ThinkHouse Unlocked: Lessons on Directors' Duties

Sharon Ayres: Welcome my name is Sharon Ayres I am a Partner in the Corporate team at Gowling and I look after our governance team. We have seen a surge of interest in the area of governance over the last few years but especially in the last 18-24 months. Quite often this has involved our providing some director duty training to client boards. Whilst this is really important I do find it is much better for our engagement and results if we can refer to practical examples and situations rather than simply run through the companies acts, statutory provisions.

As we have seen a number of high profile corporate collapses and now have the benefit of the BEIS committee inquiry reports these provide a really useful opportunity to consider what went wrong. Each report states how it effectively lies with the board and so what could the board do better?

To prevent it happening again it is useful to know what caused these issues and then consider how we can minimise the risk of them happening again. At the outset I do need to confirm that I cannot do full justice to an analysis of these failures of the two phenomenal organisations in 20 minutes. That is certainly beyond the scope of this talk but I have read the BEIS committee reports and recommendations and it is largely that and related analysis and articles that I am relying on. I have not looked at the individual interviews with directors to directly hear their defence. I am very conscious that we are now sitting with the benefit of hindsight whilst the boards at that time had to make what were very tough decisions in very tough circumstances.

Notwithstanding that though I think it is useful to take advantage of those investigations to see what is carried out, see what conclusions were made and what they point to by way of lessons that can be learnt. So with that let us look at the agenda.

So what I am going to do is just spend a few moments setting out the background to Carillion, Thomas Cook in the collapse, I am then going to look at the six key areas where I felt that the inquiries identified flaws in how the boards of those companies operated and as such the improvements could then be made. I am then going to look at some recent developments that have happened following these collapses and other collapses. We are then going to conclude just with some takeaway and really learning from the mistakes of others. What I am not going to do I should state, is look at the position of the auditors and the FRA who were also subject to some criticism in both of those inquiries and that would be the subject of a whole new seminar, but what we could note is that there are changes and reforms in that area too.

So taking the background then, if we look at Carillion first. Carillion was Britain's second largest construction firm. It was a FTSE 250 company with annual revenues at £4.4 billion. A huge successful company. So what went wrong?

The liquidation itself had repercussions for all types of stakeholders. Shareholders losing their investment, 43,000 employees whose jobs were threatened, 28,000 pension scheme members whose retirement income will be reduced, and thousands of sub-contractors creditors whose invoices are unlikely to be paid and the local community and environment also being affected. It was said that the company's delusional directors drove Carillion off a cliff and then tried to blame anyone but themselves. So there were a lot of useful quotes and statements through these reports and you will see I have tried to include some of these on the slides. But the conclusion being reached is that the board were responsible and culpable for the company's failure.

So if we look and turn to Thomas Cook. Again another sad tale really. Thomas Cook operated for almost 180 years but it the end it had £1.7 billion in debt to its banks and £1.3 billion owed to suppliers. It also involved the largest repatriation in peace time history. For UK citizens there were 150,000 persons that had to be returned home and 9,000 Thomas Cook staff lost their job. So how and why did these incredibly successful companies fail? What went wrong?

So having read the reports and the recommendations from the inquiries I pinned down six areas where I think boards could be improved or certainly the finger being pointed to the board of Carillion and Thomas Cook and I am sure others can learn from mistakes made. So what I will do now is just run through what I saw is that common theme running through the unfortunate collapse of both of those companies.

So the first one here is the board being willing to properly challenge and scrutinise key decisions. It is often quoted as the most common reason for corporate failure and with this it is not going along with the flow of things or feeling you are disrupting a lot of work that has been done in investigating things. The role of the chairman and the non-executives have a big part here. So in relation to Carillion it was Philip Green was the chair and he was criticised in particular for what is quoted to be his unquestioning optimism when his role should have been to challenge. The chair needs to create the right environment where constructive challenge is accepted and encouraged. There were lots of examples throughout the reports where there were these key decisions but the investigation did not feel they had been properly aired and under the scrutiny they should have been.

There were very aggressive accounting policies and practices which the finger was pointing almost to the auditors and such but the board should as well take responsibility as information misled the market. There was this pressure to continually award bonuses even though companies they were declining, they were collapsing, but bonuses being issued right up until the end on top of what are pretty significant salaries.

The pressure at Carillion was to constantly declare dividends when there was a shortage of funds and those funds could have been used elsewhere. Bidding aggressively to win work when that work that had been won was unsustainable on the terms secured. And in relation to Thomas Cook it was taking on constant levels of debt that were crippling the company and arguably were a good cause of it collapsing in the end. The company in the end, Thomas Cook were paying something like £100 - £170 million just in financing costs per year. So the inquiries noted a number of these key decisions that would impact the viability of a company and if the board had scrutinised those decisions or challenged them more then maybe they would have had a different outcome.

So the next area again common to both Carillion and Thomas Cook, is this idea of getting the alignment of remuneration and particular bonuses to that long term success of the companies. So in relation to Carillion there you will see that the executives received a total of £4 million in bonuses during 2017 and that was just before the liquidation hit early 2018. The directors' bonus scheme did not directly address at all the enormous debt levels at Thomas Cook and yet that was clearly one of the chief reasons for the downfall but the bonuses were not aligned to addressing that key issue. And neither company had effective clawback arrangements it would appear so that, if targets were not achieved, the company could try to get some of those payments back. Bonuses should be based on criteria that are genuinely stretching and reward only exceptional performance rather than simply being expected as an element of annual salary.

The next issue that is again common to Thomas Cook and Carillion, was the failure to take due consideration of key stakeholders. I listed at the top there, the supply payments in relation to both Carillion, it paid its suppliers extremely late offering standard payment terms of four months and then asking for a price cut if earlier payment was expected and it was criticised as using these arrangements to really shore up its balance sheet so just disregard really for those suppliers. Thomas Cook in a similar position, it was quoted as being just simply a lousy payment record, suppliers regularly getting paid in well over 90 days and as it turned out in the end not getting paid at all. A quote from the reports in relation to Carillion, just looking at the next item in relation to its huge pension deficit was that the long term obligations such as the adequacy of funding for Carillion's pension schemes were just treated with contempt.

So this engagement with customers, addressing suppliers fairly, huge criticism. It is all part of good governance and possibly as well part of the push for the introduction more recently of large firms having to report on their Section 172 Companies Act Compliance, so that is the board in making key decisions not only looking at acting in the best interest of its members but taking into account other key factors and this engagement with stakeholders, employers, suppliers, pension scheme members are all critically important to good governance.

The fourth issue I pulled out of the reports was this requirement for the board to understand properly the issues that it is facing, the risks it is facing and where needed engage with director training and development. And so great quotes again from the reports there with the first Carillion has shown the importance of boards awareness just of its own effectiveness and the willingness to enhance its own performance in claiming ignorance or misinformation and this largely related to the accounting information which both companies did not get right and reported to the failure of the audit. But the board should not rely on that ignorance and the expectation just to rely and point the finger at the auditors, it is not good enough. Directors should arm themselves with the requisite knowledge.

So in the case of Thomas Cook the accounts were effectively propped up by goodwill of £1.6 billion, it was not challenged by the auditors sufficiently or indeed though the board, and the rise and fall really being based as they say on questionably accounting practices that misrepresented the reality of the business. And the training and development I think as well goes hand in hand with being able to go back to that first issue I raised, challenge and scrutinise the key decisions that the board are facing. Yes you can delegate certain tasks and bring in experts but the board still need to get their hands on and take responsibility for it, get that decision right.

Diversity again appears in the inquiry and recommendations of both the review for Thomas Cook and Carillion, both boards not diverse at all. Great quote there on the slide that came from recommendations of the Thomas Cook inquiry, noting the obvious, the more similar that directors think, act and look, the more likely it is that they are not going to challenge each other or innovate or think imaginatively. Similar comments in the Carillion inquiry as well. Both boards lacked real diversity. Now whilst there is no causal link that can be established, the growing wisdom is certainly that diversity should improve good governance and hopefully help to limit the chance of large corporate collapses. This topic of diversity constantly in the spotlight, we know it can be difficult to get right but you have to try.

Finally my last issue to deal with was the culture and getting a culture that supports long term success, long term goals and vision. And again with both Carillion and Thomas Cook their culture was really criticised in the inquiries so there are great quotes again. Carillion's collapse was also a stark illustration of a rotten corporate culture. The company took imprudent risks, acquired huge debts and disguised its problems with aggressive accounting practices. And equally in relation to Thomas Cook, it just had a flawed corporate culture. And culture really does come from the top down and the board need to embrace it and get that right and it is a culture that embraces long term sustainable growth and success and this was just reading as lacking. The boards in both instances really focusing on short term wins so in relation to paying dividends constantly where the cash could have been used better in other ways, devising ways to ensure bonuses were paid, not looking at trying to find ways to get that debt reduced, the debt that was strangling the company in the case of Thomas Cook.

So a quick recap then. Having read through the inquiry reports and recommendations and other articles really that gave some analysis to these conclusions reached. These are the six key areas where I think that there could be lessons for boards of all companies to learn from. Challenge those key decisions, get that right, get the remuneration and bonuses to really support long term success and make sure that all due consideration is being given to key stakeholders, employers, suppliers, customers, they are all key for the success of a business. Make sure that the board are getting that regular development and training in areas that they need to so that they can properly understand the issues and risks that they're analysing and making decisions on.

Diversity, greater effort really needing on those corporates that haven't got there yet to do so and then clearly getting that culture right, culture that will promote long term sustainable growth profit.

So there are definitely lessons to be learned from both of these cases and ones prior to that. I am sure other examples than my six could be pulled from the enquiry reports but I hope that that sample has been useful to give that practical example in relation to learning.

I mentioned at the start that I would also touch upon some of the more recent developments that have taken place in part because of these corporate disasters but otherwise just because of this push to see better government in particular large corporates. So the first one really is the corporate governance code in relation to listed companies, that has been subject to significant revision of late and equally pressure now, or actually obligations now on large private limited companies to adopt a corporate governance code for the first time and we are just seeing this come into play now where those corporates as well are having to report on their compliance with the code and do that every year and make it available to the public.

The next item I think I touched upon with early Section 172 Companies Act, so this is not new law but it is a new requirement for the larger corporates to actually publish and report how they are complying with that section. That section requiring corporates to largely act in the best interest of the members but to equally have due regard to other stakeholders when key decisions are made and as we've mentioned earlier those key stakeholders are employees, your suppliers and your customers, the environment, we've seen a big push on ESG factors of late, so looking at the impact on climate and communities. So a great push there and the reporting here again for the first time this year both the listed companies and the large private companies need to be much more transparent in the way they are complying with Section 172.

Diversity initiatives, they are constantly coming forth and great and so we really do need to see those corporates that aren't embracing it to do so and make sure those changes come through. There has been lots of guidance issued by a number of governance bodies. I have mentioned there the ICSA recent guidance because it has literally been published in the last week or two and it is really good. It is looking not only at directors' duties but equally because of this new requirement of reporting on Section 172 it is looking to give some practical help in relation to that.

I have then bullet pointed all of the FRC reform because as much as I haven't touched upon it, it was the subject of a great deal of focus in both of those enquiries and reform is afoot and so things are happening.

So as I say this is just a flavour of some of the developments that are going on at the moment. Good governance is being pushed and it will continue to do so and that seems to be the case notwithstanding COVID-19 or Brexit. The government clearly seeing that for these corporates to survive governance really does need to be improved.

And so that brings me to the end and lessons learned and this is a great quote: it is good to learn from your own mistakes but even better to learn from the mistakes of others and actually in relation to Google, a number of people were attributed with that quote, hence I have not put anybody on it. But it is a good quote nevertheless and it is applicable to boards of whatever size really, large and small, can learn from the mistakes of others and clearly hopefully it makes those, you know the disasters of these collapses less if we can get something from them, lessons can be learned, some good at least coming from it and we also know that even well run boards will make bad decisions from time to time, it will happen but it is always looking to see if we can improve and minimise the risks.

So thank you for joining me on this webinar. If you have any questions at all then please do get in touch.

Thank you.