In an article in the April edition of Governance & Compliance, I wrote about the government’s consultation on Restoring trust in audit and corporate governance. As I said in that earlier article, this is one of the most significant consultations in the governance arena for some time and I am grateful to all those members who joined our roundtables to share their views. In total, more than fifty members helped us with this response, so thank you all very much. Last month, I reported back on the positions that we reached with regard to Public Interest Entities, directors’ accountability for internal controls, dividends and capital maintenance, new corporate reporting, and audit purpose and scope. In this article, I will report back on the remining issues raised.
Regular readers of G&C will know that we have adopted a consistent position on the future of audit that there are three key issues that need to be addressed in order to improve audit quality. These are the expectation gap, the delivery gap and what we have termed ‘the Challenger challenge’. We reiterated those in our response. We also made the point that, in our view, there is a greater need to restore trust in audit than in corporate governance; the UK enjoys an international reputation for high-quality governance and trust is not as fractured as some may suggest. As strong supporters of the UK corporate governance model of ‘comply or explain’, we cautioned against diluting or, in some cases, removing this flexibility. We are concerned that a number of the proposals set out in the consultation document will replace provisions of the UK Corporate Governance Code with set rules and also argued against proposals that increasing number of internal management processes that are being put to a shareholder vote at the AGM.
Finally, we emphasised the critical importance of the competitiveness of the UK market. Our members with international businesses, particularly those with large US interests, are already reporting difficulties in both executive and non-executive recruitment, with the UK being perceived as over-regulated, especially in relation to remuneration, and unattractive to business and it is important that the UK retain its international competitiveness.
Corporate Reporting, Directors and Audit Quality
We strongly supported the Government’s proposals for strengthening the regulator, but once again reminded the Government that the regulator’s objective to “promote brevity and comprehensibility in company reporting” does not sit well with the Government’s tendency in recent years to produce a stream of new reporting requirements, in some cases, it might be argued, in response to small but vociferous lobbies.
We also argued that in order to avoid future difficulties arising from overlapping regulatory responsibilities and the consequent risk of ‘double jeopardy’ in respect of the same issue, it would be better were ARGA to have ultimate responsibility for the supervision of directors duties, including responsibility for audit, and of corporate reporting, with it being the only regulator able to initiate action in these areas.
That said, also believe that it is inappropriate that ARGA act as standard setter, regulator, prosecutor, judge, jury and executioner. We suggested some guidelines with which future regulatory action should be based. These were that:
• Action should be both prompt and proportionate with a ‘statute of limitations’ for regulatory action
• Action should not be retrospective in the sense of applying hindsight to what may have seemed perfectly reasonable decisions at the time. The Courts have been historically reluctant, and rightly so, to second-guess directors judgement
• Enforcement should be in respect of neglect of duties, rather than mistakes
• Enforcement should not assume that all directors are experts – this would have an impact on the diversity of skills and age on boards.
We were also struck by the condition for ‘reputational damage’. It is entirely possible that reputational damage may arise from decisions or actions that were, at the time, completely reasonable and the condition should contain a safe harbour for such cases.
One of the most contentious areas of our response was in response to the question about the regulator being given access to documents that the auditor reviewed as part of the audit which were subject to legal professional privilege (LPP). There were strongly held views both for and against LPP but, on balance, we agreed that the limited restriction proposed – that legal professional privilege should not apply in respect of documents that the auditor reviewed as part of the audit - seems a reasonable compromise because these will not normally relate to advice obtained in expectation of legal action. However, this relaxation should be strictly limited to the role of the regulator in its assessment of audit quality. We believe that the real problem lies with the scope allowed to legal professional privilege which, in our view should either apply only to advice taken to support existing or immediately contemplated legal action, or should apply to any advice given by any professional adviser in that capacity – not just those advisers who happen to be lawyers. We regularly receive complaints from members who have had to pay for their own advice to the board to be repeated by a lawyer in cases where privilege is felt appropriate.
Audit Committee Oversight and Engagement with Shareholders
This was another area of the consultation on which members expressed strong views. We agreed that ARGA should be given the power to set additional requirements which will apply in relation to FTSE 350 audit committees, provided that these are subject to appropriate consultation and, in the same way as the rest of the UK Corporate Governance Code, introduced on a ‘comply or explain’ basis. If such requirements are to be mandatory, they should be subject to Parliamentary oversight in the normal way. We do not believe that it would be appropriate for ARGA to have an observer at audit committee meetings as our members indicate that decisions made by the audit committee are often set in context by the deliberations of the board as a whole and an observer will not have a full understanding of the background to decisions made.
The consultation dealt at some length with measures to increase shareholder engagement with risk and audit planning. Our members’ experience is that many shareholders are less inclined to engage around audit issues in comparison with, for example, remuneration matters and many do not have the resource or expertise to do so. They appoint directors to represent shareholder interests and it is the (non-executive) members of the audit committee who have primary responsibility for oversight of risk and audit planning. Shareholders have access to the chair and non-executive directors, including the chair of the audit committee, throughout the year and although some of our investor members indicate that they would like greater access, feedback from corporate members is that this is a minority and it can be difficult to engage effectively with shareholders on audit issues. In our view, it might be helpful were specific obligations on shareholders to be included in the Stewardship Code.
Competition, Choice and Resilience
This was one of the key issues in the consultation document. We made the point that whilst competition in the audit market is an important issue, it is a different issue from that of quality in the audit market and, indeed, the remedies may conflict. Our view is that the issue is more the perceived capacity – in terms of scope, capability, resource, specialism or expertise to audit more complex organisations (because the issue is complexity rather than size) - of the Challenger firms than their existence. It is essential that the validity of any perception of gaps in auditing capability is independently investigated as the inclusion of Challenger firms in the audit market will not serve to improve that market if those firms genuinely do not have the capability, resource, specialism or expertise to audit more complex organisations. The issue of audit gridlock, where companies find that existing relationships with firms can mean that they are conflicted from tendering for the audit, means that companies would be very keen to see more firms in the audit market.
Some of our members with experience of shared audits have indicated the significant additional cost entailed and the difficulties for the company in reconciling the often conflicting requirements of two auditors whose capability levels and audit processes may be very different. Some of our members with longer memories reminded us that, thirty or so years ago, many large public companies had joint or shared audits in that different audit firms audited different divisions or subsidiaries, and/or different geographical divisions. Their recollection was that these were, effectively, banned at the instance of government and regulators to ensure that there was commonality of standards, accuracy and process, although some also mentioned an inflationary pressure on audit fees.
The single most important step that the Government could take to address the lack of resilience in the audit market is that of commissioning an authoritative independent review to address, once and for all, the capacity of the Challenger firms. If this can be demonstrated, then all objections to their appointment will be negated. If not, then steps will need to be taken to encourage the Challenger firms to build their capability and capacity.