Letter to the Chairman from Lord Sharman
I was interested to read the announcement of
the Treasury Committee inquiry into the financial regulation of
the public limited companies. As a former Chairman of KPMG International
(I retired in September 1999) I do have some considerable experience
of the issues which you will be addressing both in terms of this
country and overseas. The purpose of this letter is to let you
know that I am prepared to give evidence to your inquiry should
you deem it desirable.
By way of background I enclose a copy of the
full text of my intended speech (it was cut short due to time
limits) in the recent House of Lords Debate on the Corporate failures.
27 March 2002
Before I begin I must first declare an interest.
My interests are set out in the register of members' interests
but that which is most relevant to the issue we are debating today
is that I am the former Chairman of KPMG and one of the so called
big five accounting firms. I continue as a paid advisor to that
It is with a great deal of sadness that I approach
the motion for debate today. When I joined the accountancy profession
some 40 years ago, it was a profession held in high esteem. Indeed
in those days girlfriends' mothers were quite keen at having prospective
chartered accountants as sons-in-law.
Today we have the greatest crises which the
accountancy profession has faced in its history. The reputation
of Arthur Andersen which took some 90 years to build, lies in
tatters, destroyed in 90 days. The indictment of that firm for
obstructing the course of justice in the USA, will if sustained
leave a stain on the whole of the global accounting profession
which will take many years to remove.
What has caused this?
Clearly the trigger has been the collapse of
Enron, the largest corporate failure in the history of the USA
(if not the world) causing the loss of livelihood and pensions
of many thousands of people.
How did it come about?
Essentially Enron built a house of cards, which
collapsed at the first breath of wind. The collapse, which happened
after it admitted it had overstated profits by $586 million, understated
debt by $2.6 billion left $63 billion in liabilities. The share
price which had traded at $90 in August 2000, closed at $1 when
trading was suspended on 15 January 2002.
Throughout the 1990s Enron experienced phenomenal
growth. Annual turnover grew from $7.9 billion in 1993 to $100
billion in 2000. This was accompanied by steady positive earnings
and a share price rise that ultimately stood at 70 times earnings.
Between 1997 and 2001, it created a series of
special purpose vehicles which removed assets and liabilities
from the Enron balance sheet, in some cases this involved the
purchase of assets from Enron on which it recognised a gain. These
schemes were constructed with the benefit of advice from the auditors,
lawyers and investment bankers. The schemes were guaranteed by
Enron and secured with its own shares.
What was unusual about these schemes was the
scale, they were very large in relation to Enron and the involvement
of both Enron insiders and other related parties as limited partners
in these schemes.
The obvious questions that arise are:
(a) were the schemes legalwell it
appears that they were;
(b) were they disclosed in the financial
statementsagain the answer is yes. If one attempts to understand
Notes 1, 7, 8, 9, 10 and 16 to the 2000 financial statements there
was enough there to alert the reader.
The rot started in March 2001 when Fortune Magazine
began an article:
"Its in a bunch of complex businesses. Its
financial statements are nearly impenetrable. So why is Enron
trading at such a huge multiple?"
Things got worse for the rest of the year, including
a third quarter restatement of earnings and falls in the share
price (exacerbated by Hedge funds shorting the stock heavily,
which triggered the calling of debt resulting in a rapid downward
spiral to collapse.
In my view what we have is:
First a failure in corporate managementa
house built on sand won't survive once the foundations start to
Compounded by a failure in corporate governance.
Clearly the Enron board did not exercise enough control on the
actvity of management.
Enabled by auditing failure, at a minimum the
reasons for the earnings restatements should have been identified
All made possible by inadequate regulation and
This series of failures was then compounded
by what is alleged to be the wholesale destruction of evidence"the
shredding" by the very peopleauditorswho are
supposed to be the "watchdog"the people who are
supposed to exemplify independence, objectivity and probity. Little
wonder then public confidence in them has taken a huge knock!
It is very important to remind ourselves that
this all took place in the USAcould it happen here? Well
I can do no better than quote Sir Howard Davis, chairman of the
FSA who in a speech to the World Economic Forum in New York at
the end of January 2002 said "the wholly honest answer to
that question if one meanscould there be a large and unpredicted
corporate failure in the UKis Yes". He went on to
explain the key differences between practice in the UK and USA.
So far as the key issues in the Enron affair
itself are concerned:
(1) The off balance sheet activities would not
have been acceptable in the UKhere there is a key differencethe
USA has a detailed rules' based system of accounting. In the UK
and internationally we proceed on the basis of principles based
accountingwhich requires the exercise of judgement as to
substance over form. The SPV's would not have been "off balance
sheet" in the UK.
(2) The use of own shares as security and to
fund retirement plans. The use of own shares as debt security
is not that common in the USA and unknown in the UK. The use of
own shares to fund retirement plans in the UK is controlled by
the MFR and limited to 5 per cent of such plans.
As regards the activities of the investment
banks and the hedge funds I take little comfort, indeed I understand
that as much as 30 per cent of the daily turnover of the LSE may
be due to hedge funds.
The motion before us calls attention to recent corporate
failures and to the case for regulation and other action to maintain
public confidence in business and accountancy.
As I said earlier let's make no mistakewhen
the Financial Times leader calls as it did on 13 March
2002 for the potential "Fat Four" to spin off their
consultancy businesses and be banned from doing non-audit work
for audit clients, we have a deep crisis in public confidence.
What should we be doing about this?
First, Management: There is no process that
I know that can make incompetent management competent. The purpose
of corporate governance is to provide a system of checks and balance
to militate the effect of poor or corrupt management.
Second, Governance: There are many who have
said the system of corporate governance in the UK is different
and generally regarded as more thorough and a role model for the
rest of the world. We seem to have overdosed all thoughts on corporate
governance from Cadbury through Hampel and Greenbury to Turnbull.
However I do agree that an examination of the role of non-executive
directors recently announced by the Government will be a welcome
addition to this batch. We should look at how many non-executive
appointments an individual can handle sensibly and also at the
desirability of full-time executives taking on more than say one
non-executive appointment in another company. It will also be
useful to see whether the real role and responsibilities for non-executives
can at least be somewhat better defined than it is at present.
Third we need to look at auditor independence
and regulation. I hope that the major firms and their professional
bodies realise how deep the crisis of public confidence is. It
is shotthey can no longer go on behaving as if they are
some sort of private club. More transparency in their affairs
is desperately needed. I am deeply disappointed that other major
firms did not follow the example of KPMG and Ernst & Young
in publishing financial statements. Transparency is what generates
public confidence and the affairs of some of these firms are remarkably
opaque. I believe this is a strong case, after all these firms
are very large enterprises. They employ upwards of 10,000 people
each and have a significant role in the economy of this country.
Why should they not have their financial statements auditied to
the same standards of public companies and publish them in the
same way. 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 in recent
past and although again I find the arrangements for it somewhat
opaque there seem to be a large number of bodies all involved
in this from the Investigation and Disciplinary Board through
the Ethics Standard Board, the Auditing Practices Board, the Review
Board and the Accountancy Foundation. Whilst all of this has the
appearance of independence all the appointments are made independently
of the accountants. It falls short in one key aspect, namely that
the funding of the Foundation is by the accountantshe who
pays the piper calls the tune. It seems to me a further step should
be considered, that of the Government taking over funding of the
Foundation and responsibility for the appointments of the members
of the Board. This I feel would go someway towards demonstrating
strong independence of regulation.
A further step also in terms of transparency
would be for the JMU, the body which conducts reviews of audit
quality, to publish the individual reports on firms that have
responsibility for auditing public companies. I recommended this
in the case of the C&AG in my report Holding to Account
I can see no valid reason for these reports not being
made public. Again transparency will help in restoring public
I turn now to other issues regarding auditors.
Sir Howard Davis in his speech which I referred to previously
in New York raised three possible steps. First, the mandatory
rotation of auditors perhaps every five years. He uses the example
of the audit committee as a support for this motion. I have to
say that I do not believe that mandatory rotation would be helpful.
In the countries where it has been tried, Brazil and Italy, it
has been abandoned as a failure. The Cadbury committee looked
at it and concluded that it would not work in this country as
have the Irish Government recently. The Audit Commission does
rotate the audit responsibilities after a fashion but it must
be remembered that the Audit Commission is responsible for the
appointment of auditors to local authority and health service
entities which are a largely homogeneous group of entities. It
is a very different thing to be dealing with very disparate businesses
and rotating auditors. However, I do think we should look again
at the issues of audit staff rotation and see if a more frequent
rotation of say five years rather than seven is appropriate. Also
the issue of audit partners joining their clients needs examination
to see if there is a case for a moratorium period of say two years
before such a partner could join a client.
The second possibility he mentions is to require
regular retendering of audit work. But not rule out the possibility
that the current auditor be reappointed. Again I think this would
have a limited benefit. Audit committees, if they are worth their
salt should be looking at the appointment of auditors on a regular
annual basis. I can see nothing that this suggestion would add
The third option mentioned both by the Financial
Times and Sir Howard Davis is limits on the amount of non
audit work. Here again I think this falls rightly into the remit
of the audit committee. The audit committee should be monitoring
all of the activity and relationships between the auditors and
the company. Artificial limits either by percentage or absolute
amounts will not in my judgement help. In many cases the additional
work undertaken by auditors is as a result of competitive tendering,
or in the case of many regulated industries a natural extension
of audit work eg Reports for regulators etc. Competitive tendering
in itself is a sensible test of the water and I don't believe
that artificial limits will help.
Those who like myself sit on audit committees
will be well aware of all fees paid to auditors by shareholder
groups such as the ABI and PIRCS which keeps such audit committees
on their toes.
My Lords, in concluding it is clear that the
accounting profession and business needs to take a very close
look at itself in the light of the Enron Affair. But let us not
forget it was not only the board of directors, management and
the auditors that were involved in this shambles. Investment bankers,
lawyers and other advisors were clearly involved as well. We must
not over-concentrate on one of the villains in the piece. There
is quite a large cast to look at.