My Lords, “Statutory Auditors and Third Country Auditors Regulations” is not an exciting title—it will certainly not have them dancing in the saloon bar of the Dog and Duck—but this is important to the country, to the companies in this country and indeed to our capital markets. I want this evening to question the extent to which these regulations will achieve the very wide-ranging and important objectives the Government expect from them and whether there may not be perverse and unintended consequences, possibly just maintaining the status quo and the risk of a further increase in the regulatory burden, which my noble friend referred to in his opening remarks.
I hope that the House will forgive me if I take a minute just to lay out my case. I make these remarks drawing on my experience as a non-executive director of a public company from 2002 to 2014. I ceased to be a director two years ago, so I do not have a direct interest to declare, but I should draw the House’s attention to my past record. The company was what they call a FTSE 250 company—that is to say not in the top 100 but in the next 250, so one of the 350 largest companies in the country.
What are the Government seeking to achieve? I draw the House’s attention to page 1 of the impact assessment, where it says:
“What is the problem under consideration? Why is government intervention necessary?”.
It goes on to say:
“The financial crash in 2008, led to calls for greater scrutiny of the audit profession. The belief was that the accounts of several financial institutions had been given unjustified ‘clean’ audit reports and so potentially misled investors and regulators, undermining confidence in the financial system as a whole and affecting the efficient allocation of financial capital”.
In reading that, one could only conclude that the fundamental purpose behind these regulations is to address issues of systemic risk. If this were not the case, why would the impact assessment focus so heavily on undermining confidence in the financial system as a whole?
If we are addressing systemic risk, there are relatively few companies that are large enough to pose a systemic risk in this country: the banks, certainly, along with other financial institutions, and some of the biggest industrial and commercial companies. How many? Possibly 50, but probably no more than that. However, the regulations, as my noble friend has told us, apply to every company called a public interest entity—a PIE. When I read the policy background on page 2 of the Explanatory Memorandum, it was clear that it applies to all listed companies of whatever size, from the biggest to the smallest. Just for the record, it would be helpful if my noble friend could give an assurance that the regulations do not apply to companies listed on the AIM. If he cannot give that assurance, I will be seriously upset.
What additional reporting requirements will be imposed on PIEs? According to paragraph 7.6 on page 3 of the Explanatory Memorandum,
“The Regulations make changes to audit reporting requirements, including the reporting of irregularities; auditors of PIEs will be required to submit an additional report to the audit committee of the audited entity”.
In order to try and tackle the challenges—or possibly the failures—of auditing the 50 or so companies which pose a systemic risk to the British economy, we are proposing to require all listed companies to prepare further reports, for which of course they will have to pay, directly or indirectly.
I have heard many politicians on both sides of the House deplore the emergence of private equity at the expense of the public stock market. Such people seem to worry about what may be happening behind the green baize door of a private company, away from the public gaze. As it happens, I do not share that view—I think there are good and bad everywhere—but I share it in one respect, which is that the man in the street cannot and probably should not invest in private equity in the way he can and should in shares traded on public markets such as the London Stock Exchange. In order to encourage general faith and confidence in the fairness of our liberal capitalist economy, we need a healthy, growing public market in which all our fellow citizens can participate. Every time the Government come up with another set of regulations to be complied with by public companies, they give another boost to the growth of alternative funding mechanisms and therefore accentuate the different investment opportunities available to different parts of our society. If the Government said: “These regulations apply only to companies which pose a systemic risk to the UK economy”, I would be entirely supportive, but I fear that is not the case.
How do the Government think that this can be remedied? My noble friend referred in his opening remarks to excessive concentration. I return to the impact assessment:
“The market failures are due to misaligned incentives, conflict of interests and lack of competition. Companies infrequently tendering audit appointments or changing auditors cause there to
be little opportunity for new entrants to compete for contracts, leading to a lack of competition in the market for the provision of audit services”.
Lack of competition? There are only four major firms in the PIE space—all other auditing practices are at present effectively also-rans—so there are only four entrants to the race, one of which must be ruled out because it will be the current auditor and another may be ruled out because it is providing corporate finance or other services. We have a race of only two horses. This is what we call competition. There is bound to be the effect of taking in each other’s dirty washing or passing the buck around when you have that limited a number of participants.
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If the Government really want to increase competition in the audit space, they need to encourage the profession to find ways to develop more effective challengers. I do not doubt that the profession will say, “Not our business, guv, nothing to do with us. It’s up to the clients”—the companies whose accounts are to be audited—“to make their choice”. It will go on to say that the companies are entirely free to make their choice of any firm, however big or small.
That is a false premise. I go back to my experience. When the company of which I was a director put its audit out to tender, I got the agreement of my board colleagues to include a leading mid-sized firm in addition to the ever-present big four. The mid-sized firm took a lot of trouble over its presentation and presented well, but the killer question was: “How many other FTSE companies do you audit from the Birmingham office?”. The answer was none. That was not surprising, because 97% of the FTSE 350 companies are audited by the big four; only 10 have an auditor that is not one of the big four. It is a very big ask to suggest to a public company board that it take the risk in these circumstances of appointing such a firm, however good its presentation. The risk/reward ratio is not in its favour.
The challenge to the Government and the profession is: how do you achieve break-in to the magic circle? One way would be to encourage joint auditing. In response to the question I posed earlier to which the answer was none, the answer could become, “We do not audit any alone, but we are joint auditors to one”, or two or three, so beginning to build confidence in the wider audit market.
Of course, this will not be popular with the four oligopolists. They will see a threat to their position and their response will be couched in terms of risk to the standard of British auditing, and so on, but in fact, if they can think more long-term and creatively, such a development will effectively buttress their position. I invite the House and the Government to think what happens if four becomes three when one of the existing four firms collapses—we have had collapses in major auditing firms—and we therefore have intense market concentration.
Extraordinarily, in the regulations, as my noble friend has told us, the Government are missing a chance at the margin to encourage the emergence of joint auditing as an interim step in the break-out and so create a more competitive market. Paragraph (20) of the preamble to the directive reads:
“The appointment of more than one statutory auditor or audit firm by public-interest entities would … help to increase audit quality … the presence of smaller audit firms in the audit market would facilitate the development of the capacity of such firms … broadening the choice of statutory auditors and audit firms for”—
PIEs.
As my noble friend said, elsewhere in Europe joint auditing is much more prevalent. As a result, there are derogations in the regulations to give additional protection. I do not understand why the Government have not taken this up, except for the hallowed phrase used by my noble friend: “That is not the way we do things here”. They have chosen not to do it, and I think that is a mistake. So despite all the stuff about the need to increase competition, the effect of the regulations that we are discussing this evening is to reinforce the oligopoly of the big four.
Just before I finish, I shall say a word on the regulatory burden, to which my noble friend referred. The impact of each individual regulation is of itself unobjectionable. It is like barnacles on a boat; one barnacle makes little or no difference, but 10, 100 or 1,000 do make a difference. The practical example that I can give of the extent of the imposition of barnacles in the corporate sector is of the company of which I was a director. When I joined the board of that company in 2002, the annual report was 61 pages long. In the last financial year to 30 September 2015, it was 128 pages long—more than doubled. The accounts and notes had risen from 27 pages to 66 pages and the remuneration committee report went up four times from five pages to 19 pages. Others must judge whether that is likely to have been a productive use of resources. It will have been welcomed by the professional services and advisers, who will have more work to do and more work to check, but whether it will advance commensurately the overall prosperity of the general population of the UK is in my view more doubtful.
These regulations are the produce of tired thinking. It is a shame that the profession and its regulators have not been able to think more creatively about the real issues and, instead, have fallen back on the old policy of, “If in doubt, stick in another regulation”. They represent missed opportunities: a missed opportunity to improve the competitive nature of the audit market; a missed opportunity to focus reform on the areas that need it; and, above all, a missed opportunity to think of better, more focused and more meaningful ways in which to measure the performance of British industry and commerce, on the success of which our country’s prosperity depends.