Brexit, HBOS, Globo and the FRC

Is it not heartening that the Brexit divorce bill, and other terms, have been settled? The exact cost is unclear but it could be up to £40 billion – a lot of money you may say! However, the fact that the key negotiators, Mrs May, Barnier et al, all looked somewhat glum about the deal when announced perhaps tells us that it was a compromise in which both sides had to concede ground. Or perhaps they were just tired. The terms of any future arrangements including trade deals still need to be worked out so it’s a long way from being concluded.

Now that £40 billion figure, sounds a lot, even if it is spread over some years. Hard line brexiteers will be unhappy. But it’s all relative. For example the annual UK Defence Budget is over £35 billion and rising. In addition, I have just read the Financial Reporting Council’s report on the HBOS audit and you can see there on page 7 that HBOS had to write off £63.3 billion in loan losses. That was only one smaller sized UK bank. According to the Bank of England, the financial crisis that affected HBOS caused £7.3 trillion of losses in total in the UK.

The report from the Financial Reporting Council (FRC) on the audit of HBOS is a quite tedious and turgid document. To remind you, HBOS was a bank that almost went bust after making imprudent commercial property loans financed by short term debt. When Lehman’s collapsed and debt became difficult to raise, HBOS had to be supported by the Government and then bailed out by a merger with Lloyds TSB. The latter’s shareholders are currently pursuing a claim against the company and its directors over that event.

The reason the audit of HBOS was examined by the FRC was because the company obtained an unqualified audit report suggesting that it was a “going concern” when it soon turned out to be otherwise. These events date back to 2008 – that’s 9 years ago which shows the speed with which the FRC typically operates.

One interesting comment made in the FRC report is that it suggests on page 11 that liquidity support from central banks may be considered “a normal funding source…..and therefore reliance on such support does not mean that the bank is not a going concern…..”. As banks with a positive balance sheet are usually assumed to be eligible for “lending of last resort” from the Bank of England that might mean that HBOS would be considered to be a going concern even if it ran out of cash (which is the reason most banks go bust, not because of defective balance sheets – Northern Rock is a good example).

The report also refers on page 29 to “market expectations” at the time. Market participants did not expect the financial crisis to get worse which affected the auditor’s views. So now we know why the FRC let the auditors of HBOS (KPMG) off the hook!

As I mentioned in a blog post a couple of weeks ago (see https://roliscon.blog/2017/11/22/standard-life-uk-smaller-companies-and-frc-meetings/ ), I attended a meeting with the FRC organised by ShareSoc/UKSA. One of the issues raised was the lack of feedback from the FRC on the progress of investigations. I followed up with one of the speakers after the meeting, specifically about the case of Globo. I asked what was the status on the investigation of the audit of their accounts by Grant Thornton. As readers may know, Globo was a company that went into administration in 2015 after it was revealed that the revenue of the company was probably fictitious (see https://www.sharesoc.org/campaigns/globo/ for details). The report of the administrators made it clear that the cash on the balance sheet of Globo plc seemed to have disappeared, bringing into doubt the preceding audit report on that ground alone let alone the revenue recognition issue.

The FRC announced an investigation in December 2015, i.e. two years ago. What have the FRC been doing, when will the investigation likely conclude, are there any preliminary conclusions, etc, etc? All of these questions are very relevant as the answers might provide the basis for legal action by shareholders against the auditors and others. After several email exchanges with FRC staff, the only answer I managed to elicit is that the investigation is on-going. It has not even been turned into a “Formal Complaint”.

The reason more information could not be supplied is that it might prejudice “the overarching requirement for fairness”. My response was “I really do suggest that the FRC needs to reconsider its policies in this area. You have too much emphasis on treating those who have been complained about (i.e. auditors) fairly, while those who have complained are treated unfairly. This rather suggests, as we already knew, that the FRC is dominated by auditors who are the people it is supposed to be regulating”.

You will be amused to read in the FRC’s Publication Policy document (para. 3) that “Transparency contributes to public confidence in independent disciplinary arrangements….” but then proceeds to spell out all the restrictions it imposes that thwart it.

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

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New Corporate Governance Code

The Financial Reporting Council (FRC) have published a new UK Corporate Governance Code – a draft that is subject to public consultation. The revised Code sets out good practice so that the boards of companies can:

  • Establish a company’s purpose, strategy and values and satisfy themselves that these and their culture are aligned;
  • Undertake effective engagement with wider stakeholders, to improve trust and achieve mutual benefit, and to have regard to wider society;
  • Gather views of the workforce;
  • Ensure appointments to boards and succession plans are based on merit and objective criteria to avoid group think, and promote diversity of gender, social and ethnic backgrounds, cognitive and personal strengths;
  • Be more specific about actions when they encounter significant shareholder opposition on any resolution, including those on executive pay policies and awards; and
  • Give remuneration committees broader responsibility and discretion for overseeing how remuneration and workforce policies align with strategic objectives.

Perhaps the most controversial change will be the requirement to consult with the workforce and suggests three ways this might be done (worker directors, a workforce advisory panel or a designated non-exec director), although it does not rule out other methods. This writer suggests this is a positive step but some shareholders might not agree.

It also suggests better engagement with shareholders although as usual there is an emphasis on a few major shareholders rather than the wider shareholder community.

The UK Corporate Governance Code has helped to improve the operation of UK company boards so it is important that any changes made are positive. On a quick review most of the changes seem to be improvements, but the devil is in the detail on such documents. More information including how to respond to the consultation is present here: https://www.frc.org.uk/news/december-2017-(1)/a-sharper-uk-corporate-governance-code-to-achieve

I may comment further at a later date.

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

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Standard Life UK Smaller Companies and FRC Meetings

Yesterday I attended two meetings in the City of London. Here are brief reports on each.

Standard Life UK Smaller Companies Trust Plc (SLS) held a meeting for investors to “meet the manager” in London as their AGM was in Edinburgh this year – only about 10 people attended the latter so there were more in London. I have held this trust for some years and the manager, Harry Nimmo, who has been with the company for 33 years has been a consistently good performer. The management company has recently merged with Aberdeen and is now called Aberdeen Standard Investments but apparently there have been no significant changes internally as yet. Mr Nimmo’s comments are summarised below.

He said they have a discount control policy which is unique to UK smaller companies trusts. They buy back shares if the discount gets about 8%. The investment policy is unchanged and they are not keen on blue-sky or concept stocks. AIM is now a better place than 5 years ago as it is now more broadly based and no longer dominated by mining stocks and blue sky tech stocks.

They have put a new debt facility in place which will ultimately replace their CULS (Convertible Unsecured Loan Stock). The final date for conversion is coming up and investors need to pay attention to that as they are “well in the money”.

The trust shows a ten year CAGR dividend growth of 23.7% and the capital return since 2003 is 851% (plus dividends of course). But there have been some bear markets during his management which one needs to allow for as investors. However, if you had sold the trust after the Brexit vote you would have made a terrible mistake – the company is up 54% since June 2016.

The trust looks for companies that can grow irrespective of the economic cycle, and those with good cash flow and strong balance sheets. Mr Nimmo covered their investment process which is somewhat formulaic using a screening process (I have covered it in past articles) but they do meet investee companies twice a year. They have about 50 holdings in the fund which is a “bottom-up” stock selection actively managed fund.

He mentioned they have 10% in animal care and still hold NMC although as it is now a FTSE-100 stock they have been selling out. They still have a large holding in Abcam and have bought RWS recently. Their second largest holding is First Derivatives where most profits come from outside the UK. They generally do not hold oil/gas/mining stocks and are very light on real-estate [note: I agree with the former and many of my individual holdings overlap with the trusts but I do hold some real estate companies]. An exception though is Workspace who recently produced an excellent set of results with a rapid growth in dividends.

They have also been selling Fevertree as it exceeded 5% of their portfolio value.

I did not manage to stay until the Q&A session as I had to go to a meeting organised jointly by ShareSoc and UKSA with the Financial Reporting Council (FRC). This was a long meeting and I hope one or other organisations will produce a lengthier report on it because it was an exceedingly useful meeting. I will simply highlight a few points of particular interest.

FRC Meeting

The FRC is responsible for audit policy, standard setting and audit quality including investigation and enforcement of past transgressions. So it is a rather important body for those private investors who have come unstuck on an investment because the accounts of the company turned out to be misleading – for example the recent debacle at Carillion was mentioned by one attendee, but I can think of numerous other examples.

The speakers covered the role of audits, both currently and how they might develop in the future (partly as a result of technology changes such as the use of data analytics). After Brexit it is likely there will be a broadly equivalent regime as investors are opposed to “unpicking”.

The FRC reviews about 150 audits every year and grades them into four categories (the reviews are listed on the FRC web site). By 2019 they want 90% to be in the top two ratings which they are not at present. It was noted that KPMG come out worse of the big audit firms. A common reason for audits falling short are lack of professional scepticism.

The FRC also undertakes thematic reviews of particular issues. I raised the issue of the lack of common standards for “adjusted” data commonly reported by companies (such as earnings, or return on capital that I mentioned in previous recent blog posts). The response was it was mandated to explain the definitions of such adjustments but I pointed out this did not help with comparability (e.g. of broker forecasts). The FRC said they will be consulting on this issue shortly, which is good news.

The role of the FRC in “enforcement” was covered. They stressed that their remit does not cover crime, they merely regulate accountants and actuaries although it is of course true that the failure of auditors to identify false accounts is one area they often investigate. It was mentioned that the size of the team on this had grown from 11 people in 2013 to 30 now and they are still looking for more bodies. This really just shows how under-resourced the FRC has been in the past. A total budget of £15m per year was mentioned. Comment: this seems hopelessly inadequate to me bearing in mind the number of public companies (and other organisations) and the number of auditors they have to monitor. It explains partly why complaints to the FRC often seem to disappear into a black hole, or why investigations often take so long as to be pointless. A list of cases under formal investigation is on the FRC web site (See here for that and two linked pages for the full list: https://www.frc.org.uk/auditors/enforcement-division/current-cases-accountancy-scheme which of course will tell you that Globo was commenced in December 2015 and Quindell in August 2015 and have yet to report).

I did suggest to the speaker that the FRC should be a party to the Code of Practice for Victims of Crime (as some audit failures involve the crime of fraud) as the Police, the SFO and FCA are, and which has improved their disclosure culture. This might assist those who report failings to get some feedback on the progress of a case. But the FRC argue that their role is not to investigate crime as such and they are inhibited by legislation/regulation on what they can disclose. However it is very clear to me that too often complaints get made to the FRC, but the complainants are not advised of progress and often have no idea on the outcome. This is an issue they will be looking at.

They hope the extra staffing will speed up investigations. The investigation process was discussed, but for example, Carillion had not even been placed under formal investigation as yet. It was suggested by audience members that the FRC was quite ineffective but recent cases such as AssetCo and Healthcare Locums were mentioned as demonstrating strong action and they have issued fines of £12 million in the last year which is the biggest ever. It was mentioned that fines go to the Treasury which is not ideal.

Confusion between the different regulatory bodies (e.g. the FRC, FCA, SFO, etc) was mentioned by attendees and the speakers, not helped by similar three letter acronyms. One attendee suggested that a unified regulatory body would help (such as the SEC in the USA). Comment: I agree at present it is unclear except to experts on who is responsible for what and the accountability of these bodies to the Government or to any democratic body of investors.

The FRC also has an interest in the UK Corporate Governance Code and the Stewardship Code. A consultation on a new Corporate Governance Code is imminent. There was also a session on the role of the Financial Reporting Lab where both ShareSoc and UKSA members have been involved in the past.

I’ll have to stop here because the budget speech by the Chancellor will commence soon and I wish to listen to it as there may be some major changes on investment tax reliefs. I’ll do another blog post later on it.

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

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Halma and Return on Capital

Yesterday I talked about Diploma (DPLM) and their calculation of adjusted return on capital. This morning Halma (HLMA) published their half year results and they also have a strong emphasis on return on capital, but in this case they call it “ROTIC” (Return On Total Invested Capital). This was down slightly at 13.4% and they define it as Adjusted Profit After Tax divided by Total Invested Capital. The latter is shareholders funds, plus retirement benefit obligations, less deferred tax assets, plus cumulative amortisation of acquired intangible assets plus historic adjustments to goodwill. This similar to the Diploma definition but it is not clear whether it is exactly the same and they call it something different.

As almost every company now reports “adjusted” figures of one kind or another, and analyst forecasts of earning are also usually based on adjusted profits, would it not make sense to have some standard for such data? That’s in addition to the current “statutory” figures which are mandated by the Financial Reporting Council (FRC).

Some of these adjustments, like the ones above in the case of Halma to calculate return on capital make a lot of sense if you wish to obtain a somewhat different view of a company’s performance. But some do not – for example I commented negatively only recently on the figures reported by National Grid.

The FRC would be the best body to set such standards, although they appear to have avoided doing so in the past. Now it just so happens I am attending a meeting with the FRC organised by ShareSoc/UKSA later today and if I get the opportunity I will raise this issue. It would certainly help investors if companies, financial analysts and information web sites reported such adjusted data in a consistent manner, would it not?

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

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