The corporate governance lessons from Carillion's collapse

Tuesday 06, March 2018

‘Our commitment to business integrity, safety, strong governance and sustainability remains a key strength of our business,’ Carillion’s 2016 annual report tells the reader. Naturally, hindsight raises some questions about the accuracy of this statement.

The scope of what went wrong at Carillion and why it failed are beyond this article. As the investigation goes on and the company’s internal state is dragged into the light, there will doubtless be more to analyse.

But there are lessons directors can learn from what we know already, even for companies not facing Carillion’s sad state.

Paying for failure

One issue repeatedly raised is directors’ pay at Carillion.

A particular point is the change of the malus and clawback conditions, which the Institute of Directors suggested were ‘relaxed’ in 2016, preventing clawback from taking place in the event of ‘corporate failure’ – a phrase which one might fairly use to describe the company’s current condition.

This is only half correct. The clawback conditions approved in 2017 are conventional ones of gross misconduct and misstatement of financial results.

Neither appear at the time of writing to apply here, but they probably represent the same terms found in long-term incentive plans (LTIPs) used by most of the FTSE. It is unlikely this was seen as a deliberate relaxation of their provisions.

Why would any company not specify that awards may be clawed back if the company goes into compulsory liquidation? The fact is that the majority do not.

This is an obvious and hopefully uncontroversial change that many might consider in the future, but presumably most remuneration committees do not consider that performance targets could continue to be met when the company is on the brink of collapse.

“Why would any company not specify that awards may be clawed back if the company goes into compulsory liquidation?”

This shows both the need to look ahead, even to unlikely scenarios, when preparing performance targets and the need to design those targets carefully. Carillion is not unique in this respect.

A contrary example might be the housebuilder Persimmon, whose shareholders are doubtless much happier with the growth in its share price in the last few years than Carillion’s backers.

Its chief executive has – like executives at Carillion – faced calls to pay his bonus back, not because of the company’s failure, but because of its unanticipated success.

Persimmon’s share price was perhaps driven more by the introduction of the government’s Help to Buy scheme than the ability of its management team, but nonetheless means its executives will be receiving a windfall.

Similarly, the government is currently consulting on the uses of share buybacks.

These can be a legitimate tool to return value to shareholders, but there are fears that they are being used to increase executive pay by artificially increasing measures such as earnings per share (EPS) without any real improvement in performance.

Wider duties

Consultation is also underway on the next round of proposed revisions to the UK Corporate Governance Code, and draft legislation is expected soon on reporting on directors’ duties to stakeholders other than their shareholders. The need for both of these can again be demonstrated by this situation.

In terms of the latter, shareholders have lost their investment in Carillion. Simply on the basic measure of the core duty to the company’s owners, the directors at Carillion appear to have failed.

Still, you might say investors expect some risk. The questions now facing the Carillion directors have focused less on shareholder losses and more on the impact on others directly affected – pensioners, employees, and suppliers.

There is always a danger of making duties too diffuse. Whether a company is taking account of its duties to its employees is harder to measure than simply whether it is profitable and therefore harder to enforce. These should not, however, be seen as in opposition.

A successful company will need to understand the context in which its profits are made.

In Carillion’s case, lengthy payment terms meant that suppliers missed out on payments for up to four months’ work already undertaken when it entered liquidation. Those poor relations with suppliers might help short-term cash flow but are hardly a recipe for long-term success.

Further, it is easy to forget the force behind directors’ duties. In general, we look at corporate governance in a constructive light, focusing on ways it can drive success and improve outcomes. The other side is that directors owe a fiduciary duty to the company they work for, and can be held accountable for failing to act in its interests.

In a well-run company, the prospect of this will be remote. But in a poorly-run company, the directors can, in the last analysis, be held personally liable. In this light, the results of the Insolvency Service’s investigation into Carillion will be interesting.

Generic statements

Other upcoming proposed changes to the UK Corporate Governance Code are also pertinent. Annual reports will need a statement of how a company has complied with the code’s principles, prepared in a manner shareholders can evaluate.

Changes are being made with the aim of linking reporting on governance to the company’s reporting on strategy. Rather than being an add-on, good governance should be seen as integral.

When asked by the select committee why the Carillion chief executive’s salary was increased by 50% over the two years before the collapse, the chair of the firm’s remuneration committee said that it had been ‘benchmarked’ and that ‘it was Carillion’s policy to pay median’.

“Clearly, the creation of shareholder value has not been a notable outcome: the current expected return to creditors is some 1p in the pound”

The sometimes counterproductive effects of disclosing remuneration are not a novel point: revealing the details of executives’ excessive pay can drive their counterparts elsewhere to demand similar treatment. Ensuring no one is paid ‘below average’ can obviously drive that average ever-higher.

It may be unfair to try to draw insight from the defence given during an (understandably) aggressive interrogation from MPs, or to dissect the usual wording on governance in Carillion’s annual reports with scepticism borne of hindsight.

But the anodyne statements found in both do seem suggestive. Advice was taken. Decisions were taken in response to the UK Corporate Governance Code. And the company’s remuneration policy, in the words of the 2016 annual report, would ‘continue to effectively support the … creation of shareholder value.’

Clearly, the creation of shareholder value has not been a notable outcome: the current expected return to creditors is some 1p in the pound. But while the targets found in Carillion’s reports might appear deeply insufficient now, much of the wording and justifications are common and conventional.

It is impossible to avoid some degree of generic phrasing in this sort of context: there are only so many ways to restate your commitment to your stakeholders, however sincere.

This does, nonetheless, seem a clear illustration of why we must move away from the ‘tickbox’ compliance that appears to be on show and towards real and thoughtful engagement with the company’s governance in practice.

Carillion may be an extreme case, but it is unlikely to be unique.

Charlotte Fleck is assistant solicitor at Pett Franklin

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