There are no free lunches in this world

"The hypothesis that actual prices reflect fundamental values is the Efficient Markets Hypothesis (EMH). Put simply, under this hypothesis, “prices are right,” in that they are set by agents who understand Bayes’s law and have sensible preferences. In an efficient market, there is “no free lunch”: no investment strategy can earn excess risk-adjusted average returns, or average returns greater than are warranted for its risk."

The "no free lunch" slogan is not restricted to the EMH as above. It is omnipresent. Here is an excerpt from an interesting article.

"My father used to tell me, "There's no such thing as a free lunch, son." One day, when I was feeling clever, I thanked my dad for the "free" lunch he had just bought me. He replied, "This lunch isn't free, son … you have to sit here and listen to me while you eat it, don't you?" Point taken."

The Hidden Costs of Free Software - Small Business Software - Entrepreneur.com


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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.

Corporate Governance and Borrowing Powers of Directors - VII

The Enron scandal deeply influenced the development of new regulations to improve the reliability of financial reporting, and increased public awareness about the importance of having accounting standards that show the financial reality of companies and the objectivity and independence of auditing firms. One consequence of these events was the passage of Sarbanes–Oxley Act in 2002, as a result of the first admissions of fraudulent behavior made by Enron. The act significantly raises criminal penalties for securities fraud, for destroying, altering or fabricating records in federal investigations or any scheme or attempt to defraud shareholders. The act expanded criminal penalties for destroying, altering, or fabricating records in federal investigations or for any attempt to defraud shareholders.

A variety of complex factors created the conditions and culture in which a series of large corporate frauds occurred between 2000-2002. The spectacular, highly-publicized frauds at Enron,WorldCom, and Tyco exposed significant problems with conflicts of interest and incentive compensation practices. The analysis of their complex and contentious root causes contributed to the passage of SOX in 2002. In a 2004 interview, Senator Paul Sarbanes stated:

“

The Senate Banking Committee undertook a series of hearings on the problems in the markets that had led to a loss of hundreds and hundreds of billions, indeed trillions of dollars in market value. The hearings set out to lay the foundation for legislation. We scheduled 10 hearings over a six-week period, during which we brought in some of the best people in the country to testify...The hearings produced remarkable consensus on the nature of the problems: inadequate oversight of accountants,  lack of auditor independence,  weak corporate governance procedures,  stock analysts' conflict of interests,  inadequate disclosure provisions, and  grossly inadequate funding of the Securities and Exchange Commission.

”

• Auditor conflicts of interest: Prior to SOX, auditing firms, the primary financial "watchdogs" for investors, were self-regulated. They also performed significant non-audit or consulting work for the companies they audited. Many of these consulting agreements were far more lucrative than the auditing engagement. This presented at least the appearance of a conflict of interest. For example, challenging the company's accounting approach might damage a client relationship, conceivably placing a significant consulting arrangement at risk, damaging the auditing firm's bottom line.
• Boardroom failures: Boards of Directors, specifically Audit Committees, are charged with establishing oversight mechanisms for financial reporting in U.S. corporations on the behalf of investors. These scandals identified Board members who either did not exercise their responsibilities or did not have the expertise to understand the complexities of the businesses. In many cases, Audit Committee members were not truly independent of management.
• Securities analysts' conflicts of interest: The roles of securities analysts, who make buy and sell recommendations on company stocks and bonds, and investment bankers, who help provide companies loans or handle mergers and acquisitions, provide opportunities for conflicts. Similar to the auditor conflict, issuing a buy or sell recommendation on a stock while providing lucrative investment banking services creates at least the appearance of a conflict of interest.
• Inadequate funding of the SEC: The SEC budget has steadily increased to nearly double the pre-SOX level. In the interview cited above, Sarbanes indicated that enforcement and rule-making are more effective post-SOX.
• Banking practices: Lending to a firm sends signals to investors regarding the firm's risk. In the case of Enron, several major banks provided large loans to the company without understanding, or while ignoring, the risks of the company. Investors of these banks and their clients were hurt by such bad loans, resulting in large settlement payments by the banks. Others interpreted the willingness of banks to lend money to the company as an indication of its health and integrity, and were led to invest in Enron as a result. These investors were hurt as well.
• Internet bubble: Investors had been stung in 2000 by the sharp declines in technology stocks and to a lesser extent, by declines in the overall market. Certain mutual fund managers were alleged to have advocated the purchasing of particular technology stocks, while quietly selling them. The losses sustained also helped create a general anger among investors.
• Executive compensation: Stock option and bonus practices, combined with volatility in stock prices for even small earnings "misses," resulted in pressures to manage earnings.Stock options were not treated as compensation expense by companies, encouraging this form of compensation. With a large stock-based bonus at risk, managers were pressured to meet their targets.

The most contentious aspect of SOX is Section 404, which requires management and the external auditor to report on the adequacy of the company's internal control over financial reporting (ICFR).

Under Section 404 of the Act, management is required to produce an “internal control report” as part of each annual Exchange Act 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.” To do this, managers are generally adopting an internal control framework such as that described in COSO.

To help alleviate the high costs of compliance, guidance and practice have continued to evolve. The Public Company Accounting Oversight Board (PCAOB) approved Auditing Standard No. 5 for public accounting firms on July 25, 2007. This standard superseded Auditing Standard No. 2, the initial guidance provided in 2004. The SEC also released its interpretive guidance on June 27, 2007. It is generally consistent with the PCAOB's guidance, but intended to provide guidance for management. Both management and the external auditor are responsible for performing their assessment in the context of a top-down risk assessment, which requires management to base both the scope of its assessment and evidence gathered on risk. This gives management wider discretion in its assessment approach. These two standards together require management to:

• Assess both the design and operating effectiveness of selected internal controls related to significant accounts and relevant assertions, in the context of material misstatement risks;
• Understand the flow of transactions, including IT aspects, sufficient enough to identify points at which a misstatement could arise;
• Evaluate company-level (entity-level) controls, which correspond to the components of the COSO framework;
• Perform a fraud risk assessment;
• Evaluate controls designed to prevent or detect fraud, including management override of controls;
• Evaluate controls over the period-end financial reporting process;
• Scale the assessment based on the size and complexity of the company;
• Rely on management's work based on factors such as competency, objectivity, and risk;
• Conclude on the adequacy of internal control over financial reporting.

Corporate Governance and Borrowing Powers of Directors - VI

The question is "How to avoid financial disaster that could have brought by reckless borrowing"? To answer this question, we take a look at the most publicized financial scandals like Enron, Parmalat and Worldcom.


 The Enron scandal, revealed in October 2001, involved the energy company Enron and the accounting, auditing, and consultancy partnershipof Arthur Andersen. The corporate scandal eventually led to Enron's downfall, resulting in the largest bankruptcy in American history at the time. Arthur Andersen, which was one of the five largest accounting firms in the world, was dissolved.

Enron was formed in 1985 by Kenneth Lay after merging Houston Natural Gas and InterNorth. Several years later, when Jeffrey Skilling was hired, he developed a staff of executives that, through the use of accounting loopholes, special purpose entities, and poor financial reporting, were able to hide billions in debt from failed deals and projects. Chief Financial Officer Andrew Fastow and other executives were able to mislead Enron's board of directors and audit committee of high-risk accounting issues as well as pressure Andersen to ignore the issues.

Enron's nontransparent financial statements did not clearly detail its operations and finances with shareholders and analysts. In addition, its complex business model stretched the limits of accounting, requiring that the company use accounting limitations to manage earnings and modify the balance sheet to portray a favorable depiction of its performance. According to McLean and Elkid in their book The Smartest Guys in the Room, "The Enron scandal grew out of a steady accumulation of habits and values and actions that began years before and finally spiraled out of control." From late 1997 until its collapse, the primary motivations for Enron’s accounting and financial transactions seem to have been to keep reported income and reported cash flow up, asset values inflated, and liabilities off the books.

The combination of these issues later led to the bankruptcy of the company, and the majority of them were perpetuated by the indirect knowledge or direct actions of Lay, Jeffrey Skilling,Andrew Fastow, and other executives. Lay served as the chairman of the company in its last few years, and approved of the actions of Skilling and Fastow although he did not always inquire about the details. Skilling, constantly focused on meeting Wall Street expectations, pushed for the use of mark-to-market accounting and pressured Enron executives to find new ways to hide its debt. Fastow and other executives, "...created off-balance-sheet vehicles, complex financing structures, and deals so bewildering that few people can understand them even now."

This is what happened to Parmalat. It was in 1997 that Parmalat jumped into the world financial markets in a big way, financing several international acquisitions, especially in the Western Hemisphere, with debt. But by 2001, many of the new divisions were producing losses, and the company financing shifted largely to the use of derivatives, apparently at least in part with the intention of hiding the extent of its losses and debt.

In February 2003, chief financial officer Fausto Tonna unexpectedly announced a new €500 million bond issue. This came as a surprise both to the markets and to the CEO, Tanzi. Tanzi fired Tonna and replaced him as CFO with Alberto Ferraris.

According to an interview he later gave Time magazine, Ferraris was surprised to discover that, though now CFO, he still didn't have access to some of the corporate books, which were being handled by chief accounting officer Luciano Del Soldato. He began making some inquiries and began to suspect that the company's total debt was more than double that on the balance sheet.

The crisis became public in November when questions were raised about transactions with mutual fund Epicurum, another Cayman-based company linked to Parmalat causing its stock to plummet. Ferraris resigned less than a week later and was replaced by Del Soldato.

In December, Del Soldato resigned, unable to get cash from Epicurum fund, needed to pay debts and make bond payments. Enrico Bondi was called in to help the company. Tanzi himself resigned as chairman and CEO. Parmalat's bank, Bank of America, then released a document showing €3.95 billion in Bonlat's bank account as a forgery. Prime Minister Silvio Berlusconi initiated a fraud investigation and appointed Bondi to administer the company's rescue. Hundreds of thousands of investors lost their money and will never recover it. The company officially went bankrupt, though the Italian government used the legal mean "commissariamento" to save the trademark.

The story of Worldcom: CEO Bernard Ebbers became very wealthy from the rising price of his holdings in WorldCom common stock. However, in the year 2000, the telecommunications industry entered a downturn and WorldCom’s aggressive growth strategy suffered a serious setback when it was forced by the US Justice Department to abandon its proposed merger with Sprint in mid 2000. By that time, WorldCom’s stock was declining and Ebbers came under increasing pressure from banks to cover margin calls on his WorldCom stock that was used to finance his other businesses (timber and yachting, among others). During 2001, Ebbers persuaded WorldCom’s board of directors to provide him corporate loans and guarantees in excess of $400 million to cover his margin calls. The board hoped that the loans would avert the need for Ebbers to sell substantial amounts of his WorldCom stock, as his doing so would put further downward pressure in the stock's price. However, this strategy ultimately failed and Ebbers was ousted as CEO in April 2002 and replaced by John Sidgmore, former CEO of UUNet Technologies, Inc.

Beginning modestly in mid-year 1999 and continuing at an accelerated pace through May 2002, the company (under the direction of Ebbers, Scott Sullivan (CFO), David Myers (Controller) and Buford "Buddy" Yates (Director of General Accounting)) used fraudulent accounting methods to mask its declining earnings by painting a false picture of financial growth and profitability to prop up the price of WorldCom’s stock.

The fraud was accomplished primarily in two ways:

A. Underreporting ‘line costs’ (interconnection expenses with other telecommunication companies) by capitalizing these costs on the balance sheet rather than properly expensing them.

B.Inflating revenues with bogus accounting entries from "corporate unallocated revenue accounts".

In 2002 a small team of internal auditors at WorldCom worked together, often at night and in secret, to investigate and unearth $3.8 billion in fraud. Shortly thereafter, the company’s audit committee and board of directors were notified of the fraud and acted swiftly: Sullivan was fired, Myers resigned, Arthur Andersen withdrew its audit opinion for 2001, and the U.S. Securities and Exchange Commission (SEC) launched an investigation into these matters on June 26, 2002 . By the end of 2003, it was estimated that the company's total assets had been inflated by around $11 billion.

Corporate Governance and Borrowing Powers of Directors - V

Company is an artificial juridical person. The company operates through directors who are its brain, eyes, ears etc.. They are entrusted with the job of managing the affairs of the company by its owners - shareholders. Thus the relationship between shareholders and directors are of principal and agent respectively, hence , the agency problem, agent may not perform his duties to the advantage of his principal. What should be done to eliminate such an eventuality? Here is an excerpt from "The Combined Code on Corporate Governance 2008".

A. DIRECTORS

A.1 The Board

Main Principle

Every company should be headed by an effective board, which is collectively responsible for the success of the company.

Supporting Principles

The board’s role is to provide entrepreneurial leadership of the company within a framework of prudent and effective controls which enables risk to be assessed and managed. The board should set the company’s strategic aims, ensure that the necessary financial and human resources are in place for the company to meet its objectives and review management performance. The board should set the company’s values and standards and ensure that its obligations to its shareholders and others are understood and met.

All directors must take decisions objectively in the interests of the company.

As part of their role as members of a unitary board, non-executive directors should constructively challenge and help develop proposals on strategy. Non-executive directors should scrutinise the performance of management in meeting agreed goals and objectives and monitor the reporting of performance. They should satisfy themselves on the integrity of financial information and that financial controls and systems of risk management are robust and defensible. They are responsible for determining appropriate levels of remuneration of executive directors and have a prime role in appointing, and where necessary removing, executive directors, and in succession planning.

A.3 Board balance and independence

Main Principle

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.

Supporting Principles

The board should not be so large as to be unwieldy. The board should be of sufficient size that the balance of skills and experience is appropriate for the requirements of the business and that changes to the board’s composition can be managed without undue disruption.

To ensure that power and information are not concentrated in one or two individuals, there should be a strong presence on the board of both executive and non-executive directors.

The value of ensuring that committee membership is refreshed and that undue reliance is not placed on particular individuals should be taken into account in deciding chairmanship and membership of committees.

No one other than the committee chairman and members is entitled to be present at a meeting of the nomination, audit or remuneration committee, but others may attend at the invitation of the committee.

A.4 Appointments to the Board

Main Principle

There should be a formal, rigorous and transparent procedure for the appointment of new directors to the board.

Supporting Principles

Appointments to the board should be made on merit and against objective criteria. Care should be taken to ensure that appointees have enough time available to devote to the job. This is particularly important in the case of chairmanships.

The board should satisfy itself that plans are in place for orderly succession for appointments to the board and to senior management, so as to maintain an appropriate balance of skills and experience within the company and on the board.

C.1 Financial Reporting

Main Principle

The board should present a balanced and understandable assessment of the company’s position and prospects.

Supporting Principle

The board’s responsibility to present a balanced and understandable assessment extends to interim and other price-sensitive public reports and reports to regulators as well as to information required to be presented by statutory requirements.

C.2 Internal Control

Main Principle

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

C.3 Audit Committee and Auditors

Main Principle

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.

D.1 Dialogue with Institutional Shareholders

Main Principle

There should be a dialogue with shareholders based on the mutual understanding of objectives. The board as a whole has responsibility for ensuring that a satisfactory dialogue with shareholders takes place.

Supporting Principles

Whilst recognising that most shareholder contact is with the chief executive and finance director, the chairman (and the senior independent director and other directors as appropriate) should maintain sufficient contact with major shareholders to understand their issues and concerns.

The board should keep in touch with shareholder opinion in whatever ways are most practical and efficient.

D.2 Constructive Use of the AGM

Main Principle

The board should use the AGM to communicate with investors and to encourage their participation.

E.2 Evaluation of Governance Disclosures

Main Principle

When evaluating companies’ governance arrangements, particularly those relating to board structure and composition, institutional shareholders should give due weight to all relevant factors drawn to their attention.

Supporting Principle

Institutional shareholders should consider carefully explanations given for departure from this Code and make reasoned judgements in each case. They should give an explanation to the company, in writing where appropriate, and be prepared to enter a dialogue if they do not accept the company’s position. They should avoid a box-ticking approach to assessing a company’s corporate governance. They should bear in mind in particular the size and complexity of the company and the nature of the risks and challenges it faces.

E.3 Shareholder Voting

Main Principle

Institutional shareholders have a responsibility to make considered use of their votes.

Supporting Principles

Institutional shareholders should take steps to ensure their voting intentions are being translated into practice.

Institutional shareholders should, on request, make available to their clients information on the proportion of resolutions on which votes were cast and non-discretionary proxies lodged.

Major shareholders should attend AGMs where appropriate and practicable. Companies and registrars should facilitate this.

Corporate Governance and Borrowing Powers of Directors - IV

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 recognised 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.

Companies can make a major contribution by spreading governance discussion with shareholders outside the two peak annual reporting periods around 31st December and 31st March and by raising further the general standard of their explanations justifying non- compliance. Shareholders for their part can still do more to satisfy companies that they devote adequate resources and scrutiny to engagement.

Corpoarte Governance and Borrowing Powers of Directors - III

Code of Corporate Governance issued by SECP in Pakistan provides guidelines regarding the responsibilities, powers and functions of board of directors. Here is a reproduction.

RESPONSIBILITIES, POWERS AND FUNCTIONS OF BOARD OF DIRECTORS

(vii) The directors of listed companies shall exercise their powers and carry out their fiduciary
duties with a sense of objective judgment and independence in the best interests of the listed company.
(viii) Every listed company shall ensure that:

(a) a ‘Statement of Ethics and Business Practices’ is prepared and circulated annually by its Board of Directors to establish a standard of conduct for directors and employees, which Statement shall be signed by each director and employee in acknowledgement of his understanding and acceptance of the standard of conduct;
(b) the Board of Directors adopt a vision/ mission statement and overall corporate strategy for the listed company and also formulate significant policies, having regard to the level of materiality, as may be determined it;

Explanation: Significant policies for this purpose may include:

• risk management;
• human resource management including preparation of a succession plan;
• procurement of goods and services;
• marketing;
• determination of terms of credit and discount to customers;
• write-off of bad/ doubtful debts, advances and receivables;
• acquisition/ disposal of fixed assets;
• investments;
• borrowing of moneys and the amount in excess of which borrowings shall be sanctioned/ ratified by a general meeting of shareholders;
• donations, charities, contributions and other payments of a similar nature;
• determination and delegation of financial powers;
• transactions or contracts with associated companies and related parties; and
• health, safety and environment

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 shall be maintained.

The Board of Directors shall define the level of materiality, keeping in view the specific circumstances of the listed company and the recommendations of any technical or executive sub-committee of the Board that may be set up for the purpose;

(c) the Board of Directors establish a system of sound internal control, which is effectively implemented at all levels within the listed company;
(d) the following powers are exercised by the Board of Directors on behalf of the listed company and decisions on material transactions or significant matters are documented by a resolution passed at a meeting of the Board:

• investment and disinvestment of funds where the maturity period of such investments is six months or more, except in the case of banking companies, Non-Banking Financial Institutions, trusts and insurance companies;
• determination of the nature of loans and advances made by the listed company and fixing a monetary limit thereof;
• write-off of bad debts, advances and receivables and determination of a reasonable provision for doubtful debts;
• write-off of inventories and other assets; and
• determination of the terms of and the circumstances in which a law suit may be compromised and a claim/ right in favour of the listed company may be waived, released, extinguished or relinquished;

(e) appointment, remuneration and terms and conditions of employment of the Chief Executive Officer (CEO) and other executive directors of the listed company are determined and approved by the Board of Directors; and
(f) in the case of a modaraba or a Non-Banking Financial Institution, whose main business is investment in listed securities, the Board of Directors approve and adopt an investment policy, which is stated in each annual report of the modaraba / Non-Banking Financial Institution.

Explanation: The investment policy shall interalia state:

• that the modaraba / Non-Banking Financial Institution shall not invest in a connected person, as defined in the Asset Management Companies Rules, 1995, and shall provide a list of all such connected persons;
• that the modaraba / Non-Banking Financial Institution shall not invest in shares of unlisted companies; and
• the criteria for investment in listed securities.

The Net Asset Value of each modaraba / Non-Banking Financial Institution shall be provided for publication on a monthly basis to the stock exchange on which its shares/ certificates are listed.

(ix) The Chairman of a listed company shall preferably be elected from among the non-executive directors of the listed company. The Board of Directors shall clearly define the respective roles and responsibilities of the Chairman and Chief Executive, whether or not these offices

Corporate Governance and Borrowing Powers of Directors - II

The position in Company Law in Pakistan is that section 196 of Companies Ordinance 1984 describes the “Powers of Directors”, the section is being reproduced for reference.

“196. Powers of directors.- (l) The business of a company shall be managed by the directors, who may pay all expenses incurred in promoting and registering the
company, and may exercise all such powers of the company as are not by this Ordinance, or by the articles, or by a special resolution, required to be exercised by the company in general meeting.

(2) The directors of a company shall exercise the following powers on behalf of the company, and shall do so by means of a resolution passed at their meeting, namely. —
(a) to make calls on shareholders in respect of moneys unpaid on their shares;
(b) to issue shares;
(c) to issue debentures or 1[participation term certificate, any instrument in the nature of redeemable capital];
(d) to borrow moneys otherwise than on debentures;
(e) to invest the funds of the company;
(f ) to make loans;
(g) to authorise a director or the firm of which he is a partner or any partner of such firm or a private company of which he is a member or director to enter into any contract with the company for making sale, purchase or supply of goods or rendering services with the company;
(h) to approve annual or half-yearly or other periodical accounts as are required to be circulated to the members;
(i) to approve bonus to employees;
(j) to incur capital expenditure on any single item or dispose of a fixed asset in accordance with the limits as prescribed by the Commission from time to time;

(k) to undertake obligations under leasing contracts exceeding one million rupees;

(l) to declare interim dividend; and
(m) having regard to such amount as may be determined to be material (as construed in Generally Accepted Accounting Principles) by the Board-
(i) to write off bad debts, advances and receivables;
(ii) to write off inventories and other assets of the company; and
(iii) to determine the terms of and the circumstances in which a law suit may be compromised and a claim or right in favour of a company may be released, extinguished or relinquished:

Provided that the acceptance by a banking company in the ordinary course of its business of deposits of money from the public repayable on demand or otherwise and withdrawable by cheque, draft, order or otherwise, or the placing of moneys or deposit by a banking company with another banking company on such conditions as the directors may prescribe, shall not be deemed to be a borrowing of moneys or, as the case may be, a making of loan by a banking company within the meaning of this section.

(3) The directors of a public company or of a subsidiary of a public company shall not except with the consent of the general meeting either specifically or by way of an authorisation, do any of the following things, namely.-
(a) sell, lease or otherwise dispose of the undertakings or a sizeable part thereof unless the main business of the company comprises of such selling or leasing; and
(b) remit, give any relief or give extension of time for the repayment of any debt outstanding against any person specified in sub-section (1) of section 195.

(4) Whosoever contravenes any provision of this section shall be punishable with a fine which may extend to 1[one hundred thousand] rupees and shall be individually
and severally liable for losses or damages arising out of such action.”

Table “A” of First Schedule to Companies Ord. 1984 contains a sample of “REGULATIONS FOR MANAGEMENT OF A COMPANY LIMITED BY SHARES”. Following is a reproduction of clauses that deal with “Powers of Director”.

“44. The business of the company shall be managed by the directors, who may pay all expenses incurred in promoting and registering the company, and may exercise all such powers of the company as are not by the Ordinance or any statutory modification thereof for the time being in force, or by these regulations, required to be exercised by the company in general meeting, subject nevertheless to the provisions of the Ordinance or to any of these regulations, and such regulations being not inconsistent with the aforesaid provisions, as may be prescribed by the company in general meeting but no regulation made by the company in general meeting shall in-radiate any prior act of the directors which would have been valid if that regulation had not been made.

45. The directors shall appoint a chief executive in accordance with the provisions of sections 198 and 199.

46. The amount for the time being remaining undercharged of moneys borrowed or raised by the directors for the purposes of the company (otherwise than by the issue of share capital) shall not at any time, without the sanction of the company in general meeting, exceed the issued share capital of the company.

47. The directors shall duly comply with the provisions of the Ordinance or any statutory modification thereof for the time being in force, and in particular with the provisions in regard to the registration of the particulars of mortgages and charges affecting the property of the company or created by it, to the keeping of a register of the directors, and to the sending to the registrar of an annual list of members, and a summary of particulars relating thereto and notice of any consolidation or increase of share capital, or sub-division of shares, and copies of special resolutions and a copy of the register of directors and notifications of any changes therein.

48. The directors shall cause minutes to be made in books provided for the purpose—
(a) of all appointments of officers made by the directors;
(b) of the names of the directors present at each meeting of the directors and any committee of the directors;
(c) of all resolutions and proceedings at all meetings of the company and of the directors and of committees of directors:

and every director present at any meeting of directors or committee of directors shall sign his name in a book to be kept for that purpose.”

Corporate Governance and Borrowing Powers of Directors

Corporate governance is to ensure that a system is in place to protect the individual as well as collective interests of all the stakeholders in a company. In this respect the role of Board of Directors becomes very important because by its very nature a company is an artificial juridical person in the sense that it can sue and can be sued. But it works through its directors who are its eyes, brain and muscle. Directors are the persons who run day to day affairs of the company and possess the first hand information about every aspects of its operations. Directors are also in the best of position to determine its future course i-e set objectives, formulate strategy, devise operational plans etc. Shareholders are the owners of the company who provide capital to the company for its operations but are not supposed to run its affairs and delegate this function to professional managers. These professional managers may also be shareholders of the company. This separation of brain and capital poses agency problem and dual role of directors, shareholders as well as directors creates conflict of interest with other stakeholders such as outside shareholders.

In the wake of recent financial crises and recent past failure of Enron, Worldcom and Parmalat, a heated debate is going on the role of directors and the board in the governance of corporate world. Much of the debate is centered round the structure of the board, integrity of the financial reports, auditing, shareholder activism, corporate governance rules and regulations etc. A very little attention has been given to the concept of borrowing powers of the directors. One of the elements of the powers enjoyed by the directors is that these may be misused and abused as well. If these are being misused, it means due care and necessary diligence has not been taken care of and if these are being abused, it means these are used for the purposes other than the benefit of the company. In both the cases, the tendency or some inclination to misuse and /or abuse powers can lead to disaster. As a precautionary measure, there is a need to put some checks on the use of powers enjoyed by the directors. One of the powers given to directors or used by the directors on behalf of the company is borrowing power. There is no restriction on the borrowing powers of the directors in Articles of Association and neither there is any law that restricts this power. However, there are rules and regulations for the lenders that prohibit them to lend in case of borrowing beyond a certain percentage of equity but generally there is no restriction on borrowers.

As directors manage a corporation for and on behalf of the shareholders who own it, it is critical that any regulatory and legal requirements placed on directors do not seriously compromise their goal of maximizing shareholder wealth. Directors’ behavior influences the efficient operation of corporations. If directors are subject to undue transaction costs in protecting themselves from personal liability, these costs will ultimately be passed onto, and borne by, the corporation itself. On the other hand, if directors are permitted to operate completely unfettered by regulation and a degree of shareholder control, investor confidence in the corporate may potentially be undermined. In this regard, it is clear from past experience, particularly in relation to the corporate collapses as mentioned above, that the conduct of directors through corporations can have a significant impact on public perceptions and market confidence.

While regulatory requirements are usually placed on directors as a means of protecting investors, or the general public, such protection may well be achieved at the expense of investors themselves. Accordingly, it is vitally important that any measures put in place as a means of promoting investor protection are properly assessed from an economic perspective to ensure that they do not ultimately act to the detriment of shareholders as a whole. To promote investor confidence and thereby facilitate expansion of capital market, investors need to be satisfied that they have sufficient opportunity for redress against a corporation and its directors in clear cases of negligent, reckless or fraudulent conduct. However, directors who effectively control the corporation, must not feel so over-burdened with a fear of responsibility that their decision-making is seriously constrained. Regulation in the area of directors’ duties and shareholders’ rights invariably involves a fine balance between maintaining investor confidence and encouraging commercial enterprise. In the interests of maximizing shareholder wealth and economic growth, directors need to be encouraged to take enterprising decisions. However, these decisions must be taken in the interests of the company and be challengeable if they are not bona fides and well informed.

In the backdrop of above deliberations, it is important to thoroughly evaluate the possibility of check on the borrowing powers of the directors. This paper shall examine the all possible ways in which such a check can be placed and a critical analysis of each alternative shall be put forward. Finally, a recommendation shall be made whether such a check is required or not and if required what necessary amendments in Company Law are required.