TUESDAY 1 DECEMBER 1998

MR RICHARD D REGAN, HUW M JONES AND MR MICHAEL MCKERSIE

  219.  Good afternoon, Mr Regan. I wonder if you could introduce your colleagues.

  (Mr Regan) Indeed, thank you, Chairman. Good afternoon, ladies and gentlemen. Just to introduce myself and my colleagues. I am Richard Regan and I am Head of Investment Affairs at the Association of British Insurers. My colleagues are Huw Jones, past Chairman of the Investment Committee of the ABI, and Michael McKersie, my deputy, so he is Deputy Head of Investment Affairs at the Association of British Insurers. I wonder if it would be helpful to allow me to make some introductory comments which might just give a bit of background.

  220.  Provided you are quite brief because sometimes we lose track of what people have said. We can talk at great length ourselves but we have difficulty following other people!
  (Mr Regan) Clearly ABI represents both insurers and investors. You have two papers which I will simply refer to. Basically where we are coming from is we believe that audit in particular occupies a privileged position and that it is necessary in order to ensure public confidence. We think it is vital for the public interest. Therefore, we believe that auditors occupy a privileged position and our comments this evening will be primarily as shareholders and on the question of audit unless you wish to question us on anything else. We were first approached by the auditors who sought relief from unlimited liability claiming the deep pocket approach and the inability to obtain insurance. We believe that there is insurance obtainable and we did discuss with KPMG a structure which we thought and they thought addressed both the concerns of shareholders, the partners of firms and indeed the public interest. We would be very happy to make that structure available to you afterwards if that would be helpful.

  221.  That is very helpful both in terms of content and its brevity. I think it is fair to say that insurance and insurers have been hanging over all of our proceedings today because obviously personal liability insurance and the like is very important. In 1997 you regarded the proposals as broadly the right balance between limiting the liability of professional firms and the interests of potential creditors. Now you say it is not a case of limited liability entities but "no liability entities". Do you think you could expand a wee bit on this and give us some indication of what you would consider to be the kind of costs of capital maintenance or LLP member guarantee.
  (Mr Regan) The second question is far more difficult than the first, Chairman. In terms of where we came from on the first discussion document, that document did provide for an amount of capital, a capital structure and transparency, and indeed we felt that it provided a reasonable framework. What has happened is that the second document has retreated on the questions of specifying a capital base, specifying a capital preservation and transparency rules and, indeed, the regulatory document to which reference was made by Mr McCartney yesterday and the proposals from the auditors themselves again makes no reference to a minimum capital base or even a relevant capital base or maintenance of a capital base. On the question of the cost of insurance, I think that has to be a market question. We are assured by both the London market and ABI members who are in PI in the limited liability market that cover is available. For auditors I suspect there may be a particular problem. That may be a question of the audit fee not being adequate to pay the premium if the risks are in fact as high as the auditors say they might be. The experience we have had is that although the claims have been very high, the actual settlements have been much much lower, perhaps 20 per cent of the claims, and that has been on an agreed basis.

  222.  There is no real protection for creditors in capital maintenance provisions in companies, is there, given that the DTI state in paragraph 3.8: "Capital is maintained in order to sustain the company, and there is no intent to require the maintenance of a fund for the benefit of creditors in an insolvency"?
  (Mr McKersie) The original proposals in 1997 had provision for members' guarantee and also for claw back. Both of those in a way are variations on the theme of capital. In a normal company liability is limited in some way. It is limited by capital which can be either paid up or to be paid up, ie, not yet called up but in the event of insolvency would be called up because that is an absolute liability for the shareholder. The company has to state what the capital is. It is true that a company may state that its capital is one pound and it may hold assets well in excess of that, but the vast majority certainly of PLCs and quoted companies have capital reserves far far in excess of that and they will be related in some way to the type of business which is being undertaken and that does provide confidence and security for creditors. The problem with the limited liability partnership proposals as it currently exists is that the whole concept of capital is missing. That would not be a problem if there was something else there such as members' guarantees or some provision of claw-back such that in the event of insolvency at least the capital which was there was still available. Obviously if a genuine trading loss is made then that capital may be depleted but the thing is the proprietors of the business cannot actually take further money out if they make trading losses which have depleted the capital below its stated level and there are no distributable reserves left. In the current proposals there is no concept of distributable reserves versus non-distributable. All the elements from company law are missing. I do not think necessarily that all elements of company law have to be present in this but there does seem to be a complete absence in this particular area.
  (Mr Regan) Just to flesh that out a little bit, Chairman. When we were talking to KPMG about the structure which was agreed, much of the discussion centred on the existing structure of the partnership and the fact that there was unlimited liability for the assets of that partnership and as to how one restructured that partnership to provide for a sensible income for the audit function when the major part of the income was probably being generated by management advice or some other function other than audit and our concerns were that the audit side should be properly capitalised and properly funded and, as in another place where we are looking at a review of company law, one had to have an adequate structure to preserve the capital reserves that were built up to sustain the business.

  223.  Is there any reason why such partnerships should not incorporate? The British Bankers Association said that people should have to choose between incorporation and partnership. Is that your view?
  (Mr Regan) I do not think we have a problem with incorporation at all. We have no problem with incorporation with limited liability, providing that the structure of that incorporation adequately preserves the business, the balance of business to carry on the sort of audit which is being undertaken. To have a small audit firm capitalised for, say, £500, undertaking the BP-Amoco audit is clearly inappropriate. So it is the appropriateness of the capital base, the structure and resource of the firm, whether it is a partnership or whether it has limited liability, which is really the issue.

  224.  You are not very happy about the proposals, are you? You say they are not well-founded and you go on in your submission to say, "In our view entities availing themselves of a regime of the type proposed in the consultation document are unlikely to command the confidence of their clients and other interested parties." You have, I believe, about 450 members, does that mean they would have doubts about using the services of solicitors or auditors who were LLPs?
  (Mr Regan) I think I said at the beginning that the audit occupies a particular position. It is there as, if you like, the arbiter of whether the accounts are a true and fair view of the company's trading. Maybe I should have said at the beginning that we recognise limited liability partnerships will have an impact on a great variety of professionals, but we believe the audit profession is in a different position from many other professions because it is there standing between the directors and investors and public at large, certifying that what is published, and if you like the confidence they may have in investing in that company, is a true and fair position. So in saying it would be unlikely to command confidence, I think our language is entirely unemotional, a thing is well-founded or it is not well-founded simply in those terms. If it is not well-founded, what we are saying is that perhaps the capital structure is not adequately provided for, or the reserves structure or transparency structure. It is totally unemotional.

  225.  Whether these things are emotional or not I cannot concern myself with given the lateness of the hour, but the statement is that entities that establish themselves as LLPs are unlikely to command the confidence of their clients. There is no qualification. It is not saying "some entities in particular activities", it is actually saying, "LLPs, no confidence", and I am saying, surely, therefore, your members will not be availing themselves of the services of solicitors or anybody else who happens to be established as LLPs. Can I assume that will be the case?
  (Mr Regan) No, Sir.

  226.  Then I have misunderstood you.
  (Mr Regan) What we were trying to say there was that if the structure of the limited liability partnership is inadequate in some way then that will not command confidence. So if I was going to mount a major court action I possibly would not use a one man firm of solicitors, I would go to a firm which was adequately staffed with competent partners who had experience.

  227.  Do you have doubts as institutional investors?
  (Mr Regan) As institutional investors we are concerned that the audit firm carrying out the annual audit or for whatever purpose is adequately capitalised to reflect the responsibility that firm is taking on. If it is auditing a £600 million firm or a £6 billion firm, then it should be of adequate size, it should have adequate capital backing.

  228.  Do you think other institutional investors have a similar view, ie pensions funds for example?
  (Mr Regan) Yes, we do. We debated this with other institutional investors who to a greater or less extent either say, "It is a matter for Government legislation whether audit firms command support or not", but there is a general consensus I think that the audit itself does occupy a special place in reassuring the public interest and therefore it should be seen to be adequately capitalised, protected and funded.
  (Mr Jones) Could I add there that in that area there is increasing interest on the part of institutional investors as to the balance between audit and non-audit fees paid by listed companies to the accountancy firms, and the incorporated structure which has specific capital commitments certainly demonstrates conclusively the importance attached to the audit function, and some shareholders have cast their votes at company meetings on the basis of whether or not there is a disproportionate emphasis on non-audit work.

  229.  We had the ACCA in this afternoon and they were talking to us in terms of a limit of £5,000 which I associated with the price of a new Lada. It did not seem to me to be very encouraging. Do I take it from the conservative position taken up by insurers that you would share my views?
  (Mr Jones) Indeed.
  (Mr Regan) We would indeed, Chairman.

  230.  Last year you welcomed the idea of LLPs and you said that you felt it would be easier to do the underwriting work and provide good cover for LLPs and individual members. Now that you are perhaps clearer about the risks involved how do you feel about them?
  (Mr Regan) I think if they are adequately capitalised and properly reserved and there is a proper structure to give this confidence, our view has not changed. The problem is that the consultation paper and indeed the accountants' own concept of self-regulation does not provide adequately for the capital backing which should be there for any organisation, in particular for an organisation trading as an auditor.

  231.  Would you like to take a stab as to whether we are likely to see a situation of premiums being higher for traditional partners than, for example, an LLP member?
  (Mr McKersie) We do not think there is going to be a material difference.

  232.  Before we leave this subject, perhaps I was a wee bit frivolous talking about a Lada because this is an important point nonetheless. At the moment there are a number of companies which operate as partnerships. How do you feel about these ones where there is no incorporation, where they are old-style partnerships. You have to deal with them; they are not all copper-bottomed, shall I say.
  (Mr Regan) Are we dealing with them as insurers or are we dealing with them as shareholders? If one took BP Amoco, one would not expect a two-man firm to be carrying out the audit. You would expect it to be a firm of substance and the substance would not just be the number of bodies but the financial backing as well. If it is as insurers then I am sure that insurers would insure a two-man firm or a 500-man firm on the business it carried out.

  233.  So you are saying if it was not the personnel that you were basing your hopes on, it would be the capital that they had? Would that be right?
  (Mr Regan) I think, Chairman, the most important thing is the personnel but if the personnel are men of straw—

  234.  I was talking in numbers but, as you say, they may be men of straw.
  (Mr Regan) It has to be a combination of both. It is a combination of skill and a combination of adequacy of backing.

  235.  If regulation is to go ahead for LLPs do you think that the professional regulation as envisaged will make much difference?
  (Mr Regan) I think it will. I am not sure whether this Committee has seen the proposals of the chartered accountants or not. I have seen an outline with the proposals they had in mind and indeed Mr McCartney has published proposals. I would have thought, yes, this can go ahead provided that the question—I am sorry to keep coming back to it—of capital backing and reserving and transparency is there. The regulations seem perfectly adequate otherwise.

  (Mr McKersie) Regulation is another way of demonstrating capital backing. When we said that the clients would not have confidence that is confidence in the structure as set out without those other ways of delivering something similar.

  236.  Thank you very much. Can I thank you for staying the pace. I ought to put it on record that there have been representatives of the DTI here all day. This certainly shows a threshold of something that is a great deal higher—Can I thank you all for coming, you have been very helpful.
  (Mr Regan) Chairman, thank you.