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Corporate Regulation
3.6 p.m.
Lord Brennan rose to call attention to recent corporate failures and to the case for regulatory and other action to maintain public confidence in business and accountancy; and to move for Papers.
The noble Lord said: My Lords, the heart of this debate is the human vice of greed. The levels of greed in the corporate sector have led to very severe hardship for ordinary people and to the loss of jobs, savings, homes and pensions. Such excesses in the corporate system can and should be dealt with by regulatory or other action.
What is the nature of the problem? Enron collapsed in probably the greatest corporate failure of our times leaving debt of 60 billion US dollars. It has put paid to one of the big five accounting firms employing more than 200,000 people world-wide. It is not an understatement to say that this is a seminal moment in the history of modern capitalism.
In the 1980s and 1990s we moved from an historical approach to business, where corporate effort was directed at firm structures, a steady hand on the tiller and a reasonable interest—but not obsessive interest—in profit. As we came towards the end of the century, we entered an era where the sole objective of much of business was ever-increasing annual profit. That difference in the ethos of business is the real explanation for the disaster of Enron.
This profit mania was worked under the rubric of shareholder value. The very objectives of decent shareholders—to make a reasonable return on their investment—became the millstone that the corporate structure in the case of Enron hung around its neck. It is simply impossible, year by year, evermore to increase your profit regardless of the world around you. But, by the turn of the century, many thought otherwise. Such a belief leads to failure. Enron was that failure.
It is not only an American failure. ICI has lost more than £400 million; Andersens employs 6,000 to 7,000 people in this country. The international ramifications of what has happened are very serious indeed. Asked by me, a friend in the financial world tried to explain what has happened in human terms in this way.
The executive, imbued with market fever, intent on making ever greater profits, becomes addicted to the task. The addiction is fed, perfectly reasonably, by the banks, which expect a return on their investment, and in this case the accountant—the "GP", who is there regularly to check on the presence or absence of serious symptoms—completely missed the problem, or chose not to diagnose it. So, in the end, the community—the "family", the "relatives" in the metaphor of the addict—entirely without expecting it, with no preparation at all, find that the addict has exploited his money and theirs to satisfy his addiction. So the problem can be translated into community terms. That is the aspect about which I propose to speak.
The first, and obvious, question to ask in this House is: could such a thing happen in our country? I regret to say that it already has. Within the last year or two, an independent insurance company collapsed in a sector of the financial world which is supposed to be the most heavily regulated in auditing terms. In response to the question, "Could it happen here?", Sir
Howard Davies, chairman of the Financial Services Authority, in an article in the Guardian on 2nd February, frankly stated:
- "The only honest answer is yes".
If it could happen here, how can we reform corporate systems in an attempt to ensure that it does not happen; and, if it does, that the impact is reduced to the bare minimum? I turn to the issue of company systems. Cadbury in 1992, Greenbury in 1995, Hampel in 1998, and the Government in 2002 have all investigated the same basic question: how can we make companies work honestly and fairly in the interests of the community?
I shall not anticipate many of your Lordships' contributions to the debate, but here are some of the obvious topics for debate. The audit committees of a company must be made to work. Off balance sheet accounting, the absence of employee share options and their value in accounts, the deep complexity of derivatives not fully explained, and an inconsistent treatment of revenue are all obvious factors which an audit committee could, and should, examine, along with company auditors.
Secondly, if it is felt that local authorities should have their auditors independently appointed by the Audit Commission—as now happens throughout the country—is it not reasonable that some similar system should operate in the private sector? I put the proposition forward. If it is wrong, I eagerly await the reasons why; but I hope that the concept behind it will not be ignored by those who seek to deal with this. The intent is that the auditing function can be separated from executive influence by the company.
I am pleased to note that Sir Howard Davies has set in progress this year several schemes or reviews to assist better control of company systems. There is already a very strict control of the auditors of financial institutions under the FSA. They propose to review their listing rules and I imagine that, in due course, they will establish appropriate disclosure rules, especially for the complexities of accounting which I have described. Above all, in company systems, let us ensure that the concept which I now understand to be commonly used in the City of "financial engineering" is never just that step ahead of the law, the regulator and the tax system.
If companies are to be audited, how can we make the auditors more effective in what they should do? Under our present statutory system, they are a watchdog for investors only in the sense that they determine, vis-à-vis the company and themselves, whether they can issue an auditing certificate of good accounting. But they have no separate duty, no separate obligation to individual shareholders, creditors or employees. That is a serious deficiency in the system.
What should happen with auditors and the companies that they audit? Is it acceptable that you audit on Monday as an independent accountant and advise the company on Tuesday, as an accountant to that company, on its investment strategy? Most ordinary people would conclude that the conflict of interest is so obvious that it could hardly occur in the business world—and yet it does.
What should we think about the rotation of auditors? What should we think about auditors leaving their accounting firm to become a consultant or employee of a company, and their previous accounting firm continuing as the auditors? I invite the House to note with particular care the following stark reality. Out of the 250,000 accountants that we presently have—ever-increasing, always present in times past—no firm of auditors of any size has ever detected a corporate failure of any size by its auditing activity. That is simply amazing.
If we are to have effective auditors, the key principle upon which they must act in the future is surely the interests of the community affected by the affairs of the company that they are auditing, and not the interests of the company with which they are dealing.
Lastly, and most importantly, if such problems continue to occur—and human nature makes it inevitable—how can we seek to influence those in corporate life better to appreciate, and more enthusiastically to seek to avoid, the damage that they can cause to the community by their activities if reasonable activity descends, or ascends as the case may be, to excess? The answer to my rhetorical question must be better corporate governance, with responsible corporate behaviour in the community.
I put forward three propositions. Every company should be ethically governed and act responsibly towards the community in which it operates, whether nationally or internationally. We are not hidebound by a company law system created in the 19th century that treated the only relevant relationship as that between a company, its shareholders and its auditors. We have gone far beyond that in our multinational world.
The second proposition is to have the International Accounting Standards Board and its American counterpart seek to reach agreement.
Thirdly, many companies seek to act responsibly. I endorse their efforts and hope that feature will evermore be present in our national corporate life.
Milton Friedman, with remarkable and unacceptable candour, once answered a question about the basis of business thus: "What kind of society is not structured on greed?" I answer, not my kind of society. I adopt the wisdom of Lord Weinstock when in charge of the General Electric Company. He observed that profit was not a target but a residual—the end result of doing the right things in the right way. That is the expectation that we should have as a society of corporate activity serving the community. My Lords, I beg to move for Papers.
3.21 p.m.
Lord Freeman: My Lords, I am sure the House is grateful to the noble Lord, Lord Brennan, for raising this issue. I congratulate him on his success in bringing it to your Lordships' attention. I declare an interest as a member of audit committees of a number of companies and a former partner, now consultant, of PricewaterhouseCoopers.
I wish to address my remarks to the responsibilities of directors—in particular, members of the audit committees of boards—in ensuring proper financial control and regulation of the companies they serve in the interests not just of shareholders but of society as a whole. I agree with the noble Lord, Lord Brennan, when he identifies the importance of the role of directors and audit committees in particular.
On 27th February the Secretary of State for Trade and Industry, Patricia Hewitt, announced the setting up of an independent review of the role and effectiveness of non-executive directors in the United Kingdom. That review is important and has been a long time coming. I am sure that your Lordships welcome the Secretary of State's announcement and hope that she will name the chairman of the committee as soon as possible, so that it can get under way.
The Secretary of State said that the independent review will examine the role and effectiveness of non-executive directors in the UK and will report to the Chancellor of the Exchequer and to the Secretary of State. The review will consider in particular strengthening the UK framework for how companies operate. I take that to mean that the review will look at how best to prevent a collapse such as that of Enron happening in this country. Sir Howard Davies asked whether that might possibly happen. The answer is, yes it could. Is it likely to happen? We can take steps by legislating and following the initial work of the Cadbury committee in 1992 for ensuring best practice to make certain that such a collapse is unlikely to happen.
The term "non-executive director" is misleading and I hope that we shall stop using it in this country. It creates the impression that the so-called non-executive director is a second-class director of a company; that he or she has fewer responsibilities than other members of the board. That is not true. A non-executive director is as much a director as the chairman, executive chairman or chief executive officer.
The term "non-executive director" conjures up a comfortable perk—as it was sometimes known to be a decade or more ago. In today's world, that is not the case. In our largest companies, the role of the so-called non-executive director is arduous and needs to be defined more clearly. The days when ex-politicians—let alone ex-accountants or distinguished members of the Bar Council such as the noble Lord, Lord Brennan—could be expected to join companies easily in the role of a non-executive director have gone. It is a demanding job and there is a shortage of competent people willing to take on the responsibilities involved.
I hope that the review will recommend increased training and guidance for all directors but particularly members of board audit committees. That follows the lines of the excellent Myners report of last year. Its recommendations concerning the pension fund industry and the role and responsibilities of trustees have been accepted by the Government.
I am grateful to Paul Myners for reminding me that a recent poll showed that one-third of pension fund trustees in this country were unclear whether a fall in interest rates meant that bond values rose or fell—a disturbing fact but true.
As to the key aspects of training that will help to improve the climate of financial regulation, directors—particularly those who are independent of full-time management—should ask the right questions at the appropriate time. Directors should have explained to them their responsibilities under corporate law and the fact that they have a direct responsibility to shareholders—as do auditors. I am sure that the noble Lord, Lord Brennan, did not mean to imply that auditors are accountable only to the management of a company. By statute law, they report to the members of a company—the shareholders.
I pay tribute to the Institute of Directors, the Confederation of British Industry, the Institute of Chartered Accountants in England of Wales and many others for the steps they have taken to improve the training of directors. But there is a long way to go.
When the Secretary of State made her announcement on 27th February, she expressed the hope that the review's focus would be primarily on improving best practice. I hope that the review will consider changing our statute law—specifically, the basis of operation of audit committees. An audit committee is a sub-committee of a board and has responsibility for dealing directly with the auditors and internal auditors of a company. It must also satisfy itself on behalf of the board that the audit is independent and that proper steps have been taken by the auditors to ensure that a fair picture of the company's results is presented.
The auditors look retrospectively, not prospectively, which is one reason for it not being surprising that it is difficult to find examples of auditors identifying the imminent or possible collapse of a company. Auditors often look at three, six or nine months of historical perspective—not into the future, which is the job of others.
We should encourage the independent committee to consider proposing in statute the responsibility of boards of directors, certainly of listed companies, to appoint a sub-committee—the audit committee—to discharge the responsibilities of financial regulation and oversight over the audit. That ought to be a statutory responsibility. At the moment, it is best practice. The code followed in recent years by listed companies in this country states that the annual report must include a statement if an audit committee has not been appointed. I believe that that should be a universal requirement.
I believe that audit committees should have a majority of independent directors and a statutory right of independent access to the auditor of the company so that they can not only challenge but support the auditor when misgivings, wrongdoings or concerns are expressed or alleged.
I believe that the audit committee itself should have a responsibility to report in the company accounts directly to shareholders, and therefore directly to the wider community, about whether it is satisfied that the audit is independent. The noble Lord, Lord Brennan, drew attention to the fact that some auditors perform non-audit services and argued that that could in some ways impede independence because of the pressure that companies could bring to bear on the auditor. I believe that it should be the responsibility of the audit committee so to report. I also very much agree with the opinion of the Association of British Insurers, which has been circulated to some noble Lords, on that point.
We should be realistic in our expectations of boards of directors, audit committees, auditors and lawyers. We can, however, take steps in a future review of company law to place clearer and more specific responsibilities on audit committees.
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