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Failures in the finance sector – Governance lessons

Fri April 11th 2014

Failures in the finance sector – governance lessons in the trenches

The latest court decision in the Nathans Finance case is probably going to become part of a long line of civil and criminal litigation against directors of failed finance companies. There is no doubt that recent media attention on key figures behind some high profile finance companies, Mark Hotchin and Rod Petricevic included, has elevated interest in the ethical and legal duties of directors and the boards of companies.

Quite apart from issues of moral probity on the part of the directors, questions have rightfully been asked about the proper management (or lack thereof) of the string of finance companies which have failed in the last few years. There is no doubt that there have been some spectacular and high-profile collapses – Bridgecorp, Nathans Finance, Capital + Merchant, and Hanover to name a few. Each time the same questions have been asked: why didn't the boards act quickly to nip problems in the bud, and how is it that directors - with all their well-publicised nous, talent and experience – didn't see billboard sized warning signs of the ruin and disaster that would befall their own companies unless they changed course? These are important questions and deserve some real answers, so one hopes that the SFO can work through its large case load and bring several outstanding matters before the courts swiftly. In the meantime, ordinary ma and pa investors across the country who are seriously out of pocket will continue to have to eat humble pie, while those behind some of these corporate collapses continue to try to evade responsibility.

If we are to examine corporate collapses in the finance sector from a corporate governance perspective we need to understand some basic underlying principles. For corporate governance to be effective, it must be thoughtfully directed through policy and objective, and rigorously maintained through sound decision making (by the board and management) and continual risk assessment and compliance. Directors, in particular, have a crucial role as they bear primary responsibility for the good management of their companies. This expectation is consistent with the requirements of the Companies Act 1993 ("the CA1993") which places significant and extensive legal obligations on directors, including a duty of care. These obligations are carried through to the board level, which must demonstrate the principles of governance effectively in its policies and decision-making.

The board is responsible for the financial success and sustainability of the business of the company. A company's board is, after all, the main governance organ in the corporate machinery. It is at this level where a number of catastrophic failures seemingly occurred for a number of finance companies: boards were either too complacent and didn't assess the risk appetite of their business diligently, or simply didn't understand the fiscal management of its businesses as well as it should have.

In order for governance to be effective in the corporate environment, it is imperative that all board members should have a basic understanding of financial management. Board members should have a general understanding of the effect of negative cash flow, a basic ability to assess the financial health of the organisation particularly in relation to the attainment of its objectives, the cost of credit to the organisation, and the ability to interpret information about the organisation's performance over time. Such standards should be the norm, not the exception, in these economic times given that the board is accountable to stakeholders (including employees and creditors) for the diligent application of the organisation's cash assets and resources. Therefore, it is only right to ask why so many boards of financial institutions continued to support and approve investment schemes which were either too fraught with risk or not sustainable in the long term. The examples are numerous – from investing in shaky off-shore luxury resorts to embarking on large property developments on the eve of the global financial crisis. The fact that some poor investments were made on behalf of trusting investors is simply a consequence of poor governance. What is now evident is that many boards of finance companies failed to carry out assessments of the financial health of their businesses in a diligent and continual manner, yet they continued to make promises of good yields to investors who were encouraged to invest.

A couple of key areas where directors seem to routinely get caught are the failure to make adequate disclosure and continuing to manage or administer business affairs when there is a conflict of interest. Codes regarding conflicts of interest and proper disclosure are foundational blocks of good governance, and a legal requirement is that a director has a duty to make appropriate disclosure under the Section 140 of the CA1993. This is particularly relevant for non-banking deposit holders, and the legal requirement is that a director must disclose whether he or she:

  • has an interest in a contract or other transaction and may or will obtain a material financial benefit from the transaction;
  • is a parent, child or spouse of a person who is a party to a transaction, or who will or may receive a material financial benefit from the transaction;
  • is otherwise materially interested in a transaction, directly or indirectly; and
  • is a director, officer or trustee of another entity that is a party to a transaction, or that will or may receive a material financial benefit from the transaction.

It is, therefore, vital to record directors' interests in the company's register, and this procedure must be regularly monitored by the Board. But, what of related party loans? Disclosure of relating party lending must be made quickly and accurately. They must also be honestly and accurately revealed in the company's prospectus and any other information provided to investors. It is no secret that related party loans have caused untold misery to countless investors over the last few years. A key reason is that in many instances, these loans can be directed to a "parent" or "partner" organisation which then utilises those funds in unidentified investment portfolios and development projects. In many cases, investors don't really know where their money will actually end up or how it will be applied within the complex business matrix operated by the company they have invested in.

Related party loans can be a real problem because they hurt debenture holders. This was shown time and again with the likes of Nathans Finance, Capital + Merchant, Hanover Finance, and South Canterbury. According to some reports, Capital + Merchant failed to record around $41million of related party loans in its books. In another example, companies linked to Eric Watson and Mark Hotchin took out around $117million from Hanover Finance in related party loans. It appears that Watson and Hotchin eventually repaid around $68million back, but not before receiving dividends of approximately $45million. This was back in 2008, nearly a month or so before Hanover suspended all repayments to its investors. Similarly, related party lending was a significant stumbling block for South Canterbury Finance, which has left thousands of investors wondering where their money all went.

It is very important that appropriate (and honest) disclosure is made in relation to actual (and potential) conflicts of interest, including where related party loans are concerned. And boards have a particular duty to enforce this, whilst working to ensure that the cash assets of the business are not depleted or manipulated to maximise private pecuniary gain by its shareholders at the expense of the company's creditors.

We have seen, through the recent wave of corporate catastrophes, that proper compliance with its legal obligations is critical to the success of a company. In a recessive economy, directors have an even greater responsibility to adhere to the principles of good governance - to carefully observe the rules of their constitutions, to monitor statutory compliance, and to ensure that they are meeting their obligations in relation to duties owed to their stakeholders and creditors. A quick survey of recent law reports suggests that there is certainly no shortage of case law in New Zealand relating to legal action against directors. This should serve as a warning to directors about the importance of taking their statutory duties seriously and demonstrating good governance in the performance of their roles.