Monday, 25 November 2019

Uber Loses its London Licence


After declining to renew the licence for Uber to operate taxis in London in 2017 – a decision which was overturned by a Magistrate - Transport for London (TfL) has repeated that action today and refused to extend the firm’s licence beyond a 15-month extension (with an extra 2-month probationary period added on) that was granted to it in 2017. As the news broke today, the potential ramifications are yet to be decided, but we shall examine what may happen and the legal processes that are likely to forthcoming.

In September 2017, TfL declined to renew Uber’s licence to provide taxi services in London on account of the company’s failure to carry out background checks on its drivers, and also for failing to report serious offences. TfL later granted the firm a 15 month extension, but only on the condition that a number of its practices were improved. A number of those practices focused upon consumer safety and, in today’s announcement, the TfL refused to extend the firm’s extension again (after the extra 2-month probationary period) on the grounds of failing to protect their passenger’s safety. TfL cited a ‘pattern of failures’ that have been identified, including but not limited to drivers found to have distributed indecent images of children still being allowed to drive, drivers being dismissed or suspended but then manipulating Uber’s systems to continue driving, and drivers uploading their pictures to other people’s accounts. TfL stated that they acknowledge there have been improvements made but, ultimately, ‘while we recognise Uber has made improvements, it is unacceptable that Uber has allowed passengers to get minicabs with drivers who are potentially unlicensed and uninsured’. This decision was cheered by certain parties, including the Mayor of London who declared that ‘keeping Londoners safe is my absolute number-one priority’ and the Licensed Taxi Drivers Association (which represents London’s Black Cab Drivers) who said ‘it is all about public safety and the mayor has taken the right decision’. Going further, Steve McNamara of the Association stated that Uber’s business model is ‘essentially unregulatable’. The Unite Union agreed, arguing that ‘Uber’s DNA is about driving down standards and creating a race to the bottom which is not in the best interests of professional drivers or customers’. However, Uber have countered these claims, stating that TfL’s decision is ‘extraordinary and wrong’. In confirming that the firm will be appealing and, as such, the company’s services will still be available to all during the hearing of that appeal, Uber defiantly declared that ‘on behalf of the 3.5 million riders and 45,000 licensed drivers who depend on Uber in London, we will continue to operate as normal and will do everything we can to work with TfL to resolve this situation’. It will be now for a Magistrate to decide on whether to uphold Uber’s appeal, or side with TfL.

However, there are a number of developments which hint at the power dynamics in the relationship between Uber and the cities within which they operate. It was reported last week that ‘Uber could soon be required to force their drivers to scan their fingerprints and faces in order to continue operating in London’. It is more than likely that this determination that biometric data be collected before every shift starts was rejected by Uber, which has now led to the removal of its licence. A representative for Uber drivers has labelled this licensing condition as ‘disproportionate and discriminatory’ and Uber has form in terms of rejecting licensing conditions imposed on them – Uber pulled out of Denmark in 2017 because they were mandated to install fare meters and seat sensors. However, whilst the firm can walk away from a market of 300,000 riders in Denmark, walking away from London is not an option for the firm. Uber recently declared through its regulatory filings that almost 25% of its sales came from just five cities – London, Los Angeles, New York City, San Francisco, and São Paulo. Losing London from that list would have a massively damaging effect on the company’s fortunes; the market in London is 3.5 million riders, and even just the news of the loss of licence led to a 5% drop in their stock on pre-trading in New York.

The legal arguments will likely be complicated and lengthy, which works in Uber’s favour as it will continue to operate as normal during the appeal process. What happens next is hard to tell, though it is likely that Uber will secede in its defence and TfL may soften in its approach – the impact of losing Uber in the British capital will be felt widely, both in terms of loss of employment and availability of private taxis. Uber is certainly not ‘too big to fail’, but it is not far off it seems.

Keywords – Uber, business, London, licence, @finregmatters

Saturday, 23 November 2019

Credit Rating Agencies and ESG Ratings: Update

Today’s post is just a small update regarding developments in the sustainability/ESG rating market. We have looked at this growing field before here in Financial Regulation Matters. One of the topics of interest is the movements that the established ‘Big Two’ credit rating agencies – S&P and Moody’s – are making into the market, which experts believe will be worth more than $200 million in annual sales this year and could grow to more than $500 million in the next five years.

In the last post, dated the 24th September, we looked how Moody’s had acquired Video Eiris and Four Twenty Seven as part of their own M&A strategy, whilst S&P had published its own ESG evaluation this year. S&P’s developments come off the back of a number of mergers, with one headline merger including that of TruCost. However, S&P continued that drive over the last few days with the announcement that they were purchasing the ESG-rating arm of RobecoSAM. The terms of the deal have not been disclosed and it is thought that the deal will be concluded during the first quarter of 2020. As part of the acquisition, S&P will not only acquire the annual survey that the arm generates – the survey is considered to be one of the leading informational sources regarding companies’ corporate sustainability practices, researching over 5000 companies – but they will also acquire the service that allows companies to purchase one-off reports on their sustainability performance and how that compares to their peers. Also, as part of the deal, RobecoSAM will continue to have access to the data for use in its investment strategies and advice on its survey methodology.

Doug Peterson, the Global President and CEO of S&P, said that the deal is an ‘exciting next step in the evolution of our partnership that will allow S&P Global to create market differentiating ESG products and deliver new content and capabilities to our customers’. This is important for the agency’s objectives because, as we discussed in the previous post and as is clearly understood by the agencies, Peterson confirmed ‘we identified ESG as one of the highest growth areas’. To be able to diversify their product range and, more importantly, the impact of those products on the investment successes of their clients, will be vital for S&P as it seeks to consolidate its position alongside the equally-developing Moody’s Corporation.

However, as I warned in my book The Role of Credit Rating Agencies in Responsible Finance last year, it is very important to monitor this consistent growth. As the development of the field is a social good, there may be a tendency to push for as much involvement by all of the large financial players, in order to grow the field as much as possible. But, we must remember that the push for better and increased rates of home ownership in the US predicated one of the largest crises on record, so we must be careful not to make the same mistake again. I have argued that it is the commodification of ESG ratings that may be problematic, in terms of either those ratings being linked to capital stress tests and the equivalent (to oversimplify a very complicated issue across sectors), or with the development of green finance-related financial products. The rating agencies will, if that market continues to grow, become a key gatekeeper in that particular marketplace which will, in theory, bring a number of inherent conflicts of interest to the surface once more. Time will tell of course of how this will all develop, but the signs are there that this market will just keep growing and growing. Expect more M&A news from the agencies very soon.


Keywords – Credit rating agencies, S&P, ESG, Sustainability, @finregmatters

Monday, 18 November 2019

Deloitte Breaks Cover in an Attempt to Reduce Reform


It was only earlier in the month that we looked at the comments made by the new Head of the Financial Reporting Council (FRC) regarding the audit oligopoly and the potential of reforms heading its way. In today’s business press, it is being reported that Deloitte – the second-largest British accounting firm – has altered its policies so that now Non-Executive Directors have the final say regarding the level of pay and bonuses that its auditors can obtain. In this short post we will look at these plans and assess the validity of the move with regards to the potential of regulatory reform making its way to the sector.

The Financial Times was clear this morning that the move was purely aimed at preventing ‘the perception of conflicts of interest between its audit and consulting divisions and avoiding a forced split’. The article says that the Non-Executive Panel – which includes former Barclays Chairman Sir Gerry Grimstone – ‘will review the policies and performance metrics by which Deloitte’s auditors are paid and monitor individual remuneration’. One of the reasons why this alteration to the firm’s policies has been brought in is because they are attempting to dampen criticism relating to the fact that auditors are paid from the firm’s total profits, which of course includes profits from the consultancy arm of the business. Sir Grimstone interestingly argued that the risks of conflicts emanating from the remuneration dynamic discussed above are low because ‘in partnerships, everyone is very aware of what everyone else gets paid and so there is a lot of self-policing that goes on’. The Chief Executive of the ICAEW was pleased with the development, which rival PriceWaterhouseCoopers are said to be considering also, stating that ‘it would be in accordance with the original vision for the audit firm governance code for them [the Non-Executive Board] to play an increasing role in decisions which are important to the public’.

However, Sir Grimstone’s assessment does not look at the wider picture. The issue for the public, as the ICAEW rightly focus on, is the perception of a transgressive culture founded upon the profits derived from consultancy services. Lest we forget, this dynamic threatened to rip apart the sector only two decades ago. It is therefore telling that Deloitte have taken this move in the same year that ‘Partners at Deloitte UK will receive their biggest payday in a decade’. This pay out, whereby the firm’s equity partners will be handed an average profit share of £882,000 – a 6% increase from 2018 – will do nothing but provide more fuel to the fire that is producing plenty of smoke in the sector. It will be interesting to see how this morning’s news is received by the wider sector on top of the comments already made by the ICAEW. Will it be the case that on the back of a number of high-profile and impactful failures on the watch of the Big Four auditors (and the top-six as well) the way out for them is to put remunerative policies in the hands of a non-executive board? That will probably appear to be quite a come-down from regulators after all the talk of incisive regulatory reform.

Keywords – Audit, Business, Deloitte, Accountancy, UK, @finregmatters

Wednesday, 13 November 2019

Gender Diversity in British Business: A Tale of Competing Narratives


In yesterday’s Financial Times, the newspaper ran with a headline that ‘Leading UK companies at risk of falling short of gender targets’. Here in Financial Regulation Matters we have discussed the issue of gender diversity within the business arena on multiple occasions, and in relation to a number of different jurisdictions (here, here, and here). However, upon reading the article it quickly becomes clear that there are competing narratives at play, whilst there are also narratives and important issues that are not included in the discussion. In this post we will look at the highlights of the article but also the wider issues.

The article is based upon the latest report from the Hampton-Alexander Review, a review set up to build on the work developed by the Davis Review. The Davis Review compiled evidence from 2011 onwards regarding the composition of Boardrooms in the largest of FTSE companies (100, 250, and 350) and, in 2015, declared that much improvement had been made; the Review starts by declaring that representation on FTSE 100 boards had doubled since 2011 to 26.1% (and 19.6% for FTSE 250). In attempting to push this further, the Hampton-Alexander Review has set a target for FTSE 350 companies to have at least 33% of Board positions held by women. Their penultimate report was recently published and forms the basis for the FT article. The headline statistics are that female representation at FTSE 350 companies had increased to 28.6% from 27% in 2018, but that ‘175 companies were still “well adrift” of the 33% goal, with a “surprising” 44 all-male executive committees across the listed market’. The concern is that this grouping will not meet the target by 2020 because, if it were to do so, then half of all available roles available in the next year would have to go to women – a statistic which is unlikely given recent and historic performance. The leaders of the Review are both positive and a little negative about the results, with the CEO Denise Wilson proclaiming that ‘there are over 900 women now serving on FTSE 350 boards, providing an ever-increasing pool of women with substantial board experience’, but that based on the fact there are only 14 female CEOs in the FTSE 350, ‘only 25 women have been appointed into the chair role, even fewer women CEOs and [this is] showing little sign of change’.

Yet, the FTSE 100 is ahead of schedule in terms of meeting the set targets, whilst the FTSE 250 is fully expected to meet its targets in time for the cut-off point. There are instances of outlying organisations – the FT focuses on Daejan Holdings and the Kainos Group who each have all-male boards, as well as 39 other so-called ‘one and done’ boards who have a solitary woman on their boards – but the sentiment displayed by those in the Review and by the article is that there is momentum on their side. The article and the Review conclude by discussing the need for further development and also further development at the Executive level, not just at the Board level. It is clear then that there are positive and negative elements. Clearly, since 2011, the rate of development has been relatively rapid, and this is incredibly encouraging. Negatively, there is still plenty of work to be done and, more importantly, at a number of different levels so that true diversity is achieved within the British sector. However, this concept of ‘true diversity’ is extremely important and, in light of some further statistics that are not discussed in this article or the Review, there is an incredible amount of work still to do.

There are only one or two references to race within the 79-page report, and this is not surprising. Writing in January, the FT found that all of the 25 female executive directors working for FTSE 100 companies were white, and 97% of the female executive directors of FTSE 250 companies were white also. The January article makes the obvious but necessary point that organisations that promote corporate gender diversity – such as the City Women Network and the 30% Club – are mostly controlled by white women, whilst Reviews such as the Hampton-Alexander Review are led by white man and women. The article states that when they interviewed senior corporate leaders about the lack of racial diversity amongst female corporate leaders, ‘some of them suggested that black women were unqualified and lacked the drive and intellectual rigour to break the glass ceiling’. Whilst this quote is very anecdotal, there are two issues that arise from it. One is that language is particularly colonial in its sentiment and the focus on black women in particular is telling. Another is that, as the article makes clear, between 2014 and 2017 ‘the proportion of Chinese, Indian, Black African and white 16- to 64-year-olds in the UK who had university degrees was 60%, 52%, 41%, and 28% respectively. Clearly then, qualifications and intellectual rigour should not be an issue. The Trades Union Congress last year declared that BME people are still facing disproportionate discrimination in the British workplace, with the FT article confirming that race is the dominant explanatory variable for imbalances in pay and promotion once differences in age, education, and gender are controlled for. It is also important to note that, not surprisingly, this level of under-representation occurs when applied to black males also – since the creation of the FTSE 100, there has only ever been one black male CEO; Tidjane Thiam of Prudential. The FT article contrasts this with the fact that, in that same time, the number of white female CEOs at FTSE 100 has risen from one in 1997 to six in 2018. Further analysis of the FTSE 100 reveals a stark situation: of the 300 senior executive positions in the FTSE 100 (chair, chief executive, or chief financial officer), the positions were held by predominantly by white people – 271 white men, 25 white women, four Asians, and no black men or women (Thiam departed Prudential in 2013).

These remarkable figures (or perhaps not so remarkable) tell us one thing, perhaps. Whilst it is vital that we celebrate advancements in gender diversity within British business, we must not fall into the trap of ‘whitewashing’ the narrative. The appalling under-representation of black women, even in the narratives being presented regarding gender diversity, must come to an end of true diversity to be achieved. This is even before we look at resolving the appalling under-representation demonstrated across the board. There is a similar narrative-based problem within other fields, like the legal field, whereby statistics applauding increases in ‘BAME’ recruitment wash over the fact that, for certain categories of people (black men and women in this instance), the rate of advancement is painfully slow. Statistics must be promoted in the right light and, crucially, from within a holistic narrative. If they are not, they only tell portions of the story, and that is of limited use. Perhaps the real need is for people to alter what the concept of ‘diversity’ means for them – it cannot mean diversity for this group or that group, because that is not diversity. There is still work to be done based upon the report from the Review discussed in this article, but closer examination reveals there is much more work to be done than even they realise.

Keywords – business, gender, diversity, race, @finregmatters

Tuesday, 12 November 2019

Royal Mail Fined a Record £50 million for Anti-Competitive Practices


Today’s post responds to the news today that a long-running 5-year saga has finally come to an end with the Competition Appeal Tribunal has dismissed the Royal Mail’s challenge to a £50m Ofcom fine for abusing its position. In this post we will review the origins of the fine and the legal developments of the case, up to today’s ruling.

In August 2018, the British communications regulator Ofcom announced that it was fining Royal Mail a record £50 million for practices that it undertook to squash the competition being offered by Whistl. Whistl is a delivery management company and was aiming to break into the wholesale mail delivery market in the UK. Whistl had alleged that Royal Mail, in its position as the market leader, had altered its pricing for firms who act as a go-between between businesses and the Royal Mail. Crucially, the Royal Mail had proposed a different set of charges for companies that also wanted to deliver the mail themselves, as well as act as the go-between. Whistl complained that this practice was discriminatory and, as such, ended plans to implement an expanded delivery network. Ofcom subsequently agreed and declared that the practices did account to ‘unlawful price discrimination’. After investigation, Ofcom found that Royal Mail had increased its prices for competitors ‘that did not reach volume targets for the whole of the UK’. The effect of this was to penalise any company who had its own delivery workers in certain parts of the country, and this included Whistl primarily. This process is a lucrative one for Royal Mail, with The Guardian suggesting that it is a £1.5 billion a year process (of delivering ‘access mail’ that is collected by other companies) but that with the proposed price changes, would have led to Whistl paying 0.25p per letter more than anybody else.

In fining the company, Ofcom’s competition director stated that ‘all companies must play by the rules. Royal Mail’s behaviour was unacceptable and it denied postal users the potential benefits that come from effective competition’. The record fine was based upon these practices, but also that documentary analysis revealed that the price changes were part of a purposeful strategy to restrict the growth of competitors, namely Whistl. Royal Mail responded to the initial fine by saying that the decision was ‘without merit and fundamentally flawed’, primarily because the price change was never actually implemented, only proposed. They stated that there would be an appeal, and that appeal was concluded today. Upon hearing that the appeal had been dismissed, an Ofcom spokesperson stated ‘Royal Mail had a special responsibility to ensure its behaviour was not anti-competitive… we hope our fine, which has been upheld in full by the Tribunal, will ensure that Royal Mail and other powerful companies take their legal duties very seriously’.

Though £50 million will not bring Royal Mail to its knees, it is statement of intent from the regulator. In many monopolies, the regulator will pay lip service to the concept of competition, so as to protect the underlying monopoly from criticism and action. However, the actions of Royal Mail, in this instance, were seen to be overly punitive and reflective of their position, which is probably the starting point of what has become the largest fine for the regulator. It will be interesting to see how Royal Mail moves forward in its position as the market leader, both in light of this fine but also the fact that their commitments to its ‘universal service’, as dictated by its privatisation, will come to an end in 2021. The company is a private company that still has obvious ties to the public sector, but the more the company moves away from that, the more it will be inclined to act in its own interest. The company is currently engaging in further legal action in attempting to block strikes that are due for the General Election and Christmas, on the grounds that Union officials have been breaching their legal duties. It is becoming evident that the Royal Mail is slowly but surely morphing into an entirely new and different entity, one which regulators may need to pay particular attention to.

Keywords – Royal Mail, Post, Britain, Business, @finregmatters

Monday, 11 November 2019

‘Fuel Tankering’ Shines a Poor Light on Airline’s Claims of Environmental Concern


In today’s business media, the concept of ‘fuel tankering’ has been highlighted, particularly with regards to the practices of British Airways (although, it is an industry-wide practice) so as to bring forward the story that airlines who claim to consider the environmental impact of their business are, in fact, prioritising profits. In this post we will examine the practice, its effects, and what the industry is claiming it will do to respond to the criticism.

Fuel Tankering’, as a practice, describes when an aircraft will carry more fuel than is required for the flight in order to reduce the amount required, or remove the need to refuel at all, at a destination airport. The reason that an airline would do this is because different airports charge different prices to refuel at their airport. According to industry research, fuel makes up between 17 and 25% of an airline’s operating expenses, and it has been confirmed that airlines will have software packages that calculate whether it is profitable to add the extra fuel at a given airport and not at others. To note, this ‘extra’ fuel relates to fuel that is added to an aircraft over-and-above the fuel required for the trip and the reserve. Research suggests that, in Europe alone, almost 20% of all flights are ‘tankered’, with qualitative research suggesting that 90% of these flights are tankered for the purposes of profit alone, rather than the 10% for potential disruption to the fuel supply line etc.  

However, there is a glaring problem when the practice is examined further. Not only does moving this extra weight increase the emissions of the aircraft, but the savings can often be as little as £10 for that particular flight. The resultant emissions can equate to the output of one person’s emissions on a trans-Atlantic flight, with the media today utilising sensationalist but accurate figures like ‘the practice on European routes could result in additional annual greenhouse gas emissions equivalent to that produced by a town of 100,000 people’. This has caused a wave of controversy, with Greenpeace arguing that this was a ‘classic example of a company putting profit before planet’, and Professor Lewis of UCL labelling Ryanair’s tree planting schemes as a ‘green gimmick’. The figures themselves do not reflect well on the airlines – an example used in the media was of a BA flight to Italy that had almost three extra tonnes of fuel on board, for a saving of £40; the aircraft emitted an additional 600kg of CO2 in the process. In response Willie Walsh, the CEO of BA, confirmed that his airline did tanker fuel (he cites the price difference between Glasgow and Heathrow, where Glasgow is 25% more expensive as a clear example of why the practice is undertaken) but that it was ‘maybe the wrong thing to do’ and that the issue may lay in the incentivising of managers. How, and if the airline responds to this criticism, remains to be seen.

The issue within the sector is clearly cost. A story today, also relating to the sector, talks of a whistleblower who is claiming that Boeing are fitting defective parts to their planes to save money, and that a number of other whistleblowers have reported the company to regulators regarding the working practices experienced by its employees. In responding to the criticism, it was telling that Walsh immediately brought up the massive price difference between Glasgow and Heathrow, perhaps just emphasising that in this particular marketplace separating oneself from the crowd, at the cost of profitability, is too dangerous a game. The likelihood of airlines making this move is minimal, meaning there will have to be cross-border and/or international regulations on the practice, or on the cost of fuel. It has been noted that in other industries – like shipping – aspects such as speed-control have had a positive impact on emissions etc., but it is difficult to see how that could be transposed onto the airline industry. Regulators have not been forthcoming on the issue, with airlines attempting to take the lead on ‘turning their attention’ to the practice. If that is what will be the driving force in changing the practice, then there may be a long wait.

Keywords – airlines, emissions, environment, business, @finregmatters

Sunday, 10 November 2019

Concerns Raised Over Credit Rating Agencies’ Assessments of EBITDA ‘Add-Backs’


After the Financial Crisis, once the actions of the leading credit rating agencies were brought to light, the sense of scepticism and suspicion regarding the actual operating policies of the agencies was at an all-time high. As such, a number of their practices have been scrutinised by onlookers with the view of determining their usefulness, their role, and their overall worth. The most recent example of this can be seen in the recent concerns raised within the business media, and from across the marketplace within certain sectors, regarding how the agencies are viewing something known as ‘add-backs’. In this post we will learn more about these concepts, and evaluate the concerns and their validity.

In May, Reuters ran with a story entitled ‘US investors sound alarm over projected add-backs’, whilst only on Friday the Financial Times ran with the headline ‘“Add-backs” stoke fears of distorted credit ratings’. The rating agencies have responded to this issue, with S&P publishing a research article in September entitled ‘When the cycle turns: The continued attack of the EBITDA Add-back’. So, before we assess the issues being raised, it is worth starting from a simple footing. EBITDA stands for ‘earnings before interest, taxes, depreciations, and amortization’, and is a measure of a company’s overall financial performance. In essence, we can think of this as a company’s ‘pure earnings’. However, even a simple definition of the concept has attached to it clear warnings, like ‘it can be misleading because it strips out the cost of capital investments like property, plant, and equipment’. The concept was said to have been developed by John C. Malone, current Chairman of Liberty Media (owners of Formula 1, amongst other things) in the 1970s ‘as a means of convincing investors that, despite a lack of profits, his company TCI was generative’. So, in theory, it seems to be, at least, a useful measure of company performance. However, concerns have been raised regarding the manipulation of such figures. The FT presents a hypothetical scenario as an explanation, whereby a fictitious company needs funding but the lender requires the company to have $10m of savings, which it does not have. In order to obtain that funding, the company could ‘add-back’ some costs – like travel expenses turning into non-recurring costs, company vehicles turning into an R&D expense, and so on – until those costs get ‘added-back’ to the EBITDA number, meaning that the company’s debt-to-ebitda ratio rises to the level which the lender requires. Whilst crude, the scenario is apparently not far from the truth, with UBS reporting that the average acquisition in 2018 had a debt-to-ebitda ratio of 5.6 times, but when add-backs were excluded this figure shot up to 7.4.

The fears examined in May suggested that investors in leveraged loans, used for leveraged buy-outs (LBOs) were concerned that companies’ usage of add-backs could cause companies to fail if the overall market goes south, leaving those investors holding billions’ worth of debt. It has been suggested that there has been movements within the markets to the lenders’ favour – in terms of more rules over ‘collateral leakage’ whereby quality assets slip out of the reach of creditors – but the fears still remain. Industry onlookers have said that ‘unjustified add-backs will be the biggest issue in this cycle… we went from ebitda, to adjusted ebitda, to further adjusted ebitda to pro-forma (ebitda)… it’s almost comical’. Furthermore the cause has been suggested to be an imbalance in the borrower’s favour, as ‘borrowers are able to exert greater influence’ due to less opportunity to make money from the lending market and, as a result, greater terminological ‘adjustments’ are allowed because investors are seeking returns. In the Reuters article in May, it discussed how ‘the market won’t just take hits on add-backs hook, line and sinker… lenders are provided with reconciliation of ebitda and adjustments. The information is there if needed’ and that, crucially, ‘credit rating agencies also provide impartial third-party analysis’. An onlooker noted how add-back-related information ‘isn’t necessarily what the company is asking us to use’, adding that rating agencies would sometimes ‘agree to disagree’ on the analysis. S&P’s report in September agrees with this view. S&P stated that its ratings are based on projection of a company’s growth and earnings, and also their own calculations of leverage ‘and not what is presented to us’. The rationale for this, according to S&P, is that ‘if we took the marketing leverage presented to us and bought into pro-forma add-backs, projected earnings, and debt reduction, our initial issuer credit ratings would likely be higher and mostly likely lowered as actual results are reported’. They continue, definitively, by declaring that ‘marketing leverage and the language around add-backs as defined by debt agreements do not determine our view of credit risk’, although they ‘often do give some credit to add-backs or synergies that we view as achievable, especially when a company has demonstrated its ability to realise on similar items in past comparable transactions’. Furthermore, S&P declare that they are ‘almost always considerably less optimistic than management when it comes to certain elements pertaining to future growth’. Ultimately, S&P state that ‘in fact, our analysis goes much deeper than EBITDA and examines the true cash flow characteristics of issuers’. So, whilst some elements of the above statements are a little subjective, S&P are clear and definitive in their pronouncement that they examine much more closely than just taking EBITDA adjustments at face value. So, why are there concerns?

The FT article from Friday starts with the example of ’24 Hour Fitness’, a California-based chain of gyms. An $850 million loan issued by the the company was recently rated single-B plus, with S&P believing that ‘any increase in the company’s leverage from leases on new gyms would be offset, eventually, by higher revenues. As a result, the company would be able to maintain a debt-to-earnings ratio of six times’. However, as the article points out, that eventuality has not come to fruition, with S&P last week cutting the debt instrument’s rating to single-B minus as the agency found that revenues generated by the chain were less than expected when the loan was issued – ‘the market price of the debt plunged to distressed levels’ as a result. The article suggests that this is a potentially systemic problem in that just 9% of new deals in 2019 carried leverage over 7 times, including add-backs. However, strip those add-backs out and that number shoots up to a massive 46%. Critics have argued that rating agencies are not keeping up with the ‘deterioration in the quality of deals’ and that, ultimately, one cannot ‘count on the rating agencies to protect you at the end of a cycle’. Yet, others have argued that the situation is much different than before the Financial Crisis, in that a. the risk of default in products are much more pronounced and therefore more well-known now and that, as the rating agencies are arguing b. a lack of protection within the debt instruments is both increasing the risk of default but also providing issuers with greater wiggle-room to avoid defaulting. After all, it is not the job of the rating agencies to define the debt practices of the marketplace, just to rate the products and those issuing them.

Ultimately, it seems that these concerns are either one of two things, or perhaps a mixture of both. There is a great deal of PTSD from the Financial Crisis and any time there is an opportunity for the agencies to transgress – as they would be here if they were to be accepting EBITDA-related adjustments without further scrutiny – the general fear is that they will do so. There is also the fear that, just like in the Crisis, a downturn could cause a chain reaction of which the rating agencies themselves would likely trigger – a few credit rating reductions and the wildfire could spread, leading to a systemic crisis. However, there are two points to raise here. First, the credit rating agencies are being scrutinised more than ever, and this EBITDA-adjustment system does not lend itself well to agency manipulation; the effects of that manipulation will be too easily discovered once the financial results are released, and they are released at too closer an interval. Second, the concern being raised against the agencies is probably misdirected. Whilst regular readers will know I have been heavily critical of the agencies, we must be fair. In this particular scenario, it is the investors who are at fault, or at least the system that is predicated upon large-scale investing. The need for returns, even in an environment that is incredibly restrictive, means that investors are taking much greater risk. Should they be allowed to do so, particularly when there is an increasing systemic risk building, is another matter – it is likely a political question and as we moved away from the Financial Crisis, right-wing governments were selected to drive the economies away from the Crisis-era; it is likely not in their remit to restrict the actions of investors on a systemic scale. But, the system needs investors to keep investing in spite of the risks, so much so that the responsibility to protect the system is placed upon institutions like credit rating agencies. In this instance, incredibly, that is likely very unfair. There is a much greater problem than the agencies at play here and, as long as the agencies do not succumb to the seduction of short-term profit (of which it would be very damaging indeed), then they will not be to blame if this particular ‘bubble’, for want of a better term, goes bang. Even the oligopolistic protection of the rating industry will not protect the agencies if they do choose to succumb, because their involvement would be so incredibly obvious. Time will tell of course, and with the Big Three we can never say never but, at the moment, these concerns are probably best aimed elsewhere.

Keywords – credit rating agencies, EBITDA, loans, LBOs, @finregmatters

Thursday, 7 November 2019

The FRC’s New Boss Takes Aim at the Audit Oligopoly

The subject of auditors, their regulators, and the conflict of interest that occurs when those auditors provide consultancy services has been well covered here in Financial Regulation Matters. We have examined the issues within the Financial Reporting Council (the UK’s main regulator of audit services) that have seen the regulator’s internal structures change recently. We have also examined a number of issues affecting the audit sector, including the presence and effect of an oligopolistic model, the so-called ‘expectation gap’ that exists between how the auditors perceive their role to how the market and society perceives their role, and also how some auditors have started to take voluntary steps to divest or spin-off their consultancy arms. With regards to the last point, we spoke about how either allowing auditors to voluntarily divest, or forcing them to divest with no long-term strategy was a mistake, so the recent comments of the new head of the FRC are worth examining.

Simon Dingemans, the former finance chief for GlaxoSmithKline and long-time Goldman Sachs employee (where he ran its European mergers practice), took over the FRC last month. Immediately he has gone on the offensive and stated that ‘this is a rare opportunity to reform something so wholeheartedly’. However, the way he is approaching the massive task is interesting. Instead of making the common regulatory mistake of championing competition within an oligopolistic sector that actively kills competition, he has argued that ‘you’re not going to be able to create another firm of that global scale. The real question is how do you create better quality audits at the Big Four, how do you make those firms more sustainable and at less risk of collapse?’. He has already rejected a proposal to enforce mandatory joint auditing – arguing that the plan leads to duplications and extra costs – but instead wants to focus on separating the firms’ audit and consultancy services and introducing ‘transfer pricing’. Transfer pricing relates to a concept whereby there are inter-company pricing arrangements, and Dingemans argues that ‘it would mean we could make sure those audit firms were robust and properly funded, and that they’re charging clients and paying partners properly’. In essence, he is attempting to bring about a scenario where audits are not loss-leaders for these firms and that they are both adequately funded and representative both in terms of profitability and incentive. Yet, there are issues in the new Head’s approach. He is arguing that new legislation that would kill the FRC and replace it with the Sir John Kingman-inspired Audit, Reporting and Governance Authority is not required because he has already started implementing the report’s recommendations – these recommendations range from changing the hiring policy of the regulator to increasing the severity of its sanctions. Dingemans defended the FRC and said that, under its previous management, the FRC ‘was dealing with a fairly unmanageable brief and no powers or money to actually deal with them’ and that, now he is in and since the number of crises that have affected the FRC and its authority (Carillion, Patisserie Valerie etc.), things will be different: ‘if they can see I’m going to have the teeth, then I can do a lot by waving the threat’.

The new focus on the oligopoly and its dynamics is to be welcomed. Too much regulatory capacity has been wasted on mis-regulating financial oligopolies (the same issues have affected oligopolies such as the banking and credit rating oligopolies). However, there is no mention, yet, of any long-term regulatory strategy to guard against mechanisms which have, traditionally, caused more harm than good. How will the regulator guard against a delayed amnesia whereby, in say 5 years time, the auditors reinstall their consultancy arms and continue transgressing? This happened after the last waves of regulation against the sector at the turn of the millennium, and is a real concern. Also, how does the regulator enforce the concept that auditors are supposed to be spotting fraud and have a social duty to do so? Finally, is a ‘threat’ enough? On one side of the argument he is only a month into his role, so there needs to be time afforded to achieving the reforms required. However, time is of the essence. The language is not really encouraging when taken as a whole. ‘Threats’ do not work against multi-billion pound organisations protected by an oligopolistic model. Companies within those environments create their own cultures, they are very rarely enforced. This is the crux of the matter; Dingemans has been tasked with regulated one of the oldest, most well-resourced, oligopolistic, and socially important financial sectors that exists – it is quite the job.


Keywords – audit, business, oligopoly, @finregmatters

Wednesday, 6 November 2019

MPs Sharpen Their Attention on Gambling Regulation


Over the years here in Financial Regulation Matters, we have looked at a number of elements of ‘consumer protection’, broadly defined. From predatory lenders to governmental policies that disproportionately affect the poor (and everything in between like the larger culture of credit dependency), we have seen a number of examples of when capitalism and vulnerable people collide, and vulnerable people are exploited. One area where this concept is visible is within the gambling arena whereby, since 2005 with the Gambling Act, the marketplace for in-person and online gambling has ballooned. However, an influential group of MPs are now seeking to address this issue, and even just that sentiment is already having a demonstrable effect.

The headlines in the media run with the fact that, since the influential All Party Parliamentary Group (APPG) for Gambling Related Harm recently published a report calling for the Gambling Act 2005 to be fundamentally reconsidered, shares in British gambling firms have tumbled and lost nearly £1.2 billion in value. One of the elements that the APPG are attempting to enforce, in line with the approach demonstrated by the Labour Party, is that the limit of £2 that applies to stakes placed on fixed-odds betting terminals should be applied similarly to web-based slot machine games. The reason why this has caused such an immediate impact in the gambling arena is because, as stated in The Guardian who cite the Gambling Commission, the income from those web-based games ‘accounts for more than a third of their income’. It is easy to see why the value would plummet. The marketplace is already reeling from a number of regulatory interventions, one of which included the restriction on stakes on high street roulette games. With the market’s fear being that a similar restriction would be placed onto online games like roulette, then it is no surprise to see online-based gambling organisations like 888 being hardest hit – they lost nearly 14% of their value in one day, equating to £91m. Ladbrokes’ owner GVG fared even worse, with their 10.5% fall equating to £547m coming off their market value.

Today, the largest gambling organisations in the country responding by declaring their adherence to ‘five pledges’ that would promote safer gambling. They are: to prevent underage gambling and protect young people; increase support for treatment of gambling harm; to strengthen and expand codes of practice for advertising and marketing; to protect and empower customers, and to promote a culture of safer gambling. However, this is unlikely to stop the advancing regulatory hoard. Research has suggested that previous initiatives like the ‘when the fun stops, stop’ campaign have been entirely ineffective, which suggests that the adherence to these pledges will not have any great affect. Research conducted before the Financial Crisis suggests that ‘disadvantaged social groups who experience poverty, unemployment, dependence on welfare, and low levels of education and household income are most likely to suffer the adverse consequences of increased gambling’. This has been further emphasised by researchers who argue that problem gambling is often supplemented by a number of other issues, like mental health issues, which contribute to a negative social impact.

One thing that can be suggested is that the gambling companies have ridden a regulatory wave that is soon to run out by all accounts. Whilst health-based regulatory endeavours like the campaigns to reduce smoking are up against traditionally large and well-resourced corporate entities, the gambling-based regulatory endeavours have much less of an obstacle in their way. With the cross-party support provided by the APPG proving influential, it may not even take a Labour Government to fundamentally restrict the growth of the gambling arena, but their election in December would almost confirm the demise of the sector. The gambling companies have left it too late to respond, with their five pledges being dismissed out of hand almost immediately. It will be fascinating to see whether the writing is really on the wall for the British Gambling scene.

Keywords – Gambling, business, regulation, government, @finregmatters

Tuesday, 5 November 2019

Credit Rating Agency News Updates


In the second update today, this post will look at two recent stories regarding the credit rating industry. The first update relates to a story we looked at in August which was based on an article I wrote for the Journal of Business Law. The second update relates to the development of a Dodd-Frank era plan that the Wall Street Journal has recently turned its attention to in a particularly scathing manner.

Dagong Re-Enters the Chinese Market

Last year, one of China’s largest agencies was banned by the China Securities Regulatory Commission from producing ratings for securities for a year, and also from making any changes to its senior management structure for the same period. Additionally, the National Association of Financial Market Institutional Investors suspended Dagong from rating debt instruments for non-financial firms. The agency was criticised for being too close to the rated entities via its consultation services, and also for poor internal management, unqualified management and assessment committee members, and missing modelling data.

Now, a year on, the agency has been allowed to resume its rating operations. In a statement yesterday, the agency stated ‘the company has fully restored credit rating business for non-financial corporate debt financing instruments in the interbank market, and securities credit rating business since November’. To enable this return, the agency has undergone internal restructuring, as demonstrated by the inclusion of China Reform Holdings Corp Ltd. Which is a centrally administered and state-owned investment firm and who now have acquired a 58% stake in the company – essentially, the agency can be said to have been nationalised.

There are two clear problems facing Dagong. First, the company has had its reputation obliterated by way of its banning, but also now by its apparent nationalisation – how a rating agency can declare independence with this ownership structure is difficult to see. Second, since it was banned S&P have entered the domestic marketplace, with it bringing an authority that Chinese rating agencies simply do not have. The culmination will likely mean a rough re-entry for Dagong.

WSJ Turns its Attention to the Failure of the Rule 17g-5 Amendments

In 2008, the SEC proposed a number of new rules that it hoped would make a mark on the inherent conflicts of interest that exist within the modern credit rating industry. One of those amendments was to ‘Rule 17g-5’, which as an amendment dictated that an Nationally Recognised Statistical Rating Organisation (NRSRO) that is hired to determine an initial rating for a structured finance product must disclose to non-hired NRSROs that a. the arranger (issuing entity) is in the process of seeking a rating and b. to confirm from the arranger that they will provide the same information provided to the NRSRO to conduct the rating to the non-hired NRSRO. Simply translated, this means that when an issuer is seeking to have its issuance rated by an agency, it must provide the same information to a non-hired rating agency that requests the information for the purpose of generating an unsolicited rating that would, in effect, act as a benchmark to the paid-for rating. The SEC added to this the restriction that the non-hired NRSRO must only access the information to produce an unsolicited rating (as opposed to for commercial gain). In furtherance of this, Regulation FD was amended so that ‘the disclosure of material non-public information to an NRSRO regardless of whether the NRSRO makes its ratings publicly available’ would be legal. However, 11 years on, there has been enough time elapsed to assess whether this plan was a success or not.

Cezary Podkul, writing for the WSJ, starts by stating that ‘a decade later, the verdict on that plan is in: the program was a failure’. The article consults reflections from agencies, trade associations, and the SEC themselves who all admit that there have been very few unsolicited ratings produced via this mechanism. The SEC have stated that after a ‘thorough search’ of their records they cannot find any instances of a NRSRO utilising the programme, whilst Moody’s, S&P, Fitch, Kroll, DBRS, and Morningstar (now merged) have all declared they have not utilised the programme. Podkul makes the obvious connection that the reasoning for this is that the agencies do not get paid for unsolicited ratings and, to add to that, are at risk of upsetting future clients if they rate them lower via the unsolicited mechanism. Furthermore, rating agency bosses have made the good point that, as this only applies to structured finance products, the work involved in coming to a rating decision within that particular area is extensive, and becomes inefficient very quickly – as a senior executive at Fitch noted: ‘we have other work to do’. Podkul goes on to make the point that a later plan to develop an oversight committee, as part of the Franken-Wicker amendment, was rejected by the SEC on the basis that this 17g-5 amendment would work. Mr. Franken is quoted as saying that the failure of the programme was ‘very predictable’, and it is difficult to disagree with him.

The failure on the SEC’s part comes from a misunderstanding, for whatever reason, of the dynamics of the rating industry. It is the paid element that has frustrated this particular effort. For example, in my very first article back in 2016, I argued that the programme could actually work if a. non-profit rating agencies were allowed to be included in the programme and b. they were adequately, and independently funded. That the programme failed is not entirely because of the lack of consideration of this proposal, but it is an important point to make – one must fully understand the market if one is to regulate it. It is either the case that the regulators do not understand the market, which I highly doubt, or that they were under pressure to do something and, as a result, rolled out an ill-thought out programme which has both not worked and prevented the idea from being promoted again, based on its failure. This programme can be probably be chalked off as a massively missed opportunity, unfortunately.

Keywords – credit rating agencies, business, @finregmatters

Update – Saudi Aramco Shelves Its Plans for a Foreign Listing… For Now


Here in Financial Regulation Matters we have discussed the potential listing of Saudi Aramco on foreign exchanges on a number of occasions (here, here, and here). We have discussed the potential impact that this listing may have had upon the regulatory arenas within a given jurisdiction, but recently the rumours were confirmed in that Saudi Aramco has chosen to list on its own stock exchange.

The company will list on the Tadawul – Saudi Arabia’s stock market – but not in a dual-listing with another stock exchange, as New York and London had been hoping for. It has been suggested that the listing, of only 1 or 2 % of the company, will see the company valued at between $1.2 and $2 trillion, making it the most valuable company in the world. Saudi Arabia is hoping to monetise its vast fossil fuel-based reserves and this move will potentially see between $40 and $45 billion raised for the Public Investment Fund, which holds stakes in companies such as Uber. Whilst the claims that the company are, by far and away, the largest contributors to global emissions (from a company) may be true, there is no sign at all that the company, and the Kingdom, have any plans of slowing their production. The aim, for Mohammad Bin Salman, is to monetise the Kingdom’s vast reserves and move the country forward into a new era – this listing is one of the major steps in making that possible. The listing is not scheduled to take place until December and has seen a number of high-profile banks involved in the move, including Citigroup, Credit Suisse, Goldman Sachs, HSBC, JP Morgan, Merrill Lynch, and Morgan Stanley.

In terms of what to look out for, the actual valuation that the listing achieves will be fascinating, as MBS has staked a considerable portion of his reputation on achieving a $2 trillion valuation. With that now looking unlikely, and the increasing threat of terrorism looking likely to affect the value of the product, how it fares on the open market will be of interest. Also, if it does continue to publically offer slices of itself, which exchange Saudi Aramco chooses to co-list with will have massive repercussions, especially for politically-unstable markets like the UK.

Keywords – Saudi Aramco, Fossil Fuels, Business, Stock Exchange, @finregmatters