Essential Corporate News – Week ending December 21, 2018

Welcome to Essential Corporate News, our weekly news service covering the latest developments in the UK corporate world.

On December 17, 2018 the Financial Conduct Authority (FCA) published an issue of its Market Watch newsletter following a review of industry implementation of the Market Abuse Regulation (MAR). In Market Watch, the FCA outlines its findings and offers clarity on some of the issues raised.

Market soundings

The FCA notes that during its review, it did not observe any impact on the ability of issuers to raise capital on UK markets following the introduction of the market soundings regime.

In relation to how investors receive market soundings, the FCA believes that investors should retain the flexibility to determine the internal organisation that best suits their business model. However, to ensure effective compliance with the regime, it advises firms to consider whether staff receiving sounding approaches are properly trained and aware of their obligations under MAR and related guidelines.  Models dependent on a gatekeeper engaging in a high-level “no-names” discussion with the relevant portfolio manager ahead of accepting the sounding should take care to only disclose information that is necessary to establish whether the approach should be accepted, and firms should be particularly careful when discussing markets that have few actors and where information could reasonably be used to identify the security in question.

The FCA points out that, depending on the approach, a declined wall crossing could still convey inside information. This could occur where the sell-side making contact only initiate soundings for a small number of securities.  Firms should consider whether a declined wall-cross has had the effect of wall-crossing the investor and apply the relevant controls.

The FCA also considers record-keeping in relation to market soundings and urges market participants to consider the most effective way of achieving compliance for their business model. It notes that firms may wish to consider maintaining a detailed record of conversations declining sounding approaches, along with an explanation of why the sounding was declined, as good practice.

In relation to “cleansing” following a sounding, the FCA advises firms to agree cleansing strategies as early as possible ahead of a transaction and to be clear in their approach, including consideration of how cleansing will operate if a transaction fails or is “parked”. It also suggests that firms should consider whether their approaches to undertaking or receiving market soundings can easily adapt to changing market conditions, including a less favourable market for new issues or an uncertain trading environment.

Insider lists

The FCA notes that market participants should remain vigilant and ensure that staff are trained on how to identify and respond to inside information. It states that insider lists are important tools for regulators when investigating possible market abuse and the FCA attaches importance to receiving the mandated template in a complete and timely fashion.  Each time new information is identified, a new section should be added to the insider list and issuers are encouraged to ensure that all staff with access to inside information are included on the insider list, including those who have accessed information according to electronic access logs.

The FCA comments that it is aware that some intermediaries, including investment banks, are receiving requests for their employees’ personal information to assist the issuer in fully populating its insider list. In this scenario, the FCA encourages intermediaries to provide a contact point and advise that they will provide a complete list to the relevant regulator upon request.

If issuers maintain a permanent insider list to document those individuals who have access at all time to all inside information within the issuer, the FCA comments that it expects participants to ensure that the number of employees on such lists is not disproportionately large and remains restricted to employees who have had access at all times to all inside information. Those who do not have access at all times to all inside information should be captured in the deal-specific or event-based insider list.

Obligations for issuers under MAR

The FCA reminds issuers of the importance of maintaining adequate procedures, systems and controls to comply with their disclosure obligations under MAR so issuers should ensure they have the systems and controls for identifying and disclosing inside information. The FCA states that issuers should ensure they can identify and assess whether they have information that could meet the test for inside information outside of normal reporting timetables and in an accelerated manner.  Where information that may not be in line with market expectations comes to light, for example, in weekly sales reports and when preparing monthly management reports, this should be immediately investigated.  If the issuer, as a result of the investigation, believes its historic or expected performance may not be in line with market expectations, then it will need to consider its disclosure obligations under Article 17 of MAR.

The FCA notes that it will continue to work closely with market participants to ensure a consistent, effective implementation of MAR.

(FCA: Market Watch – December 2018, 1.12.18)

On December 18, 2018 the Competition and Markets Authority (CMA) published an update paper following the launch of its market study into the statutory audit market in October 2018.

In the update paper, the CMA summarises its concerns that the audit market is not currently delivering consistently high quality and it also sets out its views on what is driving these quality concerns. Section 4 of the paper then sets out a proposed package of remedies to address the issues it has found.  These are as follows:

Regulatory scrutiny of audit committees – remedy 1

The CMA proposes that audit committees should be subject to specific regulatory requirements and obligations. It currently believes that this regulation should include:

• A requirement that audit committees report directly to the regulator before, during and after a tender selection process. The regulator would also have the ability to include an observer on all or a sample of audit committees.
• A requirement that audit committees report directly to the regulator throughout the audit engagement.
• The ability for the regulator to issue public reprimands or direct statements to shareholders.

The CMA proposes that this remedy should apply at least to all FTSE 350 audit committees but it welcomes views on whether the remedy should be extended to cover a wider group of companies, such as all public interest entities.

Mandatory joint audit – remedy 2

The CMA’s provisional view is that joint audits would increase competition without risking audit quality. In terms of design, its initial views are:

• The main aim of the remedy is to reduce the barriers facing challenger firms. The CMA’s preferred way of achieving this would be by mandating that at least one of the audit pair is a challenger firm.
• The remedy should at least apply to FTSE 350 companies, possibly with some limited exceptions where the nature of the company would not sensibly justify a joint audit. Views are sought on whether the remedy should apply to other large companies or whether specific types of company should be excluded.
• Each joint auditor should have to be granted a significant proportion of the audit work. The minimum proportion to be assigned to any joint auditor might vary across FTSE 350 companies and over time to allow challenger firms to build their capacity.

A possible alternative to a mandatory joint audit would involve imposing a market share cap on the Big Four firms so that a given proportion of the market is reserved for challenger firms. Again, this remedy would initially apply at least to FTSE 350 companies but the CMA seeks views on whether it should apply to other large companies that could be in the public interest.  However, the CMA prefers mandatory joint audits to a market share cap as a means of breaking down barriers to non-Big Four firms competing successfully for larger audits.

Additional measures to support challenger firms to be considered further – remedy 3

The CMA favours the prohibition or limits on the length of non-compete clauses as they make it harder for audit partners and staff to switch firms. Partner switching is seen as necessary for challenger firms to build their capacity.  The CMA is to investigate this matter further and asks for evidence to support the claim that there are csignificant and unreasonable barriers to senior staff switching between the claim that there are significant and unreasonable barriers to senior staff switching between firms.  The CMA also proposes to look at a number of other measures such as technology sharing as access to technology could, in principle, make challenger firms better able to compete for FTSE 350 audits and so increase auditor choice for companies.

Market resilience – remedy 4

This remedy would create a market oversight and resilience regime in the event of a likely or actual failure of a large audit firm in the UK. It would ensure that there remains adequate choice of auditors in the market, while maintaining competition and quality both on its own and as part of a package of remedies.

The CMA notes that the remedy warrants further consideration and it asks for views on how an effective resilience regime could be designed to avoid going from the Big Four to the Big Three. It states that the remedy should apply at least to the Big Four.  However, it may also be appropriate for some large challenger firms to come within scope if they grow in relative size.

Full structural or operational split between audit and non-audit services – remedy 5

The CMA does not believe that the current framework for managing non-audit services conflicts is sufficient to focus auditor’s incentives on high quality audits. It considers that one way to address the reality and perception of non-audit service related conflicts would be to structurally separate audit and non-audit services.  However, it recognises that there are important practical challenges in creating audit-only firms and so it is considering other variants of this remedy that could be effective, but less costly.  For example, one possible solution might be for firms to implement an operational split between the audit and non-audit parts of the firm, with separate profit pools and governance arrangements for audit and non-audit.

Either form of separation, whether it is full structural or an operational split, should apply to at least the Big Four but the CMA seeks views as to whether this remedy should also apply to challenger firms.

Peer review – remedy 6

The CMA proposes that an important element of the regulator’s toolkit should be a peer reviewer who can identify under-performance as it happens and whose presence may actually stop any under-performance occurring. The peer reviewer should be independent, appointed and paid by the regulator, and owe a duty of care only to the regulator.

The CMA proposes that the regulator should have the ability to determine the scope of the peer review function, perhaps initially targeting this at companies that it considers high risk or which require additional scrutiny.

Next steps

The CMA notes that at this stage, it is minded not to make a market investigation reference because it sees recommendations to the Government as a more effective route to implementation. Submissions on any of the issues addressed in the update paper are requested by January 21, 2019.  The CMA will continue to gather evidence, meet with stakeholders and undertake analysis with a view to refining its proposed remedies and issuing a final report as soon as possible in 2019.

(CMA Statutory Audit Services Market Study – update paper, 18.12.18)

On December 18, 2018 the Department of Business, Energy and Industrial Strategy (BEIS) published the final report of the independent review of the Financial Reporting Council (FRC) led by Sir John Kingman (Final Report). The purpose of the review was, broadly, to assess the effectiveness of the FRC’s governance and to assess its independence, impact and powers.

The Final Report considers the FRC’s strengths and weaknesses and makes a number of recommendations, including the following:

• The FRC should be replaced as soon as possible with a new independent regulator to be known as the Audit, Reporting and Governance Authority, which should be accountable to Parliament. Its overarching duty should be to promote the interests of consumers of financial information, not producers.
• The Government should review the UK’s definition of a public interest entity (PIE) which comprises UK entities with securities traded on an EEA regulated market, credit institutions and insurance undertakings
• PIEs and their auditors have to adhere to requirements for auditor rotation, capping the provision of non-audit work and prohibiting some forms of non-audit work. The Final Report notes that some countries have a wider definition of a PIE than the UK and is concerned that the UK’s narrow definition may exclude entities whose audit arrangements are a matter of public interest.
• The corporate reporting review process should extend to the entire annual report, including corporate governance reporting rather than just to the strategic report, directors’ report and annual accounts as is currently the case.
• The Government should work with the Financial Conduct Authority (FCA) and the new regulator to consider whether there should be more regulation around a wider range of investor information (such as earnings release and investor presentations that may include forward-looking information) which is not currently covered by the FRC’s existing corporate reporting work.
• The new regulator should be tasked by the Government to develop detailed proposals for an effective enforcement regime for PIEs that holds a company’s CEO, CFO, chair and audit committee chair (not just those who are members of a professional accountancy body) to account for their duties to prepare and approve true and fair accounts and compliant corporate reports, and to deal openly and honestly with auditors. Relevant requirements or statements of responsibilities in relation to auditing and corporate reporting should also be set out so that directors are individually accountable for their roles.
• The UK’s Stewardship Code should focus on outcomes and effectiveness, not on policy statements.
• The Government should introduce a duty of alert for auditors to report viability or other serious concerns and engage with the auditor where the auditor of a PIE parts company with a client outside the normal rotation cycle.
• The new regulator should have the power to commission a skilled person review, paid for by the company, where, for example, it has significant concerns about the accounting treatment of key areas of audit judgement or where there is evidence of significant investor concern. The new regulator should then have power to require additional assurance on the viability statement or any other aspect of the company’s report and accounts, require an independent boardroom evaluation focussing on areas such as the effectiveness of the audit committee, notify the board of its views of the risks to financial viability and require the board’s formal response or order the removal of the auditor or an immediate retendering.
• In addition, the new regulator should have the power, in the most serious cases, to report to shareholders suggesting that the company’s dividend policy should be reviewed, or that they consider the case for a change of CEO, CFO, chair or audit committee chair or for strengthening the board.
• BEIS should look at whether the framework around internal controls should be strengthened, learning lessons from the operation of the Sarbanes-Oxley regime in the US and viability statements should be reviewed and reformed to make them substantially more effective. If that cannot be done, consideration should be given to abolishing them.

On December 18, 2018 Sir John Kingman published his letter to the Secretary of State in response to the request put to him to consider whether there is any case for change in the way in which auditors are appointed and their fees set. The letter is separate from his final report following his review of the Financial Reporting Council.

The letter proposes a model whereby, in the case of public interest entities (PIEs), instead of an auditor being proposed by the PIE’s board and approved by shareholders, the appointment would be made by an independent body representing the public interest (the new Audit, Reporting and Governance Authority Sir John has proposed in his final report) which would also set the audit fee. The new regulator’s decision on auditor appointment would be subject to shareholder approval.

Sir John believes this approach would make a shift in the commercial incentives on auditors as the regulator would be interested in seeing challenging and high quality audits, but he acknowledges that audit committees would need to work with the regulator. He also notes that investors are very clearly opposed to a change of this nature as they are concerned it deprives shareholders of the right to choose the auditor and so accepts that the case for change needs to be explored further with investors.

Sir John recommends the following in the letter:

• The new regulator should have the right to appoint an auditor where (i) quality issues have been identified around a PIE's audit; or (ii) where a PIE has parted company with its auditor, other than as part of the normal rotating cycle; or (iii) where there has been a meaningful shareholder vote against an auditor's appointment. In all three cases, the letter suggests that it would be in the interests of investors, other stakeholders and the PIE for the regulator to have the ability to intervene; and
• The new regulator should have the right to approve audit fees where the regulator sees a case for doing so in the interests of quality.

(Sir John Kingman letter to Secretary of State, 18.12.18)

On December 18, 2018 the Department of Business, Energy and Industrial Strategy (BEIS) launched an independent review of the quality and effectiveness of standards in the UK audit market. The review will be led by Donald Brydon, outgoing Chairman of the London Stock Exchange.

The Brydon Review will build on the findings of the independent review by Sir John Kingman of the Financial Reporting Council (FRC), and the Competition and Market Authority’s (CMA) market study looking at the effectiveness of competition in the audit market.

Building on the work of the FRC and CMA reviews, the Brydon Review will consider what the future standards and requirements should be for audits and will examine:

• How the current model can be made more effective and how far audit can and should evolve to meet the needs of investors and other stakeholders.
• How auditors verify information they are signing off.
• The public’s expectations of an audit and how to manage any residual gap between what audit can and should deliver.
• What can be done to make audits more effective and reputable, and what standards and requirements should apply in the future.

The Brydon Review will also test the current model for audits in the UK and consider whether it can be made more effective, as well as look at how audit should be developed, taking into account changing business models and new technology.

Detailed terms of reference and a project plan will be published in 2019.

(BEIS: Independent review of the UK audit market press release, 18.12.18)