In the early 1990s, two American economists, George Akerlof and Paul Romer, wrote an academic paper with the eye-catching title: “Looting”.
Its subject was the Savings & Loan crisis of the 1980s, which ended up costing the US taxpayer some $132bn in a string of bailouts. What intrigued the authors was the way some S&L owners ran their failing real estate lenders into the ground, wholly focused on value extraction and without a thought for the losses that they would leave behind.
They displayed a “total disregard for even the most basic principles of lending”, failing to verify the most basic information about their borrowers or, in some cases, not even bothering even to ask for it. Why, the economists asked, had they behaved in so cavalier a way? One reason, they concluded, was the existence of a government backstop. The state stood behind deposits that the S&Ls had taken.
But that was not the only thing encouraging the owners to loot their own operations. There was another big factor: poorly framed regulation. Easy-to-arbitrage rules and sloppy accounting standards kept S&Ls nominally afloat when in reality they were not viable. That created the circumstances in which owners could plunder dividends out of capital, as they either prayed for a miracle, or prepared to cast the depleted creditors into the taxpayers’ lap.
Echoes of this unsavoury situation can be found in the case of Carillion, the British outsourcing and construction group that has just collapsed owing more than £2bn to its banks. Once again, the government bobs up on the periphery, in this case chucking out state-funded contracts like confetti that appeared to underwrite the group’s viability. Carillion’s board may not have looted, but it does seem to have practised what one might call “reckless abstraction”. It sucked out cash to placate stock market investors even as executives wrote the mountain of under-priced contracts that ultimately buried the business, triggering a £1.2bn writedown in the second half of last year.
In the five years to 2016, the directors recommended paying £357m of dividends to shareholders, despite generating just £159m of cash from operations. Over the same period, the bonuses for the two top executives climbed from nothing to more than £1m a year in 2016.
Carillion is hardly the first listed business to base today’s juicy payouts on (inaccurate) estimates of tomorrow’s outcomes. One of the more notable features of pre-2008 banks was their enthusiasm for using mark-to-market accounting to write up unrealised profits on assets, thus conjuring large and imaginary surpluses out of complex securities. The swag was then packaged up and paid out largely in the form of debt-funded bankers’ bonuses. As for the later losses; well, of course, the taxpayer paid.
Clearly, it is unhealthy for the state to backstop private corporations — although in Carillion’s case, the government’s involvement fell short of a fully-fledged bailout. But no less worrying are the signals sent by modern accounting standards, which continue to give great leeway to recognise unrealised gains.
Under company law, it is a cardinal principle that limited companies should only make distributions out of distributable reserves, not capital, to protect investors’ cash. Yet in a world where anticipated revenues count towards today’s profits, it is hard to know precisely where that crucial line lies. The investor’s main defence is the auditor being required to call out imprudently recognised sums.
In Carillion’s case, it is reasonable to ask whether this happened. We do not know yet how KPMG came to rubber stamp accounts supporting the payment of a £79m dividend last year, leaving distributable reserves of just £93m on the group’s balance sheet. What we do know is that Carillion wrote off £1.2bn just a few months later; a move that not only obliterated its reserves many times over, but also all of its profits over the previous eight years.
If the rules permit excessive latitude, that raises questions not only about standards, but also about the auditor’s watchdog, the Financial Reporting Council. Other past scandals exhibit similar features, including the overstatement of supplier rebates by supermarket owner Tesco, and the implosion at Quindell, an insurance software group.
Accounts are supposed to show a “true and fair” view of a company’s affairs. If they do not, it is pretty concerning. The S&L crisis highlights the peril of allowing directors to write their own figures. Faulty standards run the risk of meaning accounts cannot be relied upon. As a group of investors, activists and academics put it this week in a letter to the FT: that poses “devastating consequences for all stakeholders who depend on businesses remaining going concerns”.
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