UK: Treasury Committee publishes banking crisis fourth report

The House of Commons Treasury Committee, as part of its banking crisis inquiry, has today published its fourth report: Banking Crisis: regulation and supervision. The report makes wide-ranging recommendations and describes as a "muddle" the manner in which responsibility for financial stability will be shared amongst the Bank of England, Financial Services Authority, HM Treasury, new Council for Financial Stability and the Bank of England's Financial Stability Committee.

With regard to bank directors, the Committee recommends that the Financial Services Authority should assess whether they possess relevant qualifications. The Committee's view is that banking qualifications should become one of the core indicators against which the FSA assesses a candidate’s competence for acting as a bank director. The Committee notes, however, a potential risk that may arise from greater FSA oversight of bank directors: the crowding out of due diligence by others. 

The Committee's earlier reports are available here:

First report: the impact of the failure of the Icelandic banks | Second report: dealing with the failure of the UK banks | Third report: reforming corporate governance and pay in the City |

Europe: update on financial services and company law reform

The Joint Brussels Office of the Law Societies of England and Wales, Scotland and Northern Ireland has published the July 2009 edition of its very useful EU financial services and company law reform update. Previous updates are available here.

UK: reforming corporate governance and pay in the City - responses to Treasury Committee report

In May this year the Treasury Committee published its report Banking crisis: reforming corporate governance and pay in the City. The responses of the Government, Financial Services Authority and UK Financial Investments Ltd., have now been published: see here.

UK: House of Lords - auditors succeed in having neligence claim struck out

The House of Lords gave judgment in Moore Stephens (a firm) v Stone Rolls Limited [2009] UKHL 39 yesterday. By a 3:2 majority, their Lordships held that a claim for breach of duty (in contract and tort) brought by a company in liquidation (Stone & Rolls Ltd.) against its auditors (Moore Stephens) should be struck out. The claim concerned the auditor's failure to detect the fraud of the company's controller, Mr Stojevic.

For the purpose of the proceedings it was accepted that the auditors were in breach of the duty to exercise reasonable care in relation to the auditing of the accounts of Stone & Rolls Ltd. The question was whether a claim for this breach of duty was precluded by the public policy defence of ex turpi causa non oritur actio (no cause of action may be founded on an illegal act). The majority (Lords Phillips, Walker and Brown) agreed that it was. The minority (Lords Mance and Scott) disagreed. 

Reasoned opinions were provided by all five judges and a proper analysis of these will take some time. It is clear, nevertheless, that auditors are now well placed to defend negligence claims where companies are controlled by a single individual and that individual commits fraud that goes undetected. The irony is, of course, that the auditor's role is critical in such companies.  Indeed, as Lord Mance observed in his dissent (para. [206]):

The world has sufficient experience of Ponzi schemes operated by individuals owning “one man” companies for it to be questionable policy to relieve from all responsibility auditors negligently failing in their duty to check and report on such companies’ activities".

Several opinions discuss auditors' duties. Lord Walker observed (para. [179]):

Checking for fraud is part of an auditor’s task, but it is not his sole or primary task (for a reputable auditor to discover that the client company’s business is wholly fraudulent and criminal must be quite unusual).

Lord Phillips observed (para. [19]):

The leading authority is Caparo Industries Plc v Dickman [1990] 2 AC 603. The duties of an auditor are founded in contract and the extent of the duties undertaken by contract must be interpreted in the light of the relevant statutory provisions and the relevant Auditing Standards. The duties are duties of reasonable care in carrying out the audit of the company’s accounts. They are owed to the company in the interests of its shareholders. No duty is owed directly to the individual shareholders. This is because the shareholders’ interests are protected by the duty owed to the company. No duty is owed to creditors – Al Saudi Banque v Clarke Pixley [1990] Ch 313. The Auditing Standards require auditors who have reason to suspect that the directors of a company are behaving fraudulently to draw this to the attention of the proper authority. The scope of the duty ... is unquestionably imposed in the interests of, at least, the shareholders of the company".

Lord Mance stated (para. [217] - [218]):

[Auditing Standard] SAS 110.12 [issued January 1995] (para. 52) provides that:

'When a suspected or actual instance of fraud casts doubt on the integrity of the directors auditors should make a report direct to a proper authority in the public interest without delay and without informing the directors in advance'.

The text at paragraph 56 explains that matters to be taken into account when considering whether disclosure is justified in the public interest may include 'the extent to which the suspected or actual fraud is likely to affect members of the public'. Plainly, one situation in which members of the public would be affected is where the fraud conceals or risks bringing about the company’s insolvency. The viability of a company as a going concern is always a matter of audit importance.

The relationship of company and auditor is not therefore a simple two-party relationship. The company cannot in the audit context be equated with its board of directors or management. The company’s shareholders are – at least while the company is solvent - the main focus of an auditor’s activity and duties. The auditor, in undertaking the statutory role and contractual and tortious duties, is 'acting antagonistically to the directors' ".

Update: a summary of the decision has been provided here by the ICLR as part of its WLR Daily service (the summary will be removed when the decision is reported in one of the ICLR's series of law reports). 

UK: introducing a protected cell regime for OEICs - HM Treasury consultation

HM Treasury have published a consultation paper containing proposals for the introduction of a protected cell regime for open-ended investment companies (OEICs). These changes were suggested in 2007 in a consultation on better regulation measures for the asset management sector. In the consultation paper published this week, which contains a draft of the Open-Ended Investment Companies (Amendment) (No. 2) Regulations 2009, HM Treasury explains (paras. 2.1 and 2.1): 

OEICs are investment funds structured as bodies corporate. Large fund managers generally operate a small number of OEIC umbrella companies with a large number of sub-funds within each umbrella, allowing them to operate a large range of funds more efficiently. The sub-funds do not have a separate legal personality, but are separately managed, charged, accounted for and assessed for tax. Under current law there is no segregation of liabilities between different sub-funds. For example, if an umbrella fund contained one cautious UK bond fund and one high-risk Far-east equity fund and the Far-East equity fund collapsed with liabilities exceeding its assets, creditors could have a claim on the assets of the UK bond fund. Investors in the cautious fund therefore bear some of the risk of the riskier fund.

In practice the probability of an OEIC collapse is small, as OEICs must comply with borrowing limits imposed by the FSA, but not zero. Current FSA rules require disclosure of the contagion risk in the fund prospectus and periodic reports, although there is a danger that some OEIC investors do not fully understand it. Thus, provided adequate protection of existing creditors can also be achieved, segregating liabilities so that the liabilities of any one sub-fund could only be met out of the assets of that sub-fund appeared desirable".