Has the tide turned for UK Plc?

Maybe the speech delivered by Gordon Brown this week will mark a major change in the regulations applicable to companies across Europe – but especially in the UK. At the same time as ending of the OFR requirement, the Chancellor challenged companies to identify areas of excessive regulation.

To quote from Mr Brown – “Best practice is of course for companies to report on social and environmental strategies relevant to their business. But I understand the concerns about the extra administrative cost of the goldplated regulatory requirement that from April next year all quoted companies must publish an operating and financial review. So we will abolish this requirement and reduce the burdens placed upon you - the first of a series of regulatory requirements which by working together we can abolish in the interests of the British economy.”

And at the same time, Mr Brown estimates that around 1,300 of Britain's biggest companies will benefit from the decision and save £33m into the bargain.

So the good news is that mandatory OFR’s – on which so much time, heart-ache and planning has been expended – are to be done away with.

Of course, would it not have been nice if those behind the OFR requirement had not tried to introduce it in the first place?

And that is exactly the point that a cast of characters – from Charlie McCreevy, the EU’s Internal Market Commissioner, to Andrew Whittaker of the UK regulator FSA, have been saying. Both have pointed out the problems of “gold plating” of financial regulation, where in the process of translation of EU regulations into UK law, we wind up with new burdens not intended by the EU.

Which brings us to the challenge that faces UK listed companies. Are there areas of regulation that are excessively gold plated, and which could be ended? If you can identify some, the Investor Relations Society and its Policy Committee would love to hear from you.

Transparency Directive – the EU’s blueprint for corporate disclosure

The European Commission’s ESC has published its working document on the implementation of the Transparency Directive. It proposes – and seeks comments on – among other things, what a half yearly report should contain, disclosure of major shareholdings, and the mechanics of news dissemination.

As a reminder of where we are; the (level 1) principles of TOD were adopted in December 2004. The Committee of European Securities Regulators was asked to provide its advice on how to flesh out the detail, which it did in June 2005. The next stage is for the Commission to define how national member states should implement TOD, and its early thinking is in this proposal.

The Commission has decided that many of the areas on which CESR provided advice do NOT need to written in binding text, rather they should be written as recommendations. In the UK, the FSA has indicated that TOD will be implemented on the 20th January 2007, and will probably consult on how this will all work in March next year.

2 key areas for IRO’s:

Major shareholding disclosures. This is a significant part of the Directive, and will potentially have a substantial impact on the 198 disclosures made - reactively - to issuers, and hence on the shareholder analysis that issuers can undertake. In the UK, TOD is running parallel with the Company Law Review, which has reviewed the current - proactive - section 212 rules.

Since TOD will be implemented by the FSA, and the new Company Law by Parliament, it is possible/ likely that different definitions of "shareholder interest" will be adopted and therefore that different disclosures will be made for each. Neither will (currently) include synthetic shareholder interests, such as Contracts for Difference - a real problem for issuers to manage.

To make this more complex, the Panel on Takeovers and Mergers has included synthetics, which means that an issuer may find itself wrestling with 3 sets of disclosures - takeover related, reactive and proactive - all with different definitions of interest. And on different forms, as TOD has gone to the trouble of defining in some detail a form that should be used in making reactive disclosures.

o News dissemination. The ESC has adopted into its working document many of the recommendations of CESR. News will have to be disseminated, fast, as close to simultaneously as possible and to media across the EU (which will be a change for UK issuers).

A major change is that all regulated information will be disseminated; ie that will include not only real time inside information, but also documents such as annual reports, circulars, prospectuses, etc.

Many of the “provider” items are not proposed as binding rules, but as recommendations – leaving room for interpretation by member states. These include ensuring that fair competition should exist between providers. And there is no requirement to use a dedicated service provider, but there are very specific requirements to meet, in terms of reporting, which many will decide are too wearisome to do themselves.

Transparency Matters will look another time at the other reporting requirements.

Regulators’ focus on management commentary deepens.

Of all the tasks in the lead up to “results day”, writing the management commentary is one of the most challenging and demanding for IRO’s. It is also one of the areas that is attracting interest from regulators around the world.
The latest interest is a discussion piece produced by the International Accounting Standards Board, which in effect tries to pull together all the work that has been done in this area. The basic idea from the IASB would be to create a set of requirements that would sit alongside nationally-based rules. These include the UK’s OFR, the Management Discussion and Analysis (MD&A) in the US and Canada, Management Reporting in Germany, and the overarching IOSCO recommendations on management reporting.
Rather than specifying disclosure requirements, the IASB have developed a
Management Commentary disclosure framework. This framework identifies the areas that management should consider when preparing and presenting MC.

The IASB has taken on a hugely ambitious task. Marrying all the different targets of regulators around the world, with a parallel set of requirements would be highly demanding. And the complexities of agreeing those common standards between the likes of the SEC, the FRC and BAFIN will be challenging, at a time when those regulators are already reviewing their national requirements. OFR is yet to win complete compliance (see post October 19th), and the SEC is saying the US issuers that they want to see MD&A’s more productive.

2 more areas play a role in this:

First, the fast developing use of key performance indicators, (KPIs). In its discussion paper the IASB quotes from a Deloitte survey last year that showed that "99 per cent of respondents agreed that financial indicators alone cannot adequately capture their companies' strengths and weaknesses". The Committee of European Securities Regulators (CESR) has picked up on this (see post on August 11th) and highlighted concerns that companies are using non standard performance measures, making it hard for investors to compare on a like for like basis. CESR has now issued “recommendations” – with no force in law – on the presentation of alternative performance measures. It defines these as non GAAP measures.

Second, the management commentary also fits with other global trends of providing different types of reporting. Non financial measures are top of agenda for many, with initiatives such as the Enhanced Business Reporting Consortium leading the way in creating a taxonomy to allow non financial measures to be delivered to investors in structured way that allows automatic analysis .

So IROs have indeed got their work cut out to represent the business fairly and accurately in the management commentary, as well as to stay compliant with all these new regulations.

Delayed Sarbanes implementation AND implementation costs on the way down.

For the 250 European companies with a listing on a US exchange, there are changes in Sarbanes Oxley, and uncertainty as to whether compliance costs are falling as expected.
First, the SEC has announced that they are extending the compliance dates for foreign issuers in meeting the provisions of Section 404 on internal compliance. The SEC has delayed their mandatory introduction by a year to July 2007. This will be good news for foreign issuers, and give them time to ensure their systems are compliant.
This is significant, as it is the second time the SEC has delayed implementation – originally slated for July 15th 2005. As a practical matter, those non-U.S. companies which have a calendar year end, will first need to comply with the SOX Section 404 internal control requirements in their 2007 annual reports filed during 2008.
The delay is good news, given the uncertainty over whether costs are falling. First, according to a survey by KornFerry International, the average cost for large US companies to comply with provisions that include auditing accounting internal controls and certifying their systems’ ability to detect fraud is $5.1 million. Ongoing compliance is costing big businesses an average of $3.7 million annually, the survey found.
However a separate survey - conducted by the Nasdaq Stock Market and the American Electronics Association - has found that public companies anticipate slight cost reductions during the second year of implementing the governance and financial reporting practices required by the Sarbanes-Oxley Act. Companies expect the costs of implementing SOX 404 to decline 7.4% this year. Smaller companies, as defined as having market caps less than $120 million, will see virtually no change in their costs.
Executives from 298 companies of all sizes and from various industries responded to the survey, which was conducted in early August 2005. It focused on the second year costs of implementing SOX 404 and streamlining its implementation. The survey also found that auditors have improved their performance since SOX was first implemented. Companies believe their auditors are well-trained and qualified to complete the implementation of 404.
However, the SEC itself is disappointed that costs have not fallen further. “The costs of businesses complying with the Sarbanes-Oxley Act have not declined in the past year as much as hoped”, said Cynthia A. Glassman, a Securities and Exchange commissioner, said this week adding ‘‘We should not do controls for controls’ sake.”

Meanwhile, the PCAOB plans some further changes, especially in the area of communications between auditors and audit committees, where changes are needed to bring the existing ground rules into compliance with new requirements for audit committee communications imposed by the Sarbanes-Oxley Act.

Still another PCAOB agenda item resulting from Sarbanes-Oxley compliance involves strengthening the existing requirements governing audit quality control. In addition to focusing on the supervision of audit work, professional development and advancement of audit personnel, and the monitoring of professional ethics, this project may also result in the development of separate standards on independence quality controls.

The value of good corporate governance

No sooner has the FRC has closed for submissions for on how well the Combined Code is working, than 3 surveys highlight the value of good corporate governance for issuers.

The Financial Reporting Council has been inquiring over the last few weeks into how well the Combined Code is working. Largely, the responses made public (from the IRS, the ABI, PIRC and others) have highlighted that in the two years since the Combined Code was introduced, the climate of communication has improved hugely.

Not that everything is perfect; the ABI’s survey showed inconsistent compliance, and concerns remain among investors that companies are defaulting to a minimum compliance rather than explaining.

However for issuers who have yet to be convinced that the time, effort and expense in complying with best practice is a wise investment, 3 surveys have been released which shed light on how companies with good corporate governance increase total returns to the investor.

First, companies with better corporate governance have lower risk, better profitability and higher valuation. More specifically, these well-run companies outperform poorly governed firms in return on investment, annual dividend yield, net profit margin, and price-to-earnings ratio.

These are among the findings of the forthcoming "Corporate Governance Quotient 3.0 Research White Paper," by Daniel Cheng, director of ISS' Quantitative Models Group, and Yi-Yen Wu, a senior analyst in that group. Applying more than 4,000 statistical tests, the researchers examined the correlation between ISS' Corporate Governance Quotient (CGQ) ratings and 16 financial performance metrics from 2002 to 2004 for more than 5,200 U.S. companies.

Next, in September, Governance Metrics International(GMI),the corporate governance research and ratings agency, announced new ratings on more than 3,200 global companies. Thirty-three companies, including twenty-two American, seven Canadian, two Australian and two British, were rated 10.0, GMI’s highest rating. As a group, these companies outperformed the S&P 500 Index as measured by total shareholder returns for each of the last one, three, and five-year periods ending September 1, 2005, providing excess returns of 11.40%, 6.09% and 15.19% respectively relative to the index. GMI ratings and company reports are used by pension funds, investment advisers, mutual funds, banks, insurance underwriters and regulators to assess governance risk, as well as corporate advisory firms and corporate issuers to benchmark performance and conduct peer comparisons.
However a contrarian view was shown in a new study by Marathon Club, which develops approaches to long-term pension fund investment, and the University of Bath. The study showed that there was a significant scope for improving corporate governance and corporate responsibility practices.
More than 80% of investment professionals support the promotion of good corporate governance and corporate responsibility, but only half believe it should be integrated into fund manager selection and review processes.
The survey, which polled more than 100 investment professionals, revealed a strong belief that good governance was an opportunity rather an obligation.
More than 88% of respondents said good governance helped manage a fund's investment risks and long-term return prospects and 80% said good corporate responsibility would help too.
Respondents said they would be keen to integrate corporate governance and corporate responsibility factors into buy/sell decisions and core investment processes with much less support of using a specialist index or screening.
Do these surveys point conclusively to a direct connection between excellence in corporate governance and total returns to the investor? Almost certainly not; after all companies well run in corporate governance, are likely to be well run in other areas.

One share – one vote proposal likely to win support from investor organisations.

European Trade Commissioner Charlie McCreevy last week called for “one share, one vote” to be accepted across the European Union’s 25 member states. The move marks a significant step towards achieving shareholder democracy in Europe. Speaking to the Financial Times recently, he said that he wants to get the "one share, one vote" principle accepted across the 25 member states. It will not be easy but success would be good for Europe's economy and good for tens of millions of investors denied their rights.

Today, the situation is highly fragmented, as is highlighted in a new study from Deminor, the governance consultancy. Approximately one third of European listed companies fail to follow the principle of one share – one vote. Some impose an ownership ceiling, limiting the stake of individual owners; others impose a voting right ceiling limiting the right of individual holders to register their opinion by voting at annual meetings. There are also “priority shares”, which give specific powers to their holders. And a 20% of the companies surveyed issue shares with multiple voting rights, which give additional rights to selected shareholders.

The Commission – and investor organisations support them – are arguing that this muddle is a real obstacle to a true single financial services market in Europe. The Commission - through its Shareholder Rights Directive – are already working to empower investors and the voting processes at AGM’s, however the proposal for one share – one vote moves on the idea of enfranchisement of shareholders.

Another reason why this move is felt to be so important is its connection to the “comply or explain” principle that has underpinned corporate governance best practice for many years. And of course the responses to the FRC’s consultation on the Combined Code were largely behind “comply or explain”. This principle subjects companies to proper oversight, but it only works well if shareholders can exercise their ownership rights.
When the rights of owners in individual markets are enough, the market will be able to improve the ability of investors to exercise their voting rights across borders. Combined with an effective comply-or-explain principle, issuers will be able to avoid expensive prescriptive regulation.