Monday, 31 December 2018

GUEST POST - High Speed Rail 2 and it’s various effects on the Country

Today’s post is a guest post from Teny Kuti, a first-year student in Aston University’s Law School. The post discusses the various effects of the forthcoming HS2 high-speed rail link, as well as some of the potential consequences moving forward. Please follow Teny via Twitter here, and his own blog The Whole Spectrum for an interesting take on a number of different issues, ranging from politics to business.

Frequently described as the most substantial rail project ever built in the UK set to open in 2026, High speed rail 2 will form a high-speed link between Birmingham and London, reducing the travel time to 49 minutes. However, the project has never been shy of controversy. Since the HS2 received Government approval in 2012, it has seen strong opposition from those who would lose their homes on the current plans and indeed, HS2 Ltd has claimed that 1,740 buildings would be destroyed by the rail line, with nearly 900 being homes. Now with the recent developments such as the Chairman of the project resigning and claims that the cost has been vastly underestimated from £56bn to potentially £100bn, it becomes pertinent to discuss whether HS2 will have a positive or negative impact on the country.

The rail line intends to link both London and Birmingham, and then a phase 2 extension is planned to connect Leeds and Manchester to the line. This could address many long running problems such as the high house prices in London caused by a dense population living there. The ability to travel from Birmingham to London in under an hour may allow for people who work in London to seek cheaper housing in Birmingham without having to suffer a 2-hour commute. As living in Birmingham becomes a more viable option, this would reduce demand for homes in London thus causing prices to decline, theoretically. Having an easy connection to London may also result in more Businesses following in the footsteps of HSBC and relocating to Birmingham, or potentially creating smaller satellite offices in the city. However, this could result in Birmingham eventually sharing similar issues currently facing London. As seen when Deutsche Bank moved to Birmingham in 2014 the demand for homes increased by two-thirds. This far exceeded the supply of houses and thus prices went up. Should other high value firms follow Deutsche Bank and make the move to Birmingham, it may just inherit the problems they were trying to escape.

The physical construction of the rail line would result in jobs being created as the Department for Transport claims that construction of the project will create 25,000 jobs in addition to 100,000 people working at the new stations and 3,000 jobs operating the trains themselves. Naturally, these jobs would benefit the country as it allows people to earn a wage and thus spend it in the country, improving the economy. However, the construction of the line would also destroy 985 businesses that are currently on the planned route of the line and thus, the people employed there would lose their jobs. Specifically, HS2 Ltd claimed that 19,590 jobs would need to be relocated but for those who were already earning a lower income in a job that was integral to the location such as a farmhand, finding a new job may be difficult. Although, the project is creating several times more jobs than it is causing to relocate, thusly the rail line would have a positive impact on the job market, as well as the benefits of a better-connected country.

The financial cost of the project has recently been found to be much more than was previously stated, calling into question how cost effective it currently is. The rail line was approved on a budget of £56bn but it has recently been leaked that it may increase to over £100bn due to underestimating how much the contractors would need to be paid to complete the project in a timely manner. This has renewed questions of whether this money could be spent on something more effective. Many have criticised the project as being a way to circumvent the existing problems in the transport network. The money used on HS2 could also be used to fix potholes, upgrade the existing train services, or expand bike and bus services. These projects would not require the compulsory purchase of land, nor would it destroy people’s homes and businesses. HS2 Ltd has also faced numerous claims of undervaluing the land that they need to buy resulting in families and Businesses being forced to move out, but without enough compensation from the Government to relocate. Not only is this damaging to the individuals it directly affects, but it also proliferates an anti-Government sentiment which conflicts with the sense of interconnected national pride they hope to achieve with HS2.
The environmental impact is also worthy of discussion as with any train, the transport is more environmentally friendly if it is replacing transport by car given that one train can take hundreds of people. However, High Speed Rail itself is not significantly better for the Environment than a normal train. Indeed, the methods used to construct the rail line are certainly not environmentally friendly and thusly, it is possible that HS2 may do more damage to the Environment when considering the wildlife disrupted and trees cut down. Given that the primary users of HS2 would likely be using a normal train otherwise, the environmental impact of HS2 is likely to be negative but to a minimal degree, largely due to the harm done during construction.

HS2 is going to have a profound far reaching effect on the UK ranging from the country wide economy to a family of farmers in Buckinghamshire. The rail line seems to have a net positive impact on the economy if it produces the amount of jobs they expect, this should offset the amount of people who have lost their jobs or need to relocate. The rail may also relieve some of the pressure on London as the hub of the largest service firms. Should these firms choose to move to Birmingham and eventually to Leeds and Manchester, this would benefit the economies of these individual cities while decreasing the price of housing in London, but also increasing the price in these various cities. When the UK gains the benefit of this economic increase is dependent on whether the project remains on budget, though this seems unlikely and the potential for it to go over budget is supported by the resignation of its Chairman in early December. Ultimately, HS2 should have a positive effect on the economy, but a negative effect on individuals and small business owners who are an obstruction to the most substantial rail project ever built.

Keywords – HS2, Travel, Railways, UK, Business, Politics, @finregmatters

Tuesday, 11 December 2018

Interserve on the Ropes, or a Model on the Ropes?

Back in August 2017 we looked at the concept of the ‘private finance initiative’, and also the differences between ‘public private partnerships’ and ‘private finance initiatives’, which has also been dissected in the literature. We looked at the issue of Carillion and the aspects that underpinned its high-profile collapse. However, for this post, the question will be whether the recent developments at Interserve, the massive provider of public services in the UK, is part of a general trend or an indication of a fundamental flaw within the model that is being adopted currently.

Interserve began as London and Tilbury Lighterage Company Limited in the late 1800s, and through a number of phases of expansion over the century and more that followed, the company was renamed Interserve Plc in 2001. The company has a global reach, but for this post our focus will be on its role within the UK, where its function is particularly vital. According to Interserve itself, it has reported revenues of £3.7 billion and, when the website was constructed, the sentiment of the narrative was progressive and expansionary. However, it was announced recently that the company was in rescue talks with creditors for the second time in nine months, as it also being reported that the company is in debt to the tune of more than £500 million. The effect of this news on a company so large is inevitable, with news that the company’s shares are operating at around 12p, which is a dramatic fall from the 2014, when shares were valued at over 700p a share, and even a year ago when they stood at 100p a share. The Financial Times opines that even though the deal to refinance sees shareholders face ‘material dilutions’ of a number of their shares, banks do not think that Interserve is to become ‘Carillion Mark Two’, on account of a variety of influencing aspects, with the primary reason being a different environment and attitude towards rescuing such societally-interwoven companies. The British Government perhaps personifies this approach – essentially a too-interwoven-too-fail approach – with news that it will continue to award contracts to the company, despite its financial difficulties. It has been noted in the media that the Government are playing a dangerous game in that they are currently facing criticism for awarding £1.3 billion’s worth of contracts to Carillion when it knew the company was in distress, but perhaps there is a reason for the Government adopted such a risky strategy.

One reason why they may have done this is because, for the Government, it is not a ‘risk’ at all. Perhaps, for this Government in particular, it is an ideological necessity that Interserve is supported, and that Carillion was supported even in the face of negative financial declarations. In the literature it has been identified that such partnerships between Government and Business are essentially a ‘brand for how governments want their interaction with business and society viewed, or, alternatively, how they want the role of government in the economy viewed’, which clearly hints at an ideological approach. The development of this form of societal investment is, seemingly closely tied to the development of globalisation, with this approach being witnessed around the world and with companies spreading their reach to meet that demand (Interserve is a good example of this). Yet, we have spoken here in Financial Regulation Matters many times about viewing global developments in a cyclical manner, so with that being said what may be the message from this uptake of public and private partnerships? The first thing to note is that the symbiotic relationship that exists between certain political outlooks and big business creates results, but that it is difficult to see how they are long-term in nature. The appalling lack of oversight on instances such as Carillion show us that the maintaining such a relationship, for the benefit of the public, is not really a concern – the real concern is developing tangible and public examples of development in order to provide support for the model; for example, pictures in the media of half-built hospitals do no good whatsoever to the development of the partnership, which as we know is underpinned by public money. The second thing to note is that this narrative of needing big business to flourish has become so entrenched, it is difficult to foresee any other model taking hold. It is not suggested here that another model should be adopted, nor that it would be any better necessarily, but it is clear that this current model of cartelisation on the back of public funds does not work, and is societally damaging – so, what does this mean?

One thing that it may mean, thinking of the UK in particular, is that suggestions that a number of key infrastructure areas will be nationalised once Labour get into power, if they do, is easier said than done. Nationalisation has taken place before, but this current era is dominated by the entrenchment of a narrative (aided by the development of the internet and social media etc.), which means change would have to be incremental if it were to be successful. It also means that the Conservative Party, for however long they remain in power, must continue to support companies like Interserve, because it is their ideological position that is on the line. The relationship between big business and government must work if the Conservative Party is to remain in power and relevant, and as such it is anticipated that only an absolute and sudden collapse would see Interserve vanish. The concept of ‘too big to fail’ is commonplace, but the connection of certain fields to politics must not be ignored. In a sense, Interserve is too politically important to fail, as it represents an ideology that has taken years to construct and implement. Yet, we are in an era where continuing corporate failures are being contextualised by societal instability, so the question may be how long will the public sit by and allow their money to be utilised as a fundamental safety net, especially when they do not directly see the financial benefit of doing so?

Keywords – Public Private Partnerships, Interserve, Politics, Business, UK, @finregmatters

Friday, 7 December 2018

Regulators Under Fire: The Serious Fraud Office and the Financial Conduct Authority Face Consequences

As is the remit of Financial Regulation Matters, it should not be surprising that analysing financial regulators is of key concern for this blog. In doing that, however, we get to see the diverging experiences of a financial regulator, and how differing approaches yield very different results. We have examined a number of regulators throughout the years in this blog, and two have factored heavily in our analyses. Today, we revisit the two particular stories which have evolved recently and left the respective regulators facing a number of criticisms.

The SFO’s Pursuit of Tesco Directors Fails

We examined the case of the Serious Fraud Office (SFO) launching proceedings against three Tesco Executives back in February. Then we discussed how the SFO were alleging that fraud by abuse of position, and false accounting were the crimes of Carl Rogberg, John Scouler, and Christopher Bush. That post asked whether the SFO would continue in their pursuit, and shortly afterwards it was confirmed that they would be. For the past two months the trial against Scouler and Bush had been ongoing until this week when, at the behest of Sir John Royce, the trial was dismissed on account of the Court of Appeal agreeing with Sir Royce that there was no case to answer. Whereas a regulator cannot be expected to succeed in every regulatory action it takes, the views of Sir Royce were scathing: ‘I conclude in certain areas – one in particular – the prosecution case was so weak it should not be left for a Jury’s consideration’. According to Sir Royce, the major weakness was of the failure to prove knowledge on the part of the defendants, whom he said were of ‘impeccable character’. The Financial Times reports that the SFO are now considering whether to push ahead with their prosecution of the remaining defendant Carl Rogberg.

The SFO is a regulator that is constantly in the political crosshairs, and this failure, when conjoined with their recent failure to bring charges against Barclays over their Qatar-based financial crisis-era funding, is a particularly dreadful start for the new head of the SFO, Lisa Osofsky. However, the failures raise a number of important issues that are worth addressing. Those issues revolve around the standard of proof required for prosecution, which is central to the failure of the Tesco case. Osofsky herself noted this year that the current standard of identifying a ‘controlling mind’ when prosecuting was too high of a standard in relation to corporate forms. Instead, she argued that an introduction of the concept of a ‘failure to prevent’ would be more suitable i.e. a person or company being held to account if it could not prove that it [they] had not done enough to prevent a crime. Here, then, is where it becomes very difficult to foresee any meaningful change, and it is questionable whether that change should occur. If the three executives are guilty, then the need to identify a controlling mind is fundamentally in the favour of the corporate form, which can protect individuals (despite of the measures available to ‘lift the corporate veil’). If the three are guilty, then the £10 million spent by the SFO will have been nowhere near enough to obtain information that surpasses such a high burden of proof. However, if the opposing model was adopted, and a failure to prevent model was in place, then there is the likelihood that three people who boast clean track records would have been indicted. It is difficult to foresee any change in this arena anyway, as we currently reside in an incredibly pro-business environment that will naturally require only the very highest standard of proof in order to prosecute corporate individuals. For the SFO, the issue remains that whilst their successes are notable (their DPA prosecution of Rolls Royce for corruption and fraud stands out), their failures are mounting and are incredibly visible. Osofsky has a decision to make as to what form the SFO adopts on her watch, as her predecessor’s approach garnered results but ultimately could not save the regulator from sitting directly within the political crosshairs of the Conservative Party. The future of the SFO will likely be dictated by her decision in the coming months.

The FCA Faces Legal Action over RBS Decision

This perhaps just serves as an update, as RBS and the FCA’s handling of this troublesome bank have occupied a number of posts here in Financial Regulation Matters. We know that RBS came in for incredible criticism regarding the actions of their ‘GRG’ unit which was established to ‘assist’ SMEs – with a number of SMEs failing under their watch. We have examined this case from its inception, and discussed how the FCA initially held back a damning report before the Treasury Select Committee, alongside a number of leaks, forced the report into the open. Yet, there has been a development recently that brings this issue sharply back into the spotlight. A former Executive of a company that failed under the GRG unit has applied for a judicial review of the FCA and its decision to drop an investigation into the GRG unit, which at the time saw the regulator declare that its options were ‘limited’. As part of the application, Neil Mitchell, claims that the FCA has been ‘unlawfully refusing or failing’ to fulfil its obligations as the chief financial regulator, and that as a result of this the decision to terminate the investigation should be changed. The FCA’s response was that the GRG, as an area of finance, ‘was largely unregulated and the FCA’s powers to take action in such circumstances, even were the mistreatment of customers has been identified and accepted, are very limited’. Yet, Mitchell is asserting that the FCA does have a role to play, mostly in terms of ruling whether former GRG managers were ‘fit and proper persons’, and whether the controls and systems within GRG were adequate.

It will be interesting to see what the decision is for this particular application. Mitchell is related to the group that recently won a settlement from RBS, rumoured to be around £200 million, and as such demonstrates the understanding that a settlement was always unlikely to be the end of the matter. Whilst it is difficult to predict the outcome of the application, a successful outcome will likely spell trouble for Andrew Bailey, the current Head of the FCA. It has already been stated in the business media that ‘Andrew Bailey must pay the price for FCA failures’, and if this application is successful then those calls will grow even louder. If the Review then finds that the FCA did have options available to them, the obvious of question will be ‘why were they not used?’ Potentially, and unfortunately for Bailey, if that question is officially asked there cannot be many other responses than a captured, or at least subservient regulator when it comes to the very elite in the business world. We have discussed before the national importance of RBS and its ‘too big to fail’ characteristic, and regrettably regulatory capture often forms part of that dynamic. This judicial review application could have massive consequences for the regulatory framework in the UK, just as it is tasked with regulating a marketplace that is entering particularly volatile waters.

Keywords – Regulators, Business, Banking, Tesco, RBS, SFO, FCA, @finregmatters

Friday, 23 November 2018

The Case of Carlos Ghosn and the Renault-Nissan-Mitsubishi Alliance: A Complete Failure of Corporate Governance

Today’s post comes from Oluwarotimi Adeniyi-Akintola, a PhD student in Aston Law School. Rotimi’s doctoral research focuses upon corporate governance forms within Nigeria. For more from Rotimi, please follow his twitter profile here and his blog page on Medium here.

As you may have heard, Carlos Ghosn, one of the most prominent figures in the automotive industry, was arrested in Tokyo on November 19, 2018. According to Japanese prosecutors, he stands accused of financial improprieties and the falsification of annual securities reports, which could result in a jail term of 10 years, a fine of 10m yen, or both. His arrest has sparked corporate crises across two continents and marks an astonishing reversal in fortune for a man many consider to be the lifeblood of the titanic Renault-Nissan-Mitsubishi (RNM) alliance. In many ways, Ghosn’s story is a demonstration of how the concentration of power in key individuals can result in a complete failure of corporate governance at even the most prominent organisations.

Having earned a reputation for returning ailing businesses to profitability through previous stints at Michelin and Renault, the legend of Carlos Ghosn really kicked off in 1999 when he was appointed as Nissan’s COO. Renault had just purchased a 36.8% stake in Nissan, thus marking the beginning of what is now known as the RNM alliance and needed someone to save Nissan from the brink of collapse. It was here that Ghosn performed his greatest magic trick. He went on a cost-cutting rampage, cutting 21,000 jobs, shutting down plants, suppliers, and introducing drastic changes to corporate-culture at Nissan. Within three years, Ghosn who was now the CEO, had halved Nissan's $19bn debt, returned the company to profitability and grown sales from below $50bn to almost $80bn. He became hugely popular in Japan after this exploit, so much that he was awarded a medal of honour by the Japanese Government, and was ranked ahead of Obama in a 2011 poll which asked the Japanese to choose their ideal Prime Minister. In the mid 2000s, his legend was cemented. Ghosn was appointed Chevalier of the Legion of Honour by the French government and subsequently made an Honorary Knight Commander of the Order of the British Empire in recognition of his achievements.

By 2009, ‘Le Cost Killer’, as he came to be known, was the simultaneous Chairman and CEO of both Nissan and Renault, and when Mitsubishi became a member of the alliance in 2016, Ghosn was immediately appointed its Chairman.

The picture being painted here is of a man with the reputation of a corporate magician, who had the entire automotive industry in awe of him and was worshiped by his loyal subjects. This same person also had near-absolute control of a car alliance which sold 10.6 million vehicles in 2017, and today accounts for more than 1 in 9 vehicles around the world. He had occupied leadership roles on the boards of the member companies for the best part of two decades, and he ran the alliance as though it were one company. He was the man. He had all the power. As the CEO of Mitsubishi recently stated, it became difficult to foresee a future for the alliance without Ghosn in the picture. In such an entrenched position, it is impossible to imagine how anyone could have possibly challenged his will and direction in the boardroom. What everyone, including people who should know better, failed to realise was that this was the ultimate nightmare scenario for the corporate governance of the three companies.

Although the issue is subject to heavy debate, the separation of the roles of the Chairman and CEO is a key component of corporate governance principles embraced by shareholder activists and other stakeholders in the UK and much of continental Europe. The bulk of the opposition emanates from the United States and France, where about 60 % and 70% of companies respectively have had one person occupying both positions according to one report, compared to fewer than 20% of companies in Britain, Germany and Japan. This principle is so strongly held, that a buffer period of at least 5 years, is often recommended before a former CEO or other person connected with the company is to be appointed as its Chairman. Term limits ranging from 5 – 10 years are also imposed in order to curb the concentration of power in one individual. Quite simply, many people believe that a company is less likely to be mismanaged if it resists domination by a single, all-powerful CEO/Chairman who is free to run the company as (s)he sees fit. The Ghosn case appears to be a perfect illustration of this situation.

The allegations against Ghosn are as follows: he collaborated with another board member, Greg Kelly, whom he instructed via email to under-report his income by about 5 billion yen ($44 million) over a five-year period; he misappropriated money allocated for other Nissan executives; using Nissan’s funds, he purchased properties in Rio De Janeiro, Beirut, Paris and Amsterdam which were rent-free and undeclared; Nissan paid his sister $1.7 million for advisory work which was never conducted; and he directly instructed a close aide by email to make a 1.5 million dollar payment to remodel his home in Lebanon. It is very important to stress at this point that these are only allegations, and that Carlos Ghosn has neither been charged nor convicted of any offences at this point in time. These relate to Nissan alone, and further allegations appear by the day.

Although the message Nissan currently projects is that this was the work of a few bad eggs, it is highly unlikely that these allegations, if true, were carried out without the knowledge of more than a few collaborators, given their scale and the length of time involved. The profile of the alleged beneficiary, Ghosn, must have a significant part in allowing and concealing these alleged improprieties. This much was admitted by Nissan’s CEO and interim Chairman, Saikawa, who stated that ‘the lesson we need to learn from the negative part of Ghosn’s rule is that too much power was concentrated in one person.’ He also suggested that there were times when Ghosn made decisions without seeking the input he should have, and called for an improvement in the company’s weak corporate governance.

Indeed, Nissan’s corporate governance structure was appalling. Ghosn, who once told investors that no CEO should exceed a term of five years, was allowed to spend nearly two decades at the helm of Nissan. In a review of governance in Japan’s largest companies in 2011, Nissan was one of very few that did not have at least two independent directors and was found to have no board committees. Without these structures, there were no checks and balances, particularly with regard to auditing, appointments, compliance, executive remuneration and other sensitive issues. Saikawa’s frank assessment of the situation at Nissan is hardly surprising when considered in this context.

The single positive thing about failures of this nature is that they usually result in the installation of stronger governance safeguards. Following Saikawa’s comments, Nissan was quick to announce a review of its corporate governance policies in a concerted effort to clean up its image. The fact that these allegations were exposed by a whistle-blower is nonetheless encouraging and serves to re-emphasise the importance of whistle-blower protections for effective corporate governance.

However, it would be remiss of me to ignore speculation that the whistleblowing was orchestrated by senior figures within Nissan who were strongly opposed to Ghosn and Renault’s plans to render the alliance irreversible by way of a merger. If true, this suggests a deeper rot in Nissan’s corporate governance arrangements, as it would mean those senior figures were happy to turn a blind eye until their personal interests were threatened.

The clear lesson to be learnt here is that incidents of Ghosn’s alleged crimes are more likely to occur when celebrated and dominant figures exist within an organisation. Whilst such dominance may arise when the positions are separated for various reasons, said dominance is almost inevitable when the same individual occupies the dual position of Chairman and CEO for a lengthy period of time, as seen in Ghosn’s case. In the words of a famous pop star, ‘no one man (or woman) should have all that power.

Keywords – Renault; Nissan; Mitsubishi; automotive, Corporate Governance, Business, @finregmatters

Sunday, 18 November 2018

The Office for Students and the Difference between Theory and Reality

We have looked at issues within the Higher Education sector here in Financial Regulation Matters before, mostly in relation to student finances, student accommodation, and also sector-related pensions. However, after some recent developments it is important to take a look at Universities as institutions and, crucially, the position that regulators are finding themselves in, despite any ideological claims as to their operating mandate. As the story develops that, recently, a British University was essentially ‘bailed out’ by the Government, it will be of interest to examine the regulatory reality that the recently-formed Office for Students (OfS) has found itself being exposed to.

It was reported towards the end of this week that ‘a UK university had to be given an emergency loan of almost £1m by the higher education watchdog to stay afloat this autumn’. The BBC continued by stating that the OfS provided the money when the university faced the prospect of running out of capital and being unable to pay its bills, whilst it goes on to confirm that the money has been repaid and the university of now financially stable. The Financial Times reports that the OfS confirmed that the university had not been at risk of bankruptcy and that the university in question had not been allowed to register new students until the money had been (quickly) repaid. Only earlier this month had Sir Michael Barber, Head of the OfS, confirmed that ‘the OfS will not bail out providers in financial difficulty’, whilst also declaring that bailing out institutions would lead to ‘poor decision making and a lack of financial discipline’. As we now know there comments were contradictory and Sir Barber would have known that, with the result being a barrage of criticism for such views. The University and College Union said that it would be writing to all MPs with a University in their constituency to outline the dangers of a university collapse, correctly adding that ‘allowing universities to go to the wall has consequences far beyond just education – Universities are often one of the key employers in the area and the impact on the local economy and on local opportunities is difficult to overstate’. The UCU continued by declaring that Sir Barber’s comments ‘demonstrate just how out of touch those in charge of our universities really are’, whilst other commentators have been quick to note that such an outcome is an almost natural conclusion to what is, essentially, a ‘bubble’ within the HE marketplace.

It has been suggested in the media that the University in question is the University of East London, which the University has denied, but the issue here is not which University sought the bailout, but that it was inevitable that one (and more) would. Universities are under increasing pressure from a number of areas, including politicians and the media, and that may manifest itself in different ways (like recent calls to improve social mobility). Yet, it is all underpinned by one key facet, and that is related to the word that concluded the paragraph above: marketplace. As the HE sector has been financialised, there came with it increasing pressures. One of the key pressures was the need to keep the system moving, as is the way with any other financialised ‘bubble’ (think housing in the pre-Crisis era). Over the years we have seen tuition fees break records, more and more students attend University, and a massive growth in developments such as student accommodation, sports facilities, and libraries. However, whilst that sounds all well and good, the reality is that the observable growth of UK campuses is mostly funded by ‘cheap debt’, with University borrowing in the UK now topping £12 billion. The Financial Times suggests that there is an impending issue in that there are falling student numbers, and that this trend is expected to continue as a result of low birth rates around the millennium and tighter immigration rules; the result being that a forthcoming report is expected to advise that tuition fees be capped at £6,500 (to induce uptake of places) and Moody’s having placed all UK universities (bar Oxbridge Universalities) on ‘negative rating watch’. All of this tells us that Universities have changed, from institutions of learning to vehicles of financialised concern – the concern now is keeping the wheel spinning. If that is true, then how universities will keep that wheel spinning is worrying, because the likely method would be reduced fees, reduced entry-grades, and probably cuts amongst the associated workforce. If that is all to be accepted, then what does it mean for the OfS?

The OfS is not a governmental body, but reports to the Department for Education. It is seen as the spear of the education regulatory framework, but it is worth noting when it was formed. It was formed at the beginning of 2018, which as one will be aware is in the midst of austerity Britain, as governed by the Conservative Party. The OfS stresses its independence, but within the UK there is an ideological trend that is prevalent amongst the institutional framework, and it is unsurprisingly Conservative in nature. Without casting judgement, it is therefore, again, unsurprising that the OfS would theoretically reject a bailout, based upon free-market principles. But, as Sir Barber would have quickly realised, theory and reality are not always aligned. The HE sector within the UK is in a very precarious position, and as the spearhead of the regulatory framework, the OfS is tasked with a thankless job – do not let the bubble burst. That is fine, but again the reality is much different. Any student of the previous two decades knows that bubbles will burst, it is inherent within their nature, and this educational bubble is no different. With so many providers, a stagnant economy exposed to an uncertain environment post-Brexit, and a reducing pool of income (via students), the bubble will burst. However, the OfS has decided that ideology cannot be the reason it bursts, and took the decision to contradict itself in a crucial fashion, less than a year into its existence. What providers will now know is that the OfS exists to protect the mechanisms of the bubble, and the situation may be that which the OfS was trying to avoid from the outset. Many commentators have been quick to note that the sector is ‘different’ to others and cannot be treated as a financial marketplace, but unfortunately every angle of the sector screams financial marketplace – education has become a product, universities are massive companies, and the public is on the line for all of it if the system breaks; there is very little difference to that and any other financial marketplace. Regrettably, those other financial marketplaces have usually suffered severe shocks, and it is likely the HE sector will be the same, despite the efforts of the OfS.

Saturday, 10 November 2018

KPMG Stops Consultancy Conflict-of-Interest: Progressive Step or another False Dawn?

We know here in Financial Regulation Matters that the audit industry is currently reeling from a number of high profile scandals regarding their involvement in corporate collapses. KPMG’s role in the collapse of both Carillion and BHS, alongside the involvement of their Big Four counterparts in the same, and in different scandals has led to calls to break up the ‘Big Four’ auditors. Whilst we have discussed this issue before, the Big Four (at least members of the Oligopoly) have now proposed a different solution, and have taken strides to enforce their will by taking action. However, there are a number of vital questions that stem from their decision.

KPMG, announcing the move on Thursday, stated that they are to drop the availability of consultancy, or ‘non-audit’ services to clients they are simultaneously auditing, focusing on FTSE 350 clients specifically. Whilst a date for the policy change has not been confirmed, the Chair of the firm’s UK division stated that the move was intended to ‘remove even the perception of a possible conflict of interest’. In unity, just as an oligopoly should operate, Deloitte have also backed the plan, which can be seen as a direct response to ongoing research and investigation by the Competition and Markets Authority regarding how the audit sector ‘is not working well for the economy or investors’. The Times suggests that this decision will cost KPMG up to £80 million in fees, although that figure is perhaps inaccurate is the Times goes on to state that the Big Four made over £3 billion in fees from audit clients last year, with £1 billion generated from non-audit services. It is also interesting to note that the beleaguered regulator the FRC has already been discussing whether to prohibit audit firms from providing non-audit services to audit clients, which demonstrates to us that this idea is perhaps the optimal one on the table.

Yet, there are a number of issues with this. The first is that the reality of the situation in this regard is absolutely vital. If the audit companies impose a prohibition upon themselves, the effect is that the regulator would have no need to do the same. What is the effect of that? The effect is clear to see, in that the prohibition is then easily reversed once the dark cloud moves on from the audit industry. It is appreciated that this is a cynical approach, but it is not without basis. In the wake of the Enron scandal at the turn of the century, this consultancy conflict-of-interest was held up as one of the key elements of the ability of Enron to collapse so spectacularly. In response, most of the large audit forms divested themselves from their consultancy offerings in response to a political backlash (Deloitte is cited for having not done so, however) and those offerings were put into the marketplace (and incorporated by other gatekeepers, but more on that later). If we look at the percentage of revenue from consultancy services in the wake of Enron, we can see that the effect was significant:

Percent of Revenue from Non-Audit/Tax Services for “Big Four”
Auditor Name
Deloitte & Touche LLP
Ernst & Young LLP
PricewaterhouseCoopers LLP

Yet, if we examine just the effect that this had upon revenue derived from their British operations during the same period, there is a surprising result:

So, what can we take from the above. The first thing to note is that the effect of divestment took around four years to really take effect. Second, the effect upon PwC’s bottom line was not negative, but in fact had no bearing at all. We cannot attribute the divestment to the rising revenues, as the most obvious reason is the upturn in the economy and the housing bubble, but any suggestion that divestment would negatively impact these firms can almost be dismissed out of hand. Yet, there is a bigger issue. We can see that the Big Four divested from the consultancy divisions they had created, but we know now that in the wake of the Financial Crisis, when the Credit Rating Agencies were really catapulted to the fore in terms of public backlash for their involvement – interestingly, as a result of acquiring many of the divisions and practices perfected by the auditors; the consultancy conflict-of-interest was, and remains to be a significant problem in the field of credit ratings), the auditing firms began rebuilding their consultancy offerings. Therefore, it is not cynical to suggest that this pattern is replaying right before us.

There are some many issues in the audit field, that presenting one proposal to remedy the ‘effect’ the sector has upon society is almost meaningless. We have calls to open up the field and incorporate the outsiders to the oligopoly, even though said outsiders, like Grant Thornton, are currently in the mire regarding their own auditing practices (in relation to the incredible scandal at Patisserie Valerie). Yet, focusing on this concept of the removal of consultancy services, this author has warned against this concept before. In this author’s first book, the point was made that the removal of ‘ancillary services’ i.e. services that are not vital to the completion of the gatekeeper’s function, should never be allowed on the gatekeeper’s terms, as they then become, inherently, reversible. In a forthcoming book, which this author will be editing (and contributing a chapter) entitled Regulation and the Global Financial Crisis: Impact, Regulatory Responses, and Beyond, the argument will be made that to defer this vital move to the gatekeeper is an incredible mistake, and that this move essentially retains the option to digress. Whilst the CRAs and the auditors serve different functions, the impact of their digression is eerily similar, and that is that the impact is systemic.

It is appalling that these lessons are not being learned. It is not as if regulators, politicians, and concerned onlookers have to go back centuries to find these patters – it was merely 18 years ago that the auditors played this same trick. Is it the case that amnesia has set in and people are unable to identify the trends? Of course this is not the case, because for anyone interested in the audit field, the Enron-era is something many can easily recite. Therefore, perhaps it is another, more negative outcome that we must arrive at – those who have the power to enforce such actions will not, because they do not want to. To enforce that consultancy services are never offered by such societally important entities, would essentially mean that a theoretical short-term hit to the bottom line would ensue. Perhaps there will not be another bubble to inflate the bottom line like last time? Nevertheless, the reason for the abolition of consultancy services – public protection – is unfortunately not a consideration, as this period, and previous periods surely demonstrate. It is up to concerned onlookers, and probably more importantly business journalists and editors, to shape the narrative so that the audit companies’ decision to divest is not seen as a positive this time. To promote to permanent prohibition, with the aim of public protection, now in the wake of the auditing scandals that are blighting the marketplace would be the socially progressive thing to do. The question is, will this happen?

Keywords – audit, CRAs, conflict-of-interest, KPMG, PwC, business, @finregmatters