Now that the dust has settled somewhat after the demise of Carillion (CLLN), it’s worth adding some more comments to my previous blog post on the subject. Ultimately it went bust for the same reason most companies do – it simply ran out of cash and could not pay its debts as they became due. As I said before, it collapsed eventually because of ballooning debt, poor cash collection and risky contracts.
Unfortunately it seems that private investors were some of the biggest losers in this debacle. Big investors had either bailed out, hedged their exposure or were actually shorting the stock. According to a report in the FT retail investors held 16% of the shares through Hargraves Lansdown towards the end, 7% on Barclays platform and 7% on Halifax meaning that overall they must have held a much higher proportion of the shares than in most large companies. It would appear retail investors are suckers for a “cheap” stock, or those that are paying nominally high dividends.
As Terry Smith of Fundsmith says in his recently published newsletter to investors, which is well worth reading, he is “asked far more frequently whether a share, a strategy or a fund is cheap or expensive than I am asked about what returns the companies involved deliver and whether they are good companies which create value or not”. He looks at the latter rather than former when investing.
Why did Carillion go straight into liquidation rather than administration? Apparently there was very little cash left in the business and potential administrators were concerned about getting paid. Administration was of course devised as a way to keep companies trading and hence protect jobs and the business of suppliers while potentially enabling it be restructured and sold in due course. Liquidation is an abrupt process where the liquidator just closes everything down immediately. In both cases, trade and other unsecured creditors, plus shareholders, usually end up with nothing although there is some flexibility and more chance of repayment in an administration. In Carillion the Government is picking up responsibility for its own contracts with the company, and the associated jobs may remain, but all others are likely to face severe difficulties and many smaller suppliers may go bust. That applies even to those contracts where Carillion was only a “partner” in a larger consortium.
Now there is one similarity between the two. Administrators or liquidators, and the major secured creditors (normally banks) to which they report, are as keen to dispose of any assets as soon as possible so they can get paid (or recover their debts) quickly. Hence any assets get sold very quickly, often to related parties at prices that the original owners think are ridiculously low. I have written extensively in the past on the abuses associated with “pre-pack” administrations where this problem is particularly rife as there is often little or no “open marketing” of the assets.
Carillion is a very good example of what is wrong with insolvency law in the UK. Carillion employed many skilled staff and some parts of the business may have been viable but the whole lot was brought down by a few dubious contracts taken on at low margins by incompetent management. The damage, and associated costs, of this debacle will be enormous – and in this case will fall on the public to a large extent as the Government has had to step in. Is there a better way? It is my opinion that the Chapter 11 process in the USA is much better. It does enable a company to be protected from its creditors before it gets into an impossible situation, i.e. it allows time for restructuring. The result for ordinary shareholders may not be a lot better, and jobs will be lost, but for everyone else it is superior.
Regrettably in the UK, insolvency law seems to have been devised mainly in the interests of insolvency practitioners and bankers. It is time for a complete reform of the law and practices in this area.
One aspect of Carillion that has been raised is whether the company should have obtained a clean audit report less than a year ago (auditors were KPMG). One thing auditors should report on is whether the company would be likely to be going concern for the foreseeable future – and that typically means more than one year. Otherwise the accounts should be “qualified”. Were the financial difficulties and potential cash flow problems not already apparent to the auditors and to the directors of the company? Is this yet another audit that the Financial Reporting Council (FRC) should be looking into?
EMIS Group (EMIS)
Yesterday, EMIS Group, issued a trading statement and a note on a “review of customer and product support processes”. The share price dropped 20% on the day. EMIS provides medical software and services to GPs and the NHS. It is one of my longer standing holdings, so I am none too happy about this. It’s one of those issues that however diligent one is as an investor, one can get caught out on.
What’s the problem? It seems that “certain service levels and reporting obligations with NHS Digital” have not been met. The financial impact might be up to £10 million which is about a third of last year’s profits.
I have sent the following note to the Chairman to try and elucidate the issues (I’ll advise subsequently on the answers):
“I was of course most disappointed to read the announcement of today’s date regarding “customer and product support processes”.
I would like to receive more information about the nature of the contracts that have resulted in the large potential liability. I understand you are still assessing the potential liability but the announcement should really have spelled out the nature of the commitments that seem to have been made by the company previously, and which have not been adhered to. I am also surprised that such a large liability is being announced when no apparent claim has been received (at least none is indicated), and no financial loss to the third party concerned is being reported.
I also question why the potential liability and risks associated with the relevant contracts were not disclosed in the Annual Report for the year ending December 2016. Indeed there is extensive discussion of “risk” in the business in that document and the risks the business face were apparently reviewed in that year by the board of directors. The risks of all kinds were generally reported as “low”, when it seems that a major undisclosed risk was being run.
One could also question why the audit by KPMG failed to identify this apparently major defect in the company’s systems and accounting for the liability. Did they not review this aspect of the company’s activities?
Lastly there is no indication in the announcement as to how long this failure which has caused the potential liability has been going on. Perhaps you could answer that question, and also indicate whether it may be necessary to restate past accounts.”
As noted above, KPMG were the auditors to EMIS as well as Carillion so this is yet another company where perhaps the FRC should look into the audit. My opinion is that investors should be able to rely on the published accounts of a company but all to frequently of late we see that this is not the case. Grossly misleading accounts resulting from incorrect if not fraudulent revenue recognition (Blancco, Redcentric, Globo, Quindell – you can probably name others), or over optimistic statements about the financial health of the business (possibly Carillion, and HBOS) are simply too common.
Auditors often say investors expectations of what an audit can achieve are too high. But surely there is something fundamentally wrong with their processes if such major failings are not identified?
One other aspect of this problem is I suggest the use of aggressive bonus schemes, particularly LTIPs, that can pay out many times the base salary of executive directors. The result is an incentive to report higher revenues and profits and to conceal the bad news from the company’s shareholders. This may have been a factor at both Carillion and EMIS. Incentives of some kind are all very good if they motivate appropriately. But when they are such a large proportion of the likely remuneration, they distort behavior in the extreme, often with perverse results.
Roger Lawson (Twitter: https://twitter.com/RogerWLawson )
Long-term incentives just need to be long-term.
Payable in equity, and with a five-year lock-in from the award would seem like a good start. But what do I know?