UK: Protecting Investors Post Enron

Last Updated: 1 May 2002
Article by Adam Fenner

The country’s economy depends on the drive and efficiency of its companies. Thus the effectiveness with which their boards discharge their responsibilities determines Britain’s competitive position. They must be free to drive their companies forward, but exercise that freedom within a framework of effective accountability

The introductory paragraph of the 1992 Cadbury Report into the financial aspects of corporate governance warned us of the importance of management regulation. 10 years after publication, the biggest corporate bankruptcy in US history is forcing the investment community and industry regulators to consider not whether shareholders and stakeholders should be better protected but how they can be better protected. The role of directors is to act in the best interests of the company and thus in the interests of shareholders collectively, both present and future. Auditors are formally appointed by shareholders and their audit should be carried out in their interests, ensuring that the financial reports for which directors are responsible reflect the economic reality of the company. Enron has shown how easy it is for these interests to be compromised. Legislators must ensure the legal framework on which corporate activity is based keeps the functions of directors and advisers, charged with acting in the company’s interests, in check.

Enron provided some graphic examples of how the regulatory environment both within and outside the company, failed to protect shareholders’ interests.

Holding Executives to Account

First there was no effective counter balance to the actions of the executive directors. It appears that the non executive directors failed to regulate adequately the activities of senior management, one of their primary duties. The audit committee did not make sufficient investigations to uncover the off balance sheet liability havens. The 1998 Hampel report on corporate governance illustrated very clearly the duty of non executive directors to take a proactive role in seeking out critical information:

“The effectiveness of a board (including in particular the role played by the non executive directors) is dependent to a substantial extent on the form, timing and quality of the information which it receives. Reliance purely on what is volunteered by management is unlikely to be enough in all the circumstances and further enquiries may be necessary if the particular director is to fulfill his or her duties properly”

One can only speculate on the reason behind the apparent failure of Enron’s audit committee to investigate the company’s off balance sheet liabilities, but it is certainly timely to consider whether as a rule non executives should always be required to be wholly impartial and independent of the executive management. Should the personal interests of any non executive be dependent on the favour of the managers of the company they are charged with scrutinising. For example should non executives be entitled to provide consultancy advice to the company or is there a real risk that this will lead to pressure on them to compromise their impartiality ? The 1992 Cadbury Committee provided guidance here when it recommended that a majority of non executives should be “independent of management and free from any business or other relationship which could materially interfere with the exercise of their independent judgement”. Perhaps a reassessment of whether all non executives should be independent is now overdue. There is no reason why their impartiality should compromise their other vital function, to contribute to the development of the company’s strategy. Indeed their monitoring role is entirely consistent with this. Furthermore, is the recommendation contained in the Stock Exchange Combined Code, which is derived from the Greenbury, Cadbury and Hampel reports, that at least one third of board members should be non executive sufficient, or can confidence in their monitoring ability only be assured if they account for a majority ? How can investors protect themselves ? The Stock Exchange already requires listed companies to provide a statement in their annual report as to whether or not they have complied throughout the accounting period with the Combined Code provisions and give reasons for any non compliance. A report produced for the DTI’s Company Law and Investigations Directorate in 1999 showed that of a sample of 64% of all Stock Exchange listed companies, over 93% had a board where non-executives comprised at least one third or more of the board and over 91% identified their independent directors in their annual reports. This may be of some comfort to UK investors. However, the existence of specific New York Stock Exchange rules on the composition of audit committees and their operations illustrates that the presence of standards and disclosure obligations is not a guarantee of effective scrutiny. Perhaps audit committees and non executive board members should be required to disclose specifically their processes of scrutinising the company’s activities and assume a greater burden of responsibility for the consequences of their failures to act accordingly. If they felt the task of scrutiny was made impossible by the activities of the executive board, their resignation would send clear warning signals to the investment community.

Conflicts of Interest

Second, it appears that a culture developed in which it was manifestly acceptable for directors to engage in activities that put them in conflict with the interests of the company and thus shareholders. The transfer of liabilities to off balance sheet limited partnerships in which individual directors had substantial personal interests hid the failings of management from the market and kept from shareholders information that would have led them to force a change of management. And of course, hiding these liabilities gave directors time to sell their personal shareholdings in the company before the whistle was blown. English law is clear that directors must not compromise their duty to act bona fide in the interests of the Company as a whole. Furthermore, directors must not make any secret profits at the expense of the Company. It is reported that Andrew Fastow, Enron’s chief financial officer allegedly made $30million dollars personally from the off balance sheet partnerships before he was removed from Enron in October last year. But how could investors be protected from these activities ?

Directors’ duties must be implemented if they are to be of any value. A director who is aware that his activities amount to a compromise of his duties is unlikely to wish to make full disclosure. And if fraud is involved, then it is likely to be even harder to detect. Are shareholders willing to accept the additional costs of more extensive audits on the remote chance that fraudulent activities might be carried on ? Again the Cadbury Report back in 1992 provided us with a potential solution:

“An effective and independent-minded audit committee is an essential safeguard. It has an important role to play in considering whether any extra work should be undertaken in addition to the normal audit procedures to investigate defences against fraud and in reviewing reports on the adequacy of internal control systems.”

Reality Check

Third, the audit process failed to result in the economic reality of Enron from being disclosed to shareholders. Leaving aside the technical basis for the accounting treatment of the key limited partnerships, in the UK the function of the audit must be to provide reassurance to those who have a financial interest in the company that the results produced by the directors give a true and fair view and that they are free of material misstatements. Auditors are appointed by shareholders and their duties are therefore owed to shareholders as a collective group. They must work closely with management. However, their impartiality and objectivity must be assured if these duties are to be fully discharged. Much debate was already in progress on the impartiality of auditors prior to the Enron collapse. Again the Cadbury Committee declared in 1992:

“Among the propositions made to the Committee to strengthen the objective relationship between auditors and management, one was that audit firms should not provide other types of services to their audit clients. The argument runs that such a prohibition would remove any pressure on the auditors to give way to management on audit matters in order not to jeopardize their other business services and that it would remove any incentive for auditors to take on audits at rates which could risk corner cutting in the hope of obtaining more remunerative non audit work”.

Cadbury rejected the call for a prohibition on the provision of consultancy services by audit firms to their clients, citing increased costs as one of the objections.. Many believe that following Enron, however, the introduction of such a prohibition and the associated cost increase is inevitable.

Reassessment not Revolution ?

Many are calling for a comprehensive regulatory response following the collapse of Enron. But as a preliminary thought, perhaps our response here in the UK in the listed environment might be a reassessment of existing corporate governance standards, already contained in the Combined Code and the adoption of an ever broadening purposive regulatory approach as opposed to a specific prescriptive approach. Arguably highly prescriptive legislation can provide a road map for abuse for those who are committed to avoiding it, if it prevents regulators from looking at the overall picture. Perhaps a broader regulatory framework that leaves the regulators with greater discretion will serve investors interests more effectively. Certainly there is some enthusiasm for this in the UK with the adoption of the new market abuse regime which came into force at the end of last year. This provides for unlimited financial sanctions against those who engage in behaviour based on a misuse of information or which gives rise to a false or misleading impression as to the worth of securities or which leads to a distortion in the market. And it can apply to the behaviour of anyone in relation to listed securities.

Enron has illustrated that the adoption of a set of rules or principles or of any particular practice or policy is not a substitute for and does not of itself assure good corporate governance. The challenge for investors is to be alert to the warning signals, to push for reform where needed, to be ready to challenge both executives and non executives on the effective stewardship of their companies and to be familiar with new regulations and codes of practice that are designed to protect them.

The contents of this article do not constitute legal or other professional advice and should not be relied upon by any person. For specific enquiries please contact Fenners at the above address

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