Delegation or abdication? - when directors must ask further questions

The trend for bringing non-executives to account for corporate failings has continued with the disqualification of a non-executive director of a former listed company who failed to deal properly with serious allegations about financial irregularities and about misconduct by the company's finance director. In Secretary of State for Trade and Industry v Swan and others [2005] All ER (D) 102 (Apr), reported this month, a senior non-executive who was deputy chairman of the board and chairman of the audit and remuneration committees of Finelist plc, and the company's CEO, were disqualified for three and four years respectively.

But it is not all bad news for directors. The case also gave some guidance on the extent to which chief executives are entitled to rely on the other directors and managers of the business to do their job and the extent to which they ought to be aware of what their managers are doing. It also offered some welcome clarification of the steps that a director must take to verify the contents of a circular for which he has accepted responsibility

Background: disqualification of directors

Whenever a company goes into administrative receivership, administration or liquidation, the insolvency practitioner is required to report to the disqualification unit of the DTI on the conduct of all those who are or have been directors of the company before the commencement of the insolvency proceedings.

A director of a company which goes into formal insolvency proceedings and whose conduct makes him unfit to be involved in the management of a company in future may, by court order, be disqualified from becoming involved in the management of a company for a period of between 2 and 15 years. An application for a disqualification order can be made by the Secretary of State for the DTI within two years after the start of the insolvency proceedings. As an alternative to full disqualification proceedings, the DTI may be willing to accept an undertaking from the director which has a similar effect to a disqualification order .

Finelist plc and its directors

Finelist plc was listed on the Official List in 1994. Over the following five years it grew significantly, and by 1999 it was a leading supplier to the UK aftermarket for vehicle parts, accessories and consumer products, with 40,000 trade customers, 7 million retail customers and 7,500 employees. For that year it reported profit on ordinary activities after tax of £26 million.

In September 1991 Christopher Swan became a director of the company, and subsequently its chairman and CEO. In March 1992 Brian North became a non-executive director and later the deputy chairman of the board and chairman of the Audit and Remuneration Committees.

In April 2000 Finelist was taken over and re-registered as a private company. Six months later it went into receivership.

Disqualification proceedings

The Secretary of State originally brought disqualification proceedings against the company's CEO, Mr Swan, its finance director, Vuchuru Reddy, the marketing and purchasing director, Brian Ritchie, and the senior non-executive, Mr North. Rather than contesting the proceedings, Messrs Reddy and Ritchie gave disqualification undertakings for periods of eight and five years respectively.

Because the proceedings against Messrs Swan and North relate to their disqualification, they do not strictly concern the standard of skill and care that is expected of directors. As the improper practices which led to the disqualification proceedings were not alleged to have played any part in the company's insolvency, no claims for breach of the duty of skill and care, or breach of fiduciary duty, were brought by the receivers. However, it seems likely that had such claims been brought the court would have applied a similar analysis, so the case has a wider significance.

Cheque kiting

The Secretary of State's case was based on various instances of "cheque kiting" that took place within the group. "Cheque kiting" is the practice of exploiting the time period during which cheques clear through the banking system and the different days upon which the payee's account is credited and the payer's account is debited with the amount of any cheque. Because a payer's account is only debited once the cheque has cleared, but the payee's account may be credited immediately after the cheque is paid in, there may be a few days in which the amount of the cheque is shown to the credit of both accounts.

By arranging for different subsidiaries of the group to write matching cheques, the effect could be further exploited to artificially inflate both companies' cash positions, particularly at times when the group needed to demonstrate a healthy cash position to meet its banking covenants.

For example, between mid-November 1999 and 6 December 1999 the total artificial credit each day for the group from cheque kiting carried out between two subsidiaries in Finelist's AEW Division was £16 million.

The whistle-blower

In October 1999, Paul Reeve, who had previously been a consultant to Finelist, was appointed as its new chief operating officer. Two months later, Mr Reeve (together with a senior HR manager) attended a meeting with an operations manager in the AEW Division who was about to leave his job. He claimed that various financial and accounting irregularities were taking place, including the manipulation of financial results by the group's finance director, Mr Reddy.

As a result, Mr Reeve then met with the finance director of the AEW Division who worked under Mr Reddy. This finance director supported the claims and gave more specific details but asked that his name not be mentioned, for fear of retribution from his superiors who were implicated in the alleged misconduct.

Mr Reeve decided that the seriousness of the allegations merited them being brought to the attention of a non-executive director, and he approached Mr North as the senior non-executive director and chairman of the audit committee. What exactly was said at the meeting between Mr Reeve and Mr North was disputed, but the judge found that Mr North was at least made aware of a number of serious allegations which if true would have very serious implications for the group.

Mr North then arranged to meet Mr Swan and Mr Reddy to discuss the allegations. After a meeting which only lasted 30-40 minutes, Mr North decided not to take any further action.

Subsequently both Mr Reeve and the HR manager who attended the previous meetings were summarily dismissed. When questioned by Mr Swan, the finance director of the AEW Division denied having made any allegations.

The case against Mr North

The judge found that Mr North did not actually know about the cheque kiting policy. However, he held that Mr North's conduct in failing to investigate the serious allegations which were brought to his attention fell well short of what was expected from a director of his experience. In particular, the fact that he:

• allowed the allegations to be dismissed after only a short meeting with the directors who were likely to be implicated;
• made no attempt to speak to the individuals who had actually made the allegations;
• did not inform the other non-executive directors of the allegations;
• failed to ensure that the allegations were discussed at a board meeting in the absence of the implicated individuals;
• did not discuss the matter with the company's auditors,

meant that he fell so far below the level of competence expected that he was unfit to be a director. The failure to do any of these things was "a very serious… lapse in judgement… at precisely the moment and in the type of situation in which decisive, courageous and independent action is required by a non-executive director". Placing the incident in the lowest category of seriousness, and taking into account other mitigating factors, the judge disqualified Mr North for three years.

The case against Mr Swan

Mr Swan, together with Mr Reddy, was one of the directors who was required to sign any cheque that exceeded £25,000 in value. In June 1999 he signed two cheques for £1 million and £4 million respectively from group company A to another group company B, and he signed two cheques for the same amounts back from company B to company A. These four cheques were cheque kiting cheques.

The judge found that there was no cogent evidence that Mr Swan actually knew that cheque kiting was taking place. He accepted that Mr Swan was "a businessman with obvious flair and drive in relation to operational matters, but he was not a person likely to pay attention to financial or accountancy technicalities or other matters of detail which he did not regard as having an obvious impact on the profit or loss of the Group".

However, even if Mr Swan did not actually know of the cheque kiting, the unusual circumstances in which the cheques were signed, which "called out for comment and enquiry", should have prompted him to ask further questions. Had he done so, the judge found that the cheque kiting policy would have come to light. In failing to make further enquiries he "wholly abdicated his responsibilities of care and control". This, and other evidence, was sufficient to demonstrate that Mr Swan ought to have been aware of a practice that he accepted was, at the very least, "commercially improper and unacceptable", and which misled investors. This made him unfit to be a director.

The judge considered Mr Swan's conduct to fall into the lowest category of seriousness and disqualified him for four years.

Mis-statements in Class 1 circular

The case against Mr Swan also revolved around a circular sent to shareholders of Finelist in July 1999 in relation to a Class 1 disposal. As required by the Listing Rules, the circular contained a statement of the group's indebtedness, a working capital statement stating that the group's working capital was sufficient for present requirements, and a standard responsibility statement that "to the best of the knowledge and belief of the directors [of Finelist] (who have taken all reasonable care to ensure that such is the case)" the information in the circular was accurate.

As a result of the cheque kiting that had been taking place, the statement of indebtedness overstated the company's cash and understated its net debts by around £8 million. The working capital statement was also based upon this incorrect information.

The Secretary of State's case was that (i) by signing the responsibility statement, Mr Swan accepted a personal and individual responsibility for the accuracy of the statements in the circular; and that (ii) certain last-minute significant changes to the cash balances in the circular should have prompted him to investigate further. Although the Secretary of State accepted that Mr Swan did not have a personal obligation to look at the group's bank statements, he contended that he should have asked further questions.

However, the judge refused to accept this case:

"Although the directors of Finelist, and Mr Swan in particular, had a personal responsibility under the Listing Rules to ensure that the information in the Circular, including the Indebtedness Statement, were correct, that personal responsibility could only in reality be discharged by doing what was reasonably practical and would have been done by any reasonably competent and experienced person in their position.

… It was not unreasonable or improper of Mr Swan, who was extremely busy with other matters, to leave to Mr Reddy, and those financial and accounting personnel and professional advisors assisting Mr Reddy, to establish or check and confirm financial details like the figures in the Indebtedness Statement, unless and until something occurred which should have alerted Mr Swan to take some personal interest in those matters. It is entirely unrealistic to suppose, for example, that it is the standard responsibility of the chairman and the chief executive of every listed company to check individual bank statements as part of a normal Class 1 transaction.

I do not accept that the late amendment of the Group's stated cash balance in the draft… Circular from £2.363m to £10.363m was something which should have caused Mr Swan to question the propriety or competence of Mr Reddy or those advising and supporting him or to alert Mr Swan that there was something seriously amiss which required his personal intervention."

In addition, Mr Swan received a reasonable explanation for the amendment, which he had "no reasonable grounds for rejecting" and which, the judge found, should not have caused him to initiate further investigations. In all the circumstances he was therefore entitled to leave the task of verifying the figures in the circular to Mr Reddy, his team and the company's advisers.

Conclusions

A number of lessons can be learnt from this case:

• Non-executive directors must not allow serious allegations made by a whistleblower to be dismissed without proper investigation. This may require the non-executive to interview the whistle-blower and/or other persons involved or even to instigate a formal investigation, perhaps with the help of external advisers. Depending on the circumstances, the allegations should also be brought to the attention of other non-executives and with executives who are not implicated. Explanations given by directors who may be implicated should not be accepted without independent challenge.
• Being asked to sign large cheques for round sums in unusual circumstances without explanation is something that ought to cause a director to make further enquiries.
• An executive director is entitled to rely on his managers and professional advisers in relation to matters the managers/advisers are responsible for, unless and until something comes to his attention that should cause him to ask further questions.
• Similarly, a director who questions information in a circular which another director has prepared is entitled to rely on the explanation given unless the circumstances clearly indicate that further investigation is necessary.
• Signing a responsibility statement in connection with a Class 1 circular (or, probably, listing particulars) only creates an obligation for the director to do what is practical and to take reasonable steps to ensure the accuracy of information; it does not raise the standard of skill and care expected from a director (although it may well increase the chances of the director being sued by investors). For example, a chief executive would not be personally expected to check all financial information in detail if he reasonably believes that someone else with appropriate skill and experience has done so.

For further information, please contact Tom Page at [email protected] or on +44 (0)20 7367 3046 or Peter Bateman at [email protected] or on +44 (0)20 7367 3145.