Queens Moat Houses: Lessons in corporate governance

Eleven years after Queens Moat Houses PLC spectacularly collapsed, the DTI's inspectors finally published their 500 page report earlier this year. In some ways, the story contains many familiar elements: a dominant chief executive; compliant lieutenants; the adoption of ever more aggressive accounting policies to generate 'profits'; auditors who lacked independence and experience; and ineffective non-executives. But in other respects there are wider lessons to be learned, and the recommendations made by the inspectors may have a bearing on the next Companies Bill.

Generally this article reflects the substance and tone of the Report. In some places, direct quotations are given. Where additional comments are made, these are in italics.

Background

Queens Moat Houses PLC ("QMH") grew, over a period of some 20 years, from being a small, owner-managed group with a handful of hotels, to a large listed group with 190 hotels in the UK and overseas. At its peak, in 1990, the Group had a market capitalisation in excess of £900m.

Throughout the period of its growth, QMH was portrayed as a successful, profitable and well-managed group. That image was created and sustained by its reporting of increased profits, on the basis of which it raised very significant amounts of finance, in the form of both share capital and borrowings, to fund its expansion.

QMH's apparent success story came to an abrupt end when its shares were suspended on 31 March 1993, just one week before it was due to announce its 1992 results. Prior to the share suspension, QMH had been widely expected to announce profits for 1992 of some £85m. When its 1992 results were eventually published in late 1993 these reported a total loss before tax for the year to over £1bn. These results were drawn up on accounting bases and principles adopted by the new management.

On 12 November 1993 Adrian Burn FCA and Patrick Phillips QC (the inspectors) were appointed by the Secretary of State for Trade and Industry, under Section 432(2) of the Companies Act 1985 (CA 1985), to investigate the affairs of the group and to report to the Secretary of State. Their report was published in March this year.

In the light of the investigation, the DTI successfully applied for the disqualification for lengthy periods of all of QMH's key executive directors.

Main factors which contributed to the downfall of QMH

Dominant personality of John Bairstow

"The seeds of the matters that led to the suspension of QMH's shares in March 1993 were sown a long time previously. They were to be found in the personality of its founder, John Bairstow. It was his initiative and drive that created QMH in the first place and generated its later expansion. Yet he also established the culture by which QMH operated, whether it lay in the philosophy of 'let the manager manage', in the insistence upon minimal central administration or in QMH's accounting.

John Bairstow is a man of forceful personality. Not brash or domineering, indeed he has considerable charm, but nonetheless capable of dominating those about him and somewhat cavalier in attitude. This, together with … other aspects of his personality, undoubtedly contributed to the problems [of the group]. [In particular,] he chose to be surrounded by, or, at the very least, he selected to work with him, people of modest ability, very much his juniors in experience and inferior in personality who were dependent upon him for promotion and pay. He cemented this dependence by promoting and paying them generously."

Adoption of questionable and unacceptable accounting policies

For example:

• Recognising as revenue in the current accounting year sums that would only be received, if at all, in a subsequent accounting period.
• In order to reduce the annual charge against profits, instead of depreciating furniture and equipment, the group decided to expense the cost of obtaining replacements. Such a policy would have been legitimate had all replacements been expensed, but instead expenditure which 'upgraded' a hotel was capitalised rather than expensed. Since most new products could be described as improvements on the existing ones, and therefore as 'upgrades', almost any new item could be capitalised.

(FRS 15 (Tangible Fixed Assets), published in February 1999, now defines the circumstances where subsequent expenditure on an existing asset can be capitalised and the circumstances in which the expenditure must be written off.)

• In 1975, QMH introduced a Management Incentive Scheme under which the manager of a hotel which was then managed centrally by the Group could 'buy' its autonomy – and with it the opportunity for the manager to earn significant rewards if it made a profit – by entering into an Incentive Fee Agreement with QMH. The manager paid a fee in monthly instalments, and provided a 'promissory note' as security for the future instalments.

This scheme became a device for manipulating the Group's profits, chiefly through the adoption of a policy to recognise a full year's fee on the inception of an Incentive Agreement irrespective of when or how late in QMH's financial year the inception occurred. However, this policy was disclosed only very briefly and opaquely in the audited accounts, so much so that neither analysts, investors nor QMH's financial adviser seemed ever to have understood its meaning or implications.

• Recognising in the interim results 50% of certain profits that the Group hoped would be realised in the second half of the year. "Not only was recognition of so much additional income a gross and distorting example of wrongly anticipating income, but it was also being doubly anticipatory by bringing half of it into an earlier half year with which it had no conceivable connection and before the fees in question had been agreed."
• A policy introduced in 1993 of capitalising three months' worth of bank interest every time the group acquired a new hotel. Ostensibly the policy reflected the costs of "rationalising" the operations of the new hotel, but it was applied irrespective of whether the consideration was funded through loan finance or through the issue of QMH's own shares, and whether or not any rationalisation actually took place. "Thus QMH quite simply gave itself an interest holiday so far as its reported profits were concerned in respect of acquisitions, whether funded by external finance or not."

Auditors who lacked independence and experience

Throughout its existence, QMH used of a small local firm of auditors, Bird Luckin, whose lead audit partner, Maurice Hart, "had neither the experience nor ability to audit such a large public group". His being in charge of the audit for at least 15 years caused his independence to become impaired. And the firm as a whole was "too dependent upon QMH from the points of view both of kudos and income". The inspectors found that Maurice Hart relied entirely upon his managers to bring forward issues for his attention, but failed to give the managers any assistance to focus on the right issues.

He also attended nearly all of QMH's board meetings, which "blurred the distinction between directors and auditors and dulled [his] critical faculties". His failure to object to any proposed policy or course of action probably also gave spurious comfort to the other directors that the steps proposed were legitimate.

Each year the audit was little more than a 'ticking' audit: one which checked the figures for arithmetical accuracy but neglected to consider the reasonableness of treatments both individually and collectively. The inspectors found that the auditors also relied upon what they were told without auditing the information, or they assumed facts without adequate justification, and that they lost sight of the fundamental concepts of a 'true and fair view' and of 'substance over form'. For their part, the executive directors simply took the view that an accounting treatment could be adopted if it was accepted by the auditors.

Ineffective corporate governance

All relevant decisions were taken solely by an 'executive board', which comprised John Bairstow, "his two principal accounting lieutenants, Martin Marcus and David Hersey", and the Operations Director, Gerry Bell. The Executive Board had no clear terms of reference, and its deliberations occurred in a very informal way without formal notice of meetings or an agenda. The main board had no control over the actions of these four directors, who simply reported to the main board, after the event, the decisions that the executive board had taken. Not all decisions were reported and, for those that were, rarely was there enough supporting information provided to show how the decision had been justified.

When an audit committee was finally established in October 1991, Maurice Hart, recently retired as the lead audit partner at Bird Luckin, was appointed as its chairman. At the committee's first meeting, it accepted a proposal from the executive directors that their last bonus should be consolidated into their basic salary (presumably because the directors anticipated the Group making insufficient profits in the following year to justify paying any bonuses) and a proposal that, for the purposes of their pension calculations, executive directors' salaries should be taken to include bonuses. No explanation was given for these proposals and no papers or details were submitted to explain or justify them or to show the cost implications.

Each non-executive director "appears to have accepted with little question the systems and mode of operation of the board that was already in place. This was partly because what was in place appeared to be accepted by all existing directors. It was also partly due to each having no experience of what to expect and thus being handicapped when it came to identifying shortcomings."

Critically, the non-executives failed to ask any pertinent questions relating to the accounts, and particularly the accounting treatments adopted, or about the discrepancies between the numbers in the management accounts which were seen by the board and the numbers which were subsequently announced to the market.

Level of skill and care expected of non-executive directors

All non-executives should take note of the following comments in the Report, which could well foreshadow the approach of a court:

"It must be recognised that non-executive directors may bring different skills to a board, some quite specialised, and that such persons may have limited accounting experience. However, accounting is not so complicated that such directors should be excused responsibility for the accounts. Accounting issues can be clearly explained so as to be understood by sensible laymen. If accounts are gone through carefully, explaining significant items in them, laymen should be able to ask pertinent questions and make informed judgements thereon. If, after all this, the layman cannot understand the company's accounts, then he ought not to be a director of that company… Often it is the director with little accounting experience whose common sense may lead him to question what those with accountancy experience may let pass…

The accounting issues in respect of which we make criticisms were nearly all ones which involved no accounting complexity and what was acceptable and what was not should have been obvious to any reasonable director possessed of the facts who sensibly applied his mind to the issue. In most instances, those directors who decided to adopt the accounting were in a better position than the auditors to determine whether the treatment applied was acceptable or not. Those directors were thus not entitled to suspend their own independent judgement and rely upon the fact that the auditors failed to prevent them from adopting an unacceptable course."

Inadequate financial information

Although QMH produced management accounts for its directly managed hotels and for certain subsidiaries of the Group, it never prepared or presented to the Board any consolidated budgets or managements accounts which brought together the budgets and results of all the divisions in the Group. The only indication the directors ever received at meetings as to how the Group was doing overall derived from general comments made, if at all, by Martin Marcus to the effect that the Group was on target.

The absence of consolidated management accounts facilitated the practice of unacceptable year end adjustments being made by the accountant directors, unbeknown to most of the other directors, to create extra reported profits. Surprisingly, the company's financial adviser, Charterhouse, appears never to have realised that the Group did not prepare consolidated management accounts, despite acting for the company on seven rights issues, four debenture issues and a number of Class 1 acquisitions. For this purpose, Charterhouse reported on two profit forecasts and, in relation to a 1982 acquisition, on the working capital requirements of the enlarged Group.

In the last few years, the first the board as a whole knew of the results to be published was when the preliminary or interim announcement was circulated 'for information' at the close of the board meeting that invariably occurred the day prior to announcement. In effect, the board as a whole never discussed the details of the results or what lay behind them. "The main board's lack of understanding of the composition of the reported results was an extraordinary state of affairs which no director should ever have tolerated."

Valuations of hotels carried out by valuers who were not sufficiently independent

Hotel valuations were carried out chiefly by a firm of valuers, WGS, and in particular by one partner, Jim Baker. "Possibly because of the length of time he was involved and the significance of the fees paid to WGS by QMH, in our view Jim Baker, in later years at least, suffered from a lack of independence and a preparedness to move closer to the client's position than was appropriate."

The auditors also failed to review the trading information given to WGS which formed the basis of the valuations.

Specific recommendations

Except where otherwise stated, the following recommendations were made by both inspectors.

Directors' experience and training

Directors of listed companies should be required to demonstrate, prior to their appointment, that they have had sufficient experience and formal training, where appropriate, on their obligations as directors and how they are expected to discharge these obligations.

The new Combined Code, published last year, goes some way towards this in requiring that "appointments to the board should be made on merit and against objective criteria", "all new directors [should] receive a full, formal and tailored induction on joining the board", and all directors should be provided with "the necessary resources for developing and updating [their] knowledge and capabilities".

Statutory obligation to maintain management accounts

Patrick Phillips recommended that the statutory obligation to maintain books and records should be extended to include also 'sufficient regular and reliable management accounts' in the case of listed companies, and that auditors should be required to report if a company has failed to maintain regular and adequate management accounts.

Obligations of financial advisers to companies raising equity funding

At the time of QMH's rights issues, the scope of a merchant bank's duties to investors were "far from clear". Charterhouse contended that their duties were "very slight". Notwithstanding this, the inspectors considered that Charterhouse had a duty reasonably to satisfy itself that matters stated in the circulars and listing particulars were fair, reasonably accurate and not misleading in all material respects and contained sufficient relevant information to enable investors to make informed judgements.

Although the Listing Rules requirements in relation to share issues are now more detailed than they were at the time of QMH's equity fundraisings, the inspectors "are not convinced that clear obligations upon those acting as [financial advisers to an equity issue] were, or are, sufficiently spelt out anywhere". For example, listing particulars for a rights issue normally state that the financial adviser is acting as sponsor and financial adviser to the issuer. But neither the Financial Services and Markets Act 2000 (or its predecessor, the Financial Services Act 1986) nor the Listing Rules require the financial adviser to take legal responsibility for listing particulars, and accordingly they do not usually do so.

The inspectors therefore recommended that responsibility for ensuring that listing particulars include sufficient and reliable information should rest not only with the issuer's directors but also with its financial adviser. To support this, financial advisers should perhaps be required to state in listing particulars that they accept responsibility for the contents.

Furthermore, whenever a company is soliciting funds from the market, making a public offer or seeking shareholder approval where an investment bank or financial adviser is acting, the financial adviser should be obliged to consider whether or not the board of directors of the company includes sufficient non-executive directors of sufficient experience and independence, bearing in mind the needs of the company and the quality of the executive directors, to provide an adequately balanced board. In doing so, the financial adviser should specifically take into account whether the balance of the board is adversely affected by a dominant personality.

On each such occasion, the financial adviser should also have a duty to consider the experience and skills of the company's auditors and to report on them to the board of directors.

Audit committee review of auditors' independence

Audit committees should carry out a formal, extensive review at least once every three years, and ask the auditors to demonstrate their competence by showing the experience of senior personnel who are engaged in the audit. They should also demonstrate their independence by giving information on annual income of the firm and its relevant offices and the names of other sizeable clients.

However, the inspectors are divided on the question of mandatory rotation of audit firms, and on whether auditors should be allowed to act as reporting accountants.

Auditor independence is a hot topic at both EU and national levels, and various initiatives are under way to strengthen the existing rules and ethical guidelines. Currently, paragraph 3.5 of the Listing Rules requires an applicant for listing to "take all reasonable steps to ensure that its auditors are independent of the applicant" and to "obtain written confirmation from the auditors that they comply with guidelines on independence issued by their national accountancy bodies". Paragraph 12.42 also stipulates that a listed company's annual report and accounts "must have been independently audited and reported on in accordance with the auditing standards required in the UK or the US or by International Standards on Auditing".

Provision C.3.2 of the new Combined Code recommends that, as part of its role, the audit committee should:

• "review and monitor the external auditor's independence and objectivity and the effectiveness of the audit process, taking into consideration relevant UK professional and regulatory requirements;
• develop and implement policy on the engagement of the external auditor to supply non-audit services, taking into account relevant ethical guidance regarding the provision of non-audit services by the external audit firm"

To support the audit committee in this task, many listed companies now require their auditors to provide detailed information about any matters which could compromise their independence, and about measures to be taken to manage conflicts of interest.

The question of mandatory audit firm rotation is still not settled. Most EU countries do not as yet require audit firm rotation, although some (including the UK) require audit partner rotation. In March this year the European Commission published a proposal for a Directive on Statutory Audits under which listed companies will either have to rotate their audit firm every seven years or the lead audit partner every five years.

Greater disclosure of accounting policies

There should be greater disclosure of accounting policies, particularly those which relate to income recognition.

Interim accounts to show a true and fair view

Patrick Phillips recommended that the obligation to prepare accounts that show a 'true and fair view' should extend to interim as well as statutory accounts. In his view, this would not necessitate the preparation of detailed notes, statements of accounting policies or stocktaking etc.

Both authors recommended that auditors should be required by the Listing Rules to review, but not audit, interim statements for all listed companies.

At present, the Listing Rules do not require companies to have their interim results reviewed or audited, although they may choose to do so. The Transparency Directive, which will probably have to be implemented by EU Member States by the end of 2005, adopts a similar position to the Listing Rules, but most listed issuers will have to include a certification by management that, to the best of their knowledge, the interim results give a true and fair view of the assets, liabilities, financial position and profit or loss of the group. To protect their own position, directors may therefore be more inclined to ask the auditors to review or audit the interim results.

More regular reporting by listed companies

Listed companies should be encouraged to provide more regular public reporting of relevant information, perhaps combined with more frequent publication of trading statements similar to quarterly results. This may also alleviate the problem of analysts being precluded from asking pertinent questions for fear of becoming insiders.

The Transparency Directive will, amongst other things, require issuers of shares quoted on a regulated market to produce an 'interim management statement' explaining material events and transactions that have taken place during the period and their impact on the financial position of the group, as well as a general description of the group's financial position and performance.

Rotation of partners in charge of valuations

Consideration should be given to the mandatory rotation of partners in charge of valuations for listed clients, since they are subject to similar issues of subjectivity as are audit partners. Audit committees of listed companies who use valuers should regularly review, and take steps to confirm, the competence, independence and suitability of the valuers, just as much as the auditors. The audit committee should carry out such a formal review at least once every three years.

Patrick Phillips recommended that a listed company should be required mandatorily to rotate its firm of valuers.

Rotation of investment bank advisers

Directors or partners in investment banks should also regularly rotate, and audit committees of listed companies should regularly review the company's relationship with its financial adviser, and at least once every three years.

Patrick Phillips recommended that a company should also be required to rotate its investment bank.

The full report can be found on the 'Company Investigations' section of the DTI's website http://www.dti.gov.uk/cld.