COVER STORY : Finance Company Collapses – a sign of poor governance?

Scrutinising the degree to which corporate governance, or lack thereof, played part in the spate of finance company collapses which have bedevilled the sector over the past two years is legitimate and necessary undertaking. Emerging from that process with clear-cut, one-size-fits-all answer to such complex inquiry is far less straightforward and infinitely more problematic.
As KPMG financial services group deputy chairman Godfrey Boyce points out, this is because well-run, reputable finance companies have been tarred in investors’ minds by the same brush as poorly run, fallen companies where governance fell by the wayside and the likely dividend repayments on monies invested are best negligible.
So what is good governance by definition? UK Institute of Directors chairman Neville Bain, writing in his book The Effective Director, says dictionary definitions of governance are of limited help.
“The ‘art of ruling or governing place’ does not tell director what they need to do to ensure that value is created and not destroyed,” says Bain, an expatriate Kiwi. He suggests it is perhaps “more enlightening” to see governance as system by which an organisation is directed and controlled.
Drilling down further to finance sector definition, Boyce says good governance means having board of directors which has “sound and prudent” lending policies, closely monitors the quality of its loan book to minimise bad exposure, and has solid liquidity and funding policy. Boyce says that also means meeting insolvency requirements and securities regulations.
Where directors have doubts about the efficacy of transaction, they are obliged, Boyce says, to probe their managers about it. “You ask for more information and then take action. That is the absolute baseline requirement for governance in finance company.”
In probes of company collapses where there is major shortfall in the money remaining which is available for redistribution to creditors, Boyce says regulators will want to know whether directors have fulfilled their responsibilities under the Companies Act.
A burning question will be whether these companies have continued to trade already knowing they are insolvent. Boyce says regulation complements good governance.
“You can toughen up the rules, but they aren’t effective unless the elements of governance are there.”
Independent directors have vital role in this and “have more on the line because their reputation is at stake”, says Boyce. “They’ll make sure the right processes are adhered to. That’s why regulation doesn’t work unless you have independently thinking directors who ask the right questions.”
Boyce says there is no doubt governance failed in some of the finance company collapses.
“I think you can conclude that if there is anything less than 70 percent payout [to investors] that will raise questions about what was going on; and what lending transactions or other transactions were waved through.
“The danger is though that it becomes an investor confidence issue: some of the better-run companies become caught up in the wash of investor sentiment swinging against them.
“I’m certainly quite comfortable in my own mind that where we’ve seen big shortfalls being predicted or pointed to by receivers in their reports, you can only conclude boards just turned blind eye to lending transactions that should have been critiqued and challenged on the way through, and clearly weren’t.”
As the domino effect of the finance sector meltdown continues apace, the inevitable post-mortems on those who have already fallen by the wayside centre on whether inexperienced investors have been sufficiently aware of the nature of the risks they took.
As Commerce Minister Lianne Dalziel points out, everyone knows that the higher the promised rate of return, the greater the degree of risk. She says some finance companies deliberately lowered their promised rate of return to minimise the apparent nature of the risk investors were taking.
Dalziel also highlights what has become recurring theme in the preparation of this story – the “particularly high” rates of commissions, which she says should have set off alarm bells for the financial advisers concerned.
Unfortunately, the minister laments, some of them only heard the “ringing of cash registers”.
“I suspect some of those will pay deservedly high penalty for their lack of vigilance on behalf of consumers who entrusted them with their hard-earned money.”
Somewhat defensively, Dalziel adds that this “puts paid” to the idea that investors are “completely without any protection” under the existing regime. Her sensitivity is understandable – this is sore point with many.
However, Coral Ingley, an associate professor of management at AUT University’s Centre for Corporate Governance, says people should resist the temptation to “beat the table”.
Tempting as it may be to cite the crisis as yet another corporate governance failure where somebody needs to wield “big stick”, Ingley cautions against that too.
“Governance is certainly implicated – I wouldn’t let the directors off the hook or say that there’s nothing wrong with the governance and that it’s outside anyone’s control. I do think governance failure is significant part of the problem,” Ingley says.
Her research indicates that when directors and senior managers become “caught up” in exciting new market opportunities, “they don’t necessarily consider the risk or the downside carefully enough”.
Many directors understand the importance of risk management, but don’t also regard it as their responsibility, Ingley says, adding that it goes further than this, and that “understanding risk is part of strategy”.
Ingley says risk and reward are two parts of that “strategic equation”.
“Usually the higher the reward is, the greater the risk associated with it is.
“That doesn’t mean you don’t take that risk. It means that you understand what that risk is and how you might mitigate or minimise it.”
In 2004, the Securities Commission introduced set of non-binding corporate governance principles (see box story) which encourage voluntary reporting.
Ingley says this underpins New Zealand’s “fairly lenient” regulatory environment here in corporate governance, compared to other developed countries.
“That may be part of the problem, but if the market operates reasonably well without over-regulation, then that’s good thing.”
Securities Commission chairman Jane Diplock says the principles were issued because there was no appetite in New Zealand for financial reporting regime like the Sarbannes-Oxley Act passed in the US in 2002. The US law enshrined set of new and enhanced reporting standards in bid to restore investor confidence after string of high-profile company collapses.
The New Zealand principles apply to entities of all types, but are not part of the law.
“That was clearly not what was thought appropriate in New Zealand – and we agreed,” says Diplock.
She says no single set of circumstances caused the finance sector collapse, but concedes governance did contribute.
“We’ve seen in some cases too few directors, sometimes even sole directors, and sometimes sole director and member of his or her family. In some cases there have been no independent directors, or if there are independent directors, they have been inadequately informed about the business, or have taken insufficient interest in it. Sometimes they have just been name on letterhead,” Diplock says.
“If you have just one director, you can’t have an audit committee by definition.”
Diplock says there have been instances in collapsed companies where there is no audit committee or no effective audit committee. “In other words, sometimes there’s an audit committee in name, but it never meets, or if it does meet, it’s not doing an effective job.”
Diplock also points to large number of instances of related party transactions which have been inadequately disclosed, not disclosed, or don’t tell the “full story”.
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