The collapse of international blue-chip financial service provider Wirecard in June 2020 shook the German market. One year on, the scandal has led German regulators to adopt a new law, the Act on Strengthening the Financial Market Integrity (Finanzmarktintegritätsstärkungsgesetz – FISG), which came into effect on July 1, 2021 and is aimed at reinforcing the auditing process.

Wirecard had inflated its balance sheet by roughly €2 billion and declared bankruptcy after allegations of fraud by the Financial Times, whistle-blowers, and short-sellers proved true. Germany’s financial regulator BaFin (Federal Financial Supervisory Authority, or Bundesanstalt für Finanzdienstleistungsaufsicht) declined to prevent the incident; instead, in an unprecedented market intervention, BaFin decided to temporarily ban the shorting of Wirecard’s shares.

The newly implemented FISG act is intended to prevent these events from recurring through a number of measures, including the following:

  • Audit Committee
    • From July 1, 2021 –
      • The audit committee must include two financial experts, one with expertise in accounting and one with expertise in auditing; previously, the two areas of expertise were not distinguished and could be alternative.
      • Management board members only allowed to participate in the meetings between auditor and supervisory board/audit committee when participation is explicitly deemed necessary by the supervisory board/audit committee.
      • Obligation to establish a control and risk management system aligned with each company’s size and risk exposure.
    • By January 1, 2022
      • Mandatory formation of an audit committee on the supervisory board of all companies listed on the regulated market, with the exceptions of boards composed of only 3 members, where the whole board will function as audit committee; previously, the formation of an audit committee was only advised, however, most companies already have the committee.
    • From January 1, 2022
      • Enhanced right for audit committee members to request information from management via the audit committee chair, along with enhanced direct responsibility for the quality of the audit.
  • Auditor
    • From July 1, 2021
      • Maximum term for the rotation of the Lead Audit Partner reduced from seven to five years.
      • Prohibition of all non-audit services outlined under Art. 5 of EU Regulation 537/2014; in case of non-compliance with this requirement, shareholders owning at least 5% or €500,000 of a company’s share capital can ask the court to replace the auditor.
      • Increase in auditor liability caps (for listed companies, from €1 – €4 million to €16 million or no cap in case of intent or gross negligence); as previously, only the companies themselves will be able to claim for liability against the auditor, as shareholders generally continue to be excluded from this right.
    • From January 1, 2022
      • Election of auditor of insurance companies by the AGM; previously, the supervisory boards of insurance companies could appoint the auditor directly, without seeking shareholder approval.
    • By 2024
      • Auditor’s appointment term strictly limited to ten years; previously, German companies could opt to extend the term further.
  • Regulators
    • From January 1, 2022 – The Financial Reporting Enforcement Panel (Deutsche Prüfstelle für Rechnungslegung, or DPR) will be abolished and all oversight functions will be centralised under BaFin.
    • The extent of BaFin’s rights and competences will be expanded.

The Act has been received with mixed reactions. For instance, the substantial increase in the liability caps for auditors was criticised as potentially leading to a further concentration of power within the Big Four, as smaller auditors may not be able to afford the additional risk and could end up being pushed out of the market. Other market participants and observers have criticised the increased concentration of powers now attributed to BaFin and to audit committee chairs, while also noting how a more frequent rotation in lead audit partner may result in a drop in auditing quality.

The separation of the two areas of expertise on the audit committee – auditing and accounting – appears particularly relevant, especially in the context of the growing focus on board refreshment process and disclosure of skills and expertise. This requirement is also deemed to have a significant immediate impact on supervisory board composition and the selection of new nominees. Shareholders and regulators will need to closely monitor how the new expert on the committee is chosen and whether their expertise truly checks out. This rule surpasses what is established internationally, either as legal provision or best practice; in fact, with few exceptions (e.g. South Africa, where all audit committee members must have a degree of financial literacy), one audit financial expert on the committee is generally enough for companies listed in Europe and the United States.

Other aspects of the incident were seemingly ignored by the Act. For example, the potential effects of the German corporate governance structure on the auditing processes, i.e. the clear separation between executive and non-executive directors in a two-tier board system, and the presence of employee representatives on the supervisory board due to “Co-Determination” rules. Notably, the Act does not include any requirements on the independence of audit committee members and chair. In theory the audit committee chair should be independent from both a company’s executives and its controlling shareholders, according to the German Corporate Governance Code (Deutscher Corporate Governance Kodex or DCGK). However that only applies on a comply-or-explain basis, and many companies choose not to comply. For 25% of supervisory boards examined during the 2021 proxy season, Glass Lewis classified the audit committee chair as affiliated.

The stricter limit on the term of an auditor’s appointment will bring German companies in line with the original cap imposed by the EU regulation. The prior allowance for a one-term extension was an exemption established by the German government during the transposition of the EU rules into local law. Currently, the average tenure of auditors at German listed companies is 13 years for blue-chips, just under nine years for mid-caps, and just under eight years for small- and micro-caps with available data. As such, the biggest impact will be on large entities, with 13 blue-chips currently employing their auditor for longer than ten years.

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For investors exercising their stewardship obligations, voting on agenda items like (re)appointment of the auditor and approval of accounts and reports is generally routine – except in the wake of a scandal. Yet even absent allegations of audit and reporting deficiencies, there are considerations before casting a ballot. Glass Lewis’ Proxy Paper research supports investors in identifying issues like lengthy audit tenure and an excessive level of non-audit fees, which can indicate potential problems with the external auditor. Similarly, our analysis highlights qualified auditor opinions, material misstatements, or an emphasis of matter on the audit report, and helps determine whether these oversight concerns should influence voting on the election of audit committee members, the supervisory board chair, and the ratification of supervisory board acts for the year under review.

In due course, Glass Lewis’ policy guidelines will be updated to reflect the new FISG rules. Amongst other changes, the updated guidelines will reflect enhanced expectations for disclosure — on the skills and expertise attributed to audit committee members, and on the intended composition of board committees, which in Germany is often only done after the AGM — and emphasise close scrutiny of the appointment of non-independent audit committee chairs.

Yet even with a stronger regulatory regime, scandals are likely to continue popping up. Glass Lewis helps investors identify companies with problematic compliance and controls through its innovative Controversy Alerts, which provide actionable alerts of the most controversial ESG issues globally, allowing you to make better informed voting decisions at crucial meetings with the latest information in hand. For instance, Glass Lewis recommended shareholders withhold from the ratification of the acts of Grenke AG’s supervisory board at the company’s AGM on July 29, 2021, as the company was targeted by short-sellers claiming an accounting fraud. While Grenke’s own auditor issued an unqualified opinion, Mazars — under appointment by BaFin — identified shortcomings in the company’s risk and compliance systems in the interim results of its special audit.

As the Act comes into effect and investigations on the cases currently under scrutiny proceed, investors worldwide will observe how BaFin will be able to learn from its mistakes and tackle large-scale accounting frauds in useful time. In the meantime, Glass Lewis’ Controversy Alerts and Proxy Paper research can help in monitoring accounting and oversight risk.

For more information on Glass Lewis’ Controversy Alert service and approach to audit risk, contact:

GROW@glasslewis.com (Institutional Investors) | ENGAGE@glasslewis.com (Public Companies)

Marie Römer contributed to this report.