Quindell and the FRC’s Role

There was a very good article written by Cliff Weight and published on the ShareSoc blog yesterday about the fines on KPMG over the audit of Quindell. Cliff points out the trivial fines imposed on KPMG in that case, the repeated failings in corporate governance at large companies and he does not even cover the common failures in audits at smaller companies. The audit profession thinks they are doing a good job, and the Financial Reporting Council (FRC) which is dominated by ex-auditors and accountants, does not hold them properly to account.

Perhaps they lack the resources to do their job properly. Investigations take too long and the fines and other penalties imposed are not a sufficient deterrent to poor quality audits when auditors are often picked by companies on the basis of who quotes the lowest cost.

Lots of private investors were suckered into investing in Quindell based on its apparent rapid growth in profits. But the profits were a mirage because the revenue recognition was exceedingly dubious. One of the key issues to look at when researching companies is whether they are recognizing future revenues and hence profits – for example on long-term contracts. Even big companies such as Rolls-Royce have been guilty of this “smoke and mirrors” accounting practice although the latest accounting standard (IFRS 15) has tightened things up somewhat. IT and construction companies are particularly vulnerable when aggressive management are keen to post positive numbers and their bonuses depend on them. Looking at the cash flow instead of just the accrual based earnings can assist.

But Quindell is a good example where learning some more about the management can help you avoid potential problems. Relying on the audited accounts is unfortunately not good enough because the FRC and FCA don’t seem able to ensure they are accurate and give a “true and fair view” of the business. Rob Terry, who led Quindell, had previously been involved with Innovation Group but a series of acquisitions and dubious accounting practices led to him being forced out of that company in 2003. The FT has a good article covering Mr Terry’s past business activities here: https://www.ft.com/content/62565424-6da3-11e4-bf80-00144feabdc0 . They do describe Terry as “charismatic” which is frequently a warning sign in my view as it often indicates a leader who can tell a good story. But as I pointed out in a review of the book “Good to Great”, self-effacing and modest leaders are often better for investors in the long-term. Shooting stars often fall to earth rapidly.

One reason I avoided Quindell was because I attended a presentation to investors by Innovation Group after Terry had departed. His time at the company was covered in questions so far as I recall, and uncomplimentary remarks made. They were keen to play down the past history of Terry’s involvement with the company. So the moral there is that attending company presentations or AGMs often enables you to learn things that may not be directly related to the business of the meeting, but can be useful to learn.

The ShareSoc blog article mentioned above is here: https://www.sharesoc.org/blog/regulations-and-law/the-quindell-story-and-the-frc/

Note though that subsequently the FRC have taken a somewhat tougher line in the case of the audit of BHS by PWC in 2014. Partner Steve Dennison has been fined half a million pounds and banned from auditing for 15 years with PWC being fined £10 million. But the financial penalties were reduced very substantially for “early settlement” so they are not so stiff as many would like. I fear the big UK audit firms are not going to change their ways until their businesses are really threatened as happened with Arthur Anderson in the USA over their audits or Enron. That resulted in a criminal case and the withdrawal of their auditing license, effectively putting them out of business. The UK needs a much tougher regulatory regime as they have in the USA.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Beaufort Settlement Improved, But…..

It’s good news that PWC have revised their proposals for the administration of Beaufort and the return of client assets. No doubt due to the efforts of ShareSoc and others. But it still leaves many issues that need properly tackling. These are:

  1. The Special Administration Regulations that allow client assets to be used to cover the costs of the administration. Client assets should be ring fenced and they are what they are called – client assets not assets of the broker or bank.
  2. The fact that most investors now have to use nominee accounts and they are therefore not the legal owner of the shares they hold. We need a new electronic “name on register” system and the Companies Act reformed to reflect the realities of modern share trading.
  3. The UK needs to adopt the Shareholder Rights directive as intended, so that those in nominee accounts have full rights. The “beneficial owners” are the “shareholders”, not the nominee account operator.

We must not let these matters get kicked into the long grass yet again due to the reluctance of politicians and the civil service to tackle complex issues.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Protecting Yourself Against Administrations

Investors now know that when your stockbroker goes into administration, your assets are not secure (or “ring fenced” as your contract with them often says) because they can be seized under the Special Administration Regulations by the administrator to pay their costs. This has become clear from the Beaufort case. That means many investors are facing losses because Beaufort client accounts, like most stockbroking accounts now, were nominee accounts with the shares registered in the name of Beaufort.

There are two possible ways to protect your assets: 1) Hold your shares in the form of paper share certificates – not the most convenient format for trading and expensive to do so even if you can find a broker still willing to handle them; or 2) Hold your shares in a personal crest account, i.e. a “Sponsored Crest” account where your broker acts as the sponsor but the shares are registered in your name and traded electronically.

Some doubts arose in my mind about whether the latter would actually provide the protection required. For example, would an administrator be able to transfer the shares into their name, or stop the transfer of the account and hence the holdings to another broker? So here are the answers provided by Killik & Co who. It provides some reassurance:

In order for a participant to change Sponsor, CREST require:  

  • For those Participants that are already Sponsored, 3 letters as follows – – One from the existing Sponsor stating they are happy for the Participant(s) to move away from them on a set date. – One from the Participant(s) requesting to move Sponsors on a set date. – One from the new Sponsor stating they are happy to take over sponsorship of the Participant on a set date.
  • However, our understanding is that, where the Sponsor is in administration, a letter is not required by the existing Sponsor.  We believe it would be possible therefore, for the sponsored member to instruct another Sponsor to take on the sponsorship of the account.  Note that CREST is not a custodian or a depository and the shares are actually held by the Sponsor, but in the name of the legal owner. 

Regarding the question of the ability of the administrator to issue instructions on the stocks or transfer them into their own nominee name, our understanding is that the administrator has no rights over the securities held in the name of the legal owner as specified on the legal register. 

This information is provided by Killik & Co to the best of their knowledge and belief. For more information contact Gregory Smith on 0207-337-0409.

There are few brokers that still offer personal crest accounts (Killik & Co are one of them), but that still leaves the problem that ISAs and SIPPs have to be held in nominee accounts. Until the administration legislation is reformed, the only solutions for them are to open multiple broker accounts so that no one of them contains assets worth more than £50,000 (the limited covered by the Financial Services Compensation Scheme) or to pick a broker which is large enough and with a balance sheet that is strong enough that it is unlikely to go into administration. Having multiple broker accounts can be wise for other reasons than the risk of administration even if it can make life very complicated and possibly less secure – for example IT meltdowns in financial services companies are not uncommon (RBS and TSB are examples). It can be very frustrating not to be able to trade even for a few minutes (as happened this morning with the LSE due to a technology problem) let alone days or even weeks as Beaufort clients are suffering.

It is perhaps unfortunate that these risks might make for an anti-competitive stockbroking market. Folks may be very reluctant to sign up with new brokers who have a limited track-record.

But we really do need some reform of the insolvency rules to stop administrators grabbing client assets, a new electronic “name on register” system that protects ownership to replace the nominee system (something I have been campaigning on for years), and the ability to hold ISA and SIPP holdings in our own name.

ShareSoc are running a campaign on the Beaufort case (see https://www.sharesoc.org/campaigns/beaufort-client-campaign/ ) and have also asked anyone who is concerned about this issue, as all stock market investors should be, to write to their M.P.s. Please do so. Only that way will we get political action on these issues. ShareSoc can provide a template letter you can use.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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RBS Sale and Blackrock Smaller Companies AGM

The Government is selling off another tranche of its holding in the Royal Bank of Scotland (RBS). By selling another 8% it will reduce its holding to 62% of the company. The Government (or “taxpayers” as some described them) will face a loss of about £2 billion on what it originally paid for the shares. There were howls of protest from some politicians. John McDonnell, shadow chancellor, said “There is no economic justification for this sell-off of RBS shares. There should be no sale of RBS shares full-stop. But particularly with such a large loss to the taxpayers who bailed out the bank”.

I think he is suffering from the problem of “loss aversion”, i.e. a reluctance to sell a losing investment rather than looking at the current value of the bank and its prospects. The market price is surely the best indicator of the value of the company – it’s what willing buyers will pay, and what sellers consider a fair price. One aspect to consider is that the value of the business may be depressed because nobody likes to buy shares in companies where there is one dominant controlling shareholder and particularly so if that shareholder is a government. The only way the UK Government can solve that problem is to reduce its holding in stages, as they are doing. Forget the prospective loss on the share sale. Better to accept the price offered and reinvest the proceeds in something else. The Government has lots of things where it needs more cash – the NHS, Education, Defence, Brexit plans, you name it.

Mr McDonnell may be particularly unhappy as he hopes to take power at the next General Election and RBS is one of the few remnants of the past Labour government’s major stakes in UK banks. After Gordon Brown nationalised Northern Rock and Bradford & Bingley, they took effective control of RBS, and to a large extent Lloyds. Only Barclays managed to escape by doing a quick deal with middle-east investors which has been the subject of legal action, only recently thrown out by the courts. For any socialist, particularly of the extreme left like Mr McDonnell, the ability to tell banks what to do is an undoubted objective. Banks tend to reduce lending when the economy worsens and their clients start to have difficulties but the claim is often that such reduction in lending compounds the economic woes.

Yesterday I attend the Annual General Meeting of Blackrock Smaller Companies Trust Plc (BRSC). What follows are some brief highlights. This company has a good track record – some 15 consecutive years of outperforming its benchmark by active management. So much for passive index investing. It has been managed by Mike Prentis for many years assisted by Roland Arnold more recently. The share price rose by 25% last year but the discount to NAV has narrowed recently to about 6% so some might say it is no longer a great bargain. The company does not have a fixed discount control mechanism and has traded at much higher discounts in the past.

It’s a stock-pickers portfolio of UK smaller companies, including 43% of AIM companies and 143 holdings in total. Many of the holdings are the same companies I have invested in directly, e.g. GB Group who issued their annual results on the same day with another great set of figures.

Mike Prentis gave his key points for investing in a company as: strong management, a unique business with strong pricing power, profitable track record, throwing off cash, profits convert into cash and a strong balance sheet. They generally go for small holdings initially, even when they invest in IPOs, i.e. they are cautious investors.

When it came to questions, one shareholder questioned the allocation of management fees as against income or capital (25% to 75% in this company). He suggested this was reducing the amount available for reinvestment. But he was advised otherwise. Such allocation is now merely an accounting convention, particularly as dividends can now be paid out of capital. But he could not be convinced otherwise.

Another investor congratulated the board on removing the performance fee. Shareholders were clearly happy, and nobody commented on the fact that the Chairman, Nicholas Fry had been on the board since 2005 and the SID, Robert Robertson, had also been there more than 9 years – both contrary to the UK Corporate Governance Code. The latter did collect 5% of votes against his re-election, but all resolutions were passed on a show of hands.

I was positively impressed on the whole.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Savings Income Tax Review

In addition to the review of Inheritance Tax previously covered, the Office of Tax Simplification (OTS) are also undertaking a review of ways to simplify the taxation of income from interest on savings and dividends. Although 95% of the population pay no tax on such income as they have relatively little, the complexities of calculating the tax due on those with higher levels are mind boggling. Here’s a couple of quotations from the OTS Report (see https://www.gov.uk/government/publications/simplifying-the-taxation-of-savings-income ) which explain why:

“Many of the issues have arisen because of a series of changes, each working well enough taken by itself but which together create significant complexity that is not easily resolved”; and:

“The starting rate for savings (SRS), personal savings allowance (PSA), dividend allowance and other allowances and features of the tax system mean that most people pay no tax on their savings, but the interactions between the rates and allowances is sufficiently complex at the margins that HMRC’s self-assessment computer software has sometimes failed to get it right. It is proving to be very difficult to create an algorithm that calculates the tax correctly in all circumstances and HMRC does not expect to bring the complete calculation online until 2018-19.”

For those with complex tax affairs, or significant levels of dividend income who are probably some of the readers of this blog, this is not a trivial problem. Even my large firm of accountants who do my personal tax returns seem to be having problems with the software they use of late. I would certainly hate to try and do my own tax returns now.

One of the past simplifications which has been very damaging to stock market investors was the introduction of a “dividend allowance” of £2,000 to replace the dividend tax credit system. Although investors can put money into an ISA where dividends are not taxed (and could be paid out), there are severe limits on the amounts that can be invested in an ISA. That limit is £20,000 in the current tax year but has been much lower in the past and may get reduced again. For those shareholdings not in an ISA or SIPP, the removal of the dividend tax credit system means that the Government is collecting tax twice on the same company profits. Once when corporation tax is paid by the company and again when dividends are paid to investors out of those profits. This is surely iniquitous even with the current relatively low level of corporation tax. This change was allegedly made to prevent small incorporated businesses from avoiding income tax by paying profits out via dividends instead of via salaries subject to PAYE, but there were other simple rule changes that could have prevented that.

What does the OTS propose to do to simplify the calculation of savings tax? They wish to introduce a “personal tax roadmap” incorporating a plan for consolidation of the savings income tax rates and allowance. Also they wish to improve guidance because it is clear that people have difficulty in understanding the existing system. More flexibility in ISAs might also be considered to allow partial transfers of money and simplify the rules.

One specific threat in the document is this: “A more radical option would be to end the differential tax rates for dividend income. If all taxable income was taxed at the same rates, it would not matter how the personal allowance was used. Making this change would have the effect of increasing the amount of tax due from those who receive amounts of dividend income above the allowance. It would also impact on the taxation of profit extracted as a salary or as a dividend, from family owned companies.”

Investors receiving substantial dividends directly have already suffered a major tax increase from the removal of the tax credit system (the £2,000 tax free allowance is trivial in comparison with the income likely receivable by a portfolio large enough to fund a retirement for example). The new suggestion that dividends should be taxed the same as earned income would be another damaging imposition (the former are currently taxed at somewhat lower rates, although Trust rates are higher – another anomaly that is difficult to explain).

You can send your own comments to the OTS via email to: ots@ots.gsi.gov.uk .

As I said in the Inheritance Tax Review you might suggest to them that the present arrangements seem to generate work for tax accountants while baffling the general public. Like IHT, income tax is certainly a tax that requires simplification. A more fundamental review is surely required. However it’s worth bearing in mind that individuals have often planned their financial affairs based on existing tax rules. Abrupt changes to tax rules and allowance should be avoided, but that’s all we have had for the past few years, driven by political imperatives. The result has been the unintended consequence of a very complex tax system that few people understand and which makes tax calculations only possible by experts.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Belated Action by FRC Re Autonomy

I commented previously on the conviction of former Autonomy CFO Sushovan Hussain for fraud in relation to the accounts of Autonomy Plc (see https://roliscon.blog/2018/05/02/they-do-things-differently-in-the-usa/ ). Just to show that this was not solely a case prompted by Hewlett Packard over their disastrous acquisition of the company and supported by a partisan California court as some have alleged, the Financial Reporting Council (FRC) have now announced formal complaints over the conduct of auditors Deloittes and senior finance staff of Autonomy – including Mr Hussain.

Allegations include: failings by the auditors to adequately challenge Autonomy’s accounting and disclosure of its purchases and sales of computer hardware; adequately to challenge Autonomy’s accounting for transactions with value added resellers (“VARs”) and to correct false or misleading communications made by Autonomy to the Financial Reporting Review Panel (“FRRP”) of the FRC.  Sushovan Hussain and Stephen Chamberlain are alleged to have breached the fundamental principle of integrity by acting dishonestly and/or recklessly when preparing and approving Autonomy’s Annual Report and Accounts for the years ended 31 December 2009 and 31 December 2010 and related charges.

There will be tribunal hearing to hear these complaints for which a date has not yet been set. It seems likely that the claims will be defended.

So 8 years later we have a non-criminal action by the regulatory authorities in the UK over accounting and audit failures while the US prosecuted for fraud. Surely this is not good enough if the allegations are true? Plus it’s been too long before action has been taken. If the claims are upheld then the accounts were wrong and sufficiently wrong not just to mislead the investors in Autonomy but to prompt Hewlett Packard to purchase the company at a grossly inflated price – that is their claim which is the subject of an on-going civil action. But it could also be seen as a fraud on stock market investors which is a criminal offence in the USA but not the UK. That is what needs changing.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Inheritance Tax Review

The Office of Tax Simplification (OTS) have published two items that will be of interest to investors. Firstly they have called for evidence to support a review of Inheritance Tax (IHT) and secondly a note on “routes to simplification” of the taxation of savings income. The latter is horribly complex so I will deal with that later in a separate post.

Inheritance tax is slightly less complex but since recent Chancellors decided to use it as a sop to the middle classes with such rules as the ability to leave property to children and grandchildren of up to £1 million, it’s been getting a lot more complex. It’s now reached the level where few people understand it and what effect it may have even when their tax affairs are otherwise relatively simple.

Part of the problem has been rising property prices. More than 14,700 homes were sold for more than £1 million last year according to Lloyds, and a lot of those will have been in London and the South-East. The Government sees it as a popular political stance to enable such homes to be passed on to children, rather like one can pass on certain pensions now, while not requiring their sale to meet medical or social care in later life.

Rather than simply raise the inheritance tax threshold, to stop the rapid increase in the number of people who are liable for inheritance tax (although that’s still less than 5%), the clever folks in the Treasury devised alternative rule changes that ameliorated the impact of increasing property wealth for certain sections of the population (e.g. property owners). But those who have to act as executors and deal with probate are faced with increased complexity.

You can see the impact of rising property prices if you know that IHT is charged at 40% and applies to assets as little as £325,000 (that’s where the nil rate band ends) – so almost everyone living in London may pay it if they have no close relations or other “allowable” exceptions such as business assets.

It’s not just property that causes complications though. Unlisted companies such as AIM stocks are business assets and hence with typical private investor share portfolios now often holding a significant proportion of such shares these complicate the calculation. That is particularly so as not all AIM shares qualify and they need to have been held for some years.

The OTS are keen to hear from individuals as well as professionals with an interest in this area. There is an easy on-line survey you can complete here: https://www.gov.uk/government/consultations/inheritance-tax-review-call-for-evidence-and-survey

Please help them by responding. You can also send comments to them via email to: ots@ots.gsi.gov.uk . You might suggest to them that the present arrangements seem to generate work for tax accountants while baffling the general public but at the same time generating very little in revenue to HMRC. It’s certainly a tax that requires simplification. The original objective of inheritance tax seems to have been the socially beneficial aspect of preventing large wealth being passed on and accumulating through the generations. But at present the rich mainly avoid it – they set up trusts or move to another country. Meanwhile the middle classes tend to pay it and suffer the absurd complexity at the same time.

Here are some personal suggestions from me for simplification:

  1. The nil rate band should be raised to £2 million – effectively covering most normal family homes and avoiding the need to sell the house to meet IHT liabilities for children still in occupation. The Osborne changes that permitted property to be passed on should be scrapped.
  2. The IHT exception for AIM shares should be abandoned. The complexities of what may or may not qualify for that make planning difficult and potential savings on IHT are a poor reason or motivation for buying high-risk AIM shares. The desire to encourage investment in early stage companies is hardly a justification for most retail investors as they can rarely buy AIM company shares in IPOs and management/founders have other tax incentives such as entrepreneur relief. If such encouragement is required then other tax concessions (e.g. on capital gains) might be better.
  3. The seven-year rule for exemption of gifts is actually more complex than it first appears to be and can extend more than 7 years if multiple gifts are made I understand. Together with the tapering of such relief, it can become difficult to predict the likely liability particularly as forecasting when the donor might die is usually not easy. I suggest this relief be restructured to provide more certainty about the tax liability and it’s worth considering switching to a tax on gifts received.
  4. The existing IHT rate of 40% should be reduced as it encourages complex, and expensive, tax planning. A lower rate of tax might actually encourage more people to pay it rather than go to the trouble of setting up complex plans to avoid it.

In summary IHT has become too complex and needs to be simplified. However it’s worth bearing in mind that individuals have often planned their financial affairs based on existing tax rules. Abrupt changes to tax rules and allowance should be avoided.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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