TUESDAY 4 DECEMBER 2007

MR RICHARD SEXTON AND MR JOHN HITCHINS

  Q1280  Chairman: In the independent auditor's report on Northern Rock's 2006 accounts you state that "you are not required to consider whether the Board's statements on internal control cover all risks and controls". Given what has happened to Northern Rock, do you think this is a possible area of reform of auditing standards?

  Mr Sexton: That statement is derived specifically from the combined code which requires us to look at controls over financial information, not the operational risks. I suspect that it would be a matter therefore for those responsible for the combined codes and others to consider that issue. At the moment we are explicitly not required to look at those aspects.

  Q1281  Mr Fallon: You are required to look at the operating and business review, are you not?

  Mr Sexton: It is correct that we have a duty to consider the operating and business review to ensure that it is not inconsistent with information presented on which we express an opinion in the financial statements.

  Q1282  Mr Fallon: But the operating and business review of Northern Rock had three or four paragraphs on liquidity risks, so you reviewed those paragraphs presumably?

  Mr Sexton: They would have been reviewed by the audit team as part of its duty.

  Q1283  Mr Fallon: Why is there nothing in the 2006 report or interim report pointing out the risk of illiquidity?

  Mr Sexton: The audit opinion in both the annual report and interim review covers the financial statements. The financial statements set out in very detailed note disclosure, as required under IFRS, information on the liquidity profile of Northern Rock.

  Q1284  Mr Fallon: Were you content with the liquidity risk?

  Mr Sexton: Our opinion explicitly covers the disclosures required under international financial reporting standards in connection with the historical information.

  Q1285  Mr Fallon: That does not answer my question. Were you content with the liquidity risk that Northern Rock was running?

  Mr Sexton: Our job is to look at the presented historical information and whether it represents fairly the actions of management and the board in managing the assets and liabilities of Northern Rock in this case. That is what is presented in the notes to the account on which we have expressed an opinion.

  Q1286  Mr Fallon: Northern Rock told us that at 30 June, 73% of its total liabilities were in wholesale funds. Excluding the main banks, no other mortgage lender comes anywhere near that. The nearest would be Alliance & Leicester at 55% or Bradford at 53%. Were you aware of the extent to which there was such a liability?

  Mr Sexton: I should say that I am not directly involved in the audit of Northern Rock. I oversee that audit and I have therefore regular contact with all of our audit partners, so the answers I give are in that context. The information presented by Northern Rock clearly set out its portfolio of mortgages. Yes, it is different from others. The accounting standard on which we base our opinion requires that information to be disclosed.

  Q1287  Mr Fallon: Did it not occur to you that this was something of an extreme business model, as the FSA chairman described it?

  Mr Sexton: The information required to be audited was thoroughly audited and presented in the financial statements for all to see.

  Q1288  Mr Fallon: Why did you approve the peculiar trust status given to Granite Finance whereby 70% of Northern Rock's mortgages were placed off-balance sheet in a separate vehicles?

  Mr Hitchins: First, I should make one correction. They are not placed off-balance sheet. You will see that all of those mortgages and the related Granite funding are disclosed in the annual report on Northern Rock's balance sheet. Securitisation is a normal structure in the market whereby notes are issued to note-holders who have recourse only to the pool of mortgages that backs those notes. They are placed into a special purpose vehicle which effectively ring-fences the pool of mortgages for the benefit of the note-holders. They are not taken off balance sheet because accounting standards still require that vehicle to be consolidated as if it was a subsidiary of Northern Rock. Overarching that is the Granite master trust that owns those vehicles and that is itself also part of the special purpose vehicle structure. That has nothing in it other than a small amount of income to cover its expenses. At the end of a securitisation structure it is normal to have a small amount of residual profit left in the vehicle company and typically that money is given to charity effectively in the form of a legacy.

  Q1289  Mr Fallon: Are you aware that a charity had been nominated without its knowledge to be the beneficiary?

  Mr Hitchins: We were not aware that the charity did not know, but in securitisation it is quite normal for the residue to be given to charities. In some cases it is just left as a charitable trust with the charity to be decided at the time the money is available; in other cases it is specified just as a testator in his will directs that an amount of money is to be given to a charity. There is no requirement to notify the charity.

  Q1290  Mr Fallon: Do you not think it is somewhat improper not to notify the charity?

  Mr Sexton: Neither of us was involved in the detail of that review. As auditors we were interested in whether the structure was properly consolidated into the balance sheet of Northern Rock and the assets and liabilities of those structures were properly reflected in the liquidity analysis. The status of the trust from a legal perspective is not a matter that is relevant to the presentation of those assets and liabilities properly in the financial statements.

  Q1291  Mr Fallon: Did PricewaterhouseCoopers advise on the two securitisations in the current year?

  Mr Sexton: We did not advise on the securitisations. The work of PricewaterhouseCoopers has been to provide comfort letters on historical information included in the prospectus offerings, as is normal for any such offering in the United Kingdom market and around the world.

  Q1292  Mr Fallon: Therefore, you were an adviser?

  Mr Sexton: We provided comfort letters as auditors and reporting accountants on information in a prospectus, in the same way that as auditors we provide short form reports on IPOs.

  Q1293  Mr Fallon: Last year you charged Northern Rock an audit fee of £500,000 in addition to non-audit fees of over £1.3 million. Do you think that ratio is appropriate?

  Mr Sexton: I think we have to be very careful about understanding the disclosure in the statutory accounts of our fees to Northern Rock because the manner in which we disclose them in buckets is mandated. The numbers you quote include: work as statutory auditor, the first number, for Northern Rock group; work as the statutory auditor of the subsidiaries which has to be disclosed separately; work as the statutory auditor in connection with the regulatory responsibilities that my colleague mentioned; and work that we provide as auditors in an audit-related sense on the offering circulars for securitisation, that is, comfort letters on the financial information in those circulars. That is normal practice and is required by the banks.[4]

  Q1294  Mr Fallon: The problem is that you were earning in fees three times as much from consultancy advice which further securitised Northern Rock's borrowing as you were getting for checking whether or not that securitisation was placing the organisation at risk. There was a conflict, was there not?

  Mr Sexton: With respect, I do not believe that it was three times our audit fees as statutory auditors. I believe the number is £1,100,000 if you include the three relevant disclosures, and the other fees are in the nature of audit-related activity providing audit and comfort letters on offer circulars which amount to £700,000.

  Q1295  Mr Fallon: The non-audit fees are listed at £1.3 million.

  Mr Sexton: As I have explained, the non-audit fees are a categorisation under UK law which includes the statutory audit responsibilities around subsidiaries and regulatory reporting in the case of a bank.

  Q1296  Mr Fallon: Do you see nothing wrong in the same firm doing the audit and checking whether the bank is liquid and at the same time charging consultancy fees for arranging securitisation that increases the risk of illiquidity?

  Mr Sexton: We did not charge fees for consulting on the creation of further securitisation. Our fees were in connection with very specific comfort letters in relation to historical financial information that appears in those documents. Our audit covers the historical financial information in the annual report.

  Q1297  Mr Fallon: Altogether last year you took fees of £1.8 million and probably £1 million or so already this year. The taxpayer has now had to lend Northern Rock £19 billion. Do you not think you should repay your fees to the taxpayer?

  Mr Sexton: All I can say is that fees were charged in connection with the work we performed and the annual report and accounts and the presentation of the historical information therein and subsequently in providing comfort in connection with securitisation offerings and in relation to specific financial information.

  Q1298  Mr Fallon: You have audited and provided comfort to the biggest banking disaster for 150 years.

  Mr Sexton: We have provided audit services in connection with auditing standards and guidance from the UK Auditing Standards Board and the International Auditing Standards Board and performed the duties required of statutory auditors.

  Q1299  Mr Todd: Have subsequent events caused you to revisit your audit practice in this particular bank; in other words, do you think there is something to be learnt from your contribution to this disaster?

  Mr Sexton: Perhaps I may answer that on a general basis and then ask my colleague to pick it up specifically in relation to the banking sector. The auditor is always cognisant of market developments in order to understand all of the information available to it to give those opinions that it does give on that historical financial information. We are reviewing and thinking about the market information now available to us and how that might influence the level of audit evidence we might require and the nature of our procedures in today's circumstances.