Spotting the red flags of corporate failure

Close scrutiny of an organisation’s governance may well be an appropriate area for in-house lawyers to become involved in, given that they’re often in a position to observe that a business is being run badly. This is particularly important in the wake of corporate collapses such as that of Carillion in the United Kingdom. Neil Hodge explains what in-house lawyers can do and what ‘red flags’ they need to watch for.

Whenever any organisation suffers a significant – or even catastrophic – corporate governance failure, obvious questions arise as to who should have been in a position to know of the impending dangers, and why corrective action wasn’t taken. Ultimate responsibility for risk management and the stewardship of the company rests with the board, yet other key individuals and functions within the organisation may also be in a position to know that the business is being run badly. Additionally, they may have the necessary influence or clout to help turn the situation around – particularly if the mismanagement suggests that criminal or unethical behaviour is taking place. As such, looking more closely at the way organisations are governed seems to be an appropriate area for in-house lawyers to get more involved in.

Recent corporate scandals have highlighted that there needs to be greater oversight of management’s actions and corporate strategy, as well as more effective scrutiny and challenge from the organisation’s assurance providers, including in-house counsel. Supermarket giant Tesco’s admissions showed, for example, that aggressive accounting policies had been in place for several months and that slow payment to suppliers had been common practice.

The collapse of UK construction company Carillion has shone a light on the inadequacy of in-house functions such as risk management, internal audit, compliance and in-house legal to flag up poor corporate practices – or even act to stop them. Up until 2017 Carillion was one of the largest contactors for UK government infrastructure projects, employing 43,000 people worldwide. Yet alarm bells about the true state of the company came from investors and fund managers who seemed to know more about the true financial state of the company than either the board or any of the company’s assurance providers did. Indeed, revenue recognition became so aggressive – matching the board’s risk appetite – that the company’s figures no longer reflected reality.

In May 2018 the UK Parliament’s Business, Energy and Industrial Strategy (BEIS) and Work and Pensions Committees published their joint final report into what went wrong. MPs found that the company’s business model was an ‘unsustainable dash for cash’ and that the company deliberately used aggressive accounting policies to present a rosy picture to the markets. Its cashflow, for example, relied on stringing suppliers’ out for months. A succession of directors maintained the image of a healthy and successful company by increasing dividend payments year-on-year, irrespective of company performance: in fact, more was paid out in dividends than the company generated in cash. Rachel Reeves MP, Chair of the BEIS Committee, in commenting on the report’s publication described Carillion’s directors as ‘delusional’ and as having driven the company ‘off a cliff’ before trying to blame everyone but themselves.

The company’s non-executives, who were meant to challenge boardroom strategy, were ‘unable to provide any remotely convincing evidence of their effective impact’, said MPs. Professional services firms were also slammed for being unable to identify effectively to the board or persuade executives about the seriousness of the risks associated with their business practices. ‘The appearance of prominent advisors proves nothing other than the willingness of the board to throw money at a problem and the willingness of advisory firms to accept generous fees,’ said the report. In-house functions also seemingly failed to provide appropriate challenge.

At the time of its collapse, Carillion left a pension liability of around £2.6bn and owed around £2bn to its 30,000 suppliers, sub-contractors and creditors. The company went into liquidation in January 2018 with liabilities of nearly £7bn and just £29m in cash. The subsequent furore has prompted the UK’s corporate governance regulator, the Financial Reporting Council (FRC), to request greater powers to investigate and prosecute all directors: currently, it is limited to pursuing only those with an auditing, accounting, or actuarial background (meaning finance directors, largely).

Graham Wladimiroff, Vice President and Assistant General Counsel at adhesive packaging solutions company Avery Dennison RBIS and Membership Officer of the IBA Corporate Counsel Forum, believes that there is a role for in-house counsel to play in checking that management is running the company properly. He says that the key areas of focus should be to look at the organisation’s approach to corporate governance, and particularly ‘the integrity of the people at the top’ – namely the chief executive officer (CEO) and chairman –and how ‘open’ the organisation is to challenge and change.

‘Is the organisation arranged in silos with everyone defending their turf, not sharing information and not communicating, or does the CEO foster an open culture, encouraging a team effort to find solutions and reach decisions with everyone with something sensible to contribute being heard?’ says Wladimiroff. ‘Is information shared across functional and business lines? Are executives challenged before issues arise – or only after the facts?’ he asks. Boardroom dynamics can also be a good indicator of potential problems. ‘A weak chief financial officer (CFO) versus a strong CEO on the board is another recipe for trouble,” he adds.

Reporting lines also often tell a story, says Wladimiroff. ‘It is key that the general counsel (GC) reports to the CEO and that the chairman regularly speaks to the GC separately. Furthermore, the GC should ideally be on the executive committee – as opposed to just dealing with legal and compliance issues for the board – as this underpins the “conscience of the company” role,’ he says.

It is also important to examine the relationship that in-house counsel has with other in-house assurance providers, such as internal audit, HR and compliance to see what boardroom, leadership and governance issues they have come across as part of their reviews, says Wladimiroff. ‘Does the GC reach out to his/her lawyers lower down, or speak to internal audit or the external auditor? Does the GC visit the organisation’s other operations around the world or speak to business to get different views and to see problems/risks coming sooner rather than later? Does the GC even speak to customers and suppliers?’ Greater communication with all of these functions and stakeholders is tremendously important, he says.

In terms of possible ‘red flags’ to look out for, Wladimiroff says that in-house lawyers should look at how the company spends its money. ‘A strong indicator of trouble is lax conduct where it comes to spending, in particular on travel and entertainment,’ he says. ‘Remuneration which does not reflect the ups and downs of the company’s performance – only the ups – is also a sign,’ he adds.

Other potential signifiers of trouble include low staff retention rates, employee turnaround (particularly among new hires who may not like what they see) and how vocal (and quick) the CEO is to act on issues relating to compliance and ethics (particularly regarding the lack of either).

However, raising concerns can always be a challenge, says Wladimiroff. General counsel can be sidelined or stonewalled if executives do not want to answer questions or be held to account by a key assurance provider that is supposed to be working on behalf of the board – not against it. Wladimiroff advises GCs to approach the CFO first of all to raise any concerns over corporate governance. If that proves unsatisfactory, they should then try the CEO. If that doesn’t work, they should contact the chairman. And if these key board members are not prepared to listen or act, GCs have the ‘nuclear option’ of contacting the regulator. However, says Wladimiroff, such a move may be regarded as either too aggressive or too problematic. Instead, he suggests that general counsel should try to create a dialogue with other assurance functions within the organisation – such as compliance and internal audit – as a way of ‘creating visibility on the issue and making it difficult for colleagues to step away from taking responsibility.’

Marcel Willems, Co-Chair of the IBA Insolvency Section and Managing Partner in the Amsterdam practice of law firm Fieldfisher, agrees that there are several ‘red flags’ that signal bad corporate practice that in-house lawyers should look out for and monitor. Late payment is an obvious one, he says, where legal counsel should check the turnaround of supplier payments against contract terms to see if payment is getting later, while monitoring the number of customer complaints (and not just for the slow settling of invoices) is another area worth looking at. Similarly, checking the company’s banking arrangements to see if it is asking for larger overdrafts is another way to check whether the business might be in trouble.

But there are also some ‘warning signs’ that might give in-house counsel an impression that they are deliberately ‘being kept out of the loop’ and which may infer that illegal or unethical activity might be taking place, says Willems. ‘For instance, is in-house counsel getting all – or the right – information upon which to give appropriate advice? Does it have a good overview of what is going on in the company, particularly around its finances and bidding strategies? Are there any areas of the business or its activities that have been barred to in-house lawyers? If general counsel is dissatisfied with any of the answers to these questions, she or he should seek to address them.’

Willems says that in-house lawyers should also look at the dynamics of the board. ‘Does the organisation have an overly strong and bullying CEO? Legal counsel needs to check that there is appropriate challenge within the boardroom and that there isn’t a majority split of executives who will just say “yes” to whatever the chief executive wants. If they have such concerns, in-house counsel should look at the minutes of the meetings to see what other strategies or actions were suggested and why they were voted down. After that, if general counsel believes that the CEO is not listening to the rest of the board, she or he should consult with the company chairman.’

Willems says that it is important for in-house lawyers to remind management that it is always best to admit mistakes, including governance failures and fraud, as quickly as possible both to regulators and shareholders. He also recommends that boards take tough decisions quickly to avoid further problems.

‘Companies are always worried about revealing bad news in case it results in the share price diving. But the opposite is true – the share price often goes up when companies disclose problems and that they are taking action to resolve them. Shareholders are interested in the long-term viability of the company and they react positively when they see that management is making tough decisions to preserve that. Boards need to remember that and in-house lawyers need to remind them.’

However, Willems says that there are limits as to what in-house lawyers can do. ‘Legal counsel is not in a position to dictate anything to management,’ he says. ‘They can raise an alarm internally or make a request to internal audit or compliance to check some areas of concern, but there is a question as to how well this works in practice.’

Other experts also believe that there is a need for in-house lawyers, as well as other assurance functions within organisations, to step up and challenge poor corporate practices (and even failing strategies) before they get out of hand. Ewan McIntyre, a commercial disputes partner at UK law firm Burness Paull, says that in-house lawyers need to speak up if they think that boards are being steamrolled by a dominant group of executives, or if non-executives are just rubber-stamping executive decisions.

‘Legal and other assurance functions should look at the minutes of the meetings to see who said what, who dissented and what recommendations and strategies were ignored, and report any concerns to the company secretary. After that, you can report your findings to a regulator or enforcement agency, but this may protect the market rather than the company,’ says McIntyre.

UK-based risk consultant Keith Blacker believes that ‘there is increasing evidence that those who are supposed to provide independent assurance on risk and corporate governance are not doing their jobs properly.’

‘Auditors, advisors, non-executives, risk managers, internal auditors, in-house legal, compliance and others are all meant to present a challenge to the board and act as a “critical friend”,’ says Blacker. ‘No area of discussion should be left unchallenged – including corporate strategy. But somehow, their contribution often falls short, or they are not listened to. Boards may have ignored them, but there is also a case to say that these people did not shout loud enough.’

Like Wladimiroff and Willems, Blacker also says that there are some simple warning signs that in-house lawyers can look for to determine whether the company is being badly governed and is about to go belly-up. For example, Blacker recommends looking at whether the company has an appropriate whistleblowing or speak-up mechanism (and how many calls it receives and how many follow-ups are carried out), and whether the organisation fails to abide by any regulatory warnings, has an increasingly poor public compliance record or is increasingly engaging in ‘sharp practice’ to win contracts. He also recommends looking at whether the company is setting tougher customer/supplier terms, or only paying for goods and services in part. Other pointers to look out for include checking to see if the company has a heavy reliance on third parties and consultants to improve governance, rather than trying to reform itself from within.

Philippa Foster Back, director of the Institute of Business Ethics, a UK-based organisation dedicated to improving business culture and executive behaviour, says that another area to examine is to gauge what the average employee feels about the company. ‘Employees pick up bad vibes very easily, and if they don’t like the company they work for, they leave as soon as they can. In-house lawyers should therefore look at staff turnover rates and exit interviews to get an idea of what the workforce thinks about the organisation and what prompted them to leave. Common gripes, such as departmental budget cuts, reduced headcount, slow authorisations, management’s ingratitude and so on, can be symptoms of much wider organisational problems’, she says.

Experts agree that the best way to uncover signs of corporate collapse is for assurance functions to ask more questions of management and the board, and to challenge more effectively and robustly the information that has informed their decision-making and strategy. ‘Executives are ultimately responsible for ensuring effective risk management and sound corporate governance, but they can’t be held solely to blame if things go badly wrong – assurance functions also need to look at their own behaviour and shortcomings,’ says Blacker. ‘You simply can’t have a situation where investors and other outsiders have a better idea of what is happening in a company than the likes of internal audit, compliance, and in-house legal do,’ he adds.