[A-List] City of London modernisation

["Keaney Michael" <Michael.Keaney@xxxxxx>]

More on the newly-established Financial Services Authority, which is
seizing its chance to shape the agenda post-Enron...

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Could Enron happen here? Yes, it could

The Financial Services Authority takes seriously the global implications
of the US energy trader's collapse

Sir Howard Davies
Saturday February 2, 2002
The Guardian

The Enron collapse in the US has been on such a scale that it has made
waves elsewhere in the world, and certainly in London. The big question
is - could it happen here?

The only honest answer is yes. But we have rather different arrangements
for the oversight of the accounting profession and for financial
regulation.

As far as accounting is concerned, our standard setters argue the UK
approach emphasises substance over form and seeks to address the
underlying economic reality in consolidated accounts, rather than
staying close to the particular corporate and legal structure adopted.

I would note that that approach has not prevented corporate failures in
which accounting treatment has been an issue, but the general principle
must be right.

The UK profession also argues that the arrangements for the oversight of
auditors and audit quality are somewhat more robust than those in the
US. In our case there is, now, after a lengthy gestation, an Accountancy
Foundation overseeing the Auditing Practices Board, which, in turn, aims
to monitor the quality of audit work.

While accountancy remains a self-regulating profession, audit is -
formally at least - covered by some statutory controls. Companies Acts
regulate the qualifications of auditors and set out their duties and
rights.

But in spite of the strong injection of public interest representatives,
the oversight arrangements remain substantially a self-regulatory
system. There is nothing so different about our system that it can stop
an audit firm becoming too close to its client and colluding in
accounting practices which mislead investors, deliberately or
inadvertently. There is nothing to stop an audit firm working
indefinitely for the same client. There is nothing to stop a firm
undertaking consulting business for the audit client on a very
substantial scale. So investors and politicians are reasonably asking
whether we should make changes to outlaw such practices. Indeed, these
were questions the FSA already intended to raise, in relation to listed
firms, in this year's review of the listing rules.

There are, in principle, three possible steps one might take to deal
with potential conflicts of interest for auditors.

First, we could require rotation of auditors at a defined interval,
perhaps every five years. The present requirement is that the lead
partner on an audit must rotate at least every seven years, but there is
no requirement for firm rotation. Would that be a justifiable intrusion
into the commercial freedom for companies to choose their own auditors?
Or would it help to prevent excessively close relationships, and
emphasise the regulatory, public interest role of the audit function?

At the audit commission, which appoints auditors to many public bodies
in the UK, audit rotation is planned as part of the process. When I ran
the commission I found it a helpful discipline, and one which had the
useful effect of making auditors more ready to challenge clients.

A second possibility, which would have a less intrusive effect, would be
to require regular re-tendering of audit work, but not to rule out the
possibility that the current auditor would be reappointed. The aim would
be to break the normal assumption that auditors are re-appointed year by
year, and would require audit committees to ask themselves direct
questions about audit performance. It would also give other firms the
opportunity to set out the case for a fresh pair of eyes.

A third option might be to impose limits on the amount of non-audit work
an auditor can do for an audit client. Once again, that is a feature of
the audit commission's regime. But there are potential drawbacks. Firms
might reasonably argue that some audit work can most effectively be
carried out by a company with a good knowledge of the clients' systems.
And policing such a restriction could also be rather difficult in
practice.

We shall be consulting formally on these possibilities later in the
year, but I can see advantages in opening up the question for debate
now, since the Enron collapse has raised these questions here.

But in each case the role of the audit committee would remain crucial.
Unless such committees work effectively, any change to the arrangements
for appointing auditors will have little impact. And we have to
recognise that there may be consequences for audit fees. It is arguable
that they do not now fully reflect the risks auditors take - and the
contribution they should make to market integrity.

The second area where there are differences in the UK is financial
regulation.

One should not overstate these differences. It is certainly possible in
the UK for a non-financial company to undertake extensive activities in
financial markets, as Enron has done. And financial regulators here, as
in the US, do not seek to regulate the non-financial parent on a
consolidated basis. But we do maintain closer regulatory oversight of
the financial subsidiaries of unregulated groups.

There are also two features of our new legislation which help.

First, we have introduced some specific powers over the auditors of
financial firms, over their terms of appointment, for instance. There
are new whistleblowing requirements. Auditors of a regulated firm must
report directly to us any contravention relevant to the exercise of our
powers. If they do not do so, we can disqualify them.

The second advantage is that our unified regulatory system allows us to
look at all of the financial activities of a diversified group together.
It is clear that almost all financial crises these days cross
traditional sectoral boundaries.

No regulatory system is foolproof, and internationally we need to work
more on implementing appropriate disclosure rules, especially of complex
derivatives, to promote effective market discipline. That is likely to
be the most effective way of preventing more Enron-type collapses.

Sir Howard Davies is chairman of the Financial Services Authority

full article at:
http://www.guardian.co.uk/enron/story/0,11337,643624,00.html

Michael Keaney
Mercuria Business School
Martinlaaksontie 36
01620 Vantaa
Finland

michael.keaney@xxxxxx