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Internal factors

Poor financial controls40

The immediate cause of failure in a company is a lack of cash available to pay bills when they are due. A common cause of corporate decline, accordingly, is failure to take adequate steps to control cash flows. In the normal course of business a company’s current bank account is liable to fluctuate from deficit to surplus levels as it issues funds to purchase materials, pays its work forces, produces its goods and then awaits the inflow of funds through payment of customers’ bills. (Such fluctuations may be compounded where the firm’s business is seasonal in nature.) Managing cash flows involves the collection of relevant information and the organisation of this: normally the charting out of anticipated cash receipts and disbursements on a weekly or monthly basis. Planning cash flows will involve consulting with lenders, negotiating appropriate credit lines and presenting potential lenders with projected cash flows, plans for product or market development and, amongst other things, programmes for cost control. Such planning has to cope with a number of situations that can decrease liquidity. These situations include: trading losses that reduce cash flows and assets relative to liabilities; bad debts or other writeoffs; needed investments in expansion; and falls in the value of assets (which reduce the company’s ability to raise cash by granting security).41

The firm’s managers will aim to make arrangements with the firm’s bankers and other creditors so that funds are available to bridge the gaps between deficit and surplus and to continue funding production, marketing and sales activities. At the same time, the firm has to remain able to pay its own debts as they fall due. Funds, accordingly, must be negotiated to allow such obligations to be met. Where the firm’s creditors are no longer willing to lend (perhaps because they have lost confidence in the firm’s management), or where loan arrangements have not been negotiated, the firm may find it difficult to keep operating or to pay its debts unless it has taken other steps to deal with cash flow problems, such as maintaining a level of cash reserves sufficient to sustain itself between the troughs and peaks.

40Poor financial controls are dealt with separately here from mismanagement but may be seen as a particular form of managerial failure: see Platt, Why Companies Fail.

41See Pratten, Company Failure, p. 8. The use of credit management procedures and services (e.g. the use of business information reports, credit insurance and debt collection services) can minimise the risk of a company failing due to poor cash flow: see T. Byrne, ‘Credit Management and Cash Flow in Businesses’ (2007) Recovery (Spring) 38.

Over-dependence on short-term financing may, in turn, lead to financial difficulties. Thus, where a firm resorts to overdraft financing in order to fund long-term investment plans, it becomes highly vulnerable. If the bank withdraws the overdraft facility the firm may not have time to obtain alternative funding before it enters difficulties.42 Lack of control over current assets is a further major cause of corporate failure. When assets are purchased on credit they have to be used in a manner that allows interest payments to be paid and a profit made. If assets are unused or wasted, a company will be in financial trouble unless other activities can carry the losses. Managers must invest in assets such as equipment so as to meet market demands, but they must be wary of possible market changes that will reduce or remove the potential profit- ability of their equipment. Assets, accordingly, must be managed so that, overall, a firm has sufficient flexibility to cope with market changes. Attention has to be paid to the balance between long-term fixed asset costs (funds tied up with, say, machines) and variable cost items (e.g. labour and fuel costs which are more easily adjusted than fixed asset costs). Long-term assets (e.g. steel production plants) can be highly profitable but they carry greater risks than variable cost items due to their inflexibility, particularly if they are specialist in nature and there is no ready market providing a means to realise their value by sale. If the balance of a firm’s investment is tilted too far in the direction of longterm fixed costs, its ability to cope with slow markets diminishes and failure may result.

Similarly, problems may arise where the company operates with ‘high gearing’: arrangements that involve a high proportion of fixed interest commitments or fixed interest capital in relation to the firm’s total assets (i.e. all fixed and current assets). With high gearing a firm devotes a high proportion of its gross profits to the servicing of loan capital. It accordingly becomes highly vulnerable to changes in market conditions and interest rates.43 Poor control of gearing may thus cause firms to fail when general economic, or particular market, conditions deteriorate or when

42The Bank of England has in the past expressed unease at the dependence of small UK businesses (highlighted by the recession of the early 1990s) on overdraft facilities to finance anything from working capital to long-term investment projects: see Bank of England, Finance for Small Firms, Sixth Report (1999), p. 28.

43On high gearing, the vulnerability of the corporate sector and the rise of private equity transactions see ch. 3 above; and Bank of England, Financial Stability Review (Bank of England, 2005) p. 14.

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there is a credit squeeze44 and there is some evidence that companies with high gearing are more likely to move into crisis than those with low gearing.45

Inadequate financing is a further cause of failure. This may occur when the company fails to raise sufficient funds by debt or equity means to render its operation profitable. If funds, for instance, suffice for production purposes but do not provide adequately for marketing and sales activities, the company is unlikely to make ends meet. Over-expansion and over-trading may also produce severe problems when a firm increases its volume of business more quickly than it is able to raise the funds necessary to finance such operations properly.46

Mismanagement

Most English company directors are untrained and unqualified.47 Poor management, moreover, has been said to account for around a third of company insolvencies.48 One survey has suggested that in 46 per cent of

44On the speed with which credit shocks can occur and the aftermath of the US sub-prime mortgage market crisis see Bank of England, Financial Stability Review (Bank of England, 2007), ch. 1; Shocks to the UK Financial System (Bank of England, 2007). See also G. Walker, ‘Sub-prime Loans, Inter-bank Markets and Financial Support’ (2008) 29 Co. Law. 22.

45See R. Hamilton, B. Halcroft, K. Pond and Z. Liew, ‘Back from the Dead: Survival Potential in Administrative Receiverships’ (1997) 13 IL&P 78, 80. Companies with cyclical markets and high gearing will be especially vulnerable – and such markets tend to be found in certain sectors, for instance, computer software, automotive, nonfood retailing, construction and media.

46Over-expansion is the most frequent corporate weakness identified by J. Stein, ‘Rescue Operations in Business Crises’ in K. J. Hopt and G. Teubner (eds.), Corporate Governance and Directors’ Liabilities: Legal, Economic, and Sociological Analyses on Corporate Social Responsibility (De Gruyter, Berlin, 1985) p. 380.

47An IOD report published in 1998 indicated that directors had become more professional since the beginning of that decade but that there were still ‘shortcomings’ in their behaviour (65 per cent of respondents had ‘prepared themselves’ for their boardroom role compared with just 10 per cent in 1990; the proportion of respondents taking training courses had also increased from 8 per cent to 27 per cent; but while 61 per cent of respondents – mainly senior directors of small to medium-sized companies – said directors should have a formal induction to the board, only 6 per cent had had such an induction themselves: IOD, Sign of the Times (IOD, London, 1998)).

48The SPI Twelfth Survey reported in 2004 that 32 per cent of company failure factors could be put down primarily to bad management. The notion of mismanagement can, however, be drawn sufficiently widely to produce far higher figures. See, for example, Campbell and Underdown, Corporate Insolvency, pp. 1–3: ‘Companies become insolvent when their management fails to develop adequate long term strategic plans to deal with problems of profitability and cash flow.’ (The most frequent managerial failings noted in the SPI Twelfth Survey were excessive overheads, engaging in new ventures/expansions/

cases, companies fail because of matters primarily in the control of the management and that in almost a quarter of cases businesses would have been rescuable if directors had sought the right advice earlier.49 Some commentators have cautioned, however, that mismanagement often provides a more convincing explanation of which firms in a trade fail than of the number of firms that fail (which may be dictated by the nature of the market, the product and the role of available economies of scale).50 One aspect of poor management already discussed is an inability to establish adequate financial controls, and poor information collection and use is very often associated with poor financial controls. Lack of cost information is a major failing since successful corporate operation demands that managers possess knowledge concerning the profitability of the firm’s different activities. It is essential to know, for instance, if the price at which a product is being sold is producing profits for the company. Selling at a price below cost will soon lead to failure. Other informational deficiencies may involve the lack of cash flow forecasts, the absence of budgetary control data and the non-availability of figures on the values of company assets.51 Information, moreover, must flow properly through the firm and poor lines of communication have been said to be one of the main causes of failure.52 ‘Creative accounting’ techniques can disguise the true state of financial affairs in a company or can delay the emergence of accurate information about the firm. Such techniques, accordingly, can contribute to mismanagement generally and can reduce the company’s ability to respond successfully to market and other pressures.53 They can also lead managers, investors and bankers to expand corporate operations more rapidly, and at higher risk, than the true state of affairs merits. Creative accounting techniques may also camouflage

acquisitions, lack of information, over-optimism in planning and erosion of margins.) The prevalence of family-run businesses in the UK has been cited as a cause of poor management: see N. Bloom, Inherited Family Firms and Management Practices (Centre

for Economic Performance, LSE, London, 2006). See also p. 158 below.

49 Se e R 3 Ninth Su rvey (2 001 ), p . 2. I n the cas e o f larg e r c omp an ies turnover R3 suggested that nearly half could have been rescued if the right advice had

been sought (ibid., p. 3).

50See Platt, Why Companies Fail, p. 6.

51Argenti, Corporate Collapse, pp. 26–7, 30–3, 94–5.

52Ibid., p. 30 (reporting the assessment of Mr Kenneth Cork, as he then was).

53On creative accounting and whether auditors should control this more rigorously, see Pratten, Company Failure, pp. 50–1; Clarke, Dean and Oliver, Corporate Collapse, ch. 2. On auditing as a preoccupation and an end in itself rather than an effective management tool see M. Power, The Audit Society: Rituals of Verification (Oxford University Press, Oxford, 1997) ch. 6.

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the firm’s true levels of debt or inflate profit and asset figures and, as a result, managers may be led to raise the gearing of the company in a dangerous manner.

It has been suggested that accountants in auditing and advisory roles might play a stronger role in ensuring that accurate information is available on a company’s financial position and in warning of dangers.54 Moves on two fronts might thus be considered: methods of reporting to management and shareholders could be rethought; and accountants’ training might be revised so as to improve their managerial advisory role.55 On the first front, however, it should not be assumed that auditing strategies and assumptions can be revised to reveal the ‘true position’ of a company. Uncertainties in markets and future prospects will always mean that such items as asset valuations contain elements of uncertainty. What can, perhaps, be done is to map out the location and extent of uncertainties in as clear a way as possible.56 A further key issue is whether auditors can make reliable assessments of the degree to which a company is at risk.57 Auditors suffer from a number of limitations in judging corporate prospects, not least their restricted knowledge of managers’ forthcoming strategies and decisions in a changing marketplace. There

54See, for example, Pratten, Company Failure, p. 48 and references to press reports therein. For doubts as to whether the present audit model is capable of identifying and dealing effectively with managers determined to perpetrate fraud see Maastricht Report 2005. The credit crisis of 2008 was reported as prompting auditors to hold ‘unusually early discussions’ with companies over year-end results focusing on their financing and ability to continue as a going concern, while the UK accounts watchdog, the Financial and Reporting Review Panel, warned that scrutiny in 2008 would be focused on banks, retailers, commercial property, leisure and house builders where it perceived the biggest risks to viability lay: see J. Hughes, ‘Auditors Seek Early Scrutiny’, Financial Times, 14 August 2008.

55Pratten, Company Failure, p. 50.

56See, for example, Power, Audit Society, p. 144: ‘The issue is rather a question of organisational design capable of building in “moral competence” and of providing regulated fora of openness around these competences.’

57Pratten, Company Failure, p. 57. See M. Power, Organised Uncertainty: Designing a World of Risk Management (Oxford University Press, Oxford, 2007) where it is argued that the rise of risk management has also coincided with an intensification of auditing and control processes. On the accountancy profession’s concern at the ‘expectations gap’ – the difference between what audits do achieve and what it is thought they achieve, or should achieve – see the Report of the Committee on the Financial Aspects of Corporate Governance (Cadbury Committee) (December 1992) paras. 2.1 and 5.4; J. Freedman, ‘Accountants and Corporate Governance: Filling a Legal Vacuum?’ (1993) Political Quarterly 285.

are dangers, moreover, that overt auditors’ warnings of risk might themselves contribute to corporate troubles.

As for training and advice, accountants might focus more on such topics as the causes of corporate failure, the requirements of success and the economics of pricing. They might, accordingly, strengthen their roles in advising corporate managers during the ongoing process of corporate decision-making. This, in turn, might be expected to improve information use and managerial decision-making more generally. The result could, for instance, be greater managerial awareness of the dangers involved in creative accounting or in failing to develop accurate costing figures.

Managers may also prove deficient by failing to respond to changes in the company’s environment.58 Thus, when key personnel depart from a company or markets or technologies move in new directions, a company’s managers must be capable of developing new staffing arrangements and new products and strategies to keep the firm competitive.59 Appropriate information and research and development systems are likely to be necessary if such lack of responsiveness is to be avoided. Being responsive, moreover, may demand that managers counter their natural inclinations to over-commit to strategies that they have set in train. It has been argued that corporate decision-makers tend to be psychologically biased in a number of ways that make it difficult to exit from losing strategies.60 One suggested bias involves an excessive focus on sunk costs and moneys already committed to a project. This produces a tendency, even when projections are bleak, to throw good money after bad in an effort to justify or make good on the past investment. A second bias favours adhering to initial estimations of potential gains and involves a slowness to adjust these to changes in market conditions. These biases, it is contended, affect the timing of decisions both to pull out of ill-fated projects and to seek help when the company meets more general financial difficulties.

58Campbell and Underdown, Corporate Insolvency, p. 18.

59Loss of an established competitive advantage has been said to be ‘generally fatal’ because it is so difficult to regain a competitively supreme position: see J. Kay, ‘Fallen Companies Rarely Make It Back to the Top’ Financial Times, 16 November 2007.

60See J. Horn, D. Lovallo and S. Viguerie, ‘Learning to Let Go: Making Better Exit Decisions’ (2006) 2 McKinsey Quarterly 64–75. ‘More often, evidence in support of management strategies is overvalued while evidence against it is undervalued … Under threat, management becomes hyper-resistant to change’: J. Baum, ‘The Value of a Failing Grade’, Financial Times, Mastering Risk, 9 September 2005. Joel Baum argues, however, that failure may, in fact, be a more valuable learning experience than success.

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A further managerial failing may involve leaving the company particularly vulnerable to changes in the market or the broader environment: as where an excessive dependence on a particular supplier contract or customer is allowed to build up and inadequate provision is made for the departure of that supplier or customer.

Managers may fail simply because they lack appropriate skills.61 They may be brilliant engineers but poor financial directors. Lack of identification with the company’s interests may be another managerial failing. This may range from a targeting of personal rather than corporate objectives through to practices of defrauding the company for the purpose of making illegal personal gains.62 Fraudsters may, for example, forge cheques in their own favour or steal the stock of the company. Directors may engage in extravagant lifestyles at the firm’s expense, employees may turn their backs on corporate interests and parent or associate companies may milk successful businesses of their profits, put no investment back into those businesses but use the proceeds to fund other operations within a group. All of these forms of conduct, illegal and legitimate, may drive a firm into failure.

In the case of small businesses, it has been suggested that a fifth of all failures are attributable to marketing errors.63 A company’s managers may have conducted inadequate research into markets and competitors, they may have failed to set up effective organisations for marketing or may have adopted weak sales strategies. Managers of small firms may, indeed, have a general tendency to focus on product development and give too little attention to marketing.64

61It has been argued, on the basis of a survey of over 730 medium-sized companies in the UK, France, Germany and the USA, that when managers are chosen from the members of the owning family the company tends to be poorly managed – and especially so if the CEO is selected by primogeniture. The reasons given in explanation are that this narrows the available pool of managerial talent drastically and that inherited rights to manage tend to reduce levels of effort. See Bloom, Inherited Family Firms.

62The Maastricht/Erasmus study of 2005 suggested that 37 per cent of European business failures involve fraudulent or unethical behaviour by managers or employees (see Maastricht Report 2005, p. 8), but, for a view that fraud-induced failures are, in fact, rare, see Pratten, Company Failure, p. 6; K. Cork, Cork on Cork: Sir Kenneth Cork Takes Stock (Macmillan, London, 1988).

63See M. Gaffney, ‘Small Firms Really Can Be Helped’ (1983) Management Accounting (February).

64See Campbell and Underdown, Corporate Insolvency, p. 21. An analysis of sixty major failures in the European Union over the last twenty-five years concluded that failed companies tended to fall into four categories: the basically unhealthy; those with overambitious management; those failing to adapt to change; and those afflicted by dominant managers and fraudulent or unethical behaviour: see Maastricht Report 2005.

Managers may perform their own tasks competently but they may prove to be poor leaders. Poor management may thus lead to inadequacies of supervision, morale and productivity. As a result, the company may operate with high costs, low productivity and diminishing levels of profit. The governance structure of a company may also prove conducive to mismanagement.65 This may be the case with notable frequency in certain circumstances: where, for instance, a single individual dominates a company;66 where there is an imbalance on the board (between, for example, financial and technical experts); or where there is a lack of representation on the board (e.g. of accountants). Where procedures for briefing managers and board members are inadequate this, again, may lead to defective control mechanisms and poor decision-making in the company.

As for the characteristics of those managers that are associated with corporate failure, Stein has suggested that the following traits tend to be exhibited by insolvency-prone managers.67 First, all bad managers tend to be ‘out of touch with reality’, a condition in which they possess little consciousness of risks. This propensity tends to be found together with high levels of technical knowledge and a willingness to learn on the technological front, or else with high ability in marketing and sales. The area of risk tending to be neglected by such managers is that associated with growth and over-expansion. Second, bad managers tend to be very strong willed, autocratic, unwilling to delegate and able to impose themselves on their business partners and co-workers.68 Such

65See C. Daley and C. Dalton, ‘Bankruptcy and Corporate Governance: The Impact of Board Composition and Structure’ (1994) 37 Academy of Management Journal 1603.

66See Argenti’s discussion of Rolls Royce’s troubles in the early 1970s: Corporate Collapse, ch. 5.

67Stein, ‘Rescue Operations in Business Crises’. In 1996 the business information group CN published research indicating that nearly 4,000 company directors (four times as many as had previously been thought) had been associated with more than ten company failures: Financial Times, 28 October 1996. (CN reported that of the 2.6 million UK company directors on its database, 952,432 (or 37 per cent) had been associated with one or more failures in the previous seven years and one in twelve directors was a ‘serial failure’ associated with at least two collapses.)

68A relevant portrait emerged when, in 2007, two directors of Independent Insurance were convicted of conspiracy to defraud (after the company plummeted from stock market darling to insolvency). The former Chief Executive’s own QC said, in mitigation, that ‘corporate arrogance’ had been fostered by his client’s belief that the company was ‘his baby’ and that with brilliance had come ‘an overbearing, unreasonable dominance, a management style that was simply unacceptable’: see M. Peel, ‘Former Insurance Executives Face Jail’, Financial Times, 24 October 2007.

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dominance tends to be underpinned by their high abilities with regard to technical or sales issues and their uncritical attitude to growth. Almost all such individuals possess ‘remarkable stress tolerance’69 and the high level of their assertiveness often translates into ambitious plans for corporate dominance of the market. In around half of such individuals there is a tendency to personal high living.

A different sort of manager is, according to Stein, also associated with corporate failure and this is labelled the ‘improvident’ manager. This individual tends to act in an ill-informed, ‘blind’ fashion in pursuit of favourable opportunities to advance in the market and tends not to carry out the necessary studies on the sustainability of an expansion or the financial underpinnings required for such a development.

Mismanagement, moreover, may be seen in the shape of single aberrant acts as well as in ongoing weaknesses. Corporate managers may make catastrophic mistakes or fail to deal with particular problems and, in doing so, may place the company in peril. A decision, for instance, may be taken to move the firm’s business into a market sector in which the firm is unable to compete, or a huge investment may be put into the production of a poor product. Corporate managers may also embark on a project so large that its failure will place the survival of the company at risk.70 Such managers may err, again, by buying other companies that are weak, over-priced and whose acquisition cannot be turned to advantage.71 Thus, a manager looking for growth will often acquire another company by paying a premium and will hope to find synergies and methods of cutting costs. Frequently, though, difficulties arise because the buying company’s directors have overestimated their understandings of the targeted firm, because the information systems of the companies are incompatible or because the expected synergies are not yielded when market realities are faced.72 Failure to deal with a key technological change may also constitute a managerial error that renders the firm’s survival uncertain. Most products become obsolete as technologies advance, substitutes come on the scene or consumers’ tastes change, and companies that fail to adapt in a suitable manner may go out of business.

69Stein, ‘Rescue Operations in Business Crises’, p. 390.

70See the discussion of the Rolls Royce RB211 project in Argenti, Corporate Collapse, ch. 5.

71An example of this was British and Commonwealth’s acquisition of Atlantic Computers in the 1980s: see Pratten, Company Failure, p. 34. See also Campbell and Underdown,

Corporate Insolvency, p. 23.

72See M. Skapinker, ‘The Growing Pains Faced by New Parents’, Financial Times, 24 January 2005.