Iona, Melissa and Sophie were law student interns, participating in the WS Society Summer Internship programme during July 2018. This article summarises their research and presentation.
In 2007 Northern Rock collapsed, closely followed by Lehman Brothers in September 2008. These events sparked a global financial crisis of systemic proportions and required huge taxpayer bailouts to companies which were deemed ‘too big to fail’. Ten years on, and the UK has seen the continued struggles and demise of several leading businesses, including BHS, Debenhams, House of Fraser, and prominently, Carillion.
Carillion was a British multinational facilities management and construction service. It went insolvent in January 2018. It was left with only £29m before going bankrupt and had racked up debts of around £1.5bn. The downfall of Carillion was a result of years of bad decision making by the board, and its nature as a company with high acquisitions. This was one of the reasons for the reported pension deficit of £587m.
Employees, customers and suppliers, to name but a few, are all ultimately the victims of the managerial inadequacy displayed by Carillion’s directors. The company’s collapse has resulted in just under 2,800 redundancies, and will cost the taxpayer £148 million. This demonstrates that lessons have not been learned since the 2008 crisis, and companies which are ‘too big to fail’ are still being allowed to operate.
The systemic risk that is posed by the collapse of a company such as Carillion, which held many public service contracts, is reason for a review of what went wrong, and the failures of the legislator to learn from past mistakes. This article will do so, focusing on both the internal and external failings which ultimately led to Carillion’s downfall.
The fundamental role played by business in sustaining our economy and providing employment means that when companies fail, the impact of this goes far beyond those with direct investment in the firm. As such, directors need to take into account the long term consequences of decisions, the need for higher business standards, and the wider consequences of their mismanagement. Carillion’s Directors failed to do this.
Although shareholder-primacy has informed many of the legal developments on corporate governance, including the Companies Act 2006, there is a case to be made for directors being regarded as agents to a much broader group of stakeholders.
This is supported by the most recent publication of the Corporate Governance Code which cites ‘contributing to wider society’ as a key role of directors who should also report on how they have considered the interests of ‘the company’s other key stakeholders’. Unfortunately this guidance on directors’ duties comes in the form of ‘soft law’, which is built on a ‘comply-or-explain’ approach.
Although this ‘comply or explain’ approach provides greater flexibility, and recognises that one size does not fit all in corporate governance, the problem is that monitoring compliance is carried out by the shareholders themselves. Research suggests that many investors display an apathetic approach to scrutinising explanations so long as the company remains profitable. Accordingly short-term gain of shareholders will always be prioritised over the interests of the wider community. Take, for example, the Carillion board which has gradually increased dividends since 2011. This shows complete disregard for the financial sustainability of the company. Over the six years from 2011–2016, Carillion paid out £441 million in dividends compared to £246 million in pension scheme deficit recovery payments. The final dividend for 2016, of £55 million, was paid just one month before Carillion became insolvent on 9 June 2017. This displays the conflict of interest between shareholders’ personal interests and their supervisory role.
While there have been calls for greater regulatory oversight from an external monitoring body, the FRC has largely rejected any kind of departure from current soft law arrangements on the basis that shareholders should remain central to comply-or-explain process. Therefore a shift away from current shareholder-centric approach to director agency seems unlikely in the foreseeable future.
Nevertheless there has always been a place for corporate social responsibility in the operation of a company even in spite of persisting shareholder supremacy. Research shows that participation in socially desirable conduct is financially beneficial and improves profit maximisation in the long term. Indeed, it has also been found that managers operating in a corporate culture which is socially responsible have a lower tendency to conceal problems within the company which, in turn, reduces risk of collapse.
In light of this it would seem that Carillion should have taken into account the interests of a wider range of stakeholders, if not because of the legal obligation then because this could perhaps have prevented an otherwise inevitable demise.
The current penalties if a person acts in breach of their director disqualification order are severe on paper, but in reality only a very small number of offences committed under the Act result in any action being taken, let alone prosecution. Controversially, following the 2008 crisis only one Wall Street executive went to jail and in Carillion’s case even one prosecution seems unlikely.
The Government has proposed plans to introduce a criminal offence to punish those found to have committed wilful or grossly reckless behaviour in relation to a pension scheme. In January, Theresa May promised to stop company bosses from profiting while putting their workers’ pensions at risk. In March the DWP published its defined benefit white paper, which sets out a series of new measures for the regulator "to undertake a tougher and more proactive role". Nonetheless, with an Act of Parliament likely to have to wait until 2019/20 and further detailed regulations needed after that, it could be a long time before the white paper has any practical impact.
That being said, stricter liability has its drawbacks. Countries such as the United Arab Emirates that penalise bankruptcy and even threaten debtors with prison are not known for their vibrant start-up cultures. Discouraging risk-taking altogether, in short, can be counterproductive.
The collapse of Carillion cannot be blamed solely on the Directors. Shareholders of a company, as the owners, also have a responsibility to monitor the activity of the Board and hold them accountable for any malpractice. The most influential shareholders in relation to this role are institutional shareholders. In Carillion’s case institutional investors, such as Standard Life, Hargreaves Lansdown and HSBC Asset Management, owned a particularly high proportion of overall shares.
These large shareholders have a tendency to be passive, and lack the engagement required to hold Directors accountable for their actions. Although legislators did learn their lesson to a certain extent after 2008 as shown through the introduction of the UK Stewardship Code, Carillion’s institutional investors still failed to act in a coordinated manner so as to successfully challenge the Board’s actions.
Lack of engagement is detrimental not only to the company itself, but also has a knock-on effect for smaller retail investors, who were dependent on the financial information published by Directors. We may, therefore, see a claim brought forward against Carillion’s Directors and major Shareholders in the near future, much like the RBS Rights Issue case post-2008. Alternatively, the institutional investors may look to bring a claim on behalf of their clients against Carillion themselves.
Nonetheless, the BEIS and Work and Pensions Committees Joint Report concluded that there is only so much shareholders can be expected to do in their supervisory role in the face of misleading reporting.
Another body which holds Executive Directors (who deal with the day-to-day activities of the company) to account are Non-Executive Directors, who contribute in those meetings and decisions which should not be decided solely by Executive Directors.
Although Non-Executives should keep a check on Directors’ pay and bonuses, this was clearly not performed adequately in Carillion. Take for example Richard Howson, who headed the company from 2012 until July 2017, and pocketed £1.5m in 2016, with a £122,612 cash bonus. Carillion’s director bonuses were often 100% of their salary, a percentage completely disproportionate to their work.
This is a reoccurring failure. One year after the 2008 crisis a director’s salary in the UK’s biggest corporations was still 81 times greater than that of the average full-time worker. Yet modern day directors’ salaries are inordinately higher compared to that of the average worker at 120:1.
Another important player in the Carillion collapse were the Auditors. Statutory audits have proved a controversial issue, with particular problems surrounding the independence and objectivity of auditors (for example Arthur Andersen’s role in the Enron Scandal 2001).
The lesson learned from the 2008 crisis in relation to auditors, according to the Government, is that “Independence should be the unshakeable bedrock of the audit environment”.
Since 2008 attempts have been made to ensure objectivity in the audit market through the requirement of ‘Mandatory Rotation’. This aims to remove the threat of familiarity between an audit firm and the audited company by limiting the term of engagement to ten years, or twenty if a re-tendering process takes place.
This, however, is evidently not enough. Carillion’s auditors clearly lacked the necessary impartiality. After 19 years KPMG unsurprisingly never found reason to offer a qualified audit opinion, despite recognising that Carillion were using ‘aggressive accountancy’ practices.
Nonetheless, it is perhaps impossible to see how objectivity, independence, and indeed high-quality auditing can be achieved in the current market structure. With only limited competition, the Mandatory Rotation requirements simply create a ‘merry-go-round’, on which each of the ‘Big Four’ take their turn.
What is more worrying is that these huge audit firms pose a systemic risk in themselves, since they may be considered ‘too big to fail’. And if anything is to be learned from the huge taxpayer bailouts of 2008, it is that a company which is too big to fail, is too big to exist. Yet the Big Four are just getting bigger.
The Joint Committee report, which followed the collapse of Carillion, not only criticised KPMG, but also proposed that the Big Four be broken up. However, as beneficial as this sounds, there is no practical way of doing this. To do so would restrict UK firms from competing in the audit market altogether, and in any event, such a policy could not be enforceable on global firms.
Yet when blaming KPMG we must also look at the FRC, which is the appropriate supervisory authority for audit firms and the external regulator of non-compliance with the Corporate Governance or Stewardship Code.
The FRC’s poor coordination with other agencies as well as internal ‘cultural problems’ were largely blamed for the drop in auditing standards, which allowed many of Carillion’s own failings to go undetected until it was too late. A mixture of toothlessness and preventable failings have sparked calls for the FRC to be heavily reformed or disbanded altogether. While the future of the Council lies in the hands of Sir Kingman’s commission, due to report towards the end of this year, in its present form it certainly cannot be considered fit for purpose.
Most companies are not run with Carillion’s reckless short-termism, and most company directors are far more concerned by the wider consequences of their actions than the Carillion Board were. But that should not obscure the fact that our current regulatory and legal framework could not stop Carillion from becoming an unsustainable corporate time bomb. Thus, as warned in the Joint Committee Report, without the necessary intervention, Carillion could happen again, and soon.