Auditor Regulation and the dozy watchdogs

The Government has published a public consultation on Auditor Regulation. This is a discussion document in response to the requirements of a new European Directive on Audit, and your responses are invited. It’s available here: although those who do not have a professional interest in the subject may find it heavy going. But it’s worth repeating the first paragraph which is:

“Effective financial reporting underpins the development of the best businesses – those that others are willing to invest in and to do business with. It informs decisions that are made, for example, by shareholders, directors, investors and suppliers. Audit is an essential safeguard to provide independent assurance that the financial reporting of businesses properly reflects their circumstances”.

Yes auditing is important as the investors and directors of Tesco are no doubt keenly aware. The Financial Reporting Council (FRC) have now confirmed that they will be investigating the audits of Tesco by PwC for the last three years. They are also investigating PwCs role at Barclays where many billions of client funds were not segregated as legally required.

The Economist published a very good article under the title “The Dozy Watchdogs”on December 13th (available on the web). It covers the past history of audit failures and shows how common they are. For example the recent failure of Banksia in Spain that had to be nationalised only a few months after an IPO. Enron and Worldcom in the USA (Enron caused the failure of large audit firm Arthur Anderson), or Polly Peck in the UK. Or consider the recent banking crisis where audit firms consistently passed the UK banks that failed as “going concerns” months before they collapsed (Northern Rock, Royal Bank of Scotland, Bradford & Bingley, Lehmans come to mind), although some people blame that on the accounting standards in use rather than the audit firms.

The Economist article does tackle some of the big issues and possible causes of audit problems. Namely that the company being audited selects the audit firm and pays them. In addition they often have a very long standing contracts with the audit firm, and the latter might also have considerable other consultancy business from the company which might prejudice their willingness to report failings or challenge management.

It is also very difficult to make auditors accountable for mistakes. Unlimited liability of audit partners no longer generally applies as audit forms have set up Limited Liability Partnerships (LLPs). In addition, auditors only have a contract with the company they audit and not with shareholders so they are no longer accountable to shareholders. That is certainly so in the UK due to the Caparo legal judgement and even in the USA it’s not easy to make them accountable.

ShareSoc has covered these problems in our Policy Manifesto (available from our web site) which says this: “In essence the legal system which acts as the framework for companies has been watered down in the interests of company directors and their professional advisors over the last 50 years, to the detriment of shareholders interests“; and “The legal framework for companies should be changed to improve accountability. Directors and auditors should have a duty to, and be legally accountable to shareholders. The legal concept of ‘fraud against shareholders’ should be introduced in a new law to cover such matters as issuing false or misleading information to the market or the prejudicing of minority shareholders, and provide a basis for legal actions. And the legal system should be reformed so that shareholders can pursue grievances at reasonable cost. In addition the penalties for fraud should be increased.”

Are we going to see any substantial changes from the EU Directive or from the Government consultation? It seems very unlikely as the changes proposed are quite minor. They are unlikely to prevent future major audit failures as have happened in the past. The Economist suggested it was time for “some serious reforms”, and this writer cannot but agree.

But if any ShareSoc member has a particular interest in audit matters and would be interested in writing a response to the aforementioned public consultation, please let me know. Response are required by the 19th February.

This is undoubtedly my last blog post of the year so I wish all my readers a prosperous New Year. The next one is likely to be on what our followers would like to see ShareSoc do in the New Year. Perhaps campaigning for audit reform might be in there.

Roger Lawson

Royal Mail and Myners’ report on other Government sell-offs

The Government sell-off of a major stake in Royal Mail was controversial in many ways. It proved to be even more so when the placing price of £3.30 was rapidly eclipsed by a market price which rose to as high as £6 although it’s been mostly downhill since (at the time of writing it’s 420p). The long term holders who were given priority in the share allocation soon turned out to be anything but with 44% of the shares changing hands on the first day of trading and 84% within two weeks.

Private investors were also disgruntled by the fact that the allocation process was not disclosed in advance and in reality most private investors either got none or an allocation that was trivial in size.

The process of establishing an “orderly market” in the shares turned out to be totally defective and many people alleged the Government lost a substantial amount by under-pricing the issue. For example a Committee of M.P.s suggested as much as £1billion was lost by the defective process.

So Vince Cable who heads the Government’s BIS Department commissioned a panel of experts to report on Government IPOs. Headed by Lord Myners, everyone’s favourite financial authority, he has now issued their report.

The conclusions are that the process of “bookbuilding” is not perfect but there may not be better alternatives. But they do suggest that  “it is inevitable that bookbuilding will transition over time to a more digital online auction with more transparent rules“. They suggest that would address the conflicts of interest inherent in the current process and reduce fees.

In the meantime, they suggest a number of detail improvements to the existing process. They also comment on the need for a retail offer which they say adds “price tension” (don’t ask me what that means) to the sale process and increases complexity and “rigidity” which might impede price discovery.

Comments:  This in essence is surely a pretty simple problem. The Government does not know what is a fair price for the shares it has on offer. Even consulting a few experts may not help a great deal because as with any stock, the price is what people are willing to pay. There was probably a great range of views on the value of Royal Mail as a business. I thought at the time that 330p was high having read the prospectus and considered all the risks but there then developed a kind of mania for the stock probably driven by index tracking funds having to buy the stock and others enthusiastic about buying a good dividend paying monopoly. Only the wisdom of crowds, and the market, will ever give you a good consensus on what is a fair price for a publicly listed company.

The book-building process and the “pilot fishing” process used in this case is an attempt to determine what people might pay for the stock without getting them to put their views on the line. It is simply an attempt to avoid an open and potentially volatile market and determine a price which can be agreed by the seller as politically acceptable.  But an auction process with the Government setting a reserve price, or limiting the amount of stock for sale at different price levels, would just as easily provide a stable and fair market price.  It would also enable the inclusion of retail shareholders who could participate in the same auction on an equal basis.

An auction or tender process is much more transparent than the existing bookbuild process (as the report points out), so would avoid the suspicion that City insiders are exploiting the process to their own advantage. In this case the bookbuilding price discovery mechanism grossly underestimated what level the free market would actually set the price to.

You can read the full report on the web if you want to learn the complexities of the existing process and the details of the panels conclusions.

Roger Lawson

Ignoring the UK Corporate Governance Code

Last week there were Annual General Meetings of the Baronsmead 1 and 2 VCTs (BDV and BVT) and the British Empire Securities and General Trust (BTEM) on the same day. These companies are all investment trusts although the latter is of course somewhat different in nature to the two Venture Capital Trusts. They do have one thing in common though – they both claim to be able to report against the AIC Corporate Governance Code rather than the UK Corporate Governance Code.

For example the Baronsmead 1 Annual Report says: “The FRC confirmed in January 2013 that they considered the updated AIC Code to be appropriate and that investment companies may report against the AIC Code” (this is based on a letter received by the AIC and circulated to their members). There is unfortunately one thing wrong here. The Association of Investment Companies (AIC) is, to quote from their web site, “the trade body for closed-ended investment companies“, i.e. it represents the interests of those companies and their fund managers, it does not represent the interests of investors in those companies.

The British Empire Annual Report says something similar – specifically: “The FRC has confirmed that AIC member companies who report against the AIC Code and who follow the AIC Guide will meet the obligations in relation to the UK Code and associated disclosure requirements of the Disclosure Rules

Now the AIC Code is useful in some regards in that it covers matters specifically of relevance to investment companies. But in respect to the length of tenure of non-executive directors it’s policy position is quite different. It says “Many shareholders and commentators have a view that lengthy service on a board can compromise independence from the manager or the executive team of a self-managed investment company. The AIC does not believe that there is any evidence that this is the case for investment companies and therefore does not recommend that long-serving directors be prevented from forming part of an independent majority. However, where a director has served for more than nine years, the board should state its reasons for believing that the individual remains independent in the annual report“.

The UK Corporate Governance Code takes a very different stance on this, and surely one that is much wiser. One of the failings in investment trusts is long serving directors who become too sympathetic to the needs and desires of the fund manager, or do not take action soon enough when the company is running into problems. Length of service tends to go along with age and can lead to inaction when it is time for change.

This issue arose at the Baronsmead VCT 3 AGM earlier in the year when the Chairman, Mr Townsend, said that the UK Corporate Governance Code allows them to simply comply with the AIC Code, i.e. that there is a specific reference in there to the AIC Code, and he suggested I read it. As I was not in a position to dispute this statement at the time, I let it pass. But I did take it up with the FRC and their Chairman, Sir Winifried Bischoff, responded with a letter that includes the statement “We do not consider the AIC Code and guidance to be an alternative standard….. nor does it absolve AIC members from their obligations under LR 9.8.6 including the obligation to provide an explanation when choosing not to follow the Code“. I subsequently sent a letter to Mr Townsend that spells out that not only is he mistaken, but it seems to me that the company is deliberately flouting the principle that directors should only serve for a limited duration.

In case you think this is an academic issue, I have many times in the past seen that boards of companies, particularly investment trusts, where the directors have been there too long are averse to change, often ignore problems, do not take vigorous action when required, and are often too sympathetic to the needs and desires of the fund managers in investment companies. The board effectively becomes a cosy talking shop with the manager dictating events (the board only meets 4 times a year at Baronsmead VCT 3 for example). There was a good reason for the “9 year” rule for length of service of directors and it should not be ignored. Saying somebody is still independently minded is not enough explanation under the “comply or explain” rule. It should really only be in exceptional circumstances that directors are allowed to continue with specific and good reasons given.

Returning to the affairs of Baronsmead 1 and 2, both have Chairmen who have been there a very long time. Number 2 also has a director, Gillian Nott, who has served since 1998 and is also on the boards of Baronsmead VCT3 and VCT 5. Yet she is claimed to be the “Senior Independent Director”. Independent she is surely not.

Now I have nothing against Mrs Nott personally and no doubt she has lots of knowledge and experience of VCTs, which would of course be enormously useful on other VCT boards which do not achieve the same performance as the Baronsmead VCTs. But ignoring the UK Corporate Governance Code regarding the length of service of directors sets a very bad precedent.

The Baronsmead VCTs have performed very well in recent years, no doubt because of the skills of the fund manager, but British Empire has not. The Annual General Meeting of the latter was a somewhat depressing affair because the fund manager repeated what had been said in previous years, i.e. that there was a lot of unrealised value in the portfolio. The Chairman, Strone Macpherson, has been on the board for 11 years and shows no sign of retiring. As in the previous year, shareholder questions and comments were cut short by scheduling the meeting for 12.00 am when lunch was scheduled for soon after 1.00 pm. In this writer’s opinion, this company needs to look very hard at whether its investment policy and/or the fund manager should be changed because the results in recent years show the strategy is not working. Would a new, younger Chairman be more likely to take the necessary steps? Perhaps so.

One can understand why the AIC and its members think that having long-standing directors on boards of investment trusts is a good idea, but as an investor I do not agree. The principles laid down in the UK Corporate Governance Code on length of service were surely sound and should be adhered to unless there is a very good reason to do otherwise.

Note that there are full reports on the Baronsmead VCT and British Empire Trust on the ShareSoc Members Network which give more background on these companies.

Roger Lawson

Law suits – Quindell, Lloyds, RBS and SIPPs

Feel misled by the Quindell board and its advisors? Then there is a new legal action being formulated by Liverpool legal firm “Your Legal Friend”. They already claim to have 250 investors interested in pursuing a claim on the basis that statements issued by the board and its advisors show that insufficient care had been taken in relation to the duty of care owed to investors.  At least that’s a brief summary of the allegations – see their web site for more information if you have an interest in this matter.

Lloyds Banking Group have issued a defense to the legal claim from Harcus Sinclair on behalf of LloydsTSB shareholders who suffered as a result of the takeover of HBOS. Among their defenses is that Lloyds had no obligation to reveal a £10bn loan facility given to HBOS and other support to HBOS from the Bank of England in the prospectus. We will no doubt see in due course whether their defense stands up to scrutiny. It might be at least a couple of years before this case gets into court. Astonishingly the FCA’s report into the failure of HBOS has yet to be published, but it is now hoped it will come out in early 2015. Why the delay one might ask?

Meanwhile the similar legal action against Royal Bank of Scotland (RBS) might apparently get into court by the end of 2016 it seems, although the lawyers for RBS wanted a later date.

Three men were jailed recently at Southwark Crown Court over the sale of dubious investment products to clients investing via SIPPs. These were based on biofuel plantations in Cambodia. To quote the SFO: ” These investors were deliberately misled into believing that SAE owned land in Cambodia; that the land was planted with Jatropha trees, and that there was an insurance policy in place to protect investors if the crops failed“. Comment: one of the big risks with SIPPs is that you can put a wide range of investments into them so they can be a target for unscrupulous promoters of dubious businesses of all kinds. As a result people can lose their life savings  when pensions should surely be invested conservatively in a diversified range of liquid holdings. More such scandals will no doubt appear unless the Government moves to tighten regulations on SIPPs.

Roger Lawson

Two more AIM Exits – Ludorum and Armour Group

Two more departures from AIM were recently announced – Ludorum (LUD) and Armour Group (AMR).

Ludorum have been developing a market for their animated children’s TV series based on Chuggington trains and associated consumer products. But revenue has never really taken off as investors hoped. Along with the interim results announced on the 15th December (again somewhat disappointing), the company announced a proposed delisting from AIM.  These are the reasons given in the announcement:

The factors taken into consideration by the Directors in reaching the conclusion above include:

– there has been a significant fall in the Company’s share price which, in the opinion of the Board, is not justified by the Company’s performance or prospects;

– like many other small listed companies, Ludorum suffers from a lack of demand for its shares and, in practical terms, a small free float. As a result, the Board believes that there is currently no reasonable prospect of the Company being able to use the listing to raise money from other investors;

– the low liquidity in the Company’s shares tends to lead to a volatility in the share price which the Board believes may distort any objective assessment of the Company’s value;

–  the Board believes that, in the light of the above, the costs associated with the listing are not justified as being in the best interests of the Company or its shareholders.

These arguments are surely sound (and match the comments made in the last ShareSoc Informer newsletter on other AIM delistings). The trading in the company’s shares was minimal. The revenue and profits of the company surely do not support the cost of an AIM listing. The company hopes to provide an alternative trading system after it de-lists.

Another company that may leave AIM is Armour Group which is the subject of a mandatory takeover bid by major shareholder Bob Morton and an associated concert party, although the bidder has subsequently said that they intend to maintain the AIM listing. The cash offer looks likely to be accepted as the concert party already holds 47% of the shares. This company actually presented at a ShareSoc seminar back in October 2013 when some investors attending developed a somewhat jaundiced view of the business after asking a few questions – well at least this writer did (ShareSoc members can read the review written at the time in a previous ShareSoc newsletter). Subsequently the company disposed of its operating divisions and became a cash shell. Surely not a company that would be missed.

What’s the moral of that story? That you can learn a great deal about a business and its prospects by listening to what the management has to say and asking a few questions. Looking at the financial forecasts alone can be very dangerous.

Roger Lawson

Better Finance comments on the EU Shareholder Rights Directive

Better Finance, a representative body for European shareholder associations, has issued a press release commenting on the review of the Shareholder Rights Directive. It points out a number of defects in the proposals. Here are extracts from the press release:

Guillaume Prache, managing director of Better Finance has stressed that many individual shareholders of EU companies will still have to pay high fees to exercise their voting rights across borders within the EU. If the internal market for capital is to carry any meaning at all, cross-border voting by EU citizens within the EU should be cost free, as is the case within Member States.

Many others, especially those whose shares are lodged by intermediaries into omnibus or nominee accounts, and those who are domiciled in a different EU Member State than the issuing company, will still not be able to vote at all, mainly due to the persistent failure of financial intermediaries to identify the beneficial owners of shares and to send them the voting material.

This is all the more unacceptable as these very same intermediaries are perfectly capable of identifying beneficial owners when it comes to paying them dividends on their shares. For voting rights to be genuine, all beneficial owners must be provided with adequate voting material in a timely manner.”

One surely cannot argue with that. For the full press release see:…

Better Finance have also published an extensive review of the Shareholder Rights Directive here:…

The policies promoted by Better Finance are very much in alignment with those put forward in ShareSoc’s Shareholder Rights campaign, such as on this point:

“Voting Rights for the underlying shares in Nominee Accounts (or for those cases where a third party is holding shares on behalf of end-investors) should be provided without any restrictions to the beneficial owner. It is important to promote a direct relationship between investors and the companies in which they invest by placing investors’ own names on share registers and thereby ensure their legal rights of ownership.”

Another idea they put forward which we have not specifically considered in ShareSoc but which may be of interest is this:  “Most individual shareholders are by nature long term holders. Issuers could reward long term shareholding further through the mechanism of loyalty shares. However, there should be no departing from the “one share, one vote” principle”.

It is good to see Better Finance promoting such ideas in the labyrinthine bureaucracy of the EU as UK legislation in this area is driven by EU Commission Directives.

Vanguard backing shareholder committees

According to a report in the Financial Times this morning, Vanguard is to promote the idea of “shareholder liaison committees” to improve corporate governance. This is of particular significance because Vanguard is one of the largest investment groups in the world and overtook Pimco last year to become the second largest fund manager.  Vanguard primarily runs low cost index tracker funds and therefore has to hold all major companies. Indeed they are one of the largest holders of shares in many American companies.

Shareholder committees are something that ShareSoc has promoted also as a step towards better corporate governance and more engagement between shareholders and the directors of companies. See the note downloadable from this web page for how we suggested they might work:

Bill McNabb, CEO of Vanguard, was quoted as saying: “Independent directors are doing a good job but we find they are not as engaged with shareholders as they should be”. He also complained that many independent directors had never met an investor.

The recent example of  BG Group in the UK and their proposals for the pay of the new CEO are surely an example of how there is little dialogue in reality despite the common claims that “major investors have been consulted”. Shareholder committees would be a way to tackle that problem.

Roger Lawson