As early as 118 BC, the people of Rome approached Magistrate, Lucius Verginius Rufus, to take control of the assets of bancus ruptus citizens. Fast forward to 2002, the collapse of Enron and WorldCom forces the introduction of the Sarbanes-Oxley Act. Then in 2008 the largest US insolvency plays out, the collapse of Lehman Brothers reporting a $4 billion trading loss. In Australia in the year to June 2012 ASIC reported 15,416 cases of corporate insolvencies.
Despite changes in governance and regulation, insolvency continues to grow, at least in Australia to the levels not seen for over 10 years. It is not surprising the business of going broke has been one of the most researched topics in business over the last seven decades (Balcaen & Ooghe, 2006a).
Australian Insolvency Statistics, maintained by the Australian Securities and Investments Commission ASIC provides useful information into corporate failure. Series 3 of these statistics covers an 8-year period from July 2004 to June 2012[i].
Every year, on average companies operating in the construction industry will make up approximately 22% of corporate failures, business and personal services making up 23% with retail approximately 10%. The industry sector league table consistently looks like this:
No. 1 – Construction,
No. 2 – Business and Personal Services
No. 3 – Retail
No. 4 – Property and Business Services
No. 5 – Manufacturing
Clients operating in these and allied industries need extra attention.
Generally, an organisation is made up of a matrix of resources, both tangible, such as cash and intangible such as social capital and policies, including strategic and operational plans and other policies such as financial management. These resources interact in a market place and success or failure will be determined on how well these resources and policies are applied in this competitive setting (Crutzen & Van Caillie 2008)[ii].
This is clearly demonstrated by the causes of failure reported in the Australian Insolvency Statistics. The table here looks like this:
# 1 – Poor strategic management of the business
# 2 – Inadequate cash flow or high cash use
# 3 – Trading losses
# 4 – Poor financial control, including lack of financial and other records
A recent trend has been the increase in poor economic conditions as a reason for corporate failure, sneaking into the top 5 in the last three years to 2012.
In their work, Crutzen, N and Van Caille D, identified four key phases of business failure. These phases are simply identified as:
Phase 1 – a deficiency in the resource base – no cash, no capital either financial or social andcore competencies reliant on the individuals involved in the business.
Phase 2 – appearance of failure such as no hold in the market place, low or no profitability.
Phase 3 – critical warning signs.
Phase 4 – insolvency.
Real focus has centred around the warning signs for insolvency and for good reason, given the risk taken by directors if they trade whilst insolvent. Again ASIC has produced a guide for directors on their duty to prevent insolvency[iii]. These warning signs overlap with some of the causes of corporate failure identified in the Australian Insolvency Statistics. These signs include difficultly in realising stock or collecting debtors or cash flow difficulties. Other warning signs include not paying taxes on time, fully drawn funding facilities or defaulting on loans or dishonoured cheques and trading losses. These warning signs usually occur during late phase 3 and 4 of the Crutzen and Van Caillie model.
Waiting around and ticking off how many warning signs you demonstrate is not a great idea. Some of the warning signs, if you can get to early enough, such as arresting trading loses or collecting debtors, could leave you with some remedies to avoid collapse but some of the warning signs leave you with no option but to cease operating, not being able to pay next week’s wage bill for example.
A better idea would be to start earlier.
Picking up on warning signs sitting in and around phases 1 and 2 is difficult. These are not as well pronounced as those signs in phases 3 and 4. Some of the consequences of implementing a poor strategy for example do not become apparent until late phase 2 or 3. You could imagine the response from senior management after implementing something new on a prediction of insolvency when seemingly the business is performing or appearing to perform well.
A great example of this is the work of Kamel Mellahi, a senior lecturer in International Business at The University of Nottingham Business School on the demise of HIH[iv]. Mellahi examines material provided during the HIH Royal Commission in an attempt to highlight the board’s contribution to the HIH collapse. Overall Mellahi’s work captures a similar process of failure as identified by Crutzen and Van Caillie.
Mellahi concludes HIH started to collapse when it established its UK operations in 1993, some 7 years before the appointment of a provisional liquidator. Critically, the UK branch had started to operate in areas which HIH had little knowledge. Not long after, HIH re-acquired its US operations (1996 having only sold 2 years earlier). Mellahi demonstrates the board did not fully understand these transactions, importantly the board failed to grasp how the acquisitions aligned with HIH’s overall strategy. Whilst, arguably, HIH had an adequate resource base at the time, the board held, as Mellahi describes it, ‘blind faith in management’.
Both qualitative and quantitative aspects come into consideration when analysing failure at this level. Mellahi for example sensibly suggests directors must have a clear understanding of an organisation’s strategic direction, whilst at the same time being vigilant for signs that matters are not tracking as they should, especially in the case were the organisation is doing well.
The next critical phase of HIH collapse was the acquisition of FAI. At this time HIH started to show signs of failure, its share price began to fall, not a lot, but below industry sector averages and in its annual report HIH reported an increase in liabilities. Management argued this represented a change in the business environment. Acquiring FAI was the tonic to solve this. When FAI was acquired there were no papers to the board and as it transpires the board knew little about FAI in particular about FAI’s financial health.
Where can you help? Get in early. The checklist can be simple enough. Education. Understand the environment, understand and develop key policies. How many times have you heard clients say, it’s not like it used to be or things are different? There is a message there. Plan. Strategic and operational plans are a good start. Critically examine underlying assumptions and implement a robust system of review and analysis. Communicate. Talk to other players in the industry, industry bodies, suppliers or regulators. Insolvency practitioners have many varied experiences. Talk to an insolvency practitioner for a different perspective.
[i] Australian Securities and Investments Commission, Australian Insolvency Statistics Series 3: External Administrators’ Reports 2012, http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/2004-2012%20ASIC-Insolvency-statistics-series3.3.pdf/$file/2004-2012%20ASIC-Insolvency-statistics-series3.3.pdf
[ii] Crutzen, N and Van Caille D, Business Failure Process – An Integrated Model, Review of Business and Economics, Vol. 3, 2008, pp 288-336.
[iii] Australian Securities and Investments Commission, Regulatory Guide 217, Duty to Prevent Insolvent Trading: Guide for Directors, July 2010, http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/rg217-29July2010.pdf/$file/rg217-29July2010.pdf
[iv] Kamel Mellahi, The Dynamics of Boards of Directors in Failing Organisations, Long Range Planning, 38 (2005), pp. 261-279