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Building a regulator that works

The collapse of Carillion could have been avoided by a proportionate and focused regulatory regime, writes the Scottish Housing Regulator’s Ian Brennan

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Ian Brennan, director of regulation – finance and risk at the Scottish Housing Regulator
Ian Brennan, director of regulation – finance and risk at the Scottish Housing Regulator

My analysis of the collapse of Carillion fits neatly into four categories: governance, accounts and audit, pension funding, and regulation.


Let’s start with governance.


The UK Corporate Governance Code defines corporate governance as the process by which a company is directed and controlled. Its purpose is to facilitate effective, entrepreneurial and prudent management that delivers long-term success.


In my experience, an appropriate culture – one which encourages informed debate and constructive challenge – is the single most important factor in determining and delivering good corporate governance.


Perhaps unsurprisingly, the report by the Work and Pensions Committee and the Business, Energy and Industrial Strategy Committee of the House of Commons on the collapse of Carillion was scathing about the business’ culture.


Carillion’s chair had testified that it was one of “honesty, openness, transparency and challenging management robustly, but in a supportive way”.


However, the committee concluded that Carillion’s governance was characterised by a “chronic lack of accountability and professionalism… the board was either ignorant of the rotten culture at Carillion or complicit in it”.


From a regulatory viewpoint, culture can be problematic.


Unlike financial health, governance cannot readily be measured by quantitative methods and ratio analysis.


And yet we know that an inappropriate culture can lead to impaired governance, which is often the prelude to financial distress.


In the case of Carillion, the poor governance was exacerbated by a lack of appropriate financial information. A review by independent consultants for Carillion’s lenders found an absence of basic financial information such as cash flows.


Accounts and audit


The report concluded that Carillion’s accounts were “systematically manipulated” and included “optimistic assessments of revenue”. This meant that the company collapsed from a publicly stated position of strength.


A key task for anyone charged with the regulation of financial health is to establish the extent to which apparent strength is actual strength.


Within any set of accounting standards there will always be discretion afforded to accountants and auditors. Therefore it is possible for accounts to be presented in a number of different ways, each of which can be said by the directors and the auditors to show a true and fair view.


The purpose of the statutory audit is to provide an independent opinion on the truth and fairness of the financial statements.


The report was critical not only of Carillion’s auditors – no qualified opinion in 19 years of auditing the company – but also of the oligopolistic market in which they operated.

 

It concluded that this is a market that “works for the Big Four firms but fails the wider economy”.

 

The report characterised the company’s employment of auditors as “badges of credibility”. This points to an issue that many regulators will recognise.


Organisations that are challenged by regulators often point to an unqualified audit opinion as evidence that all is well. It’s important.


It is especially important for those on governing bodies to have a clear understanding of the differences between the roles of regulators and auditors.

 

An unqualified audit opinion relates to a past period and should not be seen as a guarantee of future solvency.


Statutory accounts necessarily contain judgements and estimates, are affected by accounting treatments and deal with past periods.


Accounts will always be necessary reading for financial regulators, but will never be sufficient. In common with other UK housing regulators, the Scottish Housing Regulator uses measures which are cash based and forward looking in order to assess financial risk.

 

Forecasts do not come with an audit opinion, but a skilled regulator can get behind the figures and establish the extent to which they are a credible reflection of the state of the business.

 

Pension funding


An unwanted legacy from the demise of Carillion is a massive and unfunded pension liability, estimated at £2.6bn. This means the 27,000 members of the defined benefit pension schemes will now be paid reduced pensions by the Pension Protection Fund. The fund itself will face its largest ever hit.


Pension funding and sustainability has been a focus for UK housing regulators for most of the past decade. In a Scottish context the regulator has engaged as appropriate with individual landlords and we continuously monitor the sector position.


The main pension scheme in the Scottish housing sector has a substantial deficit but it has a recovery plan in place. The funding ratio has improved from a low point of around 55 per cent in 2012 to around 76 per cent at the latest three-year valuation.


But more than half of all registered social landlords continue to offer defined benefit pensions. So how landlords manage the position will remain a regulatory focus for the foreseeable future.

 

Regulation


Unlike in the social housing sector, there is no single regulator to cover private companies – even those like Carillion, which carry out essential public functions.


However, the functions of the Financial Reporting Council and the Pensions Regulator gave these various regulators some oversight of aspects of the company.


In addition, the government’s Crown Representative is intended to monitor risks in key strategic suppliers. However, recruitment problems meant that there was no government representative monitoring Carillion even after it issued a profit warning in July 2017.


These three organisations have their own distinct locus but none have an explicit responsibility to monitor and assess financial health and governance.


Conclusion


Given the dysfunctional governance and financial problems of Carillion, it is likely that a proportionate and focused regulatory approach would have detected the issues and may have been able to mitigate the damage to public services and the cost to the public purse.


Creating such a regulatory regime would be complex and it would take a lot of work to ensure that such a regime was consistent with the obligations that already exist for private listed companies.


But the case of Carillion demonstrates that the cost of failure – tangible financial costs as well as the huge cost of disruption to those who relied upon the company for services – are massive.

 

It follows, then, that the rewards for an effective regulatory regime are commensurately large.

 

Ian Brennan, director of regulation – finance and risk, Scottish Housing Regulator

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