Corporate Governance and Borrowing Powers of Directors - VIII

Proposals on how to restrict boards from imprudent or irresponsible borrowings

As discussed in previous blogs, in Pakistan majority of listed companies are managed by controlling shareholders who are close family members. Other investors in these companies are in minority. According to section 196(2) of Companies Ordinance 1984, directors can exercise borrowing powers of the company by means of a resolution at board of directors meeting. Code of Corporate Governance also allows directors to exercise all powers on behalf of the company and only binds them morally to do this “with a sense of objective judgment and independence in the best interests of the listed company.” Further, it asks to maintain “A complete record of particulars of the significant policies, as may be determined, along with the dates on which they were approved or amended by the Board of Directors.” Practically, there is no check on the directors regarding imprudent decisions. Following are the three proposals to redress the situation.

Proposal 1

There should be a maximum limit on the borrowing powers of directors such as a certain percentage of net equity. That limit should be prescribed in the Company Law.

The obvious advantage of this limit on borrowing is that this limit will itself take care of the excessive borrowing to hide the mismanagement by the directors. The directors of a company shall not be able to borrow beyond this limit.

The disadvantage is that sometimes directors have to borrow heavily to capitalize on an opportunity. Obviously heavy borrowing will increase the risk level for the company but at the same time it can be said that no risk no profit. Sometimes opportunity is there but the company does not have enough funds available to capitalize it. Therefore, this limit on borrowing at times may be detrimental to the concept of maximizing shareholder value. Another disadvantage in this limit is that law provides general guidelines. Law provisions cannot cover every situation and all the possible scenarios. Such a limiting provision may seriously hamper the growth of corporate sector in the country.

Proposal 2

There should be a provision in the Articles of Association of every listed company that sets a maximum limit on the borrowing powers of directors such as a certain percentage of net equity or total assets.

The advantage in this proposal is that it gives flexibility on case to case basis rather than one solution fit all situations like law provision. Another advantage is that while giving certificate of incorporation regulators can verify that the borrowing limit is in line with the industry standard or not. This pre-checking will definitely protect the interests of the stakeholders.

The disadvantage in this proposal is that sometimes directors genuinely and for the benefit of the company and its stakeholders need to go beyond the limit prescribed in the Articles but cannot do so. This would be a very serious impediment in the way of maximizing shareholder value. Even if the shareholders in AGM allow them, they have to go a lengthy procedure to avail the opportunity – amendment in Articles of Association – and by the time they are through the opportunity may have gone.

Proposal 3

There should be a system of internal controls that plug the loop holes and strengthen the decision making procedures thereby reducing the chance of imprudent borrowing.

It is highly recommended that following provisions in the Companies Ordinance 1984 should be inserted to comply with mandatorily by all listed companies.

The board should include a balance of executive and non-executive directors (and in particular independent non-executive directors) such that no individual or small group of individuals can dominate the board’s decision taking.

There should be a formal, rigorous and transparent procedure for the appointment of new directors to the board. This procedure should be reported along with the compliance report of Code of Corporate Governance.

The board should maintain a sound system of internal control to safeguard shareholders’ investment and the company’s assets.

The board should establish formal and transparent arrangements for considering how they should apply the financial reporting and internal control principles and for maintaining an appropriate relationship with the company’s auditors.

The board should maintain a clear procedure for whistleblowing so that anyone within the company or outside the company is able to blow the whistle of any irregularity at an early stage.

Section 404 of the Sarbanes–Oxley Act may be adopted in true spirit that requires management to produce an “internal control report” as part of each annual report. The report must affirm “the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting.” The report must also “contain an assessment, as of the end of the most recent fiscal year of the Company, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting.”

Provision should be inserted for criminal penalties for violation of any of the above provisions. Here, section 802 of the Sarbanes–Oxley Act may be adopted.

Provision should be inserted for criminal penalties for retaliation against whistleblowers. Here, section 1107 of the Sarbanes–Oxley Act may be adopted.

Recommendation to SECP

We recommend to SECP that Proposal 3 may be adopted. The recommendation is based on following:

Borrowing Powers of Directors and Corporate Failures

The analysis, subsequent passage of the Act and its requirement as described above shows that borrowing power of the directors per se has nothing to do with the bad performance of a corporation. Rather bad performance and subsequent sudden collapse was the result of factors other than the borrowing powers of the directors. Heavy borrowing was done to hide the imprudent investment decisions. Mainly, these factors were:

1. Ineffectiveness of the board
2. Weak internal controls
3. Weak risk management
4. Lack of independence of external auditors
5. Insufficient financial information disclosure
6. Conflict of interests’ of directors, analysts and auditors

The Combined Code on Corporate Governance 2008 has something to say about directors’ role. Here is an excerpt:

“Good corporate governance should contribute to better company performance by helping a board discharge its duties in the best interests of shareholders; if it is ignored, the consequence may well be vulnerability or poor performance. Good governance should facilitate efficient, effective and entrepreneurial management that can deliver shareholder value over the longer term.

The Code is not a rigid set of rules. Rather, it is a guide to the components of good board practice distilled from consultation and widespread experience over many years. While it is expected that companies will comply wholly or substantially with its provisions, it is recognized that noncompliance may be justified in particular circumstances if good governance can be achieved by other means. A condition of noncompliance is that the reasons for it should be explained to shareholders, who may wish to discuss the position with the company and whose voting intentions may be influenced as a result.

In relation to the requirement to state how it has applied the Code’s main principles, where a company has done so by complying with the associated provisions it should be sufficient simply to report that this is the case; copying out the principles in the annual report adds to its length without adding to its value. But where a company has taken additional actions to apply the principles or otherwise improve its governance, it would be helpful to shareholders to describe these in the annual report.

If a company chooses not to comply with one or more provisions of the Code, it must give shareholders a careful and clear explanation which shareholders should evaluate on its merits. In providing an explanation, the company should aim to illustrate how its actual practices are consistent with the principle to which the particular provision relates and contribute to good governance.

In their turn, shareholders should pay due regard to companies’ individual circumstances and bear in mind in particular the size and complexity of the company and the nature of the risks and challenges it faces. Whilst shareholders have every right to challenge companies’ explanations if they are unconvincing, they should not be evaluated in a mechanistic way and departures from the Code should not be automatically treated as breaches. Institutional shareholders should be careful to respond to the statements from companies in a manner that supports the ‘comply or explain’ principle and bearing in mind the purpose of good corporate governance. They should put their views to the company and be prepared to enter a dialogue if they do not accept the company’s position. Institutional shareholders should be prepared to put such views in writing where appropriate.

Companies and shareholders have a shared responsibility for ensuring that ‘comply or explain’ remains an effective alternative to a rules-based system.”

Two very important points emerge from the reading the above excerpt that are relevant to our discussion:

1. The Code is not a rigid set of rules. Rather, it is a guide to the components of good board practice distilled from consultation and widespread experience over many years. While it is expected that companies will comply wholly or substantially with its provisions, it is recognized that noncompliance may be justified in particular circumstances if good governance can be achieved by other means.
2. Companies and shareholders have a shared responsibility for ensuring that ‘comply or explain’ remains an effective alternative to a rules-based system.

Laws cannot cover everything and every situation. These are broad guidelines much like control charts having lower and upper limits within which different behaviors are acceptable. It is the intention that is required because laws can be circumvented when required. Therefore, both guidelines as well as intention to implement the guidelines in true spirit are required to avoid financial fraud.