Insolvency Regime Changes – A Step Forward

There’s nothing like issuing a major Government announcement on the Sunday of an August bank holiday weekend to get good media coverage is there? But as it’s raining and I have nothing much else to do, I have read the announcement and here is a summary:

The announcement is entitled “Insolvency and Corporate Governance – Government Response” (see https://www.gov.uk/government/consultations/insolvency-and-corporate-governance ). It is the Government’s response to past public consultations on how to tackle some of the perceived problems when companies get into difficulties or go bust. Such examples as House of Fraser (see my past blog posts on that subject where I called for reform of pre-pack administrations), Carillion, BHS, et al.

It aims to tackle issues around company director actions when a company gets into difficulties but one of the main proposals is very significant. That is that the Government intends to introduce a “Moratorium” scheme where a company can hold off its creditors for up to three months while it seeks to develop a restructuring proposal. Although a Moratorium will be a court process and will be supervised by a “Monitor” who is likely to be an insolvency practitioner, the directors of the company will remain in control albeit with some limitations.

Representatives of secure creditors (e.g. bank lenders) did not seem to like this idea at all based on their responses to the consultations, but it’s not quite as generous as first appears. Apart from the “monitoring” requirement to protect the interests of creditors, the initial period of a Moratorium will only be 28 days and can only be extended to 3 months if justified, and the company must be able to meet the normal insolvency rule that current obligations must be capable of being met as they become due during the Moratorium. But it is surely a step in the right direction in that it will provide more chance of those businesses that are not pure basket cases of being rescued to the advantage of trade creditors, pensioners and shareholders. That’s as opposed to the present situation where a pre-pack administration can instantly dump everyone except the secured creditors with massive damage to everyone else.

But directors of companies will need to act more in advance to ensure that a Moratorium is of help. To encourage them to do so the Government hopes to improve shareholder stewardship by identifying means to help the actions of institutional shareholders and others to escalate their concerns about the management of a company by its directors.

In addition the Government wishes to improve board directors effectiveness and training including raising awareness of their legal duties when making key decisions, and developing a code of practice for board evaluations. Comment: it is certainly the case that in smaller public companies the directors often seem to be unaware of their legal obligations and this sometimes extends to larger companies. I have argued in the past that all public company directors should have some minimal education in company law and their other responsibilities when acting as a director.

One issue examined was the payment of dividends by companies when companies were apparently in a weak condition such as having substantial pension liabilities or were paying dividends shortly before they went bust. Whether a company can pay dividends is governed by the calculation of whether it has “distributable reserves”, but that is a calculation that only the company and its auditors might be able to do. It’s not obvious from the published accounts. The Government is to work with interested parties on a possible alternative mechanism.

There were also concerns expressed that some companies are now paying dividends only as “interim dividends” which can escape approval by shareholders at Annual General Meetings. The Government has asked the Investment Association to report on the prevalence of the practice and they will take further steps to ensure that shareholders have an annual say on dividends if the practice is widespread and investor pressure proves insufficient.

In summary, I welcome all of these proposals as a step forward in rectifying some of the defects in the existing insolvency regime. The slight concern is that companies will be reluctant to enter a “Moratorium” due to the adverse publicity it might generate and the costs involved so we will have to see whether that turns out to be the case or not. But almost any restructuring solution is better than a formal administration or liquidation.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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Quindell and the FRC’s Role

There was a very good article written by Cliff Weight and published on the ShareSoc blog yesterday about the fines on KPMG over the audit of Quindell. Cliff points out the trivial fines imposed on KPMG in that case, the repeated failings in corporate governance at large companies and he does not even cover the common failures in audits at smaller companies. The audit profession thinks they are doing a good job, and the Financial Reporting Council (FRC) which is dominated by ex-auditors and accountants, does not hold them properly to account.

Perhaps they lack the resources to do their job properly. Investigations take too long and the fines and other penalties imposed are not a sufficient deterrent to poor quality audits when auditors are often picked by companies on the basis of who quotes the lowest cost.

Lots of private investors were suckered into investing in Quindell based on its apparent rapid growth in profits. But the profits were a mirage because the revenue recognition was exceedingly dubious. One of the key issues to look at when researching companies is whether they are recognizing future revenues and hence profits – for example on long-term contracts. Even big companies such as Rolls-Royce have been guilty of this “smoke and mirrors” accounting practice although the latest accounting standard (IFRS 15) has tightened things up somewhat. IT and construction companies are particularly vulnerable when aggressive management are keen to post positive numbers and their bonuses depend on them. Looking at the cash flow instead of just the accrual based earnings can assist.

But Quindell is a good example where learning some more about the management can help you avoid potential problems. Relying on the audited accounts is unfortunately not good enough because the FRC and FCA don’t seem able to ensure they are accurate and give a “true and fair view” of the business. Rob Terry, who led Quindell, had previously been involved with Innovation Group but a series of acquisitions and dubious accounting practices led to him being forced out of that company in 2003. The FT has a good article covering Mr Terry’s past business activities here: https://www.ft.com/content/62565424-6da3-11e4-bf80-00144feabdc0 . They do describe Terry as “charismatic” which is frequently a warning sign in my view as it often indicates a leader who can tell a good story. But as I pointed out in a review of the book “Good to Great”, self-effacing and modest leaders are often better for investors in the long-term. Shooting stars often fall to earth rapidly.

One reason I avoided Quindell was because I attended a presentation to investors by Innovation Group after Terry had departed. His time at the company was covered in questions so far as I recall, and uncomplimentary remarks made. They were keen to play down the past history of Terry’s involvement with the company. So the moral there is that attending company presentations or AGMs often enables you to learn things that may not be directly related to the business of the meeting, but can be useful to learn.

The ShareSoc blog article mentioned above is here: https://www.sharesoc.org/blog/regulations-and-law/the-quindell-story-and-the-frc/

Note though that subsequently the FRC have taken a somewhat tougher line in the case of the audit of BHS by PWC in 2014. Partner Steve Dennison has been fined half a million pounds and banned from auditing for 15 years with PWC being fined £10 million. But the financial penalties were reduced very substantially for “early settlement” so they are not so stiff as many would like. I fear the big UK audit firms are not going to change their ways until their businesses are really threatened as happened with Arthur Anderson in the USA over their audits or Enron. That resulted in a criminal case and the withdrawal of their auditing license, effectively putting them out of business. The UK needs a much tougher regulatory regime as they have in the USA.

Roger Lawson (Twitter: https://twitter.com/RogerWLawson )

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