UK seeks views on corporate governance, audit

The clock is ticking. It doesn't stop just because the economy has and because nothing very much has changed. But it's time to revisit corporate governance again. The UK Financial Reporting Council adopted its latest provisions two years ago, so it's time to crank up the consultation machinery to fine tune them. But the consultation follows several other initiatives that have not yet become policy, so this paper concerns in part what the consultation itself will not address. It won't look at board diversity – it has done that last year. It's also not seeking views on remuneration, subject of a different government inquiry. The FRC is seeking views on two interrelated themes:

• Corporations and boards: The 2010 UK Corporate Governance Code narrowed the scope of this iteration to concentrate on what boards do and how they are built. Some small issues have arisen in the implementation of it, and the FRC will take another look. More fundamentally, it wants to make a big revision to the notion of compliance. "The FRC also proposes to set out in the Preface to the Code the features that it regards as the characteristics of an informative explanation," it said. That means incorporating the themes of a paper it published in late February entitled: "What Constitutes an Explanation under 'Comply or Explain'?" It wants the code itself to help companies understand "what was expected of them when they choose to deviate from the provisions of the Code, and to provide shareholders with a benchmark against which to judge explanations".
• Audit: Boards will need to state in the annual report the reasons why they consider the report to be fair, balanced and understandable. The remit of the audit committee will be extended expressly to advise the board on this issue. More informative reporting by audit committees, including on the process for appointing the external auditor, will be encouraged. And the 350 largest companies will be expected to put the audit contract out to tender at least every 10 years.

In addition, the FRC is consulting separately about the Stewardship Code, which concerns the actions of shareholders and in particular institutional investors.

Source document: The overview page has links to the consultation paper and two appendices.

What is stewardship? The FRC wants to know

The UK watchdog for accounting and corporate governance plans to take a fresh look at how shareholders related to the companies whose shares they own, and it would like your views. Just two years after the launch of its Stewardship Code, the Financial Reporting Council thinks it's time to "to build on a promising start by reinforcing it where necessary, but not fundamentally changing it". It notes that a similar view was expressed in the interim report of the Kay Review, published in February. "For that reason the FRC does not propose to change or add to the Code's seven principles," the FRC said, but neither that nor the prospect that John Kay's final review, due in July, might rethink the nature of stewardship gives the FRC reason to pause in its revision. Its draft revised Code "does look rather different" from the one launched in 2010, when these themes were removed from the old Combined Code so they could achieve greater attention. The reasons for the proposed new introductory sections include:

:
• Definition: The FRC said: "it has become clear that there is no common understanding of what is meant by the term 'stewardship', or of the respective roles and responsibilities of asset owners and managers". It attempts to provide greater clarity.
• Lending: The first iteration of the Stewardship Code deliberately left out consideration of the practice of stock lending, wanting its other provisions to become bedded into practice first. It's time now to take a look at whether investors who have lent shares – often to support short-sellers – should be allowed to recall them for voting purposes.
• Bug fixes: The FRC also wants to take into account various lessons learned in implementation of the code, including those highlighted in its "Developments in Corporate Governance" report, published in December.

Among its specific measures, the FRC wants to encourage the practice of companies discussing major strategic moves with their key investors before those plans are fully developed. It follows a case where a planned merger involving one of the UK's largest 100 companies faltered, owing to investor displeasure over the terms. It suggests investors provide named individuals who would become "off market", that is, would not trade shares for a time, who could then become insiders in advance of deals being disclosed.

The new draft also seeks to incorporate a change in the discourse, one viewed skeptically in parts of the investment landscape but promoted by the powerful lobbying force of insurers and pension funds: the concept of "asset owner" as a way of focusing attention on the beneficial owner often lost in the investment supply chain. The consultation paper puts it this way: "Where a statement in the Code refers only to one type of firm the words 'institutional investor' have been replaced with either 'asset manager' or 'asset owner'. Where a statement refers to both managers and owners, the term 'institutional investor' is used. Lastly, the word 'shareholder' has been replaced with 'investor', to avoid debate and confusion over whether the asset manager or owner is considered the shareholder."

It also wants views about the use of proxy voting agencies, another hotly contested theme that the first version of the Stewardship Code set aside for attention later.

Source document: The consultation paper is a 13-page pdf file.

UK seeks tougher sanctions on auditors

The UK's Accountancy and Actuarial Discipline Board thinks it's time to get tough with misbehaving auditors. In a consultation paper, the ASDB, an operating body of the Financial Reporting Council, revealed plans to give guidance on possible sanctions that the tribunals hearing abuse cases could follow. "There is considerable precedent for such guidance," it said. "Sentencing guidelines are widely used and provide a structured approach to determining the appropriate sentence while still allowing for judicial discretion. Sanctions guidance has been adopted by a number of other disciplinary regulators, including the General Medical Council and several of the AADB's Participants."

Source document: The consultation paper is a 47-page pdf file.

ICSA guidance on voting at annual meetings

First the good news: participation at company annual meeting in the UK is on the rise, with voting at annual meetings of the top 100 companies now above two-thirds of the shares in issue. The Institute of Chartered Secretaries and Administrators takes heart in that, especially in view of the rise in share ownership by foreign investors, who have traditional been less likely to vote. But then there's the bad news: Criticisms of UK processes persist. Cross-border voting still seems to result in lost ballots. ICSA's Registrars Group blames a lack of clarity and loss of control within the intermediated forms of shareholding. Miscommunication of voting instructions and entitlements results in votes failing to be lodged. Into the breach comes new guidance, concerning the amount of notice needed, setting the proxy deadline and record date, how long voting should be open, what happens after the proxy deadline, and more.

Source document: The registrars' guidance note is a nine-page pdf file.

FSB details progress on G20 regulatory agenda

The Financial Stability Board has provided an update on the progress made in the three years since it came to live as a creature of the Group of 20 nations. It comes in the form of four separate reports. First is a letter providing an overview of the work on making financial institutions more resilient and dealing with shadowing banking and derivatives. Second is a progress report on ways of dealing with banks that are too big to fail, while the third deals with strengthening the regulatory and supervisory infrastructure. The fourth, a joint report of the US-based Financial Accounting Standards Board and the International Accounting Standards Board, discusses the issues in seeking convergence between their respective systems and the governance of the IASB.

Source document: The FSB news release, a two-page pdf file, has links to the specific documents.

Turner on the 'inherent danger' in shadow banking

Shadow banking is the term commonly given to activities of certain type of investors and intermediaries that take on the substance – if not quite the appearance – of lending. The growth of securities markets trading in obligations assembled from banking lending instruments like mortgages had quite a lot to do with creating the financial crisis. Lord Turner, chairman of the UK Financial Services Authority, thinks that securitisation itself has brought from benefits. But in a thoughtful lecture at Johns Hopkins University in Maryland, he argues that the resulting developments in shadow banking were "inherently dangerous". Moreover and more generally, financial innovation has brought benefits, but he concludes: "there are fundamental reasons why innovation and finance tends to be less likely to produce beneficial social impact and more likely to produce rent extraction, than innovation in other sectors."

Source document: The Turner speech is a 54-page pdf file.

ESMA provides technical advice on short selling

We all know what short selling is, right? It's when you sell something you don't own. Except the practice is something rather different, involves repurchase agreements, implicit interest charges, delayed settlement dates and a lot of technicalities of market trading. The European Securities and Markets Authority has produced its final report, providing technical advice about short selling to support a new Regulation of the European Union on short selling. A Regulation, in the language of the EU, is a law binding in all member states and not subject to local interpretation. ESMA tries to define what is and is not a short sale, looking separately at practices in a variety of instruments: shares, sovereign debt, credit default swaps.

The concept of ownership in the Member States concerning securities is not harmonized," it said. "This issue may be considered by the Commission in its future proposal on the Securities Law Directive. This Delegated Act should not anticipate that proposal. For the meantime, it seems appropriate to define legal and beneficial ownership according to the respective civil law or securities law applicable for the relevant sale."

Source document: The ESMA final report is a 92-page pdf file.

Group of 30 looks to behaviour more than regulation in governance of finance

The governance of banks and other financial institutions pretty clearly contributed to the economic distress we continue to endure, four years after the main events. Much reflection and some action has followed it. While knowing the something needs to be done is easy, knowing what to do is harder.

That sentiment is in evidence in a reflection published by a loose group of financiers, academics and financial regulators. They call themselves the Group of 30, and they've been around, in a shifting constellation of actors, for more than 30 years. Policy takes the forefront, with Jacob Frenkel, a retired governor of the Israeli central bank, acting as chairman of its board of trustees of the non-profit group. Jean-Claude Trichet, the retired governor of the European Central Bank and the Banque de France, is chairman of the G30 itself. The group commissioned research into the corporate governance of banks and concluded that, well, good governance is more easily said than done. Let's listen into its thinking:

Nature of governance: Good corporate governance requires checks and balances on the power and rights accorded to shareholders, stakeholders, and society overall. Without checks, we see the behaviors that lead to disaster. But governance is not a fixed set of guidelines and procedures; rather, it is an ongoing process by which the choices and decisions of FIs [financial institutions] are scrutinized, management and oversight are strengthened and streamlined, appropriate cultures are established and reinforced, and FI leaders are supported and assessed.

Bank boards: Boards control the three key factors that ultimately determine the success of an FI: the choice of business model (strategy), the risk profile, and the choice of CEO – and by extension the quality of the top-management team. Boards that permit their time and attention to be diverted disproportionately into compliance and advisory activities at the expense of strategy, risk, and talent issues are making a critical mistake.

To those convinced that more regulation is required, this report will disappoint in its lack of a clear game-plan of action. To those willing to be persuaded, the report urges thoughtfulness on the part of the governing and governed. To those who don't consider it at all, the prominence of the backers suggests the report may still end up as part of the discourse in which they operate.

Source document: The Group of 30 report, "Toward effective governance of financial institutions," is a 96-page pdf file.

EU eyes regulating proxy advisory industry

Calls for greater stewardship by institutional investors are almost certain to lead to demand for wider use of corporate governance ratings and advisory services. The field of proxy voting agencies has had its share of controversy over the years. While their presence in the marketplace has certainly caused many corporations to pay attention to codes and best practice, there's a downside as well. What we hear frequently – from corporate directors, in the main – are complaints that the scrutiny of these agencies is driven by a tick-box mentality and that the voting decisions they lead to bear little resemblance to the conversations that take place between senior management and the fund managers who buy and sell the shares. Into this controversy steps the European Union.

The European Securities and Markets Authority has published a discussion paper which seeks to provide an overview of the industry, its role in the market and the possible policy options available to regulators. It looks in particular at:

• Internal issues: Factors influencing the accuracy, independence and reliability of the proxy advice such as such as the potential for conflicts of interest to play a role, proxy advisors’ methodology and their dialogue with issuers; and
• Transparency and disclosure: Degree of transparency on management of conflicts of interest, dialogue with issuers, the voting policies and guidelines, the voting recommendations, and the procedures for elaborating a voting recommendation report.

The paper makes clear the policy options are open, ranging from taking no action, to letting member states deal with, adopting quasi-regulation or even binding legislative action. The consultations closed in June and a feedback report will come sometime before the end of the year.

Source document: The ESMA discussion paper is a 40-page pdf file.

What constitutes materiality?

One of the problems faced by any public company is knowing when it has to make public significant news. In the US, the law gives management a fair amount of latitude, in large part because quarterly reporting means it's never too long before companies are obliged to tell the world what has happened in the last three months. In most of the rest of the world, however, a different standard apply. In the European Union it's knows as ad hoc disclosure, and it kicks in as soon as practical after a "material" development. The difficulty comes in recognising when a development is indeed material. Last year, the European Securities and Markets Authority set a consultation about it, and then extended its duration to gather as many views as possible. The views are now in and published for all to see. Among them:

• Mazars: The Paris-based international accountancy firm argues that a principles- rather than rules-based approach is appropriate because the circumstances of each company are different. An example arises in its response to question 10, concerning whether failing to include a note to the accounts constitutes a misstatement. Mazars argues no, because materiality is a matter of judgement. Automatic qualification of results by the auditors would lead to a checklist mentality among issuers.
• SIX Regulation: Concerning the view of materiality in interim reports, the regulatory arm of the Swiss stock exchange argues that half-yearly reports are more often based on estimates than are the final set of accounts. Nonetheless, the principles of materiality are the same.
• SAP: The German listed company, whose software envelopes the accounting systems of many large corporations, said that practice suggests that companies apply rather different standards of materiality in reporting their affairs. "While one might argue that this diversity in practice indicates that the concept of materiality is not clearly and consistently understood," it wrote, "we believe that the different application of the concepts is due to the management judgment necessarily involved in the evaluation of the question when a misstatement or omission could be material enough to influence the economic decisions of users of financial statements."
• CRUF: The Corporate Reporting Users' Forum, an umbrella body of analysts in fund management, didn't think ESMA needed to get involved. It welcomed the opportunity to debate, of course, but it felt the accountancy boards, like the International Accounting Standards Board and the auditors' equivalent were a better venue for conducting it.

What happens next will be a considered response from ESMA, which could mean no action, some, or much.

Source document: The list of responses has links to the individual documents submitted.

ESMA updates guidance in transparency directive

The European Securities and Markets Authority has published a new version of its questions and answers concerning the 2004 Transparency Directive. New in this edition are two points:

• Where's "home": Determination of the home member state for third country issuers in case of delisting and admission to trading in another member state – the home state of the issuer remains the jurisdiction even if the issuer delists at home and lists in another member state.
• Agents and rights: Designation of an agent for the exercise of financial rights – issuers have to provide a service for home-country securities holders to exercise their financial rights even if the company is listed abroad. But the agent providing such a service needn't be resident in the home country.

In all, the document deals with 18 questions.

Source document: The ESMA update is a 13-page pdf file.

Risk governance moves up the FSB agenda

The Financial Stability Board, tasked with coming up with means of preventing future financial failures in the Group of 20 nations, has issued a call for ideas that put the governance of risk higher up the list of priorities at financial institutions. "The global financial crisis highlighted a number of corporate governance failures and weaknesses in financial institutions, including inappropriate Board structures and processes, weak risk governance systems, and unduly complex or opaque firm organisational structures and activities," it said. It is conducting a thematic review of risk governance, using its "peer review" process, in which experts from one (or several) states examine the practices underway in others. The review will look specifically at board responsibilities and practices, how the risk management function works, and the role of audit and assurance in risk governance. It's a short consultation. Responses, please, by May 12.

Source document: The FSB statement is a 26-page pdf file.

SEC targets Ponzi schemers preying on the prayerful

Sometimes having faith isn't enough. A vengeful and less distant authority helps. The US Securities and Exchange Commission has been active in the two-and-a-bit years since the Madoff scandal broke and reacquainted us all with the term Ponzi scheme. The SEC was caught asleep at the wheel when the $65 billion fraud was building. But having been stung by the criticism of its failures, the SEC has been working with a vengeance at hooking the small fish that swim in similar waters.

Madoff targeted many investors, among them Jewish individuals and charities supporting Jewish causes. In its latest sweep, the SEC closed down two other Ponzi schemes that preyed on other faith-groups. It sought an emergency court order to close down a scheme in which, it alleges, that for the past two years, a fraudster raised more than $7.5 million from investors by claiming to be a hedge fund manager. His aim was to extract funds from Persian-Jewish families in California. In a separate action, the SEC charged a self-described "social capitalist" with bilking socially-conscious investors in Christian church congregations across the country, raising about $11 million.

Such actions, and the resulting disgorgements, may not make up for the billions lost through the SEC's Madoff mistakes. But they may go some way to reviving faith in Washington.

Source document: The SEC's actions are detailed in a news release for one and then the other.

Goldman charged with not policing the 'huddles'

The US Securities and Exchange Commission wants investment banks to take action to prevent sensitive information from flowing where it shouldn't be. To make the point it has attacked Goldman Sachs – the firm most resembling American football's legendary Green Bay Packers – and its use of a pre-game huddle to share ideas around the trading floor. "Goldman, Sachs & Co. lacked adequate policies and procedures to address the risk that during weekly 'huddles,' the firm's analysts could share material, nonpublic information about upcoming research changes," it said. "Huddles were a practice where Goldman's stock research analysts met to provide their best trading ideas to firm traders and later passed them on to a select group of top clients." The investment bank agreed to pay a fine of $22 million and alter its practices. It also reached a settlement with FINRA, the industry regulatory body, for other issues with the way it conducts the huddles.

Goldman and its senior managers have been on something of a losing streak recently, not unlike the Green Bay Packers. But it's too early to count them out of the contest.

Source document: The SEC news release gives further details.

A new model of ownership?

Is the short-term focus of business a result of a "default model" of ownership? That's the conclusion of a report of an independent commission looking into how different approaches to ownership might alter the economic landscape in Britain. The Ownership Commission, a panel of business people and pundits set up in 2010 in the final months of the Labour government's long term in office, has reported on its findings. While it said that the limit liability model of listed companies with widely dispersed shareholders, known as PLCs, has virtues, it has come to be seen as the "default corporate organisational form". Investors, financiers, regulators and even government treat it as the normal way, "to an extent that reduces opportunities for other ownership forms to grow and prosper. Plurality of ownership forms should be viewed as an economic good in its own right," it added. The short-term focus was making it difficult for companies to operate with a long-term business model. "The ease with which British PLCs are open to hostile and foreign takeover is a further concern," it said. The focus given to this form hides the fact that other types of ownership are present and functioning in the economy: private equity, partnerships, families, state-owned businesses, sovereign wealth, employee ownership, and mutuals. The commission, therefore, urges markets and regulators to think more widely about three points:

• Plurality: Recognise the diverse range of ownership available, which gives investors and savers more avenues consumers more choice.
• Stewardship: It is a somewhat woolly term, one that relates to the need for a long-term perspective about the purpose of the business. "Shareholders, trustees, investment management companies and directors should have the definition of their fiduciary obligations widened to include better stewardship, and for this to be better enforced by closer links between the ultimate owners and managers," it said.
• Engagement: Management needs to interact with employees, shareholders and other business stakeholders to increase performance and accountability.

Whether there's any steam behind this report is a little difficult to judge. It was a creation of a different government, after all. But its recommendations are broadly in the direction of travel of other bits of private as well as public policy-making. The 2010 Stewardship Code endorsed by some major investors has changed the vocabulary of investment in similar ways. The commission wants institutional investors to be "required to sign, comply with and implement the Stewardship Code". But the practice of investment is different from the discourse that surrounds it. Much depends upon who is doing the talking.

Source document: The Ownership Commission report "Plurality, Stewardship and Engagement" is a 110-page pdf file. http://www.ownershipcomm.org/files/ownership_commission_2012.pdf