Carillion Mustn’t Be Just Another Failure

We must never loose sight of the fact that the failure of Carillion has happened before. So many times before. I’m not just talking about a company failing and people not having a job. That happens all the time and is an essential facet of capitalism. If your employer goes bust well it’s time to move on. Get your final pay check pick yourself up and move on. It’s not that yet another big company has gone bust and the shock waves will ripple through the economy for a while. It’s much more subtle than that.

It happened when BHS went bust. They fail with huge debts pulling the rug out under the feet of suppliers due to the typically long payment terms offered by big companies that little companies have to accept if they are going to be a supplier. For as long as I can remember that has been a problem and one that the state has tried to fix but you can’t legislate it away you have to coerce it away. Unfortunately there are really good (some of them selfish) reasons for long payment terms. Long payment terms aren’t the problem. They make failures worse when they happen but in and of themselves they’re not a problem. The supplied need to have confidence that the supplier is not going to go bust and mess up their carefully crafted and expensively optimised supply chain. Long payment terms are just part of that picture.

It happened when Woolworths went bust. There was a black hole in the pension pot. There’s always black holes in pention pots. When companies fail the state steps in and you and I pick up the pieces through general taxation. And we don’t notice. The entire pensions black hole from Carillion (not the accounted one of £600m the one estimated by the receivers of £900m) could be paid EVERY YEAR with change with what the government plucked out of the ether to give to the DUP. For the government the absolute amounts of money involved in bailing our the pension black holes is a little bit more than pocket change. The problem isn’t that companies fail with holes in their pension pots. Pension pots always have holes. Holes in pension pots are the result of accounting for risk and the companies ongoing existence. If the accountants weren’t considering risk and planning for the company to continue to exist they would be clearly failing the shareholders. We just have to accept that pension pots have black holes and huge pension schemes have huge pots with huge holes and there’s nothing we can do about it unless you want to argue with the mathematics of risk and economics.

So what is the problem then. Why is it that Carillion must not be just another big failure in the long line of big failures that litter history if there was nothing exceptional about it.

The point is there is nothing surprising about how Carillion failed and that’s the problem. The problem is that when big companies fail they make a big mess and failing companies are an essential facet of capitalism. So we either accept a big mess every now and again or change the game.

Before you start thinking that I am some Bolshevic Marxist revolutionary you couldn’t be further from the truth. I’m a dyed in the wool Darwinian capitalist.

History has shown us many things and the following two are relevant here. The greatest advances of humanity have all, by and large, been the result of capitalism. The fittest systems are the ones that evolve. Thank you Darwin.

Before rushing in to evolve the capitalist system there must be a failure of the system that needs to be improved. I have already explained that failing companies are an integral facet to capitalism. It is not therefore a fault in the capitalist system that a company can fail. In fact the opposite is true. If a company cannot fail then the capitalist system is failing. Don’t forget the banking crisis was exacerbated by banks being “too big to fail”. Failing companies are fine, they are needed and expected. The fault that needs to be solved is the result of a company failing.

Companies fail for all sorts of reasons but no matter how a company fails the result is always the same. Indeed the way a company fails is defined by the rules that are applied to regulate the capitalist system. It can be said therefore that the result of a company failing is systematic. If we want to change the result of large companies failing we must change the rules that define the system.

The thing that is wrong with the result of companies failing is that innocent parties are invariably the ones who end up paying the cost while those that caused the problem typically miss management by the company executives walk away unscathed and dividends that should have been kept in the company are kept by the shareholders.

Let’s first consider the parties that are involved in the failure of a company.

  • Shareholders
  • Banks
  • Other companies that have loans agreements and the like with the company
  • Suppliers
  • Customers
  • Employees
  • Retired employees
  • Company executives
  • The recievers

The shareholders (those actually in possession of shares when the company goes into receivership) are protected by the limited liability of the company they loose their investment.

We all know what the banks are I leave it you to describe them. When a company fails the banks work hard to claw back as much of what is owed to them. They rarely get it all back but they are a powerful force fighting for their own ends from limited amount of assets.

Other companies that have agreements with the company are largely cut loose unless they owe the company money in which case the recievers will get back as much as they can. If they hold loans on the company they’re last in line and typically get nothing.

Suppliers are those who supply goods and services to the company. The only ones of interest are those that haven’t yet been paid for the goods and services supplied. These may get a portion of the money owed to them. The amount is defined by the recievers and suppliers have no say.

Customers those who consume goods and services from the company. The only interesting ones are the ones that haven’t yet paid for the goods and services. They are chased by the recievers and as much as possible is already retrieved from customers by the recievers almost certainly around 100%.

Employees are those currently employed by the company and are owed their final salary and are one of the first to be paid by the recievers. Employees don’t get severance pay if the company fails.

The company has a liability to pay the retirement income of previous employees with a company pension. There is rarely sufficient funds to pay any of this liability instead this liability is covered by the tax payer and the retirement income of retired employees may be reduced if the companies pension liability is too high.

Company executives are employees of the company but they are responsible for running the company on behalf of the shareholders.

The recievers are an independent accountancy organisation that deal with collecting money owed to the company and sharing it and the company’s assets among those that are owed money.

On the face of it the system seems fair and has been in place in the UK and working since 1844 when the Joint Stock Companies Act came into force and defined a limited liability company. The idea of a limited liability company is to allow an investors risk in investing in a company to be limited to the sum invested. This encourages investment in new companies. The company is owned by the shareholders and run on behalf of the shareholders by the company executives. The owners of the company are therefore isolated from all interactions with the company. One of the rules about having a limited company is a requirement to publish each year a set of accounts that are certified by an accountant. These accounts provide the means by which other organisations and individuals can evaluate their risk in dealing with the company. This structure allows investors to invest knowing their risk and interactions with the company to be evaluated for risk using accounts that have been assured to be true thanks to the standards defined by the accountancy profession. So when a company fails all that happens is the risks that people have taken in relation to the company become realised. There doesn’t appear to be a problem here. But there is.

During the 1980’s and the rise of financial markets all sorts of alternative ways of investing in risk were created along with accounting practices to enumerate those risks. In 1980 Neil Crockford wrote the first edition of ‘An Introduction To Risk Management’ and in 1986 the second edition was released. These books revolutionised our understanding of financial risk management and allowed the creation of the complex investment vehicles and accounting practices used to manage them.

This improved understanding of risk allowed companies to make much better informed decisions about the risks they were taking. It also allowed companies to better insure themselves against these risks. As a result the accounts of a company became much more complicated with the inclusion of assets held to mitigate risk. Companies gained the ability to hedge the risks they were taking through complex insurance policies and accounting practices.

The implication of this is that companies are able to hide the risks they are taking through accounting practices and investment vehicles created since the 1980’s.

This is where we start to see the problem. The very idea of a limited liability company set into law in 1844 made the assumption that the risk of trading with a company can be evaluated through inspection of the accounts provided annually for that company. But since the 1980’s that has become less and less true especially as companies get larger and larger and spend more on managing and accounting for the risks they are taking.

Managing and accounting for risk is a very good thing. It makes companies less likely to fail. But the very same practices if poorly or more likely maliciously used can obfuscate risk which is a very bad thing.

The financial crisis of 2008 was a direct result of the obfuscation of risk made possible buy by the ideas put forward by Neil Crockford in the 1980’s. The mistakes made by the bankers of 2008 were warned against by Neil Crockford but that’s another story.

Unfortunately there are very real benefits to a company of obfuscation of the risks its carrying. It allows companies to gain better credit terms than they would otherwise get. It makes the company look less risky for the same profit and so a better investment and a commensurately high share price. The only thing that keeps a company honest is its requirement to publish yearly accounts. A company’s accounts however are prepared by the company’s accountant. They are part of or act on behalf of the company and their loyalty is to the company and its shareholders.

For PLCs (public limited companies) these accounts must be audited by an independent accountant. This makes it harder but not impossible to obfuscate risk.

The problem then is that the assumption made in 1844 about the ability to evaluate the risk of trading with a company is less and less valid in the light if today’s accounting complexity unless the individual or organisation understands the complexity of financial risk management and how it can be used to obfuscate risk and has access to all the accounts of a company. Banks have access to a companies accounts often beyond the published accounts and the greatest understanding of financial risk management. Suppliers on the other hand have no access to a companies internal accounts and at best a poor understanding of financial risk management. Employees have no access to a companies accounts and no understanding of financial risk management. Yet there is an inherent incentive for company executives to use financial risk management to maximise the perceived value of the company for the shareholders. We have seen that the obfuscation of risk up to a point benefits the shareholders but this benefit comes at the expense of suppliers and employees who have no way of evaluating the risk to which they have been exposed.

The question now becomes what can or should be done to redress this inherent bias.

It would be very hard, even impossible to legislate against the poor implementation of financial risk management since financial risk management as an idea is a very good thing and is extremely complex.

There is an alternative. Restrict the limitation of liability conferred through limited company status.

If it were the case that the shareholders of a company remained liable for the goods and services consumed by the company and the labour used by a company on their behalf in the event of failure of the company the shareholders would insist that the executive’s of the company did not allow those liabilities to become out of control. Essentially restricting the limit of liability creates the very incentive for the executives to not overuse financial risk management and complex accounting practices to obfuscate risk while protecting suppliers and employees in the event of the failure of the company. This inherently reduces the repercussions of the failure in the wider economy.

This only leaves company pension liability. Financial risk management allows the successful management of pension liability without the requirement to maintain the entirety of the liability in current assets by evaluation of the risk that the company continues to exist and therefore service its annual pension expenses. Again this is a good thing. It therefore would be unfair and impossible to hold the shareholders liable for the ongoing liability of pension provision. However it would be possible to legislate a formula based on the number of pension accounts and the benefits offered to determine the maximum amount that the tax payer will cover for a failed companies pension liability. The shareholders could and should be held liable for the difference. Again this would compel the company executives to not run the pension fund at an excessive current liability as doing so would negatively affect the share price.

These two changes evolve the capitalist system to be better run and fairer while only effecting the downside risk of poorly run large companies.

The benefit of long payment terms would be counterbalanced with increased risk.

Failing companies would have less effect on the wider economy.

Those with no ability to protect themselves would never be exposed to a risk they don’t understand and can do nothing about.

If the change was phased in over a number of years the effect on share prices would be minimal as the change simply discourages poor financial management.

It cannot be right that those that gain financial advantage through labour and the consumption of products or services can escape their liability to pay for them.

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Simon Emmott

Simon Emmott

Free thinker and opinionated blue sky dreamer.