Examination of Witnesses (Questions 1360
TUESDAY 4 DECEMBER 2007
Q1360 Mr Brady: You have been very
particular in responding to one or two colleagues to make clear
that the proportion of your fee income derived from audit-related
activity is higher than has been suggested. Do you think there
is an acceptable and unacceptable ratio between those two things?
Mr Sexton: The purpose of the
disclosures of fee ratios is to ensure that users of financial
statements are aware of the amount of work we do. We take independence
incredibly seriously and look at every piece of work, whether
or not it approaches some sort of magical ratio, to see if it
can possibly impair our independence. We decline to act where
we feel that would be the case. I do not believe that a cap in
itself is the right way to look at things. You have to look at
each individual piece of work and be comfortable that it has no
impact on independence.
Q1361 Mr Brady: In the past accounting
period what has been the ratio of fees as between audit-related
services and other services?
Mr Sexton: In all companies?
Q1362 Mr Brady: In Northern Rock?
Mr Sexton: In Northern Rock it
is disclosed in the accounts. The ratio in terms of our role as
statutory auditor and the work we have to do is less than one
Q1363 Mr Brady: What ratio would
give you cause for concern?
Mr Sexton: I merely observe what
the market analysis as a whole shows. If one looks at the FTSE100
analysis in the 12 months broadly to 31 Decemberyou will
appreciate that year ends are different for different companiesthe
ratio is of the order of 1.1 to one.
Q1364 Mr Brady: Looking at some of
the fee income that you have received for assurance services in
relation to securitisation transactions, it appears to me that
a significant amount of it was dependent upon the particular business
model being pursued by Northern Rock.
Mr Sexton: It was a fee income
reactive to the transactions that they performed.
Q1365 Mr Brady: So, the more securitisation
transactions were performed the more letters of assurance you
would expect to provide?
Mr Sexton: That is correct, but
under our ethical standards we cannot provide any kind of management
input to a company to encourage it to perform one transaction
or another. That is completely forbidden under our ethical standards.
We cannot create a transaction flow in order to charge fees; it
is purely a reaction to the level of transactions that a company
may or may not choose to undertake.
Q1366 Mr Brady: When Northern Rock
decided to pursue a business model which led to a great expansion
of certain types of transactions clearly that provided an increased
flow of fee income for PwC.
Mr Sexton: Northern Rock's entry
into those transactions has that consequence given market practice
that typically requires the audit firm to provide comfort.
Q1367 Mr Brady: There seem to be
some parallels between what happened to Northern Rock and the
German bank Sachsen LB which in some ways was pursuing similar
business models, particularly through its Irish subsidiary. There
was a report in the Financial Times on 23 November which
commented that KPMG had undertaken a review of the activities
of Sachsen's Dublin-based market business. The FT reported
that as early as 2005 KPMG had cautioned, presciently, that the
Dublin strategy was based on the premise that markets never malfunctioned
and it warned that the bank could be forced to sell assets if
investors stopped buying the bonds being used to finance the various
funds. Was KPMG able to see something that PwC could not?
Mr Sexton: I am afraid I do not
know on what facts KPMG based that report. Presumably, it would
have been a private report commissioned by the bank or other parties.
I do not know the information behind it or on what they would
have based that conclusion.
Q1368 Mr Brady: But in your dealings
with Northern Rock or your statutory audit function there was
no point which would have caused you to raise concerns of a similar
nature as to whether or not the model was sustainable.
Mr Sexton: I think that what you
describe is a specific piece of work that KPMG as consultants
to the bank were engaged to do on behalf of that institution.
We cannot act as consultants to our audit clients.
Q1369 Mr Brady: I accept that, but
during the course of the work that you undertook in terms of your
assessment of the bank's practices as statutory auditor there
was nothing that led you to have concerns of a similar nature.
Mr Sexton: For the purposes of
looking at the annual accounts, the interim report and preparation
of our opinions thereon we would have looked at all pertinent
information, including the liquidity in the markets at those points.
Mr Hitchins: I think it is important
to remember how liquid those markets were in the first half of
2007. In May, June and July there was over $30 billion of residential
mortgage-backed security issues.
Q1370 Mr Brady: I accept that. My
point however is that albeit KPMG may have been acting in a different
capacity for Sachsen LB two years ago when there was significant
liquidity in those markets it was cautioning that the strategy
was based on the premise that markets never malfunctioned.
Mr Sexton: As auditors clearly
we have been conscious of the fact that for a number of years
valuations have been rising in respect of various asset classes.
Therefore, part of our work has been to focus carefully on the
values based on the information that we have available at the
time we do our work. That encompasses a whole load of facts. Our
opinions at that moment in time are based on the best information
available to us, so we would have been cognisant of that kind
of issue for the purpose of looking at annual financial reports.
Q1371 Mr Brady: You would have been
cognisant of that presumably not only for the purposes of the
financial report but also in relation to letters of assurance
relating to securitisation transactions?
Mr Sexton: During the first half
of 2007, yes. The last securities issue that Northern Rock entered
into of which I am aware was in June.
Q1372 John Thurso: First, is it right
that neither of you was involved in the audit of Northern Rock
and neither of you is a client partner or anything like that?
Mr Sexton: We are both client
partners but not of Northern Rock.
Q1373 John Thurso: In other words,
you are not in the direct client relationship chain?
Mr Sexton: That is correct.
Q1374 John Thurso: Clearly, I understand
that an audit is really about establishing the veracity of what
has happened in the past rather more than about the sagacity of
the actions that have been taken. I want to turn to the questions
that my two colleagues have been asking about the relationship
between the audit committee and risk committee and the auditors.
It seems to me that the core failure of Northern Rock was the
fact that the risk committee failed to see the risk of an illiquid
market. When they came before us they said that it was unforeseeable.
From the conversations that have just been going on it seems that
others, including KPMG, foresaw it, so maybe it was foreseeable.
Asking you not as this company's auditors but as serious practitioners
in this field, what can be done to improve the performance of
a risk committee of a financial institution and the way in which
it interacts with an audit committee? One of the points which
struck me was that the chairman of the risk committee and audit
committee was the same person and mostly the same independent
executives were involved. Is there anything that you would like
to see done in that part of the mix of corporate governance?
Mr Hitchins: Banks tend to have
risk committees at different levels. There is usually a management
risk committee that manages the business day to day. Many banks
have now established risk oversight committees as committees of
the board. The reason for their establishment is that the workload
of audit committees has become too great for the committee itself
to handle both audit and risk oversight. What one needs is a clear
link and common membership, not exactly the same. Having common
members is an important way to ensure that the audit committee
is aware of what the risk committee is doing.
Q1375 John Thurso: Would you think
it a wise precaution to say that the risk committee chairman should
not be the same individual as the audit committee chairman?
Mr Hitchins: I do not believe
that would necessarily be a weakness.
Mr Sexton: One of the challenges
is that there are pros and cons. Obviously, on the positive side
they are aware of both aspects of that part of the management
of the business, but, frankly, the downside is the amount of work
involved to do both jobs. Therefore, one has to balance the two.
As with all committees of the board, they are acting on behalf
of the board as a whole, so there is a role for it.
Q1376 John Thurso: My worry is that
the audit committee's job is basically for the independent directors
to ensure the audit is being done correctly and you as client
partners have been given the opportunity to meet with the audit
committee without any members of management. All of that is designed
to try to make things as robust as possible. But if you have exactly
the same chairman and people on the audit committee as are on
the risk committee the chances are that the same problems can
occur as between the audit committee and the full board.
Mr Sexton: Having variation in
committees and different people looking at different aspects is
a good thing, and we see that today in many of our client companies.
They will select their independent non-executive directors for
specific skills and deploy those in particular ways.
Mr Hitchins: Today some banks
still have combined audit and risk committees.
Q1377 Chairman: From the questions
put by a number of my colleagues it appears they are not particularly
satisfied that you have adhered to general principles, for example
the issue of regulatory returns raised by Mr Cousins. In light
of those comments I shall be writing to you for further details
and I hope you can reply as quickly as possible, say, within a
couple of weeks.
Mr Sexton: We will certainly do
that. We did come in the spirit of answering questions on financial
stability rather than Northern Rock specifically, so I hope we
have been able to help you.
Q1378 Chairman: Northern Rock is
the elephant in the room, is it not?
Mr Sexton: I understand that as
Chairman: Thank you very much.
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