“What Personal Liability?” One Question For The CFO From Their Board Colleagues

fdu’s guest blogger, David Tilston is a Chartered Accountant, a Fellow of The Association of Corporate Treasurers and a member of The Institute for Turnaround. He has held CFO roles in both listed PLC and PE-backed companies and has significant experience of managing turnaround situations.

We are currently experiencing a period of unprecedented financial turmoil. Liquidity is being focused on, as trading performance is generally under pressure. Some companies are having to book impairment charges on certain assets. Interest yields have fallen to very low levels and pension deficits have ballooned. Financial covenants are being renegotiated and restructuring is rife in certain sectors.

With all these developments going on is there a possibility that some Boards of Directors could find themselves exposed to the risk of personal liability from an unexpected quarter? I am afraid the answer is “yes”.

Some Boards of Directors could find themselves exposed to the risk of personal liability.

The source of the risk

UK companies have their constitution outlined in their Memorandum of Association and Articles of Association. The Memorandum deals with the objects for why the corporation exists. The Articles explain how the company should be operated. It covers matters such as how shares may be issued and what their rights are, how general meetings should be run and the powers and duties of directors.

Within this latter category it is normal for there to be a clause detailing how directors may exercise the powers of the company to raise borrowings. This includes any limitations on how these powers may be exercised (such as the maximum amount which may be borrowed). If directors allow a company to borrow more than the maximum amount then there are circumstances (normally when the company is in financial distress) when the directors can be personally liable for any excess borrowing.

Why is oversight limited?

The Company’s scrutiny over challenges to its financial strength normally focuses on either (a) cashflow constraints or (b) financial covenant restrictions contained within its borrowing documents. These matters are the subject of regular reporting to, and review by, the Board.

Borrowing powers in the Articles often falls between two stools. The CFO may often regard them as a company secretarial issue, whereas the Company Secretary will not monitor compliance as this depends on financial calculations (the realm of the CFO). Consequently it is not unusual, in my experience, for neither party to be reviewing compliance on a periodic basis.

How are the borrowing limits calculated?

The Articles need to be referred to in each case as there are a variety of approaches that have been adopted in the past, and the method used is likely to be a function of normal market practice at the time the Articles last received a major update. One approach quite commonly adopted uses the following structure:

“Moneys borrowed shall not exceed [multiple] times Adjusted Capital and Reserves.”

The multiple specified varies from company to company, but in my experience is usually in the range of 2x – 6x.

The definitions of “moneys borrowed” and “Adjusted Capital and Reserves” are critically important and calculation of the relevant numbers (normally from the last audited accounts) can require some careful interpretation.

Moneys borrowed may include:

  • All secured and unsecured bank/listed debt
  • Redeemable share capital
  • Hire purchase and lease liabilities
  • Sometimes permit the deduction of cash balances and short term deposits

Adjusted Capital and Reserves may include:

  • All share capital (possibly excluding redeemable share capital)
  • All reserves attributable to shareholders in the consolidated balance sheet
  • May require the deduction of goodwill and intangible assets on the consolidated balance sheet
  • May exclude minority interest balances

An example of how such problems can arise – Consort Medical plc

During 2017, when I was interim CFO of Consort Medical plc (a company just outside the FTSE 250) I calculated our borrowing powers capacity and realised that we had a problem. Moneys borrowed significantly exceeded the permitted maximum.

The reason that this had arisen was due to the fact that the Group had embarked on an acquisition campaign in earlier years. The result was that the Group’s balance sheet had evolved such that it now carried significant amounts of goodwill and intangible assets in its consolidated balance sheet. As these amounts needed to be deducted in calculating Adjusted Capital and Reserves that figure had dwindled to a low level and the “moneys borrowed” figure was substantially greater than the x2 multiple limit mandated in the Articles.

The “moneys borrowed” figure was substantially greater than the x2 multiple limit.

At that point Consort Medical plc was very comfortably within its financial covenants contained in its banking documentation, these restrictions being calculated on completely different bases.

The Board of Directors acted immediately when they realised that they were potentially subject to very significant personal liability and convened an Extraordinary General Meeting where the borrowing powers were changed. This was fortunately perceived as a technical breach at a point in time when the company was financially very stable and had sound growth prospects, and so was fully supported by shareholders.

Why might this be an issue currently?

There are three key drivers which may have depleted the Adjusted Capital and Reserves figure in recent years (where this is an applicable concept in a company’s Articles):

  • Trading in recent months may well have been challenging, resulting in losses
  • For those companies facing significant restructuring, material impairment costs may need to be booked for accounting purposes
  • For companies with defined benefit pension schemes the reduction in interest yields may have caused significant increases in pension deficits in recent years, and these increases reduce shareholder reserves (as shown in the consolidated statement of changes in equity in the annual report).

Ask their CFO whether the Company complies with its borrowing powers.

The question for the CFO

Consequently Boards of Directors may want to ask their CFO whether the Company complies with its borrowing powers in its Articles of Association, and will it also comply when the next audited results are signed off.