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
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.
II. UK BACKGROUND
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
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
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
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
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
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 exceptionsee
next paragraph regarding Combined Code) to be independent of the
company and the executive directors, apart from the position of
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
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
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 auditorsthe 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
V. ROLE AND
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
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
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.