Essential Corporate News - week ending 15 June 2012
15 June 2012

The Sharman Inquiry: Final Report and Recommendations of the Panel of Inquiry

On 13 June 2012, the Sharman Inquiry, led by Lord Sharman of Redlynch, published its Final Report and recommendations. The Sharman Inquiry was launched in March 2011 by the Financial Reporting Council (FRC) as a Panel of Inquiry (Panel) led by Lord Sharman into the lessons that companies and auditors could learn in relation to addressing going concern and liquidity risks. The Panel published its Preliminary Report and recommendations in November 2011 together with a number of consultation questions.

The introduction to the Final Report makes it clear that respondents to the Preliminary Report supported the view of the Panel that the aim in requiring directors and auditors to consider and report about going concern should be to create a framework which encourages appropriate corporate behaviour. However, sensible risk taking is critical to the growth and maintenance of economic activity and so should not be inhibited. As a result, the risk that economic or financial distress will arise or the possibility of failure cannot be eliminated but, in considering and reporting about going concern, the aim should be to support better risk decision-taking, ensure that investors and other stakeholders are well protected and informed about those risks, and sustain an environment in which directors recognise, and acknowledge and respond to economic and financial distress sooner rather than later.

The Final Report makes five recommendations as follows:

• Recommendation 1 - The FRC should take a more systematic approach to learning lessons relevant to its functions when significant companies fail or suffer significant financial or economic distress but still survive.
• Recommendation 2 - The FRC should engage with accounting standards bodies to agree a common international understanding of the purposes of the going concern assessment and financial statement disclosures about going concern, and of the related thresholds and descriptions of a going concern, in international accounting and auditing standards. The FRC should also seek to clarify the accounting and stewardship purposes of the going concern assessment and disclosure process and the related thresholds for such disclosures and the descriptions of a going concern in the UK Corporate Governance Code and related guidance for directors and auditors, and in auditing standards. The FRC should also work with the UK Listing Authority to seek to maintain the existing congruence of the UK Corporate Governance Code and the related guidance for directors with Listing Rule 9.8.6R(3) in light of these changes.
• Recommendation 3 - The FRC should review the “Going Concern and Liquidity Risks: Guidance for Directors of UK Companies 2009” (Guidance for Directors) to ensure that the going concern assessment is integrated with the directors’ business planning and risk management processes. It is recommended that this should include a focus on both solvency and liquidity risks, whatever the business, it may be more qualitative and longer term in outlook in relation to solvency risk rather than in relation to liquidity risk and it should include stress tests, both in relation to solvency and liquidity risks, that are undertaken with an appropriate level of prudence.
• Recommendation 4 - In taking forward its work on reporting under its January 2011 “Effective Company Stewardship - Enhancing Corporate Reporting and Audit” paper, the FRC should move away from a model where disclosures about going concern risks are only highlighted when there are significant doubts about the entity’s survival, to one which integrates going concern reporting with the Effective Company Stewardship proposals. This should be done by ensuring that the discussion of strategy and principal risks always includes, in the context of that discussion, the directors’ going concern statement and how they arrived at it, and the audit committee report should illustrate the effectiveness of the process undertaken by the directors to evaluate going concern. This should be done by confirming that a robust risk assessment has been made and commenting on or cross-referring to information on the material risks to going concern which have been considered and, where applicable, how they have been addressed. The Panel recommends that the FRC should amend the standards and guidance for directors and auditors accordingly when the Effective Company Stewardship proposals have been finalised.
• Recommendation 5 - As part of its work on auditor reporting arising from the Effective Company Stewardship proposals, the FRC should consider moving UK auditing standards towards inclusion of a statement in the auditor’s report as to whether the auditor has anything to add to or emphasise in relation to the disclosures made by the directors about the robustness of the process and its outcome, having considered the directors’ going concern assessment process.

In terms of the scope of the Panel’s recommendations, the Panel is proposing that initially recommendations 4 and 5 should be limited to those companies that the FRC’s Effective Company Stewardship requirements are applied to. Implementation of these recommendations would be through amendment to the Guidance for Directors, the FRC’s Guidance on Audit Committees and a number of the UK auditing standards. The Panel suggests that recommendations 2 and 3 can be implemented initially through amendments to the Guidance for Directors. Although this applies to all companies, it is noted in the Guidance for Directors that directors should apply the Guidance in a manner proportionate to the nature of their business.

In their Preliminary Report, the Panel asked whether the banking sector should be treated differently in relation to going concern disclosures because of the especially intense nature of the solvency and liquidity risks that those entities are exposed to. Having considered responses, the Panel believes that it should not be necessary to have a separate going concern disclosure regime for banks. However, the Panel does consider it is critical to that conclusion that, in taking forward the recommendation to clarify and harmonise the differing definitions of going concern and related risks, the FRC should clarify that a conclusion that a bank is or would be reliant, in stressed circumstances, on access to liquidity support from central banks that is reasonably assured does not necessarily mean that the bank is not a going concern or that material uncertainty disclosures or an auditor’s emphasis of matter paragraph are required. The Panel also believes that the FRC should take forward the production of a bank-specific appendix to the Guidance for Directors.

The FRC has announced that it will now consider the most effective way to take forward the recommendations of the Panel and it will explore the matters relating to banks with the Government, the Bank of England and other stakeholders.

(The Sharman Inquiry: Final Report and Recommendations of the Panel of Inquiry, 13.06.12)

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HM Treasury: White Paper on banking reform - Delivering stability and supporting a sustainable economy

On 14 June 2012, HM Treasury published a White Paper setting out the Coalition Government’s proposals for implementing the recommendations of the Independent Commission on Banking (ICB), chaired by Sir John Vickers. The ICB report, published in September 2011, recommended a package of measures, consisting of ring-fencing vital banking services, increasing banks’ loss-absorbency and enhancing competition in the banking sector. In December 2011, HM Treasury and the Department for Business, Information and Skills issued a response statement to the ICB report in which it announced plans to publish a White Paper in 2012.

The White Paper covers the following areas:

Ring-fencing: The Government believes that a robust ring-fence separating investment banking and related activities from more traditional personal and business lending, is vital to reduce structural complexity and to make banks easier to resolve in a crisis where speed of execution is vital. The Government’s proposals include the following:

• ring-fenced banks should not carry out any activities through non-EEA subsidiaries or branches;
• a separate risk committee should be set up in the ring-fenced bank, whose risk management function should introduce additional safeguards, over and above what the ICB recommended;
• firms with an annual turnover above a certain threshold and high net worth individuals will be exempt from the requirement to place their deposits in ring-fenced banks; and
• ring-fenced banks should be able to offer simple hedging products, subject to the necessary safeguards, in order to provide the UK’s small and medium-sized enterprises with essential banking services.

Shock absorbency: The Government argues that to be more resilient and resolvable, banks need to hold sufficient capacity to absorb losses. The Government’s proposals include the following:

• banks providing vital services to the UK economy must hold extra equity to withstand shocks (in line with international consensus for higher levels of bank capital);
• the UK’s globally systemic and ring-fenced banks should hold minimum levels of loss absorbing capacity that bears losses ahead of other liabilities and the Government believes that a primary loss absorbing capacity (PLAC) of 17 per cent of risk-weighted assets is broadly the appropriate level for UK banks. Their overseas operations will be exempt if they are resolvable without risk to UK taxpayers, but additional loss absorbing capacity may be required of firms if resolvability concerns persist;
• a binding leverage ratio (a minimum capital requirement that is independent of banks’ risk-weights) of 3 per cent is proposed, in line with Basel III proposals, as a “useful backstop to risk based capital ratios”; and
• the implementation of an effective bail-in tool (already endorsed by the G20 and the Financial Stability Board), through a European resolution framework, to ensure losses fall on those most able to assess bank risks, with preference given to insured depositors.

Competition: The Government reiterates its strong support for a more competitive UK banking sector and also notes the following measures to improve competition in UK banking:

• the Government has actively engaged with the European Commission and Lloyds Banking Group to ensure that the forthcoming divestment of part of Lloyds Banking Group’s business results in as strong a challenger bank as possible, regardless of the final commercial arrangements Lloyds Banking Group arrives at;
• reviews are being carried out by the Bank of England and the Financial Services Authority of prudential and conduct requirements to ensure that these are proportionate and do not pose excessive barriers to entry for prospective new entrants;
• a new, industry-funded switching service consisting of a new current account redirection service for individuals and small businesses wishing to switch their bank account to a new provider, will be operational by September 2013; and
• the Government will issue a consultation on a number of options to reform the strategy setting of payments, to ensure that the UK payments systems meet the current and future needs of consumers, businesses, other users and the wider economy.

The deadline for comments on the White Paper is 6 September 2012. The Government is hoping to introduce all necessary legislation as soon as Parliamentary time allows. The Government remains committed to completing all primary and secondary legislation by the end of the current Parliament in May 2015 and banks will be required to comply with all of the measures proposed in the White Paper (in line with the ICB recommendations) by 2019.

(HM Treasury, Banking reform - Delivering stability and supporting a sustainable economy, 14.06.12)

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European Commission: Delegated Regulation amending Prospectus Regulation published in Official Journal

On 11 June 2012, delegated Regulation 486/2012/EU of 30 March 2012 (the delegated Regulation) amending the Prospectus Regulation 809/2004/EC was published in the Official Journal. The text of the final version of the Delegated Regulation is broadly the same as the draft delegated Regulation published on 30 March 2012, containing only minor drafting changes. As was summarised in Essential News - week ending 6 April 2012, the main points covered in the delegated Regulation relate to: the format and detailed content of key information to be included in the prospectus summary; proportionate disclosure regimes for rights issues and for SMEs and issuers with reduced market capitalisation; and the content of final terms to a base prospectus.

The delegated Regulation is proposed to have effect from 1 July 2012 with the changes only applying to prospectuses and base prospectuses that have been approved by a competent authority on or after its entry into force.

(European Commission: Delegated Regulation (EU) No 486/2012 0f 30 March 2012 amending Prospectus Regulation published in Official Journal, 11.06.12)

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