What FDs need to know about contract risks...

Finance directors need to play a larger role in risk management across their business, in particular, non-financial risk. And FDs should do this by leading better communication between departments.

Who says? Two of the UK’s highest-profile insolvency experts, who have been busily picking up the pieces from organisations that perhaps failed to heed that advice. That's who.

Speaking with Financial Director after a breakfast briefing on business recovery hosted by our sister publication Accountancy Age, Neville Kahn – a Deloitte partner and lead administrator for the Woolworths wind-down – and Tony Lomas, a PricewaterhouseCoopers partner leading the administration of Lehman Brothers UK and Europe – said FDs' lack of lateral thinking on risks elsewhere in their businesses puts them in danger of missing the full risk implications from their commercial contracts.

"On financing, you have to look at two different communities and two different sources of risk," says Lomas, who is lead administrator of Lehman Brothers' UK and Europe business. “They have trading relationships and finance relationships with third parties. There can be complexities in that financing structure that definitely are the domain of the FD - that he should understand - but maybe doesn’t quite understand what the consequences of those arrangements are.

"The FD should be aware of the financial impact of operating contracts - looked after by your contracts manager, your manufacturing and sales directors, people who share responsibility for managing the company, the people who should understand the small print and the consequences of a counterparty going bust. This feeds back into the functionality of the board and whether complete information is shared across directors about financial issues that confront the business,” Lomas says.

"But in that area, examples will come up where there is something lurking in some trading arrangement that is a ticking time bomb, and the finance director isn’t aware of it," he warns.

Deloitte’s Kahn believes FDs don't always need to understand the fine print of all contracts, but must be more instinctive in seeing how those contracts can create a chain of risks feeding into the financial stability of a company.

"I'm not convinced it's always the FD's role to be looking at that sort of documentation," Kahn says. "But the key role of the FD here is to understand the risks and procedures to make sure before they do any trade – whatever it is - that they have taken account of the contractual risks."

Lomas and Kahn - who worked together on the administration of Enron's European business in 2002 and have worked on a raft of other complex administrations separately - believe the credit crisis is catching out FDs who fail to see the full risk profile of what are often very complicated financing agreements, both of their own business and those of their trading partners. The pair questioned whether FDs have the skills to navigate this level of interconnectedness.

As an example, Lomas points to the collapse last autumn of Dunedin Property Capital Fund and Dunedin Property Industrial Fund (Holdings), the holding companies for commercial property fund Industrious. With some tenants unable to pay their rent on time and the value of the portfolio falling, it was placed into administration last September by primary lender RBS when the two companies failed to secure funding. [Click here for case study on next page]

"It was an academic problem," Kahn says. "There's a ratio between debt and net asset value that is threatened because, as you revalue these properties and the market's slowing down, suddenly, you have a breach.

"What's the consequence of that? The FD would have known about all those documents but he wouldn't have contemplated that would happen. So you have to pose the question: are directors - not just FDs - aware of the financial risks embedded in their business?" he adds.

"There is a massive risk out there sitting in some businesses - either because of the complexity of the financing structure, or because of the complexity of the contractual arrangements with their trading counterparties," says Lomas, mulling the challenges FDs face in their emerging role as risk man and numbers man.

That ugly word – consequences – rears its head again. "A pretty complex structure with swaps and all the rest of it: does everyone involved in such a company understand the consequences of that? That’s quite complex stuff," Deloitte's Kahn says. "That's why all this stuff about complex structures is going to be a challenge to unravel.

"You also have to ask,” he adds, “do you, as FD, given this complexity, have the skill-set to understand?"

CASE IN POINT: Industrious

Commercial property fund Industrious failed when its two holding companies under the Dunedin group could not get funding from its bankers, because some of its tenants could no longer pay the rent. Neither could it secure funding from other lenders.

PwC's Tony Lomas views it as an example of how an FD's ability to see the risks to their business from the potential weakness of other businesses needs closer examination.

"The company was perfectly capable of managing its leases even though the individual tenants were in distress - more voice than you’d like, pressure on rents – it was suffering a bit but had very professional people running it," Lomas says. "But the financing structure had £750m debt on it [reported as £650m total debt by Property Week] and had become levered and levered and levered to this point. It just needed a bit more cash, at least £15m. It had £10m but was locked in a waterfall and couldn't use the cash for the purpose it needed it for without everybody's consent.

"Then it needed just another £5m - a tiny problem, really, but the lenders wanted everyone signed up – then, crucially, £500m of its £750m debt had a credit default swap on it and the bank that had the benefit of that [RBS] didn't want to jeopardise it. So the company said, 'If I let them use that money to stay alive the [other] guys might say I shouldn’t have done that, so I better go and ask them.'”

Those other guys turned out to be a special purpose vehicle and the £500m in assets came from it having issued six strips of bonds to investors.

"So this bank says, 'I want [the SPV] to say, 'It's ok to do this'; but they say, 'I'm not doing anything - I'm just the SPV, I'll ask these people over here [other lenders]. The guy at the top says, 'The first loss is down there, so I'm not saying anything, I'll just sit on my hands.'

"The guy at the bottom panics - and they can't get the consent. So what do they do? They stick it into insolvency."