Tag: Audit Failures

Renold Accounts, Audit Quality and Abnormal Price Movements

Chain maker Renold (RNO) has provided the latest example of sloppy accounting work. On the 9th July it reported that it had identified accounting issues in the three years ending March 2017, 2018 and 2019. Assets and profits were overstated and liabilities were understated in the Torque Transmission division. In total adjusted operating profits were overstated by £1.8 million. As a result the AGM is being postponed to give time for revising the Annual Accounts. Their auditors are Deloitte.

The Financial Reporting Council (FRC) have reported on their latest assessment of audit quality and it makes for dismal reading. Their target for assessed audits is 90% being “good or requiring limited improvements” but only 75% of FTSE 350 audits met that target. Overall there has been no improvement on last year.

Grant Thornton and PwC came in for particular criticism. Scrutiny of Grant Thornton has been increased and PwC is required to take “prompt and targeted action” to address their decline in performance. KPMG also continues to be subject to increased FRC scrutiny. The FRC suggests that all audit firms suffer from failing to challenge management sufficiently on judgmental issues, and need to work harder to solve this problem.

Comment: this has certainly been a long-standing issue that is driven by the desire of audit firms to reduce their prices to win business and reluctance to challenge management. Renewal of audit contracts with the same firm over many years contributes to the problem. The only way to break this system is to change how auditors are hired. At least that’s my personal opinion.

But the good news for investors is that the Financial Conduct Authority (FCA) have reported that abnormal price movements before deals are announced were down last year. In other words, market abuse has fallen by 12% and is now at its lowest level since 2006.

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

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Redcentric – Devasting Report on Audit Quality

I have commented on the accounting problems at Redcentric (RCN) before – see https://roliscon.blog/2019/06/13/pwc-fined-over-audit-at-redcentric/ . Mark Bentley of Sharesoc has written a good article on the audit issues at this company on their blog here: https://www.sharesoc.org/blog/regulations-and-law/redcentric-rcn-campaign-important-developments/

He covers the report from the Financial Reporting Council (FRC) on the audit which has only taken them two years to produce – that’s fast for the FRC. But if you read the report you will see that it is a devastating critique of the quality and professionalism of the audit by PwC.

An investigation by the Financial Conduct Authority (FCA) is still on-going apparently and ShareSoc is talking to lawyers about possibly legal action to recover losses suffered by investors from reliance on clearly inaccurate accounts.

But there are simply too many such cases and shutting the stable door several years after the horse has bolted is not good enough. The Government needs to look at how to prevent such problems by improving the standards of accounts, and improving the auditing of them. Some reforms have already been proposed in that regard but whether they will have an impact on the activities of smaller AIM companies, where a lot of the problems occur, has yet to be seen.

At the core of the problem is the failure to make the individuals (i.e. the directors and senior management) in such companies personally responsible. Pursuing the companies or their auditors is only a limited solution and shareholders often bear the costs when the individuals concerned need to be deterred by prison sentences I suggest. But that means changes to the law to make it easier to prosecute such cases.

And the FCA needs much more resources to enable them to pursue such cases quickly and forcefully. There is so much fraud taking place in the financial world that most goes undetected, unrecognised and unprosecuted.

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

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Horizon Discovery – Defective Accounting Discovered

Horizon Discovery Group (HZD) announced their full year results this morning. Horizon is a biotechnology company focused on cell engineering and CRISPR screening. Revenue was up by 68% to £58.7 million helped by an acquisition. But the “reported loss” increased to £35.8 million due to the exceptional write-off of past investment in “In Vivo”. Although this is a non-cash impairment it suggests that there was past over-optimism in the viability of that business unit and excessive capitalisation of development expenditure. This follows from a strategic review of the company last year by new CEO Terry Pizzie.

They also have a new CFO. There has been a review of revenue recognition policies that has led them to restate 2017 revenue down from £36.5 million to £35.0 million. This is what the company has to say about that: “In 2019, the Group became aware of potential revenue recognition matters in connection with certain license revenue contracts. As a result, the Group undertook a detailed review of all such contracts and determined that the terms and conditions in some of those contracts had been misinterpreted and as a consequence, the accounting periods in which the revenue is recognised have been reassessed, due to license revenues being recognised before they were committed”. Who were their auditors you may ask? Answer: Deloitte. This looks like yet another case of a basic accounting failure that the auditors failed to pick up.

At the last AGM of the company, which I attended as a small shareholder, I questioned why the company was losing money on services. Surely if services were unprofitable, they don’t need to be provided to customers? Good to see that in the latest announcement they are withdrawing from “investment” in parts of the services portfolio. Another interesting comment in the announcement is this: “Our ‘Investing for Growth’ strategy will see the business shift from a scientifically-led life sciences company to a fully commercial tools company, which will mean that Horizon is increasingly well placed to capitalise on its market-leading position to drive sustained top-line growth”.

Apart from the above issues, the company does seem to be moving in the right direction and the comments about future prospects from the CEO are positive. The share price was unmoved at the time of writing.

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

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LCF – Another Audit Failure & the latest on Brexit

I have not covered the events at London Capital & Finance (LCF) before although the national press has done so extensively. LCF sold “mini-bonds” to 11,500 people who invested £236 million in them and are likely to recover very little. These “bonds” were promoted as being “ISAs” in some cases when they were not, and that they were FCA regulated when in fact they were not – only the company was FCA “authorised” for certain activities but that did not include selling these bonds.

The company paid very generous commissions on the sale of the bonds, as much as 25%, and the money raised was invested in small companies with few assets and who are very unlikely to provide a return.

But it has now been disclosed in the Financial Times that based on the 2017 accounts of LCF it appears that the company was technically insolvent even then. However it received a clean audit report from auditors EY. Administrators Smith & Williamson report on a series of “highly suspicious transactions” linked to a number of individuals where money appears to have been diverted to them.

I have written repeatedly on the failures of the audit profession, and the lackadaisical approach of the Financial Conduct Authority (FCA) to improve standards and enforce them. Reforms are in progress (see https://roliscon.blog/tag/arga/ ) but it cannot be too soon. In the meantime, as always, the underlying problem is the gullibility of the public and their lack of financial education. Anyone who had undertaken more than a cursory look at the background of LCF and its finances would have shied away rapidly. But certainly being able to claim FCA authorisation was misleading and that is an issue that needs resolving.

Brexit

It seems Prime Minister May could have another attempt at passing her preferred EU Withdrawal Agreement which got defeated for the third time yesterday. Not that MPs managed to get any majority for alternative solutions in previous indicative votes. I supported the Prime Minister’s solution as a reasonable compromise although it was some way from being a perfect Agreement. However, with no time remaining to renegotiate it, refusal of the EU to countenance changes, and the general desire of the public to see the matter closed with no more debate, it was the best option available. However it was clear from watching yesterday’s debate that there are many MPs, both remainers and brexit supporters who had fixed opinions on the subject and were not going to change them. Mrs May’s problems were compounded by the Northern Irish DUP contingent, the awkward squad one might call them, and by Jeremy Corbyn doing all the could to obtain a general election by opposing any compromise in the hope of winning power.

What would I do if I were Prime Minister now? Decisive action is required which could include I suggest the following options: a) Ensure we exit the EU with no deal a.s.a.p. so as to force both the remainers and brexiteers to face up to reality, and the EU likewise – a rapid agreement on a free trade deal might then be concluded or the wisdom of Mrs May’s compromise would be made plain; or b) call a General Election with a new Conservative party leader and with a manifesto that is pro-Brexit. That would force all Conservative MPs to support the manifesto or be de-selected, i.e. they either support the manifesto or quit. The Labour party and other parties would also need to clarify their position on Brexit in their manifestos thus thwarting any more bickering about where they stand. With a bit of luck the outcome would be a clear majority in Parliament for a Government not beholden to minorities.

The EU might permit an extension of Article 50 to allow time for a General Election – at least 2 months is probably required, although there is no certainty on that. Some EU bureaucrats still seem to think that if they are awkward enough the UK will decide Brexit is not worth pursuing after all, but that ignores the political split that will remain in the UK with the Conservative party still disunited.

Will Mrs May take any decisive steps such as the above? I doubt it.

There is one advantage arising from the Brexit debate. The pressure on Parliamentary time has meant that the massive increase in Probate Fees for larger estates has been delayed. They won’t now take effect from the 1st April as proposed. Now might be a good time to die if you are fed up with this world so as to avoid more Brexit debates and save on probate fees!

Rather than finish on that depressing note, let us welcome a sunny Spring day that will lift all spirits, and with the pound falling (which helps many UK companies) and the stock market rising, life is not so bleak as politicians would have us believe.

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

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FRC Revolution to Fix Audit and Accounting Problems

A major announcement that will impact investors was made yesterday by the Government. You may not have noticed it in the midst of political turmoil, but it’s worth studying.

The Kingman review of the Financial Reporting Council (FRC) was published last December. It was a quite damning criticism of many aspects of the current regulatory regime that had resulted in so many audit failures and poor-quality financial reporting. See my previous blog post on this subject here: https://roliscon.blog/2018/12/18/all-change-in-the-audit-world/

There are few experienced investors who have not suffered from audit failures in the last few years. Accounts need to be accurate, reliable and trustworthy but they have been far from that in the last few years. It is now proposed that the FRC, which regulates the audit world and sets accounting and corporate governance standards, be scrapped and replaced by a new body to be called the Audit, Reporting and Governance Authority – ARGA as it will no doubt be abbreviated to. ARGA will have stronger powers, a new mandate and new leadership.

There is a public consultation on the proposed new body and supporting legislation which can be obtained from here: https://tinyurl.com/y55a376d . Anyone with an interest in improving auditing, and preventing company failures such as those at Patisserie or Carillion and major banks in 2008 should respond. But there are so many changes proposed that the document may take time to digest. I pick out some of the more important ones below:

A new Chairman and Deputy Chairman are being recruited to head ARGA so there will be change at the top. Let us hope they manage to change the culture of the FRC even if many of the FRC’s staff move into the new body. It needs to be more than a change of name.

The ARGA will have clear statutory powers with a clear purpose and objectives, supported by a “remit letter” from the Government. One objective will be “to protect the interests of users of financial information and the wider public interest…” which is a positive statement and replaces the unclear historic accumulation of limited powers by the FRC.

The new board responsible for the ARGA will be smaller, more diverse and less representative of “stakeholder” interests. Let us hope that this means less dominated by major audit firms and the audit profession.

The Audit Firm Monitoring Approach will be put on a statutory basis and with enhanced skills and seniority in the team. There are also proposals to improve the Audit Quality Review system which sound promising although such reviews only affect large companies. There will also be expansion of Corporate Reporting Review activity focused on higher risk companies and the new regulator will have the power to change accounts without going to Court.

The “audit expectation gap” where, for example, investors expect auditors to detect false accounting or even fraud whereas auditors don’t perceive that as part of their job will be reviewed. There is indeed a problem with the failure of auditors to challenge the information they receive from management and the latter’s forecasts and interpretation. Let us hope that is a meaningful independent review that results in some changes.

A new “pre-clearance” system will be introduced to enable companies and their auditors to obtain approval for “novel and contentious matters in accounts in advance of their publication”. This may assist auditors to “pass the buck” to someone else if they have doubts about how to present the financial figures.

More transparency in the new body is encouraged on such matters as disclosure of undertakings from concluded cases and it will become subject to the Freedom of Information Act. There will also be more publication of information on complaints and improved handling of them. Such changes are to be encouraged to stop the current secrecy under which the FRC operates which frustrates investors.

The oversight of the accountancy profession is proposed to be improved although the details are unclear and it may require primary legislation. The wording suggests that audit firms may escape substantial change.

The prevention of corporate failure is to be tackled by developing a market intelligence system to identify emerging risks in companies. This will enable a change from a purely historic analysis of corporate failures which is rather like shutting the stable door after the horse has bolted to a more proactive, future-looking approach. Auditors may also be required to warn of concerns about viability.

The AARG will be able to commission a “skilled person review” where concerns are raised about a company. Details of how this will operate are to be determined, but this appears to be a useful step forward. The cost would be charged to the companies where it is invoked.

The Government accepts that there is merit in improving internal company controls by something along the lines of the US Sarbanes-Oxley regime. They will explore options in this area and do a consultation on it in due course. This is a welcome move and I covered the benefit of such a change in a previous blog post: https://tinyurl.com/yxmx9gzg

It is proposed to improve “viability” (i.e. “going concern”) statements and the FRC has been tasked with taking that on immediately. Such statements are certainly ineffective at present and could be improved in several ways, e.g. to avoid the “all or nothing” approach at present. Such questions are not simple black and white issues in most cases.

It is proposed to replace the existing, and most peculiar, voluntary funding arrangement of the FRC with a new statutory levy for the ARGA. This is surely welcomed as money is the key to improving many of the regulatory functions. It is clear that the FRC is under-resourced in terms of the numbers and skills of staff.

In summary, most of the recommendations in the Kingman review are being taken forward.

Comment: These long-overdue reforms are certainly welcomed and the Government does seem to be applying some urgency to them, although with a log-jam in Parliament at present it may take time to get some of the needed statutory law changes in place. But cultural changes in organisations are never easy. Old bad habits in the FRC may persist, while it remains to be seen whether adequate funding will be put in place for the ARGA. There is also a lot of detail yet to be worked out. Let us hope it is a case of welcome to ARGA and not AARGH when we learn the details.

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

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AssetCo Case and the Grant Thornton Defense

I mentioned in a previous blog post yesterday the judgement in the case of the alleged breach of duty by Grant Thornton (GT) when acting as auditors of AssetCo Plc (ASTO) in 2009/10. See https://www.bailii.org/ew/cases/EWHC/Comm/2019/150.html for the full judgement. For those who have not had the opportunity to read all 300 pages of the judgement, here are some interesting points from it:

It was conceded that the audit was negligent in a number of respects, but GT’s defense against the damages claim was based on what it asserted were six “insuperable obstacles”. Some of the key points they made are below:

  1. They deny that if the true accounting position had been known they could have avoided an insolvent liquidation. Indeed they claim that AssetCo was better off not knowing, in 2009 and 2010, the truth of its own position.
  2. They claim that the steps that AssetCo took (a scheme of arrangement) mitigated all their losses and otherwise avoided all harm.
  3. That none of the damage claimed by AssetCo was caused by Grant Thornton but by the directors of the company.
  4. That the Letter of Representation supplied by AssetCo as part of the audits contained falsehoods and hence GT should be relieved of all liability.

They also disputed the quantum of losses suffered by the company and their entitlement to interest thereon.

The judge concluded that GT’s conduct was “not reasonable”, and upheld the claim. The defense that AssetCo were better off not knowing their true financial position is a very remarkable one indeed! How are companies expected to avoid losses if they do not know their true financial position?

But this case is a good example of how civil claims arising from company fraud are simply too expensive to pursue in most circumstances and take much too long to get into court. Expecting civil claims to discourage bad auditing and somehow police audit work is simply not a realistic proposition.

If GT’s defences had been upheld, it would effectively make it impossible to challenge any incompetent audit work however bad it was and however damaging the consequences. If the case does go to appeal, let us hope the judgement is upheld.

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

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FRC Review of Auditing Standards – They’re Looking At The Wrong Things

The Financial Report Council (FRC) have recently published a “Post Implementation Review: 2016 Ethical and Auditing Standards”. It concentrates on the changes made in 2016 to improve the independence of auditors but will that solve the lack of trust in financial accounts and audits thereof? I doubt it.

This is what I said in response to some of their questions (answers in red):

  1. Do the current ethical and auditing standards drive the auditor to deliver work that meets the expectations of users within the current scope of an audit? If there are expectations that are not being addressed, please state those along with your proposals as to how they can be addressed. The expectations of users are still not being met because simply introducing ethical rules to be followed by auditors does not tackle the basic problem that many audits do not identify false or misleading financial accounts.
  2. Are there further steps that the FRC should consider as part of this review to ensure the delivery of high-quality audit? If so, please state what they are and why. The FRC needs to spend effort to identify why fraudulent accounts can still be produced by companies and not be identified as such by auditors. In other words, they need to look at what rules or procedures could be put in place to identify such failings as false balance sheets (e.g. reported cash not being available or undisclosed overdrafts as in Globo and Patisserie), incorrect revenue recognition (Quindell et al), excessive risks being taken and poor internal controls (Conviviality, banks in 2008, etc), and other aspects of companies that cause them to fail.
  3. Do you believe the current restrictions on non-audit services are sufficient to address threats to independence, objectivity, integrity and audit quality, and address stakeholder expectations? If not, please explain why, by providing examples where audit quality has been compromised as a result of non-audit services being provided by the auditor. They do very little to affect the objectivity, integrity and audit quality or to address stakeholder expectations.
  4. Is the work required of an auditor on an entity’s compliance with laws and regulations, and those procedures to identify irregularity, including fraud, sufficient to meet the needs and legitimate expectations of users? If not, what additional work would you require and why? A lot more work would be required to identify fraud and meet the expectations of users of financial statements. What that work might be can only come out of an examination of past audit failings.
  5. Should the FRC take further steps to increase the value of extended auditor reporting to users of financial statements? If you agree, what material would you like to see included in auditor’s reports? It’s not a case of more extended auditor reporting being required – more information will just cloud the picture. We just need to have more confidence in the accounts as reported.
  6. to assess whether management’s use of the going concern basis of accounting as required by IFRS or UK GAAP is appropriate. How could auditors make their assessment of greater value to users of financial statements? Please set out what steps you believe should be required to better underpin confidence in audit and audited financial statements. The “going concern” requirement is clearly inadequate as so many companies pass the current standard and yet go into administration or have to be bailed out before the next year end. There should not be a single “black/white” comment on the financial health of a company, but a range of reported measures. One problem at present is that both auditors and companies are desperate to avoid “qualified” accounts with the undesirable consequence that minor issues (which might point to major problems) are not reported.

There was a very interesting letter in today’s Financial Times on this subject. It was from Rodger Hughes of The Family Building Society. He said that the key driver of audit quality is the ability and attitude of audit partners and managers, but he suggested that increased compliance regulations and more auditor insecurity might have made matters worse. He concludes by saying “What is lacking and urgently needed is an authoritative study of audit failures and the underlying causes”. I wholeheartedly agree with that comment as it seems the FRC has been focussed on other than the key issues.

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

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Improving Auditing – It’s Certainly Time

Readers don’t need to be reminded that many of the most damaging events for investors in public companies in recent years have arisen because of the failures of auditors to identify misleading accounts, if not downright fraud in some cases. The Kingman review of the FRC and the views of the Competition and Markets Authority (CMA) suggest that there is a widely recognised problem in the quality of work done by auditors and the regulation of the profession.

I have mentioned previously a report entitled “Reforming the Audit Industry” commissioned by the Labour Party which has advocated the break-up of the big four audit firms that dominate the audits of FTSE-350 firms. The report, co-authored by Prof. Prem Sikka et al (see https://tinyurl.com/yb68pfr5 ) is particularly good on the subject of how auditors have ducked any liability for their failings over the last 50 years – see Chapter 10.

If we want auditors to do a good job, then they need to be made accountable to both the companies who commission them and to investors who rely on the accounts that are published. That includes both audit firms and individual audit partners and managers. But we now have a situation where auditors have ducked both obligations by forming into Limited Liability Partnerships (LLPs), by writing contracts with their clients that exclude liability and by legal judgements such as that in the Caparo case. The aforementioned document spells out how this came about and is well worth reading. It shows how the FCA, FRC, and the Government have avoided their responsibility for ensuring that auditors are properly accountable with the result that one might expect – in essence shoddy work by auditors. One can only conclude that audit firms and accountants have had too much influence over the regulation of the audit profession. Or as the report puts it “the accounting cartel sets the rules”.

As the report says, “current liability laws do not exert sufficient pressure on auditors to be diligent or even exercise reasonable care and skill. In this environment, some audit partners cannot even be bothered to spend enough time on the job, or supervise audit staff”. It mentions that the PwC audit partner spent just two hours on the final audit of BHS and its parent company; while the Audit Senior Manager recorded only seven hours and was not involved in the final stages of the BHS audit. And at Quindell, auditors KPMG failed to obtain reasonable assurance that the financial statements as a whole were free from material misstatement, failed to obtain sufficient appropriate audit evidence and failed to exercise sufficient professional scepticism.

The reforms recommended in the report are:

  • Auditors must owe a ‘duty of care’ to individual stakeholders who have a reasonable justification for placing reliance upon auditors.
  • The incidence of liability must act as a pressure point for improvement of audit quality. Individuals and society must be empowered to seek redress from negligent auditors
  • There must be personal liability for audit failures upon partners responsible for audits.
  • Where a partner of the audit firm acts negligently, fraudulently or has colluded in the perpetration of fraud and material irregularities, civil and criminal liability must fall upon the partner of partners concerned and upon the firm jointly and severally.
  • Class lawsuits must be permitted to empower stakeholders as many stakeholders are not always in a position to seek redress from negligent auditors.
  • In the event of negligent and fraudulent practices, audit fees for the relevant years shall be returned to the audited entity.

These appear to be eminently sensible proposals to this writer.

The report covers the issue of lack of competition in the audit market as was covered by the CMA and their proposals are similar. Also covered are the failings of the FRC – lack of urgency, investigations abandoned and puny sanctions after audit failures. An example of the latter is that the fines imposed as a proportion of a firm’s global audit fees after major failings is a miniscule 0.016% on average. In other words, audit firms have no great incentive to avoid mistakes.

The concluding paragraph in the report says this: “History shows that much of the change in the world of accounting and auditing has been introduced in the teeth-of-opposition from accountancy trade associations and accounting firms. The same approach must be taken in order to make audit work for, and be accountable to, the many, and not the privileged few. Otherwise, there will be more avoidable scandals resulting in loss of pension rights, jobs, businesses, savings, investments and tax revenues, social instability and ultimately loss of faith in the ability of institutions of democracy to connect with the plight of the innocent bystanders”.

I hope everyone in the Government who has responsibility for company regulation reads this report. It is certainly time to make major changes in the audit profession.

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

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Big Audit Firm Break-Up and Northern VCT AGM

A report commissioned by the Labour Party has advocated the break-up of the big four audit firms that dominate the audits of FTSE-350 firms. The report, co-authored by Prof. Prem Sikka et al, even goes so far as to suggest that their share of that market should be limited to 50% and that joint audits be promoted. In addition it argues that audit firms should be banned from doing non-audit work for the same company, and an independent body to appoint audit firms and agree their remuneration should be set up.

It also calls for the auditors to owe a duty of care to shareholders, not just the companies they audit, which would enable shareholders to pursue litigation over audit failings which they have great difficulty in doing at present. It is surely sensible to reinstate what was always assumed to be the case before the Caparo judgement.

These are revolutionary ideas indeed to try and tackle the problems we have seen in recent years and it seems to be now generally accepted by investors, if not the audit profession, that there have been too many major failings and the general standard is low. Even the Financial Report Council (FRC) seem to accept that view at a recent meeting with ShareSoc/UKSA.

But would breaking up the big four, effectively forcing some larger companies to use smaller audit firms improve the quality of audits? I rather doubt it. In my experience problems with smaller audit firms are just as common as in large ones – it’s just that the big companies and their audit failings get more publicity. Larger firms do have more expertise in certain areas and more international coverage. So there are good reasons to use them. But this report is certainly worth reading because if Mrs May continues to make a hash of Brexit and proves unable to stop dissension within her party we may see a Labour Government looking to implement these policies. See http://visar.csustan.edu/aaba/LabourPolicymaking-AuditingReformsDec2018.pdf . I may make more comments on the report after I have read the whole 167 pages.

Note that this issue of audit firm size came up at the Northern Venture Trust (NVT) Annual General Meeting which I attended today. This is a long-established Venture Capital Trust – it was their 23rd AGM, many of which I have attended. One shareholder voted against the reappointment of KPMG on the “show of hands” vote, and there were 1.2million votes against them on the proxy counts (versus 10.9 million “for”). It is unusual to see so many voted against such resolutions. When I asked the shareholder why he voted against I was told it was because he thought that a smaller audit firm might do better as VCTs are relatively smaller investment companies. However I pointed out that VCT legislation is very complex so it makes sense to use an audit form that is more knowledgeable in that regard.

The other possible reason for high proxy votes against the auditors is that Nigel Beer, who chairs the Audit Committee is a former partner in KPMG although he told me later that he had departed many years ago. Anyway I did raise this issue in the meeting and the fact that both Nigel Beer and Hugh Younger had just passed 9 years of time on their board. In addition, Tim Levett, who is Chairman of NVM, the fund manager, is on the board. So according to the UK Corporate Governance Code that’s three directors out of 6 who should be considered non-independent.

I urged the Chairman to look at “refreshing” the board although I did not doubt their experience and knowledge. It was also pointed out to me after the meeting that there are no women on the board. So effectively this is really a stale, male, pale board. However the Chairman said they do regularly review board structure and succession.

Other than that there were some interesting comments given by Tim Levett in his presentation. He said that due to the change in the VCT rules in 2016 they have changed from being a late stage investor to being an early stage one. In the last 3 years they have built a new portfolio of 22 early stage companies and are probably the most active generalist VCT manager other than Titan. NVM have opened a new office in Birmingham and built up the Reading office. There were also a number of new staff who were introduced at the meeting.

He also said that like all the top 10 VCTs, an awful lot of special dividends had been paid in the last three years. This was because of realisations and the VCT rules that prevented them from retaining cash. This has meant a reduction in the NAV of the trust but in future they will try and maintain that at the same time as maintaining a 5% dividend. Note: that historically it means that capital has been paid out in tax-free dividends that investors might have reinvested in the trust and hence collected a second round of up-front income tax relief. One can understand why the trust does not want to continue doing that as it may otherwise spark some attention from HMRC. I also prefer to see VCTs maintain their NAV as otherwise the trusts shrink in size which can create problems in due course as we have seen with other VCTs.

NVT are doing a new share issue in January which will of course improve their NAV and I was glad to hear that at least some of the directors will be taking up shares in the offer and adding to their already considerable holdings. That inspires some confidence that they can cope with the changes to the VCT rules that mean there will be more emphasis on investing in riskier early stage companies.

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

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LSE General Meeting and Blancco AGM

Yesterday I attended two company general meetings (I hold a trivial number of shares in each). Here’s a brief report on events, with the later one being more interesting than the first one.

London Stock Exchange (LSE) General Meeting.

As readers may be aware, a General Meeting was called at the LSE by The Children’s Master Investor Fund (TCF), which is led by Sir Christopher Hohn, in an attempt to remove the Chairman Donald Brydon. That was the only item on the agenda. This arose from a dispute over the removal of CEO Xavier Rolet after the board decided to do some “succession planning”. Mr Rolet has been a very successful leader of the LSE for eight years (the share price has gone up more than 6 times since he was appointed to the board in 2009).

Mr Rolet was going to depart after the Deutsche Borse merger but when that fell through the board apparently decided that he should be replaced. Sir Christopher Hohn objected to him being eased out. There then appeared a number of press reports (e.g. in the FT) suggesting that Mr Rolet was a difficult person to work with – rude to colleagues, tended to not pay attention in meetings, and other defamatory remarks. The company’s defence document for the meeting referred to Mr Rolet’s “operating style” as an important factor in seeking a replacement.

The meeting was attended by mainly “suits”, with very few private shareholders as is more common at these kinds of events – only the latter asked any questions. Neither Mr Rolet or Mr Hohn attended but the latter certainly had representatives present.

The meeting was chaired by the Senior Independent Director, Paul Heiden, and the acting CEO Donald Warran also spoke. Mr Brydon said little. Mr Warren emphasised the need for a “team” to deliver business success and made positive comments about the prospects for the company.

One shareholder commented that it was a “sorry affair” that had generated considerable opprobrium against the company.

The vote was taken on a poll, with results announced some time later. The votes were 79% opposed to the resolution to remove the Chairman (i.e. 21% supportive although there were also 9 million votes Withheld). Sir Christopher Hohn suggested afterwards that this shows considerable support for a change of Chairman and that the board should look to do that sooner rather than later.

Comment: I agree with the views expressed by one shareholder in the meeting. This seems to have been handled badly. Succession planning for non-executive directors who have reached ten years’ service are routine. But when you decide to remove an executive director you have to tread a lot more carefully. This resulted in a public battle, and then having to pay off Mr Rolet with a very generous compensation package.

The allegations about Mr Rolet’s management style may or may not be true. But forceful personalities are very common in high achieving leaders (Steve Jobs and Bill Gates are two very good examples). Organisations are wisest to put up with such personalities in my experience. Having heard what was said at the meeting, I voted in favour of removing Mr Brydon as Chairman. 

Blancco (BLTG) Annual General Meeting

Blannco is an AIM listed software company that specialises in data erasure and mobile phone diagnostics. It transmogrified from a business named Regenersis which was into hardware repair and there were changes of management and restructuring when that happened.

The meeting was chaired by Rob Woodward with about a dozen, mainly disgruntled, private shareholders present.

The reason for their unhappiness is no doubt the substantial losses reported in the last three years (£4.3 million in the year ending June 2017) compounded by the need to restate the 2016 accounts following the discovery by a new interim CFO that sales worth £3.5 million booked in June and December 2016 were uncollectable. The company had to raise additional funds as a result at that time. The former CEO, Patrick Clawson, departed and the interim CFO is now interim CEO. They are looking for a new permanent CEO.

Mr Woodward opened the meeting by introducing the board and said “last year was a year of substantial challenge”. He summarised the events mentioned above and said “several members of the senior management team had departed”. He suggested the company needed to rebuild trust with all stakeholders, but the market opportunity remains strong. He said he was unable to comment on some of the investigations undertaken into past events for legal reasons.

Shareholders asked questions about current revenue recognition policies. Then the question of who might be accountable arose, e.g. the auditors for failing to spot the abuse or the former CEO. But Mr Woodward said the board did not believe it was in anyone’s interests to take action against individuals.

Note: the auditor at the time was KPMG but they were replaced by PWC at this meeting. Past events were not given as a reason but open tenders following length of service and other platitudes. Mr Woodward stated the auditors correctly prepared the accounts based on management information provided and that the management overrode controls. The company had taken legal advice but were unwilling to disclose it.

I asked whether there had been any report to the FRC asking them to investigate the audit. Apparently not.

A vote on the resolutions was taken on a show of hands. All resolutions passed with 100% voting For in several cases. But there were over 11 million votes Withheld on some of the resolutions. I asked who that might be as clearly some institution was unhappy. Although the Chairman declined to say, a shareholder pointed out that the number matched the holding of M&G/Prudential (see page 29 of the Annual Report).

Simon Herrick, acting CEO, gave us some information on his background (he had recently helped to float Ramsdens, a financial services company). He said Blancco had a great position in the market. Data erasure will be a big market but it is really only just beginning to kick off. The company seemed to have been rationalising its operations by introducing Salesforce everywhere and a new accounting system (NetSuite). He said the company did not need more cash in the short term but they are not generating large amounts either. He suggested shareholders study the last results presentation on their web site where cash flow is analysed (page 14).

Apparently the company is well down the process of finding a new CEO with a software background, strong leadership capabilities and who can grow the business. They are focusing on a US background which is their major market at present and where such people are easier to find. (Comment: but they are also expensive).

Note it is remarkable that this company only has one person on the board with any software industry experience. To my mind this is a major defect.

Concluding Comments: This problem of revenue recognition at software and other IT companies persists, with auditors apparently incapable of identifying the signs. The rules in the accounting standards have been tightened up, but the activities of over enthusiastic management keen to achieve their bonuses or even ramp up the share price persists. This is in reality a fraud on the company and on their investors.

Why auditors are still proving incapable of spotting such frauds is probably because they are not sceptical enough about the information they are given. But they are not that difficult to identify. Large deals done near financial year ends, where the cash is not yet collected or the agreed payment terms are very extended should be examined very closely.

Not that these are foolproof. As we are coming up to the year end, I recall the case of Software International some years ago who got their sales staff to book sales to customers near the year end which were then invoiced. The customers were told they should simply cancel them in the new year. They employed very persuasive female sales staff who begged the customers to help with their bonus entitlements. The company collapsed when this process was discovered.

But there are way too many of these problems still arising, e.g. HP/Autonomy, Globo (both audits still under investigation), and more recently IDOX. Readers can probably suggest others.

As regards the prospects for Blancco, there is certainly a market opportunity but whether it can be exploited profitably remains to be seen. They really do need a good new CEO but they are not easy to hire. In the meantime, the events in the last couple of years must have been somewhat demoralising for the company staff. If I worked for this business, I am not sure that I would have great confidence in the current board. These kinds of businesses need visionary leaders who can promote the merits of the new technology enthusiastically and who have a very strong technology background.

With profits somewhat uncertain, but on a revenue multiple of 1.5 times, the uncertainty is probably reflected in the current share price.

Postscript: Feel sorry for KPMG losing the audit of Blancco? You don’t need to. The average pay of partners in the UK at the firm last year was £519,000 and according to the last annual report there were 623 UK partners. But those at PWC, EY and Deloittes did even better (the latter on £865,000).

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

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