Causes of Carillion’s Collapse
Table of Contents
COMPLIANCE WITH 2016 UK CODE OF CORPORATE GOVERNANCE(CG)…….4
RELATION WITH SHAREHOLDERS…………………………………….5
LESSONS LEARNED FROM COLLAPSE…………………………6
1. CARILLION’S OVERVIEW
Carillion Plc was an integrated support services organization operating four business divisions namely Support Services, Public Private Partnership(PPP) projects, Middle-East Construction services and Construction services(excluding the Middle-East). The Support services included facilities management, road maintenance, consultancy, site accommodation, energy and rail services in the UK, Middle-East and Canada. The PPP projects invested and offered construction services for PPP’s in UK and Canada. The Middle-East Construction services included its civil engineering and building services in Africa and the Middle-East. It offered aviation, financial, transportation and healthcare services(Bloomberg 2018). Carillion was the sixth largest UK government contractor providing accommodation, catering and construction services, which accounted for 45% and 33% of its UK and total revenue respectively(National Audit Office 2018).
Carillion demerged from Tarmac in 1999 and expanded into facilities management. Through acquisition of rivals such as Mowlem and Alfred McAlpine, it grew rapidly, removing major contracts competitors from the market. The company had about 43,000 employees, with 19,000 in the UK(House of Commons 2018) and reported revenues of £4.394 billion for the fiscal year ending December 2016, with an operating margin of 3.02%(London Stock Exchange 2018). The company was owned by its shareholders, with the Board comprising of two executive and four non-executive directors, and chairman, Philip Green, before its liquidation in January 2018(Reuters 2018).
2. CARILLION’S COLLAPSE
Carillion’s growth and surprising collapse is a story of recklessness and greed. Its business model was a “relentless dash for cash, driven by acquisitions, rising debt, expansion into new markets and exploitation of suppliers” (House of Commons 2018). It collapsed after failing to meet huge debt commitments in 2017, resulting from over-expansion. The collapse followed speculations after profit warnings were issued in 2017, eventually leading to a compulsory liquidation order on the 15th of January, publicizing the issue(Hussain 2018). Implementation delays of its PPP projects, following UK government’s assessment the strategies and struggles with Brexit resulted in cash-flow issues, hidden in the past by continued expansion of PPP’s. By July 2017, an £845 million debt was recorded(Loxley 2018). The Board was majorly responsible for the organization’s liquidation, displaying accounts that mis-represented the reality of the organization and increasing dividends each year, come what may. Long-term obligations such as efficiently funding employees’ pension schemes were neglected and despite these, the Board focused on executive bonus increment. The aggressive accounting method originated by Richard Adam, Carillion’s ten-year Finance Director neglected contributions to the company’s pension schemes, considering it a waste of resources. Internal and external checks and balances that prevent Board failures of degrees evident in Carillion were insufficient because the company’s audit committee inadequately scrutinized the reckless executives. Accounts were methodically altered to create optimistic valuations of revenue, in defiance of internal controls. KPMG, Carillion’s nineteen-year external auditor did not once qualify its audit opinion, complacently signing off directors’ increasingly fantastical figures. Also, despite being signatories to the Prompt Payment Code, Carillion treated its suppliers with contempt. Carillion’s collapse shook the UK, leaving noticeable negative impacts. A pension liability of around £2.6 billion incurred, is claimed to be the largest hit on the Pension Protection Fund(PPF) till date. Workers will lose 10-20% of their expected earnings despite the existence of State PPF, that compensates defaulting Direct-Benefit schemes.It also owes about £2 billion to its suppliers, sub-contractors and short-term creditors(Mor et al 2018). Its provision of school dinners and services to hospitals have been negatively impacted, as the government must intervene to ensure students and hospital patients are fed(Sandle and Fraser 2018). Although some construction projects continued uninterrupted where a joint-venture partner was involved, others have stopped until the employment of a new contractor. The estimated net-loss of £314-£374 million will be borne by taxpayers, subject to a range of uncertainties such as extent of asset sales, resulting in a late determination of the actual cost of the collapse. Also, the Construction Industry Training Board will incur costs of finding other apprenticeship training providers for apprentices under Carillion(National Audit Office 2018).
However, the liquidation has led to some positive changes, pushing issues such as goodwill to the forefront of discussions. The International Accounting Standards Board(IASB) has realized that companies delay the recognition of goodwill impairments. Rather than comparing recoverable amounts of a unit with its carrying amount at the current date, a headroom approach is suggested(Deller 2018). The collapse highlights ongoing flaws in the UK Corporate Governance(CG) system, with the company law requiring directors to prioritize shareholder interests over those of other stakeholders. The collapse has led to increased scrutiny of the corporate governance code and the impact of firms’ strategies on stakeholders (Institute of Chartered Accountants in England and Wales 2018). This has intensified debates on private companies’ role in the UK public service sector. Similar examples such as withdrawal of the Stagecoach/Virgin franchise on the East-Coast Mainline have displayed failure of these companies to deliver the promised performances on government contracts, impacting negatively on taxpayers and the government(Trade Union Congress 2018). This collapse is expected to be a change catalyst and provide CG lessons relating to current acts and omissions thus, ensuring claw-back application in the event of corporate collapse/economic downturn(McPhilamy 2018).
3. COMPLIANCE WITH 2016 UK CODE OF CORPORATE GOVERNANCE(CG)
The Corporate Governance Code is a set of good governance principles, with some sections embedded in the UK company law, covering listed London Stock Exchange companies. It is a non-rigid set of rules consisting of principles and provisions that govern an organization’s activities, utilizing a comply or explain approach as a trademark(Financial Reporting Council 2018).
i) LEADERSHIP: The code states that each company should have an effective Board, with clear division of responsibilities. Carillion had an adequate proportion of executive(29%) and non-executive(71%) directors who constructively monitored the Board, and an independent Chairman responsible for the Board’s leadership functions. Nonetheless, the Board did not comply with the need for effective long-term success, neglecting necessary actions(failure to halt acquisitions and liabilities buildup)(Burgess 2018).
ii) EFFECTIVENESS: The code recommends that Boards and Committees should have the appropriate balance of skills and experience, with a rigorous procedure for new Board appointments. Carillion’s Board members had diverse range of skills, thereby complying with the code. Directors were subject to re-elections at regular intervals, and appointments were made by the nomination Committee, complying with the voluntary code of conduct if nomination was outsourced. Also, Directors were given a comprehensive induction on legal duties and obligations and informed of the commitment levels required for their positions. This complied with the provision of joining induction and sufficient information/support on their roles. Nonetheless, there was non-compliance with the need for Board diversity, as Carillion had only two female directors’(Carillion Annual Report and Accounts 2016).
iii) RELATION WITH SHAREHOLDERS: The Board should ensure adequate communication with shareholders in general meetings. The Board had adequate number of meetings yearly, both in UK and overseas, facilitating understanding of the overseas operations (Carillion Annual Report and Accounts 2016). However, the Board did not comply with the need for satisfactory dialogue with shareholders, as a major shareholder stated that they were provided with limited and vague responses to key issues(Work and Pensions Committee 2018).
iv) ACCOUNTABILITY: The code recommends companies’ sound risk management, internal control systems and fair assessment of the financial position. Carillion only complied with the provision, regarding internal and external auditors’ appointment, and an audit committee to review the objectivity and effectiveness of audit functions. However, Carillion’s board was questionable (Giles 2018) withthe group rather than addressing the underlying challenges in respect to problem contracts and balance sheet credibility, entered transactions, and made accounting assumptions to enhance reported profitability and net debt position. The group failed to convert reported profits into cash, through incurrence of further debt (both on/off balance-sheet) and aggressive working capital management by the company’s executives for several years. Whilst circumstances beyond the group’s control led to some operational challenges, lack of management attention to key issues, governance failures over the risk level being taken, and a focus on short-term financial benefits at the expense of long-term profitability and viability, were contributing factors. The detailed presentation and availability of robust historical financial information relating to working capital movements of the group (principal drivers of cash-flow) and business unit profitability, were extremely weak. This was due to poor accounting information systems, lack of finance resources at group-level and weak corporate knowledge resulting from extensive management changes throughout the business(Work and Pensions Committee 2018), with the audit committee inadequately scrutinizing reports of internal auditors(Chartered Institute of Internal Auditors 2018).
v) REMUNERATION: There should be a formal procedure for determining executive remuneration, to promote the long-term success of the company. Carillion had a remuneration policy which rewarded directors and employees accordingly, as prescribed by the remuneration committee, thereby complying with the code. Nonetheless, in 2016, the company relaxed their claw-backs and continually increased executive bonuses’, which did not promote the long-term success of the company (Fleck 2018).
4) LESSONS LEARNED FROM COLLAPSE
A flawed corporate governance design, inadequate internal, external and audit committee functions contributed to Carillion’s collapse, highlighting many lessons. Carillion’s Board lacked integrity, showing no concern about shareholders/stakeholders’ interests. In application of corporate governance models, I believe organizations should tailor the model to suit their business structure. The public interest and service(pension funds) ethos should be placed at the heart of decision-making, involving a greater number of independent non-executive Directors, monitoring service lines and management performance for companies, thereby emphasizing shareholders’ interests. Also, there should be larger number of Directors for companies the size of Carillion. A model along these lines would ensure the main Board is more challenged in its responsibilities, ensuring stakeholders receive timely/sufficient information regarding the financial risks of the company. The corporate governance code requires Boards to evaluate their effectiveness, which in reality is perfunctory and focuses on processes and priorities, ignoring the actual evaluation of the code’s effectiveness. I believe the code should require Boards to evaluate their corporate governance model, to ensure proper scrutiny of the performance. This collapse teaches non-executive Directors to improve their performance, with the Financial Reporting Council’s current review of the code’s effectiveness. To avoid collapse, Boards’ should properly examine business risk potentials of companies. Cash-flows and cash-holdings should be considered instead of revenue forecasts because “the best way to assess a company’s underlying financials is to see how much cash it actually holds” (International Chartered Accountants in England and Wales 2018).
It is a better practice for remuneration and compensation committees to ensure that claw-back applies in the event of a corporate collapse or economic downturn. The revision of the code is currently under consideration to emphasize Directors’ duties to stakeholders other than just shareholders, and this will become more prominent and a greater focus of regulatory scrutiny. I recommend that the internal audit function of a company should be performed by an independent body of employees who would monitor and recommend effective internal control systems, unlike Carillion which outsourced its internal audit to Deloitte. The “corporate governance code explicitly requires regular monitoring and reviewing of the independence and objectivity of internal audit” (Chartered Institute of Internal Auditors 2018). This should be implemented effectively, thereby ensuring effective scrutinization of companies’ internal audit. Public contracts should be diversified so that small companies with roots in the communities where services are being offered can bid for and win contracts, rather than concentrate them in few large companies. The corporate governance code should have a maximum threshold for Directors’ earnings, commensurate to their duties and commitment. These suggestions are aimed at averting the type of collapse witnessed by Carillion.