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Lord Brightman: My Lords, can the noble Lord tell the House when the office of non-executive director came into existence? When I took my examinations some 70 years ago, there was no such office as non-executive director.
Lord Freeman: My Lords, I very much agree with the thought that lies behind that intervention. The arrangement is not enshrined in company law, but it has become common currency to refer to directors who are not in full-time management as "non-executives". I believe that that is wrong and that it should cease.
3.31 p.m.
Lord Sharman: My Lords, before beginning, I must first declare my interests. My business interests are as set out in the Register of Members' Interests, but my most relevant interest in relation to this topic is the fact that I am a former chairman of KPMG—one of the so-called big five—and continue as a paid adviser to that firm.
I must confess that I approach this Motion with a great deal of sadness. When I joined the accountancy profession 40 years ago, it was a profession held in high esteem. In those days, my girlfriends' mothers were quite keen on having a prospective chartered accountant as a son-in-law. That is not the case today; it is certainly not the case for Lady Sharman. Today, the accountancy profession faces the greatest crisis in its history. The reputation of Arthur Andersen, which has taken 90 years to build, lies in tatters, destroyed in 90 days. The indictment of a firm of accountants for obstructing the course of justice in the USA will, if sustained, leave a stain on the global accounting profession that will take many years to remove.
As the noble Lord, Lord Brennan, said, the key factor in all this has been the collapse of Enron—the largest corporate failure in the history of the USA, if not the world, resulting in the loss of livelihood and pension for many thousands of people. I do not have the time to engage in a detailed analysis of how Enron developed, nor of how it failed. Suffice it to say that it was an unusual set of circumstances and that, as early as March 2001, Fortune magazine was pointing out the organisation's frailty. Clearly, however, it was a failure in corporate management—a house that is built on sand will not survive once the foundations start to move—which was compounded by a failure in corporate governance. Clearly the Enron board did not ask enough questions nor exercise enough control over the management.
Noble Lords who have sufficient time to look at Enron's financial statements—about six weeks should do—will see buried in the notes all sorts of disclosures. Although the situation could by no stretch of the imagination be said to have been hidden, it was very difficult to interpret. That was made possible by an auditing failure. At a minimum, the circumstances leading to the massive restatement of reported earnings, in late 2001, should have been identified and prevented. I believe that that was all made possible by poor regulation and inadequate accounting rules. This series of failures was compounded by what is alleged to be the wholesale destruction of evidence—the shredding—by the auditors, the very people who are supposed to be, as the noble Lord, Lord Brennan, said, the watchdogs. They are supposed to be the ones who exemplify independence, objectivity and probity. It is therefore little wonder that public confidence in them has taken a knock.
It is very convenient to remind ourselves that all this happened in the USA. However, that begs a question to which, as the noble Lord, Lord Brennan, said, Sir Howard Davies has given an honest answer: "Yes, it could happen here". There are, however, two key factors in the Enron affair that I do not think could be present here. First, our approach to accounting principles is highly beneficial, entailing principles based on substance rather than mere form and detailed rules. When one devises a set of rules, the first thing that others do is start spending a lot of time figuring out how to get round those rules.
The second factor—a key one in Enron's collapse—is companies' use of their own shares as security for borrowings and to fund their retirement programmes. The use of own shares as debt security is relatively uncommon in the USA, but it is almost unknown in this country. Moreover, in the United Kingdom, the use of own shares to fund retirement programmes is of course controlled by the MFR—minimum funding requirement—and is limited to 5 per cent of any pension plan.
As I said, however, let us make no mistake about the situation. When the Financial Times calls in a leader, as it did on 13th March 2002, for the potential "Fat Four"—a new term for your Lordships—to spin off their consultancy businesses and to be banned from doing non-audit work for audit clients, we have a deep
crisis in public confidence. The issue is what we should be doing about it. Management is the first point. I know of no process other than good training to make incompetent management competent. I also know of no means other than counselling to make corrupt management not corrupt. So we have to rely on governance.Many have said that the UK's corporate governance system, as it has developed, is thorough and should be seen as a role model for the rest of the world. I join those who have said that we probably have about reached the overdose level on corporate governance reviews—from Cadbury, through Hampel and Greenbury, to Turnbull. However, I agree with the noble Lord, Lord Freeman, that we really do have to examine the issue of the so-called non-executive director. We have to consider how many such appointments people can sensibly handle. We have to examine whether full-time executives can take more than one or two non- executive appointments, as they are called. We have to examine the desirability, or otherwise, of cross-directorships. I should also hope that the review will come up with something approaching a better definition and understanding of the role and responsibilities of so-called non-executive directors who do not spend all their time on a board.
We clearly need to look at auditor independence and regulation. I hope that the major firms and their professional bodies will understand the depth of this crisis. There needs to be much more transparency in their affairs. I am deeply disappointed that other major firms did not follow the example of KPMG and Ernst & Young in publishing audited financial statements. It is transparency that generates public confidence and an understanding of what these people are about. These firms each employ upwards of 10,000 people in the UK and have a significant role in our economy. Why should their financial statements not be audited and published to the same standard required of the public companies on which they report? There would be one benefit aside from the rest, which is that proper financial disclosure and segmental reporting would once and for all resolve the issue of whether auditing is used as a loss leader.
Progress has been made on regulation. Although I find it complex, with all the bodies involved, I think that there is a further step to consider. The key body is funded by the accounting companies themselves, but I think that the Government should consider taking over that funding which would get us away from the notion that he who pays the piper calls the tune.
A further step in transparency that should be considered is that the quality control reports carried out by the joint monitoring unit on those firms that audit public companies should be made public. I recommended that in my report, Holding to Account for the C&AG last year. There is no reason why that could not be extended to those firms that have a role in public companies.
I do not have time to comment on other issues such as the rotation of auditors. All our knowledge and experience leads us to believe that that will not work.
It is better to focus on the rotation of audit personnel. Clearly we need to look at arrangements for former audit partners joining their clients, and to consider the role of the audit committee in determining what fees should be paid to accountants and auditors for other than audit services.Before concluding, I wish to make the observation that it is difficult to be prescriptive because in regulated industries, in particular, large amounts of work flow from the audit function itself, such as reports for regulators and so on. They are not audit fees and are not disclosed as such.
In conclusion, it is clear that the auditing profession needs to take a very close look at itself in the light of the Enron affair. Let us not forget that it was not only the board of directors, management and auditors who were involved in that shambles. Investment bankers, lawyers and other advisers were clearly involved as well. We must not over-concentrate on any one of the villains in that piece. There is quite a large cast of characters to look at.
Lord Grocott: My Lords, I gently remind the House that there are three minutes in the gap. This is absolutely no criticism of anyone, but unless everyone keeps fairly close to the nine-minute limit, we shall have very little time for the wind-up speeches.
3.42 p.m.
The Lord Bishop of Oxford: My Lords, I am grateful to the noble Lord, Lord Brennan, for this debate because it highlights certain crucial principles, which I believe are essential to the healthy functioning of our society. I would not presume to go into the detail of what kinds of regulatory and other action is necessary to maintain confidence in business and accounting, but there are a few fundamental points that are relevant to the issue.
First, there is the value of business and the business community to society as a whole. There was once an anti-business mood in this country. People believed that it was best to be born with a large estate, but if one did not have that good fortune, the second best thing was to make a lot of money quickly in order to buy one and then get out of business. In recent years attitudes to business have, quite rightly, been much more positive. It is vital that society feels good about its core activity. If people who work in business, or the rest of the community feel ill at ease with the work on which society depends, it sets up a tension that cannot be healthy. It matters that there is public confidence in business and accountancy.
I do not believe, any more than the noble Lord, Lord Brennan, does, that the business of business is simply to make money. Of course a business must be profitable, but I think that the mission statement of Dayton Hudson, the American retailing firm, is right when it says:
- "The business of business is serving society, not just making money. Profit is our reward for serving society well. Indeed, profit is a means and measure of our service—not an end in itself".
The work of Charles Handy highlights the fact that most people who work in business do not want to work simply for the bottom line. They want to do something that they regard as worth while and which has meaning. Business is a worthwhile activity in principle. I always very much enjoy talking to groups of business people. There is a note of reality in the air, for if they do not succeed the company goes bust. That is very salutary for a mere talker.
If the first point is the value of business, the second is its values. Just because business has value, it is all the more important to ensure that its activities reflect and are permeated by its core values. One of the encouraging features of business over recent decades is the number of companies that have adopted mission statements, ethical codes and statements of best practice. Of course, no doubt some are simply there to reassure shareholders when they look on the inside of the glossy front cover of the annual report. But even that is better than nothing, for as the Duc de Rochefoucauld said:
- "Hypocrisy is the tribute that the vice pays to virtue".
Other businesses, some of which are our most profitable, take these themes extremely seriously. They have not just been jotted down on the back of an envelope by the chairman during a boring part of a meeting, but are the result of a process of long consultation throughout the company and are subject to regular monitoring. My questions in relation to recent scandals would be as follows. What publicly stated principles did those companies have? How were those principles drawn up in the first place, and what steps were in place for monitoring them? I do not know the answers; I should be interested to hear them. My guess is that companies with such codes, agreed on after extensive consultation and subject to monitoring, need very little, if any, exterior regulation. My guess is also that such companies are among our most successful.
Clearly, however, some companies need regulation. Greed, compliance with a culture of conformity and cowardice are part of us all. In an article in the Telegraph last month, the most reverend Primate the Archbishop of Canterbury, pointed to the excesses of particular forms of capitalism and businesses that are less devoted to the production of goods and services that people need and want than to speculative buying and selling of things that no one can touch and which few understand. We need to be reminded of the danger that the pursuit of wealth turns into an end in itself as the need to see profits rise and rise becomes a temptation to excess and selfish irresponsibility. In relation to that temptation and perennial danger, regulation will always be necessary.
A few years ago the noble Lord, Lord Laing, and I co-operated to produce a booklet entitled The value of business and its values. As I have tried to suggest, the two halves of this sentence go together. They are integrally related and reinforce one another. Business has value and therefore it will want to be shaped and permeated by a set of values; and, vice versa, being shaped by a set of values will enhance a sense of the value of the work as a worthwhile human endeavour.
The more perceptive were those who in the 1980s argued in favour of a market economy—some of whom came from all sides of this House. They argued that in order for a market economy to work properly it depends on, and is underpinned by, a set of values. Therefore, it is not just individual companies that need such values. To function appropriately, the whole market economy does so, too. For example, markets depend on contracts, but the efficacy of contracts depends on the assumption that they will be honoured. As the social thinker Durkheim said:
- "Not everything in the contract is contractual".
Regulation, whether internal or external, is necessary, for two reasons. First, it stops rogue companies. The drive to excess will always take some people and some institutions close to the line and over it. Secondly, it reinforces good corporate practice. Regulation is necessary and more, or different regulation, may be needed to prevent the recurrence of recent scandals.
My main point is that, in the end, it is the ethos of a company more than anything else that matters. In this life, virtue does not always result in prosperity, but in the field of commerce it is more likely to do so. It will certainly help to avoid some of the financial collapses that we have seen recently.
3.50 p.m.
Lord Haskel: My Lords, corporate failures have always been with us. They are part of an enterprise culture. Competition in the market sorts out the good from the bad.
My noble friend Lord Brennan is right to look at this matter rather more deeply and ask why some firms fail; not because they cannot compete in the market, but because of fraud or other unacceptable practices. As he said, it is a serious matter affecting people's jobs, pensions, savings and livelihoods. It is that kind of failure which affects the relationship between business and the public. The spectacular failures have usually led to some kind of inquiry. As other noble Lords have said, after Maxwell we had Cadbury, then Greenbury followed by Hampel.
All those inquiries concentrated on the role of the non-executive director. Certainly, non-executive directors are expected to watch out for and be alert to any situation which could endanger the business. But they are also expected to set and maintain the strong values referred to by the right reverend Prelate and to set high standards of corporate governance in all areas of the business. Some fulfil that role well, but obviously many do not. I am not sure what the forthcoming review by the DTI of the roles and responsibilities of non-executive directors will add, but, like the noble Lord, Lord Freeman, I hope that it will do something to provide non-executive directors with the skills and encouragement to do the job of governance better, especially on audit committees.
The difficulty is that non-executive directors are largely dependent upon management for information about the business. If two or three executives decide to hide, distort or falsify information, there is little that a non-executive director can do except to use his or her intuition and then conduct an inquiry. Inquiries are impossible if auditors shred the records. Like the noble Lord, Lord Sharman, I found the shredding of documents by the auditors perhaps the most disturbing aspect of the whole Enron affair.
Auditors are in much the same position of dependence. If there is collusion in a business to hide or falsify information, it requires a lot more than a traditional audit to detect it. That explains the point made by the noble Lord, Lord Brennan, about major frauds not being detected by auditors. Indeed, the auditors may turn a blind eye to some irregularities. Although legally appointed by the shareholders, the auditors are selected by the directors with whom they want to maintain a good relationship, especially as the directors and managers can also retain them for other work, or even give them a job, as noble Lords have said. Recently, some accountancy firms have taken steps to avoid those conflicts of interest. Like other noble Lords, I welcome that.
What about more detailed accounting rules? Along with the rest of the European Union, we in Britain are committed to adopting international accounting standards fully by 2005, but that still leaves many jurisdictions where sloppy accounting and disclosure rules will apply.
If accountants and non-executive directors cannot stop these corporate failures, what about the regulators? We live in a complex economy and there are limits to regulation. I was in the United States when Enron went bust and was amazed to read in the newspapers that Enron was not really an energy company but a trading company, trading in the futures of 1,200 different products, many of which were totally unrelated to energy and a lot more risky. Yet Enron was regulated by the energy regulator, and those greater risks should probably have been better regulated by the banking regulator.
But if regulation is too tough, so-called investors can always operate outside the disclosure rules by spread betting, which in practice avoids both regulation and tax. So there are limits to regulation. Meanwhile, the banks have to ensure that their share analysts in the assets management arm do not promote the shares of companies with which their banking arm is doing business.
What is it about our business life in this country that has brought all this about? What is it that has created these difficult conflicts of interest? I put it down to the single-minded insistence on shareholder value and its narrow interpretation, as expressed in the share price. My noble friend Lord Brennan called it greed, yet most financial institutions, businessmen, managers and executives insist that the primary purpose of an enterprise is to deliver that narrow version of shareholder value. That takes precedence over
everything. That is what justifies the dodgy deal that violates the code of practice; drives the cosy relationship between the auditors and directors with valuable share options; and makes it difficult for the non-executive director to argue for social responsibility if it stands in the way of the share price. I do not think that new rules for regulators, auditors, and non-executive directors will do a lot to change that. No, the solution lies in changing the culture of a company. The right reverend Prelate mentioned that.There is nothing new here. As long ago as 1993, the RSA started an inquiry into Tomorrow's Company. It realised that the narrow view of shareholder interest brought only short-term success. The RSA stated:
- "Only through deepened relationships with and between employees, customers, suppliers, investors and the community will companies anticipate, innovate and adapt fast enough, while maintaining public confidence."
Each company needs to develop its own inclusive approach; one which fits its needs. For some years, the centre for Tomorrow's Company has been quietly helping companies to do that. I welcome that. I believe that that bottom-up change of culture is the most practical way to raise public confidence in business and to avoid dramatic business failures.
3.58 p.m.
Lord Hodgson of Astley Abbotts: My Lords, I, too, add my thanks to the noble Lord, Lord Brennan, for giving us the opportunity to discuss this important topic today. As one would expect from a distinguished lawyer, there was a powerfully argued case. He rightly drew our attention to the appalling personal consequences inter alia of these major collapses. However, rather than retread the Enron ground, I hope he will forgive me if I come at the issue from a slightly different angle.
I begin by declaring interests present and past. I am currently chairman of an investment bank in the City, and what is called a non-executive director—for the reasons referred to by my noble friend Lord Freeman I prefer to call myself an independent director—of three companies, one of which is listed on the Stock Exchange. Historically, I was a founder director of the Securities and Investment Board, the first City-wide regulatory authority, set up under the Financial Services Act, and until last December was director of the Securities and Futures Authority until it was swept away in the new structure.
I mention those organisations because I want to make clear that I am no Luddite as regards corporate governance. Indeed, a good many of my years within the City have been devoted, in a voluntary capacity, to
raising standards and nailing popular misconceptions. For example, when I first went to work in the City 25 years ago, there used to be a widespread view that insider dealing was a victimless crime. That is far from being the case. Although perpetrator and victim never meet, and will never even know each other, the one has robbed the other as surely as if he had hit his victim over the head and taken his wallet—not as obvious and not as bloody, but just as certain.Therefore, when people talk about the need to root out fraud, I am there with them. Fraud too, after all, is theft. But in making, and while making, such a condemnation we must be careful to distinguish between fraud and risk. We live in a litigious age. Every night on the television there are advertisements by legal firms inviting one to contact them if one wishes to make a claim.
Too often a risk that goes wrong can be seen as a fraud. None of us likes to believe that our judgment is fallible, so we seek someone to blame. That cannot be right. In commercial dealings there has to be what bankers like to call "the moral hazard", without which people do not take the trouble properly to assess what they are being offered and their own self-interests in accepting the offer.
I talked about popular misconceptions that have been nailed. One that has not been nailed is that regulation comes for free. Probably people feel that, because in many cases there is no charge to the taxpayer, there is no cost. But there is a cost.
I give a brief example from the City concerning the Financial Services Authority. The FSA is the top regulatory body that now controls every aspect of those of us who work in the City. Its budget will be £180 million. It will be paid for by the industry. But the external costs are not the whole cost. There are huge internal costs of complying with the regulations laid down by the FSA. The extent of these have been the subject of learned treatises by the London Business School, Warwick Business School and others. But they work out at roughly two to four times the cost of the external authorisation.
If we take the mid point, it is a cost to the City of around £720 million every year for the present regulatory structure—a short £0.75 billion. Who pays for that? Investors, pensioners, and savers pay, and maybe in the long run UK plc will pay if the sum becomes large enough. A balance has to be struck between too little regulation which drives people away because they fear malpractice in the market and too much regulation which drives them away because of the cost of doing business. If your Lordships feel that the City's position is unassailable I invite you to visit Frankfurt to see the German Government's plans for Finanzplatz Deutschland.
When I previously raised such uncomfortable questions the Minister in his response, quite fairly and properly said to me, "What about Barings bank?" That was 10 years ago. It was before the present regulation. But for the purposes of today's argument let me accept it as a "fair cop". But, interestingly, the total liabilities of Barings at the time of implosion were about £800 million.
We are spending nearly that sum every year on regulation. Are we stopping a Barings a year? We shall never know. The trouble with the comment made by the noble Lord, Lord Brennan, about not stopping fraud is that the fraud you stop is never a fraud. That is one of the difficulties.
There are two much more significant points arising out of that comment about Barings. First, we must remember that in the end not a depositor, saver, creditor nor a customer lost a penny. ING bought the business—the market worked. The losers were the shareholders—the moral hazard again.
Secondly, with great respect to the noble Lord, Lord Brennan, and other noble Lords who have talked about the need for increased legal statutory regulation, we must not expect that the law will automatically provide a remedy to all these matters.
I was a member of the SFA's enforcement committee which considered the Barings case. It seemed to us on the committee that greed had clearly outrun judgment. Moreover, there was considerable public anger over the way jobs had been saved and, above all, the way that bonuses had been paid. We found our hands tied, not by the old pals act, but by the law. I had never heard of the legal doctrine of "vicarious liability". That principle states that if one asks a subordinate member of staff a question which one has reason to believe he will answer honestly, one is entitled to rely on his answer. However, it became clear that, despite the best legal advice, our powers to proceed and pursue were limited. Our sentences were seen to be inadequate. But even then one senior member of the Barings team was able successfully to attack his sentence and get it expunged, and even force us to pay his costs.
In this country we are in the process of settling down a huge volume of legal and quasi legal codes—the Financial Services and Markets Act and statutory instruments aplenty. There are the voluntary codes of Cadbury, Greenbury and Hampel to which many noble Lords have referred. The weight of responsibility on non-executive directors has already become very heavy. They are in danger of reacting by becoming box-tickers rather than by using their judgment, which should be their proper function, as was pointed out a few minutes ago by the noble Lord, Lord Haskel. Unfortunately, one can never be proved wrong as a box-ticker but one can be proved wrong in one's judgment.
Of course there is no room to be complacent. The recent collapse of Enron has clearly raised issues. The implications of that need to be considered carefully. That is why I welcome the noble Lord's debate today. But if every large corporate failure is to be accompanied by an unthinking legislative banging of stable doors behind apparently bolted horses we shall be doing no service to the UK economy or to our competitive position in the world.
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