CORPORATE GOVERNANCE COMPANY LAW AND LITIGATION
CORPORATE GOVERNANCE COMPANY LAW AND LITIGATION
[By Nazhat Shameem]
A legal history of company law has its basis in the monasteries and guilds of medieval England. By the end of the 17th century, companies had evolved from partnerships, and existed in perpetuity, owned property, were able to be parties to legal proceedings and could enter into contracts in their own right. By the 18th century, the trading companies, such as the East India Company, were taken over by companies involved in domestic trade, which in turn led to the growth of commerce. In 1855, the limited liability company was born, whereby shareholders were liable only to the extent of the nominal value of their shares. This was the basis of modern company law.
In the United States, during the second half of the nineteenth century the governing of companies changed from that of control by the owners, to a separation of ownership and control . This led to the breakdown of the concept of the ownership of the corporation by shareholders, and to the birth of the corporation as a social institution. Nevertheless, the profit-making role of business corporations remained paramount.
This theory gave way to the neo-classical economic theory “agency theory” which is that all persons or bodies are free to contract with anyone they please and that they will evitably act to maximize their own self-interest. Managers are the agents of shareholders, and the relationship between them is a contractual one, based on market exchange. But how can a shareholder prevent the agent from maximizing the agent’s self-interest? Or put another way, how do the owners of capital protect their investments? How do shareholders control their managers? And does the law have a role in this relationship at all?
Regulation and Corporate Governance
A theory which has increasingly become popular, is that the manager or CEO of a company is the steward of the company’s assets, and that the economic performance of a firm increases when power and authority are concentrated in a single executive, who is not influenced by external non-executive directors.
Another theory is that a board of directors is the trustee of the company assets, and has motivations other than simply maximizing profits. Whichever theory one prefers, on the philosophical basis of corporate governance, the concept of trust, and of accountability are central to the relationship between the owners of capital and the managers of it. The law then has an intimate relationship with both concepts.
The Madoff scandal, Enron, payoffs to “sokaiya” (Japanese corporate racketeers), bribing public officials and fraudulent accounting are all problems of corporate governance which involve the law, both criminal and commercial.
When I was a prosecutor I found a direct relationship between bad corporate governance and unlawful corporate conduct. The collapse of companies elsewhere has been directly linked to inadequate monitoring of business strategies, failure to adequately supervise management staff, and failure to investigate suspicious financial trends.
In most jurisdictions of the world, the duties and liabilities of directors of companies are set out in legislation. For instance in Australia, under the Corporations Act and other legislation, directors have a duty to act in good faith, in the best interests of the company, to avoid any conflicts of interest, to act honestly, to prevent the company trading while it is unable to pay its debts, and if the company is being wound up, to assist the liquidator and report to him or her.
But legislation is not the only mode of regulation. The Commerce Commission in Fiji, and the Australian Stock Exchange have their own regulatory practices which impact on corporate governance. The Australian Stock Exchange principles state that good corporate structures encourage companies to create value “(through entrepreneurship, innovation, development and exploration) and provide accountability and control systems commensurate with the risks involved.” Among the stated principles are that a company should safeguard integrity in financial reporting, promote ethical and responsible decision-making and establish a sound system of risk oversight and internal control.
These, of course, are guideline principles only. Should corporate governance be more rigorously regulated? In an article in the Australian Financial Review , Justice Neville Owen, who presided over a Royal Commission into the collapse of HIH said that:
“the law may be too blunt an instrument to deal with corporate governance problems. It would be unproductive and ultimately self-defeating to impose a new layer of regulation …. I wonder though, if we are not making it all too difficult. Is it not enough to go back to the simple idea of the director as a fiduciary?”
Yet the law has acknowledged that directors have duties and responsibilities over and above those set out in statute. In 2003, the Australian Securities and Investments Commission brought a civil action against four directors of the telecommunication group One.Tel. The non-executive Chairman of the Board tried to get himself excluded from the action, saying that his role was largely “ceremonial.” The judge refused the application, holding (per Justice Robert Austin):
“…. The court’s role, in determining the liability of a defendant for his conduct as company chairman, is to articulate and apply a standard of care that reflects contemporary community expectations.” (my emphasis)
The judge went on to find that company chairmen have a greater duty of care to ensure corporate governance principles are observed, than other directors. (ASIC v. Rich NSW Supreme Court (2003).)
No measured analysis has ever been conducted into the collapse of Fiji’s National Bank. Such an analysis would make a good basis for a doctoral thesis for a keen economist. Certainly the Reserve Bank report into the Bank’s demise was never made public. But the same questions could be asked of the Bank, as they are of Enron, WorldCom and Tyco. And now of Nasdaq and Madoff. Were the directors asleep at the wheel? Were they in a conspiracy with the corruption in the management teams? Or were they incompetent?
An article in the Harvard Business School (September 2002) suggest that these boards were none of these. They simply followed accepted standard for company boards. The boards had corporate governance principles, audit teams, codes of ethics and relied on the management teams briefings at regular board meetings.
The problems arose not because of dishonesty but because of a lack of commitment. If the same board members serve on a number of boards, how will they adequately prepare for meetings? Further, how financially literate are the board members? It is not enough to be a famous rugby player, or a celebrity. Nor is it enough to be a former financier. The disastrous ENRON board had on it a former Stanford dean, a former CEO of an international bank, a hedge fund manager and an economist who was formerly the head of the U.S. Government’s Commodity Futures Trading Commission. Yet members of the Board said they were confused by Enron’s financial dealings.
What appears to work is not the age, seniority or fame of the Board, but the respect and trust they share amongst themselves and with the management team. This ensures timely and accurate information. Often board papers are voluminous and informative about information which is largely irrelevant. Was the NBF Board ever told that large sums of money were being lent without security? Perhaps we will never know. But we do know that Enron’s CEO never told the Board that whistle-blower Sherron Watkins had raised important issues about financial irregularities in the company.
Then there are other signs of corporate malgovernance. One is board members developing their lines of communication with line managers within the company. Another is the development of political factions on the board. Often the CEO will use these factions to play off one against the other. Another problem is the tendency of human beings to conform, not to dissent. The “consensus factor” is not just a Pacific way. It is human nature to desire consensus. After all, one is then not required to put one’s head above the parapet! Yet dissent is healthy particularly on a board, because it can encourage better information, and greater transparency.
Then there is the controversial role of regulatory bodies. A recent Daily Post editorial on July 4th 2009, argued that Bernard Madoff was not just an evil “one-off” in an otherwise honest financial industry, but that he got away with billions of dollars because of the lack of regulation in the world of private investment. The editorial written by Robert Scheor, points out that the policy of successive Presidents of the United States, was abandon any form of oversight into the investment advice industry. For years, funding for the Securities and Exchange Commission was cut, until only 10% of investment advisors could expect to be examined once every three years. The rationale behind deregulation was that the “operations of private investor groups, such as hedge funds, were thought not to require government supervision because these were conducted by professional financiers dealing with sophisticated investors who knew what they were doing. If the investment went south, it was on their dime – and there would be no innocent victims. As we saw with the collapse of AIG and now Madoff, that notion is false because private investment contracts can involve the resources of charitable organizations and pension funds, and can end up costing the homes, savings and jobs of ordinary citizens who have no idea which end of this arcane stuff is up.”
Finally, there is the problem of the lack of individual accountability of board members. Directors should not appear at meetings twice a year for a comfortable chat and an enormous lunch. They should each be given projects and tasks to do which will require engagement with the affairs of the company. And these projects must be evaluated at the meetings. Board evaluation is surely good corporate governance practice, and should include individual directors’ self-assessments and peer reviews. After all, boards are teams.
Yet none of these principles are (or indeed can be) enforced by law. A study of companies which failed, shows up that regulation by law has a minimal effect on success. Ultimately corporate governance is about human values, about trust, respect, responsibility and accountability.
What then, is the role of the law in relation to corporations and businesses? I believe that the law’s role is a pessimistic one. Litigation becomes relevant when the company has already failed, when partnerships have broken down and contracts dishonoured. We rarely see cases about directors’ duties indeed attempts to codify them have proved unsuccessful. A footnote in Gower’s “Principles of Modern Company Law” states that an attempt “in the 1978 Companies Bill to codify directors’ duties proved abortive, to the regret of those who believe that a comprehensive statutory restatement of those duties would make it more likely that they are observed; a belief strengthened by the fact that the main reason for giving up the attempt was the impossibility of obtaining agreement of the legal profession on precisely what the duties are.”
The law then confines itself to regulating the registration of companies, the articles, the requirements of annual general meetings and to the procedures when a company has failed and is being wound up.
Winding Up and Bankruptcy
In other jurisdictions legislation has been passed to try to revive a dying company which cannot pay its debts. Examples are Chapter 11 of the U.S Bankruptcy Act and the U.K Insolvency Act 1986. In the latter, a receiver and manager is appointed to administer a “floating charge” over the company’s undertakings and assets, by the bank. The responsibility of the administrative receiver is to realize sufficient of the assets to enable the preferred creditors to be paid and the indebtedness to the debenture-holder and the costs of receivership to be discharged. The advantage of the system is that a company could (in principle) be nursed back to profitability and the creditors paid.
In practical terms the receiver appointed is one appointed by the bank and one whose principal concern is the interest of the bank and not of the company. The British solution resembles the South African “judicial management” solution and the Australian “official management” solution, both of which have their critics from the point of view of the rescuing of the company.
In Fiji, insolvency law revolves around sections 220 and 221 of the Companies Act, a section which is for several reasons inadequate. Section 221 provides:
“A company shall be deemed to be unable to pay its debts –
(a) If a creditor, by assignment or otherwise, to whom the company is indebted in a sum exceeding $100 then due has served on the company, by leaving it at the registered office of the company, a demand under his hand requiring the company to pay the sum so due and the company has, for 3 weeks thereafter, neglected to pay the sum or to secure or compound for it to the reasonable satisfaction of the creditor; or
(c) if it is proved to the satisfaction of the court that the company is unable to pay its debts, and, in determining whether a company is unable to pay its debts, the court shall take into account the contingent and prospective liabilities of the companies.”
A company therefore, in principle, can be wound up over an unpaid debt of $100. The principles relevant to the section 221 “deeming provision” have featured frequently in litigation. In Arjun & Sons Timber Mills Ltd. v. Babasiga Timber Town Ltd. (1994) FLR 260, Justice Pathik examined these principles. Arjun and Sons petitioned the court to wind up Babasiga Timber over a debt of $7000. The petition was opposed. The company (Babasiga) denied owing the sum saying that on purchase of a machine from the creditor, it discovered that it did not work despite repair. It was said that the debt was in dispute and that the company was solvent.
Section 220 of the Companies Act provides that a company may be wound up by the court if it is unable to pay its debts and if the court is of the opinion that it is just and equitable that the company should be wound up.
The judge found that under section 221, a demand had been served on the company, that the machine had been purchased “as is where is” that a cheque paid to the creditor of $7000 had been dishonoured by the bank and that the Company was therefore unable to pay its debts. The judge did not find that the debt was disputed. He referred to case law which said that the dispute must be “on substantial grounds.” If there is no such dispute, the company is deemed to be unable to pay its debts. At page 244 of the judgment his Lordship said:
“Even if the company can show that it is able to pay its debts, it will do no good whatsoever. If the situation exists, it is deemed to be unable to pay its debts whether or not that is in fact correct.”
Nor is a dispute as to the amount of the debt sufficient to upset the deeming provision of section 221. (In re Tweeds Garages Ltd.  1 Ch 407, 408. He referred to dicta in Mann v. Goldstein  1 WLR 1091, 1096 which was (per Thomas J):
“When the creditor’s debt is clearly established it seems to me to follow that this court would not, in general at any rate, interfere even though the company would appear to be solvent, for the creditor would as such be entitled to present a petition and the debtor would have his own remedy in paying the disputed debt which he should pay. So, to persist in non-payment of the debt in such circumstances would itself either suggest inability to pay or that the application was an application that the court should give the debtor relief which it itself could provide, but would not provide by paying the debt.”
The company in Arjun and Sons Timber Mill was wound up.
In Offshore Oil NZ –v- Investment Corporation of Fiji Ltd 30 FLR 90 the Court of Appeal held that the court had a discretion to decline to hear the petition for winding up “where the debt is contested on substantial grounds.” And a dispute as to quantum of debt is not a substantial ground.
Other provisions in the Companies Act provide that where in the course of winding up, the company acts with intent to defraud its creditors a court may examine and inquire into the alleged activities of the company (sections 324 and 325) and there are sections dealing with liquidation, the duties and powers of the Official Receiver and the role of the courts. In Mohammed Sheik Khan v Sheik’s Rent-A-Car Ltd 1999 45 FLR 220, Pathik J examined the role of the Official Receiver and found that the court would not interfere with the exercise of his/her powers unless the acts “were wholly unreasonable.” In the course of the judgment his Lordship said this about the effect of winding up:
“Upon the making of the winding up order there is transferred to the liquidator all the powers of the directors which can reasonably have been intended to vest in the liquidator and the powers of the directors come to an end with the appointment of a permanent liquidator. After this the directors do not have any power, inter alia, to conduct proceedings on behalf of the company. In a compulsory winding up, as in this case, there is no winding up until the Court makes an order, but the winding up is deemed to have commenced at the time of the presentation of the petition. The relevance in most cases is the occurrence of the winding up itself and this, inter alia, has an effect on the right to commence or continue actions or proceedings against the company. The control of the company’s affairs is upon a winding up taken from the directors and vested in the liquidator.
As is clear from the provisions in the Act, in a compulsory winding up the decisions of the liquidator makes from time to time are in effect under the authority of the Court. He is expected to discharge his duties impartially and properly.
In a winding up by the Court, the liquidator is an officer of the court, and as such he has public responsibilities to investigate past activities with the Company and in appropriate cases to initiate such further proceedings, civil or criminal, as the circumstances may dictate.”
And all of this as a result of the non-payment of a possibly disputed debt of, as little as $100! The effect of sections 220 and 221 of the Companies Act is potentially draconian, and unlike other jurisdictions there is little hope for rehabilitation once the petition is allowed.
Sadly, fraudulent activity within companies, is widespread and common. Studies conducted in other countries show that fraud is committed by employees, management and by directors. A study conducted by the Australian Institute of Criminology and Price Waterhouse Coopers in 2003 on 155 police and prosecution files in Australia and New Zealand, showed that the most common fraud was obtaining finance or credit by deception (21%) followed by cheque fraud (15%). 36% of the cases were about identity-related fraud and 25% involved fictitious identities. The total losses on all the files were $260.5 million, but there was a recovery of only $13.5 million. The most common motive was greed.
Other studies show that in almost all large-scale fraud, lawyers and accountants are indispensable. Indeed we know this anecdotally. On July 9th 2009, 13 individuals were indicted in Manhattan for operating a mortgage fraud scheme which defrauded banks to the tune of $12 million. 3 of the defendants are lawyers. Of course each defendant is innocent until proven guilty, but the District Attorney alleges that the defendants set up a scheme in which “straw” buyers were recruited to make fictitious purchases of properties owned by home-owners who were financially desperate. Lawyers drafted false papers to induce banks to make loans on bogus deals created by bankers and accountants. The lawyers then allegedly represented the false buyers, and used their trust accounts to shift the money to the fraudulent mortgage brokers AFG Financial Group. Two of the lawyers have pleaded guilty and await sentence.
We are told that fraudulent activity increases in a recession, or when a company runs into insolvency. In the United Kingdom, there has been a 31% increase in the number of insolvent companies whose directors have had disqualification proceedings launched against them in the past year. If successful, disqualification proceedings may ban individuals from becoming a director of a limited company for up to 15 years. In the UK there was a 72% increase in such companies facing disqualification proceedings from 2007 to 2009. The most common complaint is criminal fraud as directors turn to fraud to take what they can for themselves before the company collapses. 37% of the cases relate to underpaying tax to the Government. Directors found to be guilty of this are held personally responsible during insolvency hearings.
In Fiji, section 324(1)(a) of the Companies Act provides:
“If in the course of the winding up of a company it appears that any business of the company has been carried on with intent to defraud creditors of the company or creditors of any other person or for any fraudulent purpose, the court on the application of the official receiver, or the liquidator or any creditor or contributory of the company, may, if it thinks proper so to do, declare that any persons who were knowingly parties to the carrying on of the business in manner aforesaid shall be personally responsible, without any limitation of liability, for all or any of the debts or other liabilities of the company as the court may direct.”
Section 325(1) states:
“If, in the course of winding up a company, it appears that any person who has taken part in the formation or promotion of the company, or any past or present director, manager or liquidator, or any officer of the company, has misapplied or retained or become liable or accountable for any money or property of the company, or been guilty of a misfeasance or breach of trust in relation to the company, the court may, on the application of the official receiver, or of the liquidator, or of any creditor or contributory, examine into the conduct of the promoter, director, manager, liquidator or officer, and compel him to repay or restore the money or property or any part thereof respectively, with interest at such rate as the court thinks just, or to contribute such sum to the assets of the company by way of compensation in respect of the misapplication, retainer, misfeasance or breach of trust as the court thinks just.”
The problem with these provisions is of course the evidence. If fraud during insolvency is common in the United Kingdom, we would be naïve to assume that it never occurs in Fiji. Fraud is difficult to prove without documentary evidence which is often held by the directors themselves. The interrogatories procedure may assist, but it is (as in most litigation) cumbersome. Further, the burden of proving fraud is a heavier one than the civil standard of “on a balance of probabilities.” The result is that fraud by directors during insolvency proceedings is rarely proven.
As is fraud as criminal activity within a company. Fraud and corruption are considered to be two of the most under-reported crimes in the Penal Code. Yet the signs of fraudulent behavior are not difficult to detect. Whether the fraud is committed by a supplier or contractor outside the company, or by directors, management or employees, or by the collusion of employees and outside agencies, there are tell-tale signs of fraud, for the discerning CEO to spot. One, the breakdown of internal lines of communication, such as orders made without entries in the order book. Two, suppliers with incorrect VAT numbers or suppliers which operate from post office boxes. Three, suppliers who deal only with one employee within the company. Four, suppliers who regularly change their buyers or auditors. Five, cashbooks and journals with many corrections and entries in different handwriting. Six, irregular internal audits. Seven, vague and dishonest board papers which fail to identify any management problems. Eight, nepotism within the company with large numbers of employees who are taken because of relationships with board members or management.
There are many more markers but these are the most obvious. And what is certain, is that the tougher the economic climate, the greater the pressure on companies to commit fraud.
The principles of corporate governance have developed considerably since neo-classical economic theory told us that companies were fundamentally about profit-making and shareholder/manager trust. The principles are about more than that. However, the law and state regulation have limited roles in the protection of good corporate governance. This is possibly because the result of bad governance is ultimately about the failure of the company, in which case the law has a pivotal (and some would say) draconian role. There may be a case for law reform at the tail end of the scenario, but judicial views seem to agree that the principles of corporate governance are better protected not by the law, but by guidelines published and policed by regulatory bodies such as the Commerce Commission, and by concerns for social justice, fairness, respect and trust.