The public and private faces of corporate governance

Thursday, 9 June 2011 00:07 -     - {{hitsCtrl.values.hits}}

By Cassandra Mascarenhas

Questioning the effectiveness of corporate governance in Sri Lanka today, a fairly thought-provoking and heavily debated topic, the Institute of Chartered Corporate Secretaries of Sri Lanka in partnership with the Daily FT as part of its series of seminars on debates in the boardroom, conducted a second debate under the topic ‘Is Corporate Governance in Sri Lanka Really working in Practice or Is it only an Apology?’

Held last month, the topic at hand at the second debate in this series was ‘Boardroom responsibility for directors; interests in contracts should not be limited to only disclosure.’

In what turned out to be a rather heated debate, proposing the topic were President’s Counsel, Nigel Hatch and Chartered Accountant, Deva Rodrigo and opposing it, Attorney-at-Law and Senior Partner Nithya Partners Aritha Wickramanayake and Chairman of Finlays Ceylon PLC, Kumar Jayasuriya, and the debate was moderated by the Editor-in-Chief of the Daily FT, Nisthar Cassim. A poll taken before the debate commenced showed that the audience leaned heavily towards the proposing side with 25 votes, three votes for the opposing side and one neutral vote.

Following the definition of parameters by Chandra Jayaratne, President’s Counsel Nigel Hatch was invited to kick off debate by proposing the subject.

A statutory pause for thought

Hatch at the outset agreed that the topic of corporate governance in Sri Lanka – if is it really working in practice or is it only an adoption, was a very thought-provoking topic and that the evening’s debate, boardroom responsibilities in contracts should not be limited to only disclosure was a second serious issue.

“Now clearly whether all is right or not with corporate governance in Sri Lanka, the aura of this debate is very timely because it give us the opportunity of reappraising and reflecting on a continuous basis what the practice is and whether it measures up to the preset. So to that extent, I think that this is a very welcome initiative,” he said.

The President’s Counsel then pointed out that company law, to be effective has to strike the right balance between modern business needs and the wider corporate expectancies of the responsibilities of the business. While having regard for the board being the dominant corporate structure, non-withstanding the shareholders and democracy, it has nevertheless over a whole period of time developed a tendency of being perceived as having evolved into a self-perpetuating and self-remunerating hierarchy with little or no accountability for transparency.

At the onset of the company law reforms, there were codes of best corporate governance that had as its launching pad, the scandals that broke out in the early 1990s particularly the BCCI scandal which also snowballed into more recent difficulties in the corporate world, particularly in the West.

“When an individual is appointed to a Board of Directors, he enters a fiduciary relationship. It means that the fiduciary duty that he owes the company that he is representing requires him to place the interests of the company over and above any personal interests he may have. The duty of disclosure is a very important component in the discharge of this fiduciary duty. The basis of this fiduciary duty in history has been the pinnacle of company law in the UK based on the doctrines of agency where the director is considered to be an agent of the company he serves and as a trustee of the assets of the company,” Hatch asserted.

He added that the present Companies Act 2007 of Sri Lanka has codified the law in terms of directors’ duties and responsibilities and in that regard, significant changes were made. For the first time in a whole raft of provisions, from Sections 184 to 190, the law statutorily spelt out that when the management of the business and affairs of a company is vested in the board, a director must act in good faith and in the interests of the company. Significantly a director cannot agree to accompany a contravening act of the Companies Act or the Articles of Association and the standard of care that is expected from directors is also spelt out in it.

“Section 19, which I think is a very key tenet, stipulated that the provisions contained in the Companies Act are in addition to any other law relating to the duties of a director of a company. With regards to the duties of disclosure that is essentially found in Sections 191 to 196, I would like to take you through the definition of what an interest of a director means. A director would be interested in a company if a director is a party or derives a financial benefit or if the director has a material financial interest in another party or if the director is related to another third person or party who may derive a material financial benefit or if a director is otherwise directly or indirectly materially interested in that transaction,” he explained.

Hatch then went on to explain what the Act would require a director to do assuming he falls within that threshold. Section 192 says that a director shall forthwith after becoming aware of the fact that he is interested in a transaction or proposed transaction, propose that his interest be recorded in the interest register and disclose to the board the nature and extent of that interest.

He also informed the audience that based on English County law precedence, the nature and extent of that interest have in serial cases been amplified to the extent that there has to be full and frank disclosure. In fact, one judgement went so far as to say that the director concerned must even err on the side of caution in regard to making this full and frank disclosure.

Section 194 and its sub-sections states that a general notice entered in the interest register or disclosed to the board shall be insufficient disclosure.

“This relates to where the member of the board, upon being inducted to the board, tells the company, look I have an interest in another company so if there are any transactions that are between that company and the current company, let it be recorded that I will automatically have an interest in those transactions,” elucidated Hatch. “Now what happens at the failure to comply with this duty? The failure to comply does not affect the validity of the transaction per se but it states in the sub-section that it could potentially expose the non-responsive or the director who has failed to comply with this duty to criminal sanctions.”

Section 193 provides that a company remain six months after the transaction and after the director’s interest has been fully disclosed to the shareholders, avoid that transaction but not if that company has received fair price, which essentially means that on an objective criteria, for example, property and so on and fair price has been obtained for it, that particular test would not be required.

There is also Section 194 which states that an avoidance of a transaction under 193 would not affect the rights of a third party. Finally 196, subject to the Articles of Association – a director who is interested in a transaction may also be present at the board meeting; he may participate and indeed vote on that transaction as well.

Apart from these statutory requirements, there is also the code of corporate governance and directors’ responsibilities which have been formulated by the Institute of Chartered Accountants which also provides the voluntary code, basically following the combined codes of the UK, which is a combination of the Cadbury, Greenbury and Hampel reports which expanded over a whole period from 1992 to 1998, explained the President’s Counsel.

“Now the issue that we have to consider today is whether mere disclosure of a director’s interest in contracts would in fact be a passport to contractual freedom. We will seek to contend that, that is not the case and that the Companies Act would set out the minimum standards. Disclosure is certainly the first step but the second is the overriding duty of good faith,” Hatch stated.

He then exemplified what that second test could potentially mean by making a very brief reference to a recent judgement in England, the man was the sole director in the company and sought to terminate his employment contract and pay himself a handsome dividend of £100,000. Now it transpired that this particular interest, that is paying himself a £100,000 had not been duly recorded and the company successfully pursued him and had him return that sum of money because there had not been compliance with the standards of disclosure and concomitant duty of the minutes of that particular board meeting reflecting that particular disclosure.

Now, in that particular case, it was stated that when it came to the disclosure of a director’s interests at a board meeting, the corresponding law in England would lead to three situations, Hatch explained. First, all directors present should know or be reminded of the interest. Second, which he said was very significant for the discussion, the meeting of the declaration of interest should be the occasion for what the court called, a statutory pause of thought.

“Now, you’ve made the declaration but that itself is not enough – you must go one step further and have a statutory pause for thought about the existence of that conflict of interest. So I think it is important for us to remember that there has to be a statutory pause for thought after that declaration and a fuller consideration about the existence of the conflict of interest and of the duty to prefer the overriding interest of the company. Thirdly, the disclosure should be in addition to the things happening at the meeting which therefore must be recorded,” the President’s Counsel clarified.

He also stated that in the West, he had come across several large corporations that have conflict of interest policies and have statements that they require their directors to sign. In fact, in larger corporations, directors must sign this at the first board meeting and are not allowed to participate until they do so.

Even in the absence of a conflict of interest policy, the duty of candour requires that the director discloses to all the other directors all facts that the directors should be aware of and could be material to the board’s consideration of the matters before it. Therefore the duty of candour requires that the director, who is interested in a contract, discloses the director’s self-interest so that the disinterested directors can make an informed decision.

It would appear that the most common causes of conflicts of interest occur in connection with procurement, decisions of supply management, consulting activities and the use of company assets and services.

“In the wake of many corporate scandals related party transactions are also attracting new attention from government officials and other business leaders and special legislations have also been passed in the West to try and pass some new codes. The question that remains is if there exists a pattern regarding what companies publically state in regard to compliance policies and how they actually deal internally with these conflict of interest issues. In a sense, is there a public and a private face to these issues?” concluded Hatch.

Adding provisions would be like using a sledgehammer

Attorney-at-Law and Senior Partner Nithya Partners Aritha Wickramanayake stepped up to the podium next to oppose the topic and stated that he would start by putting the debate back into context.

“What Nigel is trying to say is that from a point of disclosure, directors should follow the actual procedures that have to be followed by them after disclosure – but I would say that those too are a part and parcel of disclosure, natural extensions of the duty and nature of disclosure. The topic that we have for today is boardroom responsibility for directors’ interests in contracts should not be limited to only disclosure,” he said.

He too then quickly brushed over some of the laws explained by Hatch previously. Commencing with Section 192, he explained that it requires the director who has an interest in the transaction to forthwith, upon becoming aware of the fact that he is interested in a transaction, to enter it into the interest register, as Hatch said, and to disclose to the board the nature and intent of that interest.

“The essence of the obligation therefore is that of the disclosure of the interest so that it is transparent and what happens if there is no compliance to this section – the law specifically provides that non-disclosure does not make the transaction void however prescribes sanctions and a Rs. 200,000 fine for non-compliance,” he added. “What is important to bear in mind is that disclosure is not made merely for the purpose of disclosure. It sets off a chain of procedures that are aimed at protecting the rights of shareholders and the company from prejudice that could result from such actions.”

Wickramanayake then moved onto Section 193 which goes on to provide that the company, which means the shareholders at the general meeting, can have the transactions set aside any time before six months after the transaction and the directors’ interest in the transactions have been disclosed to the shareholders whether by means of the company’s annual report or otherwise unless the shareholders receive information that there is something wrong with the contract and it is set aside.

“So that is the law on how directors’ interests contracts with the company are treated. Disclosure and the right to set aside the contract are part and parcel of this process. So the very suggestion that more than disclosure is required necessarily invites arguing that directors should not be permitted to have interests in contracts with the companies on whose boards they are on and that the law should be tightened by putting further restrictions on the rights of directors with contracts with the company,” Wickramanayake stated.

He then delved into the facts and discussed whether the laws should be tightened further. At the very outset, he reminded the audience that they have to remind themselves of a very basic point.

“As we all know, companies and company laws were created to facilitate business and commerce and not to play the playing field sitting in ivory towers in a perfect world. As it is, company law provides a gamut of checks and balances to prevent unlimited use of provisions of stakeholders. For instance, directors are given responsibilities when they act as directors. The responsibility to act on the interest of the company which is part and parcel of the company law, it’s nothing new,” he pointed out strongly.

He added that the law also contends various ways to enforce these responsibilities such as actions arising from oppression, derivative actions and has given the right of single shareholder holding a single share against injunctions of various articles of law. To add to these existing provisions with the pretext of corporate governance by creating conditions and activities, he said, could and would in most cases be like using a sledgehammer.

The attorney-at-law then explained that it has to be understood that most companies are private companies or companies with a few shareholders. When discussing corporate governance and shareholder protection, most tend to take on the perspective that they are helpless and unsophisticated shareholders of public limited companies, he criticised. In his viewpoint, these concerns are largely misplaced in most cases.

“To limit the rights of directors in being able to do business with a company would therefore be draconian and stifle the limited use of the corporate form as a vehicle for business. We also must recognise that the strategy of disclosure is not a half-baked criterion. It is a system that has evolved out of years of experience and development of case law. The law also probably recognising that the placing of more and more restrictions will lead persons to finding other means to have contracts with companies,” Wickramanayake said. “We have all heard of instances where dummy companies are created and transactions occur through third parties or else it may make people hesitant to sit on boards. The point that we should not lose sight of is, what is the greater good? A perfect set of company laws or the facilitation of growth?”

He then went on to explain why disclosure itself is a sufficient safeguard against the possibility that directors’ interest in contracts could result in a conflict with those of the company.

“When directors enter a contract with a company, they have to be mindful of the fact that they do not have the freedom of wild assess – that’s a privilege reserved for politicians. Company law, and in our case, it’s recognised by statute, requires that directors have a duty to act in the interests of the company and that is part and parcel of our company law, it’s nothing new,” he said.

These responsibilities are fundamental and are subject to the limitation that directors can enter into contracts with the company, he stated but explained that once disclosure is made, then no one can downplay disclosure, the company can have the transaction set aside and the law provides that proper disclosure should be full and frank.

Disclosure to the board is also not a mere formality; the law provides that disclosure has to be made to formally convene board meetings. The law also specifically provides that merely entering it in the interest register itself is not a criteria for  disclosure to shareholders and that the transaction can be set aside at anytime within a period of six months before being disclosed to all shareholders.

“So is this all not enough? It is the argument of the proposition that the shareholders of the company that shareholders of the company are incapable of protecting their interests, I say that the law cannot provide spines to the shareholders,” Wickramanayake finished.

The director should leave the room

Chartered Accountant, Deva Rodrigo up next, first expressed his surprise at what his friend Aritha Wickramanayake had to say about the very topic. The topic is very clear to me, he said – boardroom responsibility for directors’ interest in contracts with the companies that they serve should not only be limited to disclosure.

“Some have taken it to the extent that the proposal could prohibit directors ever having any interest in a contract in a company. The way I understood it, that was the main theme that Aritha used to oppose this subject, saying that if we are saying that disclosure alone is not adequate then it means that you are proposing that there should be no interest in contracts in the company. That is not what we are proposing and it seems that at the outset, Aritha in fact agrees with the proposal that boardroom responsibility for directors with interest in contracts should not only be limited to disclosure,” he clarified.

In his life as an accountant in Sri Lanka, Rodrigo said that he has witnessed, at certain meetings, where a director says, gentlemen, I am a director of this company and I have this particular interest and I would like to note that today in the papers before us that there is a proposal to enter into a contract with a company, amounting to so much.

In this process, he has met with the requirement of disclosure but is that adequate, questioned the accountant. Coming back to the topic, he repeated that a director’s interest in contracts should not be limited to only disclosure.

Now what that director did, is not adequate because when he sits at the board meeting, looks around at the members, and therefore influences the decision, he does not allow by his mere presence for a free and fair debate or discussion of that contract and at the time of voting, because they are his colleagues, he again has a very unfair influence on the other directors who are to vote on the proposal, he explained.

“So therefore, what I contend is, having made the disclosure as required by law, no doubt about it, you should not take part in that discussion in that board meeting. You should reduce yourself from the discussion and I would even go to say, not vote because you are interested – let it be a vote by uninterested parties on the board,” proposed Rodrigo. “Now the company law permits you, after disclosure, to take part in the discussion and vote. What we are proposing is not to prohibit a director from entering a contract in which he is interested. If we find that the mere disclosure stops at what I stated then one day, when the next revision of the Companies Act comes in, then I consider extending that to say that a director who is interested in a contract should not only disclose his interest but should not take part in the discussion altogether.”

Another interesting thing that Ajitha pointed out, he said, is that disclosure is not merely for formality but in the spirit of the law and as your fiduciary responsibilities as a director, fairness always comes into play and Rodrigo felt what he really proposed was that beyond this disclosure, that a director should stay away from the discussion and should not vote and do everything possible to ensure a proper discussion of the proposal, which the proposing side agrees with.

This all arose from the very fundamental principles directors are to have towards the company and its shareholders, he pointed out. If a company is to benefit when it enters into a contract with any other individual company, and the issue is at when the decision is made by the directors themselves, so there is a requirement to disclose, that’s the first step. Then the second step is to make sure that in the decision making, they have considered all the facts and then you decide upon the course of action and only at that point, the director is asked to leave the room.

There is another company on whose board Rodrigo serves on, a multinational, which he explained has an annual declaration made by each director. A set of governance rules are sent around, asking directors to declare that they have studied the corporate governance rules and understood them. Now the corporate governance rules in that company do exactly what the proposing side is asking for, according to the accountant; that the director should disclose and should refuse himself from the meeting and should not take part in the voting.

“Now these are companies that have developed their internal rules. That is because the Companies Act stops at disclosure and is not considered adequate for corporate governance and many rules of corporate governance are not covered in the law. Just because it is not written in the law, it doesn’t mean that the right thing to do is otherwise,” he said.

Drawing upon another example, he said that there was another instance at a large conglomerate where a senior director was a partner at a large audit firm and he got a subsidiary company of the conglomerate to be audited by his own firm. Now while the partner has made the disclosure, he goes even beyond that to do the very opposite of its intention by influencing the other directors to get the audit firm to audit the subsidiary company, Rodrigo pointed out. Other issues also come in there apart from the conflict of interests as the audit is supposed to be carried out by an independent firm but here again is a situation where disclosure, clearly is not sufficient.

Directors should not be spineless

Finally, the Chairman of Finlays Ceylon PLC, Kumar Jayasuriya took to the podium to oppose the topic.  

“I propose to take a businessman’s or a commonsensical view on this subject. I would like to focus on the need why disclosures are considered necessary for corporate governance and I believe that disclosures are necessary to inform stakeholders but not necessarily limit them of issue, events circumstances that if made known to them will be reasonably expected to affect their decisions in whatever dealings they may have or intend to have in the company,” he began.

Conversely, he added, if they are not aware of these very same issues, then they take a position that is significantly different to what they have may have taken if they had been otherwise informed.

Now this being the general principle, he felt that it is acceptable that with compliance with law, that the disclosure be had and in terms of corporate governance there must remain some point of interest in the company, with disclosures being made upfront, disclosures being made annually through various statements of disclosure — that is the accepted norm.

Jayasuriya, talking about directors having fiduciary responsibilities looked at directors interested in contracts, the number of financial statements annual reports etc. from a different angle. Some companies have lent pages and pages to such transactions, transactions that are otherwise recorded and yet make their way into annual reports. Companies have a meticulous way of recording such transactions, he pointed out.

Taking the example of an individual being both a director of a bank and of another company, he correctly stated that often, with the fairly moderate number of banks that there are chances that the company will deal with this particular bank and when the facilities of this particular bank are taken up, a director would naturally as required by law, state his interest and at the end of the financial year. Again one would find a whole host of information pertaining to the transactions that the company has entered into the bank.

Jayasuriya said that there are circumstances where during the deliberations of the board, that a director may find that he has a particular interest in a contract that he has a personal interest in or that he is a director of a company in which some business dealing is occurring. In that situation, as mentioned before, it is correct for that director to say that he is interested in the contract but should he, as contended by the proposing side, excuse himself completely and not participate in the discussion or not be present at all, he questioned.

“Now that director in question, sometimes may have some expert knowledge on the particular subject and if he were not to participate in the discussion perhaps the company loses out because that expertise could have otherwise been put to good use. So I contend that in such situations, when expert knowledge is available, that it is not out of line for that director to be present and for the board in turn to make use of that available information,” he stated.

Assuming that if we are to go down the path where people with such knowledge and have such expertise etc. do not participate, Jayasuriya asserted that we are assuming that the other directors in the room are actually allowing this director to influence them which is why they take away his viewpoint.

“I don’t think that happens all the time and in any case, the other directors should not be spineless, they should be able to speak up and identify if this director is particularly moving the discussion,” the Chairman said.

A poll conducted at the end of the debate, although it included a few more people as opposed to the first vote, showed that the crowd still seemed unmoved by the heated debate with 24 votes for the proposing side, eight for the opposing side and, even at the end of the debate, one neutral vote.

Pix by Daminda

Harsha Perera