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The Black Swan

27 August 2019 by Peter Swabey

The Black Swan

An unforeseen event can cause havoc for even the most well-governed company

In the last edition of Governance and Compliance, I was struck by Professor Paul Moxey’s article on the challenges of being able to distinguish an effectively governed company from a poor one as this is a question to which I have given some thought recently. Are there indicators which we can use and how can these be applied across companies or, indeed, across sectors in the same way that we have identified a number of ‘red flags’ that may indicate cultural problems in organisations?

For example, is compliance with the UK Corporate Governance Code a proxy for good corporate governance? Of course, in many ways it is. The Code is the product of many years consideration of the behaviours most likely to indicate that a company is well governed. However, the Code is explicit that it should be applied on a ‘comply or explain’ basis – recognising that different companies have different circumstances which may lead them to adopt a non-standard solution – and I have often heard investors and other governance professionals say that they prefer to see a well-argued explanation for non-compliance over a simple ‘ticking of the box’ because the decision to explain rather than comply demonstrates that the easy option has not been taken and that considerable thought has gone in to the decision. And this is not binary: explanation constitutes compliance with a ‘comply or explain’ code.

The Carillion Case

This made me think of the case of Carillion, which Paul used in his article, as I was aware of their pride in their governance, with Secretariat processes accredited under ISO9001. To be clear, I have no inside knowledge of the company’s situation and there are a number of ongoing enquiries, including those by the FCA, FRC and Insolvency Service which have yet to report. These will no doubt cover for example, whether the accounts were, as Paul suggested, misleading, if they were, whether they misled the directors and whether this was the fault of the company or of the financial reporting requirements to which it was subject.

As Paul said, “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. He went on to note that “its directors, executive and non-executive … expressed surprise that their company had failed”.It is very easy for us to assume that, when a company goes bust, particularly when it does so in so spectacular a fashion as Carillion, that ‘someone had blundered’; that there is an individual or individuals to whom we may point and say ‘they did it’. The board are an obvious target in such cases – and in many cases rightly so, as they have ultimate responsibility for the success of the company. 

But it is also important to consider the external environment. The sector in which the group operated has significant issues. Interserve has collapsed. Kier has undergone a refinancing and a rights issue which left a significant proportion of the issue with underwriters. Balfour Beatty had seven profits warnings in 2013-14. Serco’s issues are well publicised and its chief executive spoke about the sectoral issues following Carillion’s liquidation. Is there an argument that the collapse of Carillion was one of those ‘Black Swan’ events, defined by Investopedia as “an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black Swan events are characterized by their extreme rarity, their severe impact, and the practice of explaining widespread failure to predict them as simple folly in hindsight.” There are one or two points here that certainly look familiar but, given the challenges of the sector, should problems have been unexpected?

Looking Back

Cognitive bias and confirmation bias can be an issue. When I did my history degree, I was trained to focus not just on what the evidence said, but also on the message that our source for the evidence wanted to believe or, perhaps more importantly, to convey. For example, evidence of the early Anglo-Saxon kings is almost entirely drawn from church chronicles and there is a tendency for their reigns to be recorded as ‘good’ or ‘bad’ more on the basis of their attitude to the church than, for example, their effectiveness as a ruler. I tend, therefore, to view evidence about corporate failures as potentially tainted by hindsight and a very human tendency to position one’s own actions in the best light possible.

We must remember too, that no board will set out to oversee the failure of a company. Directors have statutory duties, but we often focus on those in s172(1) of the Companies Act 2006, to “promote the success of the company for the benefit of its members as a whole [having regard to a number of factors]” but sometimes overlook the statutory duties under s173 to exercise independent judgement and under s174 to exercise reasonable care, skill and diligence.

Certainly, therefore, we can expect the enquiries to focus on the ‘overly optimistic judgements of the board’ and, specifically, the chairman and chief executive, asserted by the select committees and to consider whether the board was prone to group-think. However I am quite sure that the Carillion board will have taken extensive professional advice from auditors, solicitors, brokers and financial advisers throughout the period and, it would be difficult if not impossible for a board to reach a judgement counter to their advice unless there are overriding considerations of which the advisers are not aware. It will be interesting to learn from the enquiries what advice the board received and how it was applied.

One argument to suggest that the problems should not have been unexpected is based on the action of investors. Paul mentioned that there are some who argue that the auguries were clear from the 2016 Annual Report and that some investors voted with their feet. However, for each of those who did, there were others buying the stock and I am not sure that it is right to draw conclusions from the fact that one of the investors which took the opportunity to meet with management behaved differently from one of those that didn’t. Obviously each will now be seeking to be seen in the best light – the one for its wisdom and sagacity, the other for its having been misled through no fault of its own. I regularly receive feedback from company secretaries and investors on engagement meetings and both sides are adamant that discussion is carefully policed to ensure that only public information is given – very few investors want to be made insiders with all the administration and, more importantly, restrictions that that entails.

I am looking forward to reading the various regulatory reports about Carillion once they have been published. As Paul says, “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”. But that is not all. I think we have to be very careful when drawing a link between governance or culture and corporate health. As may have been the case with Carillion, the reality is that a ‘Black Swan’ issue can overtake a well-governed company very quickly in spite of that governance.

And now, for something completely different. I promised in my last column an update on where we are with our review of Board Evaluation. We received 55 responses and are now working through the very helpful feedback that we have received. Thank you to all those who responded – we have held one meeting with our steering group already and are planning a further discussion in September.
Finally, more sad news: soon after the last issue went to press, I was sorry to learn of the sudden death of Julian Roberts, CEO of ShareGift, an organisation with which ICSA has worked closely for a number of years. RIP.

Peter Swabey FCIS is Policy and Research Director at ICSA: The Governance Institute

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