Clause 497

Company Law Reform Bill [Lords] – in a Public Bill Committee at 4:15 pm on 13th July 2006.

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Offences in connection with auditor’s report

Photo of Justine Greening Justine Greening Vice-Chair (Youth), Conservative Party

I beg to move amendment No. 362, in clause 497, page 239, line 3, leave out ‘knowingly or recklessly’ and insert ‘dishonestly or fraudulently’.

Photo of Eric Illsley Eric Illsley Labour, Barnsley Central

With this it will be convenient to discuss the following amendments: No. 363, in clause 497, page 239, line 5, leave out ‘misleading,’.

No. 364, in clause 497, page 239, line 7, leave out ‘knowingly or recklessly’ and insert ‘dishonestly or fraudulently’.

Photo of Justine Greening Justine Greening Vice-Chair (Youth), Conservative Party

The three amendments relate to the same subject. The clause was debated at length in the other place and also on Second Reading in the Chamber. I still have grave concerns about it, and I have a number of questions on how it will work in practice. Some of my queries result from the comments of Lord Sainsbury, who said:

“That is wrong, not because prosecutors would have to prove dishonesty—they would not.”—[Official Report, House of Lords, 10 May 2006; Vol. 682, c. 1032.]

That subtly changes the well understood definition of what reckless means, which is that there would generally be some underlying dishonesty. It was suggested in the other place that that might not need to be the case. Concerns were naturally expressed that still need to be cleared up, and I hope that the Minister can do so.

Audits are essentially risk-based work, and they allow the auditor and the audit company to sign off, or otherwise, company accounts. Audits involve considering random and non-random samples of transactions that the company has engaged in, so that it can get a feel for the overall materiality of the figure on a balance sheet and ensure that it is correct. All that involves making judgments. I am concerned that simply exercising judgment badly could lead to a potential offence.

The other aspect is that existing fraud law and the duty of care and negligence could arguably give a legal remedy for anyone who suffers a loss as a result of an auditor’s negligence. The clause may be about catching auditors who turn a blind eye when carrying out an audit, but Baroness Noakes said:

“The Government have produced no evidence that there is a problem with auditors who are not fraudulent or dishonest, but who turn a blind eye to problems. I do not believe that it is appropriate to create a criminal offence on the basis of an unproven hypothesis.”—[Official Report, House of Lords, 10 May 2006; Vol. 682, c. 1026.]

I have to say that I agree. If the clause remains unamended, it may lead to an unforeseen negative impact on companies. I shall endeavour to demonstrate some of my concerns.

I have no doubt that if the clause remains unamended, there is a danger that auditors will need to do more work to be more assured that the financial statements that they are signing off are indeed true and fair. For example, when deciding whether to write off bad debts that are provisional on the balance sheet, auditors are likely to take a far more risk-averse approach to financial reporting. That will not necessarily be of help to British companies.

The clause may lead to more qualified audit reports, as auditors will be unwilling to take the level of risk that they might do now. By definition, if they sign audit reports but do not flag up worries about whether a company is a going concern, they themselves might create real problems for companies. Audits would be at risk of becoming more burdensome as more work is required to deliver a full, clean audit—that could damage audit quality. There is the risk of changing fundamentally the relationships in the audit teams—several people are necessary to conduct audit tests and to deal with the multiple layers of review and risk assessment—that undertake audits. There is a danger that the provisions will not even work as intended in the courts.

I return again to the corporate manslaughter Bill. It is very difficult to place a duty of care on any one individual successfully and to demonstrate that they had taken the action that led to the breach of the corporate manslaughter regulations. In reality, if auditors were being pursued for recklessness, it would be difficult to say which one had committed the offence. Was it the audit junior who had not carried out the right test or followed up an invoice containing a suspicious item? Perhaps it had not been recorded properly in the ledgers or accounting records. Or was it the audit senior who did not tell their junior to go back and follow it up with the client? Or was it the audit manager who reviewed the audit file and noticed the item, but in the context of the overall audit felt that it was probably an isolated case, that it could be discounted and that it did not necessarily lead to a negative audit opinion? Or was it the partner who reviewed the work of the audit manager and reached a similar conclusion? Which one of those auditors would have committed the offence of recklessness? It would be difficult to point a finger at a particular individual.

That could lead to a culture in which auditors did not race towards risks when they saw them and looked at them in detail to understand whether they might damage their ability to sign off an audit report as “true and fair”, but instead had an incentive not to look at risks in detail in case they uncovered problems leading to the perception that they failed to follow up sufficiently on those risks. That would be a very bad thing.

I shall offer an example: an audit manager is carrying out an audit and receives an anonymous e-mail saying, “You ought to check out whether the level of stock is at the level on the balance sheet”. They check it out and find that everything is fine. They then receive another e-mail saying that another aspect of the debtor’s activities is inaccurate. So, again, the auditor checks it out but, again, everything is fine. They receive another nine or 10 e-mails and finally think, “This is ridiculous. I have had so many of these and they have all been wrong so I am going to ignore it and get on  with the audit work”. What happens if it is subsequently proved that that final e-mail, which they did not follow up, was correct and material? Would the auditor be viewed as having acted recklessly?

That demonstrates that, in reality, during an audit, an auditor must make fine judgments often in the light of many years of experience. At the moment, the system works very well and we need to be careful not put that at risk unwittingly with this new offence. It might be that we need some clarification of Lord Sainsbury’s comments. I hope that we will get that.

Our amendments propose to replace “knowingly or recklessly” with “dishonestly or fraudulently”. We think that that would capture better the offence that the Government want to hone in on. I hope very much that the Minister will respond sensibly to Lord Sainsbury’s comments in the Lords and provide some clarification. If we do not receive clarification, there is a grave risk that auditors will not be willing to put themselves at personal risk of committing the offence in question. We may therefore lose some of our best and brightest people and people will be less willing to enter the audit profession. Companies will find that their audits take significantly longer and are far more detailed than has ever been necessary in the past, and are therefore also more costly. The irony is that at the end of the process, the audit might be less robust than in past. That is a risk. I hope that the Government will consider the amendments in detail and respond to my points.

Photo of Quentin Davies Quentin Davies Conservative, Grantham and Stamford

My hon. Friend has made an extremely good speech that was well thought through. She made some powerful arguments, which I hope the Committee will weigh up carefully. I agree that we do not, in principle, want to increase the cost to companies if we can avoid doing so, nor discourage people from going into the auditing side of the accounting profession. I know that my hon. Friend is herself an accountant, although I do not know whether she is an auditor. My experience has been that bright young accountants are increasingly not drawn to the audit side of the profession, because they can make more money in tax or management consultancy and perhaps because those areas do not have the same risks as auditing.

The whole integrity of our financial system—it is not too much to say the whole viability of capitalism—depends not merely on the honesty of accountants, which we must take for granted except in exceptional circumstances, but on their thoroughness and professional competence. My hon. Friend argues that it would not be right to create criminal liability for auditors when there is no criminal intent. I believe that that was the essence of her very reasonable argument. The word “recklessly” does not involve criminal intent, dishonesty, corruption or a deliberate decision to deceive.

I take a balanced view of the issue, because I am conscious that we do not want to increase the cost to companies of compliance with the Bill. We have rightly said so in many contexts. We do not want to drive bright, young, ambitious accountants away from the essential job of auditing to other aspects of the profession. I am also conscious of the potential unfairness of giving someone a criminal conviction in a  case in which there was no criminal intent. That raises issues of legal philosophy that we should all consider.

On the other hand, the idea of recklessness in an accountant is terrifying. It is like recklessness in a doctor, surgeon or airline pilot. There are certain professions in which it has horrific consequences, and we should send a message from the Committee that we regard recklessness among auditors as terrifying. We do not want an Enron or a WorldCom in this country. Such scandals and disasters do enormous damage not only to their immediate victims, but to the credibility of the financial system, and ultimately to the cost of capital and therefore the wealth of everybody.

There are strong arguments on both sides, and I shall tell you why I stood to speak, Mr. Illsley. The right way to resolve the matter is for the Government—I do not often ask for their attention, but I would be grateful for it for the next 20 seconds—to explain in Committee that recklessness will have a very high threshold. It will be when an accountant does something that he knows from his professional training he ought not to do or, more likely, when he does not do something that he knows from his professional training that he ought to do. An example would be if he does not ask essential questions and pursue anomalies and discrepancies. If he sees that liabilities do not make much sense when compared with a declared charge, he must ask questions and need to be persuaded as to why the discrepancy exists.

There needs to be an explicitly high threshold so that honest people doing an honest job do not have to lose sleep and have the nightmare that they could open themselves to prosecution by making an inadvertent mistake that any of us could make, let alone by themselves being victims of fraud or conspiracy to defraud on the part of directors, managers or others who lie to them and produce false invoices and bank statements. There have been examples of that on both sides of the Atlantic recently. Which of us can say that we will be able to tell whether an invoice is forged? When we get a bank statement from Bank of America, which was a famous case, and it looks perfectly all right, we cannot ring the chairman of Bank of America.

Sitting suspended for a Division in the House.

On resuming—

Photo of Quentin Davies Quentin Davies Conservative, Grantham and Stamford

I was saying that auditors are vulnerable to the mistakes of others, and indeed sometimes to the fraud of others. It would unreasonable if, every time an auditor looked at a letter from a bank stating that a facility had been granted or whatever, they had to ring up the bank to check that the letter was genuine. It would be impossible for them to do so, and such a requirement would be impracticable.

I shall give another striking example. A few years ago, Shell greatly overstated its oil reserves. If an auditor is told by the directors of a reputable oil company such as Shell and by its geological head—I am not sure what he calls himself, but he is a man who appears to have had many years’ experience of  evaluating oil reserves—that the oil reserves are X, the auditor is entitled to believe that. If it turns out that they are Y, it would be totally unreasonable for anyone to have a go at the auditor.

What I have in mind is that auditors should set themselves the highest professional standards. They should always probe any clear discrepancy, as well as anything that is slightly odd, anomalous, out of line or inconsistent, and they should not be fobbed off. They should ask questions that need to be asked and pursue matters. That is what we require.

Recklessness should apply only to the most egregious examples of non-criminal behaviour. There is already provision in respect of criminal behaviour in the clause, and we all agree that it should be sanctioned. Recklessness, while not requiring any criminal intent to be proven, should be egregiously greater than ordinary negligence or ordinary mistakes. If the Minister can put some assurance of that kind on the record, she might well solve the problem.

It is a general opinion that the response of the Minister’s colleague in the other place, Lord Sainsbury, on this subject, to which my attention was drawn a moment ago in the interval that we just had, was not adequate, did not do the necessary job or provide for that sufficiently high threshold. I hope that the high threshold will now be set out in clear and unambiguous language by the Minister.

Photo of Lorely Burt Lorely Burt Opposition Whip (Commons), Shadow Minister (Northern Ireland), Shadow Spokesperson (Northern Ireland)

I rise to echo, to some degree, the point made by the hon. Gentleman. In the House of Lords, Lord Sainsbury mentioned that it is possible to commit an offence knowingly or recklessly without being dishonest. People were confused by that and were trying to imagine how accounts could be put out knowingly or recklessly, but not dishonestly. In which circumstances could such an event take place?

Let us draw a comparison with the Fraud Bill. An important element of fraud is the intention to make a gain or cause a loss, but under clause 497 it does not appear that one has to act in that way. We are trying to ascertain what Lord Sainsbury meant. Perhaps the Minister will explain.

Photo of David Howarth David Howarth Shadow Minister (Energy), Trade & Industry

My hon. Friend is making an important point. It seems possible that what Lord Sainsbury meant is precisely that the offence under clause 497 is different from that of fraud under the Fraud Bill. Fraud under that Bill requires the specific intention to cause a loss or to make a gain. If that is what he meant by it being possible to commit the offence without dishonesty, what he said was perfectly harmless, because the offence we are talking about would be slightly stricter than true fraud, but not go as far as the hon. Member for Grantham and Stamford feared it might.

Photo of Lorely Burt Lorely Burt Opposition Whip (Commons), Shadow Minister (Northern Ireland), Shadow Spokesperson (Northern Ireland)

I am grateful to my hon. Friend for that elucidation. We are seeking to ascertain whether the Government intend to create a crime that can be committed negligently or inadvertently. If so, we cannot support the provision.

Photo of Vera Baird Vera Baird Parliamentary Under-Secretary, Department for Constitutional Affairs

I shall answer the hon. Lady in the negative straight away and then turn to issues raised by others.

The hon. Member for Grantham and Stamford is concerned about the absence of criminal intent. I know what he means—the absence of deliberate criminal intent—but recklessness is of course an element of the state of mind in many, many crimes, so it is in that sense a criminal state of mind across the board in criminal offences, as long as they are not ones of specific intent. Therefore, there is nothing particularly unique or scary about this provision.

Recklessness is certainly a high threshold, which I shall set out for the hon. Gentleman in a moment, and it is certainly not what the hon. Member for Putney suggested. She referred to the possibility of someone making an error of judgment after years of being in practice and getting something slightly wrong. That is really the same question as the hon. Member for Solihull asked, so I shall set out what recklessness is and how dishonesty does or does not come into it. I think the hon. Lady also mentioned that there are penalties already and asked why we need an offence. I shall try to deal with all that.

It is important to make it clear what “recklessly” means. It has been suggested that the provision is so broad that it is criminalising negligence. That is not the case. It has also been asked whether making misleading, false or deceptive statements recklessly must involve dishonesty, so let me elaborate on what Lord Sainsbury said and talk about the difference between recklessness and negligence.

“Recklessly” does not mean “carelessly” or “negligently”. It does not involve not thinking of something or not noticing it. Negligence is not thinking of something. Negligent auditors are ones who do not do their job to the required standard through inattention and incompetence. It may be simply a momentary absence of mind with serious consequences. The hon. Member for Putney said that that is a disciplinary offence, but it is not recklessness. A person who is merely negligent will not be guilty of this offence, even if the negligence is gross.

I suppose that that almost touches on the issue of corporate manslaughter. When I define recklessness, the hon. Lady will appreciate the state of mind that has to be found in an individual before the crime can be committed, so there is no question in this case of any kind of attributable responsibility to a firm. This is not like corporate manslaughter at all; it is about an individual.

The hon. Lady asked who in the whole sequence of events will be responsible or criminally liable. It will be any person who is found to have the state of mind that I shall set out. Any such person will be criminally liable and anyone who does not have that state of mind will not.

The test of recklessness will catch only auditors who consciously do not care about doing a good job. To prove that an auditor has behaved recklessly, it is necessary to show that the auditor was aware that an action or—as the hon. Member for Grantham and Stamford said, this is far more frequent—a failure to act carried risks and that, having known that those risks were present and not reasonable ones to take, he  none the less consciously decided to go ahead. Therefore, someone cannot be reckless inadvertently; they have to have directed their mind toward it, become aware of the risks and gone on regardless. It cannot be done by inadvertence or carelessness.

Photo of Justine Greening Justine Greening Vice-Chair (Youth), Conservative Party

Does the Minister have any indication that what we are discussing is a serious problem in the audit profession at the moment, that it has been in the past or that it will be in future? Does she have any indication that swathes of auditors consciously do not care about doing a good job? My experience is that we do not have any such indication, but I want to understand what the problem is in the auditing profession that the Government believe they might be solving with this measure.

Photo of Vera Baird Vera Baird Parliamentary Under-Secretary, Department for Constitutional Affairs

The hon. Lady has already made that point and I shall come to it in due course, but I hope that, at the moment, I have accomplished my task of setting out what recklessness is and establishing that it is a high threshold.

Photo of Jonathan Djanogly Jonathan Djanogly Shadow Minister (Business, Innovation and Skills), Shadow Solicitor General, Shadow Minister (Justice), Shadow Solicitor General

I am no auditor or expert on auditing, but when auditors do their job they might find a number of possible leads. They will not know whether a lead that they find will necessarily produce a problem, and I suppose that at some point they will have such a number that they have to find a ratio or level at which they start asking questions. There are only so many questions that they can ask. Given what the Minister said, my concern is that it might be argued that an auditor who does not follow every single lead is reckless.

Photo of Vera Baird Vera Baird Parliamentary Under-Secretary, Department for Constitutional Affairs

I was just being courteous. The answer is no. Let me repeat what I said; that is not difficult, as I have been reading my brief, although I do understand the issue.

To prove that an auditor had behaved recklessly, it would be necessary to show that he had been aware that an action or failure to act—much more likely, a failure to act—carried risks and that he had known that the risks were not reasonable. That relates to the matrix of small risks that was mentioned and the question whether an auditor would have to follow up every lead. Clearly, it would not be reasonable to suggest that he would.

The failure would have to be fairly gross, involving a risk that a reasonable person would think ought to be followed up. The auditor, having apprised himself of the risk, would have to have gone ahead without following it up. If he had made a conscious decision to go ahead despite having turned his mind to the risk—seen it and acknowledged that it was not reasonable—he would be guilty of recklessness.

Photo of David Howarth David Howarth Shadow Minister (Energy), Trade & Industry

The Minister answered my point in her final words. It is important that the definition that she is using should include the idea that the unreasonableness of the risk must be subjectively  known by the defendant. If that is the case, I do not think that there will be the problems that people fear will arise from the clause.

Photo of Vera Baird Vera Baird Parliamentary Under-Secretary, Department for Constitutional Affairs

If the risk was not required to be objective but was subjectively linked to what was going on in the auditor’s mind, we would be reducing this to negligence because it would fall short of a reasonable standard—that is pretty well the definition of negligence, which is not what we are talking about, though we are considering the state of mind of the individual in question, so we must consider how it appeared to him, as it were. That is what juries frequently have to do. I hope that that is satisfactory.

Photo of Justine Greening Justine Greening Vice-Chair (Youth), Conservative Party

I fully appreciate what the Minister has said and her clarification is helpful, but audits regularly come across a particular invoice that has not been properly accounted for, purely because there is always an element of human error.

The difficulty for an auditor is how he would be expected to make a judgment between what was almost certainly a human error, for which a reasonableness test could apply, and something that could be not just an isolated case, but symptomatic of an underlying problem. That is the reality of how audits take place.

I understand the Minister’s explanation that there will be this reasonableness test, but in reality it is sometimes difficult to say, hand on heart, “That is definitely an isolated example of a problem with an invoice, and I am certain of that.” Often, that is very likely to be true, but one can never be absolutely certain. An audit can never test every single invoice; it can check only a sample.

Photo of Vera Baird Vera Baird Parliamentary Under-Secretary, Department for Constitutional Affairs

If in the ordinary course of events such human errors occur frequently, it does not sound as if they would be likely to indicate an unreasonable risk that the auditor had acknowledged and decided not to act on. If he was in any doubt, the safest thing would be to check things through, and he would be in danger of being negligent if he did not. The hon. Lady’s scenario falls a long way short of the offence.

I cannot realistically deal with every conceivable factual position. If, from the evidence, it was realistic to suppose that an auditor was more than 50 per cent. likely to be convicted of being reckless according to the test, that would be a matter for a court to deal with. Otherwise, no action would be taken. I cannot envisage every scenario, but the one suggested by the hon. Lady does not sound as if it would fit the test. That is just my view.

The test is fairly clear. The auditor would have to know that a failure to act carried unreasonable risks and consciously decide to go ahead despite that. The real point is that that is a long way above negligence. One cannot be reckless inadvertently; a degree of consciousness has to be proven. In criminal law, although not in the Bill, the phrasing is usually that a person has to have “directed their mind” to the risk—become aware of it and its unreasonableness and carried on regardless.

In another place, it seems to me that the Government went further. My noble Friend Lord Sainsbury said that the guidance to be issued under the clauses would  say that for a prosecution to be brought, there should be specific evidence of recklessness, and that no one should seek to prosecute in reliance on an inference of recklessness from hindsight, even when such hindsight showed a judgment to be so wrong that it was not credible that the auditor did not know the risk.

Sitting suspended for a Division in the House.

On resuming—

Photo of Vera Baird Vera Baird Parliamentary Under-Secretary, Department for Constitutional Affairs

Because of the obviously serious interest in how recklessness is defined, I went to the Library and looked at “Archbold Criminal Pleadings”, which is the criminal lawyer’s bible. I can confirm that the latest authority, the Crown v. G [2004] 1 appeal cases, deals with the point raised about the subjectivity or objectivity of reasonableness. It was held in that case

“that a person acts recklessly with respect to (i) a circumstance when he is aware of a risk that it exists or will exist, and (ii) a result when he is aware of a risk that it will occur”— this is the important point—

“and it is in the circumstances known to him, unreasonable to take the risk.”

The fact that that is a subjective test is clear and conclusive. I will give a copy of that ruling to anyone who wants it. I hope that I have dealt with the meaning of recklessness. There is a sharp distinction between that and negligence, and the levels of conduct that were being canvassed as possibly getting unwitting auditors into trouble.

Let us consider recklessness and dishonesty. In every day colloquial speech, we would expect that someone who makes a false assertion without knowing whether it was true or false was not being honest. In that sense, we would describe as dishonest most actions that would be caught by the new offence based on inter alia recklessness. In law, however, dishonesty has a more developed meaning. It means acting for personal gain to which one knows one is not entitled, and that is not an element of recklessness.

An auditor who is reckless is most unlikely to be acting honestly, but we do not believe that it should be necessary to show that the person was motivated by the prospect of unfair personal advantage that would be the effect if dishonesty had to be proven. That is recklessness as opposed to dishonesty. I hope that I have put people’s minds at rest. Good auditors who behave honestly have nothing to fear from the offence. If they genuinely believe what they are saying is true, that they had made reasonable, honest judgments about risks and had undertaken the appropriate level of work to assess them, they will not have behaved recklessly and need not worry—nor need they do any more than comply with the standards of their profession.

“Knowingly or recklessly” is a well established phrase. It is referred to many times in the Bill. It is used under the 1985 Act and it has not had the chilling effect that the hon. Members for Grantham and Stamford and for Putney suggested would be the consequences for the audit profession. It has been in place since 1985, so such a suggestion does not seem well founded. I have  already said that there are existing disciplinary procedures. Negligence is a different case entirely from recklessness and anything under the amendment tabled by the hon. Member for Putney that was dishonest or fraudulent would be caught by existing offences, so in that sense the amendment is redundant.

The hon. Lady’s other question was whether there was any need for such a provision. It was a reaction not to a particular scandal but to major worries that had been expressed about the integrity of auditors and the need for effective sanctions to underpin matters. There are 700,000 audits carried out annually. Auditors are keen to do a good job and to report what they find in a straightforward manner. However, there can be pressures from directors, for example, to bend the truth in order to conceal or minimise problems. If even a small percentage of such people were tempted to give into pressure, there could be a significant number of inaccurate audit reports. If the offence persuades even a small number of auditors to resist temptation, it would have contributed to improving standards of financial reporting.

The hon. Lady did not refer to the question of misleading, which is the substance of amendment No. 363, but she indicated to me privately that she regards it as part and parcel of her argument. For the sake of completeness, if the word “misleading” were removed, the clause would not apply to material in the audit report that was misleading and only to material that was false or inaccurate. The auditor’s report should not contain misleading material—material which may itself be true but which misleads the reader because other material is left out. It is like the earlier comment of the hon. Member for Grantham and Stamford about not doing something—not showing the full picture.

If “misleading” were deleted, the offence would no longer catch auditors who manage to give the impression that there is no problem with the accounts—that there is nothing seriously wrong—without saying anything that is untrue. I am sure that the hon. Lady believes as we do that it is important that shareholders and other readers of the audit report should not be misled. If an auditor is concerned that the audit report might be misleading, the remedy is to redraft it so that it is clear. That would be an altogether positive change in behaviour. There is no justification for departing from the normal phrase, which includes “misleading”. It is used elsewhere in the Bill and in the 1985 Act.

I hope that I have dealt with everyone’s concerns. If I have not, I am sure that they will tell me, but I respectfully suggest that the amendments are not necessary and that the Bill includes the high threshold that the hon. Member for Grantham and Stamford sought.

Photo of Justine Greening Justine Greening Vice-Chair (Youth), Conservative Party

It has been useful to get further clarification from the Minister on what the offence will mean in practice. There was a great deal of uncertainty when the clause was debated in the other place, so it has been helpful to discuss a little more practically how the concepts will work in reality. The debate has given me some confidence that there has been some genuine thought about the practicalities of the offence in relation to conducting audits.

I am not fully convinced that there is any evidence that the auditing profession in this country shows any signs of needing such an offence to encourage it to behave responsibly; there seems to be every indication that it is responsible. Nevertheless, I shall not press the amendment to a vote. I will take time to study exactly what the Minister said and to reflect and consult on it. I beg to ask leave to withdraw the amendment.

Amendment, by leave, withdrawn.

Clause 497 ordered to stand part of the Bill.

Clauses 498 and 499 ordered to stand part of the Bill.