Enron: It couldn’t happen here.

The Enron collapse in the US has been on such a scale as to make waves throughout the world, and certainly in London. Most recently, press commentary has focused on questions of lobbying and the funding of political parties, neither of which, I am thankful to say, is a matter for me.

But the more general question which has been asked in the UK is – could it happen here?

The only wholly honest answer to that question, if one means – could there be a large and unpredicted corporate failure in the UK – is yes.

But there are two particular dimensions of the Enron failure which do have different implications in a UK context. We have rather different arrangements in the UK for the oversight of the accounting profession, on the one hand, and for financial regulation, on the other.

As far as the accounting issues are concerned, which have been perhaps the most important and high profile, there are two features of the British environment which may make similar events less likely here.

Our approach to accounting
First, there is our approach to accounting, where our standard-setters argue the British approach emphasises substance over form and seeks to address the underlying economic reality in consolidated accounts, rather than staying close to the particular corporate and legal structure adopted.

I would note that that approach has not prevented corporate failures in which accounting treatment has been an issue, but the general principle adopted here must be right.

Secondly, the UK profession argue that the arrangements for the oversight of auditors and audit quality are somewhat more robust than those in the US. Indeed Arthur Levitt, the immediate past chairman of the SEC, has quoted our system as a useful example for the US.

In our case there is, now, after a lengthy gestation period, an Accountancy Foundation overseeing the Auditing Practices Board, which, in turn, aims to monitor the quality of audit work in the UK.

While accountancy remains a self-regulating profession, audit is formally at least, covered by some statutory controls. So, for example, our companies acts regulate the qualifications of auditors, set out their duties and rights (e.g. of access to documents), and so on. But in spite of the strong injection of public interest representatives, the oversight arrangements remain substantially a self-regulatory system.

Our legislation does not contain some basic requirements on auditor independence but I think it may reasonably be argued that there is nothing so fundamentally different about our system that it can stop an audit firm becoming too close to its client and colluding in accounting practices designed to, or have the effect of, mislead investors, whether deliberately or inadvertently.

There is nothing to stop an audit firm working indefinitely for the same client. There is nothing to stop a firm undertaking consulting business for the audit client on a substantial scale. Though in the UK, as no doubt in the US, the value of such services must be disclosed in company accounts.

Making regulatory changes
So investors, and politicians are reasonably asking whether the UK should make regulatory changes to outlaw such practices. Indeed, these were questions we already intended to raise, in relation to listed companies, in our review of the UK listing rules, which has been planned for this coming year.

When we took over the listing rules responsibility from the Stock Exchange 18 months ago, it was on condition that we review first the arrangements for disclosure of regulatory information, which we have done, and second that we reviewed the content of the listing rules, which we are now starting to do. As we do so, we shall take full account of the DTI inspectors report into the Maxwell affair, which raised similar issues.

There are, in principle, three possible steps one might take to deal with potential conflicts of interest for auditors in the listing rules.

(An alternative approach would be to change company law, affecting all companies, not just those listed, but that would be a matter for government).

Rotation at defined intervals
First, we could require rotation of auditors at a defined interval, perhaps every five years. The current requirement is that the lead partner on an audit must rotate at least every seven years, but there is no requirement for rotation at the level of the firm. Would that be a justifiable intrusion into the commercial freedom for firms to choose their own auditors? Or would it help to prevent excessively close relationships, and emphasise the regulatory, public interest role of the audit function?

At the Audit Commission, which appoints auditors to many public bodies in the United Kingdom, audit rotation is planned as part of the process. When I ran the commission I found it a helpful discipline, and one which had the useful effect of making auditors more ready to challenge their clients.

A second possibility, which would have a less intrusive effect, would be to require regular retendering of audit work, but not to rule out the possibility that the current auditor would be reappointed.

One argument for such a requirement would be to break the normal comfortable assumption that auditors are reappointed year by year, and would require audit committees to ask themselves direct questions about audit performance.

It would also, of course, give other firms the opportunity to set out the case for a fresh pair of eyes.

Imposing limits on non-audit work
A third option might be to impose limits on the amount of non-audit work which an auditor can do for an audit client.

Once again, that was a feature of the Audit Commission’s regime, which require that no firm could undertake more than a minimal amount of consultancy work unrelated to the audit, except with special permission from the Commission.

They were, of course, free to undertake consultancy work for non-audit clients in the same sector, and one could imagine a similar arrangement in the private sector marketplace. Audit clients might, however, reasonably argue that some audit work can most effectively be carried out by a firm with a good knowledge of the clients’ systems. And policing such a restriction could also be rather difficult in practice, though the profession would be able to take action if an audit firm had falsely certified that it met the requirements.

We shall be formally consulting on some or all of these possibilities later in the year, but I can see advantage in opening up the question for debate now, since the Enron collapse has put these questions firmly on the table here.

In each case, however, the role of the audit committee itself would remain crucial.

Unless audit committees carry out their role effectively, any change to the arrangements for appointing auditors will have little impact.

And there may be consequences for audit fees. It is arguable that they do not now fully reflect the risks auditors take, and the contribution they should make to market integrity.

Financial regulation
The second area where there may be differences in the UK is financial regulation.

One should not overstate these differences. It is certainly possible in the United Kingdom for a non-financial company to undertake extensive activities in financial markets, just as Enron has done. And financial regulators here, no more than they do in the US, do not seek to regulate the non-financial parent on a consolidated basis.

I do not believe it would be practical, or necessarily desirable, to do so, so we have to rely on some ring-fencing of the financial companies within the group, to ensure that their customers, and the integrity of the marketplace, are adequately protected from the parent’s potential failure. That system worked quite well, as far as the UK subsidiaries of Enron are concerned.

The one substantial subsidiary, Enron Metals, has continued to trade and has now been sold to a new owner. But we do maintain closer regulatory oversight of the financial subsidiaries of unregulated groups.

Legislation that helps
And there are two features of our new legislation which helps. First, we have introduced some specific powers over the auditors of financial firms, over their terms of appointment for example. There are new whistleblowing requirements. Auditors of a regulated firm must report directly to us any contravention which is relevant to the exercise of our powers, for example. If they do not do so, we can disqualify them.

The second advantage is that our unified regulatory system allows us to look at the all of the financial activities of a diversified group together, on a consolidated basis, and provides a focal point for co-operation with regulators internationally.

It allows us to draw lessons for bank counterparties from problems in securities and derivatives markets. It is clear that almost all financial crises these days cross traditional sectoral boundaries. A number of countries which have recently reviewed their regulatory systems have seen advantages in adopting a similar model.

It is not fool-proof, however, and internationally we need to work more on implementing appropriate disclosure rules, especially of complex derivatives, to allow more effective market discipline.

They would also allow a market-driven focus on a group’s total exposures to be a useful check on prudence and viability, supplementing the regulator’s direct work.

  • Howard Davies is chairman of the Financial Services Authority. This is an edited extract of a speech he gave to the World Economic Forum meeting in New York at the beginning of February.

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