Harnessing the market through principles and disclosure

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Speech by John Tiner, Chief Executive Officer, FSA
Association of Corporate Treasurers
24 April 2007

Thank you very much for inviting me here to speak to you this evening.

There has been a lot of interest recently in the competitive position of London as a global financial centre, and we are keenly aware of the impact that our regulation has on the attractiveness of the city as a place to raise capital. The McKinsey report for Mayor Bloomberg and Senator Schumer underlined sharply the impact that a regulatory framework can have on the global position of a financial centre. The report contrasts the US situation with the FSA’s increasing emphasis on principles and our more ‘collaborative’ approach to regulating markets. I do not think it is helpful to portray this debate as New York versus London, particularly given the increasingly global nature of financial services – especially in the capital markets – which makes the fortunes of all centres inter-linked. And there is, of course, room in the world for more than one leading, global financial centre. However, I think there are important issues in this debate for market participants, lawmakers and regulators. The question I think for regulators is one of balance. Balance between strength of the regulatory regime and its flexibility to deal with rapid and often unforeseen change in the market.

Whilst the FSA does not have a statutory objective to promote the competitive position of the UK, under our principles of good regulation we are required to have regard to the impact of both the regulatory framework and the style of our approach on the competitive position and on innovation. And we take these principles of good regulation very seriously in deciding on our policies and our ongoing supervisory approach.

To this end, I would like to spend a little time this evening focussing on how we think principles-based regulation centred on disclosure can enhance the efficiency of the capital markets. In particular, I would like to set out why principle based accounting standards produce more relevant and useful financial statements for investors, how our principles-based regulatory approach is followed through in our listing regime, and how these two factors come together to enable investors to make informed decisions.

Before I develop these themes, however, I thought it would be useful to make a few introductory remarks about our high level approach to corporate governance.

UK code

As you know, the UK's approach to corporate governance is a market-led one which aims to enable a board to retain flexibility in the way it organises itself and exercises its responsibilities.

At the heart of corporate governance in the UK is the code of best practice otherwise known as the Combined Code - a disclosure-driven regime based on a 'comply or explain' approach.

It is fair to highlight here that the FSA's role in the UK corporate governance regime is limited, although we do endorse the code. Whilst the FSA ensures that listed companies insert a 'comply or explain' statement in their annual report through the listing rules, the primary responsibility for the Combined Code lies with the Financial Reporting Council which develops, monitors and keeps the code under review.

But importantly, the real enforcement of the Code is carried out by the institutional investors, as it is they 'who are enjoined to enter into a dialogue with the companies based on mutual understanding of objectives' and to 'consider carefully explanations for departure from the code and make reasoned judgements in each case'. They are the ones who determine on behalf of the company how they want their company to be governed.

So, the Combined Code identifies good governance practices. But companies can choose to adopt a different approach if that is more appropriate to their circumstances and the stage of development in their life-cycle. Where a company chooses to adopt a different approach, it is required to explain the reason for non-compliance with the Code to its shareholders who decide whether they are satisfied with the company's explanations. It is, therefore, up to the investor to choose whether it wishes to continue to invest in such a company, so promoting market discipline.

The 'comply or explain' approach works because it is underpinned by an appropriate regulatory framework through the listing rules and the engagement of investors aims. Together they ensure genuine compliance rather than 'box ticking' or defensive compliance with the Code. This approach is only effective to the extent that shareholders and other stakeholders engage with the company.

So far the approach has worked and as Sir Christopher Hogg noted on 18 April during the recent launch of the FRC's initiative to assess the effectiveness of the Combined Code ' …while there are some points of concern, the Code is working reasonably well and having a broadly beneficial impact…'. I look forward to seeing the conclusions of the FRC's review.

Our flexible approach to corporate governance in the UK and indeed to regulation generally is firmly grounded on the premise that companies should not be laden with unnecessary costs or unduly fettered by overly prescriptive regulation. Also that the management of a company should be able to drive forward the entrepreneurial agenda of the company as they see fit in the interest of the owners. This is important if we are to promote competition, innovation and growth for the wider benefit of our economy.

Corporate governance is of course not an end in itself but a means to achieving good management which involves productive relationships with the owners of the business and other stakeholders. This is not to say that good corporate governance can eliminate all risks but it is more about managing what risks there might be and a regime that encourages dialogue with the managers of a company makes this more feasible. Emerging evidence suggests that there is a positive correlation between good corporate governance and performance by a company. Research carried out by Deutsche Bank found a clear link between corporate governance and share price performance when it carried out a survey of FTSE 350 companies. They found that during the four and half year period investigated, the share prices of the top 20% of these companies from a corporate governance perspective outperformed the bottom 20% by over 30%. Similarly, the Mckinseys’ ‘Global Investor Opinion Survey’ reflects that there is a growing perception amongst market participants that well governed companies may benefit from a lower cost of capital. Enhanced performance translates not only into wealth and value creation for the shareholders but also, from the regulator's perspective, an efficient capital market which results in a prosperous economy and benefits society as a whole.

Other jurisdictions, notably the US of course, have a more rules-based corporate governance regime. It is not appropriate to state that one approach is demonstrably superior to the other. The approach taken must be based on the structure, history and experiences of a jurisdiction. So the ‘complex and fragmented’ legal system (as – I would stress - described by the McKinsey report on competitiveness), the historical approach to public policy, and the multi-layered structure of the regulatory system all influence the US approach to corporate governance. Of course, given the higher level of direct retail participation in equity markets, the US may consider it more appropriate for them to operate a rules-based regime. But a study conducted by Oxera on behalf of the London Stock Exchange found that the less prescriptive corporate governance requirements in the UK were one of the main factors influencing the choice for issuers between a US and UK listing – to the advantage of the UK.

Increasingly, however, I think that there is recognition in other parts of the world that in a complex regulatory environment a principles-based regime which focuses on outcomes may be the way forward. To quote the US Secretary of the Treasury, Henry M. Paulson, in a recent speech¹:

"a rules-based regulatory system is prescriptive, and leads to a greater focus on compliance with specific rules. We should move towards a structure that gives regulators more flexibility to work with entities on compliance within the spirit of regulatory principles".

It is also interesting to note that the UK's approach of 'comply or explain' has been adopted recently by the EU in the 4th and 7th Company law directives. I would go so far as to suggest that in a world where regulatory regimes show signs of a degree of convergence, that convergence is taking place around a more principles-based approach.

Principles-based accounting standards

This is a trend that also extends, I believe, to the accounting profession.

On 1 January 2005 all EU listed companies were required to use International Financial Reporting Standards for their consolidated annual accounts, so we now have about 18 months’ experience of applying IFRS across 25 countries and 8000 listed companies in the EU. In most member states this has been the biggest change in financial reporting for a generation, as we have moved away from legal-based accounting rules that derive from the Company Law directives to the International Accounting Standards Board's more principles-based standards that seek to balance relevance with reliability.

So far, the changeover has gone very well. There have been no major problems reported in implementing the standards, and the process of coordination of enforcement of the standards through CESR is working efficiently. The next issue for regulators is to work with the SEC in particular to reach a point where there is mutual recognition of IFRS and US GAAP for cross border offerers in the US and EU markets.

All accounting standard setters have the objective of writing principles-based standards (as do many financial services regulators, or the European Commission). For the IASB this is particularly important because their standards have to be capable of consistent application, interpretation and enforcement in any country around the world. It is impossible for standards that are designed for global application to have enough detail to address every issue that might arise, and Sir David Tweedie, the chair of the IASB, often says that his standards are intended to deal with 80% of transactions.

The IASB's standards are often contrasted with the rules-based system of accounting standards that applies in the US (US GAAP). As I have said, all standard setters set out to write principles-based standards, and that is as true of the US FASB as it is of the IASB. However, US GAAP is widely seen as a highly detailed set of rules where every standard has exceptions to the principle, with hundreds of pages of interpretations and guidance, and specialist application of the standards for various arcane industries. There are, in my view, two major reasons why US GAAP has developed in this way. First, the standards are rigorously enforced by the SEC, and secondly preparers and auditors are reluctant to back their own judgement when there is any element of uncertainty or ambiguity. As a result, every standard is rapidly underpinned by detailed guidance that ensures all companies apply the rules in the same way. This can have the effect of encouraging some companies to look for ways to get round the rules – a risk that is mitigated but does not vanish with more focus on principles. However, it is not my intention to criticise US standards. Both the SEC and FASB are driving towards more principles-based standards, and the IASB-FASB convergence initiative can only help that process. As with any convergence process, there should be give and take on both sides and, where appropriate on individual issues, there should be recognition of the benefits of the FASB approach.

Having said that, there are dangers in a focus on convergence as an end in itself. While there is much to be gained from mutual recognition of accounting standards between the EU and the US, there is a widespread and growing concern in the UK and elsewhere across Europe that the costs of greater convergence may outweigh the benefits. I have already outlined the problems inherent in trying to reconcile the FASB's detailed rules-based standards with the IFRS principles, and beyond that there are emerging concerns about the differing underlying decision-usefulness objectives of financial reporting in the US compared with the principles of stewardship that underpin UK GAAP. Annual financial statements are getting ever longer (over 450 pages without any photographs of the Board in the case of HSBC), with detailed disclosures that few experts are competent to understand fully.

There is a sense that the IASB and FASB are seeking to converge on a model of financial reporting that is technically more complex than the framework that either follows currently. It would be better if they were to focus on simplifying the current model, both in moving towards principles, and in reducing the levels of disclosure. We need practical standards that reflect the way management run the business, and the standard setters should spend their time on the important work of making sure the current standards are effective before they embark on technical improvements in areas where there may not be evidence of a market failure.

The best example of a focus on the interesting rather than the important is the standards setters' plans to increase the use of fair value. I support the use of fair value for financial instruments that are actively traded as well as for stock options, investment properties, or even Norwegian salmon. Often, it is by far the most relevant measure of an asset or liability's value to the business. However, I am concerned that fair values of illiquid instruments that are based entirely on proprietary models may not be sufficiently reliable to be recorded in the accounts. The standard setters need to do a lot more work on how the gains and losses on such instruments should be recognised before they press ahead too far.

With 8000 companies using the same standards across the EU, the European regulators have been rightly concerned about consistency of application of IFRS. There are three ways in which consistency of application can be assessed in accounting. First, it is fundamentally important that the standards should be applied consistently year on year; second, it is often argued that the standards should be applied consistently between different companies in the same sector; and finally the standards should be applied in a way that is consistent with the underlying principles and objectives. It is very tempting for regulators to focus on that second objective: if all companies in the same sectors apply the standards in exactly the same way then investors will make more informed decisions. However, that consistency will be illusory. In reality, major transactions are rarely identical, and absolute consistency can only be delivered by developing the detailed rules that the US regulators are now trying to dismantle.

The best approach, in our view, is to focus on consistency with the underlying objectives: the same approach that the FSA is advocating in our work on more principles-based regulation of financial services companies. If the objective of the standard is clear then companies should be able to assess the intended outcome and apply that to their transaction. As long as there is sufficient disclosure of the assumptions made and the way the standard has been applied, then investors will be confident that the accounts are consistent with the standard and represent management's best available view of how the transactions should be measured and presented.

This approach to accounting is one with which we are very familiar in the UK, and it is important to remember that it can be achieved only if all of the checks and balances are in place. Principles-based accounting standards will work only if companies' management are determined to provide relevant, reliable, comparable and understandable information to their investors (what might be seen as a belief in the stewardship role they have for shareholders); if auditors are independent and prepared to exercise their professional judgement and disagree when they think the standards have not been properly applied; and if audit committees police the relationship between management and the auditors. The UK system of corporate governance is designed to make sure that all three legs of the system operate effectively.

Principles-based approach to financial services regulation

At this point, it is perhaps worth emphasising that no regulatory system should have only principles. A balance of principles, which express outcomes (and which have the status of rules in law), and detailed rules will always be necessary. It’s the balance that counts. I think the arguments to shift the balance more towards principles are now compelling:

A burgeoning rule book of financial services regulation in the UK developed over 20 years has not prevented major shocks and investor detriment – pensions mis-selling (cost £11bn), mortgage endowments (cost £2.5bn), spilt capital trusts (severe reputational damage to sector and compensation of £200m), and high income bonds (one company alone paid compensation of £100m)
Financial markets are dynamic and innovative. Rules based regulation will always play quite slow catch-up. Principles are more enduring and applicable in fast changing markets.
Whether explicit or not in their relevant legislation, regulators should have a responsibility to regulate in a way which fosters competition and innovation. Principles provide the mechanism to do this.
Sensible, proportionate regulation is demonstrably a factor in the international competitiveness of a country’s financial market, where capital is increasingly mobile. But this must not become a race to the lowest standard simply to attract business, as it will be the wrong kind of business.
Boards and senior management of companies must explicitly recognise their responsibilities for making the decisions which affect their business, their investors, and their customers – it should not be the regulator’s job to tell them what precisely they should do in all situations. Principles provide the latitude to do this.
Principles should help drive a confluence of interest between customers, shareholders and management. For example, making money through treating customers fairly seems a sound long-term business proposition; whereas making money from the exploitation of customer ignorance or inertia will either be taken out by new business models and entrants or forced out through public policy making.
Principles (which address the spirit of regulation) are much more difficult to avoid than rules (which feed armies of lawyers, accountants and bankers in order to meet the letter of the rule, but not the spirit of the outcome).

But being regulated and regulating in a MPBR environment is not an easy option either for firms or for the regulator. It is difficult and can expose both sets of parties to more risk. The challenge for firms is to make a cultural change from looking for a safe harbour within the rules to one in which they get comfortable with disclosing to the regulator how they choose to apply a principle. This means Boards and senior management taking more responsibility and encouraging their staff to do so.

In asking firms to make this cultural change, we as regulators must also make changes of our own. Specifically, I believe that it is important that we become more effective and open in our exercise of judgement and be more willing to explain how we arrived at our decisions. This will require us to attract, retain and develop our people and improve our knowledge management systems and technologies. We will also need to work with industry bodies to identify areas in which industry guidance can supplement the principles – in place of rules.

Listing regime

Similarly our listing rules are principles-based and complement the UK corporate governance regime. As many of you will know, we completed a review of our listing regime just under two years ago. As part of the new regime, we introduced principles for the first time in the listing rules. These principles are designed primarily to ensure adherence to the spirit as well as to the letter of the listing rules in the interests of promoting fair and orderly markets. They also allow for flexibility so that a company which can demonstrate that it is adhering to a specific principle in another manner other than that specified by a rule may apply for a waiver to depart from compliance with a specific rule. By doing this, in line with our principles-based regime, we are discouraging 'box ticking' but instead encouraging a real dialogue between the listed company and us, its regulator.

As I said earlier on, it is not in our interests or the interests of a prosperous economy to fetter the development of businesses with excessive rules or inflexible application of our principles or rules. We do not authorise issuers to do business, as we authorise financial services firms; nor do we supervise issuers on an ongoing basis in the same way that we supervise financial services firms. Rather, we have a regime of what is sometimes referred colloquially as 'event-based disclosure', with some of these disclosures – such as prospectuses – approved by the FSA. Through this regime, we require listed companies to disclose all the material information which an investor might need to make an informed investment decision. This approach is at the heart of the EU securities regulation. Thus, an issuer wishing to raise capital from public markets or more specifically, obtain admission to the official list must disclose information about itself, the securities it is listing and the risks attaching to these securities or indeed to the company.

Against this backdrop, let me explain our function as the competent authority for listing and the way we go about discharging this function. HM Treasury sets some specific regulatory objectives for us in our capacity as the competent authority for listing, otherwise known as the UK Listing Authority. These objectives in addition to some key operational performance targets are:-

to provide an appropriate level of protection for investors in listed securities;
to facilitate access to listed markets for a broad range of enterprise, and
to seek to maintain the integrity and competitiveness of the UK market for listed securities.

As I mentioned earlier, in discharging our functions we are also required by the Act under which we operate to have regard to, amongst other things, the international character of capital markets and the desirability of maintaining the competitive position of the UK. Our principal philosophy in meeting these objectives is to facilitate choice both for investors and issuers alike whilst maintaining appropriate levels of protection for investors.

The choice we provide is of course partly driven by the requirements of the EU Financial Services Action Plan (FSAP) and the directives that underpin this plan.

We, therefore, operate a disclosure-driven and principles-based regime where market participants are able to make informed investment decisions depending on the business model of the company or the risk appetite of the investor. Whilst our emphasis is on disclosure and therefore transparency, it is not the only building block. Our listing regime nevertheless comprises other features that ensure we keep our investor protection objective at the forefront of our minds. For example, the eligibility requirements provide that a company may not be admitted to the official list unless it has:

a trading record of three years, underpinned by audited accounts for that period,
a 'clean' working capital statement showing that it has the requisite working capital to stay afloat for the next 12 months, and
sufficient liquidity for secondary trading (25% of its shares must be in public hands).

These eligibility criteria have the support of the market as illustrated in the market survey on the work of the UKLA which we have just published in our newsletter, LIST!

Having met these criteria, a listed company must then disclose all the relevant information through a prospectus before a listing of its securities is permitted. We do not, however, generally determine on behalf of investors whether the risks disclosed by a company (which has become eligible and meets the disclosure requirements) are risks which investors should take. This is, quite rightly, a matter for investors and their own risk appetite. Thus, we do not assess 'suitability', only 'eligibility'. To do the former would create a false impression that all listed companies are 'risk free'.

The principles-based regime works because it encourages transparency and this is achieved through disclosure. Most importantly, it provides flexibility in the way listed companies organise themselves and are regulated. This, in my view, is the only way to successfully approach ever increasingly complex securities markets. Of course, it remains important to continually assess whether the listing regime remains appropriate in the light of how capital markets are developing, both in the UK and globally. We are witnessing significant growth in certain areas of the market and this growth represents the changing nature of our capital markets today and the global markets generally. Please let me provide you with some illustration: Whilst there has been a decrease in the number of companies issuing debt and equity securities, there has been an increase in the activities of debt issuers already listed. On the other hand, the number of overseas listed companies issuing Global depositary receipts (GDRs) has increased by about 21% since 2000. On AIM which, of course, is not a listed market, the number of companies trading on AIM have tripled since 2000 and overseas companies on AIM have grown by more than 10 times since 2000.

We announced last month that we want to engage the market in a wider debate about the structure and quality of the UK's listed markets, the rights of participants in them, and their relation to other markets both in the UK and overseas. This debate is against the background of a developing single European capital market and increased listing activity by non-UK domiciled companies in London. We plan to formalise this debate through discussions with stakeholders over the next few months, with the aim of publishing a document later on this year. In particular, we plan to develop our thinking about how we can achieve greater clarity over the regulation of various categories of securities (such as equities, GDRs, securitised derivatives and debt) that overseas and UK issuers and investors can now respectively list and access.

I have talked mainly about the public markets. Before finishing, I would like to touch briefly on hedge funds and private equity, both of which now play a material role in the functioning of capital markets.

Whilst hedge funds are not necessarily the biggest institutions, their impact is not to be underestimated. Given their active management, they can represent up to 50% of daily liquidity on the LSE. The funds themselves are, of course, not within our regulatory remit but the hedge fund managers are and we have over 300 managers in London, representing some 90% of EU hedge fund business. We believe we have designed a sensible fit for purpose regulatory approach for this sector, including a regular survey of prime brokers which helps us to assess leverage in the hedge fund market. But, of course, this is limited to UK prime brokers only and I welcome the comment yesterday by Ed Balls to discuss at the forthcoming G8 summit the extension to other major markets in order to collect aggregate data. Nevertheless, there are a number of policy questions which remain. In particular, the impact that the transfer of risk to them via credit derivatives and other financial instruments, which reduces the ability of regulators and central bankers to have a clear picture of where risk sits in the financial system. This raises real questions for our ability to monitor and manage financial stability. Other issues include the need to ensure adequate disclosure and accurate valuations and we have been putting in place a fit for purpose regulatory regime to deal with these risks in a proportionate way. This includes addressing the question of whether hedge funds should be available to retail investors. We don't believe there is a reason to prevent informed retail customers accessing this type of risk per se and we have recently issued a consultation paper on the retailisation of funds of alternative investment funds.

Moving on to private equity. In both of the last two years UK based private equity firms have raised over £33bn of funds, a larger figure than in the rest of Europe combined. Clearly this makes it a very important source of capital. Linking back to my earlier comments, there is a question about what impact the increase in private equity has on public markets. There are arguments that the increasingly active profile of private equity encourages market discipline through the push for shareholder value. There is also a question of whether it is reducing investor choice in the public markets and, of course, public policy concerns which go beyond our remit in respect of the impact on employees of private equity deals and transparency of private companies.

Conclusion

I hope I have gone some way to setting out the inter-connection between transparency and clarity of financial disclosure and principles-based regulation. It is, of course, the dynamism of market participants – both investors and the financial institutions - that brings about this success. Our part is to put in place a regulatory framework and adopt an approach that does not inhibit this success (and, where possible, facilitates it). And doing so whilst maintaining that all important balance with strong oversight, which is essential to maintaining market confidence. And I think we are well placed to do that. If you will permit me a brief moment of immodesty, I would like to quote the recently-published City of London report on The Competitive Impact of London’s Financial Market Infrastructure which noted that “The FSA has added significantly to this success by developing a regulatory system that is both intelligible and appreciated by the market community”.

Of course, we have some way to go to fully embed more principles-based regulation. We have, however, made a very positive start down this road and I look forward to more progress along that journey.

¹ Speech on the Competitiveness of the US Capital Markets at the Economic Club of New York, November 20, 2006.

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