Supplementary written evidence from PIRC (CVG0169)

There is a problem with the evidence the Financial Reporting Council (‘FRC’) has submitted and presented in the hearing session. The problem becomes apparent simply by comparing what the legislation says to the evidence the FRC gave as well as with FRC guidance.

There are similar patterns to, and knock on effects with, things that the FRC has also got wrong on other matters (see sections 2 to 4 below). These issues are also relevant to other enquiries that have been undertaken by other Parliamentary Committees: The Parliamentary Commission for Banking Standards, the Treasury Select Committee and the House of Lords Economic Affairs Committee.

The consistent thread is the law setting “signposts” in one direction and the FRC setting signposts in another direction. The problem becomes cumulative if new reporting/governance requirements are added into legislation, as the law intends the various components to fit together, but the FRC’s model gets in the way of that. A recent Freedom of Information Act request has shown how the FRC’s defence of its wrong model has relied on simply false assertions and go to prove that what it says can’t be taken at face value.

One consequence is that the FRC often appears on the back-foot when various scandals occur within its perceived purview and why it is consistently criticised by Parliamentary Committees over the years.

1. The FRC and reporting on Section 172 requirements (directors’ duties) Companies Act 2006 (CA 2006)

The evidence that Mr Haddrill gave in the session on 18 November 2016, is materially wrong. Mr Haddrill states that he is looking for powers and a mechanism to have companies report on Section 172 (the wider stakeholder responsibilities). However, the mechanism is already there in the legislation in a clear and unambiguous way.

The first clause of Section 172 requires the following (this is a verbatim extract)-

Duty to promote the success of the company

(1)              A director of a company must act in the way he considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole, and in doing so have regard (amongst other matters) to—

(a)  the likely consequences of any decision in the long term,

(b)  the interests of the company's employees,

(c)  the need to foster the company's business relationships with suppliers, customers and others,

(d)  the impact of the company's operations on the community and the environment,

(e)  the desirability of the company maintaining a reputation for high standards of business                          conduct, and

(f)  the need to act fairly as between members of the company.

However, from what was said in the session on 18 November 2016 (and reflected in the transcript) there is a discrepancy between what Mr Haddrill says and what the existing law is. The key discrepancy is Mr Haddrill stating that there is not a reporting mechanism to achieve reporting on section 172. He says (Q2 and Q3):-

However, the legislation is such that Section 414C CA 2006 - the legal requirement for a strategic report, which was mandatory from 1 October 2013 – is the basis to deliver reporting on Section 172. It could not be clearer:-

“The purpose of the strategic report is to inform members of the company and help them assess how the directors have performed their duty under section 172 (duty to promote the success of the company).”

Section 414C CA2006.

Summary – there is a legal requirement but the FRC has not said so

Mr Haddrill states that he is looking for powers and a mechanism. However, the mechanism is there in the legislation. He also failed to refer to the fact that the FRC indeed published guidance on Section 172 and Section 414C. That is relevant, as the problem lies with that guidance, as set out below.

2. The FRC Guidance on Section 172 “The Strategic Report”

The FRC published guidance in 2014 on Section 414C and Section 172, which took effect from 1 October 2013. However, if one reads the FRC Guidance without reading the legislation, the substance and form of the legislation is lost.

The guidance does not list the integral stakeholder contents of Section 172 1(a)-(f) until the end of Section 4, and by then the FRC has already created alternative constructs for the Strategic report.

Furthermore, when the crucial legal requirements 1 (a)-(f) are listed at the end of Section 4, they are placed with juxtaposed wording such that it appears that these requirements are “complementary”, when in fact they are integral[1].

Later on in the session to the BEIS Committee there is an admission of a kind from Mr Haddrill as follows:-

However, that statement gives us at least two problems:-

• it fails to mention that Section 172 is required by Section 414, i.e. this is not a failure of omission of thought but a failure to apply the legislation properly

• it fails to deal with the fact that it is the FRC’s own Guidance on section 172 and 414 that has pushed things in the wrong direction. From reading the Guidance there was “thought” but the thought was to push things in a different direction.

Summary – the FRC not only failed to refer to the legislation, it failed to refer to the fact that it has guidance on that legislation, and that guidance is part of the problem

It is not the lack of legislation but the position of the FRC guidance on it that may explain why companies are not actually executing the form or the spirit of the law, i.e. what Mr Haddrill is ruing is self-inflicted by the FRC and what needs “invigorating” is not the legislation but the position of the FRC on the legislation.

The FRC Guidance in creating extraneous constructs on its terms (i.e. not the legislation), deals instead with what it calls “narrative reporting” that “links to the accounts”. That may seem fine superficially, but it is not acceptable if it is not actually what the legislation requires and if it is eclipsing what the legislation does require.

If the FRC has an agenda here (other than supressing the stakeholder side) it may be that the FRC’s desire to do something different to the legislation was partly a response to criticism in other Parliamentary hearings concerning banks (Treasury Committee, Parliamentary Commission for Banking Standards and House of Lords Economic Affair Committee) referring to consistent criticism that the numbers in accounts were wrong. The FRC approach in that case was to obfuscate getting to the nub of the matter – getting the numbers right – by saying that ‘more could be done on narrative reporting’ (the words).

That is not only an unsatisfactory trade-off, but the fact that there is a problem with the numbers can also be explained (section 3 and 4) on the basis that the FRC has got the law with regard to that issue wrong too.

3. The FRC and problems with the main content (the numbers) in the Annual accounts: Transcribing legislation wrongly.

Parliament has decided that the output standard for the numbers in the accounts takes precedence over any prescribed accounting methods. That standard is known as the “true and fair override” which is in the legislation as Section 393 CA2006. Put more simply, the law requires that common-sense is not subordinated to rules. (As an analogy, it is akin to a customer being able to expect an omelette as the output to be delivered to the table, rather than something cooked that might have followed the recipe but failed.)

However, if one looks at various pieces of FRC guidance on Section 393 and ‘the true and fair view’[2], the words are changed from what the legislation actually states. The FRC versions put new words in and some words were left out.

The result is that the various FRC versions give the false impression that the Section 393 requirement applies loosely to the information in the accounts rather than specifically to the numbers themselves. The impact of this problem is best explained by looking at the impact of the numbers being wrong, i.e. the impact of the accounts not being fit for purpose (section 4 below).

4. Solvency, lawful distributions and the numbers in the accounts. QC opinion that the FRC is wrong and misstating the position of the government’s lawyers

In 2013 Mr George Bompas QC (a deputy judge of the High Court) gave a legal opinion for a group of large institutional investors (including the Local Authority Pension Fund Forum) which made clear that the FRC has got the law on the fundamental objective of accounts wrong, or has at best confused things.  Mr Bompas is clear that the standard for the numbers (the Section 393 CA 2006 true and fair view) is attached to the purpose of accounts for solvency and lawful distributions (Part 23 CA 2006).

The area is technical and facts are not fully rehearsed here. However, Company Law sets a net asset (solvency) system for companies and a lawful distribution system (dividends) based on the numbers as stated in the annual accounts. Problems with this will arise if likely losses are missing from the accounts, or unrealised (paper) profits are booked indistinguishable from realised profits (cash or near cash). Both of these things are apparent with the standards that the FRC sets (UK-GAAP) and endorses international standards for use in the UK (IFRS). (This area of law is relevant, for example, as to whether BHS was in a position to pay dividends, given the size of its pension scheme given the low capitalisation that was left as a result.)

Mr Bompas’ opinion was published in the final report of the Parliamentary Commission for Banking Standards in June 2013.

The FRC published a rebuttal in October 2013, relying on Martin Moore QC. Then in July 2014 Mr Haddrill is asked by the Economic Affairs Committee about the problem. That Committee was concerned about auditors signing off accounts of banks as going concerns – with the appearance of a rosy financial position - when they were on the brink of needing bailouts. Mr Haddrill replied that the government has confirmed that the FRC position (Mr Moore) is correct and the LAPFF/investor/Bompas position is wrong[3].

In 2015 Mr Bompas gave a further opinion for the Local Authority Pension Fund Forum explaining that Mr Moore is wrong due to: applying a common fallacy of false logic, and reading clear legislation wrongly. As in its evidence to the House of Lords Committee the FRC rebuttal relied on its assertion that the government has confirmed that the FRC position is correct and that LAPFF/Bompas is wrong.

However, in September 2016 a Freedom of Information revealed that the government (BIS lawyers) have never said that LAPFF and Mr Bompas is wrong. Indeed the government had to tell the FRC that it (BIS) can’t confirm either way, only a court can. That is because it is unconstitutional for the government to usurp Parliament and the judiciary by giving legal opinions.

At the time of writing this evidence the House of Lords Economic Affairs Committee is pursuing this matter and it has published a letter to Mr Haddrill dated 29 November 2016. From comparing the correspondence between the FRC and BIS setting out the governments’ actual position, to what the FRC told the Economic Affairs Committee on 2014 was the governments’ position, we believe that Parliament was misled.

Overall summary and conclusion

There is clear evidence with Section 172 and Section 414, and Section 393 and Part 23 of the Companies Act 2006 that the FRC is not adhering to the law.

The effect is that whilst Company Law is setting signposts in one direction, the FRC has been setting signposts in different directions. The problem escalates each time a new “signpost” is set by company law. Until the FRC admits that it has got existing signposts wrong, then it has to set up new signposts wrongly too. We see no evidence that the FRC is prepared to admit fault, indeed the Freedom of Information request reveals that the FRC was at pains to present a false position regarding the government’s position.

The fact that the FRC has persistently got the law wrong, might seem difficult to comprehend were it not for the fact that, the FRC has not been operating wholly independently from the accounting profession. That can be seen in at least two examples:-

      the FRC has been using the same legal counsel that the ICAEW uses (the party the FRC regulates, and essentially the trade body of the accounting profession). Not only is that arrangement unsatisfactory – we can’t envisage the Department of Health using the same legal Counsel as the tobacco industry – but on the basis of Mr Bompas the position of the ICAEW has been wrong.

      the FRC has used an FRC board member for FRC legal work (whose career included acting on defence matters for the accounting firms) who has been on one or other FRC board for more than 30 years. We believe that is unsatisfactory in principle, and unsatisfactory as it is far too long a tenure. Every document that we identified as transcribing Section 393 wrongly could be attributed to that individual.

We believe the FRC in its current form is unsupportable.

      The Treasury Select Committee has recently recommended that the FCA rule setting and enforcement functions are separated. That principle should be applicable to the FRC as well for the same reason. If the rules are wrong, then the enforcement side may be conflicted due to not being able to criticise the rules.

      We believe it wholly unsatisfactory for the FRC to use any lawyers or barristers with links to the accounting profession setting standards or giving guidance. It is not possible to be an advocate for the public interest at the same time as being an advocate for the profession’s self-interest. Again to use an analogy, we can’t envisage the Competition and Markets Authority using the same legal counsel as the large supermarkets or the electricity supply industry.

Tim Bush

Head of Governance and Financial Analysis

5 December 2016