Parliamentary Assembly
Assembl�e parlementaire

Corporate ethics in Europe

Doc. 10103
26 February 2004

Report
Committee on Economic Affairs and Development
Rapporteur: Mr Christian Brunhart, Liechtenstein, Group of the European Peoples’ Party

For debate in the Standing Committee — see Rule 15 of the Rules of Procedure

Summary

The present report sees the recent Parmalat scandal – like those of Enron, Arthur Andersen, WorldCom, Ahold and Tyco preceding it – as being a sign of both slackening corporate ethics and a lack of preparedness on the part of society to prevent their occurrence. Public confidence in the economic system as such could well suffer as a result unless strong action is taken in a series of fields.

Thus, in the first place, the current concentration in the accounting industry toward a few dominating companies should give way to more competition and that industry’s auditing services should be strictly separated from its non-auditing businesses, such as consulting or investment advice. Similarly, there should be a strict organisational separation within investment banks between advice given to management and that offered to shareholders and to the public. The creation of a “European Oversight Body” should be envisaged and corporate legislation and practice harmonised as far as practicable across the continent. Council of Europe work in this field, such as its Convention on Insider Trading, should be pursued and adapted for the purpose. A balance has to be struck at both national and European level between overly detailed laws that could stifle economic initiative and growth and regulations which, due to their lack of precision, risk giving rise to renewed scandals.

The report goes on to call for efforts within companies to raise ethics via training programmes and for greater shareholder activism to bare any irregularities, including excessive payments to executives. Here, the report argues, transparency may well be the best weapon.

I.          Draft Resolution [Link to the adopted text]

1.         Given their potentially damaging economic impact, the recent series of corporate scandals in the United States of America and Europe demand a reaction from both governments and regulatory bodies. They reflect a climate of poor corporate ethics which risks undermining trust in the economic system as a whole. Without accurate and reliable financial statements, corporate management, investors, shareholders and business partners cannot have true confidence in each other. The key reaction to this crisis must be to restore transparency in the European and global corporate world.

2.         As well as a failure of control over financial accounting, these scandals reflect a broader breakdown in the corporate culture. Conflicts of interest arising from the “principal – agent” split between the owners of companies (i.e. shareholders) and their management will always exist. However, these conflicts become impossible to reconcile when rewards available to corporate executives rise to exceedingly high levels, which are perceived by the general public as unacceptable, and prove even more dangerous when unrelated to performance and entail no downside risk. A more rigorous system of checks and balances needs to be introduced.

3.         To remedy such a breakdown in corporate ethics will require not only legislative change but also a broader cultural response. Some of the recent legislative reforms in the United States, particularly regarding accounting firms, could be used as a starting framework and should be complemented by a European approach based more on principles than law, utilising oversight and guidelines.

4.         The Assembly recommends:

i.          that the European accounting industry be reorganised, along the lines of recent United States legislative reforms, including the requirement that firms provide fully independent auditing services, separate from any other non-audit business. Greater competition within the industry should also be encouraged to prevent the potentially harmful concentration of power within a few dominant firms. The creation of a European Oversight Body is further recommended.

ii.          the harmonisation of accounting rules, thus preventing international “loopholes” which may encourage poor corporate governance.  In order to reconcile the different “legal” versus “principles” based approaches to accounting in the United States and Europe, respectively, a ‘’omply or explain” based method could be adopted where strict guidelines are in place with a clear explanation being required by companies if they choose to deviate from them;

iii.         that the Council of Europe’s previous work in the field of market manipulation – such as the 1989 Convention on Insider Trading - be built upon and implemented more strictly in order to prevent further market abuses. Common regulation in this field should be introduced across Europe, combined with stricter regulation and sanctions for insider trading offences;

iv.         the tightening and supervision of so-called “Chinese Wall” requirements for investment banks, separating advice given to corporate management and shareholders, to avoid future conflicts of interest within the financial community;

v.          corporate social responsibility training for corporate executives in order to heighten management awareness of good corporate ethics. Training should also be provided for non-executive directors, shareholders and trustees in order to ensure greater checks on management and the observance of a suitable code of corporate ethics. Greater shareholder activism should also be encouraged through more regular voting at companies’ Annual General Meetings, through the use of proxy voting or possibly through the outsourcing of governance oversight to specialist divisions or companies;

vi.         dividing the role of the Chairman of the Board and Chief Executive Officer for listed companies over a certain size, as the fusion of these roles risks placing excessive power in the hands of one official and serves to confuse the operational function of running the company with one involving the oversight of management. A genuinely independent Chairman should be sought with the responsibility to protect the interests of the full range of stakeholders in the company;

vii.        increased controls over executive compensation, since the rise in recent years of executive pay to levels incomprehensible to the general public may have contributed considerably to the observed deterioration in corporate ethics. Control could be imposed by shareholder voting on board compensation and by restrictions on non-cash components of remuneration. More important than levels of compensation is full transparency in all aspects of remuneration.

II.         Explanatory Memorandum by Mr Brunhart, Rapporteur

Contents

1.         INTRODUCTION

2.         RESPONSES SO FAR

a. United States

b. The European Union

3.         THE COUNCIL OF EUROPE

Cultural Changes

3.1        Developing a culture of integrity

3.2        Corporate Governance

a. Regulating the compensation of CEOs

b. Structure of the board

c. Promoting the separation between Chairman and Chief Executive Office

d. Institutional Investors

            Legal Changes

3.3        Oversight of Public Accounting Firms

a. Creation of a European Oversight Board

b. Auditor independence

c. Increasing competition in Auditor industry

3.4        Revision and international harmonisation of accounting rules

3.5        Market abuse

3.6        Conflicts of interest in investment banks and in the financial community

4.         CONCLUSION

1.         INTRODUCTION

1.         In October 2002 the Rapporteur and several of his colleagues introduced a Motion for a Resolution to the Assembly on ‘The Need for Greater Transparency in the Light of Recent Corporate Scandals’ (Doc. 9585). The Motion drew attention to “the recent series of major corporate scandals and accompanying accounting malpractices in the United States - but also in Europe” saying that they “point to the need for greater transparency as regards the real financial situation of companies and any actions of self-enrichment by managers at the cost of shareholders.”

2.         The Motion went on to deplore “the loss of savings on the part of millions of people” which it said “has seriously undermined public confidence in the market economy at a time of considerable economic uncertainty. It also said that “continued economic development requires that this trust be urgently restored” and called on “Council of Europe member states to strengthen their legislation as well as European and worldwide conventions in order to ensure that needed improvements are reached and that those guilty of wrongdoing can be adequately sanctioned.”  It concluded by asking that “particular attention should be paid to the possibility of strengthening the Council of Europe Convention on Insider Trading and to its efficient implementation in the Council of Europe area and beyond.”

3.         Indeed, the recent series of major corporate scandals and accounting malpractices in the United States, but also in Europe, points to the need for greater transparency both in releasing financial results and in exposing unlawful self-enrichment pursued by certain unscrupulous managers.

4.         The effects of the implosion of companies such as Enron, Arthur Andersen, WorldCom - and more recently in Europe Parmalat and Ahold, have led to a serious erosion in investor confidence, including among the general public, and has contributed to lengthening the longest and deepest downward business cycle since the end of the Second World War. Investor confidence also continues to be challenged by revelations of abusive practices within the US and European investment fund industries.

5.         The outcome of the Enron scandal of falsified reporting and outrageous self-enrichment, along with its far-reaching repercussions, showed how crucial general confidence in financial reporting is for the functioning of the economy.  When numbers in financial statements are not ‘honest’, users of these statements are misled, investors cannot make informed decisions; employees cannot trust their employers; business partners cannot collaborate effectively; competitors can not engage in true competition; government cannot collect fair taxes; financial markets cannot operate properly; the public loses confidence in business; and business loses its legitimacy. Those in charge of financial reporting, whether providers or certifiers, not only violate their professional duties and lose their integrity, but jeopardise the whole financial reporting system.

6.         The continuing revelations of wrongdoings at the Italian dairy-cum-miscellaneous conglomerate Parmalat are looking to be Europe’s largest ever financial scandal. The SEC has referred it to as “brazen corporate financial fraud”. It shows that the problems to be raised in this report are not limited to US companies and do not simply stem from ‘anglo-saxon’ business practices. Warning signs should have been up for several years over this tightly owned family business, its questionable diversification strategies and highly complicated financial structure (which latter characteristic it shares with Enron). How could the truly staggering hole of € 8-10 billion (the final figure is not known at the time of writing) appear in the company’s balance sheet without banks, regulators, bond holders, credit agencies or auditors noticing? Company Chairman and Founder Calisto Tanzi has admitted to siphoning off up to € 800 million to other struggling companies in the group (such as a travel firm run by his daughter), but the whereabouts of the remaining missing billions remain a mystery. This scandal rightly brings the role of all of these players into question, including auditors.

7.         The loss of millions of savings on the part of ordinary people has seriously undermined public confidence in the market economy, at a time of considerable economic uncertainty. Lasting economic development requires that this trust be urgently restored.

8.         Corporate scandals and their consequences can not be considered as a simple behavioural outcome of a few people undermining the system’s health.  A broader question of what provoked these scandals also needs to be asked. In any structure involving a ‘principle-agent’ split between managers and owners conflicts of interest will always exist. Several issues gave rise to the recent crisis of this conflict including:

9.         In view of such developments, Council of Europe Member States need to promote two types of change. First legislative changes are required to prevent future illegal activities.  Member statesneed to strengthen both national legislations and European and worldwide conventions in order to ensure that needed improvements are reached and that wrongdoing can be adequately sanctioned. Secondly, a profound cultural change is required to prevent rewards from becoming so great that conflicts of interest become impossible to resist.  The two are clearly linked as new rules produce new behaviours, and would also be instrumental in stimulating the needed cultural change.  In this process, reform and change should focus on both corporate governance and ‘financial system gatekeepers’, i.e., accountants, auditors, analysts, bankers, lawyers) who constantly consider incentives and risks when performing their tasks.

2.         RESPONSES SO FAR

10.        For many years, both in the United States and in Europe, new rules for companies and financial markets have been introduced. However, recent corporate scandals have accelerated reform.

a.         United States

11.        The United States, the world’s leading economy and the epicentre of the recent scandals, reacted quickly, adopting a radical legislative approach to the problems.  This has led to commentators talking about a well-intentioned, though so far incomplete, response.

12.        The Public Company Accounting reform and Investor Protection Act (also known as the Sarbanes-Oxley Act) was promulgated in July 2002 to “protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes”.

13.        Three new rules stand out in the Sarbanes-Oxley Act:

14.        However, such measures have been criticised for not addressing issues such as abolishing staggered boards, banning expensive stock options, and disclosing corporate environmental and social liabilities.  In addition, the Act met strong resistance in Europe, as it was imposed on European companies operating in the US without prior consultations.  European companies feel that a number of thorny issues, such as access to working papers and registration with the new oversight board requested by the Act, have not been addressed by it.  

b.         The European Union

15.        Europe also reacted to corporate finance scandals that hit the USover the last few years, some would say in a less ‘knee jerk’ fashion, and certainly at a slower pace.  Ahold’s scandal dispelled claims about the supposed inherent superiority of continental Europe’s two-tier boards over Anglo-Saxon unitary boards and brought to the fore the urgency to step up efforts and tighten rules and legislation, particularly following a period when many European firms had begun to adopt ‘Anglo-Saxon’ management models (such as the use of stock options in compensation).Corporate governance moved to the forefront of the Corporate Europe agenda. The difference in the European approach has been to focus on cultural rather than legislative changes. The aim now is to find an integrated approach which strengthens shareholder democracy and improves corporate responsibility.

16.        At EU level, the Ecofin Council created the Committee of Wise Men on Regulation of Securities Markets in July 2000.  In agreement with EU Economic and Finance Ministers, the Committee delivered its final report named “The regulation of European securities market” in February 2001. The report proposed regulatory changes based on a four-level approach, recommending the establishment of two new committees: the European Securities Committee (ESC) and the Committee of European Securities Regulators (CESR). The two committees provide advice to the market, market participants, end-users and consumers. They work on joint interpretation recommendations, consistent guidelines and common standards, peer reviews. They also compare regulatory practices to ensure consistent implementation and application in different countries. 

17.        In 2001 the Commission of the European Communities proposed a “Directive of the European Parliament and of the Council on insider dealing and market manipulation (market abuse)”. Its scope is to revoke Directive 89/592/EEC and to replace it with a new legal framework covering both insider trading and market manipulation at the same time.  Another initiative worth noting is the Proposal for a Takeover Bids Directive, presented by the Commission in 2002, which seeks to offer European companies greater legal certainty for cross-border takeover bids.  One of the main objectives of the proposal is the fight against entrenched boards and the protection of minority shareholders.

18.        The EU is also working on an Action Plan on company law and corporate governance that would seek to identify the necessary actions, define priorities and, most importantly, determine whether the necessary initiatives should use binding or non binding instruments.  Furthermore, the creation of a European Securities Exchange Commission, i.e. an independent administrative agency dealing with securities, is also under consideration.

3.         THE COUNCIL OF EUROPE

19.        Against the background of its statutes and guiding principles, the Council of Europe and its member states lay great store on greater company transparency. Already in 1989, the Council of Europe proposed a Convention on Insider Trading, a treaty open to memberStates and non-memberStates alike, as well as by international organisations. The Convention provides for mutual assistance through the exchange of information between those responsible at national level for the surveillance of stock exchange transactions, the purpose being to unearth as rapidly as possible insider trading under way. 

20.        However, given the quantitative, qualitative and continuous changes in international financial markets, the existing legislation should be updated and complemented in order to ensure consistency in judging market manipulation.  Additional or new legislation is needed to avoid loopholes that could be used for wrongful conduct and undermine public confidence and the smooth functioning of markets.

21.        In this context, Council of Europe Member States need to undertake a wide process of reforms aimed at transforming market rules and the behaviour of economic players.  In Europe as well as in the US, the problem is to find equilibrium between, on the one hand, ensuring protection deemed necessary by an increasing pressure for fair rules among all market participants and, on the other, avoiding excessive regulation which might cause paralysis to the economic system. A balance needs to be found between legislative and cultural changes and incentives.

22.        In view of the above, the search for solutions should be for a set of complete rules not limited to legislation alone.  In order to establish efficient capital market within the Council of Europe area and help restore investors’ confidence in such markets, MemberState will need to tackle the following issues and work on the following suggested measures:

A.                  Cultural Changes:

  1. Developing a culture of integrity

  1. Corporate governance

B.                  Legal Measures:

  1. Oversight of public accounting firms:

  1. Critical review and international harmonization of accounting rules

  1. Market abuse

  1. Conflicts of interest in investment banks and within the financial community

A.         Cultural Changes

3.1        Developing a culture of integrity

23.        Whilst the sorts of legislative changes outlined above are important for protecting against future corporate abuses, member states of the Council of Europe should also focus attention on promoting cultural changes. These are vital to prevent the type of conflicts of interest, and irresistible rewards which encourage the disregard for fiduciary duties seen in the late 1990’s. Education and training of managers, shareholders, non executive directors and other actors, is of paramount importance in the process of promoting transparency and ethical behaviour.  While changes can also come via new laws and regulations, it is very important that firms and other market actors act proactively with initiatives of their own.

24.        The educational system at all levels has a crucial role to play in fostering ethical behaviour.  In the Council of Europe member states, business ethics and related subjects are not given sufficient attention and are not adequately represented in curricula.  There is a need to increase funding available in order to promote the subject of Business Ethics in management training as well as to develop teaching materials and courses in educational institutions. Provided funds are made available, universities and business schools can address the issue by:

25.        Last year the UK’s ‘Higgs’ report on the role of non executive directors laid out the key role these actors have in checking management behaviour and protecting shareholder interests. One recommendation of the report was to increase training for those in this role. Corporate governance training and awareness for major institutional shareholders and fund trustees should also be encouraged to provide a more rigorous check and prevent future management abuses.

3.2        Corporate Governance

26.        Based on the above, and taking into consideration current practices and systems, it can be said that the European system enjoys some advantages when compared with that of the US.  Accounting control systems seem to work better in Europe.  In recent years several member states have introduced new rules on corporate governance referring to listed companies.  While there is general agreement on the need to further improve corporate governance frameworks in Europe, the debate has recently focused on whether to establish binding or non-binding instruments, or a mixture of both, especially in the EU area.  A series of corporate governance codes have been adopted over the past decade with the aim to better protect the interests of shareholders.  Although these codes have some basic principles in common, they also show considerable differences that need to be addressed if deep and liquid European capital markets are to be achieved. In environment of asymmetry of large potential reward with little risk, internal system of checks and balances broke down in Europe as well as in the US and cultural changes also need to be worked on in our region.The OECD’s Principles of Corporate Governance issued in 1999, (which are currently under assessment), have already led to the formulation of a coherent set of basic corporate governance principles.  Taking those principles as a point of departure, future work should address the following concerns:

a.         Regulating the compensation of CEOs

27.        A re-examination of executive compensation packages has become a necessity for Europe, following a number of outlandishly generous ‘golden parachutes’ in companies such as, for example, ABB.  In numerous companies lavish compensation packages linked to the company’s stock price have encouraged executives to pump up profits, thereby damaging shareholders’ long-term interests.  The growing pay gap between CEOs and workers could threaten the very credibility of leadership.  One of the most important elements of a common regulation in the Council of Europe area should therefore be to create incentives that align management and shareholder interests over time.  This may include the diffusion of a correct treatment of stock options and the request for executives to announce that they are going to sell stock before they proceed to doing so.

28.        There has been debate within the Committee as to whether pay levels should be left in the hands of the market. Though intuitively one may support this solution as necessary for attracting the world’s best management into European companies, academic research and empirical evident do not offer such strong support. For example, a study by a UK management consultancy, Kepler Associates, found that in 2000 there was an inverse relationship between pay and performance in the FTSE-100. The typical boss of a poor performing company was earning �175,000 a year more than a world-class player. Moreover, staff at the wrong end of big pay differentials tend to compensate in other ways, such as taking more sick leave. Despite mounting public criticism of their run of excessive increases, UK company directors awarded themselves a fresh rise of 23% in 2002, during a period when average earnings increased by only 3.2% and when shares had slumped 50% since their peak three years earlier. The 2002 rise of 23% followed 17% in 2001 and 28% in 2000, a cumulative increase of over 80%. Very few of these rises were justified by performance and a worrying number were disincentives, rewards for failure.

29.        It is believed that such pay inflation is partly caused by the increasing use of pay consultants who advise of the remuneration of executives. Most companies clearly wish to attract the best talent, and therefore are prepared to offer ‘above average’ compensation, which clearly leads to an inflation of the average. As the recent scandal with the head of the New York stock exchange has shown, peers used to assess such industry comparative pay levels may also be highly suspect in the first place.

30.        The key here is that compensation committees, shareholders and non executive directors have clearly not been proving the necessary checks and balances to stop such absurd pay levels being approved in the first place. This partly stems from the fact that many directors sit on each others boards and have pay assessed in line with each other. They are clearly, therefore, not providing as independent a check as they as supposed to. In the UK for example it has been estimated that just 392 people, some sitting on more than one committee, made up the remuneration committees of 98 of the largest UK companies.  With such incentives directly available to management, it is no wonder that interests of individual investors become overlooked.

31.        It should be noted that the key problem behind the public’s loss of trust in corporate management, and indeed which can be argued to contribute strongly to the environment of poor corporate ethics is the culture which allows managers to be paid for failure. It is not so much high absolute wages which are unacceptable in the eyes of the public as large payouts guaranteed for poor performance. Recently the drugs group GlaxoSmithKline became the first company in UK business history to suffer a majority vote against a huge pay deal for its chief executive, Jean-Pierre Garnier, not so much on account of his actual salary level, but largely due to the (approx Euro 19m) potential payout he would receive if fired. Numerous other stories abound, with Pierre Bilger the former Chairman of Alstom being a high profile European executive being forced to hand back his 3.8mEuro ‘golden parachute’.

32.        Radical proposals for the prevention of such excess could involve introducing a maximum as well as a minimum wage, taxation disincentives for very high pay levels, controls on wage differential multiples between highest and lowest employees or percentage pay increases being reflected across all employee levels, but in reality it is unlikely that such measures would be either acceptable or successful. The key to good governance seems to be linking pay properly to performance. Rewards for failure should become unacceptable, with a proper balance of risk and return being factored into employment compensation. Conflicts of interest will therefore be easier to overcome in future. To ensure this truly independent non executive directors and compensation committees need to be established. Also, as had recently become the case in the UK (to Mr. Garnier’s expense) shareholders should have the power to vote on remuneration recommendations. The Committee should support trade union movements in European countries other than the UK (such as in Holland and Germany for example) who are pushing for such voting measures to be adopted. Directors’ contracts could also be limited to shorter notice periods rather than on multi-year timeframes, and pay could be limited to a certain percentage of non cash compensation with options being linked more closely to longer term performance targets rather than the vagaries of short term share prices movements.

b.         Structure of the Board

33.        The configuration of corporate governance is a core issue when looking at company transparency.  In particular, the structure and functioning of the Board of Directors and the different corporate control bodies have a direct influence on the work of public accountants.Proposals from the Higgs report issued in the UK on the role of non executive directors should be considered across Europe. The report focuses on the calibre of non executives, requiring more rigorous selection (only 4% of FTSE-100 non-executives had a formal interview for the job), more training, performance evaluation, and the capacity of non-executive directors to challenge senior management should be enhanced. A more far-reaching approach could be to increase the personal liability threshold for non-executive directors. The key to the Higg’s overhaul comes with his proposal to widen the "gene pool" of independent directors - the subject of a government taskforce led by the dean of the LondonBusinessSchool, Laura Tyson, though she stopped short of proposing an approved government list non commercial candidates. Cronyism is a charge often laid at the door of non-executives, with their selection having more to do with their ability to effect commercial introductions or industry experience than their independence and board checking abilities. Such a charge is a difficult one to disprove, if only because the evidence shows that many individuals hold a string of board positions and inevitably overlaps occur. A larger pool of non-executive talent should also be a more diverse one. The need for increased independence is being clearly demonstrated currently with the Grasso case where the Chief Executive of the New York stock exchange saw his large pay package approved by a board of directors coming from the very firms he was supposed to be regulating.

c.         Promoting the separation between Chairman and Chief Executive Officer positions

34.        Many of the recent problems are connected to the extraordinary concentration of power in the hands of one single person, in many both private and public companies.  The separation between Chairman and CEO is a good way to avoid having power at the top of the pyramid concentrated in only one person.In order to provide a key internal check, and to properly reflect shareholders views, it is important that the chairman does not perform operative tasks.This is already regarded as best corporate governance in the UK, where recent reports have gone further and suggest that the chairman should be non-executive and serve for no more than six years. Whilst it is accepted that such a division of roles may be uneconomical and impractical for smaller and particularly privately owned companies, the division of these roles should be encouraged for larger, publicly listed firms.

d.         Institutional Investors

35.        Another group of key corporate governance players are the shareholders themselves, increasingly represented by large institutional fund managers. As the recent mutual fund scandals in the US have shown, however, these institutional investors can themselves add yet another layer to potential conflicts of interest. Their business models, based on increasing fees as the size of their assets grow, has led to conflicts with their fiduciary duty to act solely in the interests of their shareholders, (i.e. individual investors), leading to problems such as the mis-selling of funds in the UK, or the abusive trading practices of the US mutual fund industry. Again greater transparency is required, with clear transaction fees and charges and industry best practice codes being tightened to prevent abusive trading. Only then will these institutional investors be able to exercise their own duty (on behalf of individual shareholders), acting as a check on corporate management.

36.        Indeed increased activism by these investors is to be encouraged. Industry bodies such as the National Association of Pension Funds in the UK have done much to prick the consciences of their members with regards to corporate governance. However, while voting rates at Annual General Meetings have improved, institutional investors still spend only a small amount of their time providing input on governance matters. By the same token, non-executives spend little time seeking out the views of investors, tending to see this as the province of the executives. The situation could be improved by publishing voting records, insisting on corporate governance representatives within major firms, encouraging the outsourcing of proxy voting and governance matters to specialist departments or outside specialist firms.

B.         Legal Measures

3.3        Oversight of Public Accounting Firms

37.        In the last twenty years two processes have characterized the public accountant industry:

38.        Such developments have led to an increase in benefits for those auditors who consented to pressure from the management of large companies.  Audit work became a ‘loss leader’ for accounting firms, which used it as a way to ‘cross-sell’ more expensive consulting services.

39.        The major corporate scandals and the collapse of the Andersen consulting firm triggered the crisis of self-regulations for auditing industry.  This industry is globally operating. Therefore, it would be regulated with largely uniform principles and methods all over the world.  In that sense, in all Council of Europe member states some of the provisions of the Sarbanes-Oxley Act should be acknowledged. Attention should be focused on the following issues:

a.       the creation of a European Oversight Board

b.       auditor independence

c.       increasing competition in the auditing Industry

a.                   Creation of a European Oversight Board

40.        Following the example of the Public Company Accounting Oversight Board (PCAOB) recently set up in the U.S., thought should be given to the creation of a new Board to oversee the activity of the audit companies operating in Europe.  The target should be to oversee those audit public companies that are subject to securities legislation and related matters, in order to protect the interests of investors and promote public interest in the preparation of informative, accurate, and independent audit reports for companies whose securities are sold to, and held by and for, public investors. Gross failings by the auditors of Parmalat only seem to make the case for such a body ever more compelling, and suggest that the issue of the level of auditors’ liability should be discussed and harmonized across countries.

41.        Following the U.S. example, the Board should:

b.                  Auditor independence

42.        Auditor independence is vital. Legislation should prohibit a registered public accounting firm that performs any audit for any issuer from providing to that issuer, contemporaneously with the audit, any non-audit service. By non-audit service is meant bookkeeping or other services related to the accounting records or financial statements of the audit client; financial information systems design and implementation; appraisal or valuation services; actuarial services; internal audit outsourcing services; management functions or human resources; broker or dealer, investment adviser, or investment banking services; legal services and expert services unrelated to the audit.

43.        Moreover, a registered public accounting firm should be prohibited from providing audit services to an issuer:

c.                   Increasing competition in Auditor Industry

44.        In the last twenty years or so, there has been a consolidation in the auditing industry, with a consequent reduction in competition between firms.  Lack of competition has resulted in: higher costs, lower quality of services, impairment of auditor independence and less choice.  Therefore, it is important to find ways to increase the number of firms capable of providing audit services to large national and multinational business organisations.  This could be the role of Antitrust Authority or another function assigned to the Board mentioned in point A above. Though the accountants (Grant Thornton) in the Parmalat affair claim not to have been involved in any fraudulent practices (despite its two Italian partners being arrested), a lack of rigor in the European industry has also been revealed. Even the Italian legal practice requiring a regular change of auditors did not succeed in revealing what must have been long-standing questionable accounting practices at the firm. Greater competition is one way that greater rigor could be encouraged.

3.4        Revision and international harmonisation of accounting rules

45.        The Enron scandal pointed to the limits of international accounting standards.  The Council of Europe should therefore press for of reform and harmonisation of accounting rules at international level.

A.       Regarding reform, important issues to be discussed include: revenue recognition, accounting for stock options (recorded as expenses), consolidation and related topics. Another critical point is if and how to include in the annual report non-financial measures that might be meaningful to investors.  One way could be the promotion of a voluntary disclosure of this information, but with a specification of standards for each industry that could evolve with input from companies, trade associations and investors.

B.       Regarding the establishment of global accounting standards, one well-known problem is how to manage the convergence between the US, rules-based accounting system (Financial Accounting Standard Board - FASB) and the European, principles-based accounting system (International Accounting Standards Boards - IASB). The decision that has been taken is to reach agreement on one set of international standards by 2005.  This objective is very difficult to reach because of the different philosophies that inspire the two systems.

C.   Those in favour of a principles-based system argue that modern financial transactions have become so complicated that a detailed, rules-based system like the American one is too difficult and costly to implement. Furthermore, because the rules-based system is so complicated, companies can meet the letter of the rules but ignore the intent and spirit of the standards.  On the other hand, the argument against the European approach is that it gives companies too much freedom in interpreting their own accounting. A ‘comply or explain’ approach could be one way to combine the two approaches.

3.5               Market abuse

46.        The existing legal framework to protect market integrity is incomplete.  Legal requirements vary between the jurisdictions of different European countries, often leaving economic players uncertain over concepts, definitions and enforcement.  In some countries there is no legislation addressing the issues of market manipulation.  In order to address these issues and strengthen the integrity of financial markets, it is necessary to promote common regulations concerning market abuse and a deeper cooperation between the appropriate national authorities.

47.        The concept of market abuse can be considered as an extension of the notion of insider trading, where the latter is commonly defined as trading in the stock of publicly held corporations on the basis of material, non-public information.  This extension is made in order to bring the scope up to date with the changes that have intervened over the last decade.

48.        Discipline on market abuse on insider dealing and market manipulation[1] intends to limit opportunities for insider dealing and market manipulation.

Insider dealing refers to information of a precise nature, which has not been made public, relating to one or more issuers of financial instruments or to one or more financial instruments, which, if made public, would be likely to have a significant effect on the price of those financial instruments or on the price of related derivative financial instruments.

Market manipulation means:

49.        Insider dealing and market manipulation prevent full and proper market transparency, which is a prerequisite for trading for all economic players in integrated financial markets.  Therefore a prompt and fair disclosure of information to the public enhances market integrity, whereas selective disclosure by issuers can lead to a loss of investor confidence in the integrity of financial markets.  Professional economic players must contribute to market integrity.

50.        Council of Europe member states should prohibit any natural or legal person who possesses inside information from taking advantage of that information by acquiring or disposing of financial instruments to which that information relates, for his own account or for the account of a third party, either directly or indirectly. Furthermore, they should prohibit these relevant persons from disclosing that inside information to any third party and from recommending or procuring a third party, on the basis of that inside information, to acquire or dispose of financial instruments to which that information relates.

51.        Natural or legal persons should be prohibited from engaging in market manipulation, such as in:

52.        In order to better confront market abuses, Council of Europe member states would need to adopt combined rules dealing with insider dealing and market manipulation.  Unitary rules would facilitate throughout the States the same framework for allocation of responsibilities, enforcement and co-operation.

53.        A variety of competent authorities in the different countries, each one with different responsibilities, create unnecessary costs and confusion among economic actors. For this reason each country should designate a single administrative authority.  The competent authority shall be given all the necessary supervisory and investigative powers for the exercise of its functions. It shall use such powers either directly or, where appropriate, in collaboration with other authorities, including judicial authorities.

3.6     Conflicts of interest in investment banks and in the financial community

54.        One of the major issues concerning conflict of interest is the connection between the different departments in investment banks.  Investment banks, analysing financial statements and making recommendations to investors, could contribute, up to certain limits, to a misleading appearance of financial statements.  As intermediaries, they are supposed to be honest brokers between companies that want to raise funds and investors who look for a profitable return on their assets.  They act as investment managers but often, at the same time, provide investment analysis for companies issuing securities.

55.        A “Chinese Wall” within the company is supposed to separate these two kinds of activities.  There is enormous pressure for financial results particularly on the analysts.  Issuing firms are interested in being analysed and presented to investors in the most appealing way.  Investment banks share this interest, to some extent, as their commission is tied to the profit of issuance. Moreover, the underwriting itself, that is the brokerage process, can be very profitable for the banks. For instance, when an Initial Public Offering is under-priced, stocks are bought and quickly sold at a much higher price and large amounts of money can be easily reaped.  This clearly conflicts with investors’ interests and the rightful and realistic pricing of equities.

56.        Serious conflicts of interest may arise in investment banks but also among individual financial analysts pressured by the culture of their employers. There are three areas particular concern:

57.        Investment banks may also alter the company's reported financial statements in ways that obscure the true financial picture of the company by:

58.        To summarize, financial reporting by investment analysts and their employers is exposed to serious conflicts of interest with far-reaching consequences.  It would be unrealistic to expect individuals and even companies to resist the enormous pressure to produce biased numbers and recommendations.

59.        Without a fair and effective regulatory framework in line with the rapid development of financial markets, the very functioning of these markets is at stake. Restrictions such as separate research departments for corporate banking and investing clients, greater disclosure of interests, tighter policing of Chinese walls should be considered. US regulators have recently shown a new preparedness to tighten up on wrongdoings by large financial corporations. Eliot Spitzer, the New York Attorney General achieved a $1.4bn settlement over ‘dotcom’ trading irregularities, and the FBI arrested 48 New York foreign exchange dealers on suspicion of swindling investors with false trades. European regulators and authorities should be prepared to show equal vigilance in order to maintain investor confidence in markets. The Parmalat scandal raises serious questions as to how major
international banks helped the company raise € 7 billion of debt over several years, not asking what this money was for before selling these bonds to their clients. Italian authorities are reacting swiftly to the affair (a draft bill has been drawn up which would significantly redesign the structure of financial regulations, creating one overarching body along the lines of the FSA). It can only be hoped that other European governments will react in a proactive fashion and that it will not take further losses on such a grand scale to provoke a response.

4.         CONCLUSION

60.        The post-Enron climate has made incorrect behaviour less likely, at least for now.  However, the self-correcting discipline of the marketplace is not sufficient to avoid such behaviour in the future.  It will be necessary to carry out reforms embracing all regulatory sectors and bodies and engaging all parties and players in order to contribute to the creation of a safer context for investors and for all market actors.  No amount of regulation, however, can assure a stable company transparency.  The whole corporate culture has to be changed to prevent irresistible rewards from clouding judgements over conflicts of interest. For prudent investors, the price of the marketplace has to be constant vigilance, with changes in the structure of management, boards, non executive directors, shareholders, accountants, bankers etc. all being required to ensure this vigilance is restored and the necessary checks and balances for good governance to operate are in place.

61.        Due to the wide diversity in systems, shareholding structure and business practices one common model of corporate governance that can apply universally to different companies in the different countries of Europe does not exist. Instead there are common principles that the different models can be based on, and these are chiefly principles of transparency and honesty. The key enforcement mechanism should be one of "compliance and explain", with clear guidelines in place which companies should follow or provide detailed explanations if they deviate from them. Council of Europe members can go a long way to encouraging and fostering such a climate of compliance which will prove a more effective system of good governance over the long term than simply reacting with short term legislation.

Reporting committee: Committee on Economic Affairs and Development

Reference to committee:  Doc. 9585 and Ref. No. 2768 of 18.11.2002.

Draft resolution unanimously adopted by the Committee on 23 January 2004.

Members of the committee: Mrs Zapfl-Helbling (Chairperson), Mr Kirilov, Mrs Burbiene, Mrs Pericleous Papadopoulos (Vice-chairpersons), Mr A�ikg�z, Mr Adam, Mr Agramunt, Mr I. Aliyev, Mr Anacoreta Correia, Mr Andov, Mr Arnau, Mr Assis Miranda, Mr Ates, Mr Pullicino Orlando, Mr van Baalen, Mr Berceanu, Mr Braun, Mr Brunhart, Mr Budin, Mr �avusoglu, Mr Cosarciuc, Mr Crema, Mr Dimic, Mr Djupedal, Mr Figel, Mr Floros (Alternate: Mr Sfyriou), Mr Galchenko (Alternate: Mr Tulaev), Ms Griffiths, Mr Grignon, Mr Gusenbauer, Ms Hakl (Alternate: Mr Grissemann), Mr Haupert, Mr H�gmark, Mr Jonas, Mr Kacin, Mr Karapetyan, Mr Klympush, Mr Korobeynikov, Mr Kraus, Mr Krivokapic, Mr Lachnit, Mr Le Guen, Mr Leibrecht, Mr Liapis (Alternate: Mr Pavlidis), Mr Makhachev, Mr Masseret, Mr Melcak, Mr Mikkelsen, Ms Milicevic, Mrs Muizniece, Mr Naumov, Mr �hman, Mr O’Keeffe, Mr Opmann, Mrs Patarkalishvili, Mrs Petursdottir, Mrs Pintat Rossell, Mr Podgorski, Mr Popa, Mr Puche, Mr Ramoudt, Mr Ramponi, Mr Reimann, Mr Riccardi, Mr Rivolta, Lord Russell-Johnston, Mr Rybak, Mr Sasi, Mr Schreiner, Mr Severin, Mr Seyidov, Ms Smith, Mr Stefanov, Mr Tepshi, Mr Timmermans, Mr Torbar, Mrs Vadai, Mr Versnick, Mr Walter (Alternate: Baroness Hooper), Mr Wielowieyski, Mr Wikinski, Mr Zhevago.

N.B. The names of those members present at the meeting are printed in italics

Head of Secretariat: Mr Torbi�rn

Co-Secretaries to the committee: M. Bertozzi, Ms Ramanauskaite; Ms Kopa�i-Di Michele, Ms Stewart

[1] Directive of the European Parliament and of the European Council, 2001