Written evidence submitted by The Association of Investment Companies (DAR0011)

The Association of Investment Companies (AIC) is a trade body for the closed-ended investment company sector.  We represent 360 investment companies, holding assets of over £187 billion.  The AIC’s members are predominantly listed on the Main Market of the London Stock Exchange.  Some have shares admitted to trading on the Specialist Fund Segment; others are quoted on AIM.

The AIC’s members include investment trusts, Venture Capital Trusts, UK REITs and non-EU companies.  Our non-EU members are usually domiciled in Guernsey and Jersey.

The AIC has responded to previous consultations regarding audit reform.  Appendix 1 provides a list of these responses and links to where they can be obtained.  This response, to the BEIS Committee’s call for evidence on delivering audit reform, summarises the AIC’s key recommendations for audit reform and how that fits with wider corporate governance reform.

Operation and governance of investment companies

Closed-ended investment companies are collective investment vehicles which pool their shareholders’ capital and hold a portfolio of assets to spread risk and generate an investment return.  Investments include listed securities, private equity, debt, property and infrastructure.

Investment companies typically:

• Are operationally very simple, with limited or no physical presence.  They do not have complex group structures, international divisions or complex accounts.
• Have independent boards comprised of non-executive directors.  They do not have executive directors or employees and therefore do not have internal audit functions.  Instead, they outsource the day-to-day running of the company to third party service providers.  This includes appointing an investment manager to make the day-to-day investment decisions, and a custodian to hold assets that can be held in custody, such as equities and bonds.  There are contracts in place with each service provider which are reviewed on a regular basis by the board;
• Do not provide goods or services and have no trading activity or customers.  They are investment vehicles for their shareholders, but do not provide services to those shareholders;
• Have no turnover, so are not within scope of regulations such as the Modern Slavery Act 2015 or the Energy Savings Opportunity Scheme Regulations; and
• Have suppliers which are typically professional advisers or regulated firms.

The majority of investment companies report against the AIC’s Code of Corporate Governance (AIC Code) which has been tailored to reflect the characteristics of the sector.  The AIC Code is endorsed by the Financial Reporting Council (FRC) as an alternative means for members to meet their obligations in relation to the UK Corporate Governance Code (UK Code).

The AIC recommends that the Audit, Reporting and Governance Authority (ARGA), which is to replace the FRC, be given powers to endorse other industry codes, such as the AIC Code, where they adapt the Principles and Provisions set out in the UK Code to make them relevant for a particular industry or sector.  The AIC Code is currently endorsed by the FRC.  It is widely used by investment companies and valued in the market.  The AIC recommends that ARGA continues to endorse the AIC Code.

Investment company audits and audit fees

The audits of investment companies would be difficult to divide sensibly between two auditors.  The investment portfolio is the key constituent. It has a direct relationship to the income received in the year and the year end net asset value (of which the investment valuation comprises a significant part) is the basis on which most management fees are calculated.  Without the knowledge gained from the audit work on the investment portfolio, it would be difficult for an auditor to provide any significant scrutiny and challenge on the completeness of the revenue or the calculation of the management fee.

For investment companies with unquoted investments, the most challenging part of the audit is the ownership and valuation of the investments.  Whilst this remains an important area of focus for investment companies with quoted investments, it is likely to be less of a key risk.  The completeness of the revenue and the calculation of the investment management fee are also likely to be key considerations for the auditor.

Investment company audit fees tend to be significantly lower than more complex trading businesses, either in the FTSE 350 or large privately owned companies.

For example, the largest investment company by total assets is Scottish Mortgage Investment Trust PLC, which is in the FTSE 100.  Its annual report and accounts for the year ended 31 March 2020 shows fees paid to the auditor for audit services of £45k.

Relatively straightforward companies to audit, such as investment companies, should not have to incur the additional cost burden of having a joint audit.  The costs of requiring investment companies to have joint audits would not be in line with the government’s or regulators’ commitment to proportionate regulation.

For these reasons, the AIC recommends any future regulation in relation to joint audit should not apply to investment companies.

Audit committees

The AIC does not agree that there needs to be any additional scrutiny of audit committees in the investment company sector.  Specifically, the AIC disagrees with any suggestion that audit committee minutes should be published.  This may inhibit the challenge and debate that the audit committee has which would not be beneficial for shareholders.

The structure of investment companies is very different from trading companies.  As outlined above, the majority of investment companies have independent boards compromised of non-executive directors.  The day-to-day operations of the company are outsourced to external providers such as the fund manager and the administrator.  Therefore, there are no executive directors or employees.

Investment companies subject to the FCA’s Chapter 15 Listing Rules are required to have a board of directors which “must be able to act independently” of the investment manager, therefore independence of the non-executive directors is already ensured.

Audit Committees of investment companies will have significantly less day to day involvement with the auditor and the “cultural fit” bias identified by the report poses less of a risk in the tender process.

It is important that any remedies are applied proportionally and take into account the unique structure of investment companies which do not have employees, senior management, or executive directors.

The AIC considers that there are already sufficient legal and regulatory requirements to ensure the proper conduct of audit committee members for investment companies.  Applying any additional rules on audit committees for investment companies would not be proportionate.

Internal controls and risk environment

The AIC recommends that the UK should not adopt a similar framework around internal controls to the Sarbanes-Oxley (SOX) Act in the United States.

SOX rules inappropriately prioritise process over outcomes.  The UK has a superior system which recognises that companies may have different approaches to internal controls based on the size, nature and complexity of their business.  Existing UK provisions are sufficient to provide that companies report on the effectiveness of the company’s internal controls in relation to financial reporting (these are set out in Appendix 2).

Where companies, shareholders or wider stakeholders demand more assurance on internal controls and risk management, this can be provided by a reporting accountant, or other appropriate consultant, based on a defined and agreed scope.  Different levels of liability can also be agreed with the reporting accountant or consultant.  For example, investment companies may receive assurance reports on the internal controls of their service providers performed in line with the Technical Release ‘AAF01/06’ published by the Audit and Assurance Faculty of the Institute of Chartered Accountants of England and Wales (ICAEW).

The AIC recommends that if any further consideration is given to strengthening a statement in respect of risk management and internal controls it should utilise the UK’s current framework and the FRC’s Guidance on Risk Management, Internal Control and Related Financial and Business Reporting paper, rather than considering prescriptive and onerous SOX-style provisions.

The AIC also recommends that any further consideration of implementing SOX type rules should consider the concerns set out in the Kingman review regarding imposing significant costs and disproportionately affecting smaller companies.  Unless these problems are addressed, SOX type rules should not be implemented.

Creating an effective reporting regime

Annual reports currently provide shareholders with historic financial information about the company.  They also seek to provide investors with an understanding of how a company is governed, its strategy and how it operates in the best interests of its shareholders.  Shareholders should remain the primary audience for financial information and their needs should be paramount.

Investors are increasingly demanding more information about companies.  Not only about their financial position, but also about every aspect of their operations.  Companies should seek to provide their shareholders with the information they want.  However, continuing to increase the scope of the annual report to address other aspects of a company’s operations is not sustainable or appropriate.  There needs to be a balance between meeting the needs of shareholders, meeting the needs of stakeholders, and making annual reports fit for purpose.

Annual reporting requirements should not become overly prescriptive or burdensome to companies.  Companies should not be required to report on a uniform basis about matters that may not be material to their operations, or of value to their shareholders.

The AIC has long been concerned about the length and complexity of annual reports.  The AIC recommends that a wider review of corporate reporting is undertaken.  The AIC also recommends that this review includes considering splitting corporate reporting into separate components to make it more effective tool for shareholders and stakeholders (see below).

All of these reports could be required to be on the company’s website so they can be easily located by users.

Components of corporate reporting

• ‘Strategic Report’ – This would be the principal disclosure for most shareholders.  It would include the current Strategic Report or Management Report.  It would provide a high-level overview of what the company does and how it has performed in the period.  It could also include more forward-looking information.  The Strategic Report should include a clear signpost for shareholders detailing where additional information, such as the Historic Report (see below), can be found online.

The Strategic Report would not be audited.  To ensure its credibility, it would include a short statement from the auditor confirming that the information is consistent with the Historic Report (see above).  This will not create a significant increase in time or cost as auditors currently perform this as part of their audit work.

Where companies, shareholders or wider stakeholders demand more assurance, for example on more forward-looking statements, this can be provided by a reporting accountant, or other appropriate consultant, based on a defined and agreed scope.

• ‘Historic Report’ – This would be a backward-looking document.  It would contain information that is required by company law and accounting standards.  It would include, for example, the directors’ report, corporate governance statement, directors’ remuneration report, statement of directors’ responsibilities, and the full financial statements.

The Historic Report would be audited.  This report would contain information that is required by company law, regulations or accounting standards.  This report would also contain the auditor’s report which explains the scope of the audit, the responsibilities of the auditor, and the audit opinion.

• ‘Bespoke Report’ – This report would be optional.  If companies chose to publish a Bespoke Report, it would include information that is not required but gives shareholders a better insight into certain aspects of a company’s operations.  It would be for each company to assess whether such a report would be useful to its shareholders and what it should contain.  This could include other information that shareholders of the company have indicated they particularly value.  For example, it could include a specific report on cyber security, ESG matters, risk or internal controls.  Where information on these areas is required by legislation that would be included in the Strategic or Historic Report, but further information could be given in the Bespoke Report.

This report would not necessarily need to be published at the same time as the company’s Strategic and Historic Reports, reducing the burden on companies.  It would also not necessarily be required to be produced each year.  The content could be different from one report to another to meet the specific demands of shareholders allowing companies to tailor the information to the company itself, its size or its sector.

The Bespoke Report would not be audited.  Instead, this report, or sections from it, could be reviewed by independent specialists with knowledge and expertise in specific fields.  Their report/(s) would be based on a defined and agreed scope.  Different levels of liability could also be agreed depending on the work undertaken and the contractual agreement between the supplier and the company.

• ‘Legal and Regulatory Disclosures Document’ – This document would be mandatory.  It would include information that is required by law and/or regulation but is not material to the understanding of the nature and performance of the company.

For example, investment companies may include a statement on greenhouse gas emissions in this document.  Investment companies do not have employees or premises.  Accordingly, many investment companies currently state in their annual reports that the company has no greenhouse gas emissions.

The Legal and Regulatory Disclosures Document would not be audited.  Companies may decide that they would like elements of these disclosures to be reviewed by independent specialists with knowledge and expertise in specific fields.  Their report/(s) would be based on a defined and agreed scope.  Different levels of liability could also be agreed depending on the work undertaken and the contractual agreement between the supplier and the company.

Splitting corporate reporting into different components, will help reduce the so-called ‘expectations gap’.  Shareholders will be clear about which element is being audited and the scope of the audit.  It will also ensure shareholders are provided with appropriate assurance over each component of corporate reporting.

Creating an appropriate governance environment

Proxy advisers are an increasingly important part of the investment chain, yet they remain unregulated.  They are not required to report against an independently written code of best practice, such as the UK Code or the Stewardship Code.

The AIC recommends that proxy advisers be required to disclose the nature of their commitment to the Stewardship Code, or an equivalent code endorsed by the FRC. If implemented, this would bring proxy advisers into line with other significant participants in the investment chain.

The AIC recommends the Stewardship Code guidance for proxy advisers is enhanced.  The current proposals meet the requirements of Article 3(j) of the SRD II.  This requires proxy advisers to disclose certain information, such as the methodologies they use and the policies and procedures they follow for voting.  It also requires them to manage conflicts of interest. These disclosures do not fully achieve best practice in relation to the governance and stewardship practices of proxy advisers.

The AIC recommends service providers:

• Establish and explain their policy on engagement with companies which are the object of their research, advice or voting recommendations.  This should include:
• Describing how they engage with companies throughout the year;
• Setting and disclosing minimum time deadlines for engagement with companies to allow companies to respond appropriately to any issues raised; and
• Describing the extent to which they engage with companies in circumstances where they make a negative research finding or voting recommendation;
• Describe whether, and if so how, they consider explanations provided by companies which are the object of their research, advice or voting recommendations and describe how they communicate these explanations to their clients;
• Establish and explain their procedures to prevent and detect factual inaccuracies in research, advice or voting recommendations; and
• Appropriately train their staff to ensure they have the expertise required to understand the companies which are the object of their research, advice or voting recommendations. This is particularly important for companies with unusual or different market characteristics.

August 2020

Appendix 1 – Responses from the AIC

• The AIC’s response to the reforming regulation initiative published by BEIS in March 2020.
• The AIC’s response to the independent review into the quality and effectiveness of audit published by Sir Donald Brydon in April 2019.

• The AIC’s response to the Statutory Audit Market final report published by the CMA in April 2019.
• The AIC’s response to the Future of Audit inquiry published by the BEIS Committee in March 2019.
• The AIC’s response to the initial consultation on the recommendations of the independent review of the Financial Reporting Council published by BEIS in March 2019.
• The AIC’s response to the update paper on the Statutory Audit Services Market Study published by the CMA in December 2018.
• The AIC’s response to the invitation to comment on the Statutory Audit Market by the Competition and Markets Authority (CMA) published in October 2018.
• The AIC’s response to the independent review of the Financial Reporting Council published by Sir John Kingman in June 2018 and the AIC’s response to the supplementary questions posed by the Kingman Review.

Appendix 2 – Existing provisions on internal control and risk management

The Companies Act requires “reasonable accuracy” in annual reports and accounts. It provides that:

• Every company must “keep adequate accounting records” that are sufficient to “show and explain the company’s transactions” and “disclose with reasonable accuracy, at any time, the financial position of the company at that time”;
• Directors of a company must not approve accounts unless they are satisfied that they give a true and fair view of the assets, liabilities, financial position and profit or loss;
• The auditor of a company must have regard to the directors’ duty as set out in the bullet point above.

Additionally, the UK Code states that:

• The board should present a fair, balanced and understandable assessment of the company’s position and prospects (Principle N);
• The directors should explain in the annual report their responsibility for preparing the annual report and accounts and state that they consider the annual report and accounts, taken as a whole, to be fair, balanced and understandable (Provision 27);
• The board should establish procedures to manage risk and oversee the internal control framework (Principle O);
• The audit committee, or similar, is responsible for reviewing the company’s internal financial controls and internal control and risk management systems (Provision 25); and
• The board should monitor the company’s risk management and internal control systems and, at least annually, carry out a review of their effectiveness and report on that review in the annual report. The monitoring and review should cover all material controls, including financial, operation and compliance controls (Provision 29).

The FCA’s Disclosure Guidance and Transparency Rules (DTR) requires the corporate governance statement to “contain a description of the main features of the issuer’s internal control and risk management systems in relation to the financial reporting process” (DTR 7.2.5).

Investment companies are Alternative Investment Funds (AIFs) within scope of the Alternative Investment Fund Managers Directive (AIFMD).  The AIFMD places certain obligations on investment companies and their managers over certain size thresholds (this includes the majority of investment companies).  These include:

•              Having a valuation of the investments performed by the Alternative Investment Fund Manager (AIFM), at least once a year.  The valuer is also required to have appropriate procedures so that a proper and independent valuation of the investment can be performed.

• Appointing a depositary whose function it is to safeguard the assets of the company.  The depositary must also ensure that the investment company’s cash flows are monitored and payments, such as dividend income, are correctly received.  For assets that are held in custody (e.g. equities and bonds) the depositary has strict liability for those assets and they must be segregated and kept in a separate account, so they can be identified as belonging to the investment company.

For assets that are not held in custody (e.g. derivatives, real estate and private equity instruments) the depositary must verify the ownership of the assets and maintain records of those assets.  The depositary is appointed by the investment company, and it reports to the company.

• Requiring the AIFM to have permanent risk management and compliance functions with adequate risk management controls, procedures and systems and review these annually.  Where proportionate the AIFM must also have an internal audit function.  The AIFM is required to have adequate systems in place to identify, manage, measure and monitor all the risks applicable to the investment fund strategy.  These rules formalise the risk management process.

The requirements of the AIFMD provide the board and shareholders of an investment company with additional comfort regarding the valuation and ownership of its investments, along with the risks involved in its investment portfolio.