Conduct risk and corporate governance - lessons from Carillion

Summary

The Work and Pensions and BEIS Committees’ report into the implications of the Carillion collapse highlights both the importance of the current regulatory focus on corporate governance, including for insurers, and the implications for senior management and their D&O insurers of getting it wrong. The report heavily criticises a number of parties, and makes recommendations with a view to preventing a similar situation from arising in future.

SM&CR and the drive for improvements in corporate governance

The collapse of Carillion has been attributed in part to a “rotten corporate culture”, and the report concludes that the collapse of Carillion has “tested the adequacy of the system of checks and balances on corporate conduct”.

The Report’s findings and proposals on culture and governance will be of interest to all firms subject to current or upcoming scrutiny from government and regulators concerning their culture and corporate governance, including firms in scope for the upcoming extension of the Senior Managers & Certification Regime (SM&CR).

Government and regulators have increased their scrutiny of large corporations over recent years, with a particular focus on seeking to improve corporate governance through encouraging changes to conduct and culture, so that the legal and regulatory environment is slowly changing (see our Conduct Risk materials here). SMCR will apply to insurers from 10 December 2018, and to insurance brokers (and other FCA-solo regulated firms including asset managers and brokers) from 09 December 2019, increasing individual accountability at all levels of firms

The proposals are intended to support improved governance and culture across the industry. Staff will be categorised according to the seniority of their role within firms. All staff (apart from ancillary staff) will be subject to five individual conduct rules; with Senior Managers subject to additional conduct rules.

One of the most significant changes for firms subject to the new regime is likely to be the introduction of the certification regime. The certification regime covers people who are not senior managers but whose job the regulators regard as potentially having a big impact on customers, the market or the firm itself. Firms will be required to identify staff captured by the certification regime and establish a new process to certify them as “fit and proper” on an annual basis.

Firms will be under an obligation to notify the regulators if they find that a person within the firm has breached one of the conduct rules. Senior Managers are subject to further scrutiny under the ‘duty of responsibility’.

Our summary of the “Ten Things Insurers Need to Know About SM&CR” can be found here, and further materials about Corporate Governance more generally can be found here. Further information about the extension of SM&CR generally can be found here.

Additional proposals made in the report to improve governance include:

• A more active and interventionist approach, including revision of the Stewardship Code (see our summary here) and a more visible role for the regulators, principally the Financial Reporting Council.
• Arming the FRC with the necessary powers to be a much more aggressive and proactive regulator including powers to investigate allegations of poor practice from whistle-blowers.

Directors duties

Directors’ duties are largely codified in the Companies Act 2006 (in particular within Part 10, Ch.2). These include to:

• act in the way the director considers, in good faith, would be most likely to promote the success of the company for the benefit of its members as a whole (section 172 CA 2006). The interests of the company are not simply those of its members, and may include consideration of the interests of employees, suppliers, customers and the wider community too.

• exercise independent judgement (section 173 CA 2006), and to

• exercise reasonable care, skill and diligence. The standard is that which can reasonably be expected of a company director (objective), with the knowledge, skill and experience of someone in that director’s position (subjective element which may raise the required standard if the director has any special skills, knowledge or experience) (section 174 CA 2006)

The Carillion board is assessed as having been unaware of the full nature or scope of their duties, and either “negligently ignorant of the rotten culture at Carillion or complicit in it”. Their failures include:

• the pursuit of pursuing “short-term gains over the long-term sustainability of the company”, funding expansion through rising debt, ignoring a rising pension deficit, with “scant regard for long-term sustainability or the impact on employees, pensioners and suppliers”

• a climate of “misguided self-assurance” and an excess of optimism of senior board members

• a failure of other board members to scrutinise or challenge “reckless executives”

• ignoring or overriding internal peer reviews which raised concerns about the financial position of particular contracts, and

• using “aggressive accounting practices” in order to recognise as much revenue upfront and present an overly positive picture of the financial position.

The remuneration committee was criticised for paying substantially higher salaries and bonuses to senior staff while financial performance declined; effective board remuneration policy should have the long-term success of the company as its only goal. The report recommends the introduction of rules rules requiring minimum standards for bonus clawback for all public companies.

The report urges investigation into the role of Carillion’s former directors, and that action be taken accordingly in respect of any breaches, including disqualification as a director.

The content of the report supports a belief that any claims against the directors and officers relating to their own conduct (eg from shareholders) are likely to fall within the standard definition of “Wrongful Act”. Bearing in mind the potential losses and the costs which may be incurred in relation to the recommended potential investigations, the limits of indemnity and apportionment may become areas of focus for both insurers and insured persons.