Legal problems with accounting standards

This is is quite a big deal. Cut & paste from LAPFF site

Leading Counsel confirms substantial legal problems with IFRS

The Local Authority Pension Fund Forum (LAPFF) has called for a full review of the process of setting accounting standards having received Counsel’s opinion which confirms substantial legal flaws with International Financial Reporting Standards (IFRS).

LAPFF was part of a group of investors which sought the opinion of leading Counsel George Bompas QC of Lincolns Inn. In addition to the Forum, the investors that sought the opinion were the Universities Superannuation Scheme, Threadneedle Asset Management and the UK Shareholders Association. The opinion suggests that directors must override IFRS in order to comply with existent company law. The opinion also finds that directors may need to ignore the legal advice obtained by the Financial Reporting Council (FRC) on this issue.

The issues identified in the opinion raise fundamental concerns about accounting practices in recent years, which have had a particularly damaging effect on the banking sectors in the UK and Ireland. This in turn raises significant questions about the decisions taken by bank directors which, in LAPFF’s view, were based on faulty numbers produced under the IFRS framework.

The Forum is therefore calling for a full review into how the defective standards were adopted, including an investigation into whether the existing financial reporting regime requires fundamental structural reform. LAPFF also believes that the role that accounting firms played in both setting the accounting standards and signing off faulty accounts must be properly scrutinised.

Given the significance of the opinion, the investor group submitted it immediately to the Parliamentary Commission on Banking Standards (PCBS) and agreed not to make it public until the Commission produced its final report today.

Forum chairman Cllr Kieran Quinn said: “Over the past two years LAPFF has repeatedly made clear its view that the IFRS framework is legally faulty. The FRC has consistently denied that. However, this opinion suggests that something has indeed gone very badly wrong in the standard setting process, leading to the conclusion that IFRS should be overridden.”

“These are extremely significant issues, given that they directly affect the accounting practices of systemically important financial institutions, and in turn affect the decisions made by those institutions, including the legitimacy of dividends paid since 2005. This also suggests that the accounts used for banks’ rights issues were in fact defective.”

“LAPFF welcomes the PCBS suggestion of a review of the method by which IFRS was introduced in the EU. The Forum also believes the role of accounting firms in signing off accounts that did not comply with law must be scrutinised, as must the involvement of particular firms in setting these defective standards.”

LAPFF highlights the following key points from the opinion -

• in his opinion the specified accounting outcomes required by IAS 39 (the standard particularly applicable to banks) are contrary to the true and fair view requirement of the law (para 10.1 and 11.1). These being;

• marking up to model profit taking and marking up to market,

• not accounting for likely losses,

• not dealing with the distributability of profits (i.e. whether they are realised or not and whether expected losses have been accounted for properly)

• in his opinion these defective accounting outcomes of IFRS should be overridden by invoking the overriding true and fair view requirment of the law (para 10.2 11.2),

On this basis the accounts of banks have been faulty since 2005, or even earlier, given that some IFRS measures had been incorporated early into Accounting Standards Board standards.

The opinion also raises significant questions about how the FRC has dealt with the matter:-

• Mr Bompas cannot reach the same conclusions as the legal advice obtained by the FRC. He cannot reach the same conclusion as at the time of that opinion (para 54, 55), and further the opinion is also out of date (para 7),

• Mr Bompas notes that the FRC continues to publicise its advice on its website. (para 56) He is concerned that directors may in fact not be able to rely on it in discharging their statutory obligations to not approve accounts that do not give a true and fair view (para 63),

He also raises the question of the EU’s adoption process:

• a defective accounting standard could be challenged on the grounds of “illegality….on the grounds of lack of competence and infringment of an essential proceedural requirement…the failure of the adopted standard to satisfy the threshold condition in Article 3(2) of the IAS Regulation”.

LAPFF has consistently been concerned not only with the quality and effect of IFRS, adopted in the EU in 2005, which can cause insolvent and loss making banks to appear solvent and profitable, but whether IFRS adoption by the EU was contrary to the “true and fair view test” required by EU and UK law.

More cut & paste fun

This is from the intro to the UK Government's response to the 2011 EC Green Paper on corporate governance:

Codes can be much more effective at raising standards than law.

For example the formation of audit codes in the UK shows how higher standards can be set by codes. The 8^th Company Law Directive was implemented throughout the EU in 2008, prior to this there was no legal requirement on companies in the UK to have an audit committee, but the UK code recommended audit committees in 1992. In 2003 the code was amended to state that all members of the committee should be independent.

The Grant Thornton survey for corporate governance in 2006 found that 100% of FTSE 350 companies had audit committees, of which 88% were fully independent. A survey commissioned by the FRC in 2006 of 465 small cap companies found that 99% of them had audit committees; and 57% had fully independent committees. This compares well with the Directive’s requirement of at least a single member of the board being independent.

Codes also evolve easily over time and can respond to changing economic circumstances. For example, in the Netherlands, the State Secretary for Economic Affairs established a committee to study the relationship between corporate social responsibility and corporate governance. The committee made specific recommendations which were then adopted by the code. This process began in May 2008 and was completed by the end of the year.

In its response the Government also said

The Financial Reporting Council (FRC) is the UK's independent regulator for corporate reporting and governance, with responsibility for the content of the UK Corporate Governance Code, and will respond in their own right.

They were right. By comparison here is some text from the doc "Effective corporate governance" that the FRC attached as an appendix to its own response to the same consultation:

Codes can be more effective at raising standards than law

.......The history of the formation of audit committees in the UK illustrates how codes can set and achieve higher standards.

Directive 2006/43/EC (the 8th Company Law Directive) requires all listed companies to have an audit committee (or body carrying out an equivalent function) and for at least one member to be an independent director. The Directive was issued toward the end of 2006 and it was implemented in 2008 in most Member States.

Prior to the Directive there was no legal requirement on companies in the UK to have an audit committee, although the UK code recommended audit committees in 1992. The initial recommendation was that all members should be non-executives, of which the majority should be independent. In 2003 the recommendation was changed to state that all members of the committee should be independent.

The Grant Thornton survey for corporate governance in 2006 found that 100% of FTSE 350 companies had audit committees, of which 88% were fully independent. A survey commissioned by the FRC in 2006 of 465 smaller listed companies found that 99% of them had audit committees, and 57% had fully independent committees13. This compares well with the Directive‟s requirement of at least a single member of the board being independent and is just one example of the effectiveness of codes.

Codes evolve easily over time in response to changing economic circumstances 

....

For example, in the Netherlands, the State Secretary for Economic Affairs established a committee to study the relationship between corporate social responsibility and corporate governance. The committee made specific recommendations which were then adopted by the code. This process began in May 2008 and was completed by the end of the year.

Regulatory turn made explicit

I've written quite a bit over the past few years that I think that the idea that shareholders 'own' companies, and therefore should be entitled to certain rights, is increasingly under threat. In particular, if you look at what has happened, and is proposed, in the financial sector, it is increasingly difficult to make the argument that shareholders are ultimately in control. They have clearly been supplanted by financial regulators and other elements of the state on issues ranging from board appointments to pay to takeovers and so on.

The Parliamentary Commission on Banking Standards is clearly sceptical about the positive role that shareholders can plan in respect of governance and standards at the banks. But it pushes things on quite a bit by arguing that Company Law should be redrawn to remove shareholder primacy in relation to the banks. This is, I would argue, rather a big deal. It will, obviously, draw a sharp response from the mainstream corporate governance community. But the important point really is that the PCBS is only making explicit what is already implicit, and not just in the UK.

The Commission recommends that the Government consult on a proposal to amend section 172 of the Companies Act 2006 to remove shareholder primacy in respect of banks, requiring directors of banks to ensure the financial safety and soundness of the company ahead of the interests of its members.

One final aside - the idea of amending the Companies Act to redefine directors' duties in response to the failures during the financial crisis has been floated before, and by the head of the FSA!

I would strongly advocate intervention in the UK through changing the Companies Act framework for directors, for example. The current requirement for directors is to promote the success of the company. This is often interpreted in terms of shareholder value. Whilst this does include the need, for example, to ‘have regard to’ the impact on the community, I do not believe that is sufficient. There must be a stronger and more explicit obligation to wider society. There must be clear recognition of the need for institutions to contribute to the common good.

Rem consultant more radical than investors

This comment from PwC on the PCBS proposals is absolutely spot on & the assertion re: deferral is consistent with all the stuff that I've read on motivation & reward (NB this is regardless of which psychological theory you hold, behaviourists say reinforcers must be applied quickly).

Tom Gosling, head of PwC's reward practice

This is a hard-hitting report from the commission and it's not surprising to see some high profile pay proposals. Overall, the pay proposals are sensible and the commission has avoided headline-grabbing but unworkable proposals.
Regulators are looking to [bonus] deferral as the answer, but we're sceptical this will do much to change bankers' behaviour as deferred bonuses hold little value in their eyes. Our research shows that people discount bonus payments by around 25% for each year they are deferred. Deferring bonuses for even longer periods, particularly if claw-back becomes more likely, will mean they are entirely disregarded in employees' eyes.

PwC have also made the point - again absolutely right - that we should be focusing on amounts, not structure, and that mucking about with ineffective incentive pay means we end up making the total amounts larger.

"It's more important to focus on what people are getting paid for than how they are getting paid. With less deferral it's possible to pay people less in the first place."

In my humble opinion, mainstream corp gov is in completely the wrong place on this, with its focus on structure not scale. This leads to obfuscation, complexity and pay being higher than it needs to be. It facilitates rent capture.

Co-ordinated lobbying against exec pay reform

Last week at work, whilst doing a bit of research into employers' views on the idea of employee representation on remuneration committees, I noticed that some well-known FTSE100 constituents had submitted identically worded responses to the 2011 BIS consultation which sought views on the issue.

For instance, here's what SABMiller said:

No. We do not believe that anyone should be a member of the Remuneration Committees unless they also sit on the full Board, for the reasons explained earlier, namely that it is not appropriate for anyone to be involved in setting remuneration policy structures and levels, who has not participated in discussions relating to overall strategy. This applies as much to employee representatives as to anyone else.
Including employees on remuneration committees would also potentially create a conflict of interest for the employees as they are not independent and, depending on the scope of the Remuneration Committee, may be participating in decisions that impact the structure of their own pay.
It is unlikely to be practicable to find a suitable employee representative who can effectively represent the views of all employees, particularly in globally diverse companies. There is significant scope for the views of an employee representative to be driven by local issues relevant to the location where they work, rather  than the global interests of the company and shareholders as a whole.
The UK Corporate Governance Code already requires Remuneration Committees to be sensitive to pay and employment conditions elsewhere in the company.

Compare that with Tesco's response, which included, amongst other text, the following:

Including employees on remuneration committees would potentially create a conflict of interest for the employees as they are not independent and, depending on the scope of the Remuneration Committee, may be participating in decisions that impact their own pay. 

The UK Corporate Governance Code already requires Remuneration Committees to be sensitive to pay and employment conditions elsewhere in the company.

There's also some  very similar, and in places identical, text in the responses from BT and Smith & Nephew.

And, finally, here's the response from the GC100 (representing company secs and general counsels in the FTSE100):

We are not supportive of compulsory employee representatives on Remuneration Committees unless that person also sits on the full Board for the reasons explained earlier, namely that it is not appropriate for anyone to be involved in setting remuneration policy structures and levels, who has not participated in discussions relating to overall strategy.Including employees on remuneration committees would potentially create a conflict of interest for the employees as they are not independent and, depending on the scope of the Remuneration Committee, may be participating in decisions that impact the structure of their own pay.
The UK Corporate Governance Code already requires Remuneration Committees to be sensitive to pay and employment conditions elsewhere in the company.
We do not advocate employee representatives on Boards, although we recognise that this can work well for some companies and indeed is recognized in different legal systems, where companies have supervisory boards and management boards, with different responsibilities and accountabilities. In some circumstances, an effective employee representative can communicate employee issues to the rest of the Board and also explain the Board’s thinking and reasoning to employees. In many cases however, it may not be easy to find a suitable employee representative who can effectively represent the views of all employees, particularly in globally diverse companies. There is significant scope for the views of an employee representative to be driven by local issues relevant to the location where they work, rather than the global interests of the company and shareholders as a whole.

And it's the same story in responses to other questions in the consultation, such as the proposal for shareholder representation on nomination committees, or for a binding shareholder vote on pay.

So, clearly, someone has produced a text which a number of big PLCs have simply cut and paste, with a few tweaks (perhaps to make them look less generic?) in their responses. My guess (and it is just a guess) is that the GC100 response might be the common text that was drawn upon. This is simply because that seems to be a way that many big PLCs would have seen the same doc. However, whatever the source, is this really any different in principle to generic campaigning emails that NGOs send out? Yet, in this case, we are looking at major companies looking to influence a consultation on a key governance issue.

Having discovered this, and being aware of a previous example of this happening, I wondered whether this had happened in relation to any other consultations. Looking at PLC responses to the 2012 BIS consultation on its actual executive pay reforms, I found the same thing going on, albeit with a slightly different group of companies.

For example, here's what Astrazeneca said about the idea of requiring a higher vote threshold to pass executive remuneration policy votes:

AZ notes that the Department for Business, Innovation and Skills (“BIS”) has recognised that raising the threshold to 75% would be inappropriate. AZ considers that setting an arbitrary threshold between 50% and 75% seems illogical when matters of potentially greater significance can be passed with a vote of 50%. AZ supports a 50% threshold.

And Kier Group:

Kier is particularly concerned with the proposal potentially to raise the threshold. The Government has rightly recognised that raising the threshold to 75% would be inappropriate, but suggesting an arbitrary threshold between 50% and 75% makes little sense when matters of equal or, perhaps, greater significance can be passed with 50% of the votes. Setting the threshold at above 50% would, in effect, make the vote on remuneration more important than most matters shareholders are asked to vote on.

And Marks & Spencer

We have concerns with the proposal to potentially raise the threshold of shareholder support required to pass the vote on remuneration policy. The Government has rightly recognised that raising this threshold to 75% would be inappropriate but have suggested an arbitrary threshold of somewhere between 50% and 75% makes little sense when matters of greater significance can be passed with 50% of the votes. The threshold should therefore remain at 50%.

And Rio Tinto

We disagree with this proposal. The Government has rightly recognised that raising this threshold to 75% would be entirely inappropriate. An arbitrary threshold set somewhere between 50% and 75% also makes little sense when matters of greater significance to a company, such as M&A transactions, can currently be passed by shareholders with 50% of the votes. This would effectively make the vote on remuneration of more importance than most matters shareholders are asked to vote on and is simply illogical. We therefore recommend maintaining a 50% hurdle for shareholder approval of the remuneration policy, consistent with the approach that is taken to other matters of ordinary business at the AGM, e.g. the advisory vote on the remuneration report, director re-elections, etc.

And SABMiller

We believe that raising the threshold of shareholder support required to pass the vote on remuneration policy is an extremely negative and dangerous proposal, and completely unnecessary to achieve the desired purpose. Imposing an arbitrary threshold set somewhere between 50% and 75% makes little sense when matters of greater financial significance – such as the appointment of the directors in the first place, or the approval or the acceptance of a takeover offer, or the payment of a dividend - can be passed with a 50% vote, and many major business decisions, such as spending billions of pounds on a new factory do not require a shareholder vote at all. This would effectively make the vote on remuneration of more importance than most matters shareholders are asked to vote on.

So, again, we see an underlying common text being tweaked a bit, but basically the same point in the same words being used. And, again, it's not just the response to one question. For example, there is similar text in several of the responses to the proposal for a binding vote.

Here's an excerpt from Astrazeneca's response:

Shareholders have had an advisory vote on companies’ remuneration reports since 2002. AZ observes that this has improved communication on remuneration policy between companies and shareholders generally.

And M&S:

We believe that the current advisory vote enjoyed by shareholders since 2002 has had a very positive effect in improving the communication between companies and shareholders.

And Rio Tinto

Shareholders have had an advisory vote on the remuneration report since 2002 and, of course, have always had an opportunity to engage with investee companies through regular investor relations interactions, including AGMs. Equally, shareholders have long had available to them the “nuclear” option of removing a director, or directors, including, in this case, the chairman of the remuneration committee. The advisory vote on the report has, it is generally acknowledged, had a very positive effect in improving communications between companies and their shareholders.T

In defence of the companies, one might argue that, if they agree with the views expressed, then does it really matter? Funnily enough, I think that argument would carry more weight if they hadn't tried to disguise the fact that a common text was being used. By changing it a bit, one might infer that companies know that simply sticking in a carbon copy might mean that the response was taken less seriously.

Anyway, there are now at least three cases of this happening and I have a strong suspicion that it has also occurred elsewhere.

One final point - companies often legitimately moan that shareholders focus too much on executive pay, to the exclusion of more important issues like strategy. But it's striking that this kind of co-ordinated lobbying occurred in respect of two consultations on... err... executive pay. They didn't do it in response to the BIS consultation on short-termism (the one before Kay) - there were very few corporate responses to that one. So maybe PLC's priorities are a bit skewed too?

Engagement architecture

Two seemingly related developments. First up, the membership of the working group that will try and get John Kay's idea of an investor forum off the ground has been announced. 

Chairman	James Anderson	Partner, Baillie Gifford
	Peter Harrison	Global Head of Equities, Schroders
	Claudia Kruse	Managing Director, Governance and Sustainability, APG
	Ida Levine	Director & Senior Legal Counsel, Capital International
	Richard McIndoe	Head of Pensions, Strathclyde Pension Fund
	Sacha Sadan	Director of Corporate Governance, LGIM
	Victoria Sant	Investment Manager, The Wellcome Trust
	Robert Talbut	Chief Investment Officer, Royal London Asset Management

This seems to correspond with a revised terms of the reference for the Institutional Investor Committee, which looks to be focusing back on lobbying on policy.

IIC revised Terms of Reference (updated May 2013)

The Terms of Reference of the IIC are as follows:

Following the authority given to it by its member associations, the Institutional Investor Committee will:
• Complement the policy work undertaken by its member organisations, facilitating better co-ordination and establishing a single voice on issues of common interest;
• Focus on policy issues which impact institutional investors and their stewardship of investee companies;
• Represent the interests of institutional investors to governments, regulators and other relevant bodies in the UK, EU and Internationally;
• Co-ordinate engagement with relevant organisations on relevant policy issues, however, will not seek to coordinate direct investor engagement with companies, this being considered more appropriately coordinated by investors themselves.

So under the last bullet the IIC loses the stewardship/engagement role (which, if you remember, was what it was originally supposed to be all about) but the trade bodies will collaborate over lobbying policymakers.

"Sensitive to pay and condition..." once more

I've blogged previously about the way that companies routinely fail to apply the bit of the UK Corporate Governance Code that says that rem comms should "be sensitive to pay and employment conditions elsewhere in the group, especially when determining annual salary increases."


Well, if I didn't just stumble across evidence of this in the words of a company itself. Being the sad man that I am, I was recently trawling through company responses to the BIS discussion paper on exec pay that led to the incoming pay reforms. I was specifically looking for views on the idea of employees on rem comms. And in one company's response I came across this as one of the reasons why this would be A Bad Idea -

Difficulty in preventing other employment issues affecting the discussions.

So the Code says that rem comms should be sensitive to "pay and conditions", but a company is worried that employee representation would lead to "other employment issues affecting [rem comm] discussions".

When I  get a bit more time I'll see if I can find some more like this.

Afren defeated, again

Afren saw its remuneration report voted down today. It was a stonking vote against, almost 80%, and is the first remuneration report defeated this year (not the first defeat on pay this year though). It comes after a bit of commentary on the lack of a Shareholder Spring 2.

However it's also the second time that Afren has lost the vote on its remuneration report, having also been defeated in 2011. I think that this is the first company to lose the vote on its remuneration report twice since the requirement to have a vote came in at the end of 2002.

But actually Afren's history of pay revolts goes further back. As I blogged back then, in 2010 although its remuneration report passed on a straight for/against split, if you include abstentions then the vote in favour dropped to 40%.

Luckily though, two defeats and a near miss in the past four years have clearly made the company sit up and take notice. As they say today "Our remuneration philosophy reflects the need to retain the most able people in a highly competitive talent market and we will provide appropriate rewards for exceptional achievement leading to the long-term increase in Company value."

Err...

More signs of progress?

I had a quick look at the voting and engagement policy adopted by NEST (available here) and was interested to see this line about executive pay.

The heavy linking of pay to performance for already high achievers is unlikely to produce the motivational drivers that investors want executives to be energised by.

To state the obvious, policy doesn't not equal practice - certainly not when it comes to some asset managers in my experience - and this is just one sentence in a large doc. But you wouldn't have found a sentence like this in any investor's corp gov policy even two or three years ago. Now, in addition to NEST, there are bits on the motivational aspects of pay in docs published by Hermes, LAPFF and BlackRock and maybe others I am not aware of. (As an aside, it strikes me that an obvious next step is for the Corporate Governance Code to be amended.)

In addition, as I've previously blogged, the rem consultants are alert to a shift in thinking. PwC have gone by far the furthest, really questioning the value of incentive pay for execs, and making the point that linking reward to performance tends to push the overall level up.

I think we'll also start to see greater policy focus on this as an issue and I personally hope that Labour gets stuck into it.

In the three plus years I've been blogging/reading/thinking about this in detail I can definitely see there has been a shift in opinion, and this is becoming more pronounced. Given the way performance pay is embedded into unthinking UK corporate governance practice this is a long-term battle, and it is still very early days. But in the battle of ideas about pay I think we're making some progress.

Turkey

While all eyes are on Turkey, it's worth remembering that this is a country where there have been alleged abuses of workers' rights in a major global company - Deutsche Post DHL. Text below from the ITF website about questions raised at last week's AGM.

DHL provides “unsatisfactory” answers over workers’ rights abuses
31 May 2013

Deutsche Post DHL provided “unsatisfactory” answers to the barrage of criticism and questions about its record of workers’ rights abuses from shareholders at its AGM in Frankfurt, Germany on 29 May, according to the ITF.

The ITF and UNI Global Union led the charges against the company, both inside the AGM and at a protest outside with members of the ver.di union and the Turkish community. Journalists at a press conference beforehand heard accounts from Aysel Simsek, a DHL Turkey employee who believes she was unfairly dismissed, and senior representatives of the ver.di and Tumtis unions, ITF and UNI. 

The ITF and UNI claim that the logistics giant would never dare commit in Germany the abuses it practises elsewhere. They have evidence that the company has backed fake unions and unlawfully fired workers in Turkey; used lie detectors against staff in Colombia, Panama and South Africa; and relied on agency workers on lower wages and with no job security in the UK, Malaysia, Indonesia and India.

Speakers at the AGM included ITF global head – supply chain and logistics Ingo Marowsky and UNI Europa post and logistics officer Cornelia Broos.

Marowsky commented afterwards: “The company’s behaviour in many countries where it operates risks alienating shareholders and clients. Around half the speakers at the AGM raised the issue of workers’ rights. Yet it became shockingly clear that not only is Deutsche Post DHL failing to implement its corporate social responsibilities and corporate governance responsibilities but it doesn’t even seem to know what’s going on in its own operations.

“For example, the chief executive officer, Frank Appel, doesn’t know how many unions or works councils they’ve got. They don’t track industrial problems. Court cases apparently ‘just happen’ in such a large company. They are not up to speed with events in DHL Turkey, don¹t want to share their investigation of events there and claim they don’t need a joint investigation.  Such unsatisfactory responses do not inspire confidence.”

Marowsky added: “It was interesting to hear Appel admit that under Turkish law DHL does not have either a recognised union or a collective bargaining agreement. The company has denied up till now our claims that it didn’t have a proper union or CBA in Turkey.”

The ITF and UNI, working with the International Labor Rights Forum and SumOfUs, have raised these matters with several major DHL customers, including Adidas, Apple, IKEA and Marks and Spencer, who have put these concerns directly to DHL.

For more information on the DHL campaign visit ‘respect at DHL’ or the ITF’s campaign page.