MoFo Perspectives Podcast
London lawyers Gareth Rees QC and Howard Morris discuss critical steps corporate senior management must consider now with regulators circling to pass judgement.
This pragmatic and informative discussion is designed to help our clients navigate the months ahead. It’s an easy listen of substantial and practical value. A concise one page summary, 10 Things You Need to Know about Financial Reporting Council Enforcement, accompanies this podcast.
Gareth is one of the most experienced white collar crime and regulatory lawyers in the UK. Before joining Morrison & Foerster, Gareth practiced at an international law firm’s London office, helping to set up and lead a team focused on white collar and investigations. Prior to that, he practiced at the UK Bar Association in fraud and business crime and regulatory work and in 2012 became Director of Enforcement at the Financial Reporting Council.
Howard heads the Business Restructuring & Insolvency Group in the London office. He has more than 25 years’ experience in UK and international restructuring and insolvency work. Howard’s experience covers every type of UK restructuring and insolvency procedure and he is one of the few English lawyers with hands on experience with the U.S. Chapter 11 process.
Speaker:Welcome to MoFo Perspectives a podcast by Morrison & Foerster, where we share the perspectives of our clients, colleagues, subject matter experts, and lawyers.
Jo Mhari Witham: Hello and welcome to this episode, “Critical Steps for the Board Chair and CEO.” I’m your host, Jo Mhari Witham, director of marketing and client development, Europe. I am delighted to be joined today by Gareth Rees, QC, and Howard Morris. Gareth is one of the most experienced regulatory and white-collar lawyers in the UK and for five years was head of enforcement at the Financial Reporting Council. Howard heads our Business Restructuring and Insolvency group in the London office. And today, we’re going to look at some critical steps that the most senior management of companies should now be taking. Howard and Gareth, welcome.
Howard Morris: Thank you, Jo. And hello everybody. Delighted to have you listening to this. At this time of crisis, I think it’s important to remember this isn’t the first financial and economic crisis that this country has faced. The advice my team always gives to senior management is not only that they need to have a hardened, dispassionate, detached look at the state of their company, but they need to keep firmly in mind that the liabilities of directors, the responsibilities they carry on their shoulders of which they might be made personally financially liable, are judged with a benefit of hindsight. And as much as the law and the judges and the lawyers might say liability isn’t to be decided with the perfect vision of hindsight, it’s absolutely crucial to put in place an approach in every company that will withstand subsequent scrutiny by people who aren’t in the moment who aren’t having to make, decisions with insufficient information and inadequate time. Reputations and personal liability and careers are at stake.
Gareth Rees: Well, Howard, it’s funny you should say that, because, since the last financial downturn, following the failure of Lehman and the bailout of the banking industry, the regulatory and policing net around financial and corporate misdemeanors has grown exponentially, and the regulators will be taking their time to look back. The lead regulators suffered a lot of criticism of their collective failure to act on those thought to be the culprits for the financial crisis. And they will not let it happen again. Regulators should be taken much more seriously in the UK. A very well-known city figure told me once that, in a crisis, he has chair of a major corporate in the U.S. would take calls from only two people—his main shareholder and his regulator. And it may well be that that sort of situation is now much more relevant in the UK these days.
Howard Morris: It’s interesting, because what we are seeing is that many very fine companies are now plunged into economic jeopardy, completely unexpectedly. These were the blue chip companies—great investments. Now, our advice when the board turned to us is always that you must monitor your finances with rigor. You really need to concentrate on cash and record carefully the decisions you make, because you’re going to have to stand them up later. Now, while the government has made a song and dance about the fact that it’s going to relieve directors of wrongful trading duty, and that’s the duty, which is akin to negligence in running of a company heading into insolvency, it’s important to note: one, that that hasn’t happened yet. I mean, it’s going to be backdated to the 1st of March, but it hasn’t yet happened, but perhaps, more importantly, is that directors are not being relieved or excused from other potential personal liabilities, including their fundamental fiduciary duty.
Howard Morris: Now, directors are very familiar with the fact that they owe fiduciary duties, and perhaps key among them is the duty to promote the success of their company, which means in ordinary times that they must do everything to make the company successful. And what does that mean? Acting in the interests of the shareholders as a general body, but when insolvency is probable—not certain, hasn’t happened yet, but when there’s sufficient financial stress to a company that there’s a likelihood of the company failing, that duty actually flips, and it’s owed not to the shareholders as a general body, it’s owed to their creditors. And that brings a very, very different complexion to the whole thing and potentially exposes the directors who don’t make the decisions that are right for the creditors as a general body, in that zone of insolvency as a company struggles and ultimately fails to survive, it exposes them to potential personal liability. So it’s crucial that they maintain good contemporaneous records that when they’re asked, why the heck did you do X, Y, and Z? They can say because of A, B, and C.
Gareth Rees: And don’t forget that the criminal offense of fraudulent trading is still in place for serious cases of failing to act with due regard for creditors. I’ve done a number of those cases over the years. Certainly, a number I remember doing in the early 1990s following that particular recession, but it’s not really the criminal threat that is any greater than it has been over the last 30 years. As I say that that would always be for the most egregious misconduct. It’s the regulators who are the greater threat to directors, and they have powers that they now use, and that those powers should make directors take a lot more care. It may well be that prison is the ultimate deterrent for criminal acts, but regulators have the ability to destroy reputations and impose substantial financial penalties. And my experience representing people like directors is that, when push comes to shove, money and reputation is what bothers them when they are found wanting in their conduct. And if you want to identify a moment in time when the world of regulation for the failures of boards, directors, and auditors changed, just look at the reaction to the collapse of Carillion. The regulators haven’t finished their work on that particular matter, but the sanctions imposed, if anyone is found at fault, will be significant with a clear deterrent element. The regulators were chastened by the criticism they have from government, parliament, and the serious media, and they will want to show that they have teeth, which bite.
Howard Morris: So it strikes me, Gareth, that you know, just by looking at the papers, listening, what one hears to is that the press, including the serious press and politicians, already seem to be keeping a scorecard of who is stepping up and behaving well and who in the corporate world is falling short. And we are seeing cases of applications for government bailout which are being declined. Do you think there will be public pressure to look hard at individual cases when we’re on the other side of this crisis?
Gareth Rees: Yes. For sure the regulators won’t decide individual cases, according to public perception or political pressure, they’re much more sophisticated than that. They have rules to follow about such matters, but all the investment made in them and their plans will be judged as a whole against the energy they put into investigating potential breaches. That means acting quickly and effectively on whichever cases they take on. Look, what we’re already seeing some caution from government as to who gets bailed out and supported. The government knows that if it uses public money to support companies who are undeserving because of the conduct of the directors behaving poorly against the accepted way that things should be done, there will be significant blowback.
Howard Morris: So, just, changing the perspective a little bit, Warren Buffet is famously quoted, everybody’s familiar with this, “You only find out who is swimming naked when the tide goes out.” Of course, right now the tide has gone out a long, long way and improving revenues and improving sales no longer exists to hide the fundamentals of underperformance and inefficiency. In the restructuring world, we, we see this most acutely at this stage of the cycle. And I’m thinking of, in particular, companies that have indulged in more window dressing of their accounts than perhaps is appropriate, perhaps gone a bit beyond what is acceptable. I’m thinking about the games that they play with the accounts receivable and payable. And there are companies out there with huge and expensive hedges or that, or massive margin loans. What’s your perspective on that area of the economy, Gareth?
Gareth Rees: Yes, and it was President Truman who had on his desk, “The buck stops here,” and that, for the regulators is a sign that perhaps should sit on the desks of chairs, CEOs, and CFOs, and, to some extent, the chairs of the audit committee. Stuff may be going on in their companies, poor habits and lack of financial hygiene, inappropriate arrangements with customers and suppliers that they know nothing about and runs contrary to what they believe is the culture of the corporate that they are running. But you know what, when the regulator, for example, the FRC or the FCA, comes along and finds it out, their gaze will fall on the guise with whom the buck stops. When ARGA, that’s the Audit Reporting Governance Authority— which is going to replace the FRC, it’s effectively rebranding—when that is in place, probably later this year now, because of what’s going on, maybe next year, but with all its new powers to regulate all those with responsibility, for the preparation of the financial statements, as well as the auditors, it will certainly become the lead regulator, in my view. For now, the FRC can only investigate the conduct of directors who are accountants. That’s still a significant number, because so many accountants, chartered accountants, sit on the boards of public companies. Others will remain to be judged for now by the FCA or possibly the insolvency service. And of course, if it’s really bad, the SFO may take a look.
Howard Morris: So what should senior management be doing?
Gareth Rees: Look, a very important point to keep in mind is that this isn’t about crooks. This is about people in crisis who don’t always make the right decisions. And that plays into my second point. The regulators need to see you’re doing the right thing, making every effort to do the right thing, notwithstanding these are unprecedented circumstances. Even if the regulator doesn’t agree with what is being done, that is the decisions you and your management team have made. They’re unlikely to penalize the individuals involved if it’s within the range of reasonable options. There will be plenty of cases where people don’t do the right thing. And sometimes they’re way out of line. That, of course, invites penalties. So how do you engage with regulators, and how do you prepare for an investigation? Well, it’s important for me to repeat a point that’s already been made by Howard.
Gareth Rees: It’s worthy of repetition, because it’s so fundamental and important. First and foremost, find the time, whatever the pressure you are under, to note down why a course of action is taken or approved and record the reason. There’s an old adage in audit, which I learned as the regulator, which is if it’s not recorded, it wasn’t done. Investigators look for evidence, and those sitting in judgment look at the evidence and want to find documents, which show that for example, a director was acting reasonably in the circumstances. Regulators really do want to find material and evidence like that, because they would like to discover that the right things were being done. It may also be helpful to discuss these issues with external advisors. And sometimes even the regulator may be contacted.
Howard Morris: As long as I’ve been a lawyer, a key element of running a company has been the board’s relationship with its auditor. It’s been the advisor, the first port of call in a crisis, a central commercial relationship. So do you include the audit firm the audit partner in that list of external advisors or has that relationship now changed a bit?
Gareth Rees: Well, this is a huge subject, but the answer in some ways is pretty simple, as the relationship is very different to how it was 10 years ago. One of the big changes, which highlights concerns that the audit partner in management were getting too close, is the introduction of mandatory rotation of auditors. One of the most frequent failings I saw as the regulator was that management and audit partners and the rest of the audit team were getting too close. And the auditor did not challenge management enough about accounting policies, about accounting treatment that they were adopting, and their financial statements. The regulator will not be impressed by claims that what was done was approved by the auditor, explicitly or implicitly, because the financial statements are the responsibility of directors. Likewise, the auditor will need to show it did a thorough audit as required by the standards. And to say that they were misled by the directors may do no more than inject some mitigation for any audit failings. The audit partner is not, these days, the consigliere for management. Indeed, I think it’s probably true to say that these days, under pressure with the regulators looking over their shoulder, they are more likely to run a mile if they get pressure from management.
Howard Morris: And we have something of an alphabet soup of regulators, do they work together, or do they compete?
Gareth Rees: Well, you’ve got to remember that when you and I started in practice, the regulatory landscape was a barren land. The modern FRC, certainly ARGA and the FCA, are creatures of this century and the insolvency service was itself reformed internally, quite substantially, since the last financial crash. When I arrived at the FRC in 2012, there was minimal contact with other enforcement teams at the regulators. By the time I left in 2017, we were having regular meetings to discuss matters of common interest, and certainly to overlap on investigations on which we all had an interest. That also applied to the pensions regulator or, or the charities commission. And of course, other overseas regulators, too. So, this is a new area for regulators and the environment and culture in which they operate is changing fast. Are there still some turf wars about which regulators should take the lead? Yes, of course there is. There always will be, but it’s now a much more minor factor, far outweighed by very effective collaboration. Again, look to Carillion, where the regulators are all working very closely together.
Howard Morris: Do the regulators then have a common mindset, a shared worldview across the different regulators and different industries that they supervise?
Gareth Rees: Well Howard, that’s a great question. Look to sectors first. Financial services stands out a mile. Then you have the economic regulators such as Ofcom, Ofgem, and Ofwat for the utilities. Then a whole host of regulators for professions, such as teachers or doctors or lawyers. And if you look at the rules and procedures for each of these, you will find fairly common language. Some of that comes from the EU, but it’s mainly because the rules, of course, have to follow the legal principles, which underpin our individual rights, such as the Human Rights Act. But we are looking here at companies, we’re looking at boards and directors. The FRC, or ARGA, has an overarching regulatory responsibility, which transcends all industries. It owns the corporate governance code. It regulates the function of audit of the largest listed entities, financial institutions, and insurance undertakings, and a few others, too. Soon, it will regulate the conduct of all board members. That may come too late to deal with the fallout from the recession, which is taking hold right now. But it’s a very powerful message from the government, which would not have been taken seriously as a prospect when I arrived at the FRC less than 10 years ago.
Howard Morris: In my field, we’ve always advised that directors must review and plan for contingencies because it’s only when the contingency you think looks like is going to happen that you really need your life preserver. Is that the right outlook for the regulatory universe too?
Gareth Rees: Well, if you mean, “Should action by these regulators be on the risk register?” then most certainly. I spoke on a platform in Oslo on compliance just before this crisis took over our lives. I said that the mistake companies make is to reduce the role of compliance when trading problems take hold in a recession. Compliance includes internal audit and all the other safeguards that are in place to ensure that the company is operating within the boundaries of law and regulation and the responsibility for that starts and ends with the board. And certainly the more serious the crisis, the more that is the case. It’s really very important, in my view, to understand that.
Howard Morris: Well, I think the message from us both is, to senior management, is act now. Otherwise it’ll be too late, Jo.
Jo Mhari Witham: Thank you, Howard. And thank you, Gareth. This now brings us to the end of our episode on “Critical Steps for the Board’s Chair and CEO.” Once again, I’m your host, Jo Mhari Witham, and we’ve been speaking with Gareth Rees QC and Howard Morris. Thank you so very much, indeed, for joining us.
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