London and County Securities: a case study in audit and regulatory failure

Derek Matthews
Cardiff Business School, Cardiff, UK

Abstract
Purpose – The purpose of this article is to look in detail into the collapse and its subsequent implications of the London and County Securities bank (L&C) in 1973, one of the most significant UK corporate fraud scandals and regulatory failures in recent decades.
Design/methodology/approach – The article is a case study drawing on the report on L&C by the Department of Trade (DT) inspectors and the national and trade press, interviews with and the private papers of some of the major participants.
Findings – The study identifies and explains the nature of the fraud, the shortcomings of the auditing of the bank, the poor performance of the DT inspectors, and the weaknesses of the subsequent changes in the regulatory system.
Research implications – The implications of the article’s findings are: that commentators, and the regulatory and legal system need to distinguish between different types of fraud; that commercial pressures impact adversely on the audit process; that DT inspections conducted by accountants are not independent in their judgements; and that self-regulation is always likely to be ineffective.
Practical implications – The findings are likely to be of interest to accounting academics and historians, practitioners and regulators.
Originality/value – Provides an insight into the collapse of the London and County Securities bank.

Keywords Fraud, Auditing, History, United Kingdom
Paper type Case study

Introduction
The collapse of Enron, and Worldcom, together with their auditors, Arthur Andersen, has recently put the spotlight with renewed intensity on the company audit (The Economist, 2002). These scandals of course have merely followed those of the 1980s and 1990s in America and Britain including: the Savings and Loans, BCCI, the Maxwell companies, Barings bank and many more (Calavita et al., 1997; Mitchell et al., 1993; Gapper and Denton, 1997). Indeed, bank fraud and audit failure have a long history in Britain. In 1859, for example, a similar fraud to the subject of this article occurred in the coincidentally named, Old London and County joint stock bank (The Guardian, 1976). In 1878 came the collapse at the City of Glasgow Bank (French, 1985; Sikka et al., 1992, p. 13); followed by that of the London and General Bank in 1892 (Dicksee, 1919, pp. 684-707); the embezzlement at the Bank of Liverpool in 1902 (The Accountant, 1909, p. 690); while in 1920 the fraud at Farrow’s Bank was exposed (Robb, 1992, pp. 77-78; The Accountant, 1921a, b). But, perhaps because the banking world had settled into a stable maturity dominated by the major clearing banks, there were no significant banking scandals in Britain from 1920 down to the fraud at London and County Securities (L&C) in 1973: which however proved to be a harbinger of the later scandals.

Although the role of the auditor was questioned in many of the early bank frauds none called the accounting profession into question as much as the L&C case, yet rather surprising nothing extensive has previously been written on the affair by accounting historians and this article sets out to close this gap. The next section analyses the nature of the fraud at L&C. This is followed by an analysis of why the financial system’s first line of defence – the audit – failed to prevent the fraud, and the following section assesses how the regulatory system in the form of the DT inspection performed. The final substantive section looks at the changes made in the law, and in the self-regulation of the accounting profession as a result of L&C, and discusses why these were insufficient to prevent the even more spectacular frauds of the 1980s and 1990s. The concluding section brings the various strands of the analysis together.

The source material for the article comes primarily from the report on L&C by the DT inspectors and the national and trade press. Two primary sources were also used. One was the private papers of one of the participants in the affair, Robin Atkins. These papers (listed in the references at the end of the article) consist of copies of letters, reports and contemporaneous notes taken by Atkins at various key meetings, and are available for consultation with the owner’s permission. The second original source is interviews with the main participants in the affair (also listed in the references) who are still alive and were prepared to be interviewed. The interviews formed part of a wider programme of oral history of auditing, edited versions of which were published in Matthews and Pirie (2001). This book also contains a discussion of the origins and construction of the project, a fuller version of the interviews used here and short biographies of the participants. The full transcripts of the interviews are also available from the author with the interviewees’ permission.

The fraud
There are characteristics of the corporate governance at the L&C bank familiar from more recent top management frauds, like Barlow Clowes and Maxwell, namely weak internal control systems and a strong dominant chief executive able to treat the company as their own property (Department of Trade and Industry, 1995; Bower, 1995; Plaistowe, 1998; Matthews and Pirie, 2001, pp. 439-440). The dominant rogue in the L&C case was Gerald Caplan; the son of a rag dealer, he was called to the Bar in 1956, but in 1961 bought a small hire-purchase company which he expanded mainly by take-overs into a substantial banking business (The Evening Standard, 1978; Grady and Weale, 1986, p. 163). Caplan was abetted by Trevor Pepperell, a chartered surveyor, who remained a consultant or “shadow director” of the bank, “preserving the appearance of being independent of it” (Department of Trade, 1976, pp. 14-42). Although the group went public in 1969 Caplan and Pepperell’s combined shareholding allowed them to keep control (Department of Trade, 1976, pp. 6-43).
In the 1960s, the Bank of England’s tight credit control over the main clearing banks had led to the growth of secondary banks like the L&C, operating under the Protection of Depositors Act, 1963, and the Companies Act, 1967, not able to style themselves a “bank”, but offering banking services and subject only to the loose regulation of the Department of Trade (DT) (Reid, 1982, pp. 29-49). The “Barber boom” of the Heath Government, coinciding with the Bank’s reforms of 1971, which relaxed control over the clearing bank’s credit creation, meant that funds were available to banks like L&C which grew rapidly, borrowing short-term and lending long-term on second mortgages, or to property speculators, or buying property or equities themselves (Reid, 1982, p. 60; Grady and Weale, 1986).
Outwardly L&C exuded success and respectability with supposedly prestigious figures like the leader of the Liberal Party, Jeremy Thorpe, on the board, and with the National Westminster bank and the United Drapery Stores’ pension fund as investors (The Times, 1972, 1973c; Department of Trade, 1976, pp. 18-58). But Caplan did not scruple at L&C operating, for example, as slum landlords, and at heart, since neither Caplan nor Pepperell had any training as bankers; L&C was incompetently run. The group’s internal controls and accounting were in a chaotic state; it was the subject of considerable public criticism in parliament and in the press, and when it was revealed that its second mortgage business was charging extortionate rates of interest it was forced by the DT to reorganise the business at great expense (The Economist, 1971; Private Eye, 1971; The Sunday Telegraph, 1972; The Guardian, 1973b). The bank was also dishonestly run.

Fraud is usually defined by lawyers as, for example, “any act of deceit made with the intention of financial gain” (Levi, 1987, p. 26). But accountants distinguish between two types of corporate fraud summed up by Woolf as: “(a) Frauds involving the manipulation of the records and the accounts (b) frauds . . . involving . . . theft, misappropriation or embezzlement, usually in the form of cash” (Woolf, 1978, p. 399), and it is of interest to distinguish the two in the L&C affair.

There is some evidence of Woolf’s category (b) fraud at L&C, although this is clouded by the fact that from 1969 to 1973 Caplan waived about £200,000 in salary entitlements and dividends (Department of Trade, 1976, p. 17). In 1968, Caplan opened a current account with his own bank under the name “J. Cartwright”, possibly as a means to abstract money for personal use, tax free (Department of Trade, 1976, pp. 24-33). Also, in one share deal the DT inspectors noted “a ‘kick-back’ amounting to £7,500 that went into Caplan’s own pocket”: while the bank also bought him a boat for £50,000 (Department of Trade, 1976, pp. 21-22). It is not clear however that these sums exceeded Caplan’s legitimate entitlements. Caplan always denied “that anything he did . . . was done for his own enrichment” (The Financial Times, 1976). Pepperell failed to account to the DT inspectors for the sum of £626,000 paid to him by the bank, although he maintained that this was used in the share support scheme discussed below (Department of Trade, 1976, pp. 145-152).

Undoubtedly, most of the money Caplan and Pepperell took out of the bank was for category (a) fraud, financial manipulation, not direct personal gain. These manipulations included “window dressing”, common among banks in the city since the nineteenth century (Edwards, 1989, p. 122). L&C and other secondary banks would deposit cash in each others’ accounts for a few days at financial year end to boost their apparent liquidity; the L&C 1973 balance sheet was inflated by £25 million, or 77 per cent of the bank’s total cash in this way (Department of Trade, 1976, pp. 132-178).

Another corrupt activity involved the management and directors of L&C buying shares in the company, using loans from the bank itself, to artificially boost their price. This was in apparent contravention of the 1948 Companies Act which forbad companies lending to their own directors except “in the normal course of business” (Department of Trade, 1976, p. 35). As the collapse of the bank loomed as much as £5 million was loaned to Pepperell, for example, as part of the share support scheme (Department of Trade, 1976, p. 245).

Finally in the list of category (a) fraud, the L&C accounts were full of creative accounting. The most glaring example of this practice arose from the take-over of a company called Drakes, purchased with L&C shares (Reid, 1982, pp. 173-174). The apparent intention was to sell off parts of Drakes to raise desperately needed cash, but when no legitimate buyers were found the various bits of Drakes were bought instead by a variety of companies associated with L&C with funds borrowed from L&C. L&C effectively sold much of Drakes’ assets back to itself. However, on the advice of their auditors, this potentially disastrous piece of business showed in the 1973 accounts as a healthy profit (Department of Trade, 1976, pp. 89-90). This was achieved by: first, halving the true market value the L&C shares used to buy Drakes, thus reducing the apparent cost of the purchase (Atkins, 1973f, p. 33). Second, the capital loss on the deal was inserted into the accounts as an asset, termed “cost of control on acquisition of subsidiary”, a phrase apparently intended to indicate the value of “goodwill” – that is in companies (which outwardly) it no longer owned (Atkins, 1973f, p. 34).

Another example of creative accounting was the bogus commitment fees (fees charged for granting a loan) paid by one subsidiary or associated company of L&C for loans borrowed from another L&C subsidiary (Department of Trade, 1976, p. 131). In other words, the bank was paying itself fees for lending itself money and calling it profit (amounting to over half the L&C reported banking earnings in 1973); apparently another common stratagem among banks like SlaterWalker at the time (Grady andWeale, 1986, p. 162).When the DT inspectors reworked the 1973 figures a L&C profit of £2,784,000 on banking activities became a loss of £75,000 (Department of Trade, 1976, p. 117).

Due to the bank’s incompetence and perceived sharp practice, the L&C share price had been on the slide since the summer of 1972. Even at the height of the boom the money markets had become increasingly reluctant to lend L&C funds, and when in the autumn of 1973 the government initiated a credit squeeze this spelled the end for the bank (Department of Trade, 1976, p. 9; The Financial Times, 1973). Once they had disentangled the accounts the liquidators eventually found a £50million deficiency in the balance sheet (The Economist, 1974; Reid, 1982, pp. 84-93). The collapse of L&C threatened confidence in the whole British banking system and the Bank of England launched a rescue operation – “the lifeboat” – which kept most of the fringe banks, some run along broadly the same lines as L&C, afloat (Grady and Weale, 1986, pp. 151-4).

Caplan was arrested in Los Angeles in 1978, living the life of a wealthy stockbroker, but he successfully resisted extradition on grounds of ill health (Accountancy Age, 1978a). Pepperell was successfully brought back from Germany and he and eight other L&C directors and executives (including the chief accountant, who had already been suspended from the ICAEW for two years for professional misconduct) were put on trial. No attempt of course was made to distinguish between the two categories of fraud, and the accused were charged with a wide variety of offences including falsifying accounting records, forgery and theft, involving £10 million in all: reportedly the largest fraud ever handled by the Metropolitan Police up to that date (The Financial Times, 1978, 1980). Pepperell was sentenced to two years in prison and the others were fined, received suspended sentences or, as in the case of the window dressing activities, were acquitted (The Times, 1981a, b).

The audit

L&C was audited by Harmood Banner which, with 29 partners, ranked about the 15 largest accounting firm in Britain in 1972 (Matthews et al., 1998, p. 204; Atkins, 1973e). In the course of preparing the L&C 1971 audit, the partner in charge, Matthew Patient, who had helped float the bank in 1969, discovered Caplan’s bank loans and share deals, and he insisted the loans be repaid with interest and properly disclosed (Department of Trade, 1976, p. 35). Next year, however, he discovered that Caplan had continued the share support scheme via a clandestine private company (Department of Trade, 1976, pp. 36-37). Patient took legal advice, formed the opinion that the transactions were illegal, and reported his disquiet in the audit working papers. His fellow partners, however, disagreed with Patient as to the transactions’ legality and no further action was taken apart from a mention of the loans in the director’s report (Department of Trade, 1976, p. 227; Atkins, 1973b, pp. 5-6). Another concern, meriting a qualification in Patient’s opinion, was the seemingly more minor matter of the bank’s practice of putting all commitment fees to the immediate credit of the profit and loss account, instead of spreading them over the period of the loan facility. Again, however, Patient was overruled by his fellow partners (Department of Trade, 1976, p. 227).

Following these upsets Patient resigned from the L&C audit. Caplan claimed that he had “requested the replacement of Mr Patient”, and the DT inspectors took the view that Caplan had had an awkward audit partner removed (Department of Trade, 1976, p. 227). That a fraudulent client had had such power, of course, reflected badly on Harmood Banner, and the firm maintained that “the change was made at the partner’s request in the light of his work load, not the client’s” (Accountancy, 1976, p. 3). Recently Patient supported the firm’s account that he was overworked:

Hugh Nicholson [the Harmood Banner senior partner] and I agreed that one of the three merchant banks [that Patient audited] was the obvious one to go to somebody else. So partly because I had had a bit of a run in and slightly stood my ground, which does not help a relationship, and partly because it is quite a good thing when you have had that for somebody else to look at it afresh, it was agreed that the best one to change was London and County (Patient, 1998).

Patient maintained that Caplan thought the change might reflect badly on himself, but he allayed his fears and offered as his replacement, Richard Plummer, a member of the Scottish Institute and: “somebody whom I could put forward as being authoritative and a very good auditor” (Patient, 1998).

It is reasonable to assume however that Patient had not relished being overruled by his fellow partners on matters of principle, and it is probably right to conclude that the relationship with the client and the internal politics of Harmood Banner effectively led to the replacement of a comparatively conscientious audit partner with what turned out to be a more amenable one. Patient’s reputation was enhanced by the L&C affair; he went on to become a leading partner in Deloittes, and a chairman of the profession’s Auditing Practices Committee in the 1980s (Auditing Practices Committee, 1986, p. 68).

After the 1972 L&C audit the personnel changes, apart from Plummer as the new partner in charge, included two new managers, one of whom was Robin Atkins, recently recruited from Peat, Marwick, Mitchell. Atkins apparently had quickly become known as something of a maverick in his new firm, had aroused complaints regarding what was considered his over-zealous conduct at other audits, and was not, in his own words, “the most popular chap in the office” (Atkins, 1973b, e; Atkins, 1998; Patient, 1998).

Atkins, and to some extent his fellow audit staff, took a sceptical view of L&C from the start. Atkins remembered:

The actual people who ran the company didn’t seem to be fully in control of it, and . . . the whole thing was riddled by a series of manoeuvres to bolster the profits (Atkins, 1998).

Atkins found Patient’s report in the working papers detailing the share support schemes and his disagreement with his fellow partners over their legality. Atkins consulted Patient who apparently remained “very disturbed” about the issue (Atkins, 1973e). Atkins and his fellow manager acquainted Plummer with the directors’ loans and the other problems. On the matter of the commitment fees Plummer agreed that in future years they should be spread over the term of the loan; he was also aware of the window dressing but he told the DT enquiry that “he did not know what could be done” (Atkins, 1973e, pp. 230-231). Atkins quickly became critical of Plummer’s conduct of the audit, and reached the view that the partner did not have the technical grasp or “the strength of character to stand up to people” (Atkins, 1998). According to Atkins Plummer agreed a figure as appropriate to write off L&C’s bad debts with his junior staff but later abandoned it at the client’s insistence (Atkins, 1973e). When Atkins complained to Plummer that he was talking more to the L&C management than to his own audit staff, the partner countered that he was unhappy with Atkins for upsetting the bank’s officials by “bringing up matters like the loans accounts” (Atkins, 1973e).

Plummer apparently took little part in the audit itself but a leading role in the framing of the L&C 1973 accounts, including the treatment of the Drakes purchase (Department of Trade, 1976, p. 112). Concerning the directors’ loans and share purchases, Plummer “insisted on a note in the accounts disclosing their existence” (Department of Trade, 1976, p. 71). However, this note read: “advances to customers, by London and County (A&D) Limited, wholly or mainly secured on shares of London and
County Securities Limited, amounted to £2,700,000” (Department of Trade, 1976, p. 20), which concealed the reality both that the “customers” in question were the bank’s executives, chairman and friends, and that the loans had been used to buy the L&C shares.

When the accounts of the L&C subsidiaries for which Atkins was responsible were ready he refused to sign them off (Atkins, 1973e). As he put it later:

I was not happy with the accounts being true and fair or indeed complying with the Companies Act (Atkins, 1998).

Atkins wrote a detailed report, and had a number of meetings with Plummer and various members of the Harmood Banner Audit Committee (which Nicholson apparently refused to attend). They discussed all the reasons why Atkins thought the L&C accounts should have been qualified (Atkins, 1973a, b, c, d, e):

. not keeping proper books of account;
. window dressing;
. the commitment fees;
. bad debt provision, and
. the share support schemes.

Following one such meeting in which he failed to convince the partners to qualify Atkins resigned, saying later:

You can’t carry on working where you’ve got a fundamental difference on a major point (Atkins, 1972a, b, 1973e, 1998). Atkins sought legal advice which confirmed that his interpretation of all legal matters to do with L&C was substantially correct, and that he had “no alternative but to resign” (Atkins, 1972c).

There followed a major meeting of the Harmood Banner partners in which all aspects of the L&C audit including Atkins’ resignation were discussed (Atkins, 1973e). The partners were aware that their junior staff, not only Atkins, were unhappy with the situation, and they also decided to seek legal advice which was to the effect that the loans could be construed as “in the normal course of business” and therefore fell just within the margins of legality, and so the accounts were signed off (Department of Trade, 1976, pp. 71-229).

Most of the financial press accepted L&C’s 1973 accounts at face value (The Guardian, 1973a; The Times, 1973b), although a number of articles were critical of, for example, the treatment of the Drakes deal (The Daily Mail, 1973; Accountants Weekly, 1973). Caplan was subjected to sustained criticism at the L&C AGM (The Guardian, 1973b), after which Atkins’ (who attended the meeting but did not speak) resignation also became public for the first time (Accountancy Age, 1976c). Atkins was then dismissed (while he was still working out his notice) by Harmood Banner on the grounds of breach of client confidentiality, and the firm also made a complaint against him, later withdrawn, to the Institute of Chartered Accountants in England and Wales (ICAEW) (Accountants Weekly, 1976; Atkins, 1974). Although Harmood Banner tried to block him, Atkins wrote two reports on the reasons why the L&C accounts should have been qualified, one he sent in a letter to the ICAEW’s Auditing Standards Committee and the other to the Department of Trade (Atkins, 1973f, g).

The accountancy profession seemed to close ranks against Atkins. At the time of the DT report’s publication Atkins received rough handling from the accounting press (The Accountant, 1976). Even the relatively progressive, Accountancy Age (1976a), denigrated his decision to resign:

Atkins’s instinct about L&C was quite correct, but he had no evidence to support his belief . . . if property prices had not collapsed and L&C had survived, his position as a chartered accountant would have been seriously compromised.

None of this was correct. Atkins had the evidence of L&C wrongdoing, and the collapse of the bank preceded that of the property market (Reid, 1982, p. 102). According to Atkins he was also effectively blackballed:
. . . it became very clear that I could not find . . . [a job] in the profession. I would hazard a guess that Harmood Banner had made it very clear with the institute and everyone around that I was persona non grata (Atkins, 1998).

Atkins never worked in auditing again and took up a successful career in industry.
There are failures in their audit from which Harmood Banner can reasonably be absolved; for example, not discovering that the “J. Cartwright” accounts were bogus. Interestingly, as a comment on the effectiveness of third party confirmations, the account was part of a sample chosen for the 1972 audit. “J. Cartwright” duly replied that his credit balance was as the bank stated (Department of Trade, 1976). But, as detailed above, there is a catalogue of deficiencies in the Harmood Banner L&C audit, indeed the audit partner was the author of some dubious aspects of the L&C accounts. Moreover, these were not just the personal failings of one partner, the Harmood Banner partners were collectively involved.

What accounts for this audit failure? One element in the situation is that even the Companies Acts made special cases of banks, discount houses and insurance companies, particularly regarding disclosure of movements in and out of reserves, in order apparently to allow them to show an appearance of stability (de Paula and Attwood, 1976, pp. 133-134). This special treatment might have, it could be argued, influenced accountants to audit banks differently. There is also an apparent reluctance amongst some auditors to qualify banks’ accounts. Ian Brindle, senior partner of Price Waterhouse at the time of the BCCI collapse in 1991 declared “you can’t qualify a bank” (The Financial Times, 1991). The argument is that since banks depend on the confidence of their depositors any indication that all is not well could provoke a fatal run on the bank. Yet other auditors argue:

You can qualify a bank . . . a qualification could stop further deposits being taken which would otherwise be lost (Milne, 1998).

Moreover, some banks did have their accounts qualified. For example, Patient’s banking client, Edward Bates, had its accounts qualified in 1975 and 1976, prior to its collapse in 1977 (The Economist, 1976, 1977; Reid, 1982, pp. 144-145). Also, the FNFC, a member of the bank’s lifeboat, had their accounts qualified in 1975 by Touche Ross and Deloittes (Accountancy Age, 1975; Grady and Weale, 1986, p. 159). These qualifications, however, came when the problems of the recipients were already public knowledge.

The most important problem seems to stem from the lack of independence of Harmood Banner from their client. Typically, a number of key accountants at L&C were recruited from their auditors, who were often therefore dealing with former colleagues. But more important are the familiar commercial concerns. There was an immediate pressure on Harmood Banner in that in the middle of the L&C audit it was announced that they would merge with Deloittes; so if they had qualified the L&C accounts and lost the audit this might have jeopardised the move (The Times, 1973a). But more directly L&C was one of Harmood Banner’s bigger clients, with audit fees for 1972-1973 of £25,000 (about £200,000 at today’s prices) (Department of Trade, 1976, p. 16); and since the audit was directly in Caplan’s gift these fees might have been lost by any further confrontation with him (Atkins, 1998). Moreover, Plummer gives the impression of seeing it as his role to enhance the value of the audit to the client by contributing creative accounting ideas of his own. The point should also be noted that although there has been much discussion of the increased commercial pressure that a firm comes under where they are also undertaking consultancy work for audit clients this was not a factor in the L&C audit (Mitchell et al., 1993, p. 15).

The DT enquiry

The inspectors appointed by the DT were A.P. Leggatt QC and David Hobson FCA (Department of Trade, 1976, p. 2). The usual procedure was for the ICAEW to offer names of potential inspectors, and Hobson, soon to become the senior partner of Coopers and Lybrand, was a very experienced accountant. Coopers put 20 accountants onto the case, the inspectors were quickly in a position to inform the DT that criminal offences had been committed, and the full 80,000 word report was published in 1976 (Department of Trade, 1976, pp. 3-4; The Guardian, 1974; Boys, 1997, pp. 129-130).

In some ways the DT investigation and report were successful; the fraud was laid out in detail and some of the felons were convicted. With regard to its findings on the audit, press coverage also tended to describe the L&C report as hard hitting, and it was certainly strong enough to create the repercussions for the regulatory system outlined below (The Guardian, 1976). However, there were weaknesses in the report, some of which exemplify those of the DTI investigatory system in general, while others relate particularly to the L&C case.

DTI investigations have been attacked for their length, cost, the time taken to produce them, and for creating some injustice, in that incriminating evidence which witnesses are compelled to give under oath might be used against them in a subsequent court of law, effectively removing the right to silence (Sikka and Willmott, 1995; Russell, 1991; Kirk and Woodcock, 1997, pp. 19-42). Caplan’s solicitor also wrote to The Times criticising the privacy of the hearings and the inability to cross examine witnesses, and both Atkins and Patient complained they were not given the opportunity to respond to criticisms (Department of Trade, 1976, p. 5; Atkins, 1998; Patient, 1998).

Other general weaknesses might be mentioned. The L&C report like its fellows is poorly printed and bound (a graph of the L&C share price is hand-drawn and inaccurate) (Department of Trade, 1976); and having no index makes it difficult to use. The inspectors received no training, being merely provided with brief notes for guidance (Department of Trade, 1980, Boys, 1997, p. 1). Importantly they did not make explicit their terms of reference. The guidance notes state an investigation’s aims as “to establish the facts where prima facie some irregularity has been shown in the way a company has been run” (Department of Trade, 1980, p. 10), so this may have been the reason why the L&C inspectors seemed to assume that they had mainly a forensic role, and the report “should be submitted with the least possible delay” (Hobson, 1998). However, a chapter in the L&C report on secondary banking was requested by the DT, and perhaps they also asked for the chapter on the audit, although there is no specific evidence of this (Department of Trade, 1976, pp. 2-235). However, perhaps because of their lack of an explicit remit the L&C report did not look at any wider issues, such as auditor independence, and it tended to pile fact on top of fact with little structure or context.

Indeed, the L&C report fits Sikka and Willmott’s (1995, pp. 357-363) general view that DTI inspectors:

Focus attention upon the misdemeanours of individuals, rather than upon the structural problems of accounting regulation, thereby shielding the accountancy profession from more fundamental critical examination.

The L&C enquiry tended to narrow criticism to Plummer. For example, with regard to the window dressing in the 1973 accounts the report went out of its way to note that Plummer “did not consult his partners”, which was untrue (Department of Trade, 1976, p. 230; Atkins, 1973d, e).

With regard to its specific treatment of the L&C audit the inspectors can be taken to task on at least six counts. Firstly, even where the report finds fault its criticism is muted. The report criticises the L&C 1973 accounts, and therefore the audit, for five reasons which, apart from the window dressing, were all relatively minor issues: not stating some advances were not repayable on demand; the breach of a loan stock trust deed; the commitment fees, and inadequate bad debt provision. But the criticism is in measured terms: the auditors had not “pursued their enquiries with due diligence”, so that “the opinion expressed in the audit reports that the accounts showed a true and fair view was not justified” (Department of Trade, 1976, pp. 231-232). In contrast, when Harmood Banner finally withdrew from the L&C audit in the autumn of 1973: “their conduct at this stage is deserving of praise” (Department of Trade, 1976, p. 250). The inspectors might have pointed out that this action by the auditors was only weeks before the collapse of their client and too late to effectively alert the shareholders.

Secondly, the L&C report offers Harmood Banner the unjustified excuse of being deceived:

Against a background of concealment and even dishonesty it would not be surprising if some things were to get past the most competent auditor (Department of Trade, 1976, p. 229).

Yet, as has been demonstrated above, a lack of awareness of the facts was not the problem with the audit. In fact, the report itself shows that issues for which the report criticises the audit were well aired between the management and the auditors (Department of Trade, 1976, pp. 119-230).

Thirdly, the report condoned the creative accounting in the L&C 1973 audit, which was often the handiwork of the audit partner. For example, with regard to the treatment of the Drakes sell off, the report stated that “the position was fully disclosed in the accounts”, when this amounted to the ambiguous phrase “cost of control on acquisition of subsidiary” (Department of Trade, 1976, p. 232). The DT inspectors also omitted mention, of which they were aware, that the under valuation of L&C shares was designed to disguise the extent of the losses on the deal (Department of Trade, 1976, p. 90; Atkins, 1973g).

Fourthly, the report absolves Harmood Banner of any blame for their treatment of the share support scheme: stating that they “acted entirely properly” on the basis of their legal advice on the directors’ loans, and “insisted on a note in the accounts disclosing their existence” (Department of Trade, 1976, pp. 71-229). But, as discussed above, the circumlocution of this note in no sense indicated that a share support scheme was in operation. The inspectors ignored Patient’s previous disagreement with his fellow partners as to the legality of the loans (although they had examined the working papers where the issue was reported) (Department of Trade, 1976, pp. 227-229), which would have required an explanation as to why the partners had gone against Patient’s legal advice. Moreover, the inspectors should have made the obvious point that, even if the share support schemes could be construed as legal, this did not make the accounts true and fair.

Fifthly, another example of the investigators’ perverse handling of the evidence is their treatment of Atkins. The well publicised resignation of an audit manager (unprecedented in the history of British auditing as far as the author is aware), on the very issues of principle at the heart of the DT enquiry, should have been examined in the report. In fact it was ignored. Of the two references in the report to Atkins, one names him as one of the 1973 audit team, which without noting his resignation implied that he shared culpability for the audit failure. The other reference blamed Atkins in part for the collapse of L&C, stating that as a result of “criticism by one of the auditors’ managers, after the annual general meeting . . . confidence [in the bank] further declined” (Department of Trade, 1976, pp. 227-259). In fact, Atkins did not offer criticism at that time; the bad publicity surrounding the AGM was not of Atkins’ making, nor indeed was bad publicity the cause of L&C’s downfall.

Had Atkins’ resignation been dealt with in the report it would of course have demonstrated again that the problem with the audit was not one of management concealment. The Harmood Banner partners would have been seen to have over-ruled their own staff who, with almost full knowledge of the facts, were urging qualifying the accounts. Tackled on the reasons for the omission of Atkins’ resignation from his
report Hobson stated:

I don’t think one would like to take some manager’s view . . . these people who are crusaders sometimes build up their case on something that is not as soundly based as it may have been (Hobson, 1998).

Finally, the DT report does not consider whether the L&C accounts should have been qualified on the grounds that proper books were not being kept.

A number of factors might account for the L&C DT inspectors’ tendentious treatment of the auditors. As Sikka and Willmott (1995) have demonstrated, that accountant inspectors will incline to leniency when sitting in judgment on their fellow professionals is a common feature of DTI investigations. When asked whether he felt uneasy in judging his peers, Hobson conceded that:

I don’t think I liked it much (Hobson, 1998).

On top of this, at the time of the report’s publication, the Bank of England was reported to be applying discreet pressure on all parties to limit law suits relating to allegations of professional negligence arising from the secondary banking crisis. So the fact that Hobson’s firm, Coopers and Lybrand, were themselves facing a claim for negligence of £1.5 million at the time, and the liquidators were suing the L&C auditors for £8 million (settled out of court for £900,000 in 1980) may have helped dampen the inspector’s criticisms (The Sunday Telegraph, 1976; Accountancy, 1980). Another factor was that publication of a more damning indictment of the L&C auditors might have fuelled the growing calls for tougher regulation of the accounting profession, or indeed an end to self-regulation entirely. Hobson himself was a strong supporter of self-regulation and argued that:

I don’t know what an outside regulator would do; issue dog licences to auditors? (Hobson, 1998).

L&C and self-regulation

There were a number of fall-outs from the L&C affair, and the other lesser secondary bank scandals at the time such as Cornhill Consolidated Group or John Stonehouse’s London Capital Group (Jones, 1981, p. 251; Department of Trade, 1977). Regarding legislative changes, the Protection of Depositors (Accounts) Regulations Act, 1976, tightened up the control of window dressing by requiring the inclusion in the accounts of banks an analysis of loans taken, although no statement as to whether these were in line with a company’s normal pattern of business was required (Boys, 1997, pp. 87-88).The 1979 Banking Act implemented the L&C DT report’s call for secondary banks to be placed under the regulation of the Bank of England, although this failed to prevent the collapse of Johnson Matthey in 1984 (Department of Trade, 1976, pp. 235-236; Sikka et al., 1992, p. 20; Reid, 1986, p. 105). The subsequent Banking Act 1987 placed a duty on bank auditors, if all else failed, to report any wrongdoing by their clients to a Financial Services Authority (FSA). Again these regulations did not stand in the way of the scandals that emerged at BCCI in 1991, and Barings in 1995. In 1994 it became a general duty for auditors of financial institutions to report wrongdoing to the regulators (Institute of Chartered Accountants in England and Wales, 2000, p. 889), and bank regulation was taken away from the Bank of England entirely with the creation of the enlarged FSA in 2001 (Stewart and Dunn, 2000, pp. 73-76; Ferran and Goodhart, 2001, p. 5).

The 1976 Companies Act made it a criminal offence for the directors or officers of a company to mislead their auditors, another recommendation of the L&C report (Department of Trade, 1976, p. 251; Boys, 1997, p. 7; Stewart and Dunn, 2000, p. 64). The L&C report’s recommendation that the “in the ordinary course of business” proviso regarding loans to directors be abolished, however, was not implemented in the Companies Acts of the 1980s, and the issue remains unresolved (Arlidge and Parry, 1985, pp. 145-162; Law Commission, 2002).

The accounting profession reacted to the L&C affair in a number of ways. A report in 1978 of a joint investigation by the Scottish and English Institutes into the affair was never published (Accountancy Age, 1978b). In 1976, the ICAEW’s Auditing Practices Committee (APC), set up in 1973 in response to earlier audit failures like those at Maxwell’s Pergamon Press, was reformed under the auspices of the Consultative Committee of Accounting Bodies (CCAB), representing all the accounting bodies in Britain (Russell, 1991; Sikka et al., 1989, p. 50). The committee had observers from outside the profession but was dominated by the very multinational accounting firms who were most involved in the audit failures themselves (Sikka et al., 1989, p. 53). The aim of the new APC was to “restore the public’s confidence in the auditing profession, with the further consideration of keeping the profession self-regulated” (Ferrier, 1991, p. 107; Chandler, 1986, p. 15). Not until 1980 did it issue its first standard, which in any case did “little more than codify existing best practice” (Foster, 1986, p. 37). It was claimed the two standards and 33 guidelines issued by the APC up to 1990 “demonstrated that the UK profession was able to respond to criticism through a process of self-regulation” (Ferrier, 1991, p. 101); but others noted they did not impose a duty on auditors to search for fraud, and avoided senior management fraud altogether (Stewart and Dunn, 2000, pp. 69-70). The APC was to be reformed again in 1991 (under the 1989 Companies Act) and renamed the Auditing Practices Board (Woolf, 1978, pp. 16-18). The relevant standard now stated that their planning should give auditors “a reasonable expectation of detecting” fraud (The Institute of Chartered Accountants in England and Wales, 2000, pp. 29-30).

Responding to a Labour backbench lobby to end self-regulation, in 1976, the Trade Secretary, Edmund Dell, called in the presidents of the accounting bodies and threatened them with government regulation if the profession did not put its own house in order (Accountancy Age, 1976b). The accountants’ response was to set up the Joint Disciplinary Scheme (JDS) in 1979, where prominent cases involving professional incompetence, which fell short of the misconduct covered by the existing ICAEW Disciplinary Committee, could be dealt with (Accountancy, 1977, pp. 80-86). The architect of the JDS, Sir John Grenside, explained that:

There were threats to take away self-regulation . . . so I was asked to try and devise some method of improving the disciplinary procedures . . . where a high profile had to be shown that something was being done (Grenside, 1997).

The JDS involved non-accountants for the first time, and a lawyer was put in charge in 1993, but the procedure was cumbersome, costly and prolonged; often handling cases over ten years old and meting out punishments of no great severity (Chance, 1993, pp. 25-26; JDS, 1992, p. 12). In one case, for example, an accountant who failed to exercise a “proper sense of the distinction between his own money, the money of a finance company and the money of clients of the firm” was censured and charged costs of £750, out of a total of £50,693 costs (JDS, 1983, p. 17). Price Waterhouse were charged £273,000 costs for failures in the Ramor case in 1987 (JDS, 1987, p. 19). Only seven accountants have been expelled from the English Institute by the JDS, and three of these came in the Barlow Clowes case in 1995 (one was a senior partner with Spicer and Pegler who had been chairman of an APC working party in the 1980s)
(Accountancy, 1995, p. 13).

Conclusions

The L&C affair raises a number of issues to do with the nature of fraud and the regulation of the financial services sector which still have relevance today.

With regard to fraud, the distinction was made between category (a) frauds involving financial manipulation, and category (b) frauds for personal gain. In fact, the L&C affair and other financial scandals in the 1970s seem to have precipitated action against category (a) fraud in a far more concerted fashion than previously (bearing in mind there had been the infamous Royal Mail case in the 1930s) (Green and Moss, 1982). The 1980 L&C court case was in effect the first prosecution for operating a share support scheme, to be followed of course by the Guinness case; while insider dealing was only made a criminal activity first in the 1980 Companies Act (Kirk and Woodcock, 1997, p. 275). Therefore: “prosecutors have ventured into territory once considered unsuitable for the criminal law and in so doing they have challenged the secretive and complex practices of the city” only relatively recently (Kirk, 2000, p. 17).

The question arises – was this a wise move? Certainly the L&C case highlighted the problems when the criminal law enters the city since the process was shown to be
imprecise and arbitrary. For example, at the L&C trial the judge directed that the defendants could not reasonably have been expected to have distinguished between the window dressing that “no one thought was dishonest” in 1973, and the “overwhelming” window dressing in which they had been involved (The Financial Times, 1980). In other words, a little window dressing was acceptable but larger amounts were criminal. Also, as we have noted, many of the L&C’s manipulations were common practice in the city in the 1970s and 1980s (Patient, 1998). For example, the fringe banks, J.H. Vavasseur and FNFC (where L&C’s liquidator was a director), also had share support schemes in operation in the early 1970s, but in neither case were allegations of fraud made (Reid, 1982, pp. 48-149). The obvious reason for this contrasting treatment is that the other banks survived (often indeed rescued by the Bank of England’s lifeboat) whereas L&C did not, which comes close to defining fraud by the success or failure of the financial manipulation concerned. Pepperell can count himself unlucky to have gone to prison out of the whole nest of vipers that was fringe banking in the early 1970s.

For these reasons some academics and commentators have argued for distinguishing between category (a) and (b) fraud and only criminalizing the latter (Spens, 1998; Clarke, 1986, p. 169; see also Kirk, 2000, p. 19). Giving an authority such as the FSA the task of disciplining category (a) fraud it is argued would reduce the number of the troublesome fraud trials, would be more effective, quicker, cheaper, less arbitrary, and more rogues would be prosecuted than the criminal justice system achieves at present (Levi, 1995, p. 192; Punch, 1996, p, 46; Company Law Review Steering Group, 2001, p. 8; Water and Hopper, 2001). However, the L&C case also suggests problems with this policy, since distinguishing there between (a) and (b) fraud would not have been easy. Also category (a) fraud is not victimless; in the case of L&C several pension funds for example lost out. It is argued therefore that the type of punishments suggested for regulatory breaches such as “withdrawal of a licence to trade or . . . civil actions for damages” (Clarke, 1986, p. 169) is not severe enough in comparison to the damage done to third parties.

To argue for the decriminalisation of category (a) fraud, however, would also argue strongly that the first line of defence against wrong doing, the audit, would need to be made more effective. In the L&C affair far from being the shareholders’ watchdog the auditors were to some extent the authors of the deceptions. One interesting point of note is that although academics have argued that auditors had by the 1970s long since abandoned their fraud detection role (Chandler et al., 1993), and the concept of the expectations gap was already well understood (Sikka et al., 1992), Harmood Banner did not seek a defence along those lines in the L&C affair. Instead they argued that much of the apparently fraudulent behaviour amounted to no more than attempts to stretch the limits of accepted city practice, and that they followed the advice of their lawyers (The Accountant, 1976). It has been argued here that the latter argument is invalid because the level of evidence required in the “true and fair” test is of a different order to establishing criminality, while the fact that share support schemes and window dressing had been allowed to become common practice was merely a condemnation of auditors generally in the historical long-term. As it was, the L&C and other fringe bank auditors failed to stop these financial abuses; had they done so, we could speculate, might have prevented the 1973 bank crisis.

The only reasonable explanation for the L&C audit firm’s behaviour was that they were under strong commercial pressure not to upset a valuable client and thereby lose the audit. The L&C affair is a clear example where public accountants put self-interest before the public interest which, Sikka et al. (1989, p. 48) reminded us, their royal charter commits them to. The L&C affair would also suggest that the importance of the commercial ethos in auditing is not as recent as Hanlon (1994, p. 107) for example has argued, and that the standard of auditing is unlikely to improve until the direct commercial relationship between auditor and client is broken in some way.

The L&C case also shows the DT inspection system to have performed well with regard to laying bare the fraud but badly with regard to its judgments on the audit. Although the treatment of the auditors in the DT report did create a sufficient public reaction leading to regulatory changes, it can be criticised for its limited scope, for lacking a wider perspective, and its conclusion, unjustified by its own evidence, that the problems were largely caused by deception of the auditors and failings of an individual rather than any systemic weakness in British auditing. It has been argued here that the inadequate performance of the DT inspectors was due to the fact that one half of the team was a prominent chartered accountant uncomfortable in criticising his fellow professionals and perhaps conscious of the legal and political implications of being too critical of the auditors, committed as he was to the preservation of the self-regulatory system.

Academics have tended to highlight the auditing industry’s “close and complex relationship with the institutions of the state” (Sikka, 2003, p. 202; Sikka et al., 1989, p. 53); both “retain an almost permanent presence in the ‘regulatory space’” (Sikka, 2002, p. 120). On the contrary, the L&C affair and its aftermath highlights how little the state and the accounting profession seemed to want to have to do with each other. It appeared as if the Labour government was about to take drastic action following the L&C report, but instead it gave the accountancy profession the opportunity of reforming itself. Why it did this is not apparent (and would make an interesting study once the papers are released under the 30 year rule), but governments have historically been reluctant to take on city regulation. As one leading Tory put it in 1990:

We have to be very careful with the city that we do not damage a national asset and one of the most important markets in the world (Punch, 1996, p. 177).

The calculation seems to be that increased regulation would damage the city’s competitiveness, out-weighing the competitive advantages of a “cleaner” market and a reduced risk of scandals that effective regulation might bring. Self-regulation is also cheap from the state’s point-of-view, and has the further advantage that when things go wrong the politicians and civil servants are one step removed from taking the blame (Sikka, 2002, p. 120).

On the profession’s part, the aftermath of the L&C and the other scandals of the 1970s reveal accountancy as committed to the preservation of self-regulation. Indeed, the resulting regulatory measures probably failed precisely because they were seen in the profession as primarily there to stave off the threat to self-regulation rather than as a determined effort to tackle the root causes of audit failure – the commercial pressures on auditors which compromised their independence. Patient, as chairman of the APC in 1986, set out these dangers:

Pressures of commercialism may impact upon professionalism so that there must be sufficient safeguards to ensure . . . a proper balance (Patient, 1986, p. 63).

But in the 1980s the commercial pressures on the auditors if anything intensified, and in the words of Sir David Tweedie, then chairman of the Accounting Standards Board:

The 1980s were an absolute disaster . . . I saw some weird things that made you ashamed. I think the auditors of the 1980s lost it . . . (Tweedie, 1998).

The audit failures at Ferranti, British and Commonwealth, Polly Peck, BCCI, Barlow Clowes, Maxwell, and Barings, were all proof that the self-regulatory reforms the accounting profession put in place in the wake of the L&C affair failed. An accountant contemplating confusing his client’s money with his own would probably not have been dissuaded by the possibility of being fined £750 by the JDS; while the treatment of Price Waterhouse clearly did not galvanise its efforts at BCCI. On the other hand, an individual auditor contemplating taking a stand on a matter of principle might well have been influenced by the fate of the last chartered accountant to have done so.