes which is going in. That could
come down either way. Do you have an inclination as to which is
a more useful aspect in the auditing process? Is it getting that
freshness in or is it getting the experience of understanding
a business over a period of time?
(Sir Howard Davies) One reason why I would probably
favour the approach I have set out rather than an absolute rule
of rapid rotation is because the circumstances can be different,
depending on the management. It is very important that we bring
the management into centre stage here in all of these issues.
It is the management responsibility for preparing accounts and
for presenting a proper view of the company. You might think differently
if you were an audit committee member, if you had just had a turnover,
a new chief executive, and you might be perfectly happy to keep
the existing auditors in place. If, however, you had had a chief
executive and a chairman who had been running this business for
a very long time together and the same auditors whom they had
grown up with, you might have a different view about the need
for rotation. You need to look at the two alongside each other.
410. The other question you raised a second
ago, which we understand the Government are considering, is whether
auditing firms should be able to lose their dual mandate, so they
should not be auditors and consultants at the same time for the
same business. You implied a second ago that you thought that
might make quite a lot of sense, because you had a concern that
companies might be trying to win other business on the back of
their auditing mandate and there could be a conflict of interest
there. Could you say a little more about your views on that and
where we might put the barrier?
(Sir Howard Davies) The key really is how to determine,
if you are the audit committee, that your auditors are really
properly independent and delivering you a true bill without being
motivated by other things. What we need is to give guidance to
audit committees on how to satisfy themselves on that. A simple
auditing yes, consulting no, is a bit difficult because there
is a spectrum of services and some of them may be audit related
and may be quite reasonable, some not. I think that what we need
is to look for some guidance to audit committees. Some things
are easy. Internal audit and external audit together is a pretty
easy one to determine that is not a sensible thing to do. Some
tax advice is easy to determine is not a sensible thing. Auditors
should not put in the risk management system which they are then
auditing to see whether it works. You could fairly reasonably
produce a codification of the kinds of services which you think
might well compromise auditor independence and where an audit
committee, all other things being equal, would not want to have
their auditors doing those things and if they were doing any of
them they would want to explain very clearly in the accounts why
they did not. There is another dimension which is to do with the
economic significance of the total amount of work you are giving
to the audit partner and to the audit office perhaps and this
was another dimension in Enron, where Enron was an absolutely
enormous proportion of the Houston office's revenues. That might
be another thing you would want to look at as an audit committee.
I suspect that amplified guidance to audit committees on a sort
of code of auditor independence, might well be a sensible compromise.
I am always uncomfortable that a white line, black and white rule
can be quite difficult to make sense of in individual circumstances.
411. You touched briefly on the issue of how
to deal with a situation where the management of the company itself
may be aware of the malpractice or misrepresentation but not taking
any action to deal with it. How much do you think an enhanced
role or a changed basis of the audit committee itself might deal
with that and how much do you think that changing the role of
non-executive directors might assist in having additional oversight
(Sir Howard Davies) The key thing is what the audit
committee thinks it is doing. It is that the audit committee is
acting for the shareholders and that seems to me to be the crucial
thing. In the case of regulated financial firms, we have tried
to set out what we see as the role of an audit committee and what
we think they should be doing in order to satisfy themselves that
they are fulfilling their role properly. I think that is particularly
appropriate in financial terms with their particular regulatory
responsibilities. Perhaps some further guidance to audit committees
on how they should fulfil their role would be appropriate, but
that is a subject at which Derek Higgs is going to have a look
in his review of independent directors and non-executive directors.
It is not something on which I would feel totally competent to
advise in relation to non-financial firms. We have set out a regime
in our rule book for financial firms, which we have showed to
Derek Higgs and it may be that there are some suggested things
in there which he could consider for broader application.
412. Would you favour limiting the number of
non-executive directorships which people could hold?
(Sir Howard Davies) Yes. Having 20 is absurd. I share
everything that Lord Sharman said to you.
413. You told the Committee that FSA accepts
the use of US accountancy rules for special purpose vehicles in
the activities of US and other banks in the UK.
(Sir Howard Davies) Yes.
(Mr Foot) Yes, this would be branches of banks where
they are looking to the consolidated supervisor in the United
States for comfort.
414. Do you have any idea of the scale of business
which is being conducted under those arrangements?
(Mr Foot) In some of the largest groups it is probably
very considerable. I draw a distinction between commercial banks
and investment firms because with commercial banks the consolidated
supervision by the Federal Reserve is normally pretty extensive.
In the case of investment firms, as we have made very clear, one
of the issues for us always has firms. We have set out a regime
in our rule book for financial firms, which we have showed to
Derek Higgs and it may be that been the fact that the SEC is not
a consolidated supervisor and therefore we do not have the same
comfort when we deal with those. We respond to that in the way
we regulate here by a greater degree of ring-fencing to protect
UK subsidiaries for example.
415. So there is a considerable amount of business
- I should like you to look into that to provide us with some
more cluesbeing conducted under those US accountancy rules
in the UK.
(Mr Foot) No, not in the UK. In the case of a branch
of a commercial bank, Bank X, here in the United Kingdom, the
health or the potential strength of those deposits is obviously
based on the strength of the whole group, not of the operations
in the UK. If there are special purpose vehicles in Houston or
wherever it may be in the United States which damage the group,
which then damage the parent, then those are at risk. I am not
saying that these special purpose vehicles are in the UK.
(Sir Howard Davies) For a financial firm, for a bank,
there is an additional kind of override over and above the accounting
which is that for every bank operating internationally there has
to be a consolidated supervisor which is responsible for the total
capital of the group. I am quite sure that as a consolidated supervisor,
the Federal Reserve or the Office of the Controller of the Currency,
does exactly what we do with our banks who have special purpose
vehicles, which is to look at the economic reality of the special
purpose vehicle, what the exposure of the entity is to it and
we make a capital charge in the consolidated supervision in relation
to that exposure. We would ignore the accounting treatment for
that purpose and I believe the Federal Reserve would as well.
416. Why do you not put a stop to this?
(Sir Howard Davies) There would be no justification
for putting a stop to it. There are all kinds of tax reasons why
people put things through special purpose vehicles. We look to
see whether they have actually laid off the risk. If they have
not, we give them a full capital charge for the exposure through
those special purpose vehicles. I would not regard that as a problem
for our regime exactly.
Chairman: No further questions. Sir Howard,
may I thank you for your attendance this morning. Mention was
made of your New York speech. In that speech you did ask the question,
could an Enron happen here? You said the only honest answer is
that it could. On the basis of that speech we decided to go for
this inquiry, so we do listen to you whether you are in the UK
or the US.