Corporate Governance

• Global corporate governance debate redefined
• EU inquires into the professions
• Limited liability for auditors
• E-mail banking scam
• The £50bn black hole

Global corporate governance debate redefined

Improving links between directors and shareholders has emerged around the globe as one of the key concepts in raising corporate governance standards.

Proposals brought forward by the Securities and Exchange Commission in the US are intended to make directors more accountable to their shareholders. Would Kenneth Lay at Enron or Bernie Ebbers at WorldCom have been able to dominate their boards and companies in the way they did if shareholders had been permitted a louder voice? The SEC, apparently, believes that they might not. Consequently, new rules proposed by the SEC would allow shareholders to replace some directors each year by popular vote.

The latest SEC move should not be seen in isolation, but as part of a process in which independent directors with strong connections to shareholders play an essential role in the raising of corporate standards. Both the New York Stock Exchange and NASDAQ have had new regulations approved by the SEC which tighten definitions of independent directors.

But despite an apparent consistency of regulators in their belief in improved corporate governance and enhanced accountability, significant differences have emerged in the focus of reforms and what these mean within boardrooms.

A new report published by communications consultancy, Hill & Knowlton, examining corporate governance reforms, reveals startling differences in the way they are perceived in different continents. While North American chief executives expected the new regulatory environment to lead to a much stronger examination of their roles, their counterparts in Europe, in particular, and in Asia, saw the long term reform focus being the separation of chief executive and chairman positions.

�The survey brought out the very different angles which the US and Europe took on key corporate governance issues,� said Andy Pharoah, head of corporate affairs at Hill & Knowlton. �In the US there is still the view that reputation and responsibility for reputation lies wholly on the shoulders of the chief executive. In Europe it is much more about collective leadership. A lot less in the US see the separation of chief executive and chairman as a good idea. They are more supportive in the US of new corporate governance standards leading to improved behaviour. Europe is more pessimistic than Asia or North America.�

To an extent, the view in Europe seems to be that it is more difficult to improve because it has not gone so far off track. �Europe feels more confident in the standards it has had,� suggested Pharoah. He argued that the survey indicated how relationships between companies and their accountants and auditors could significantly change in the future.

Auditors and advisers will be expected to be more forthright, taking greater responsibility for warning clients of dangers. �Going forward, one of the most important things will be the communication of risk,� said Pharoah. Companies, in turn, will have to learn how to tell shareholders and the wider public what business risks they face. Investors and analysts, meanwhile, need to be educated to take a mature approach to risk, avoiding knee-jerk reactions.

The Hill & Knowlton survey challenges assumptions that improved corporate governance will necessarily lead to improved ethical behaviour by companies. It found that a mere 19% of respondents believed that ethical standards would rise, even though three-quarters of chief executives expected the stronger corporate governance structures to be permanent. The top three corporate governance priorities identified by the chief executives were improving internal controls, reviewing relationships with auditors and accountants and revising codes of conduct.

There were some notable differences in perception according to location. European chief executives were much more likely than their North American counterparts to see corporate social responsibility (CSR) issues as significant to their business reputation. But across the whole sample, unethical corporate behaviour was seen alongside product and service problems as the biggest reputational threat facing businesses.

The impact of the new corporate governance environment is now being felt strongly in British boardrooms. A study from Deloitte reported a sharp fall in the number of executive directors on boards, in readiness for the implementation of the UK�s new Combined Code which took effect at the beginning of November. The code requires at least half of boards to be non-executives. According to the Deloitte survey, almost a third of FTSE 350 companies remain short of non-executives to comply with the code. In addition, says Deloitte, many companies are breaching independence definitions in their use of non-executives.

A new climate of shareholder strength in the UK was most dramatically illustrated in the ditching of Michael Green, who had been earmarked as the chairman of the new ITV Plc - a merger of broadcast companies Carlton and Granada.  Institutional shareholders led by Fidelity effectively blocked Green�s appointment by resolutely arguing against it. The move was the culmination of two years in which - with government backing - fund managers have been increasingly involved in Plcs� corporate governance.

Yet there remain some large Plcs which defy the Higgs� guidance on corporate governance best practice, especially in the suggestion that chief executives should not move on to become chairmen. Both Sir Peter Davis at Sainsbury�s and Matt Barrett at Barclays will become their companies� chairmen once they complete their terms as chief executive.

In other parts of the world, the adopted or proposed strengthening of corporate governance regulations have been criticised as over-prescriptive. This is the view in the US by some of the SEC�s measures. There is similar unhappiness in Australia about its corporate governance reforms.

Australia�s proposals - CLERP 9 - have been criticised as too rigid by both the Australian Stock Exchange and ACCA. The volume of new rules and regulations could swamp Australian businesses, especially with the threat of instant fines of up to A$1m for breaches of disclosure laws, warned ACCA. It predicted the reforms could lead to more investment moving to competitor nations elsewhere in the Asia Pacific region.

Richard Francis, head of ACCA Australia, said: �Although appearing to ensure good corporate governance, if adopted, the on the spot fine proposal could lead to companies spending considerable time and resources ensuring that they meet the letter of the new law rather than on ensuring profitability. This may lead to more emphasis on compliance and less emphasis on competing for international markets. It may be better for CLERP 9 to be slimmed down before it becomes law, to enable it to be focused on proposals which will make a difference without imposing a bureaucratic nightmare on companies.�

The issue of independent non-executives is particularly controversial in parts of Asia, where there is a strong tradition of board family membership. But the Hong Kong Stock Exchange has introduced new rules requiring at least three independent directors on boards, increased from the previous minimum of two, while the Hong Kong SAR administration has proposed strengthening the regulation of corporate governance and audit. Suggestions include the creation of an independent oversight board to regulate auditors, a mechanism to investigate allegations of auditor fraud and a financial reporting review team to examine listed companies� results.

There is broad support for the proposals, but disagreement on how they should be funded with the Hong Kong Government reluctant to pay for them. Sonia Khao, head of technical affairs, ACCA Hong Kong, argued that a system similar to that adopted in the UK could be used, with accountants� professional bodies, the government and companies jointly meeting the costs. She added that, in the light of Hong Kong�s own corporate scandals, it was essential that stronger corporate governance codes be adopted.

Yet, a recent survey of senior executives of Hong Kong listed companies conducted by insurance brokers and risk management advisers, Jardine Lloyd Thompson, concluded that corporate governance standards in Hong Kong remain among the best in Asia. It did, though, also find that 91% of respondents believe that publicly listed companies in Hong Kong could be doing more to raise their corporate governance standards. It confirmed the view of the survey�s sponsors that directors should take out greater liability cover to protect themselves from legal actions citing weak corporate governance: many fewer directors in Hong Kong have liability insurance than do directors in the US or the UK.

The survey found that the vast majority of directors believed that there is substantial variation in the standards of corporate governance among Hong Kong companies. Causes include smaller companies not having a comprehensive system of checks and controls in place, a lack of understanding of the benefits of good corporate governance and the absence of a corporate governance benchmarking system in Hong Kong. While most respondents believe that Hong Kong ranks well in corporate governance standards compared with the rest of Asia, only a minority believe it matches those of the US or the UK.

Weaknesses quoted by directors were lack of transparency, inadequate checks and balances within companies, the need for stronger independent non-executive directors, the need for more independence from professionals and inadequate recording of contingent liabilities. Over two-thirds of respondents believe that Hong Kong�s new Securities and Future Ordinance will be effective in protecting the interests of investors and minority shareholders. Almost as many believe that the SFO will encourage public companies to strengthen their corporate governance and prevent market malpractices or manipulation. The vast majority think that liability risks for directors and officers in Hong Kong have increased.

Meanwhile, China has introduced its own new regulations aimed at stemming fears that the fast increase in IPOs is unsustainable and could lead to a sequence of damaging corporate failures. The China Securities Regulatory Commission is concerned that, in many cases, companies have declared a series of losses after becoming quoted companies. Accordingly, CSRC is limiting the size of an IPO to twice a company�s audited net assets at the previous year. From 2004, companies, other than state owned enterprises, will also have had to be trading as such for at least three years.

There remain, then, significant national differences in the detail of regulatory reform, in line with varying perceptions of what is wrong in particular countries. It could take many decades before governance regimes achieve harmonisation.

EU inquires into the professions

The European Commission is launching a major investigation into the operations of the accountancy, legal and other professions to determine if charges are fair and regulatory structures appropriate. The latest investigation builds on provisional work conducted on behalf of the Commission over the last two years.

In relation to accountants, the Commission will consider whether there is sufficient competition between firms and whether accountants� professional bodies adopt rigorous and independent disciplinary standards.

Philip Lowe, director-general of Competition for the Commission, said in a newspaper interview that the investigation would be led by his directorate with involvement from the Single Market Directorate, to promote greater competition in the professional services.

It is clear that one concern of the Commission is that the collapse of Andersen may have left too few accountancy firms to provide an effective competitive system. One possible result of the investigation, Lowe speculated, was that mergers of mid-tier firms below the current 2bn euros threshold could in future require Commission approval. However, the logic of this seems peculiar as it risks undermining attempts by mid-tier firms to gain the strength through amalgamation to challenge the Big Four practices.

Competition commissioner, Mario Monti, explained the context of the Commission�s approach to the accountancy and other professions earlier this year. He explained that one of the concerns was that information on what the professions did was �asymmetric� - that the professional knew what was being done and what it was worth, but the consumer was in a position of weakness to assess this.

Monti pointed out that while Spain, Denmark and the UK had reviewed professional self-regulation, some other member states had not.

Another priority, added Monti, was to increase cross-border trade in services, including professional services. While services represent 70% of EU GDP, they constitute a mere 20% of cross-border activities. If the Commission genuinely intends to influence cross-border trade in accountancy services this may imply a major change in the regulatory structure of the profession.

The background to the latest investigation was provided by an earlier report, published in March, on the regulation of professional services. This concluded that some member states - including Germany, France and Italy - had a higher intensity of regulation of accountants than others - such as the UK. The report suggested that accountants may, in some instances, earn �excess profits� because some member states� systems of regulation have the effect of limiting the number of practitioners, thereby enabling accountants to raise fees above what would otherwise be market levels.

The authors concluded that there was an inverse relationship between the degree of accountants� regulation and their productivity. But they also suggested that, while lower levels of regulation could enable professional firms to operate in larger business units without leading to high market concentration, the single exception was in accountancy. This reinforces the perception that the Commission is very worried by high market concentration in the accounting sector.

As accounting & business went to press, it was unclear how the latest Commission investigation will be structured. Crucially, it had not been announced whether all the professions would be examined by a single review team, or if the major professions would be evaluated simultaneously by separate expert groups. If all professions are treated together the risk is that there will not be sufficient attention to the differences that apply to each discipline.

Ross Midgley, ACCA�s policy director, points out that a recent OFT enquiry in the UK found little to criticise in the accountancy profession. �Admittedly, this took place before the demise of Andersen reduced the Big Five to the Big Four,� he comments. �But one would think that the best chance of enhanced competition in the transnational audit sector would come through encouraging mergers among the mid-tier firms, not restricting them.�

Peter Moizer, professor of accountancy at Leeds University, is sceptical that the Commission�s investigation is likely to achieve much, especially if a broad brush approach is adopted. He suggested that a generic review of the professions might focus on matters such as the rules and disciplinary procedures of professional bodies, leading to requirements for neutral outsiders to be involved in disciplinary hearings.

A review may also conclude that there should be mutual recognition of qualifications to assist professionals operating across borders. Moizer pointed out that past studies have found that, while the big firms operate effectively across borders, there is little cross-border activity by small firms. Addressing this may be a priority for the investigation. There might also be proposals for changes in laws banning what might be regarded as restrictive practices that impede the formation of multi-disciplinary practices.

�In accountancy you have a huge variation in the way things are conducted,� said Moizer. �I don�t know where you would start in addressing that. It�s going to be very difficult for the Commission to wade into all these cultural practices in member states.�

There must also be concerns whether an investigation which is clearly motivated by the desire to cut professional fees can do so without having unintended negative effects on quality. Moizer confirmed: �Driving down prices could mean driving down standards - especially in auditing where it�s so difficult to lay down standards which impact on the real quality of what people do.�

Limited liability for auditors

Ernst & Young is leading a campaign for a change in law to enable firms to specify in contracts with clients a limitation of liability for audits. E&Y itself faces possible destruction if Equitable Life wins its legal action against the firm over the quality of its audit of the collapsed life assurer. But a spokesman for E&Y confirmed that the firm recognised that retrospective protection from the full scale of the impact of the £2.6bn negligence action was not possible.

Nick Land, chairman of E&Y in the UK, said that while his firm was confident it would win the E&Y case, it was important to increase protection for auditors in the future. He wanted the repeal of legislation which barred firms from capping their audit liabilities. Land added that failure to do this could lead to the loss of one of the Big Four through other liability legal actions, which would be damaging to the public interest.

Some fund managers believe that they need the protection of auditors remaining fully liable. But the Association of British Insurers confirmed that it was sympathetic to the case for capping of liabilities because of the risk to investors from a wholesale withdrawal from auditing by the major firms. Leonie Edwards, a spokeswoman for the ABI, added: �It�s an issue we are looking at, at the moment. We are discussing this with our members.� She explained that many accountancy firms self-insure on liability risks, but where policies were in place these were likely to be capped.

In deciding that Equitable Life could proceed with its claim against E&Y, the Court of Appeal said that the debate about the limitation of the scope of legal consequences of negligence was an area of law �in a state of development and flux�. This is clearly recognised by the firms and adds to their state of anxiety. Several firms are facing major liability claims arising from past audits.

Limited liability partnerships (LLPs) have been introduced in several countries, including the UK and US, with Australia interested in doing the same. But the concept is only partially helpful to the firms. While this potentially prevents individual partners or directors from facing personal ruin, it would still allow a firm to go to the wall if it lost a major law suit.

E-mail banking scam

Major banks around the world - including Citibank, Barclays and Lloyds TSB - have been targeted in a sophisticated fraud that is allegedly masterminded by Eastern European crime syndicates with links to illegal arms trading and drugs supply.

The scam is reminiscent of the long-standing fraud associated with Nigeria in which banks� customers are persuaded to release details of their accounts. Under the so-called �419� fraud - illegal under code 419 of the Nigerian law - individuals or companies are promised a cut of money to be transferred out of West Africa, in return for paying an advance fee. An alternative fraud is to ask target businesses for details of a bank account into which money is promised to be paid, but which the fraudsters then withdraw money from using the information supplied by the victim.

This latest banking fraud is a development which takes advantage of the massive increase in on-line banking. Individuals are targeted with requests apparently from their bank to confirm account details in order to continue to use their banking facilities. E-mails can look authentic, with the banks� own logo reproduced. A similar tactic has been used by programmers spreading computer viruses who have sent e-mails purporting to be from Microsoft which appear genuine.

Spoof e-mails are called �phishes�, in reference to being sent out as a �phishing� exercise. They provide links to counterfeit websites, which also reproduce logos and templates that are good copies of the genuine thing. Web addresses may also appear realistic - those going out falsely claiming to be from Lloyds TSB provided links to a web address which began www.lloydstsb.co.uk. Several of the counterfeit websites were reportedly hosted by Internet services providers based in the United States, while that targeting Citibank was allegedly hosted in China.

The websites themselves require all the personal details of a customer needed to access their on-line bank account, or to use credit cards in �cardholder not present� transactions. Banks in the United States, Canada, Australia, New Zealand and the United Kingdom have all found themselves victims of the fraud and repaid customers caught out by the deception.

Lloyds TSB�s legitimate website now carries the warning: �A number of fraudulent e-mails, alleging to be from Lloyds TSB, have been sent to customers and non-customers encouraging people to visit a website where card details are requested. Lloyds TSB never sends e-mails that ask for confidential information or security details to be recorded on-line. If you get such an e-mail, please delete it immediately without responding.�

Similarly, Citibank�s website now contains a section headed �e-mail fraud�, which advises customers: �Recently our customers have reported receiving fraudulent e-mails that appear to be from Citibank but which are, in fact, sent by imposters. How can you tell the difference? Fraudulent e-mails typically include attachments, request personal information, or both.� Citibank, like the other banks affected, also notified its clients that it is working closely with law enforcement agencies to tackle the fraud.

While examples of similar frauds have occurred repeatedly in recent months they have until now tended to target on-line retailers, including Amazon, AOL and eBay. Now the target is often a bank. This has led the US Office of the Controller of the Currency to issue a warning to all banks in the country of the prevalence of the crime. American banks have also been asked by OCC to educate customers about the threat to on-line transactions. A similar warning has been issued in the UK by the National Crime Intelligence Service, which suggested that those who are infrequent users of the Internet were mostly likely to fall for the fraud.

Internet security analysts mi2g report that 17 banks in three continents, plus the FBI, have now been targeted by the phishing fraud, with some banks responding by putting a maximum daily payment cap of $500 or $750 to limit losses. The company identified hackers and criminals in a variety of countries, including China, Nigeria and Russia, as being behind the fraud. It also suggested that some of those responsible were Eastern European crime syndicates involved in complex money laundering operations. Meanwhile, reports in the United States have speculated on a mafia connection.

There is growing concern that the incidence of on-line fraud will increase with the clampdown by credit card companies on in-store fraud. The issuing of �chip and PIN� cards means that there is likely to be a big reduction in �cardholder present� fraud. Credit and debit cards which contain a microchip logging the holder�s key personal details and which are authorised by use of a PIN instead of a signature has been used for several years in France, and their use is currently being rolled out across the rest of the European Union and in some other countries. In the UK alone, the investment involved totals £1.1bn.

But with greater security in place within shops, on-line transactions and Internet transfers have become the new focus of criminals. The 3rd Man, a consultancy which advises retailers on the threat of on-line fraud, is telling shops they should now concentrate on protecting themselves from fraud in �cardholder not present� transactions. In most cases, pointed out the consultants, it is retailers not cardholders who are likely to be the victim from cardholder not present fraud.

Cardholder not present fraud already accounts for more than a quarter of total credit card fraud in the UK, despite these transactions counting for a much smaller proportion of card turnover. John Walker, policy chairman of the UK�s Federation of Small Businesses fears that his members may find little to celebrate under the new system. He says: �Cardholder not present crime is a big growth area for fraudsters and shot up by 15% last year. There is a real danger that, as chip and PIN takes off, fraudsters will just use the Internet and telephone instead. Chip and PIN cards are a great leap forward, but the banks need to do much more to combat cardholder not present fraud.�

The £50bn black hole

British Energy was privatised in 1996 to take over the Government�s more recent - and apparently more profitable - nuclear power stations. The older Magnox reactors remained in public ownership within British Nuclear Fuels Ltd. By 1999 BE had a market value of £5bn. Yet it has become one of the world�s most extreme cases of privatised failure - alongside the UK�s Railtrack - after posting a single year loss of £500m.

Changes in the electricity trading system through the introduction of the New Electricity Trading Arrangements which dramatically drove down the price of wholesale electricity are widely regarded as the key factor which caused British Energy�s collapse. Many of England�s electricity power plants have been mothballed as a result of the price reductions, but BE was particularly badly affected because of the impracticality of mothballing nuclear plants and by its commitment to long term fixed price supply agreements.

There has been speculation that the introduction of FRS 12 in 1999 and the low interest environment have also been key factors in the fall of BE. �Under FRS 12, when you have long term liabilities you should estimate them and then discount them at an appropriate rate,� explained Allan Cook, technical director of the UK�s Accounting Standards Board. �As interest rates decline, as has happened in recent years, the discounted amount rises. So you are not leaving so much to be caught up in the future. We think that is realistic and that is the way things are done internationally. But it can cause problems to some companies.�

FRS 12 also required companies to use more accurate measures of their future liabilities.

A spokesman for BE denied that the introduction of FRS 12 was a material factor leading to the need for a rescue.

BE was floated at privatisation for £1.5bn, but the company came with liabilities for waste management and decommissioning which were then valued by the Government at £14bn on an undiscounted basis. BE built up its Nuclear Liabilities Fund as a reserve against decommissioning costs, but the value of this stands at a mere £775m. As it has been trading at a loss since the introduction of NETA, it became essential not merely to attract cash to maintain operations, but also to transfer the long-term liabilities - which the Government has now picked up as part of the rescue deal.

The problems of BE also impact on the still government-owned BNFL. In order to establish commercial viability for BE, it was necessary to renegotiate some contracts for reprocessing with BNFL, with the result that BNFL�s commercial situation has been damaged and reducing the prospect for it to be privatised as planned.

BNFL had itself some £39bn in liabilities (undiscounted) for future decommissioning, which are in the process of being transferred to a new body, the Nuclear Decommissioning Agency. These liabilities had not merely exceeded BNFL�s assets, but did so by a factor of 100 - in 2001 it had equity of £356m against liabilities of £35bn. The continuing rise in those liabilities contributed to the company making a massive £2bn loss in the 2001/2002 year, after its decommissioning liabilities shown in the accounts rose substantially. Its undiscounted liabilities rose from £34.8bn to £40.5bn after the company reassessed its liabilities in compliance with FRS 12. Losses for the 2002/2003 year continued to be in excess of £1bn.

Despite the move towards the creation of the Nuclear Decommissioning Authority, this is not the end of the story. It remains unclear what the Government will now do with BNFL and its relationship with the company�s auditors, Ernst & Young.

The Office of National Statistics has not yet resolved whether the liabilities of the NDA should be on or off the Government�s accounts. And the rescue deal for BE has still to be cleared by the European Commission. KPMG will stay on alert for another year in case it has to move in as BE�s administrators.

Worse still, even the amended figures may prove to be optimistic. If BE is forced into the early decommissioning of excess capacity - and BE says this is not being considered - this is likely to cause the early years liability burden to rise. Further, there are concerns that the political environment could force the figure to rise.

Grant Hodges, a director of PricewaterhouseCooper�s infrastructure, government and utilities group, said that the full cost of dealing with nuclear waste could increase if it was left in storage rather than reprocessed. Hodges said that he understood £23bn of the BNFL liabilities related to nuclear waste. PwC is urging the Government to enter into a PFI contract with a capital spend of £1.5bn to reprocess BNFL�s waste.

�I certainly feel [the Government] will come under increasing pressure to do something,� said Hodges. �The option of just looking after the stuff is not really viable. And the environmental regime they will have to comply with will only get tougher. So the capital costs may be a lot higher in 10 years time.�

This is no minor story. Total liabilities of the LMA are slightly under £50bn on an undiscounted basis. To put this in context the UK�s total annual budget for the National Health Service in 2002/2003 was £58bn.