Competition Commission's audit market reforms could actually deter borrowers from switching auditor, says expert

Lucy Shurwood of Pinsent Masons, the law firm behind Out-Law.com, was commenting as the Competition Commission (CC) published its final recommendations to improve competition in the market for supplies of statutory audit services to large UK companies. It has confirmed that competition in the market, which is dominated by the so-called 'Big Four' firms, is restricted, in  its final report.

In its final recommendations, the CC has retained a proposed prohibition on clauses in loan agreements that would limit the borrowing company's choice of auditor to a preselected list or category. In doing so, it had disregarded feedback on its provisional remedies from the Loan Market Association (LMA), the organisation representing stakeholders in the syndicated loan markets, which had objected to the inclusion of this remedy, Shurwood said.

"The LMA explained that lenders need to ensure that companies to which they lend are subject to appropriate audit services, which is why they include provisions in loan agreements relating to the identity of the auditors" she said. "If these provisions  are prohibited the only option for a borrower wishing to change its auditors is likely to  be to seek lender consent. This will be time-consuming and costly and is likely to deter borrowers from switching."

"As the LMA also notes, the prohibition could make it  impossible for lenders to include any mechanism in a loan agreement that pre-approves a change of auditors. Any list of pre-approved auditors will fall foul of the prohibition," she said. "However, the CC in its final recommendations has offered a possible solution by allowing the parties to require any auditor to meet "objectively justified criteria". Hopefully the CC will now issue some guidance about what this term means to allow lenders and borrowers to devise an acceptable approval mechanism."

As part of its work in the loans market, the LMA produces a suite of standard form syndicated loan agreements as well as related guidance and documentation. Its current standard 'auditor clause' states that a borrower must use one of [the Big Four], or any other firm approved in advance by the Majority Lenders.

In its response to the CC's report on provisional remedies, the LMA warned of the "adverse unintended consequences" of prohibiting the inclusion of any preselected list or category of auditors in a loan agreement. A "less intrusive measure requiring the deletion of specific reference to the names of the Big 4 firms in our template documentation" would achieve the desired effect while still allowing parties to agree "the parameters or an appropriate pool of acceptable auditors upfront", its submission said.

"If, as appears to be proposed, there can be no provision which has the effect of restricting a company's choice of auditor to certain 'categories' then it is not clear what, if any, guidance the LMA can provide to its members in relation to auditor selection," the submission said.

"For example, would a footnote to the template clause suggesting that a company under a cross-border loan arrangement should be audited by a firm with cross-border capability be prohibited as a 'categorisation' of eligible auditors? If so, we regard this as a very unfortunate outcome that would be clearly contrary to the interests of lenders, companies and shareholders," it said.

The 'Big Four' auditors are PwC, KPMG, Deloitte and Ernst and Young; and between them they earned 99% of the auditing fees paid by the top 100 companies by share capital in 2010. The Office of Fair Trading (OFT), the UK's consumer protection and competition regulator, referred the market to the CC in 2011, citing concerns about lack of choice, low levels of switching and substantial barriers to entry into the market by new firms.

The CC has now confirmed that competition in the market is restricted, partly due to factors that discourage companies from switching auditors and partly by the incentives auditors have to satisfy management rather than the needs of shareholders. It said that its proposed remedies in response to these findings would improve the bargaining power of companies and encourage rivalry between audit firms, as well as increase the influence of companies' audit committees and encourage shareholder engagement.

The main recommendation is a requirement for companies listed on the FTSE 350 to put their statutory audit engagement out to tender at least every 10 years. This is a considerable loosening of its provisional remedy, which would have required re-tendering once every five years, but still goes further than changes to the auditing rules introduced by the Financial Reporting Council (FRC) last year. The FRC requires companies to tender their auditing services every 10 years on a 'comply or explain' basis, meaning that they do not need to do so if they can provide an explanation to the regulators.

"After listening carefully, in particular to shareholders whose interests have been our main focus, and the FRC, we have decided that ten years is the appropriate backstop period for mandating that the audit engagement be put out to tender," said Laura Carstensen, who chaired the CC's market investigation.

"Whilst we think many companies would benefit from a greater frequency of five years (and that an increasing proportion would benefit from going to tender as the period since the last tender process lengthens), we have accepted that requiring this in all cases could dilute the benefits we all want to see. However, in keeping with the greater responsiveness to shareholders we are promoting, companies will be required to spell out when they next intend to hold a tender process if five or more years has elapsed since the last one," she said.

As auditors would now have to "prove their worth in a competitive tender process" in order to retain the company's business, mandatory auditor rotation was an unnecessary additional step, she added. However, the CC's work in this area may be overruled by the European Commission, which is currently discussing legislative proposals that could result in the creation of an EU-wide mandatory auditor rotation requirement.

The CC has also proposed tougher regulatory oversight by the FRC's Audit Quarterly Review team, and additional measures to strengthen the accountability of external auditors to the company's audit committee rather than management. Shareholders would also be expected to vote at the company's AGM on whether audit committee reports in company annual reports are satisfactory. It will now draw up an Order for those elements of the package that it can require and make recommendations to other regulators for the others, with the changes anticipated to come into force in the last quarter of 2014, it said.