Called to Account: Proposed Overhaul of the UK’s Audit and Corporate Governance Regime

[Jaysen]

This thread is for the general discussion of the Article Called to Account: Proposed Overhaul of the UK’s Audit and Corporate Governance Regime. Please add to the discussion here.

 

[Jacob Miller]

Background:
As a bit of a corporate governance ('CG') nerd, I'm really interested by these latest proposed changes to the CG landscape.

In order to fully understand the relevancy/ importance of this particular white paper, it's first necessary to understand a bit about how CG actually works in the UK. The following will be very brief, and highly simplified, so if you're already fairly familiar with the general CG landscape you'll probably want to skip on to the next section!
The UK Corporate Governance Code ('UKCGC') as we know it is fairly new, with its origins in a series of reports into the state of corporate governance (mainly the Cadbury Report and the Hampel Report) through the 1990s. The UK CG model is not a legislative one. Instead, the UKCGC is primarily voluntary, with only a few provisions made enforceable by their inclusion in the UK Listing Rules on a 'comply or explain' basis whereby the company must either comply with the UKCGC or explain in their annual report why they have elected not to comply with it. This isn't particularly specific to auditing requirements, just a general backdrop.

Auditing challenges within UK CG:
On the topic of auditing specifically, this has been a hot-button issue since around 1990 and the seminal ruling in Caparo Industries Plc v Dickman ([1990] UKHL 2). Although primarily known as a tort/ duty of care case, the facts actually related to an auditing firm and whether they had a duty of care in relation to providing audit information to shareholders and prospective shareholders. Very briefly, in the case, claimants raised an action against an audit firm, alleging negligence in the audit process resulting in losing money in an investment. It was held by the House of Lords that no such duty existed and, while the main ramifications of this case were in changing the face of suing for damages in tort, the ramifications on the audit industry (although given little thought generally) were also massive. The case led really led to an erosion of a certain layer of responsibility for auditors, with firms (to an extent) taking it as cart blanche for questionable conduct and also being dragged heavily into conflicts of interest with the firms they were auditing. Although there were a set of 2005 Regulations in regards the management of conflicts of interest etc in auditing, arguably these were scant and ineffective.

I'm going to slightly gloss over the elements of CG which contributed heavily to the 2007 financial crisis for expediency's sake (although these are vast and highly interesting, they don't relate so much to auditing specifically. I'd be happy to jot down a few brief thoughts on this if there's sufficient interest, though!) and flash forwards to more recent times, with some recent major insolvencies. Focussing particularly on Carillion's collapse in 2018, KPMG were found to have committed several breaches of standards in its audits immediately before the construction company's demise. KPMG declared that the Carillion was 'profitable and sustainable' in audits just a few months before the firm issued the first of its profit warnings. There were also major questions raised about auditing during the collapse of Thomas Cook and BHS, among others. It is still acknowledged that auditors are stuck in a major conflict of interest with clients, this effect is amplified even more where those same firms often carry out other business services work for the same clients, such as management consultancy - it appears that the white paper aims to tackle these in some new ways which haven't been considered to this point.

Relevancy to firms:
Now... the above is all well and good, but how does this actually relate to law firms? Well, there are a few considerations to make here. First and foremost, financial services/ regulatory advisory teams will need to get to grips with any changes in standards to be able to advise auditor clients. Any changes in this vein, though, will also affect transactional teams who need to fully understand the appropriate regulations when advising clients on the amount of weight they should put on any information, the obligations of of their clients in obtaining and compiling audit information in transactions (and, similarly, how much audit information given to their clients can be trusted) and, further still, how this impacts on the sort of warranties and indemnities, or other elements of sale contracts.

Do you have any other thoughts on the new changes? @Neville Birdi @Dheepa I'm looking at you guys!

 

[Anon08]

Preamble​

I have to confess, I am not a big fan of the topic of 'auditing', so I'll focus on some more of the juicy areas of the white paper (the increase in directors' accountability) (if one can find a White Paper 'juicy' at all...).

For context, in light of all the collapses and corruption scandals (which Jacob has alluded to), directors are getting away with too much and need to, as the article suggests, be called to account.

Content of the Paper Regarding Directors​

The paper details a new regulator, ARGA, and much like the similar AGA, it is bringing some heat. ARGA is proposed to have the power to investigate and hold to account directors who breach their duty regarding corporate reporting and auditing. New standards would be imposed on directors regarding corporate reporting and auditing, which involve their behaviour. Shock, horror, gasp...directors will be subject to behavioural standards of honesty and integrity...who woulda thunk it... (and yes, if they breach these standards, the directors are liable to face civil enforcement action).

The paper also proposes that directors must make a statement about any proposed dividends and how such dividend payments affect the distributable reserves. Basically, the directors have to declare that the money they dish out probably won't cause the company to go insolvent.

Finally, the paper makes some crucial changes to directors' remuneration packages. In summary, directors can't do bad things and still get paid. Amazing.

Why This is Important for Your Interviews/Commercial Awareness​

This is all broadly covered/alluded to in the linked article, but I just thought to do a little focused summary here. Now, what's the impact for law firms and, most importantly, your interviews?

The first point is that this is a white paper - it is but a mere proposal. We will likely see the conception of ARGA (a good name for a post-rock band) and a smattering of other things detailed in the document. Nevertheless, as of present, this lies somewhere in between a pipe dream and reality - so take it with a pinch of salt, and discuss this less like certainty and more like a trend (that's my opinion which is, unsurprisingly, not gospel!).

Instead, what I would recommend taking away from this topic is the general feeling from the UK government. Alok Sharma hit the headlines for saying that 'there is no back door to the U.K.' - this was concerning the National Security and Investment Bill. Now, the government is looking to further intervene in the markets with this ARGA-Bill.

This was always going to be the problem for post-Brexit Britain - be a Singapore-on-Thames, ultra-liberal economics, and accept that FDI, foreign takeovers, and so on, will squeeze out British economic actors, or raise the drawbridge, hoist the Union Flag, and protect British businesses from the big bad outside world. I'm being facetious - but it really does feel like a trade between economics and patriotism/control. Clearly, the UK government, obviously also feeling the financial squeeze as a result of coronavirus, has gone for the latter option: higher taxes, increased market intervention, and increased barriers to entry (in some respects) - as indicated by first the NSI Bill and now this white paper.

So, what could this all entail? Well, for starters, it could put people off investing in Britain. Britain hasn't done itself many favours with Brexit (international-popularity-wise), and additional market intervention can put economic actors off further. Combine this with higher taxes, and what you have is a Britain that simply isn't worth it...for some. This could cause businesses to move abroad, so consider how law firms can advise their clients with such a move or advise their clients on how to minimise the increased taxation.

A new regulator means there will be a tonne of new corporate governance/auditing tickboxes, hurdles, and so on, which law firms will have to help their clients manoeuvre through. Furthermore, if clients fall foul of these rules and regulations, they will be subject to penalisation, so you can imagine that law firms will have increased work regarding regulatory disputes/appealing civil enforcement action and so on.

All in all, I don't think you'll be bringing up the nitty-gritty in your interview (though it is nice to know about and to expand your general commercial knowledge). However, this is a nice elucidatory example of how the U.K. government (considering it is a Tory government) is being rather economically conservative and market-meddling-ly - which you can use in a discussion about market trends/FDI/M&A, the whole nine yards, to be fair.

Alright - enough waffle from me, @Dheepa feel free to add anything extra if you want! And, of course, this discussion is open to any and all forum members too!

 

[Dheepa]

Super interesting thoughts Jacob and Neville! For one, I never actually realised that Caparo had wider implications for the accounting industry and I also didn't think to consider the political side to this move. Completely agree that it does indicate a more protectionist stance and actually might also put off more companies from listing on the LSE at all (considering it's only PLCs who are subject to these reforms of course). Ties in quite nicely to the discussion we were having last week on the UK needing to do more to widen it's appeal for listings via SPACs actually.

You've already given some excellent background to this Jacob but I think next to BHS (audited by PwC) Patisserie Valerie (audited by Grant Thornton) and Carillion (audited by KPMG) one of the biggest and most recent accounting scandals worth looking into is Wirecard (audited by EY)

It’s worth emphasising that with regards to all four scandals above, the audit firms maintain that they did nothing wrong and in fact were defrauded in the same way that investors and shareholders in the company were. Grant Thornton is still fighting a lawsuit (led by Mischon de Reya) for about £200m in damages. Of course, if your job is to identify the very risks your claiming to have been deceived by, well, then it’s easy to see why the call to break up and regulate the Big Four is so strong.

Side note: Auditors don’t just audit books and numbers. They also investigate the processes in place to make sure employees are using their authorised powers over the financials properly. I worked in a compliance related role briefly and a huge chunk of my time was spent helping to straighten out the gaps auditors had identified in internal processes. So again, while I don’t doubt the complex layers that form part of the scandals, it’s actually very difficult to believe auditors when they say they too were deceived because they don’t just have visibility over the books they tend to also have visibility over the trail and role of each person involved.

Conflict of Interest

Aside from consistent failures to detect fraudulent schemes, a key reason for wanting to regulate The Big Four is the conflict of interest point Jacob alludes to. Firstly, external auditors have to be independent and provide an unbiased opinion the company’s accounts. But how independent can a review be if the company you’re striving to be independent from is paying your fees? Secondly, as Jacob mentions, The Big Four often sells its services in a pair, i.e. it offers auditing and consulting services to the same company. For those of you that are familiar with the Enron scandal, Enron’s audit firm had a much greater focus on the larger fees it earned for the consulting services it offered Enron as compared to its auditing services. Don’t bite the hand that feeds you once, let alone twice, right?

Proposals

Aside from the proposals on dividend payments and the ARGA that Neville discusses, I think the two worth looking into are:

1. Claw back of bonuses – Interestingly enough, a similar provision already exists under s.214 of the Insolvency Act of 1986. It essentially allows the court to require directors to make a contribution to the company’s assets if before the liquidation, the directors were aware that there was no reasonable prospect of the company avoiding liquidation. This provision is rarely ever used because evidentiary hurdles are extremely high. So it will be interesting to see if the proposed reforms on the bonus claw backs are easier to actually use in practice.
   
   
2. Managed shared audits – Essentially this requires companies to use a smaller accounting firm to complete a “meaningful share” of its audits. Despite being what the government thinks is the answer to the conflict of interest issue, I actually find this to be the most questionable reform. Logically speaking, smaller firms are more likely to be reliant on the large source of revenue from big corporates, and so less likely to remain independent. I also think that if there is a main auditor and a secondary smaller auditor as the proposal suggests, there’s a high likelihood that audits by the latter will be vetted again by the former before reporting is done. This makes the introduction of smaller firms all the more redundant. It’s also worth noting that pinpointing errors is difficult enough as is with a single auditor being in charge (see the long running hearings on Wirecard and EY) and so splitting responsibility for an audit in this way will only make matters more complex in case of future discrepancies.

I don't have much to add by way of how this will affect law firms. Jacob and Neville have said it all. What I will say is that I actually spent a large chunk of a corporate seat at one of my vacs last summer researching this very topic for a client brief. So in case you're doubting its viability as something to bring up in an interview, don't! I can promise you law firms have been looking at this for awhile now already.