Select Committee on Treasury Minutes of Evidence

Examination of Witnesses (Questions 400-416)



  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 on this?
  (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 provisions.

  403. Your document will come out when? It sounds a helpful document.
  (Sir Howard Davies) Probably around the end of this month.
  (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 UK.
  (Sir Howard Davies) There would be time to pick this up.

Mr Mudie

  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 Government negotiation.

  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.

Mr Laws

  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 into place?
  (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 point—and in a way I am relieved that this is ultimately not my decision—I 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 partners—seven years is quite a long time and I would favour shortening that to five—and 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 regular re-tendering.
  (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 decision.

  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 and scrutiny?
  (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.

Mr Cousins

  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 clues—being 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.

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