Corporate governance is inevitably an area of constant focus for financial leaders and the organisations they serve. Yet over the course of the last 12 months, a series of corporate scandals and organisational collapses of cataclysmic proportion have totally redefined the critical role effective governance has to play within the global business ecosystem. More important still, the major corporate failures that plagued markets in 2018 serve as a terrifyingly real cautionary tale for organisations hoping to escape similar ruin.
In order to draw valuable lessons from corporate scandals gone by and learn how to prevent similar catastrophe, it’s worth first examining three of the biggest collapses that rocked the UK in 2018 – and believe it or not, those three scandals shared a dizzying array of common factors and failings.
Not too big to fail
Last year’s tumultuous series of corporate scandals began with a bang following the collapse of Carillion. The British multinational facilities management and construction giant was the UK’s second largest building and outsourcing provider prior to its fall. At its height, Carillion was listed on the FTSE 250, had been raking in an annual £5bn worth of revenues and employed around 43,000 workers across the globe.
Unfortunately, things looked a lot healthier for the construction giant from the outside looking in.
According to Parliament’s post-mortem, the UK’s Financial Reporting Council (FRC) first raised concerns about Carillion’s future in 2015 while conducting a regular review of the company’s accounts. The FRC highlighted 12 potential problems with Carillion’s books, ranging from a lack of clarity in goodwill assumptions to a non-existent explanation on the major decline in Carillion’s book-to-bill ratio. Banks saw the warning signs, too, and warned investors to expect a profit shortfall because of Carillion’s overreliance on reverse factoring.
Yet for whatever reason, huge tenders continued to go to Carillion, HMRC agreed to defer £22m in tax liabilities and the company’s unqualified accounts continued to be signed off until March 2017 – when its dire financial position finally unravelled. Within the span of just nine months, Carillion issued three profit warnings, disclosed £845m worth of write-downs, had 39% wiped from its shares and lost its CEO. On 15 January 2018, Carillion was pushed into compulsory liquidation – by which time the company had racked up debts of £1.5bn with less than £30m left in the bank.
So, what went wrong? There were several key areas that led to Carillion’s decline, and the first was board performance.
With the gift of hindsight, it’s fair to say Carillion’s board failed to adequately manage the company’s principal risks by allowing it to take on high debts while trading on low margins. It’s also been questioned whether the board had a firm grasp of Carillion’s contract risk management and its razor-thin risk-reward equation. In terms of viability, authorities have since particularly called into question the company’s stress-testing procedures of cash flows to demonstrate viability.
More crucial was the board’s insufficient handling of annual reporting and accounts – including revenue recognition on significant contracts, massive carrying value of goodwill and alternative performance measures.
“There were pretty clear warning signs that the debt levels of the company were increasing, and that operating cash flow was completely used to pay dividends – leaving nothing for future investment,” explains Daniel Bens, Professor of Accounting and Control at INSEAD.
“This was clear to an outsider and therefore should have been evident to the Board who could have pressed management for more information on the sustainability of the situation.”
MPs raised concerns following the wake of Carillion’s demise regarding the repeated clean bill of health handed to the company as part of regular but unqualified audit reports – with the FRC going on to investigate the lack of red flags in subsequent audits concerning Carillion’s revenue recognition and accounting for pensions.
Similarly, internal auditing likely failed to include modelling in relation to capital and liquidity risk, which could have potentially raised the alarm quicker.
Pension woes and black holes
Before delving into the frantic final days of British retail institution British Homes Stores (BHS), it’s worth pointing out the iconic department store chain began its slow and painful demise long before 2018.
Founded by American entrepreneurs in 1928, the UK high street staple enjoyed generations of success and even sat on the FTSE 100 until it was purchased by retail magnate Sir Philip Green in 2000 and taken private. Green subsequently sold the chain to his family-owned Arcadia Group for £200m, and BHS actually enjoyed several years of profit and a pension scheme that was in surplus after the sale. But according to a damning report compiled by Westminster’s Work and Pensions and Business, Innovation and Skills Committees, this seemingly profitable and healthy business was effectively sucked dry by Green’s team.
Following their investigation, MPs asserted the board allowed for abnormally high dividends to be taken out of the business between 2002 and 2004, equating to around £423m off the back of just £208m worth of income. While Green has since argued this wasn’t unprecedented, it’s been pointed out BHS dividends were around twice the proportion of net profits attributable paid out by competitors like Primark or M&S.
While shareholders of the private company were enjoying questionably large dividends, further cash was extracted from BHS through the sale of property. In 2001, Green sold ten BHS stores to a Jersey-based property company owned by his wife as part of a sale-and-leaseback arrangement that saw the company pay more than £153m in rent to Green’s family firm. These buildings were ultimately resold to BHS in 2015 for £70m after Green decided to hand over the floundering and underinvested retail chain to Dominic Chappell for the cost of just £1.
Chappell had no retail experience and took on BHS with a pension scheme in deficit. Chappell’s team had no funding to bring to the deal either, no equity and MPs claimed Chappell took on no personal risk as part of the transition arrangement. As a result, Green was lambasted for agreeing to sell BHS to Chappell in the first place. Meanwhile, subsequent investigations found Chappell then personally removed £2.6m from the failing business alongside a £1.5m family loan.
In the end, BHS lasted just 13 months under Chappell’s leadership before it entered into administration. Against all odds, part of the chain crawled on for another two years after the Al Mana Group scooped up the chain’s digital business – trading online until June 2018. As part of the retail giant’s slow death, 11,000 workers lost their jobs and the future of some 20,000 pensioners was thrown into uncertainty as the result of the company’s flatlining pension scheme.
The BHS pension scheme was ultimately rescued in July 2018 after a specialist insurer agreed to buy out its £800m worth of liabilities. Yet as the media focused on the uncertain future of former BHS employees, the rapid decay of a similarly iconic British high street staple was beginning to spread, too.
Patisserie Valerie opened in Soho in 1926, and over the course of several owners and nine decades swelled to a chain of 192 bakeries across the UK. Patisserie Valerie’s success was totally meteoric, with rapid expansion taking place only in the last decade of its life – but the fast-rising star shattered in October 2018 when it was abruptly announced trading in shares of parent company Patisserie Holdings was to be suspended because of material misstatements in the company’s accounts
The board later conceded there was a £20m blackhole between the chain’s reported position and the company’s actual financial status – and told shareholders without an immediate cash injection, the directors would need to shut Patisserie Valerie down. Within a matter of hours, a rescue plan was agreed in which the company would borrow £20m from chairman Luke Johnson and sell 31m ordinary shares to raise further capital.
Yet after news of accounting fraud continued to surface concerning alleged unreported overdrafts of almost £10m, along with the launch of multiple investigations and a failure to secure a more sustainable lifeline from banks, Patisserie Valerie fell into administration on 22 January 2019 – leading to the immediate closure of more than a quarter of stores and 900 job losses. Mike Ashley’s Sports Direct made a bid for what remained of Patisserie Valerie in February 2019, but administer KPMG rejected the offer as insufficient.
Picking up the pieces
At first glance, the respective corporate scandals at Carillion, BHS and Patisserie Valerie appear fairly disjointed. Each disaster took place in starkly contrasting industries under seemingly unique circumstances. Yet there are actually a number of gaping common factors shared by each collapse – and there are valid lessons financial leaders can draw from those commonalities to escape falling into a similar trap.
First and foremost, it’s fair to say each corporate scandal was facilitated by inadequate auditing – both internally and externally. The FRC launched an investigation in November into the behaviour of Patisserie Valerie’s auditors Grant Thornton, whose whose chief executive appeared before MPs on the Business, Energy and Industrial Strategy (BEIS) Committee in January 2019 and transparently argued it wasn’t actually the role of auditors to look for fraud in the first place.
Just like Carillion and BHS, auditors failed to pick up on what should have been repeated red flags because of their limited remit – and similarly, subsequent work carried out by forensic accountants in the case of Patisserie Valerie demonstrated a clear lack of internal controls in terms of quality assurance. These factors are precisely why UK politicians are now pushing for regulatory changes to create a more active auditing regimen, including the monumental task of potentially breaking up the Big Four accounting firms.
“Misleading audits have been at the heart of corporate failures over recent decades. Recent accounting scandals at BHS, Carillion, and at Patisserie Valerie have shown accounts bearing closer resemblance to works of fiction than an accurate reflection of the true financial performance of the business,” BEIS Committee chair Rachel Reeves said following the launch of the ongoing enquiry.
Yet 2018’s top corporate scandals extended far beyond insufficient audits or quality controls. According to INSEAD’s Professor Bens, passive and weak board management undeniably helped to seal the fate of both BHS and Carillion.
“In the BHS and Carillion case, more active Board of Director management was necessary to link financial outcomes to very competitive environments. That is, when a company is in a highly competitive setting, the Board must review the financials carefully because the margin for error is so small,” he says.
“The board should be asking how the competitive actions management takes will realistically lead to future cash flows. They should not just take the past outcomes as given and be happy if an internal accounting target is met.”
Although it’s hugely unlikely the global business space will ever inhabit a realm of “zero defects”, it’s important to note there are several proactive steps financial directors can take to mitigate many of the ongoing risks that facilitate poor corporate governance – and one of the simplest preventative measures is to combat groupthink and inactivity at the board level by incorporating non-executive directors (NEDs).
“Broadly speaking, there is often a lack of skills at board level,” says Jean-Phillipe Perraud, General Director of NEDonBoard, the professional body for non-executive directors and board members.
“The unfortunate collapse of Carillion has had the merit to raise awareness of directors’ duties and liabilities and has highlighted the importance of non-executive training and professional development.”
According to Perraud, truly independent NEDs paired with more effective corporate governance could possibly have saved BHS, Carillion and Patisserie Valerie from eventual collapse. Effective NEDs ask difficult questions, don’t approve unsustainable dividends and both support and challenge executive teams to create stronger and more informed leadership.
The ripples of 2018’s formidable corporate failures are far-reaching, and will undeniably continue to affect former stakeholders, impact pensioners and motivate lawmakers to create change across 2019 and beyond. As those changes continue to evolve and materialise, it will ultimately fall upon financial leaders and the organisations they serve in order to draw crucial lessons from these scandals and avoid a similar fate.
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