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Auditing and Accounting

5.48 p.m.

The Parliamentary Under-Secretary of State, Department of Trade and Industry (Lord Sainsbury of Turville): My Lords, with the leave of the House I shall now repeat a Statement made in another place by my right honourable friend the Secretary of State for Trade and Industry. The Statement is as follows:

So there was no need for the UK to rush into a Hewitt/Brown equivalent of the Sarbanes/Oxley Bill. But equally it would have been folly to sit back and say, 'It couldn't happen here'.

    "Structures, standards and regulations can never be a complete defence against individuals determined to do wrong, nor can they wholly protect us against a culture of corporate greed and loose ethics. But we owe it to savers, investors and employees, as well as to all the honest business people whose reputation has been tarnished by these scandals, to ensure that our defences are as robust as they sensibly can be.

    "The reforms I am announcing today, along with those proposed last week by Derek Higgs and Sir Robert Smith will raise standards of corporate governance—I should emphasise that the reforms essentially cover only listed companies—strengthen our accountancy and audit professions, and provide for a more effective system of regulating the profession. Together, they make up a complete package of reforms—comprehensive and mutually reinforcing.

    "First, I address the issue of boardrooms. Following Derek Higgs's proposals, the combined code on corporate governance will be strengthened to provide that at least half

    "the board (as well as the chairman) should be independent—as should all members of the audit and remuneration committees, and a majority of the nomination committee; the definition of an independent director should be strengthened and clarified; the separation of roles of chairman and chief executive should be reinforced; and new descriptions should be given of the respective roles of the board, the chairman and non-executives.

    "Mr Higgs's report showed a startling picture of the way top level appointments are handled, with over half of directors being appointed through

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    personal contacts and friendships. I welcome his proposals to promote meritocracy through an open, fair and rigorous appointments process. As part of the follow-up, a group led by Laura Tyson of London Business School will look at ways of bringing candidates from the non-commercial sector to greater prominence—including women—and will report to me in May.

    "In revising the combined code, the Financial Reporting Council will also implement the recommendations of Sir Robert Smith's group that the audit committee should consist entirely of independent members, with at least one having relevant financial experience; monitor the auditor's performance, especially on independence and objectivity; and develop and implement policy on the purchase of non-audit services from the auditor, with reference to tough new ethical guidance.

    "Following well established practice, listed companies will be required either to comply with these provisions or to explain to their shareholders why they are not doing so.

    "The second aspect of our reforms concerns tougher measures to underpin auditor independence. Following the recommendations of the co-ordinating group, I can announce that, as well as an enhanced role for audit committees and a tightening up of the provision of non-audit services by auditors, the professional bodies have already changed their regulations so that the lead audit partner has to be rotated within five years; partners and senior employees of audit firms will not be able to take up employment with a company they audit within two years of leaving their audit firm; and most of the UK's large audit firms have already agreed to publish an annual report, provide management and financial information, and reveal levels of dependency on single clients, including how the firm handles conflicts of interest and interdependence issues. I believe that that third aspect will work on a voluntary basis. If not, we will make such disclosures a condition of auditing listed companies.

    "I am also calling for the standards and ethical guidance for auditors on the provision of non-audit services to be toughened up further.

    "We will also strengthen enforcement of accounting standards. At the moment, the Financial Reporting Review Panel only steps in if particular concerns are raised with it. But the co-ordinating group recommends, and we agree, that enforcement of these standards must be proactive. From now on, the Financial Services Authority will help the Financial Reporting Review Panel on enforcement—particularly in identifying the high-risk cases which most merit investigation. The FSA and panel will need to agree as soon as possible a memorandum of understanding to clarify their precise roles and responsibilities.

    "These measures will be underpinned by the third element of our reforms—more effective regulation of the professions. The Financial Reporting Council will assume the functions of the Accountancy

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    Foundation. This will create a unified, independent UK regulator with three clear roles: setting accounting and audit standards; proactively enforcing and monitoring them; and overseeing the self-regulatory professional bodies.

    "The Financial Reporting Council, under Sir Bryan Nicholson, has developed an excellent reputation. The Accountancy Foundation, chaired by Lord Borrie, has also done valuable work, for which I thank it. The new combined body will build on these achievements.

    "After wide consultation, the DTI's review team recommend, and again I agree:

    "First, the Auditing Practices Board should take over from the professional bodies responsibility for setting standards for independence, objectivity and integrity. Oversight of other ethical standards will become the responsibility of a new professional oversight board. The Ethics Standard Board will be wound up in due course. I have greatly appreciated the work which its chairman, Christopher Jonas, and his colleagues have done to take forward the ethical agenda and to provide the basis for the new board's work;

    "Secondly, a new independent inspection unit, located within the FRC, should take over from the professional bodies responsibility for monitoring audits of listed companies, major charities and pension funds, and;

    "Thirdly, the long delayed Investigation and Discipline Board should come into operation quickly to provide a truly independent forum for hearing significant public interest disciplinary cases.

    "It is vital for the new structure to have clarity of accountability and responsibility, together with the appropriate powers, to operate effectively in the public interest. There is a strong case for statutory underpinning to make the new body work. We will consider that further and report our conclusions to the House.

    "The proposals that I have outlined today are substantial and mean significant changes to the way companies and their auditors carry out their work. This package must be implemented as quickly as possible. Changes to the regulatory structure will be taken forward immediately. The DTI will lead an implementation steering group on which Sir Bryan Nicholson, Lord Borrie and Peter Wyman, president of the ICAEW, have kindly agreed to serve.

    "An FRC with enhanced responsibilities will require more investment. The Government will pay their share of core running costs, but I also expect companies from the profession to contribute. It is in all our interests to make these changes work—and it is fair that we all pay for the improvements. Changes to the combined code arising from the Higgs and Smith reports will be made in the early summer once the FRC has consulted on the precise wording. All these measures will be taken forward alongside the

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    Government's longstanding programme of company law reform, following last year's White Paper.

    "These proposals are not a response to short-term market movements. They are about strengthening the foundations of our capital markets for the long term. I want in particular to thank Derek Higgs and Sir Robert and his group for their excellent reports, as well as all those who participated in the co-ordinating group under the joint chairmanship of my honourable friends the Minister for Competition and Consumer Affairs and the Financial Secretary to the Treasury. I also want to pay tribute to the officials who so swiftly took forward the review of the regulatory regime.

    "The overall package is tough where that is needed, but measured and proportionate throughout. It will ensure that our corporate governance structures remain among the best in the world—for the benefit of the millions of pensioners, savers and businesses that depend on them".

5.57 p.m.

Lord Hodgson of Astley Abbotts: My Lords, I am grateful to the Minister for repeating the Statement made in another place. Bearing the public matter in mind, I begin by declaring an interest as a non-executive or independent director of two listed companies and a mutual building society.

On these Benches, we welcome measures designed to reduce the possibilities of fraudulent activity. Trust is a vital ingredient in financial markets, giving confidence to those who wish to save, especially over the long term. However, it is a bit rich for the Government to claim that the proposals are not a reaction to short-term market movements, for that is precisely what they are, and the Government are being disingenuous to pretend otherwise.

We welcome the Government's attempts to try to avoid a one-size-fits-all approach to corporate governance by applying the new standards to what the Statement describes as "essentially only . . . listed companies". However, it would be helpful if the Minister can explain what is meant by the word "essentially". It is potentially a weasel word. Either they apply to listed companies exclusively, or they do not. Secondly, do the new standards apply to AIM listed companies, which are listed on the alternative investment market? Thirdly, do they apply to foreign companies listed on the London Stock Exchange? If so, how will they be enforced? If not, how will potential investors in those companies be aware of the greater risk that they are running?

Finally, are the Government aware of the huge range of listed companies—multi-billion, multinational companies at one end of the spectrum and the 50 million capitalised local engineering company at the other? For the latter to have over half its board made up of independent directors will be quite a challenge. Could thought be given—or has it

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been given—to focusing the new rules so that they fall most heavily on larger companies, say those listed in the FTSE 100 or the FTSE 250 index?

As I say, these new rules are the by-product of fraudulent activity but we must always be careful to distinguish between fraud and risk. Too often people are inclined to view fraud as their risk that went wrong. In the previous debate mention was made of the importance to UK plc of design. But UK plc also needs risk takers. Risk takers need freedom to manage and a competitive base from which to run their businesses. The new rules will undoubtedly represent another regulatory and cost burden. We understand why they are being introduced but will the Government undertake a study of the cumulative effect of the increasing regulatory burden on UK businesses' world competitive position?

Will the Minister also clarify the chain of command in the new structure? We have, as I understand it, the Financial Reporting Council, which will take over the Accountancy Foundation. We have a new professional oversight board taking over the Ethics Standards Board. We have a proposed independent inspection unit and a new investigation and discipline board. We have an implementation steering group and a financial reporting and review board. Circling over all that we have the Financial Services Authority, the Department of Trade and Industry and, last but not least, Professor Laura Tyson. How will we ensure that there is no duplication of effort and of cost?

It is very welcome that the Statement repeats the importance of separating the roles of chairman and chief executive. In those circumstances it is an even greater shame that the Government do not follow their own precepts and that it took enormous pressure in your Lordships' House to persuade them to split the roles of the chairman and chief executive of the Office of Fair Trading in the Enterprise Bill. I invite the Minister to take this opportunity to announce that the Government will forthwith split the roles of chairman and chief executive of the Financial Services Authority, particularly given the FSA's important role in enforcing the new proposals announced today.

Finally, it goes without saying that we on these Benches find any form of fraud unacceptable. Fraud enables the greedy to prey upon the weak and the unsophisticated. We therefore give a broad welcome to the proposals. But before more legislation is put on the statute book, if legislation is required, we need to have an informed public debate as to how effective the detailed proposals will be in the real world.

6.3 p.m.

Lord Razzall: My Lords, I join the noble Lord, Lord Hodgson, in thanking the Minister for repeating the Statement made in another place. It seems to me that your Lordships' House is exactly the place where detailed comments on such a Statement can be made. The noble Lord, Lord Hodgson, mentioned some important issues. I look forward to hearing the Minister's response, particularly with regard to the FSA, without wishing to intrude on past private grief.

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As the Minister rightly said, the Statement brings together three reports raising different issues that are relevant to corporate governance in the UK. First, I refer to the Higgs proposals on conduct in boardrooms and the way in which listed companies should conduct themselves. It is not for me to respond to the noble Lord, Lord Hodgson, but it is fair to say that the Derek Higgs report makes clear that he proposes applying the most onerous requirements on the leading 350 listed companies. There is a section in the report in which he recognises that the smaller listed companies will not be able to comply—certainly not immediately—with the more onerous requirements. I believe that the Minister with his business experience would be the first to agree that the Higgs report is at the very soft end of what might have emerged in relation to corporate governance. I am sure that some of the Minister's noble friends, who are not present today but are often present at Question Time, will consider that the Higgs proposals do not go as far as they would wish.

The noble Lord, Lord Hodgson, made an important point with regard to small listed companies. I refer to a fundamental concern—I hope that the Minister will give his views on the matter—namely, from where will the people come to provide the non-executive directors that the Higgs report requires? Looking around your Lordships' House I see a number of noble Lords and noble Baronesses who sit on boards of directors as non-executive directors. Given the current state of liability, I am not sure that any of them would readily take on a new post as a non-executive director. We are not talking here about people who are effectively seconded from major companies to sit on those boards. Although the Higgs report wishes to increase vastly the pool of non-executive directors its recommendations will restrict the number of executive directors who can take up non-executive appointments in other companies. I should welcome hearing the Minister's comments, not only his comments as a Minister but also those arising from his own practical business experience, in regard to where all these non-executive directors will come from.

I believe that the noble Lord, Lord Hodgson, indicated that the essence of the Higgs recommendations is that this matter should not be a case of "one-size-fits-all". I cannot let the moment pass without commenting that Mr Higgs himself sits on the board of directors of British Land but has so far been unable to persuade the chairman and chief executive to stand down from one of those positions. That situation is rather ironic. I believe that a similar irony arose in the Greenbury report that was issued years ago.

I turn to the recommendations regarding the accountancy profession. I believe that those measures are at the soft end of recommendations compared with some ideas that have been floated. For example, there is no recommendation that there should be any form of statutory split between audit and non-audit work. Noble Lords who follow these matters are well aware that that is a major issue both in Europe and in the UK. I should also welcome hearing the Minister's

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views on whether the trend towards separation of audit and non-audit work will continue and whether the Government will support that.

What views does the Minister hold on an idea that my noble friend Lord Sharman has floated on a number of occasions as former chairman of KPMG; that is, that the National Audit Office should be allowed to compete in the private sector for big company audits? We believe that the National Audit Office would be keen to do that and that it could develop a degree of audit expertise which would be outside that of the big four which dominate the FTSE 100 companies. In the case of the National Audit Office there would obviously not be the problem of wanting to compete for non-audit work.

I turn to the alteration of the position of the regulators. I draw noble Lords' attention to the sentence on page 7 of the Statement which states:

    "There is a strong case for statutory underpinning to make the new body work".

I hope that the Minister will comment further on that sentence. I should have thought that what the words,

    "There is a strong case for statutory underpinning to make the new body work",

actually mean is, subject to negotiation to get it into the Queen's Speech, there will be statutory underpinning to make the new body work. I hope that the Minister will develop that point.

In conclusion, I take up the sentence where the Government say that the proposals are substantial and

    "mean significant changes to the way companies and their auditors carry out their work".

I would consider that as going a little far. These proposals will only mean what the quotation states if the voluntary provisions recommended here are actually complied with by companies and auditors. Is the Minister prepared to be drawn on what action the Government will take if it transpires that many of these recommendations are not adopted in practice by companies and auditors? In those circumstances do the Government propose to legislate?

6.10 p.m.

Lord Sainsbury of Turville: My Lords, I shall deal first with the point made by the noble Lord, Lord Hodgson. He said that these measures were a response to short-term market movements. Given that they have spent a long period in gestation, I do not believe that we can say that they are such a response. It can be fairly said that they were a response to events which took place in America. It seems to me wholly right that where we have that situation in America, which was outlined at the beginning of the Statement, action should be taken because of it. If we had not taken action, I believe that the noble Lord would have said with some justification that we were in danger of being complacent. I do not believe that that is the same as making a response to short-term market movements.

As regards to whom it applies, we very carefully said that it applied to "essentially" listed companies. That was not the use of a weasel word, but to be strictly accurate about the situation. It is a whole package of

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proposals. The Co-ordinating Group on Accounting and Audit alone has 27 recommendations. What we mean by "essentially" is that the vast majority apply only to listed companies; for example, a measure such as a pro-active enforcement of accounting standards will apply beyond purely listed companies and in fact to some large private companies. It was for that reason that we did not want to say misleadingly that all the measures applied only to listed companies.

We have not taken the view that one size fits all. In many cases we are saying that there will be a model and that companies, through the listing agreement, will either have to go along with that or explain to the market why that is not being done. It will be the market's judgment on the matter. That is the wholly appropriate way to proceed.

I do not believe that there is a great deal of extra regulatory burden although some of those burdens may be different because they require people to do different things. That is not the same as increasing the regulatory burden.

As regards the new bodies, there is equally a reduction in their numbers. For the new arrangements for the Financial Reporting Council it can be fairly said, having looked at the pages where the Accountancy Foundation is set out, that we are simplifying and probably cutting down the number of bodies involved.

The noble Lord, Lord Razzall, asked where the non-executive directors are to come from. There are substantial sources from which people can come. The Laura Tyson taskforce will look at how we can increase the number coming from outside the corporate world. Within it there are executive directors of other companies where it is regarded as good for their development that they should be non-executive directors of other companies. That source could be drawn on much more in future.

As regards the separation of audit and non-audit work, the co-ordinating group considered various approaches to the problem of auditing independence. I believe that an outright ban would be the most extreme response. The co-ordinating group recommends against it and we very much agree. The UK approach is based on key principles and safeguards, not on lists of banned activities. If no adequate safeguards can be implemented then the auditor must not carry out the work. But the thrust of the matter is that each situation must be judged on its merits against the overall standards. That is why the role of the audit committee is so crucial.

As regards the statutory underpinning of the Financial Reporting Council, the noble Lord is right. We shall consult on that as to exactly which parts of that council should be underpinned statutorily. We do not believe that it is necessary that all its activities should be. There are some quite fine judgments involved in that. We shall consult on it and return to the House on the matter.

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As I said at the beginning, a great deal depends on voluntary action in some cases, but in many others it is underpinned by the fact that a listing agreement will require companies to explain why they do not take the necessary action. In that event there will be a market judgment and in others there will be new statutory underpinning. I believe that the total package gets the balance right in terms of taking firm action, but proportionately.

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