Year: 2008

These are difficult times for Thailand. Last year’s military coup was a major shock in a country that foreign investors regarded as relatively stable. Since taking power, military leaders have made worrying noises about shutting the door to investors from overseas. The new government is insisting that it will press ahead with changes to investment laws that would make it harder for foreigners to control Thai companies, even though its trading partners believe they would breach the country’s commitments to the World Trade Organisation. But Pridiyathorn Devakula, the government’s leading economic policymaker, has been trying to play down the effect of the plans, saying they are simply closing a loophole in existing rules and that foreign manufacturers, exporters, or companies with investment privileges would be unaffected.

Restructuring
Even so, foreign executives are unsettled. Several have appeared in media reports saying that it is too early to know whether the changes would force them to sell some Thai holdings or not. The British Chamber of Commerce, meanwhile, has said all foreign investors would be “forced to divest shares currently held by nominees.” That would leave some firms with a choice of selling down their holdings to be truly Thai-owned, or of restructuring and applying for licenses to operate as a foreign-owned company. Western diplomats complain that the legal overhaul would give Bangkok too much control over the activities of foreign companies. One diplomat told the Washington Post that the government was “playing with matches.” He added; “It is a clear policy decision that at least in the service sector Thailand will be a closed market and foreign capital will only be authorised if it is a minority both in shareholding and in control.” Yet the government insists it does not want to limit inward investment. Mr Devakula has insisted that the government was forced reluctantly to overhaul the laws after the furore that surrounded Temasek Holdings’ takeover of Shin Corp, the telecommunications empire founded by ousted former Prime Minister Thaksin Shinawatra. Last year, the commerce ministry ruled that Temasek had violated Thai foreign equity restrictions and asked police to investigate – alarming other foreign companies using similar structures for their Thai holdings. The legal changes relate to Thailand’s Foreign Business Act 1999, which regulates the rights of foreigners to carry on certain businesses in Thailand. The details of the act are quite complicated, but the basic structure is simple, according to a briefing produced by lawyers Herbert Smith.

Governmental approval
Foreigners are prohibited from carrying on certain businesses that are especially reserved to Thai nationals. These ‘list one’ businesses include, for example, media ownership and certain farming activities. Foreigners are also prohibited from carrying on other ‘national interest’ and similar businesses without government approval. These ‘list two’ businesses include weapons production, domestic transportation and domestic airlines, mining, and Thai arts and cultural activities. Finally, and of greatest impact in practice, according to the lawyers, foreigners are prohibited from carrying on various other businesses without official permission. These so-called ‘list three’ businesses include accounting, legal and other professional services; advertising businesses; many construction and engineering services; retail and wholesale businesses, with some exemptions; hotel ownership; and other service businesses. The government’s plan is to change the act, and draft proposals are working their way through the legal system. “It is not clear when these changes may come into force, though it is likely to take several months. Neither is it clear what form they may finally take,” says Herbert Smith. “The current proposals have attracted significant criticism in Thailand and overseas, and there is scope for further changes during the legislative process.” The controversial element of the changes to emerge so far is that ‘foreigner’ will be redefined under the act. Currently, a foreigner is a foreign national, a foreign-registered company or a Thai company with majority foreign shareholding. Under the new proposals, this definition will be extended to include companies that are currently treated as Thai due to majority Thai share ownership but where foreign individuals or foreign companies have more than half of the voting rights by law, agreement or under the articles of association. Many foreign businesses have previously adopted such structures in order to be treated as Thai while maintaining effective foreign control of the business. This enabled them to carry on a business in list one, two or three without having to comply with the Foreign Business Act. “The effect of the proposed amendment will be to re-classify such companies as ‘foreign’ and therefore to bring them within the scope of the Foreign Business Act,” says Herbert Smith. “They will therefore become subject to all of the restrictions that apply under that Act.” Foreigners wishing to set up a new Thai business after the changes come into force will have no choice but to comply with the amended law. That is why worried observers have said that the revised law will deter new foreign investment. “There is concern that the extended scope of the Foreign Business Act will deter foreigners from investing in Thailand and will encourage them to look elsewhere,” says Herbert Smith. “It remains to be seen whether these fears are well-founded.”

Notification date
However, the lawyers point out that for businesses already operating in Thailand, the draft amendments contain important relief’s. Any such company that falls within the scope of the Foreign Business Act will have one year from the effective date of the act to notify the Ministry of Commerce of that fact and to apply for a certificate to continue trading. The criteria for getting a certificate are not yet known. But once a company gets one, those from list one or list two activities will have two years to restructure their shareholdings or voting rights in order to ensure full compliance with the law. Those engaged in list three activities will be allowed to continue to operate indefinitely, without any need to restructure, until the business is finally dissolved. Herbert Smith says that this ‘grandfathering’ arrangement could mean that businesses already operating in Thailand will be able to continue under corporate structures that will not be permitted to new market entrants, unless they apply for permission under the new laws. However, there’s not enough information to know yet, they add. The changes to the law also propose a redefinition of what types of business fall into the list three category. “Primarily, this is simply to remove certain businesses that are now regulated under other laws, but one very important change is to remove an exemption that previously applied to retail and wholesale businesses with capitalisation above prescribed levels,” says Herbert Smith. “All retail and wholesale businesses will now be included, irrespective of capitalisation.”

Maximum fine
Finally, the new proposals will significantly increase the fines that may be imposed on Thais and foreigners found to be in breach of the amended Act, including directors and shareholders who connive in the commission of offences or who do not prevent the commission of offences. The maximum fine will be raised to five million baht, which is around $140,000. Despite the legal changes, Prime Minister Surayud Chulanont, an army general, has been telling foreign businessmen and diplomats that the country welcomes foreign investment and businesses. He told a lunch organised by the Joint Foreign Chambers of Commerce in Thailand that changes to the Foreign Business Act and capital control measures were meant to strengthen transparency and good corporate governance within Thailand. He said the moves were just part of the government’s efforts to create a level-playing field and remove obstacles to foreign investment activities. While uncertainty always worries investors, Thailand’s underlying economic performance has remained strong. According to the latest edition of the Asian Development Bank’s Thailand Economic Monitor, the country’s GDP growth will remain at 4.5 percent in 2006, the same as in 2005. High export growth has greatly contributed to Thailand’s economic performance, even as domestic demand has remained depressed. Growth this year is expected to be 4.6 percent – a notch higher than 2006. Domestic demand is expected to perform better, but export growth will be held back by lower growth in the global economy and world trade.

Economic crisis
Looking back further, average GDP growth has fallen from the six percent levels achieved in the years between 2002 and 2004. “This is in part because the easy gains from utilisation of post-crisis excess capacity are over,” says Kazi Matin, World Bank Lead Economist for Southeast Asia – referring to the country’s 1997 economic crisis. “Higher growth can now come mainly from efficient adjustment to high oil prices, higher private investment to expand capacity,” he added. “As a middle income country, Thailand’s growth must come more and more from more rapid productivity growth, and for that the firms have to innovate products and processes, the workers have to acquire more skills to compete with labour in China, Vietnam, India and other competitors producing technology intensive goods, and the government has to urgently support these initiatives of firms and workers through policies and investments.” Thailand needs to focus on supply-side reforms to promote private investment and higher productivity growth and several measures can be taken quickly with good effect, he says. Reducing regulatory burden is one and this could include rationalisation of price controls, clarification of foreign ownership rules, speeding up customs processing, and so on. Renegotiating a US trade deal that is about to expire and signing a treaty with Japan are two steps that would help to sustain strong export growth. Similarly, supporting improvements in secondary education, and vocational training including English language and IT skills and promoting greater private participation in education service delivery can relax skill-constraints that companies have said are holding back investment and productivity growth. Also, actions to improve infrastructure services could reduce costs and raise rates of return to private investment. Can all that be achieved? Despite the recent crisis, “Thailand’s strengths in terms of sustained macro-stability and increasing openness remain,” says Dr Kirida Bhaopichitr, country economist and author of the Thai Economic Monitor. The fiscal situation remains strong, with the government running a balanced budget this year and a slight deficit next year,” he said. Public debt as a share of GDP is 41 percent and is projected to remain below 50 percent over the next five years. Dr Bhaopichitr also said that Thailand’s external vulnerability is low – with a current account in surplus and pre-coup foreign reserves standing at $59bn. Also, total external debt is around 28 percent of GDP, one of the lowest levels in the region. A military coup is hardly the sort of event to settle investors’ nerves, but Dr Bhaopichitr says that “political uncertainty has diminished” since the interim government was established in October. “Nevertheless, both consumers and investors are waiting to see the policy direction of the interim government.” 

After a depressingly dismal spell, a spectacular return to corporate deal making last year gave a knock-on boost to global foreign direct investment levels. The outlook is good for this year too, with another big increase expected, although some countries are set to benefit far more than others. Foreign direct investment (FDI) inflows surged ahead in 2006, clocking up the third consecutive annual increase, according to figures produced by the United Nations. The total for 2006 was $1.2trn, a 34 percent increase on 2005, and just a few deals shy of the record $1.4trn set in 2000. The rapid rise in FDI flows largely reflects high economic growth and strong economic performance in many parts of the world, according to the United Nations Conference on Trade and Development (UNCTAD), which calculates the figures. Such growth has occurred in both developed and developing countries. Increased corporate profits and resulting higher stock prices have boosted the value of the cross-border mergers and acquisitions (M&As) that constitute a large share of FDI flows. UNCTAD said continued liberalisation of investment policies and trade regimes gave FDI levels a further kick. But there are warning signs, too. In some African and Latin America countries there were notable changes in economic policy towards a greater role for the state, says UNCTAD, as well as changes in policies that directly concern foreign investors or industries, in particular the natural resources industry. These are likely to depress FDI growth.

Recovered position
FDI performance has varied greatly among regions and countries. Investment in developed countries rose by 48 percent last year, well over the levels of the previous two years, and reached $800bn. The US recovered its position as the largest single host country for FDI in the world, overtaking the UK, the top FDI recipient in 2005. The European Union (EU) as a whole continued to be the largest host region, accounting for 45 percent of total FDI inflows in 2006. But UNCTAD warned that several risks for the world economy – most of them not new – may have implications for FDI to and from developed countries. Global current-account imbalances have widened dramatically and could cause abrupt exchange-rate shifts. High and volatile oil prices have caused inflationary pressures, and a possible tightening of financial market conditions can’t be ruled out. High fiscal deficits in Europe, in combination with rising interest rates, could lead to tax and wage pressures. “All these considerations underline the need for caution in assessing future FDI prospects for developed countries,” it said. For now, these countries are doing well. FDI inflows to developing countries and economies in transition – which comprises south-east Europe and the Commonwealth of Independent States – rose by 10 percent and 56 percent, respectively, in 2006. Those are both record levels. In Africa, FDI inflows in 2006 exceeded their previous record level of 2005. “High prices and buoyant global demand for commodities were once again a key factor,” says UNCTAD, “particularly in the oil industry, which attracted investment not only from developed countries but also from some developing countries.” Cross-border M&As in the extraction and related service industries of Africa tripled in the first half of 2006, as compared to the same period in 2005. However, UNCTAD warned that, “the regional FDI picture is not uniformly bright across sectors, countries and sub-regions.” Most of the inflows are concentrated in the West, North and Central African sub-regions. “Inflows will continue to be small in low-income economies lacking natural resources,” it said. FDI inflows to Latin America and the Caribbean slowed in 2006. Mexico and Brazil, in that order, remained the largest recipient countries with inflows remaining virtually at the same level in Mexico and increasing by six percent in Brazil, in spite of a fall in cross-border M&As. FDI inflows to Chile increased by 48 percent due to a continued rise in reinvested earnings resulting from windfall benefits from mining. FDI inflows to Colombia and Argentina decreased by 52 percent and 30 percent, respectively, because of a decrease in cross-boarder M&As.

Additional changes
In the Andean countries, growing demand for commodities and resulting higher prices propelled changes in policy in the direction of more control by the state. That resulted in less favourable fiscal regimes for investors in such countries as Bolivia, Ecuador, and Venezuela. The possibility of additional regulatory changes and of their extension to more countries may have raised uncertainty among investors in the primary sector, resulting in the decrease in FDI flows to the region. In addition, high commodity prices and resulting improvements in current-account balances have led to an appreciation of the value of many countries’ currencies. That could affect prospects for FDI in export-oriented manufacturing, said UNCTAD. FDI inflows to South, East and South-East Asia, and Oceania maintained their upward trend in 2006, reaching a new high of $187bn, an increase of 13 percent over 2005. Investments in high-tech industries by trans-national corporations (TNCs) are growing rapidly, particularly in China. Meanwhile, other countries, including India, are attracting increasing FDI for traditional manufacturing. At the sub-regional level, a shift continues in favour of South and South-East Asia. China, Hong Kong and Singapore retained their positions as the three largest recipients of FDI in the region. India surpassed the Republic of Korea and became the fourth largest recipient. Outward FDI from the region surged with China consolidating its position as an important source of FDI. India is rapidly catching up, with 2006 FDI outflows almost doubling. China and India are challenging the dominance of Asia’s newly industrializing economies as the main sources of FDI in the developing world. In West Asia, FDI flows, both inward and outward, maintained their upward trend in 2006. Turkey and oil-rich Gulf States continued to attract most FDI inflows, accounting for a record level in 2006 in spite of geopolitical uncertainty in parts of the region. Energy-related manufacturing and services were the most targeted industries. FDI outflows from the region increased, mainly from the Gulf countries led by the United Arab Emirates. Cross-border M&As, particularly by state-owned enterprises, continued to be the main mode of outward FDI. Such outflows are increasingly taking place in energy-related activities, supported by the region’s tightening ties with China and India and other economies in Asia and Africa.

Buoyant
After a minuscule increase in 2005, FDI inflows to the 19 countries of South-East Europe and the CIS expanded significantly in 2006, the sixth year of uninterrupted growth of FDI in the region. The Russian Federation, the region’s largest host country, experienced a mini-boom, with inflows almost doubling. UNCTAD says that FDI is likely to be particularly buoyant in the countries that joined the EU on January 1, 2007 – Bulgaria and Romania – and in the large economies such as the Russian Federation and Ukraine. FDI prospects for the Russian Federation are, however, affected by the impact of tightening Russian natural resource regulations and by disputes that emerged in 2006 over environmental protection and extraction cost, such as those involving two major oil development projects in Sakhalin. “It is uncertain whether large increases in such sectors as chemicals and petrochemicals, services, and real estate – categories where investor confidence is currently high – could fully compensate for a possible slowdown of oil-related FDI,” said UNCTAD.

One of the most significant developments in FDI over the past two or three years has involved natural resources and related industries. Despite some bad news for foreign investors in such industries, high demand for natural resources – and, as a result, the opening up of new potentially profitable opportunities in the primary sector, such as gas and oil development in Algeria – are likely to attract further FDI to the extractive industries. Economic growth in 2007 is projected to slow moderately. Continuing global external imbalances, sharp exchange rate fluctuations, rising interest rates, and increasing inflationary pressures, as well as high and volatile commodity prices, pose risks that may also hinder global FDI flows. Combined, those factors “could lead to a slowdown in the fast growth in global FDI registered over the past few years,” UNCTAD believes.

The UK’s reputation for cracking down on bribery and corruption has taken a battering in recent months. The decision to halt a police investigation into allegations that defence company BAE Systems bribed officials in Saudi Arabia to secure a lucrative contract provoked international outrage. Now the government has reneged on a promise to introduce new anti-corruption laws this year.          

The Serious Fraud Office (SFO) stopped the Saudi part of its BAE investigation in December after the Attorney General, Lord Goldsmith, advised that, if continued, it would threaten national and international security. The SFO is still investigating other allegations against BAE involving South Africa, Tanzania and the Czech Republic. The company denies any wrongdoing.

Lord Goldsmith didn’t elaborate on the nature of the security threats created by the Saudi probe, but stressed that commercial or national economic interests had nothing to do with the decision.

If such factors had been taken into account, the government would have fallen foul of section five of the OECD Convention on Combating Bribery of Foreign Public Officials. The convention, introduced in 1997, is part of an effort to get countries around the world to enact anti-bribery and corruption legislation similar to the US Foreign Corrupt Practices Act. The United Nations has produced a similar Convention Against Corruption for countries not in the OECD.

Bribes
Laurence Cockroft, UK head of anti-corruption lobby group Transparency International, describes the BAE decision as ‘a huge setback’ in efforts to get governments to tackle bribe-paying companies. Despite what the government says, the block on the enquiry has been seen around the world as an act of political expediency, he says, creating the impression that “the guys with the big bucks, in this case the Saudis, can call the shots.”

In a letter to the head of the OECD, the group said the decision to stop the Saudi investigation “poses the most serious threat to the success of the OECD Convention since it was adopted. The credibility of the UK Government commitment to prohibit foreign bribery must be rebuilt, in order to restore the collective commitment on which the success of OECD Convention depends.”

Transparency International now wants the government to make BAE publish a statement clarifying the business practices it has in place to prevent bribery and corruption, and what steps it takes to ensure compliance is independently verified. “It is essential to clear the air for future international transactions,” the group said.

Like many other countries around the world, the UK has done little to enforce the OECD convention. According to a Transparency International monitoring report, the UK has not brought a single prosecution for bribery of overseas officials. The group’s latest report – for 2006 – found no prosecutions in Australia or Japan and only one in Canada. But other countries are starting to become more active. France prosecuted eight cases in 2005, with three in Germany and three in Belgium.

Annoyed at the BAE decision, the OECD has decided to launch an inquiry into the UK’s efforts to fight bribery.
Its working group on bribery and corruption, which brings together all 36 countries that have signed and ratified its convention, said in a recent statement that the UK had made some progress, but not enough. The government has made efforts to raise awareness of the issue, but has repeatedly failed to enact modern foreign bribery legislation. The Working Group said it was ‘seriously concerned’ that the UK hadn’t implemented legal changes requested by the OECD. In addition, UK law on the liability of legal persons remains deficient and the Working Group reaffirmed that it should be modified. 
In 2005, the Working Group recommended that the UK monitor decisions not to open or close foreign bribery investigations.

Remaining vigilant
Ironically, before the Al Yamamah decision caused such a furore, the UK had shown signs of raising its game. In December 2005 the Home Office set out proposals to reform the law on bribery, at home and abroad. “Although the crime of bribery remains relatively rare in the UK, it is vital that we, through our actions and principles, remain vigilant and promote high standards of propriety at home and abroad,” Home Office Minister Fiona Mactaggart said at the time.

Ms Mactaggart noted that in 2001 the government gave courts the power to investigate overseas, but said the existing criminal offences stem from the common law and the Prevention of Corruption Acts 1889-1916 and are widely considered to be fragmented, outdated and unclear. They are not used often, and a lack of clarity in legal definition can lead to acquittals on technicalities. The government wants to ensure that UK nationals and companies do not contribute to bribery in other countries, and clarifying the law will make investigating corrupt activity easier, she said, adding: “The existing law is complex and outdated, and can be difficult for law enforcers to use. I want to make the law clearer for all concerned.”

There were further positive steps six months later when Prime Minister Tony Blair unveiled new measures to tackle international corruption. He appointed Hilary Benn, the International Development Secretary, to be the ‘ministerial champion for addressing international corruption.’ This new role would see him “working with other Ministers across government to tackle corruption wherever it threatens to undermine the fight against poverty.”

At the same time, Blair said the government would establish a new team to investigate international corruption, including money laundering in the UK by corrupt politicians from developing countries, and bribery by UK businesses overseas. This would include members from the City of London Police and the Metropolitan Police Service, funded by the Department for International Development. “The UK has a responsibility to tackle money laundering and bribery where it stems from our own shores, and to support developing countries in fighting corruption,” said Blair. “We have to recognise that where there are bribe takers, there are also bribe givers. The new taskforce for investigating corruption will help to put the UK at the forefront of efforts to tackle international corruption in all its forms.”

But in March this year a vital part of these efforts – the legal reforms led by the Home Office – was postponed. After at least three years of consultation, the government said there was broad support for reform of the Prevention of Corruption Acts, and that it was committed to a fundamental reform of our bribery laws, but it would not push ahead with the draft Bill it published in 2003.

Home Secretary John Reid told the House of Commons there was ‘significant and influential opposition’ to the Bill and it was unsuitable for presentation to Parliament. The problem, he said, was a lack of agreement about what the new offences should look like. Instead, he asked the Law Commission to undertake a thorough review of the UK’s bribery laws “with a view to fundamental reform.” The Commission has already considered the issue at length, but Reid said that “the context of reform has moved on.” In particular, the Commission will take into account “the issues and views that have emerged” since the Bill was published, including “additional practical experience of UK law enforcers in operating the existing law and other countries’ experience of implementing international conventions in this area.”

Cockroft says the referral back to the Commission was ‘very bad news’ and ‘absolutely ridiculous.’ There is unlikely to be a new draft bill before the end of 2008. “They are going to be at least two years behind their own deadline, and this creates a lot of uncertainty.” Transparency International has contributed to a Private Member’s Bill on corruption that Lord Chidgey has introduced to Parliament. This defines the necessary offences perfectly well, says Cockroft. And while some countries might be slack to prosecute overseas bribery and corruption, the US has prosecuted over 100 cases over the last two year. Cockroft, and other campaigners, says the UK needs to show that it is still committed to fighting overseas corruption. He wants so see accelerated legal reform but, more importantly, some prosecutions. Otherwise, the UK risks not only damaging its own anti-corruption goals, but also undermining the efforts of countries that are starting to take the issue more seriously.

High-profile
The halting of the Saudi probe is frustrating for anti-bribery campaigners because it comes at a time when other EU countries have started to pursue high-profile investigations. In Germany, engineering giant Siemens is embroiled in claims that staff paid bribes to win contracts. In France, the authorities have become much more active, encouraged by the successful prosecution of two senior employees from oil company Elf Aquitaine, including its CEO, who were sent to prison for paying bribes to win overseas contracts.

Such activity seems long overdue. It’s now 10 years since the OECD published its Convention, and all of its member nations are committed to implementing its measures. But, to date, most have done little. Since 2005, Transparency International has published a progress report on enforcement of the Convention. Last year it had little activity to report. France had prosecuted eight cases, with three in Germany and three in Belgium. But Italy only had one, and the UK had none at all. The situation was worse in the Czech Republic, where the authorities had brought no prosecutions and hadn’t even started any investigations.

Other countries have shown what can be done. A week after it chastised the UK for its inaction, the OECD praised Norway for the progress it has made towards implementing the convention. It published a report commending the country’s ‘impressive effort’ and said Norway had satisfactorily implemented all of the OECDs recommendations.

The country has raised awareness and improved corruption detection measures. It has also brought two successful prosecutions involving the bribery of foreign public officials. In the first case, the defendant company and an executive of the company were fined €2.4m and €24,000 respectively. In the second case, three defendants were convicted of violating bribery laws and sentenced to imprisonment for periods of between ninety days conditional and 14 months (of which four months were conditional).

Corruption team
Norway has also taken significant steps to enhance the institutional framework for investigating and prosecuting cases of corruption. For instance, the Corruption Team at the Norwegian National Authority for Investigation and Prosecution of Economic and Environmental Crime has been permanently assigned a police solicitor, and all local police districts have established multi-disciplinary economic crime sections, which will be closely monitored by the Ministry of Justice, Police Directorate and Prosecution Service.

Other measures include the production of a manual by the corruption team, for publication in 2007, on the detection, investigation and prosecution of corruption cases. There has also been a heightened focus on the confiscation of the proceeds of crime, reflected in a significant increase in the number of confiscation orders. If international efforts to tackle bribery and corruption are to succeed, more countries need to show the same kind of enthusiasm as Norway. The UK’s lame performance is so troubling to the OECD because it gives other laggard countries a further excuse to do nothing.

Internal control has been a major bugbear for big companies lately. The Sarbanes-Oxley Act has forced anyone with a US listing to put hundreds of checks in place in an effort to guarantee that their financial statements are correct. Most have shoveled money into the problem. One argument is that much of this investment is wasted, and the compliance burden is too heavy. The implication is that regulators think internal controls are a good idea, but businesses don’t.

If that were the case, then those companies not forced to tighten up their controls by legislation or regulation wouldn’t be putting more of them in place. The fact is, they are. Three quarters of the companies are planning to invest more in internal control, according to a new survey by accountants Ernst & Young. The survey covers large businesses that do not come under the Sarbanes-Oxley rules. They are spending in this area because they see real business benefits, the accountants say.

“There is now widespread recognition that effective internal control directly impacts business performance in a number of areas,” says Adrian Godfrey, of Ernst & Young’s Risk Advisory Services. “What arises from the survey is that this is a highly dynamic area, with management exploring the ways that taking a more professional approach to internal control can contribute to driving competitive advantage.”

No surprises
One reason why companies are investing more in this area is that investors are calling for more transparency and ‘no surprises.’ They are fed up with companies restating their financial results or fouling up in an area that damages their reputation. Half the respondents in the survey said they were taking controls more seriously because it had a positive influence over investor confidence.

Other drivers for future investments were also business-benefit related, focusing mainly on enhancements to processes and the underlying control structure and on better understanding of major risk areas. These investments are most likely to be in key operational and business risk areas, and specifically in information technology controls.

One in four of the respondents said they were seeking to achieve better alignment of their internal controls to company strategy and the key risks they face. The same proportion were planning to invest in strengthening their company-level controls, such as activities conducted by senior management to set direction – such as policy and tone from the top.

Spending on controls might make investors feel more comfortable, but only if they believe those controls are actually going to make a difference. Many chief finance officers and heads of internal audit in the Ernst & Young survey admitted they still had ineffective controls. The biggest ‘blind spots’ related to over-expansion into international markets, post-acquisition integration, and real estate and construction projects. Controls over IT program change management and user access and security were also singled out as areas of concern.

Even in the area where companies say they are doing well – financial reporting controls – that confidence has to be doubted. In general, the majority of financial reporting activities were seen as areas over which most respondents felt that they had effective controls. Responses attesting that controls were either ‘very effective’ or ‘effective’ ranged from a high of 79 percent for revenue recognition, to 52 percent for contract accounting. However, in all cases, the proportion of respondents claiming that controls were ‘very effective’ was relatively small.

In areas that required a greater degree of judgment or specialist technical knowledge, such as tax and contract accounting, companies admitted to weaknesses or a lack of knowledge about the controls in those areas.

Controlling the situation
The areas where all the companies clearly felt a lot less confident in what they were doing were those relating to business and operational areas. Less than half the respondents said they had effective controls over situations such as expansion into new markets, and post-acquisition integration. These are clearly not trivial issues. Given that these activities are strategic in nature and therefore fundamental to business success, Ernst & Young say it is a worry that survey respondents query the effectiveness or, worse, are unaware of controls.

“This suggests a mismatch between risk priorities and the controls structures and accountabilities to support them,” their report says. “It is possible that capabilities and knowledge required to assess control in certain business areas may not be available to the functional area – likely to be internal audit – charged with this role and may reveal some ‘blind spots’ beyond the scope of controls professionals who are generally tasked with providing an opinion of the overall internal control environment.”

Companies were also performing badly in the information technology area. Again, a lack of relevant skills and knowledge contributed to poor levels of control. The survey found that critical issues such as user access and security – where 39 percent believed their controls to be less than effective and nine percent did not know or failed to answer the question – were a source of potentially major risk for all businesses.

“The criticality of information technology systems across the business and the considerable investments required in information technology are obvious drivers of the need to make sure that controls are effective,” the report said. “The results of the survey show that there is a pressing need to assess risk and establish greater control in these areas and to make sure that once established, control is maintained, particularly given the role that effective information technology plays in improving processes and efficiencies.”

The last big problem area was fraud. Nearly three quarters of the companies in the survey did not have a formal fraud prevention programme in place. That contrasts with the fact that over a third said such a programme was important or very important. In that case, why haven’t they got one? This is a particularly worrying finding given the growth in corporate fraud over the last few years and the reputational havoc a fraud can inflict on a company, even if the amount of money involved is small. These organisations really ought to be looking for ways to make anti-fraud measures more comprehensive and integral to their operations.

Risk and control
Though there is obviously an awareness of the need to invest further in controls in many of these areas, it is critical that senior management take as broad a ‘risk and control’ view as possible of all the business and operational functions that have an impact on bottom-line performance, say Ernst & Young.

The survey showed that executives felt there was ‘significant scope for improvement’ in just about every category of internal control. More worrying still was the high level of respondents who replied ‘don’t know’ to the questions about how well their controls were working.

“If the ‘control professionals’ are saying they don’t know what is going on, that’s a major concern for the board and other stakeholders in the business,” says Mr Godfrey. He adds that many companies acknowledged the danger of these blind spots. They were planning to invest in these areas over the next year.

There is no point having controls in place if nobody checks to see if they are working. Most respondents had a good approach to this. They monitored controls in a balanced way, making survey’s that covered strategic, compliance, operational and financial reporting areas. But a significant number are getting it wrong: one in five said they only monitored the controls that made sure their published financial statements were correct.

“This imbalance could mean that controls over some major operational risks may not be receiving any real scrutiny,” says Mr Godfrey. Some companies seem unclear about just what they are doing in this area. The survey suggests that the perception of the status of internal control varies depending on who you ask. While 36 percent of CFOs responding to the survey said that their risk assessment covers operational and business areas, only 19 percent of heads of internal audit believed that these risk areas are assessed in their companies.

That overlap needs urgent attention. “CFOs are beginning to ask questions about where to take the controls agenda wider than compliance,” says Inge Boets, global business risk services leader for Ernst & Young. “The answer is to shift the balance between financial controls and wider business and operational controls.”

Internal infrastructure
There are significant benefits for the companies that can tackle this, she says. “Establishing an internal control infrastructure that effectively covers all parts of the organisation will mitigate the risks in areas that are currently overlooked or underestimated, and this will deliver major business benefits. Businesses need to ask whether they have an agenda for internal control within their organisation, as the ultimate prize from effective controls is not simply a compliant business, it is a better business.”

Of course, it’s no surprise that a firm like Ernst & Young is banging the drum about internal control. Like its fellow Big Four accounting firms, the introduction of the Sarbanes-Oxley Act has generated a huge amount of fee income. Every time a company puts a control in place, it creates a box that has to be ticked, and a role for someone to come along afterwards and check that the box has been ticked. If some companies are struggling to make sure they have all the controls they need, or they simply don’t know what they should be doing, then Ernst & Young will, no doubt, be happy to advise. And the fact that this latest survey shows that the drive to set up internal controls to cover just about every risk has become deep-rooted in a whole range of businesses – not just those affected by Sarbanes-Oxley – will suit the firm just fine.

However, that shouldn’t cloud the issue. It is true that more and more companies are investing heavily in this area. Partly, they are doing it to keep their regulators happy; partly, they are doing it as a way of showing investors how well managed they are.

There must be a question mark about the reality that underpins that second point. People who work in this area usually say that when they try to talk to investors about control and risk management they meet a wall of silence. Nobody is interested. Perhaps they are now listening more closely, as this survey suggests. But are they questioning companies about what they are really doing to improve control, or are they just nodding politely while the finance director makes vague statements about his embedded enterprise risk architecture?

Another problem is this: You can throw as much money at this area as you like, and have a control to match every conceivable risk. But the risks that are likely to do the most damage are often the ones nobody ever thought of; there’s nothing much you can do about those.