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Judicial review of FRC Executive Counsel's decision to deliver a formal complaint
In Baker Tilly UK Audit LLP (2) Richard Hamilton King (3) Steven Laurence Railton v (1) Financial Reporting Council (2) Financial Reporting Council Conduct Committee (3) Executive Counsel to the Financial Reporting Council, the court examined the guidance issued by the Financial Reporting Council (FRC) for the delivery of complaints against auditors and considered whether judicial review was the correct forum to challenge a decision to deliver a formal complaint.
The second and third claimants are partners of the first claimant accountancy firm, Baker Tilly. Together, the claimants sought judicial review of a decision made by the Executive Counsel to the FRC, to deliver a formal complaint about them to the FRC Conduct Committee.
The formal complaint arose out of the claimants' audit of Tanfield Group Plc for the year ended 31 December 2007. Baker Tilly was first notified in September 2009 that an investigation was being commenced to determine whether there may have been an 'act of misconduct' under the then applicable Accountancy Scheme rules. However, it was not until 3 June 2014 that the formal complaint was actually served on the claimants.
First ground of challenge
Paragraph 12(f) (or 12(f)) of the FRC Guidance on the Delivery of Formal Complaints provided an example of where public interest facts favoured delivery of a formal complaint:
"The gravity of the alleged misconduct....It is likely that a hearing is desirable in the public interest where there is evidence that the alleged misconduct........(f) involved a non-trivial failure on the part of the Member or Member Firm to act with professional competence or due care...."
The claimants argued that paragraph 12(f) was unlawful, since it inferentially supported a legally erroneous approach to 'misconduct' and contained a misdirection as to what constituted 'serious misconduct' within the Accountancy Scheme, resulting in a legally flawed approach to the public interest test.
The court rejected this submission, highlighting that paragraph 12 did not make any suggestion that a 'non-trivial failure' was to be equated with either 'misconduct' or 'serious misconduct'.
It did not seek to define the term 'misconduct' (which could be found at paragraph 2 of the Accountancy Scheme) as it was widely known. Further, paragraph 12 did not state that if a breach was non-trivial, a formal complaint must be made. Rather, it was clear that the public interest test involved a balancing act, and no single factor or combination of factors was necessarily decisive.
Second ground of challenge
The claimants asserted that the decision to make a formal complaint was improper, as it was based upon an erroneous approach as to the meaning of 'misconduct'.
- First, the Executive Counsel allegedly equated the concept of 'standards reasonably to be expected' found in the definition of the Accountancy Scheme with breach of standards contained in the International Standards on Auditing (ISAs).
- Secondly, he allegedly treated the need for a 'significant' departure from such standards as being commensurate with a 'non-trivial departure' and/or treated a 'non-trivial' departure from ISAs or lack of professional competence as constituting misconduct.
- Finally, he allegedly failed to appreciate the requirement for a serious or gross breach of standards of professional competence in order to demonstrate misconduct.
The court again rejected these submissions, holding that ISAs were relevant to the issue of the standards to be expected of a Member or Member Firm. It was a question of the facts of the particular case and the judgment of the Executive Counsel as to whether a breach of an ISA amounted to a failure to comply with the standards reasonably to be expected.
The Executive Counsel had relied upon the advice of both an independent expert and external counsel, and had given examples of conduct, which were in breach of an ISA, but not so serious as to be 'significant'. Importantly, they had applied the definition of 'misconduct' found in the Accountancy Scheme to the facts of the instant case. They had only decided that a Formal Complaint should be made at this stage; a full assessment of the merits would be undertaken by the Disciplinary Tribunal.
Third ground of challenge
The claimants' third argument was that the Executive Counsel was irrational in his view that the delay in the case could be overlooked because the misconduct was 'serious'. The court considered that his conclusion was neither irrational nor unlawful. He had properly consulted the guidance with regard to delay and considered all relevant matters.
The court disagreed with the claimants' submission that, due to the lack of abuse jurisdiction vesting in the Disciplinary Tribunal, there was no adequate alternative remedy, and the claimants were thus entitled to seek judicial review by analogy with decisions to prosecute in criminal cases.
As a matter of principle, the public interest required hearings of cases involving alleged misconduct to be heard fully in a Disciplinary Tribunal, which was the expert Tribunal in this field. They should not normally be heard by way of judicial review, with the consequential delay to Tribunal proceedings. The Tribunal also had jurisdiction to stay proceedings on the ground of abuse of its own process.
This case provides useful guidance on whether a challenge to a decision to issue a formal complaint should be made. The case also highlights the court's reluctance to interfere with the decisions of regulatory bodies.
Without prejudice communications with a regulator can be exempt from disclosure - in the right circumstances
The High Court has held that without prejudice communications with a regulator can be withheld from inspection in civil proceedings. However, in Property Alliance Group Limited v The Royal Bank of Scotland Plc, the court held the defendant bank had lost its right to withhold the documents in question.
Property Alliance Group (PAG) entered into four interest rate swaps with Royal Bank of Scotland (RBS) between 2004 and 2008. Each swap employed GBP LIBOR as a reference rate. PAG claimed RBS made misrepresentations about LIBOR, inducing it to enter into the swaps. PAG argued that, by proposing LIBOR as a reference rate, RBS represented it was not rigging the rate for its own ends.
Defending the claim, RBS admitted misconduct in relation to Japanese Yen and Swiss Franc LIBOR but denied misconduct relating to GBP LIBOR. Those admissions and denials stemmed from the Financial Conduct Authority's (FCA) final notice in relation to RBS.
This was published following settlement discussions between the FCA and RBS in which regulatory findings were made as to misconduct for the Japanese Yen and Swiss Franc LIBOR, although no statements were made regarding misconduct relating to GBP LIBOR.
Because of the wide scope of PAG’s claim, RBS was required to disclose a large amount of documents (it was estimated about 25 million documents would need to be reviewed). In order to provide more focused disclosure, it was agreed RBS should disclose 'high level documents' relating to the allegations of LIBOR misconduct.
Although RBS was happy to disclose the documents, it withheld them from inspection on the grounds of without prejudice privilege, arguing they represented negotiations with the FCA in connection with its Final Notice. PAG argued that without prejudice privilege was concerned with civil litigation, whereas these communications arose in the context of a regulatory investigation. The FCA supported RBS's without prejudice privilege claim.
Did without prejudice privilege apply to the settlement negotiations between RBS and the FCA?
The judge conducted a detailed examination of the FCA enforcement process. He noted that paragraph 5.3 of the FCA's Enforcement Guide described settlements in the FCA context as "not the same as "out of court" settlements in the commercial context. An FCA settlement is a regulatory decision, taken by the FCA, the terms of which are accepted by the firm or individual concerned…".
Conversely, paragraph 5.9 of the Enforcement Guide indicates that the FCA expected settlement discussions to be on a basis similar to without prejudice negotiations in civil litigation. The FCA explained in a letter to the court that in settlement discussions, it was standard practice for drafts of the statutory notice exchanged between it and the firm to be marked 'without prejudice'.
In that same letter, the FCA indicated that its ability to conduct settlement negotiations on a without prejudice basis was "vitally important" to the success of the discussions, and it was concerned that firms may choose not to enter into settlement discussions if they think there is a risk that admissions could be disclosed or inspected in separate proceedings.
The FCA further submitted that the public policy argument in favour of the without prejudice rule is stronger for the FCA as a public body than it would be for normal commercial litigants because early settlement benefits consumers and the UK financial markets.
It also said it was wrong to classify FCA enforcement processes as purely 'administrative' and not involving a dispute which may lead to litigation, noting that matters may be referred to the Upper Tribunal and become contested in inter partes litigation.
PAG contended that the only basis for RBS's sensitivity against disclosure must be because communications which were not recorded in the final notice contained further admissions of misconduct. The final notice made findings of misconduct in relation to other currencies, but not in relation to GBP LIBOR. The judge observed that it would be tempting to conclude that RBS had been exonerated in that regard, but that would be wrong - the final notice was the product of a settlement agreement and not a full investigation.
The judge referred to RBS's defence which admitted manipulation of the other currencies, but denied manipulation of GBP LIBOR. RBS also positively pleaded that "there have been no regulatory findings of misconduct on the part of [RBS] in connection with GBP LIBOR".
He believed RBS had itself put in issue the basis on which the regulatory findings were made because it went further than admitting the other findings of misconduct, positively relying on what was not said in the final notice as supporting its denial.
Modified application of the without prejudice rule in regulatory settlements
The judge recognised that the without prejudice rule could apply to settlement negotiations with the FCA, but in a modified way, distinct from that in civil litigation. In civil litigation, a waiver of without prejudice protection requires the agreement of both of the parties.
Here the judge indicated that, since RBS had put in issue the basis on which the regulatory findings were made, the without prejudice privilege could not be maintained. The FCA was not in the same position as a counterparty to without prejudice negotiations in civil litigation and could not prevent inspection if a firm relied on a final notice and put the basis on which it was produced in issue.
It is likely that the FCA will feel very uncomfortable that firms could conceivably make a unilateral waiver of without prejudice communications, even inadvertently, in circumstances where the FCA could not then resist such disclosure. There seems to be no clear basis for departing from the usual rule that consent of both parties is required for an effective waiver of without prejudice privilege.
Collateral benefit not to be taken into account when calculating damages owed by negligent accountants
In Swynson Limited v Lowick Rose LLP (Formerly Hurst Morrison Thomson LLP), the Court of Appeal confirmed that a firm of accountants' liability in negligence could not be reduced where loans drawn down on the basis of negligent advice had been reduced for tax reasons and not in the ordinary course of the borrower's business. The repayment was a collateral matter and did not reduce the damages to be paid by the negligent accountants.
Swynson is owned by Mr Hunt. In October 2006 Swynson lent £15 million to a company called Evo medical Solutions Limited (EMSL), to facilitate a management buyout of Evo (the 2006 loan). The 2006 loan was subject to interest and an arrangement fee. It was secured by charges over EMSL's and Evo's assets - accompanied by personal guarantees limited to £500,000. The 2006 loan was to be repaid by 31 October 2007.
The 2006 loan was made by Swynson in reliance on a due diligence report prepared by the defendant firm of accountants, known as Lowick Rose Limited (Lowick Rose) by the time proceedings were issued.
In July 2007 Mr Hunt was told that Evo was at risk of financial collapse, unless it was subject to further investment. On 13 August 2007 Mr Hunt caused Swynson to grant a further loan facility to EMSL of £1.75 million (the 2007 loan). The 2007 loan was also to be repaid by 31 October 2007. Neither the 2006 loan nor the 2007 loan were repaid by that date and interest and other fees also remained outstanding.
Mr Hunt believed that to have any chance of recovering his investments he had to support Evo further, until it could be floated on a stock exchange or financed by a private equity investor - neither of which was possible at that time. Mr Hunt therefore caused Swynson to grant a further loan of £3 million to EMSL, which in turn would loan the funds to Evo (the 2008 loan). As part of the deal Mr Hunt effectively became the majority shareholder of EMSL.
At the end of 2008 EMSL and Mr Hunt entered into a loan agreement, in accordance with which terms Mr Hunt made funds available to EMSL in the sum of just over £18.6 million (the partial refinance). EMSL then paid Swynson just over £17 million, settling the 2006 and 2007 loans in full. The partial refinance was made in part because once Mr Hunt had become the majority owner of EMSL, Swynson and EMSL had become connected entities. Mr Hunt was therefore advised, for tax reasons, that the loans should be restructured, with him arranging for EMSL to pay off most of the sums due with monies provided by (and now owed to) him personally.
Evo subsequently encountered severe financial difficulties and was wound down - with neither the 2008 loan nor the partial refinance ever being repaid. Swynson commenced proceedings against Lowick Rose, seeking to recover the amounts of the 2006, 2007 and 2008 loans from it as a result of its breach of duty. Lowick Rose admitted it had been in breach but it argued it could only be held responsible for the 2008 loan because the 2006 and 2007 loans had since been repaid by EMSL.
At first instance the court held that the repayment effected by the partial refinance was a collateral matter which did not go to reduce the damages recoverable from the negligent accountants. Lowick Rose appealed to the Court of Appeal.
Court of Appeal
The Court of Appeal confirmed the well-established principle that an innocent party, who claims for breach of contract, is under a duty to take reasonable steps to mitigate his loss (the first category of cases). In doing so he may reduce the damages payable - or in fact increase them. If the loss is partially or wholly avoided the court must consider whether that avoided loss should be taken into account when damages are considered.
The court also confirmed that a claimant's loss may be partly or wholly avoided when a claimant takes no steps at all to mitigate his losses (the second category of cases). In the second category of cases, if the transaction which results in an 'avoided loss' arises by virtue of circumstances which are collateral to the breach, the avoided loss need not be taken into account. However, if the transaction giving rise to the avoided loss arises out of the consequences of the breach and in the ordinary course of business, it is to be taken into account.
Lord Justice Longmore accepted that if a debt incurred in reliance on negligent advice given to a lender has been repaid, that repayment must ordinarily be brought into account in an action by the lender against the adviser.
However, he did not accept that there was an inflexible rule to this effect. He went on to say that if the lender is in no position to exert any influence on the borrower to repay the loan and the borrower is unable to repay, no repayment will be made and there will be nothing to bring into account. Nor can the loan be sold on the open market since it will have no value and the negligent adviser will be liable in full.
Swynson was in no position to mitigate its loss resulting from Lowick Rose's breach of duty and it did not take any steps to do so. As a result the case did not fall within the first category of cases. Swynson's claim against Lowick Rose fell within the second category of case.
The 'avoided loss' should therefore be taken into account if the transaction (here the partial refinance) arose as a consequence of the defendant's breach of duty and in the ordinary course of business. In this case the 2008 partial refinance no doubt arose because of the defendant's breach - but it did not arise in the ordinary course of business.
The Court of Appeal therefore found (by a majority) that the repayment made pursuant to the 2008 partial refinance was not to be taken into account for the purpose of assessing the damages for which Lowick Rose was liable to Swynson.
Although the decision is not a unanimous one the case does provide helpful guidance on when an avoided loss should be accounted for in a damages calculation - especially in circumstances where the loss is avoided, in part or in full, despite no steps have been taken to mitigate the loss in question.
FRC review of the Audit Firm Governance Code - four years on
Four years on from the introduction of the Audit Firm Governance Code (the Code), the FRC has reviewed its operation and the progress that has been made by firms following the Code.
Background and purpose of the Code
Issued in January 2010, the Code applies to firms auditing 20 or more listed companies. While not a regulatory requirement, the FRC considers that firms to which it applies have used it as a catalyst to improve the governance of their businesses. The Code's principal purpose was to benefit the shareholders in listed companies by providing a formal benchmark of good governance practice against which firms that audit listed companies can report to them.
Has the Code achieved its purpose?
Underpinning the purpose of the Code are a number of objectives falling into three broad categories. The FRC's review considers whether the objectives have been met and what changes are required to the Code to fulfil those objectives:
Improving firms' governance to support the provision of high quality work in order to give confidence to shareholders and improve the way they are run
The most significant changes the Code introduced were appointing Independent Non-Executives (INEs) and developing a dialogue between firms and shareholders in listed companies. INEs were envisaged as providing an external voice in the firms to enhance commitment to the public interest in the firm's governance and decision making. Four years on, the FRC recognises that the role of INEs needs to be better understood by stakeholders and the need for clarification in the Code as to their purpose and to whom they are accountable. The FRC also acknowledges that the INEs need clarity over how the public interest is defined and whether it is synonymous with shareholder interest.
Increasing competition in the audit market and reducing the risk of a firm exiting the market
The FRC does not consider that the introduction of the Code has had an impact on the structure or concentration of the audit market. The Review does, however, consider that improved governance structures as a result of the Code may reduce the risk of a firm failing as management and INEs should be better placed to identify potential issues before they become a crisis.
Enhancing firms' reporting and transparency to make them visible examples of best practice
The FRC was not convinced that transparency reporting was drawing wider attention to firms' governance arrangements. It has been suggested that the FRC could invigorate reporting and increase the visibility of the Code by highlighting particular disclosures by firms in its own publications. The FRC is considering how best it can implement this. In addition, the FRC would like to see firms adopting the Code throughout their international networks, rather than just at a national level.
The FRC acknowledges that, while firms have made great strides in appointing INEs, the Code should remain sufficiently flexible to allow firms to apply it in the manner which best suits their governance structure.
The FRC also recognises that the Code needs to be restated in order to define the public interest more specifically so that it can explicitly recognise the importance of audit quality.
The FRC is seeking feedback on further possible changes to the Code in light of its review. These should be sent by email to email@example.com by 28 August 2015.
FRC practice aid issued - guide to evaluating audit quality
In May 2015, the FRC issued its practice aid to assist audit committees in evaluating the quality of external audits. This was produced in response to changes introduced by the FRC to the UK Corporate Governance Code, obliging audit committees to include a section in their annual reports explaining the steps taken by them to assess the effectiveness of their external audit process, as opposed to just the service levels of the audit.
The practice aid is not intended to provide authoritative guidance or impose a prescriptive set of requirements; rather, the FRC is keen to encourage audit committees to adopt procedures which are relevant to the specific circumstances of their own audit engagement, having regard to the content of the practice aid.
According to the practice aid, evaluation of audit quality should be based upon various sources of evidence. Input will primarily be obtained by way of the audit committee's observation of, and regular communication with, the external auditors. Feedback can also be acquired by way of interaction with the company's management, and in particular, individuals such as the finance director and head of internal audit. In addition, support for assessment will be gained from external parties, such as regulators, prudential supervisors and shareholders.
When evaluating audit quality, the FRC advise that there are four vital elements to be addressed:
- mind-set and culture
- skills, character and knowledge
- quality control.
Auditors must demonstrate that they have made appropriate judgments about materiality and risk assessment in the planning stage, the nature and extent of audit work to be performed, and the conclusions and methods of reporting.
It is important that the auditors adhere to high professional and ethical principles throughout, exercising a suitable degree of challenge to management, maintaining independence and reporting with candour. It is highlighted that a high quality audit is based upon strong investigative, analytical and communication skills, as well as a sound knowledge of the business, its industry and the regulatory framework within which it operates.
Finally, audit committees should ensure that effective quality control procedures have been implemented, with regard to the overall audit plan, remedying any deficiencies identified in quality inspection findings, and the resources used to address contentious issues and key judgments.
Companies House new public beta search service is now up and running
For some time the government has confirmed its commitment to providing public digital data free of charge, so that it is accessible to all. Reinforcing that commitment, Companies House has now made available - on its new public beta search service - all public digital data held on the UK register of companies.
This provides access to over 170 million digital records on companies and directors including financial accounts, company filings and details on directors and secretaries throughout the life of the company.
There are additional features planned for the future which will include details of disqualified directors, company name availability and details of dissolved companies.
You can access the service and provide feedback on it here.