Select Committee on Treasury Appendices to the Minutes of Evidence


Memorandum submitted by the CBI


  1.  The CBI welcomes the opportunity to submit this evidence to your Inquiry, whose terms of reference are:

    "To examine in the light of the Enron collapse, the arrangements for financial regulation of public limited companies in the United Kingdom."

  2.  The Committee is interested to receive views on issues such as the adequacy of accounting and audit procedures, the role and responsibilities of auditors, and corporate governance issues, such as the role of non-executive directors. We seek to address these issues in this submission.

  3.  The CBI, and its member companies and associations, naturally support robust systems of company law and corporate governance, based on integrity openness and transparency, with a place for some statutory regulation and controls, but also in an environment in which company managements have the freedom and flexibility to manage and grow the business in a very competitive international environment for the benefit of their shareholders, employees, customers and suppliers as well as the community generally.

  4.  The United States, and perhaps the world at large, may not have suffered a corporate failure on the scale of Enron before, and one must have regard to the particular legal and regulatory regime and environment that exists in the United States, when assessing what the ramifications may be for the UK and the world at large.

  5.  A natural reaction to something like Enron may be that the right response is more regulation. Hard though it is to resist this reaction, it is in fact entirely the wrong one.

  Enron is a US, not a UK, company. The US has a very prescriptive rules based regime, but Enron still happened. Instead there should be a reinforced focus on judgement and balance, and substance over form. In cases of a major failure like Enron, the general approach should be first to consider whether there are persons who have been fraudulent, reckless, negligent or otherwise deficient in their behaviour, and if there have been, whether the legal and regulatory system properly identified such culpability and at the earliest realistic opportunity. If it did, then no changes to the legal and regulatory system are prima facie required. If the regulatory system could have worked better by identifying the failure sooner and reduced the losses which occurred, then legal or regulatory reform may be for consideration. However, no regulatory system can be foolproof in preventing and identifying human failure and misconduct.


  6.   Following the rapid growth in the economy at the end of the 1980s and the sharp recession that followed, there had been concern at the apparent rapid failure of some major companies, when the accounts had been prepared in accordance with then current accounting standards, and signed off by the auditors, although failure was often linked to fraudulent conduct including the later Maxwell scandal.

  7.  At this time the Accounting Standards Board was established as a new independent body authorised to set accounting standards operating under the auspices of the Financial Reporting Council and supported by a new Financial Reporting Review Panel with authority to require companies to amend and re-publish their accounts that fail to comply with applicable accounting rules. The Accounting Standards Board introduced a series of new Financial Reporting Standards requiring more detailed disclosures and removing uncertainty as to the appropriate accounting treatment. The CBI has given consistent support to the establishment of the Accounting Standards Board and the new regulatory structure in order to improve standards of financial reporting, (albeit if not always with the detail of every proposal like any commentator). We consider that the Accounting Standards Board supported by the Review Panel has been a great success, which we take this further opportunity to publicly acknowledge. The CBI is represented at Deputy Chairman level and amongst the other members of the Financial Reporting Council.

  8.  The series of corporate failures at the beginning of the 1990s also brought about the other leg of the reforms at that time, namely the establishment of the Cadbury Committee, with which the CBI was closely associated, and the unique lead the UK took at that time in addressing issues of corporate governance.

  9.  We would argue that the UK continues to lead the US and the world in establishing practical and effective means of addressing issues of corporate governance, through the ground-breaking approach established by Sir Adrian Cadbury and his Committee.

  Their approach, which has served the UK well for more than 10 years now, is based on accountability, transparency and disclosure, and recognises that much of corporate governance is not suitable for legislation and statutory prescription, but on the integrity of the individuals involved, and a dialogue between the board and its shareholders employees and other stakeholders. Cadbury established a corporate governance code of good practice, which acknowledges the freedom of the board to manage the business as they see fit, but who should account for their stewardship through disclosure in the annual report and accounts, in which the board explains its corporate governance policies and the extent of its compliance with the governance code, and identifies and explains any areas of non-compliance. These requirements are enforced via the FSA Listing Rules.

  10.  Corporate governance in the UK was subsequently taken forward in 1995 by the Greenbury Committee, which considered the particular problems of directors' pay, and the perceived conflicts of interest which could arise. This was followed in 1998 by the report of the Hampel Committee in 1998, which reviewed and updated the Cadbury and Greenbury recommendations, and also laid down some Principles of corporate governance as part of a new Combined Code of good practice. The CBI was again closely involved in the establishment of the Greenbury and Hampel Committees, and supported their recommendations and approach.

  11.  Corporate governance has most recently been considered by the group of experts and practitioners led by Jonathan Rickford, which conducted the Company Law Review, whose report was published in July 2001. Again, the CBI actively participated in this review, and the Government's response is awaited to their report. The Report has recommended the creation of a new Standards Board, which would operate under the aegis of a new Company Law and Reporting Commission, having apparent responsibility for both financial reporting and corporate governance.

  12.  We wait to see how the Government intends to respond in its proposed Companies Bill to the CLR proposals for a new institutional structure, but the CBI has emphasised that the flexibility and good practice approach to corporate governance epitomised by the Combined Code and its predecessors should not be jeopardised or lost, and likewise the substantial achievements of the Accounting Standards Board and the Financial Reporting Review Panel.

  13.  As noted earlier, no system of regulation can be foolproof against human and business failure, and the UK has continued to suffer some major failures, particularly in the financial services sector. The UK now has another major regulator in this area in the Financial Services Authority, but it only assumed its full powers at the beginning of December 2001, and it is too early to judge the effectiveness of this new regime.


  14.  The UK regime is therefore currently based around the following:

    —  legislation, primarily the Companies Acts 1985 and 1989 and regulations made thereunder;

    —  accounting and auditing standards promulgated by the Accounting Standards Board and Auditing Practices Board respectively;

    —  Listing Rules promulgated for listed companies by the Financial Services Authority;

    —  best practice on corporate governance, financial reporting and accountability to shareholders set out in the Combined Code promulgated by the Hampel Committee, enforced via the Listing Rules, supplemented by the Turnbull guidance on reporting on internal controls and risk management, and the Accounting Standards Board guidance on the Operating and Financial Review.

  15.  We consider the current arrangements in the UK broadly satisfactory as to their structure. The Company Law Review report last year has made many recommendations for modernising company law itself, much of which can be supported, although we consider that the current flexible approach to the Operating and Financial Review (OFR) via the Combined Code, aided by the guidance from the Accounting Standards Board, (currently under review by them), is preferable to the statutory approach recommended in the CLR Report.

  16.  As noted, the Review's proposed new institutional structure, if it is to work, should seek to maintain and build on the key strengths and successes of the current system and existing regulatory framework. The role of best practice, as reflected in the Combined Code, and the freedom for companies, boards and auditors to exercise discretion and judgement where appropriate, and not the universal application of mandatory rules prescribed by regulation, remain important and fundamental in any revised institutional and regulatory structure affecting companies and the auditing profession.

  17.  For business, the strength of the Combined Code and its antecedents has been that they have rested on principles established by wide consultation in the business investor and professional communities made effective by disclosure and the need to justify departures from them. The Financial Reporting Review Panel and the Listing Rules, with the active support of institutional investors, have proved to be an effective means for ensuring compliance with accounting standards and accepted best practice in financial reporting and corporate governance.

  18.  This is a fundamentally different approach from that in the United States, where there is a legalistic and tick box approach to financial reporting and corporate governance, based on an array of detailed rules, whereas the UK approach is based on a set of Principles which form the framework against which the detailed standards are drawn up. However, it appears that the US has no equivalent to the UK's FRS 5 Reporting the Substance of Transactions which regulates the disclosure of off balance sheet vehicles and structures, a key feature in the Enron collapse. Under UK accounting principles, accounts should reflect the substance of the transaction rather than its legal form. UK financial reporting is also based on the premise that the accounts present a true and fair view overall, and the auditors are required so to state in their report attached to the annual accounts. The true and fair overriding principle in UK financial reporting is absent in the US.

  19.  Financial reporting internationally is moving towards a set of global standards promulgated by the International Accounting Standards Board, and EU listed companies are due to publish their accounts in such format from 2005. We also look forward to increasing US recognition of such standards. An international consensual approach to business regulation must be the route for the future as far as practicable.


  20.  The original Cadbury Committee Report recognised the important role played by non-executive directors and board committees, in particular the audit committee, in improving standards of corporate governance and accountability, and the principles of disclosure and transparency in the way boards of directors exercise their stewardship on behalf of the company's owners, the shareholders. This was taken forward further in the Hampel Report and the Company Law Review in recognising that the paramount obligation of the board is to the shareholders, whilst acknowledging and having regard to the interests of the other stakeholders, the employees, customers and suppliers of the business, and the community in which the business operates generally, nationally and internationally. The CBI and its members strongly support these principles and approach, if companies are to be successful and wealth creating.

  21.  As the business of companies grows and becomes more complex in an increasingly competitive international marketplace, the burden on boards, and that placed on the role and responsibilities of non-executive directors, grows likewise. The Government has recognised this, in announcing its inquiry into the role and responsibilities of non-executive directors, in which the CBI looks forward to participating.

  22.  Some see non-executive directors as fundamentally playing a policeman's role in exercising a supervisory or monitoring role over the activities of the CEO, finance director and other executive management. Whilst some aspects of the work and role of non executives may be seen in this light, companies and board members regard non executives as members of a single unitary board and responsible with the executive directors for the stewardship of the business on behalf of the shareholders. This is reflected in company law itself, which refers only to directors. This is also one of our concerns with the Government's recent consultation on its proposed draft Directors' Remuneration regulations, which seeks to draw a distinction in company law between the board as a whole and the remuneration committee, which is no more than a committee of the board.

  23.  The audit committee, made up of non-executive directors, clearly plays a key role in setting and reviewing the company's accounting and financial reporting policies, and in liaising with, in conjunction with the finance director and the board, the company's auditors, and the terms of their engagement, and responding to matters they may raise.

  24.  Non-executive directors are expected wherever possible, (but not necessarily always without exception—see next paragraph regarding Combined Code) to be independent of the company and the executive directors, apart from the position of director itself.

  There are sometimes calls for a statutory or regulatory definition of independence.

  We do not think this is sensible or practicable, because essentially independence is essentially a matter for the individual concerned and the perceptions of those making the judgement. Independence is essentially for each person to assess based on full disclosure of the individual's background, and in companies is a matter for the board's nomination committee, the company chairman, and the individual himself.

  25.  The Combined Code provides at A.3 that the board should include a balance of executive and non-executive directors (including independent non-executives) such that no individual or small group of individuals can dominate the board's decision taking.

    Code provision A.3.1 provides that the board should include non-executive directors of sufficient calibre and number for their views to carry significant weight in the board's decisions. Non-executive directors should comprise not less than one third of the board.

    Code provision A.3.2 provides that the majority of non-executive directors should be independent of management and free from any business or other relationship which could materially interfere with the exercise of their independent judgement. Non-executives considered independent should be identified in the annual report.

  26.  The Government's proposed inquiry into non-executive directors will no doubt consider whether further guidance on the issue of independence is appropriate, but we would be against prescriptive statutory regulation. This is very much a Combined Code/good practice issue, along with the means and frequency used by the board, board committees and/or individual directors to communicate with their shareholders, and their largest institutional investors. Such dialogues, and the means to conduct them, already exist and take place. Again statutory prescription is unnecessary and inappropriate.

  However, we would not support any statutory restriction on the number of non-executive director appointments an individual may hold. This must be a matter of judgement for the company, board and individual concerned. Moreover, a person who does not hold an executive director position will normally be able to undertake more appointments than an executive director, who wishes to lend, as well as broaden, his experience in a non-executive capacity.

  27.  Rather the main danger from increasing the burdens and liabilities placed on directors, including non-executive directors, is that it will become increasingly difficult to attract the right candidates to fill these positions, particularly when seeking to recruit from an international pool. UK regulation must not be significantly out of line with, in particular should not be significantly more onerous than, that applying internationally.

Internal Controls and risk management

  28.  One of the key features of the Cadbury and Hampel Reports was the importance each Committee attached to the board's responsibility for internal controls and the management of risk, and each report recommended additional guidance be prepared to assist companies, boards and auditors—the Rutteman guidance following Cadbury, and the Turnbull report following Hampel. A common factor in many corporate failures has been the lack of effective systems of internal control and risk management.

  29.  The current Turnbull guidance recommends a risk based approach to establishing a sound system of internal control with a board review of its effectiveness. The report also makes clear that to remain effective systems of internal control and risk management must be subjected to ongoing monitoring. The board needs to receive and review reports on internal control, undertake its own at least annual assessment, if the board is to be able to make its own statement on internal controls within the company in accordance with the Combined Code requirements. CBI members support these initiatives and requirements, which mark another difference from the regime applying in the United States.


  30.  The regulation of auditors has recently been revised, following the establishment of the Accountancy Foundation which now has responsibility for the Auditing Practices Board, and a new Ethics Standards Board and an Investigation and Discipline Board.

  31.  The CBI and member companies naturally support a strong and effective auditing profession if auditors are to provide reasonable assurance to shareholders and investors.

  The role and effectiveness of the auditor is particularly important where there is a divergence between the management and ownership of a business, which is a feature of a listed company, but is also the case for many non quoted, non family owned businesses as well.

  32.  The role of audit and the auditor is not always understood. The auditor does not analyse every financial transaction a company may make to ensure that it is correctly recorded. Nor does the auditor guarantee to detect fraud, although hopefully a fraud which materially affects the financial statements will be discovered. The accounts are those of the board, and the audit and the subsequent auditors' report which appears in the company's accounts are intended to provide reasonable but not absolute assurance to shareholders, but nevertheless (in the absence of, or subject to, any specific qualification) contain the auditors' opinion that the accounts do provide a true and fair view as a whole.

  33.  In the UK the requirements for auditor independence are embodied in the ethical codes of the professional bodies. The key fundamental principles are integrity and objectivity, which necessarily require the auditor to be independent. The European Commission is expected to endorse the UK approach in some guidelines to be published shortly.

Rotation of audit firm and audit partner

  34.  Following Enron, it has been argued that there should be compulsory rotation of audit firms. CBI member companies do not support such a suggestion. As companies grow, particularly internationally, they need the availability of global audit firms. Until recently there has been a "Big Five", but if following Enron, this now becomes the "Big Four", companies will have little choice, if they have to compulsorily appoint a new audit firm at whatever interval is prescribed. For many listed companies, particularly those operating internationally which most are, an audit firm does in practice mean one of the Big Four or Five.

  35.  However, the issue for companies is not just about choice of audit firm. Any change in audit firm will cause great upheaval for the company, and a short and sharp learning curve required from the new audit firm to learn and understand its new client's business, particularly for large and ever growing companies with international operations. With any change over, there must be a greater risk of an audit failure occurring.

  36.  The aspect to consider on auditor rotation, at least where one of the Big Four/Five is involved, is not rotation of the audit firm, but possibly a review of the rules regarding rotation of audit partner. Professional rules currently set this at seven years, and consideration could be given to shortening this period to perhaps five or four years, alongside the professional rules regarding oversight of the work of audit partner or partners by other partners in the firm. These rules are perhaps the more important to review in the light of the ability of accountancy firms to conduct their audit practice by means of a separate limited liability company, or to conduct their practice by means of a limited liability partnership.

  37.  Such a review could also consider any appropriate requirements regarding audit personnel joining the company client, particularly to a senior position such as finance director, and any moves by company staff to the audit firm.

Provision by the audit firm of non-audit services

  38.  Another aspect of the debate is whether further rules and restrictions are appropriate on the ability of a company to engage the audit firm in the provision of other services, in addition to audit, such as taxation advice and consultancy services. Currently there are no restrictions apart from the requirement for companies to disclose in the annual accounts the amount of fees paid to the audit firm for audit and non-—audit services.

  39.  CBI members do not support any further regulation and restrictions in this area.

  Companies welcome the freedom and flexibility to seek non-audit services from their auditors. The audit firm knows the business and can therefore often provide better quality and/or speedier advice and services at less cost. Some services can only realistically be provided by the audit firm, such as taxation, review work on financial statements for an industry regulator, working capital review work for acquisitions, disposals, new issues of securities etc. Nevertheless there will be many occasions and situations when companies and boards will wish to seek services from other firms or advisers. This area is therefore primarily a company management issue, and companies should be free to employ audit firms and others, as they judge appropriate. Companies do not wish to have their management discretion fettered, beyond the current disclosure obligations regarding fees.

  40.  The audit committee will nevertheless no doubt wish to be satisfied with the nature and extent of non-audit work the audit firm is asked to undertake.

April 2002

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