Examination of Witnesses (Questions 40-59)
MR MICHAEL GROOM, MR PETER WYMAN, MR DAVID BISHOP, MR ROGER ADAMS, MR BRUCE EPSLEY AND MR RICHARD MALLETT
WEDNESDAY 10 APRIL 2002
40. Can we come back to Enron; but just to pursue this point. You want a mandatory operating and financial review, with the potential of legal sanctions on the directors; you have not closed your mind to the fact that the standards, the accounting standards, under which that review of risk is prepared, should themselves be mandatory. Does that therefore mean that you are prepared to accept the possibility that the auditors, who sign off the statements that, so far as they know, the company has properly prepared its operating and financial review, should owe a duty of care, which is also subject to legal sanctions?
(Mr Wyman) The first point is that the directors' report, and the OFR, is currently outside the scope of the audit, that was a point that was made earlier, and you have to overcome that hurdle; and that is quite a difficult hurdle to overcome.
41. The problem we have is, is it not, that, for you, the body that represents the external auditors, we can come in a moment to the Management Accountants, for you, the people who represent the external auditors, the operating and financial review system is a huge commercial opportunity, is it not?
(Mr Wyman) There is an extension of work, yes. I must keep coming back on this; there is a massive, a massive, extension of risk, and that is a very serious worry that I have.
(Mr Bishop) But there is a fundamental point about the operating and financial review, and why we would find difficulty in doing tests in there to check what people are saying is true and fair, for instance, is that it is all subjective, it is the management's opinion about the future, and they are saying things whichand the fear is that if we went the American route, and we have gone some way towards that, it would be just boiler-plating, it would be standard terms.
(Mr Adams) The detailed disclosure of risk in US MD&As is driven by the fact that if they had left something out they would be sued, at the end of the day, so they detail everything. The point I made earlier, that, as you move into the area of the issues that drive corporate value, they become increasingly less quantitative and more qualitative in nature; everyone who writes about the OFR talks about seeing the firm through the eyes of management, and when you make disclosures "seen through the eyes of management", I think it is inevitable. I do not think one should get into the area of auditor liability for it, I think, before you even start to discuss that. I think you need to discuss what do people want in an OFR; do they want some details. What ASB is trying to work out at the moment is, are there some key performance indicators about return on capital, about profitability, and so on, that legitimately can be constructed, disclosed, and disclosed on a comparative trend basis. But there are other issues about the quality of the intellectual capital, how you measure innovation, how you place values on research and development, which I do not think we are anywhere near, at the moment, being able to put quantitative values on, that an auditor could then come along and certify as a true and fair view, and hence be held liable for. I think you are running ahead, I think, into an area of more work for auditors; in fact, I think the OFR comes out of the Company Law Review.
Chairman: It is a wide canvass.
42. But here is a situation where you have made it quite clear that you do want the operating and financial review to be a mandatory requirement, with the possibility of sanctions, through the courts, exercisable against the directors, who are responsible for that review, but when we come on to the responsibility of the auditors for signing off that review you have, to use a colloquialism, run a mile?
(Mr Wyman) The sanction would be, the directors would be required to set out the risks as they see them, the sanctions would be either if they just simply did not put in an OFR in the first place, or if they knowingly, negligently, or fraudulently, misled people around the risk. But, at the end of the day, assuming people are acting in good faith, what they are saying is, "In our judgement, this is the future." Now I do not think you have a legal sanction that says, "Well, actually, with hindsight, your judgement was the wrong judgement;" and that is the issue.
43. But do you not think that there is a concept of duty of care, for these things?
(Mr Wyman) But duty of care is to use your best judgement, in other words, the directors' judgement.
44. But, as you know, we are operating at the present moment, as a result of previous legal decisions, where the auditors' duty of care effectively is armour-plated, it cannot be challenged in law; do you think it is sensible to go on with that system?
(Mr Wyman) That does take you back into the liability issue.
45. Indeed, it does.
(Mr Wyman) And, speaking personally, I would be very happy to see an extension of the auditors' responsibility, but it needs to be matched with a liability reform, otherwise we are simply not going to get people to do audits in certain companies.
46. That is very interesting, and possibly helpful. What about the view of the Management Accountants about this, because you are much closer to the firing-line of responsibility, if we are to have mandatory assessments of risk?
(Mr Epsley) Yes, we certainly are; but I think it is the whole board that does have a responsibility to report the risks of that company, and it does not only stop at the doorstep of accountants, the boards of companies are made up from very, very many qualities. The suggestion, as far as we are concerned, is that we think that it is important that one has the balance between the board and non-executive directors, and perhaps it is an area where, if mandatory reporting of the future is brought in, the non-executive directors should be able to have an assistance in that.
47. That is fine; that is in the evidence. But what we are trying to establish here is, do you think that legal responsibility, in some form, should reach the accountants, whether the internal ones or the external ones; what do you think about that?
(Mr Epsley) At the moment, certainly, we are looking at the whole issue; we have an audit working party, which is due to pronounce its findings in July. It is certainly something that, sitting at this table today, we have not, as an Institute, formed an opinion of; but we certainly do believe that the way to go forward is to have full transparency and disclosure.
48. That is wonderful.
(Mr Epsley) Except that the board is, in fact, liable for the good health and the good wealth of the company. Whether that then is extended beyond, to internal or external audit, certainly, from the internal point of view, we accept that quality management control, risk management assessment, is a vital function of the company and should be reported upon.
49. So to summarise then, what you want to see is a mandatory requirement to produce a risk assessment, under rules that may be mandatory, with much greater responsibilities to lie upon the boards of directors; but when we come to the accountants, whether the internal ones, the Management Accountants, or the external ones,
(Mr Epsley) That was not what I said.
(Mr Adams) I would challenge the notion that we are asking for a mandatory assessment of risk. We have been discussing something called the operating and financial review statement, which is far broader, and, as I said before, contains both a management assessment of the issues that add value, that add constructively to the intangibles that this particular session of the hearing started on, so there is an exploration of issues of value within that document; there may also be an assessment of risk. There may be also, and, I think, because we have not really got into corporate governance yet, there should also be some discussion there, in a sense, about the risk protection mechanisms, whether it is internal audit, in its traditional sense, or whether it is audit committees. But I would simply challenge the notion that we are talking about a mandatory assessment of risk; we are talking about an operating and financial review statement, which, in our vocabulary, I think, has a far broader purpose. You may wish to see it narrowed.
50. We have been 25 minutes on this particular topic, and we are quite happy, but we would like to crystallise it. You are leaving us with the impression that you want one rule for the board of directors and another rule for the accountants, and that is what you are pressing; so if you could bring a bit of clarity to that, and then we will move on to corporate governance?
(Mr Groom) What I was about to do was summarise the submission we made on the Company Law Review, which I think answers very directly the points that Jim was making. Our view, and I suspect we are all broadly in the same ball park, is that there should be a statutory OFR, and that should apply to both listed companies and to certain large companies as well; those OFRs should be set by an independent Auditing Standards Board, and it should provide users with forward-looking, relevant information. The auditors should have a responsibility to review the process used by a board, to make sure they have gone through a proper process and that they have not come out with unreasonable results. And the Financial Reporting Review Panel, in a much strengthened role, where appropriate, should be able to enforce action where a board of directors, in effect, has gone wrong. You then asked, is there any legal recompense if something goes wrong; it seems to me very clear there is. There would be action against the directors, under Company Law, and there would be, as now, the ability for shareholders, liquidators, etc., to sue the auditors, if they had failed to do their job.
Chairman: Are you clear?
Mr Cousins: Reasonably clear. I would like to think about it.
Chairman: You are ahead of me. James.
51. Let us now go a bit further into the corporate governance side of it. Do you feel you can say with confidence that we have got the position and responsibilities of non-executive directors arranged, in this country, in such a way that, again, there is sufficient safeguard against an Enron happening here?
Chairman: Do not be shy.
(Mr Groom) I will hazard a view. I suspect not; and I think our line is, very strongly, we support the review that has been set up by Patricia Hewitt, if they can find a chairman to carry out the review. There is a whole host of issues that do need looking at. There is no evidence, that I can see, that suggests that the process is wrong, but, nevertheless, because of what has happened in the States, in particular, I think it is time to have a very close look at the whole range of corporate governance; part of that must be non-executive directors.
52. But where do you expect the weaknesses are, in our structure, with respect to non-execs?
(Mr Wyman) I do not think it is a structural weakness. My view, if I can just add to what Michael has just said, is that in the best companies corporate governance in this country is superb and it is very effective. The problem is, it is not necessarily in the best companies that you need the most effective corporate governance; and the difficulty, I think, we have got is how do you make sure that you have first-class corporate governance, effective corporate governance, in every company. So I do have some ideas where I think we do need to change aspects of corporate governance, but they are relatively at the margin. The big problem is finding quality people who are able to spend sufficient time to do a proper job, acting as independent directors, both adding value for shareholders but also protecting all stakeholders' interests; and I think that is the difficulty.
53. But the crucial test is, surely, it has got to work in the companies where something is going wrong?
(Mr Wyman) Yes.
54. So it is no good sort of pocketing the good operations and saying, "Therefore, we think the system is right," it has got to be tested where they have an important role to play; and are you confident, as your colleague was not, that it is not right, and, if so, where do you think the problems lie?
(Mr Wyman) No, I am not confident. I think the problem is not the structure or the system, the problem is the people; at the end of the day, this is an exercise of judgement. If you have non-executive directors who are unable or unwilling to stand up for what they think is right, or invest insufficient time to know whether what they are being presented with is right or not, then you have whatever system you like, but actually it will not provide the protection that I think we all believe that we are seeking through effective corporate governance. I have no answer, which is obviously a disappointment, as to how you find this pool of people who will act independently and effectively for every public interest company.
55. But what you seem to be saying is that, where it goes wrong, it is because there is a poor quality of non-executive director, and that is not a sufficient explanation, is it?
(Mr Bishop) I do not think that is right; it can be, in some cases, but in other cases, no. Very able people have failed to pick up major problems in an organisation, because they did not have the right information, in some cases they may have been too close to the people involved and trusted them, and we can all be in situations where we believe somebody but they let us down. And we have got plenty of examples of very able people being in positions of a non-executive nature where they have not picked up the problems in an organisation, Marconi is one.
56. But that sounds structural to me?
(Mr Bishop) It is information, you are always behind the game with the information, if you are a non-executive director; in addition, I think you have particular problems in high technology, where the industry is changing very quickly, and it is a high-risk situation, in the assumptions, in devilling the assumptions on which their forecasts are based, the assumptions about volume and price, and the cost of actually delivering stuff to the market.
57. Do you think we just expect too much of non-executive directors?
(Mr Bishop) I think that is one view. In the US, they have lots of non-executive directors, and there is only one person on the board by right, that is the chief executive and chairman, in a combined role. Now they say that that is benign dictatorship, if you like, it is a paternalistic approach; but they hire and fire there very rapidly. So they put their feet to the fire with performance measures, they look at the strategy, that there is a process, it has been applied and it looks reasonable, and they look at the information they get to see that they are on track; and, apart from that, they do not do much more. The Americans will argue, "Our economy has done very well, so why change our system?" The German system, they have got a two-tier board and you have got representative roles on that oversight board, and they have problems as well. We have a state where you have independent non-executives, who should be the majority, they are the majority on the audit committee and the nominations committee and the remuneration committee, and they have a very onerous role to undertake, it has become clearer over the last ten years what that role is, and I believe they do, in the main, we do not hear about the problems they have and the problems they resolve, but underneath that iceberg they are working pretty effectively, overall. But we get cases where, collusion, if management gang up against the non-execs, very, very difficult, and sometimes it does occur.
(Mr Groom) Can I just say, James was really looking for something, when you were talking to me, about sort of practical issues that I would wish to look at, and I think I would summarise it by saying I believe that the Patricia Hewitt review, amongst other things, needs to look at box-ticking, as opposed to qualitative issues, which was the point Peter was making. One can envisage companies where you can tick all the boxes, you have got the right number of non-execs and execs, you have got the audit committee, etc., but if they are poor-quality people it does not really help. And I do not know whether any of you have come across it, but I am aware that Standard & Poors and Dun & Bradstreet were doing some experimental work, in terms of trying to measure the quality of corporate governance, in its widest sense, in individual companies; so how they do it I do not know, but, in effect, you would be able to look and say, "Well, first of all, can we tick the boxes; secondly, what about the qualitative issues, do these directors look to be the sort of people who will do a good job?" etc. So that may be an area that you might want to explore.
(Mr Adams) Can I just supplement that. It is almost impossible to think that we have got to a situation now where we do not already have a shopping-list of ways in which we could improve the corporate governance area. I think, by having lead non-executives who interact with institutional shareholders, by redefining our view on what independent non-executives are, to make sure they are truly independent, by looking at the time commitment, by reviewing and researching the time commitment that audit committee chairmen and members provide to the tasks, by looking at training of directors, including financial literacy, and I think financial literacy of directors is something that, I suspect, if you run across most of the cases that have been alluded to this afternoon, of corporate failure, at some point or other we are going to come back to poor management, poor financial literacy of individuals involved. So, as was mentioned by Michael just now, people like Standard & Poors are developing methodologies for rating Hong Kong listed companies on a straightforward rating scale, in the same way as they rate debt, and they are publishing the ratings, and they are doing this in co-operation with the companies, and it is an extremely complex methodology which goes far beyond the sort of Combined Code type requirements. There are huge bits of innovation and tinkering. I do not think that we see a fundamental change in the system. We see directors, executive directors, non-executive directors, audit committees, these things are appropriate; how you get institutional stakeholders to become more involved in the Government's process, I do not think that is something that the auditing or accounting profession can necessarily give you an answer to. But they are issues that need addressing. So there are issues all the way round corporate governance, but I am not clear that the fundamental structure is in need of complete rebuilding.
58. Finally, is there not one fundamental plank, when we are assessing whether the non-execs can do their job, they are the right people to do their job, and whether we have the right expectations of them, and that is, who controls the supply of information to them?
(Mr Adams) This is the point about creating a lead non-executive, who takes a much stronger role, in fact. The difficulty always is going to be in creating a two-tier board system, and the moment Cadbury, etc., came through there were always fears of moving away from a unitary board to a board which was somehow categorised by some sort of opposition, the non-execs were actually against the interest of the execs. But I think that there is merit in exploring the notion of simply increasing the role of one lead non-executive, and also, I think, both the English Institute and ourselves, in our submission, have commented on the need to make the audit committee itself more visible in the governance disclosure process. That we believe that the audit committee is in a position to assess the various issues relating to the accounting policies used by the organisation and of the independence of the auditors, but it should actually be charged with making a more formal public statement that it has assessed these issues and is satisfied, both with the accounting policies and with the position of the auditors. There are a number of things one can do to strengthen the role of NEDs without necessarily creating a divisive board.
(Mr Wyman) Could I express a slightly contrary view to what you were saying, that it is all about the supply of information; that is very critical, but good non-executives who are determined to get information will go on and on demanding it until they are satisfied they have got it, and they can demand it from the company, they can demand it from the external auditors, they can demand it from the internal auditors, if necessary, and, this is in extreme, they can commission independent people, and all of those, to give them advice and do work for them. I think the biggest problem, perhaps I expressed it badly to start with, is not necessarily the quality of the people, and very good quality people, but if they have not got the time they may not do the job properly. And I think the challenge that we have, at the end of the day, is finding a sufficient pool of able people, with sufficient time to devote to the company, to be able to be effective in the role that, as you say, we are asking a lot of non-executive directors, to be able to do that role takes time and it takes competence.
(Mr Groom) I do agree with James, if I may say, Chairman, that obtaining that information is absolutely critical, and I would not consider personally joining a board unless I was 100 per cent satisfied I was going to get the right information. There is plenty of literature in the field, by bodies like PRO:NED, like the Institute of Directors, which tells you the approaches, but again it comes back to Peter's point, you need the right people to stand back and say, "Am I being given the right information; do I actually want to be involved in this board or not?"
Mr Beard: But is not one of the problems that non-executives are actually taking on too many appointments, some are taking on six, a dozen; how can they possibly exercise the sort of interest on any one case?
59. Can I add onto that then, just two points. Could you put a number on how many non-executive directorships an individual can handle sensibly?
(Mr Groom) I do not think you can.