Select Committee on Treasury Appendices to the Minutes of Evidence


Memorandum submitted by Committee of The Law Society

  I regret that it has not been possible in the short time allowed and over the Easter period to produce a fully considered response. However, we would like to make the following points:

  First, the Enron collapse should not be the excuse for precipitate action in the UK. The Enron collapse was a uniquely American phenomenon. That is not to suggest either that a similar collapse could not happen in the UK or that UK accounting and auditing standards are superior. However, a principal cause of the collapse appears to have been the result of the deliberate decisions of certain individuals to evade American standards in misrepresenting the company's true financial position. No regulatory standards will ever prevent such negligent/fraudulent behaviour, either by company directors or their auditors. Ultimately, the criminal law will have to be relied upon to enforce sanctions against those who transgress and (more relevantly) the provision by Government of adequate resources for enforcement.

  Secondly, the European Parliament approved the draft Regulation on International Accounting Standards on 12 March and the Council of Finance Ministers is expected to adopt the Regulations in May. The Regulation will require all listed companies to report in accordance with EU approved international accounting standards from 2005. It would be unwise and nugatory for the UK alone to seek to impose new financial reporting requirements in the meantime. Additional regulation in the area of financial reporting by PLCs merely to be seen to be responding to the Enron collapse would be neither desirable nor helpful. Indeed, if the UK embarks on its own initiative, imposing more "red tape", it could disadvantage UK companies' competitiveness (compare the UK's knee jerk reaction to the Maxwell case regarding Minimum Funding Requirements which are now proposed to be abolished). Furthermore, the European Commission is to publish a series of recommendations for auditing best practice within the next couple of weeks. It is anticipated that there will be a code of conduct throughout the European Union dealing with matters relating to auditors' independence, audit and consultancy services and rotation of auditors for companies. We see little justification, at present, for independent UK action and, indeed, consider that it may be a disadvantage to companies in the UK should that course be followed.

  Again, the DTI is in the process of digesting the final report on the reform of company law produced by the Company Law Reform Steering Group with a view to producing a new Companies Bill. That exercise includes changes to the system of financial reporting by companies in the UK. The Committee would be totally opposed to the derailment of that project in order to idle down the siding of inquests into the Enron affair.

  The starting point for any review of the audit function must be the present legal position. In the UK the audit is at the heart of the corporate regulatory system. Under the Companies Act 1985 the directors of every UK PLC are required to lay the company's annual accounts, the directors' report and the auditors' report before the annual general meeting. The auditors are required to report to the company's members on the annual accounts. The auditors' report must state whether, in their opinion, the accounts have been prepared in accordance with the Companies Act 1985 and whether the balance sheet and profit and loss account give a true and fair view of the company's financial position. The principal function of the audit is thus to monitor compliance with the statutory requirements for company accounts. The auditors' contractual relationship is with the company and under UK case law (Caparo) the auditors' legal liability is restricted to the company and its current shareholders. Auditors are not responsible to other parties such as employees and prospective investors.

  That legal background may be raised in the forthcoming Companies Bill, although we think that major changes are unlikely. The Company Law Review concluded, after much consultation, that there is no case for a statutory extension of the duty of care of auditors to other parties and that it is premature to prohibit the same firm providing audit and non-audit services to a company. The Committee would generally endorse those recommendations. The Committee opposes the creation of any new criminal offence of knowingly or recklessly preparing statutory accounts calculated to deceive or mislead. It considers existing criminal offences to be adequate and that shortcomings are more the result of inadequate enforcement than vires.

  The accounting and auditing procedures established in the UK generally have proved to be sound. As lawyers we are not competent to judge whether UK accounting standards are tougher than American standards. However, it is perhaps worth pointing out that we believe that two of the key misrepresentations which are claimed ultimately to have led to the undoing of Enron would not be permitted in the UK—boosting earnings by accounting for all of the anticipated profits over the lifetime of an investment in the first year and off balance sheet affiliates (transferring to subsidiary companies debts of $27 billion in order to avoid having to account for them). Unlike the USA the UK has tough "substance over form" accounting standards for off balance sheet financing in the private sector (although the Treasury has refused to adopt these for the public sector).

  Corporate governance arrangements at Enron appear to have fallen well short of what would be expected in the UK. The Board of Directors failed to control the company's executives (in particular by asking the right questions as to what was going on and its accounting treatment). The Audit Committee either failed to fulfil its proper function or was given false or inadequate information. Non-executive directors either lacked the information or failed to pursue issues. Both American regulators and politicians appear to have been prepared to turn a blind eye to the practices of Enron. To extrapolate from that one company would, we contend, be to over-react. The constraints on companies in the UK are much greater, not least from the UK's listing requirements, codes of corporate governance and a vigilant financial media.

  There may be issues of principle arising from the relationship between Enron and its auditors, Andersen. The lessons being drawn in the media are that it is questionable whether a company should employ the same firm to provide audit and consultancy services; and the case for requiring companies to rotate their auditors after a certain period, either to change their audit firm or to change the partner at the firm responsible for the auditing of the company, has been revived. The Committee is not at present convinced by those arguments although it shares the general concern to ensure that the independence of auditors is maintained and enhanced.

  The Institute of Chartered Accountants in England and Wales already provides ethical guidance on the need for integrity, objectivity and independence on the part of the auditor which highlights possible risks to the standards to be expected from auditors. They include the possible risk to auditors' objectivity resulting from the provision to a client of both audit and non-audit services. Failure to meet those standards may be taken into account should an auditor face disciplinary action by his professional body. We are not sufficiently close to the case to be able to judge whether, on the basis of the Institute's guidance, the Enron—Andersen case would be classified as failing to meet the standard of independence expected of auditors in the UK. Nor do we have any particular views at present as to whether in relation to the issue of auditor's independence it is no longer safe in the public interest to leave enforcement to self regulation. We understand that in the USA the question has been reviewed and the conclusion was that there did not need to be a separation between the firm providing audit services to a company and the provision of non-audit services.

  A further angle to the Enron affair is that some people inside Enron knew of abuses which they did try to raise but their concerns either did not get through or did not get through to the right people in time, both within the company and at the Securities and Exchange Commission. This does raise the question of whether existing "whistle blowing" legislation is effective enough to encourage employees of a company to whistle blow to non-executive directors, for example, particularly where the employees feel they are being blocked by superior executives.

  I hope that in the short space of time available the Law Society's Company Law Committee has been able to provide the sort of opinions, which the Treasury Select Committee was seeking. The Committee would welcome an opportunity to give more detailed consideration to the issues arising from the Enron collapse.

18 April 2002

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