www.pwc.

com

PwC Briefing document

Update on EC initiatives on corporate governance, reporting and audit policy

June 2011

PwC Briefing document

European Union initiatives on corporate governance, reporting and audit policy

The objective of this briefing is to provide an update on some legislative initiatives that are currently being debated by the European Union (EU), and could have a major impact on businesses. The initiatives include a review of corporate governance and reporting practices in the EU, and the way audit firms provide services to their clients. Boardroom practices are set to change if the current initiatives on corporate governance and audit are adopted. In this briefing we look at the possible impact of these elements of the EUs financial reform programme. The impact on individual companies may vary, depending on the existing national legal and corporate governance rules. Similarly, companies that are located outside the EU may be impacted only in an indirect way. Some of the ideas being considered would require affected companies to: review and change the way the board functions, alter their choice of and interaction with auditors, increase disclosure to shareholders, for example of the companys risk appetite.

Despite the extensive range of ideas put forward, surprisingly little attention is paid to the role of audit committees in overseeing, on behalf of shareholders, the integrity of corporate reporting and the auditors work. Most of the proposals covered in this briefing are currently only being considered and nothing is yet cast in stone. However, some of the initiatives are now well advanced and a few trends are becoming clear. Companies are encouraged to get involved in these debates and make their views known, as described later in this briefing.

The EU legislative process

The process for developing legislation is, in principle, relatively straightforward.

EC decides to examine an area of policy

Public consultation with proposed reforms

Private sector, academia, governments, regulators comment

Comments summarised and published (except where private)

European Parliament may comment

Proposals for legislation developed (possibly incorporating consultation results) and an impact assessment is published

In practice, the process for agreeing final legislation is far from straightforward - not least because of the complexity of agreeing proposals that are appropriate for all Member Sates and the political negotiation this necessarily entails. The European Commission (EC) has the sole power to propose EU legislation. Once a formal PwC proposal is made, it must be approved by a large enough majority of EU member state governments and by the European Parliament. The process of debating and amending the proposed legislation before approval typically takes nine to eighteen months. The initiatives covered by this briefing are progressing through this process, but even at this stage nothing is decided.

Update on EC initiatives on corporate governance, reporting and audit policy

PwC 1

PwC Briefing document

Financial sector and capital markets reform programme

As a response to the widespread series of collapses within the financial sector and the consequent impact on Europes capital markets, the EC has set in train a far-reaching programme to reform the financial sector and capital markets. Its aims are to reduce systemic risks, improve transparency and bolster confidence. Within the programme are three focal points for proposed change that, if adopted, would change how boards of directors operate: corporate governance and remuneration policies within financial institutions, external audit, corporate governance for listed companies.

The EC has issued a consultation paper, Green Paper, to deal with each of these topics. It has received substantial responses to the first two, with the comment period for the third open until 22 July 2011. Two EC consultations on other initiatives of interest, dealing with aspects of corporate reporting, are summarised at the end of this briefing.

Update on EC initiatives on corporate governance, reporting and audit policy

PwC 2

PwC Briefing document

1 Corporate governance and remuneration policies in financial institutions

The Green Paper Corporate governance in financial institutions and remuneration policies was issued in June 2010, following the ECs decision to examine a report on corporate governance practices in financial institutions before, during and after the financial crisis. The results of the consultation, which the EC is currently reviewing, have been published. The Green Paper considers how to: improve the composition and functioning of boards to improve supervision of senior management establish a risk culture at all levels, to ensure the businesss long-term interests are taken into account enhance the involvement of shareholders, financial supervisors and external auditors in corporate governance change remuneration policies to discourage excessive risk-taking.

The ideas to improve corporate governance in financial institutions that are likely to make headway include: limiting the number of directors board memberships requiring more specific expertise from board members strengthening the role of supervisors towards corporate governance structures mandating risk committees and strengthening the authority of the internal risk management function strengthening the legal liability of directors by expanding the net of what duty of care covers regulating or restricting stock options and golden parachutes separating the roles and responsibilities of the chairman and chief executive officer requiring auditors to be stricter when flagging serious issues to boards and their supervisors encouraging or compelling institutional investors to publish voting and engagement policies and records, and adhere to stewardship codes.

The Green Paper specifically considers the legislative proposals that might be necessary over and above those proposed in the 2005 and 2009 Recommendations for directors of listed companies (including directors of listed financial institutions) on the subject of remuneration policy, by asking a number of questions. Does the favourable tax treatment of stock options and other similar remuneration existing in certain member states encourage risk-taking? Should the role of shareholders, employees and their representatives in establishing remuneration policy be strengthened? Should severance packages (golden parachutes) be regulated at EU level, be prohibited, and/or awarded only to remunerate effective performance of directors?

Although the solutions explored within this Green Paper are considered to be relevant to all regulated financial institutions, particular emphasis is placed on the practices within banks and life insurance companies.

Next steps The European Parliament broadly supports the ECs proposals. A legislative proposal including an impact assessment will be published in July, focusing on strengthening the authority of a companys internal risk management function, the composition of board of directors and the role of supervisors of financial institutions.

Update on EC initiatives on corporate governance, reporting and audit policy

PwC 3

PwC Briefing document

PwC View
We believe that good corporate governance - in particular, effective audit committees - is critical to the auditor's successful representation of the public interest and investors.
The Green Paper contains a number of pragmatic ideas; but the introduction of prescription into the corporate governance framework at an EU level needs to be evaluated carefully, due to the complexity of different legal and regulatory arrangements across the EU member states. In this regard we primarily favour the use of corporate governance codes on a 'comply or explain' basis as regards financial institutions. We also support a strengthening of the role of supervisory authorities, in such a way that there is appropriate harmonisation of their practices and the adequacy of their resources throughout the EU.

Update on EC initiatives on corporate governance, reporting and audit policy

PwC 4

PwC Briefing document

2 External audit
The Green Paper Audit Policy: Lessons from the Crisis was issued in October 2010. The aim of the paper was to initiate a debate on the: role of the auditor governance and independence of audit firms configuration of the audit market supervision of auditors.

In its introduction, the Green Paper considers that an improved audit function would contribute to increased financial stability, restoration of trust towards institutions and improved market confidence, and greater investor protection. One aim is to increase the capability and capacity of smaller audit networks to be able to handle the audits of large complex institutions. The EC has also launched two external studies to assess the implementation and impact of current EU audit legislation and to gather data on the structure of the audit market. The results of the studies are due to be available in the autumn. In our view, the more likely ideas to be tabled by the EC which would directly impact the role of Boards of Directors include the following: requiring audits to provide comfort on the financial health of companies requiring auditors to provide a higher level of assurance to stakeholders improving communication between external auditors, internal auditors and the audit committee establishing a mandatory time limit on continuous audit firm engagements by mandatory rotation or mandatory tendering further restricting by legislation the provision of non-audit services by audit firms to companies they audit obliging companies to appoint two different firms as joint auditors, perhaps with one being a smaller firm mandating communication between auditors and the relevant securities regulator for all large or listed companies.

In addition we expect the EC to make proposals in areas such as the supervision of audit firms and measures to reduce the likelihood or impact of a failure of a major firm. There are also a number of other ideas considered in the Green Paper which could be reflected in draft legislation, such as the appointment of auditors by a third party rather than by the Board of Directors and more specific measures designed to restrict the audit market share of existing major firms.

Next steps On 22 June, the European Parliament is scheduled to vote on a detailed report on the Green Paper. The EC is currently working on policy options for proposed legislation and possible nonlegislative measures. The EC currently expects to publish this outcome together with an impact assessment in November 2011.

Update on EC initiatives on corporate governance, reporting and audit policy

PwC 5

PwC Briefing document

PwC view
PwC believes there is much to be gained from a serious in-depth consideration of how to enhance the role of audit to meet the changing needs of the capital markets, audit quality and confidence in audit. However, a number of the concepts in the Green Paper may not improve audit quality and may unnecessarily increase costs and administrative burdens for companies. We believe that reforms and changes should be supported by empirical evidence of the extent to which they would be more effective in meeting the needs of those who rely on auditors work. Measures with unclear cost benefit analysis should be subject to proper impact assessments to justify effectiveness and efficiency. Also, we welcome the recent report by a Committee of the European Parliament which calls on the Commission to strengthen the role of audit committees.

Update on EC initiatives on corporate governance, reporting and audit policy

PwC 6

PwC Briefing document

3 Corporate governance for listed companies

The Green Paper The EU corporate governance framework was issued on 5 April 2011. The ECs view is that corporate governance, based largely on self-regulation, could be more effective and that companies should be better run and therefore more competitive. The Green Paper seeks to improve the: professional, cultural, national and gender diversity within boards quality of corporate governance statements monitoring and enforcement of existing national corporate governance codes level of stakeholder engagement with companies.

The initial ideas to improve corporate governance include: fostering increased shareholder interest in holding management to account introducing specific requirements for smaller listed companies developing voluntary codes for unlisted companies publishing a board diversity policy limiting the number of non-executive directorships evaluating board effectiveness disclosing individual directors remuneration shareholder voting on the remuneration report and remuneration policy issuing reports to shareholders on risk appetite, including key societal risks protecting minority shareholders through additional rights explaining in detail departures from applicable corporate governance codes.

Unfortunately the EC has not considered in this Green Paper how the role of audit committees could be further enhanced. As the consultation process has only just started, it is too early to identify which of the ideas may end up in legislation. Companies are encouraged to make their views known, by responding to this consultation either on their own behalf or through a business association.

Next steps Comments to the EC are due by 22 July. These comments will be summarised and published by the EC. Thereafter, the EC will consider the comments, including any from the European Parliament, and in due course (possibly towards the end of 2011) announce how it intends to proceed.

PwC view
PwC will be submitting a response to this Green Paper. We would welcome the views of our clients as we develop our views. We will however be emphasising the important role that can and should be played by Boards of Directors, in particular through important Board committees such as Audit and Risk, in enhancing the quality of corporate reporting and audit.

Update on EC initiatives on corporate governance, reporting and audit policy

PwC 7

PwC Briefing document

4 Further initiatives of interest

EC consultation on country-by-country reporting by multinational companies
The EC conducted a public consultation between October and December 2010 to gather stakeholders' views on imposing additional transparency requirements on large European companies operating outside the EU. Two types of disclosure could be considered in this context. The first is country-by-country tax reporting by multinational companies. The main goals of such disclosure would be to help investors better assess the different national activities of multinational companies and to enhance transparency about capital flows, for instance, to better enforce tax rules. The second type of disclosure is specific transparency obligations for companies that are active in the extractive industry (minerals, oil and gas) in countries outside the EU. The main goal of such disclosure would be to provide more transparency about the payments made by the extractive industry to governments in those countries. Some EU-based companies active in the extractive industry are listed in the US and will therefore be subject to this legislation. In the US, all extractive companies listed on US stock-exchanges are already required to publish similar information under the US Dodd-Frank Act. NEXT STEPS According to the EC, an impact assessment is currently being prepared and will be published in due course.

EU consultation on non-financial reporting

The EC has published a public consultation on non-financial reporting. Its objective is to improve existing policy on disclosure of corporate social and environmental information, and respect for human rights. The consultation includes suggestions for new initiatives and revised legislative measures. In April the EC published a summary of the responses received to this consultation. A majority of respondents suggested that better information on the following aspects are relevant; (1) whether or not the company has a CSR policy (and if so, how it is implemented), (2) the principal business risks and opportunities arising from social and environmental issues and how these are taken into account in company strategy, and (3) key information on other specific issues. Respondents generally considered that there could be value in reporting on non-financial aspects based on overall principles such as those established by GRI, UN Global Compact, the OECD Guidelines, ISO 26000 etc. On the issue of which companies should be covered by enhanced requirements, the majority of respondents recognised the importance and relevance of company size. A significant majority argued in favour of excluding small businesses from mandatory requirements. Whether or not a company is listed on financial markets was not considered to be of great relevance. NEXT STEPS The EC will consider possible actions in the coming months.

Update on EC initiatives on corporate governance, reporting and audit policy

PwC 8