[21-12-2009]

[Muhammad Saeed Babar Reg. # MM073003M Asim Ullah Reg. # MM081023

Shahat Khan Reg. #Ashfaque Habib Reg. # MM073007]

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[BORROWING POWERS OF DIRECTORS OF PUBLIC LIMITED COMPANY]

Group I

Borrowing Powers of Directors of Public Limited Company

IntroductionCorporate governance is to ensure that a system is in place to protect the individual as well as collective interests of all the stakeholders in a company. In this respect the role of Board of Directors becomes very important because by its very nature a company is an artificial juridical person in the sense that it can sue and can be sued. But it works through its directors who are its eyes, brain and muscle. Directors are the persons who run day to day affairs of the company and possess the first hand information about every aspect of its operations. Directors are also in the best of position to determine its future course i-e set objectives, formulate strategy, devise operational plans etc. Shareholders are the owners of the company who provide capital to the company for its operations but do not run its affairs and delegate this function to professional managers. These professional managers may also be shareholders of the company. This separation of brain and capital poses agency problem and dual role of directors, shareholders as well as directors creates conflict of interest with other stakeholders such as outside shareholders.

In the wake of recent financial crises and recent past failure of Enron, Worldcom and Parmalat, a heated debate is going on the role of directors and the board in the governance of corporate world. Much of the debate is centered round the structure of the board, integrity of the financial reports, auditing, shareholder activism, corporate governance rules and regulations etc. A very little attention has been given to the concept of borrowing powers of the directors. One of the elements of the powers enjoyed by the directors is that these may be misused and abused as well. If these are being misused, it means due care and necessary diligence has not been taken care of and if these are being abused, it means these are used for the purposes other than the benefit of the company. In these both cases, the tendency or some inclination to misuse and /or abuse powers can lead to disaster. As a precautionary measure, there is a need to put some checks on the use of powers enjoyed by the directors. One of the powers given to directors or used by the directors on behalf of the company is borrowing power. There is no restriction on the borrowing powers of the directors in Articles of Association and neither there is any law that restricts this power. However, there are rules and regulations for the lenders that prohibit them to lend in case of borrowing beyond a certain percentage of equity but generally there is no restriction on borrowers.

As directors manage a corporation for and on behalf of the shareholders who own it, it is critical that any regulatory and legal requirements placed on directors do not seriously compromise their goal of maximizing shareholder wealth. Directors’ behavior influences the efficient operation of corporations. If directors are subject to undue transaction costs in protecting

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themselves from personal liability, these costs will ultimately be passed onto, and borne by, the corporation itself. On the other hand, if directors are permitted to operate completely unfettered by regulation and a degree of shareholder control, investor confidence in the corporate may potentially be undermined. In this regard, it is clear from past experience, particularly in relation to the corporate collapses as mentioned above, that the conduct of directors through corporations can have a significant impact on public perceptions and market confidence.

While regulatory requirements are usually placed on directors as a means of protecting investors, or the general public, such protection may well be achieved at the expense of investors themselves. Accordingly, it is vitally important that any measures put in place as a means of promoting investor protection are properly assessed from an economic perspective to ensure that they do not ultimately act to the detriment of shareholders as a whole. To promote investor confidence and thereby facilitate expansion of capital market, investors need to be satisfied that they have sufficient opportunity for redress against a corporation and its directors in clear cases of negligent, reckless or fraudulent conduct. However, directors who effectively control the corporation must not feel so over-burdened with a fear of responsibility that their decision-making is seriously constrained. Regulation in the area of directors’ duties and shareholders’ rights invariably involves a fine balance between maintaining investor confidence and encouraging commercial enterprise. In the interests of maximizing shareholder wealth and economic growth, directors need to be encouraged to take enterprising decisions. However, these decisions must be taken in the interests of the company and be challengeable if they are not bona fides and well informed.

In the backdrop of above deliberations, it is important to thoroughly evaluate the possibility of check on the borrowing powers of the directors. This paper shall examine the all possible ways in which such a check can be placed and a critical analysis of each alternative shall be put forward. Finally, a recommendation shall be made whether such a check is required or not and if required what necessary amendments in Company Law are required.

Root Cause Analysis of Corporate FailuresA variety of complex factors created the conditions and culture in which a series of large corporate frauds occurred between 2000-2002. The spectacular, highly-publicized frauds at Enron, WorldCom etc. exposed significant problems with conflicts of interest and incentive compensation practices. The analysis of their complex and contentious root causes contributed to the passage of Sarbanes–Oxley Act in 2002. In a 2004 interview, Senator Paul Sarbanes stated:

“The Senate Banking Committee undertook a series of hearings on the problems in the markets that had led to a loss of hundreds and hundreds of billions, indeed trillions of dollars in market value. The hearings set out to lay the foundation for legislation. We scheduled 10 hearings over

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a six-week period, during which we brought in some of the best people in the country to testify… The hearings produced remarkable consensus on the nature of the problems:

1. Inadequate oversight of accountants

2. Lack of auditor independence

3. Weak corporate governance procedures

4. Stock analysts’ conflict of interests

5. Inadequate disclosure provisions, and

6. Grossly inadequate funding of the Securities and Exchange Commission.”

Response

In line with the findings of the Senate Committee, Sarbanes–Oxley Act was enacted in 2002. The Act requires from the management and the external auditor to report on the adequacy of the company's internal control over financial reporting (ICFR). Under Section 404 of the Act, management is required to produce an “internal control report” as part of each annual Exchange Act report. The report must affirm “the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting.” The report must also “contain an assessment, as of the end of the most recent fiscal year of the Company, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting.” To do this, managers are generally adopting an internal control framework such as that described in COSO (Committee of Sponsoring Organizations of the Treadway Commission). The Public Company Accounting Oversight Board (PCAOB) approved Auditing Standard No. 5 for public accounting firms on July 25, 2007. This standard superseded Auditing Standard No. 2, the initial guidance provided in 2004. The SEC also released its interpretive guidance on June 27, 2007. It is generally consistent with the PCAOB's guidance, but intended to provide guidance for management. These two standards together require management to:

1. Assess both the design and operating effectiveness of selected internal controls related to significant accounts and relevant assertions, in the context of material misstatement risks;

2. Understand the flow of transactions, including IT aspects, sufficient enough to identify points at which a misstatement could arise;

3. Evaluate company-level (entity-level) controls, which correspond to the components of the COSO framework;

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4. Perform a fraud risk assessment;

5. Evaluate controls designed to prevent or detect fraud, including management override of controls;

6. Evaluate controls over the period-end financial reporting process;

7. Scale the assessment based on the size and complexity of the company;

8. Rely on management's work based on factors such as competency, objectivity, and risk;

9. Conclude on the adequacy of internal control over financial reporting.

Corporate Culture in PakistanIn the context of Pakistani corporate culture where listed companies are mostly controlled by families, shareholder activism as suggested by the Combined Code of CG is not possible. It is also not possible to wholly rely of the Board of Directors since all the directors are from the same controlling group or do not have necessary independence. Neither there is any culture of non-executive directors and nor there is any concept of independence. Since, the majority of listed companies are controlled by families; therefore, their boards are dominated by strong personalities. Auditors are also out of question because of their conflict of interests mainly due to non-audit business and long time continuously auditors of the company. In these circumstances, we are left with only one option and that is mandatory law provisions to check any misuse of powers.

The Companies Ordinance 1984 states:

“Sec. 196(2) The directors of a company shall exercise the following powers on behalf of the company, and shall do so by means of a resolution passed at their meeting, namely. —(a) to make calls on shareholders in respect of moneys unpaid on their shares;(b) to issue shares;(c) to issue debentures or participation term certificate, any instrument in the nature of redeemable capital;(d) to borrow moneys otherwise than on debentures;(e) to invest the funds of the company;(f ) to make loans;(g) to authorize a director or the firm of which he is a partner or any partner of such firm or a private company of which he is a member or director to enter into any contract with the company for making sale, purchase or supply of goods or rendering services with the company;(h) to approve annual or half-yearly or other periodical accounts as are required to be circulated to the members;

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(i) to approve bonus to employees;(j) to incur capital expenditure on any single item or dispose of a fixed asset in accordance with the limits as prescribed by the Commission from time to time;

(k) to undertake obligations under leasing contracts exceeding one million rupees;

(l) to declare interim dividend; and(m) having regard to such amount as may be determined to be material (as construed in Generally Accepted Accounting Principles) by the Board-(i) to write off bad debts, advances and receivables;(ii) to write off inventories and other assets of the company; and(iii) to determine the terms of and the circumstances in which a law suit may be compromised and a claim or right in favor of a company may be released, extinguished or relinquished:”

Code of Corporate Governance issued by SECP in Pakistan provides guidelines regarding the responsibilities, powers and functions of board of directors. Here is a reproduction.

“RESPONSIBILITIES, POWERS AND FUNCTIONS OF BOARD OF DIRECTORS

(vii) The directors of listed companies shall exercise their powers and carry out their fiduciaryduties with a sense of objective judgment and independence in the best interests of the listed company.(viii) Every listed company shall ensure that:

(a) a ‘Statement of Ethics and Business Practices’ is prepared and circulated annually by its Board of Directors to establish a standard of conduct for directors and employees, which Statement shall be signed by each director and employee in acknowledgement of his understanding and acceptance of the standard of conduct;(b) the Board of Directors adopt a vision/ mission statement and overall corporate strategy for the listed company and also formulate significant policies, having regard to the level of materiality, as may be determined it;

Explanation: Significant policies for this purpose may include:

1. risk management;

2. human resource management including preparation of a succession plan;

3. procurement of goods and services;

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4. marketing;

5. determination of terms of credit and discount to customers;

6. write-off of bad/ doubtful debts, advances and receivables;

7. acquisition/ disposal of fixed assets;

8. investments;

9. borrowing of moneys and the amount in excess of which borrowings shall be sanctioned/ ratified by a general meeting of shareholders;

10. donations, charities, contributions and other payments of a similar nature;

11. determination and delegation of financial powers;

12. transactions or contracts with associated companies and related parties; and

13. health, safety and environment

A complete record of particulars of the significant policies, as may be determined, along with the dates on which they were approved or amended by the Board of Directors shall be maintained.

The Board of Directors shall define the level of materiality, keeping in view the specific circumstances of the listed company and the recommendations of any technical or executive sub-committee of the Board that may be set up for the purpose;

(c) the Board of Directors establish a system of sound internal control, which is effectively implemented at all levels within the listed company;(d) the following powers are exercised by the Board of Directors on behalf of the listed company and decisions on material transactions or significant matters are documented by a resolution passed at a meeting of the Board:

1. investment and disinvestment of funds where the maturity period of such investments is six months or more, except in the case of banking companies, Non-Banking Financial Institutions, trusts and insurance companies;

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2. determination of the nature of loans and advances made by the listed company and fixing a monetary limit thereof;

3. write-off of bad debts, advances and receivables and determination of a reasonable provision for doubtful debts;

4. write-off of inventories and other assets; and

5. determination of the terms of and the circumstances in which a law suit may be compromised and a claim/ right in favor of the listed company may be waived, released, extinguished or relinquished;

(e) appointment, remuneration and terms and conditions of employment of the Chief Executive Officer (CEO) and other executive directors of the listed company are determined and approved by the Board of Directors; and(f) in the case of a modaraba or a Non-Banking Financial Institution, whose main business is investment in listed securities, the Board of Directors approve and adopt an investment policy, which is stated in each annual report of the modaraba / Non-Banking Financial Institution.

Explanation: The investment policy shall inter alia state:

1. that the modaraba / Non-Banking Financial Institution shall not invest in a connected person, as defined in the Asset Management Companies Rules, 1995, and shall provide a list of all such connected persons;

2. that the modaraba / Non-Banking Financial Institution shall not invest in shares of unlisted companies; and

3. the criteria for investment in listed securities.

The Net Asset Value of each modaraba / Non-Banking Financial Institution shall be provided for publication on a monthly basis to the stock exchange on which its shares/ certificates are listed.

(ix) The Chairman of a listed company shall preferably be elected from among the non-executive directors of the listed company. The Board of Directors shall clearly define the respective roles and responsibilities of the Chairman and Chief Executive, whether or not these offices.”

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Proposals on how to restrict boards from imprudent or irresponsible borrowingsAs discussed above, in Pakistan majority of listed companies are managed by controlling shareholders who are close family members. Other investors in these companies are in minority. According to section 196(2) of Companies Ordinance 1984, directors can exercise borrowing powers of the company by means of a resolution at board of directors meeting.

Code of Corporate Governance also allows directors to exercise all powers on behalf of the company and only binds them morally to do this “with a sense of objective judgment and independence in the best interests of the listed company.” Further, it asks to maintain “A complete record of particulars of the significant policies, as may be determined, along with the dates on which they were approved or amended by the Board of Directors.”

Practically, there is no check on the directors regarding imprudent decisions. Following are the three proposals to redress the situation.

Proposal 1There should be a maximum limit on the borrowing powers of directors such as a certain percentage of net equity. That limit should be prescribed in the Company Law.

The obvious advantage of this limit on borrowing is that this limit will itself take care of the excessive borrowing to hide the mismanagement by the directors. The directors of a company shall not be able to borrow beyond this limit.

The disadvantage is that sometimes directors have to borrow heavily to capitalize on an opportunity. Obviously heavy borrowing will increase the risk level for the company but at the same time it can be said that no risk no profit. Sometimes opportunity is there but the company does not have enough funds available to capitalize it. Therefore, this limit on borrowing at times may be detrimental to the concept of maximizing shareholder value. Another disadvantage in this limit is that law provides general guidelines. Law provisions cannot cover every situation and all the possible scenarios. Such a limiting provision may seriously hamper the growth of corporate sector in the country.

Proposal 2There should be a provision in the Articles of Association of every listed company that sets a maximum limit on the borrowing powers of directors such as a certain percentage of net equity or total assets.

The advantage in this proposal is that it gives flexibility on case to case basis rather than one solution fit all situations like law provision. Another advantage is that while giving certificate of incorporation regulators can verify that the borrowing limit is in line with the industry standard or not. This pre-checking will definitely protect the interests of the stakeholders.

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The disadvantage in this proposal is that sometimes directors genuinely and for the benefit of the company and its stakeholders need to go beyond the limit prescribed in the Articles but cannot do so. This would be a very serious impediment in the way of maximizing shareholder value. Even if the shareholders in AGM allow them, they have to go a lengthy procedure to avail the opportunity – amendment in Articles of Association – and by the time they are through the opportunity may have gone.

Proposal 3There should be a system of internal controls that plug the loop holes and strengthen the decision making procedures thereby reducing the chance of imprudent borrowing.

It is highly recommended that following provisions in the Companies Ordinance 1984 should be inserted to comply with mandatorily by all listed companies.

The board should include a balance of executive and non-executive directors (and in particular independent non-executive directors) such that no individual or small group of individuals can dominate the board’s decision taking.

There should be a formal, rigorous and transparent procedure for the appointment of new directors to the board. This procedure should be reported along with the compliance report of Code of Corporate Governance.

The board should maintain a sound system of internal control to safeguard shareholders’ investment and the company’s assets.

The board should establish formal and transparent arrangements for considering how they should apply the financial reporting and internal control principles and for maintaining an appropriate relationship with the company’s auditors.

The board should maintain a clear procedure for whistleblowing so that anyone within the company or outside the company is able to blow the whistle of any irregularity at an early stage.

Section 404 of the Sarbanes–Oxley Act may be adopted in true spirit that requires management to produce an “internal control report” as part of each annual report. The report must affirm “the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting.” The report must also “contain an assessment, as of the end of the most recent fiscal year of the Company, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting.”

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Provision should be inserted for criminal penalties for violation of any of the above provisions. Here, section 802 of the Sarbanes–Oxley Act may be adopted.

Provision should be inserted for criminal penalties for retaliation against whistleblowers. Here, section 1107 of the Sarbanes–Oxley Act may be adopted.

Recommendation to SECPWe recommend to SECP that Proposal 3 may be adopted. The recommendation is based on following:

Borrowing Powers of Directors and Corporate FailuresThe analysis, subsequent passage of the Act and its requirement as described above shows that borrowing power of the directors per se has nothing to do with the bad performance of a corporation. Rather bad performance and subsequent sudden collapse was the result of factors other than the borrowing powers of the directors. Heavy borrowing was done to hide the imprudent investment decisions. Mainly, these factors were:

1. Ineffectiveness of the board

2. Weak internal controls

3. Weak risk management

4. Lack of independence of external auditors

5. Insufficient financial information disclosure

6. Conflict of interests’ of directors, analysts and auditors

The Combined Code on Corporate Governance 2008 has something to say about directors’ role. Here is an excerpt:

“Good corporate governance should contribute to better company performance by helping a board discharge its duties in the best interests of shareholders; if it is ignored, the consequence may well be vulnerability or poor performance. Good governance should facilitate efficient, effective and entrepreneurial management that can deliver shareholder value over the longer term.

The Code is not a rigid set of rules. Rather, it is a guide to the components of good board practice distilled from consultation and widespread experience over many years. While it is expected that companies will comply wholly or substantially with its provisions, it is recognized that noncompliance may be justified in particular circumstances if good governance can be achieved by other means. A condition of noncompliance is that the reasons for it should be

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explained to shareholders, who may wish to discuss the position with the company and whose voting intentions may be influenced as a result.

In relation to the requirement to state how it has applied the Code’s main principles, where a company has done so by complying with the associated provisions it should be sufficient simply to report that this is the case; copying out the principles in the annual report adds to its length without adding to its value. But where a company has taken additional actions to apply the principles or otherwise improve its governance, it would be helpful to shareholders to describe these in the annual report.

If a company chooses not to comply with one or more provisions of the Code, it must give shareholders a careful and clear explanation which shareholders should evaluate on its merits. In providing an explanation, the company should aim to illustrate how its actual practices are consistent with the principle to which the particular provision relates and contribute to good governance.

In their turn, shareholders should pay due regard to companies’ individual circumstances and bear in mind in particular the size and complexity of the company and the nature of the risks and challenges it faces. Whilst shareholders have every right to challenge companies’ explanations if they are unconvincing, they should not be evaluated in a mechanistic way and departures from the Code should not be automatically treated as breaches. Institutional shareholders should be careful to respond to the statements from companies in a manner that supports the ‘comply or explain’ principle and bearing in mind the purpose of good corporate governance. They should put their views to the company and be prepared to enter a dialogue if they do not accept the company’s position. Institutional shareholders should be prepared to put such views in writing where appropriate.

Companies and shareholders have a shared responsibility for ensuring that ‘comply or explain’ remains an effective alternative to a rules-based system.”

Two very important points emerge from the reading the above excerpt that are relevant to our discussion:

1. The Code is not a rigid set of rules. Rather, it is a guide to the components of good board practice distilled from consultation and widespread experience over many years. While it is expected that companies will comply wholly or substantially with its provisions, it is recognized that noncompliance may be justified in particular circumstances if good governance can be achieved by other means.

2. Companies and shareholders have a shared responsibility for ensuring that ‘comply or explain’ remains an effective alternative to a rules-based system.

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Laws cannot cover everything and every situation. These are broad guidelines much like control charts having lower and upper limits within which different behaviors are acceptable. It is the intention that is required because laws can be circumvented when required. Therefore, both guidelines as well as intention to implement the guidelines in true spirit are required to avoid financial fraud.

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