Brussels pushes for shake-up of audit

The European Commission is pressing ahead with rather radical plans to transform the market for audit services in the European Union. In one possible scenario the draft regulation might see a reconfiguration of the networks of the Big Four accountancy firms and a split between audit and non-audit services. The key elements of the planned regulation are:

• Mandatory rotation of auditors: With some exceptions, organizations would need to change auditors every six years, and there would be a "cooling off" period of four years before an auditor could return to work for the client.
  
• Mandatory tendering: Audits of public-interest entities would be made by an open tendering process, in which the organisation's audit committee would play a central role.
  
• Ban on non-audit work: Audit firms would be barred from providing non-audit services to audit clients. Large firms would need to legally separate audit and non-audit activities to reduce conflicts of interest.
  
• EU supervision: Regulation of the audit industry would be overseen by the European Securities and Markets Authority.
  
• EU passport: Auditors in one member state could offer audit services in others under a "passport" system. This would make it easier for smaller audit businesses to compete with the big networks.

Internal market commissioner Michel Barnier said: "Investor confidence in audit has been shaken by the crisis and I believe changes in this sector are necessary: we need to restore confidence in the financial statements of companies. Today's proposals address the current weaknesses in the EU audit market, by eliminating conflicts of interest, ensuring independence and robust supervision and by facilitating more diversity in what is an overly concentrated market, especially at the top-end."

The commission's proposal is for what the special language of Brussels calls a "regulation". That means that whatever measure is finally adopted by the European Parliament and the European Council of national governments would become mandatory across all 27 member states, without scope for national variations in approach.

Source documents: The draft regulation is an 87-page pdf file. The version we saw was a late draft, due to be replaced by a final version with the correct date. The audit website has links to other documentation.

UK chairmen slow to use reports to inform governance – Grant Thornton

Chairmen of the larger UK companies have missed the opportunity to steer corporate governance through their reporting to shareholders. A study by the accountancy firm Grant Thornton suggests that only one in 10 of the chairmen of the top 350 companies shed any genuine light on their companies' governance in the annual report. The new UK Corporate Governance Code, adopted in May 2010, called upon chairmen to "report personally" on corporate governance, rather than delegating the practice to, say, the company secretary. Moreover, the Financial Reporting Council March 2011 guidance on board effectiveness emphasised a need for the chairman's guidance and direction for the board. Grant Thornton said: "As old challenges are addressed, new ones emerge," and then listed several:

• Gender bias: Seventy two per cent of companies do not discuss gender, with only 6 per cent measuring and describing their progress against gender quotas and 140 companies still having all-male boards
  
• Audit tenure: The average tenure of a FTSE 350 audit appointment is 34 years, with 248 companies making no mention of when they last tendered their external audit
  
• Internal control: Only 25 per cent of companies give real insight into how they review the effectiveness of their internal control systems
  
• Board evaluation: External board evaluations may have been embraced by nearly all companies, but only 24 per cent share the outputs of such evaluation

The report notes that the European Union is examining whether voluntary codes are really the best way to conduct corporate governance. "Our review suggests that the Code's 'comply or explain' approach has achieved significant success over the last ten years," it said. "But, as stakeholders and regulators call for more informed reporting, the bar will continue to rise. So, as guidance and practice evolve, companies and the audit committees must recalibrate their expectations."

Source document: The Grant Thornton review is a 33-page pdf file.

Moody's wary of Europe, affirms US rating

Moody's Investor Services has signalled its worry that the creditworthiness of the eurozone and even European countries outside the 17-country bloc is threatened by issues with sovereign debt in the area. "In the absence of policy measures that stabilise market conditions over the short term, or those conditions stabilising for any other reason, credit risk will continue to rise," it said. Some countries may lose access to funding in light of the lack of political impetus to find a solution, threatening to move those countries' ratings into speculative grade. Moody's said the likelihood of "even more negative scenarios" had risen in recent weeks. Moody's said: "the situation is fluid and fast-moving. Policymakers are likely to respond to the escalating risks with new measures, the credit implications of which will require careful consideration. In the meantime, new shocks to financing conditions -- whether the announcement of new programmes or simply a further acceleration in the rise of funding cost across the euro area -- are likely to lead to selective rating changes."

By contrast, the failure of a so-called "supercommittee" of legislators in the US to reach a political agreement on budget deficit reduction will not affect the country's Triple-A rating, the agency said. That's because the lack of agreement triggers an automatic cut of the same amount. It added, however: "the committee outcome indicates that significant deficit reduction measures are unlikely to be adopted before the November 2012 elections". Moody's currently has a negative outlook on the US rating given the need over time for further deficit reduction to reverse the country's upward debt trajectory.

Source documents: The eurozone warning followed hard upon the US affirmation.

After Olympus, Japanese government rethinks company law

The Japanese government is planning to revamp company law in response to the ongoing controversy of mysterious payments made by Olympus Corp., exposing by the abrupt firing of its newly appointed, non-Japanese CEO last month. The ruling Democratic Party of Japan is holding one inquiry, and the Legislative Council, which advises the justice minister, is conducting a second review, according the Yomiuri Shimbun, a major Japanese newspaper. Current company law provides two options: a board of directors with a separate board of internal auditors, or a US- or UK-style board with an audit committee, as well as other committees where outside members dominate discussions of remuneration and nomination. Despite the greater transparency and accountability of the second type, only 63 of the country's 4,000-odd listed companies use it. Moreover, Yomiuri reports that only about half the listed companies have any outside directors on their boards.

Last month, the Japan Association of Corporate Directors released a corporate governance survey showing that only 61 per cent of the outside directors on Japanese listed companies were independent of management, and only 35 per cent of the 577 companies listed in the first-tier of the Tokyo Stock Exchange had appointed any. Among larger listed companies, those in the Nikkei 100, more than two in five lacked any independent directors.

Source documents: The Yomiuri news story gives an overview. The JACD report is a seven-page pdf file.

Guarded responses to EU corporate governance consultation

Some clear views emerged from responses to the European Union's green paper on corporate governance earlier this year, though it's far from clear whether the ideas it tossed into the debate will see the light of legislation. The consultation attracted more than 400 responses, a large number for a specialist subject, and for a green paper, which by definition is still quite a long way from generating legislation. In its summary document, the European Commission avoided strong policy guidance – that may come later – but it did give its view about what the respondents had to say.

• Tiered recommendations: A majority of respondents – of those, that is, who expressed a clear view – rejected the idea that member states should develop different governance recommendations for large and smaller companies. "Opposition to the idea was particularly strong from business (companies and business federations) and investors (both institutional and retail) alike," it noted. The summary of arguments against is so powerful that you have to wonder who supported the idea.
  
• Codes for unlisted companies: Here the views split, and in a way that would seem to make it difficult to create a policy. Some 70 per cent of respondent took a clear stance, and of those 70 per cent didn't like the idea that the EU should get involved. The other 30 per cent, however, were pretty uniformly representatives of employees, retail investors and civil society groups, pitting the big and powerful against the small and defenceless.
  
• Split chair and CEO: Three quarters of the respondents were clear on the matter, but that's as far as clarity goes. Half those with clear views wanted a split, the other half didn't. Employees, institutional and retail investors, civil society groups, the insurance sector, proxy agents and accountants were generally in favour; companies were generally opposed.
  
• Diversity and skills: What should EU policy say about recruiting the right skills to the board, and the right mix? Here the responses were muddy. Some of those who liked the idea of a strong policy didn't want the EU to get involved in enacting it. National standards would be more appropriate. Others wanted the EU involved, but only with "soft law". Others saw no need. If this were any provision other than the one involving the gender mix on boards, you would expect to see no action at all. This question wasn't quite the same as two others:
  
• Diversity policy: Most respondents thought it would be okay to tell companies to publish a policy statement, on the basis that transparency would give investors the information to act as they saw fit.
  
• Gender balance: Should listed companies have to have a certain proportion of women on the board? The majority rejected a compulsory quota system, like the one that operates in Norway, but some thought a policy that urged companies to adopt a target was fine.

And more. Limiting the number of directorships an individual could hold didn't win very much favour. The idea of getting an outsider to conduct a board evaluation every three years split the respondent pretty much down the middle.

Source document: There are more questions and answers in the feedback statement, an 18-page pdf file.

EU pushes for country-based financial reporting

The European Commission is seeking changes to the Transparency Directive of 2004 and two accounting directives to require listed companies and large private ones to reporting their financial results on a country-by-country basis, and not just on a global level. It also plans to widen the range of reporting required when an investor builds a stake in a business, to include all instruments with a link to equity, rather than just the shares themselves.

• Country-based reporting: The move is quite a controversial one, and not just because of the increased cost associated with it. Country-based reporting could yield a trove of commercially sensitive information for competitors, and especially those based outside the EU, who would not have to make such disclosures themselves. Moreover, such reporting could expose the value of individual customer transactions or trading volumes, if a reporting company has only one or two clients in a particular jurisdiction. More importantly from an investor's viewpoint, country-based reporting may have little to do with the shape of the business model for some companies. But, as the commission points out, investors are not the prime beneficiary. Rather, this move is intended to give outsiders a view. The commission puts it this way: "Reporting taxes, royalties and bonuses that a multinational pays to a host government will show a company's financial impact in host countries."
  
• Stake-building: The reason for this proposal is to reduce scope for market abuse, and it follows cases of covert stake-building in a variety of companies through the use of derivative instruments, including contracts for difference. Of particular note was the market distortion surrounding the failed attempt by Porsche to build a stake in Volkswagen, and the resulting attempt by Volkswagen to secure control over Porsche. It wants trading in all instruments to be reported, once they achieve a certain threshold.

At the same time, the changes to the directive would end a requirement for small and medium-sized companies to report on a quarterly basis.

Source document: The proposal is a 25-page pdf file.

EU wants curbs – but not stops – on sovereign ratings

When the shot came, it fell short of its threatened power of penetration. The European Commission is laid out paid to regulate the credit rating industry in quite fundamental ways, but not quite so fundamentally as the commission itself had trailed in the weeks before the announcement. Credit rating agencies already have to register to do business in the European Union. If the commission's plans go ahead, they will need to do a lot more than that. The commission's plan seeks to achieve four main goals:

• Reduce investor demand: Institutional investors use credit ratings in lieu of making their own analysis. So the commission wants to eliminate many references to ratings in the Capital Requirements Directive and then require financial institution "to do their own due diligence".
  
• More transparency and frequency: Ratings of sovereign debt will need to be issued at least every six months, not once a year, as it is at present. Moreover, agencies will need to inform investors and governments of the reasons for the ratings. Ratings should only be published after close of business to avoid disrupting the market.
  
• Reduce conflicts of interest: The commission wants greater diversity of ratings and greater independence. So it proposes that borrowers rotate their ratings agencies every three years. Two ratings would be required for more complex structured products, and a big shareholder of a credit rating agency should not simultaneously be a big shareholder in another credit rating agency.
  
• Greater accountability: Ratings agencies should liable for infringements of the planned "regulation", if they did so intentionally or with gross negligence, and thus harm the investor who relied on the rating. Investors "should bring their civil liability claims before national courts", it said. "The burden of proof would rest on the credit rating agency."

The plan involves both a "directive" and a "regulation". In the parlance of the European Union, a directive is only outline legislation, which member states then "transpose", giving the law its final form. A regulation is fixed; member states have to enact it as is. The directive here concerns how investors use ratings. The regulation affects the agencies themselves.

Internal Market Commissioner Michel Barnier said: "Ratings have a direct impact on the markets and the wider economy and thus on the prosperity of European citizens. They are not just simple opinions." Indeed, they are not simple at all. "We can't let ratings increase market volatility further. My first objective is to reduce the over-reliance on ratings, while at the same time improving the quality of the rating process," he added. "Credit rating agencies should follow stricter rules, be more transparent about their ratings and be held accountable for their mistakes. I also want to see increased competition in this sector."

Barnier said, correctly, that rating agencies have made serious mistakes, too. But others of his concerns seem less clear-cut. He worried, for example, about the timing of announcements of rating changes. Why did the agencies make rating changes during the negotiations about an international aid programme for a country? Why? Because the risk profile of the borrower that changed materially, which might materially impair investors' assets.

Source document: The project website has links to the news release and related documentation.

Shaking the habit of ratings – or debt?

When addicts try to come off drugs, they often suffer symptoms of the withdrawal. They sweat more profusely and more easily. They grow paranoid, thinking everyone is out to get them. They get angry and lash out, sometimes inappropriately. The crisis in European sovereign debt feels a little like that sometimes. Now we read these words:
Ratings currently have a quasi-institutional role. We need to reduce our reliance on them.

They come from the European Commission's news release concerning plans for what the European Union calls a directive and a regulation on credit ratings. While the commission backed off its threat to demand that rating agencies withhold comments on sovereign borrowers that undertake financial restructuring, its plans are still at best something to address the symptoms without addressing the cause. Cold turkey it isn't.

Ratings do have a "quasi-institutional role", but that's because they are designed to give confidence in and achieve legitimacy for the borrowers and their ability to pay back their loans. Suspending credit ratings in a time of distress would make little sense as the suspension would be just a downgrade in disguise. One way or the other, credit ratings would still be a part of the institutional framework in which public borrowers operate. Reducing reliance on them could mean things like ensuring that legislation and regulation avoids measures that embed credit ratings in their fabric. But it's not really the borrower or the legislation that "relies" on ratings. The investors rely on them as a check on the system, as a mechanism to ensure the borrowers don't lie. Borrowers "rely" on credit ratings the way a drug addict "relies" on needles. Borrowers "need" money the way a drug addict "needs" a fix.

The solution to the sovereign debt issue in Europe is likely to involve a slow and painful adjustment to the withdrawal of money. Only when that happens will the reliance of credit ratings disappear. If the credit ratings themselves disappeared while the need was still present, borrowers would still be in a fix.

Source document: The news release outlines the commission's planned move.

Consob commissioner sees virtue in governance dualism

Luca Enriques is both a scholar and a practitioner. His seat at the University of Bologna has been empty much of the last several years that he has spent on the Italian securities commission Consob. He brings, therefore, a dual perspective to issues in corporate governance and financial regulation, and he thinks the dual tracks may be the right way forward. He told a meeting of the European Union's Corporate Governance Forum in Warsaw to cut through the red tape company law needs to head in two different directions, which some people may find contradictory.

• Protection against expropriation …: Investors in European companies need better protection from managers and dominant shareholders, who can extract economic rents at the cost of "minority" shareholders. Europe needs to extend rules on insider trading to require notification of trades by controlling shareholders as well as managers.
  
• … but with limited application: Controlling shareholders are a big and powerful force, and they would seek to block such legislation, enlisting other vested interests in their support. So Enriques suggests the new rules apply only to companies newly coming to the stock market. "A new regime, lighter in terms of strings attached to ordinary course of business, non-conflicted decisions, and specifically and effectively addressing expropriation by managers and dominant shareholders, could be one way ahead," he said.

To get around the stigma of a company listing under a lighter weight regulatory regime, he suggests that such newly listed companies would, by default, still meet the tighter rules, but could choose to opt out of them in exchange for greater minority protection.

Source document: The remarks of Enriques can be read in full in a five-page pdf file.

SEC chairman sees more rules, soon, on governance and pay

Mary Schapiro thinks that investors are pretty happy with the say-on-pay rules in the US, used for the first time in the proxy season this year. The chairman of the Securities and Exchange Commission said she hoped it would lead boards to start asking themselves some penetrating questions. But say-on-pay is only the most high-profile of the measure that the SEC has had to deal with in response to the Dodd-Frank Act, and there's more to come, soon.

• Proxy voting services: The SEC staff are looking into possible rules to governance the governance agencies and their perceived conflicts of interest, where concern has grown with the introduction of say-on-pay. "I can’t guarantee our timing in light of all that we have on our plate," Schapiro told an industry workshop. "I hope we can address concerns over their role, including disclosure of conflicts of interest and the information upon which they base recommendations, by the end of the year or early in 2012."
• Four other measures: The Dodd-Frank Act requires the SEC to make rules in four further areas relating to governance and compensation matters: pay ratio, pay-for-performance, claw-backs, and employee hedging of company stock. Schapiro said she recognised that the requirements may be costly to implement. "As we move forward, however, please keep in mind that the statutory framework for these rulemakings is, in some cases, quite prescriptive," she added. "As with all other aspects of Dodd-Frank implementation, we have made outreach to stakeholders a linchpin of our rulemaking efforts. I encourage you to reach out to us as we work to complete our Dodd-Frank requirements and to address other issues of concern." Subtext: "not my fault."

While the act doesn't set a deadline for SEC rulemakings, the SEC itself has. It hopes to propose them by the end of this year or early in 2012.

Source document: The Schapiro speech gives further details of her views on the virtues of say-on-pay.

Study shows political spending, board oversight on the rise in US

This is one of those stories journalists like to call "dog bites man" – that is, it's no surprise. Such stories are rarely worth reporting. But this one is. Two think-tanks – the Investor Responsibility Research Center and the Sustainable Investment Institute – have been looking into how much money has been flowing from US corporations into the political system, and who's responsible for it. They found that the boards of 31 per cent of S&P 500 companies now explicitly oversee such spending, compared to 23 per cent in 2010. This increased oversight and transparency does not, however, translate into less spending. Companies with board oversight of political expenditures spent about 30 per cent more in 2010 than those without such explicit policies.

It's been almost two years now since the US Supreme Court ruled that companies could make unlimited campaign contributions and other donations to political parties. That made political giving an issue for board scrutiny because of its potential dimension and the resulting materiality of the cost. It also made such gifts a tool for corporate strategy.

Source document: The IRRC-Si2 report "Corporate Governance of Political Expenditures: 2011 Benchmark Report on S&P 500 Companies" is a 92-page pdf file.

Shareholders value female directors – look at the share price

Around the world, the movement to get more women on boards of directors in gaining momentum. The move comes in part of the dissatisfaction that all the things we've tried in corporate governance haven't seem to have provided any benefit. If the "problem of corporate governance" is rampant executive pay, without demonstrable downside risk for the executive and without demonstrable upside benefit for shareholders, then clearly not much has happened. The "agenda problem" of the literature is still in full force. If the "problem" is risk management, in which corporate governance is an insurance policy, then the insurer has gone bust. Again. So all the mechanisms of incentive alignment, board independence, structure, procedures and disciplines haven't done the trick. Perhaps it's time to try something else.

According to a study by three Asian-based scholars, there is some evidence that putting women on boards helps the share price. Their working paper uses data on mandatory announcements of new director appointments, and the analysis shows that on average, "shareholders value additions of female directors more than they value additions of male directors". Moreover, companies with workplace practices that promote workplace equality seem to benefit the most from boardroom gender diversity. "This suggests that appointing female directors may help resolve value-decreasing stakeholder conflicts," they conclude.

This isn't just another study. The leader of the research, Renée Adams at the University of Queensland, was author of a related study a couple of years ago that showed rather mixed messages coming for woman on boards. Simplifying a subtle argument a bit too much, they found gender-diverse boards were better at monitoring but less good at strategising.

Source document: The working paper "Does Gender Matter in the Boardroom? Evidence from the Market Reaction to Mandatory New Director Announcements," by Renée Adams and Stephen Gray of the University of Queensland and John Nowland of City University in Hong Kong, is a 55-page pdf file.

What good are independent directors?

Some good, and possibly quite a lot. A study of German companies, focused on the role that outside directors play on supervisory boards, threw up evidence that for innovation, the right outsiders can bring a lot of benefit. Three academics examined the patent applications of innovative companies to see if there was a link to the configuration of the boards. Supervisory boards can be quite distant from the business. They have no representation of senior management. Moreover, the German variety must also have half the seats in the hands of members of the ordinary workforce. So logically, you might think, such boards would serve a narrow, compliance function. That's not the place to expect to see new ideas getting knocked around, leading to the occasional stunning breakthrough. But this study shows a rather different story. Based on panel data of the largest German companies the econometric analysis they found a "robust and significant positive influence of external executives on innovative firm performance", as measured by patent applications. When the outside directors came from innovative companies patenting activities were higher. When people from non-innovative companies dominate, the opposite occurs. "The results indicate that outside board memberships can serve as a channel for scarce specific knowledge and expertise," they conclude. It's a conclusion a lot of directors would like to believe, too.

Source document: The research paper "Outside Directors on the Board and Innovative Firm Performance," by Benjamin Balsmeier , Achim Buchwald and Joel Stiebale of Nottingham University Business School, is a 50-page pdf file.