The Uncooperative: How the Co-op found itself in a governance crisis

CORROSIVE, manifestly dysfunctional and one of the great national business calamities: Lord Myners’ assessment of the management and governance failings that led to the worst losses in the Co-operative Group’s 150-year history makes for grim, but essential reading for any aspiring finance or board director.

The one-time bastion of corporate citizenship and standard-bearer for the mutual movement reported record £2.5bn losses for 2013, results which came after it suffered the loss of its chief executive, Euan Sutherland, and of Paul Flowers, the disgraced former chairman of its banking arm.

Add to that the Co-operative Bank’s calamitous merger with Britannia Building Society, as well as the subsequent discovery of a £1.5bn accounting black hole, and one has to ask how this longstanding vanguard of co-operative principles ended up pretty much on its knees.

Since it was brought to the brink of collapse in 2013 by the emergence of near-catastrophic losses at its banking division, the Co-op has faced numerous inquiries – most notably reports from Lord Myners and Sir Christopher Kelly – that have laid bare the failings in its practices, culture and structure.

Nevertheless, the Co-op has said it is committed to far-reaching and fundamental reforms, which, if enacted, will help the UK’s largest mutual business recover from the traumatic shocks it has suffered over the last year.

“The implication for the Co-operative Group is straightforward. It needs to have a compelling strategy supported by tightly disciplined financial management. The catastrophic losses that have arisen over recent years are the direct result of a failure to put these in place,” Lord Myners, the former independent director who quit the board after being appointed to review the group’s governance structure, wrote.

The process of healing has been a painful one. Myners himself has cited “significant resistance” to some of his recommendations, while a series of boardroom leaks that threatened to destroy the group’s ability to govern and manage itself with any coherence and credibility were hinted at by Sutherland when he hit out at “an individual, or individuals, determined to undermine me personally” on the Co-op’s Facebook page prior to his resignation.

“Until the group adopts professional and commercial governance, it will be impossible to implement what my team and I believe are the necessary changes and reforms to renew the group and give it a relevant and sustainable future,” Sutherland explained in his resignation statement. “The group must reduce its significant debt and drive major efficiencies and growth in all of its businesses, but to do so also urgently needs fundamental governance reform and a revitalised membership.”

In response to Myners’ review, Ursula Lidbetter, chair of The Co-operative Group, said: “I see this as essential and urgent work that is critical to our future, enabling us to build a more effective organisation which can deliver for all our members, customers and colleagues.”

It’s not who you know…
In his review of failings at the Co-operative Bank, Sir Christopher Kelly neatly sums up one of the essential problems with which the bank’s board – as well as the wider group’s executives – has continuously wrestled.

“Failures in board oversight are inevitable if the criteria used to elect its members do not require those elected to have the necessary skills … the composition of the Co-operative board, and the limited pool from which its members were drawn, made a serious governance failure almost inevitable,” Kelly writes.

This criticism is particularly true of the Co-op Bank’s board. The merger of the bank with the Britannia Building Society in August 2009 was a major contributor to its subsequent difficulties. While the bank’s board was aware of some of the risks, it believed that management had performed appropriate due diligence and stress-testing and had made a prudent allowance against future impairment of the more risky assets.

“In practice, though the board does not seem to have been aware of it at the time, the due diligence performed on what turned out to be the most risky part of the acquired assets – the corporate loan book and in particular the commercial real estate lending – had been cursory,” Kelly writes in his report.

The chief issue, explains Eric Tracey, the former FD of Wembley and a senior independent director of Chloride Group, is that the board did not have the requisite experience and nous to challenge the assumptions made by the management team, which were at times incredibly optimistic.

“The first line of failure is management; they made some very big mistakes and these mistakes were allowed to be piled one on top of the other because of poor governance and monitoring,” explains Tracey. “It was the accumulative effect of lots of poor judgements.”

According to Roger Barker, director of corporate governance and professional standard at the Institute of Directors, the same lack of knowledge was evident at the group board level.

“Fundamentally, the group’s twenty directors – something of a full payload – proved too inexperienced and lacked the skills to promote the company’s financial success,” Barker says.

“There was, for example, the ‘value-destructive’ takeover of Somerfield and Britannia, which entirely absorbed the board’s attention, leaving far too little time to devote to overseeing management performance. Regrettably, none of this came to light earlier because no one, either externally or internally, held the board to account.

The Co-op’s members were hamstrung where shareholders would have been able to speak out.”

However, John Thanassoulis, a professor at Warwick Business School who researches corporate governance and has studied the Co-op, thinks blame for the mutual’s failings should not be laid squarely at the feet of inept directors.
“If a strategy is so complicated that a qualified teacher or university graduates cannot grasp it, then the strategy is too complicated,” he says.

Political pressures
Alongside the board’s inability to direct and monitor the group, the organisation’s electoral system produced directors who lacked the necessary experience to provide effective board leadership and to challenge management. Myners also suggests that there was a “democratic deficit” whereby ordinary members had a limited ability to steer the group’s social goals and activities to reflect their interests and values.

At its core, the Co-op is run by a three-tier electoral hierarchy which, Myners says, raises the issue of whether such a system, widely categorised as labyrinthine in complexity, discourages individuals with talent, but limited time, from active participation and facilitates the entrenchment of a small number of powerful individuals.

The group’s structure is made up of a group board, a regional board and area committees, in which the majority of members are elected in one way or another. Such a model, when it reaches the scale and complexity sustained in the current group, creates deep tensions, Myners explains.

“There is tension in determining the appropriate boundary between democracy and professionalism; there is tension between local or regional autonomy and central direction,” he writes in his report, adding that the resistance of a number of traditionalists to change owes much to the culture of entitlement that has grown up within a very small but highly active proportion of the membership.

“This has undoubtedly created strong vested interests and a reluctance to rethink existing ways of doing things,” Myners writes.

“I have myself witnessed repeated instances where there has been denial of responsibility, corrosive suspicion, deliberate delay and a practice of hiding behind ‘values’ in order to deflect or stifle criticism and protect self-interest. It was the combination of these factors, when discussing the approval of this year’s accounts, that obliged me to resign as a director of the group after only four months.”

According to Thanassoulis, too many people on the board did not have the long-term success of the business at heart, largely at the result of the electoral system. “They were busy politicking,” he says. “They didn’t want to support controversial policies.”

Helping the medicine go down
So what is the medicine Lord Myners has prescribed and what can the Co-op do to get back on track? Firstly, he wants to see a the creation of an elected, smaller board made up of people with relevant experience, while the second suggestion is to create a new National Membership Council that gives Co-op members the power to hold the board to account.

The third core element of his proposed reforms is the extension of full membership rights to all individual members, consistent with the fundamental co-operative principle of ‘one member, one vote’ and substantially increasing the scope for genuine participatory democracy.

Thanassoulis agrees that democracy should form a pillar of the reconstituted group structure, but adds there are several models to which Lord Myners can look for inspiration.

“Plcs have a governance geared to maximising returns for shareholders; universities have a governance which seeks to marry the pressures of academic rigour and excellence with profitable nous; charities have to be true to their purpose while delivering services under very tight cost control; John Lewis has perfected an employee ownership model,” he says.

Crucially, under Myners’ proposals, all the directors would be recruited primarily on the basis of having the relevant skills and qualifications needed to run the group, but they would also need to demonstrate they held views consistent with the values of the co-operative movement.

Above the board would be a council representing members’ views, which would also set the vision, mission and values of the organisation. The members’ council would, at last, have significant authority and be able to appoint/annually re-elect the members of the board in accordance with the above.

“This has the look and feel of a robust, sustainable response. One that should inject much-needed professionalism into the boardroom while also including checks and balances to ensure greater accountability,” says Barker at the IoD.

“Simply put – the fact that Co-op is run as a mutual should not in any way impact on boardroom efficacy, nor should it imply that directors are any less skilled than those within shareholder-owned organisations.”

Steps are already being taken. In May, the Co-op’s members voted unanimously in favour of a resolution on governance reform proposed by the board.

At the group’s Special General Meeting, 100% of votes were cast in favour of the resolution, which contained four key principles for reform.

Lidbetter said:”There is a huge task ahead of us if we are to deliver the reforms necessary to restore the group’s reputation and return it to health but the board will work hand in hand with our members to ensure that we seize this opportunity. It is vital that the right changes are put in place as soon as possible to build a more effective organisation for our members, customers and colleagues.”

Peter Craddock, an independent consultant who holds a part-time role at the FCA and is also an IoD chartered director, believes that the debate about ownership is “a bit of a red herring”.

He has worked within a number of different ownership structures, including a mutual and a plc. He observes: “Mutuals are required to achieve the same high standards of corporate governance as plcs or private equity-owned businesses.

“The most important issue for any board is the quality of the individuals that are appointed to sit around the table, and who between them have the right mix of skills, experience and know-how to deliver great results. It’s that blend of talent that determines whether any board is a good forum for decision-making.” ■

 

The auditor’s role

As the Co-operative Bank’s auditors, KPMG, which was recently replaced by EY, has faced criticism for failing to discover the problems within the bank that led to a capital shortfall being discovered in June last year, as well as signing off on the takeover of Britannia.
In his report into the events that led to its merger with Britannia, Sir Christopher Kelly questions the bank’s accounting judgements and its “consistent tendencies” to favour short-term financial performance where accounting rules allowed it to, “even if that was not fully within their spirit”.
“With hindsight, some of the accounting judgements might have proved to be inappropriate. But that does not necessarily mean they were unreasonable at the time,” Kelly writes.
Typically, the auditors would discuss a range of accounting assumptions with both management and the audit committee chair.
“Were they complying with the [reporting] standard? Yes. Were they in the right range? Yes,” says Tony Cates, head of audit at KPMG, which has rigourously defended its work at the Co-op Bank.

Time line

24 April 2013
The Co-op Bank scraps its plan to acquire 632 Lloyds Bank branches
10 May 2013
A £1.5bn capital shortfall at The Co-op Bank is revealed
5 June 2013
Former Morrisons FD Richard Pennycook named as interim CFO at the Co-op Group
30 August 2013
Revealed that KPMG warns of Co-op Bank’s going concern status
4 November 2013
Co-op Bank rescue plan published
22 November 2013
Co-op Bank chairman Paul Flowers arrested in connection with drugs supply investigation
29 November 2013
Retail bondholders back Co-op Bank recapitalisation plan
12 December 2013
Lord Myners appointed to lead review into Co-op Group’s governance and management failings
6 January 2014
Formal investigations into the Co-op Bank crisis launched by Financial Conduct Authority and Prudential Regulatory Authority
20 January 2014
The FRC launches an investigation into Co-op Bank audit
10 March 2014
Co-op CEO Euan Sutherland resigns
11 March 2014
Sutherland is replaced by CFO Richard Pennycook as interim boss
19 March 2014
Announced that Pennycook will become COO once new chief executive appointed
10 April 2014
Lord Myners steps down from the board only four months after being appointed
17 April 2014
The Co-op Group announced a £2.5bn loss for 2013, the worst in its 150-year history
30 April 2014
Sir Christopher Kelly’s report into the events that led to the Co-operative Bank’s calamitous merger with Britainnia is published
1 May 2014
Co-op Bank ends 40-year audit relationship with KPMG
7 May 2014
Lord Myners’ review into management and governance failings at the Co-operative Group is published
17 May 2014
Elected members of the Co-op Group vote unanimously in favour of governance reforms based on Lord Myners’ review

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