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Watch and Learn

Mon April 14th 2014

"WATCH AND LEARN" – what SMEs should learn about corporate governance from the finance sector collapses

One of the things highlighted in the recent wave of corporate catastrophes in New Zealand is that a critical factor in the success of a company is its ability to comply with its legal obligations in an effective and timely way. In a recessive economy, company 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. In light of the recent media attention on the directors of several failed finance companies, various questions about the ethical and legal duties of directors of companies have been raised in the public sphere. These questions have tremendous relevance for the SME sector for two simple reasons: most of the finance companies affected were technically small or medium sized enterprises, with small(ish) boards and management teams; and, the legal duties imposed on the directors of the finance companies are similar to those expected of directors of small and family run companies.

So what can SMEs learn from the recent failures in the finance sector? Well, a lot really, but there are a few things that particularly stand out as essential skills for company directors:

1.Understand your governance obligations

For corporate governance to be effective, it must be thoughtfully directed through policy and rigorously maintained through sound decision-making, continual risk assessment and compliance by the board and management. Directors, in particular, have a crucial role: they, more than others, bear the responsibility to ensure that the business and affairs of their companies are well managed and successfully governed. 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. The board of the company also carries a heavy burden as it must demonstrate the principles of governance effectively in its policies and decision-making.

It's been widely suggested by business commentators that a major reason why there have been so many examples of corporate governance lapses in New Zealand is because, generally speaking, many private company boards don't fully understand the legal requirements imposed on companies. SMEs can solve this difficulty by developing a board culture that is compliance focused, assesses risks continually, and diligent in its performance oversight.

2.Pay attention to warning signs

When problems arise within a company, the board has the prime responsibility to ensure that they are dealt with quickly and within the bounds of the law. If there are billboard sized warning signs of the ruin and disaster that would befall a company unless its leaders change course, then the board has to put everything else aside (including company retreats, holidays, and corporate functions) to deal with pertinent issues to avoid a crisis. A quick review of the company's books, a frank chat with relevant stakeholders, and good legal advice are often good starting points to avert disaster.

3.Demonstrate proper financial management

It is imperative that board members have a basic understanding of financial management. An awareness of financial systems and sound monetary management are critical to good governance, and board members, whether experienced in accounting and financial matters or not, have responsibility for the financial success and sustainability of the company and its businesses. It is an advantage to the company when board members have a general understanding of the effect of negative cash flow, a basic ability to assess the financial health of the company, particularly in relation to the attainment of its objectives, and the cost of credit to the organisation. These elements are not only especially vital for the finance sector but for all SME organisations because the board is accountable to stakeholders (including employees and creditors) for the diligent application of cash assets and the prudent investment of stakeholder funds.

4. Manage conflicts of interest and make disclosure

Conflicts of interest and proper disclosure are foundational blocks of good governance, and it is not uncommon for SMEs to encounter problems due to self-interest and a lack of disclosure on the part of the business owners and senior management. The CA1993 requires a director to make appropriate disclosure (Section 140) and imposes the obligation that he or she must disclose to the board and shareholders 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.

Apart from making disclosure to the board and shareholders, it is vital that the board carefully records whenever a director is "interested" in a transaction in the company's interests' register. Making disclosure should ideally mean that the director (or senior manager) is excluded from the decision-making process in the matter in which he or she has an interest but this can also depend on the facts or the size of the transaction. It is also important to remember that boards have a particular duty to ensure that the assets of the business are not depleted or manipulated to maximise private pecuniary gain by its board members and shareholders at the expense of the company's creditors.

Final Thoughts

Corporate governance is not something that only concerns large corporates and listed companies. It is equally relevant to SMEs and family run businesses. In order to ensure continual success and longevity, it is vital that small and medium businesses embrace some level of corporate formality around the boardroom table. Corporate governance in a SME structure is about ensuring the efficiency of the organisation through commercial skill and the effective use of resources. Family run businesses may choose to embrace a holistic approach to governance which involves propagating values of responsibility, guardianship, strategic planning, vision and probity within the organisation, beginning at the board level and permeating the tiers beneath. Like finance companies, SMEs are also prone to disaster when governance goes wrong. A lack of corporate responsibility, transparency and probity have characterised the performance of many of our failed SMEs, with devastating results for employees 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 company 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.

Vincent Naidu