22 July 2019 by Paul Moxey FCIS
Being able to distinguish an effectively governed company from a poor one is critical
Over a quarter of a century since the Cadbury Code, we should fully understand governance and be able to tell a well, from a poorly, governed company. Unfortunately it remains difficult to distinguish good from bad. When I was asked by ICSA in early 2017 to write a text book for the new Certificate in Corporate Governance I tried to make this distinction – how to tell good from bad.
I was writing during the most intense period of regulatory focus on governance in governance’s relatively brief history. Shortly after I completed the first draft in Autumn 2017, the FRC launched its consultation on a new code. I rewrote the text to take account of this and the Guidance on Board Effectiveness and address the other regulatory activity taking place and then undertook further revisions to reflect the final Code and Guidance published in July 2018 along with other developments such as the wide ranging Companies (Miscellaneous Reporting) Recommendations 2018. The text was published in November 2018.
In January 2018 Carillion plc went bust causing some people to question corporate governance and what if anything had been learned since Cadbury. As I revised the book, which included chapters on risk management, the question constantly in my mind was how Carillion could have happened in what looked like a well governed company and how to prevent similar failure in future.
Carillion gave the impression of being both financially sound and profitable. It claimed high standards of corporate governance, with rigorous policies and procedures, training and a responsible business culture. It also claimed rigorous risk management and gave assurances that there were no risks that would significantly affect business model, future performance, solvency or liquidity. The board and committee performance evaluation concluded that the board, each of the committees and the directors were all highly effective.
The audit committee report claimed it had considered significant accounting judgements, in particular regarding revenue recognition, contracts and goodwill, going concern and viability. The Committee declared the annual report and accounts a ‘fair, balanced and understandable assessment of the Group’s position’. During the inquiry into Carillion’s failure by the House of Commons Business Energy and Industrial Strategy and Work and Pensions Committees its directors, executive and non-executive, called to give evidence expressed surprise that their company had failed.
After the event it became clear Carillion was neither financially sound nor profitable and the board should have known this - but did they? It is difficult not to conclude the financial statements were misleading. Although after the failure people claimed that it should have been obvious back in 2016 or early 2017 after the publication of the 2016 Annual Report that Carillion had terminal problems, it was not obvious ex ante to many apart from those, like Standard Life Investments, with access to the executives.
There were some disclosures which, with the benefit of hindsight, gave some indication of problems to come. These included flat profitability when stated revenues were increasing – suggesting undisclosed problems with contracts or that new contracts may not be profitable and cash flow which was slightly lower than reported profit. There was disclosure of £112m of funding secured from the Schuldschein market; this is a German private debt market popular in recent years with non-German companies wanting finance without all the burdensome documentary and disclosure requirements of most debt markets.
In nearly all other respects the Annual Report strongly conveyed a picture of a well governed, established, profitable, financially secure, competent and sustainable company. It claimed ‘leadership positions in good markets’, good contracts, good staff, an effective board, a strong order book, sufficient finance for its needs and a track record of performance.
The Report emphasised that there was adequate funding stating that ‘the vast majority of the Group’s £1.5bn of funding matures in November 2020 and beyond’. The Report confirmed that the directors had carried out a ‘robust assessment of the principal risks facing the Group, including those that would threaten its business model, future performance, solvency or liquidity’ and ‘on the basis of both reasonably probable and more extreme downside scenarios, the Directors believe that they have a reasonable expectation that the Company will be able to continue in operation and meet its liabilities as they fall due over the three-year period of their assessment’. The Report also said the Group is ‘well positioned to continue funding the dividend, which continues to be well covered by cash generated by the business’.
Just a few weeks after publication of the Annual Report, a trading update was issued in early July 2017. It reported progress against strategic objectives, strong work winning performance and cost reduction underway but also disclosed ‘an unexpected contract provision of £845m. There was little detail of what this was but the City was not fooled and realised this meant a catastrophic loss.
The half year financial results published in September showed a further provision of £200m and the company balance sheet showed negative net assets of £400m. The goodwill of £1,500m was almost certainly an overstatement. Carillion looked bust but nevertheless the half year statement was upbeat about prospects and the company reported that ‘Taking account of the projected trading for the Group over the remainder of the year and the additional bank facility, the Board has a reasonable expectation that the Company and the Group will be able to operate within the level of its available facilities and cash for the foreseeable future’ and ‘The Group is compliant with its covenants at 30 June 2017 and is forecast to be in compliance with covenants as at 31 December 2017 and 30 June 2018’. By December, however, the group had run out of money.
The contrast between the actions of two major shareholders is interesting. At the start of 2016 Standard Life Investments, now part of Standard Life Aberdeen, held over 10% of Carillion. SLI was an active investor with a programme of regular engagement. In a letter to the Work and Pensions Committee SLI reported it reduced its holding as it did not like what the company’s management told them in response to SLI’s concerns about debt, earnings and cash generation. SLI had sold all its shares by July 2017 when trading update was issued.
Another institutional investor, Kiltearn Partners LLP, also held c10% of Carillion. Unlike SLI, it relied on public information from Carillion. In their letter to the Work and Pensions Committee Kiltearn noted that ‘Nothing in Carillion’s 2016 Annual Report indicated to Kiltearn that Carillion was likely to announce a significant provision within the next six months’. Kiltearn held its shares until after the trading update and lost considerably as a result. The benefit of engaging with companies is obvious. But this is not available to all, not all investors are resourced to engage and companies will not want to engage with retail investors.
Leadership is so important that with the benefit of hindsight more of us could have been on the alert. Carillion’s chairman, Philip Nevill Green, was managing director of Coloroll, the wallpaper and home furnishings group, when it collapsed amidst an accounting scandal in 1990. He was fined by the Pensions Ombudsman in 1994 for breach of trust and maladministration of the pension scheme. It was the failure of Coloroll, along with BCCI, which led to the Cadbury Committee’s review of the financial aspects of corporate governance and the Cadbury Report and Code in 1992.
In presenting a rosier situation than the facts allowed, was it a masterpiece of spin or was it the result of judgement or lack of challenge affected by optimism and confidence bias? Even after inquiry it is not clear what the board knew. Although it is hard to believe that the directors who gave evidence could have been as surprised by events as they claimed, it is plausible if you consider cognitive biases.
The inquiry report referred to the confidence and misguided self-assurance of the chief executive and to the chairman being unquestioningly optimistic. The report made frequent mention of optimism. Over optimism led to a failure to challenge and reckless pursuit of growth. Optimistic judgements led to the annual report presenting an over optimistic picture and may have enabled the board to believe its statements about going concern and viability. Over optimism and confidence may have enabled the board to conclude in its effectiveness review that it, its committees and all the directors were highly effective. It may have enabled the board to think it could turn the company around when it should have realised that was impossible. Another bias is confirmation bias where decision makers reject with little consideration any information which challenges their position but rely on information which supports it. In conjunction with optimism and confidence bias it is toxic.
It the responsibility of the board as a whole to question whether cognitive bias is affecting them and ensure their decisions are unaffected. One approach is for the board to imagine scenarios where a crisis affects the company and then consider the root causes of failure. Known as a pre-mortem, such an exercise can go a long way to removing bias.
The Carillion board may also have been prone to groupthink. Alfred Sloan, who ran General Motors from 1923 to 1956, said in one executive meeting ‘I take it we are all in complete agreement on the decision here’. After everyone nodded he postponed further discussion of the matter until the next meeting to give everyone time to develop disagreement.
Sloan knew how to reduce groupthink and encourage challenge.
It remains difficult to tell from public statements a well governed healthy company from a company where the board misguidedly believes it is well governed and healthy. The greater focus now on culture may help boards and management be more aware of inadequacies, including their own, but there is no guarantee. If you are interested in knowing more about how boards can be a risk factor, the study text discusses these issues, and more, in detail.