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Imperial Audit: 42 Billion Reasons Why Directors Should Be Cautious

[vc_row][vc_column width=”2/3″][vc_column_text]A pilot was welcoming passengers to the flight shortly after take off. “Thank you for flying with us this morning. The weather is…..” He broke off his welcome with a sharp scream followed by, ”Oh my God, this is going to really hurt. It’s burning.” There was complete radio silence for a full minute before he returned. “Ladies and gentlemen I sincerely apologize for that incident, as I dropped a very hot cup of coffee on my lap. You should see the front of my trousers!” Out of the back came a worried shout from a passenger, “If you think yours are bad, you should see the back of mine.”

The Imperial Bank forensic report is out and any bank director, actually scratch that, any director of a Kenyan company should be having severe indigestion right about now. Following its findings, the Central Bank (CBK), the Kenya Deposit Insurance Corporation (KDIC) and the bank in receivership have sued nine individuals, one deceased person’s estate and eight companies in a bid to recover Kshs 42.4 billion of the banks assets and deposits. Yes, the figure is simply eye watering by its sheer size. This civil suit represents a watershed moment for corporate governance in Kenya. With the exception of three independent non-executive directors (INEDs), the other seven individuals (including the deceased) were directors representing the eight companies that were shareholders in the bank.

While the individuals are being sued for breach of fiduciary duty – a basic tenet of corporate governance – the companies therein named are being sued as being beneficiaries of what may come to be Kenya’s single largest corporate fraud since the 19th century explorer Henry Morton Stanley stepped off a boat onto Kenyan shores.
Over the period of ten years from 2006 to 2016, the bank was found to have operated two banking systems, with the illegitimate system passing through over billions of shillings in fraudulent disbursements over that period. The non-executive directors, including the chairman, were tightly joined at the hip and had cross shareholding in various other companies some of which were property related. In view of the fact that this was starting to look like a brotherhood of veritable kleptomaniacs, the three INEDs who joined in quick succession- two who joined on 1st of July 2014 and one on 1st February 2015- may not have been on the board long enough to cotton on what was, and had been, going on for the previous nine years. But today they are jointly and severally liable for years of mismanagement. These chaps were probably pleased as punch to have made it to the board at all and may have been snookered by the fast talking CEO, whose verbosity is alleged to have steamrolled various discussions on the board audit committee which he regularly attended. Now the three INEDs have to get lumped with the other directors all of whom have been painted with a mouthful of accusations over and above breach of fiduciary duty including negligence, gross negligence, fraud and theft.

One could very well argue then, that banks owe a duty of care to their directors to provide rigorous training in both corporate governance and risk management. There are now 42.4 billion reasons why bank directors need to know what they are signing up for. Actually, I could kick it up a notch and say that the CBK should require a made-for-purpose bank director training that one must undertake before they sign off on those ‘Fit and Proper Forms’ that are required for any bank director and senior officer before appointment to the board.
Yet the CBK is not entirely blameless in this mess, as all this happened on their watch. The regulator cannot claim that it relied on audited accounts to arrive at their conclusions for renewal of licenses. There were glaring irregularities in the governance such as the Board Executive Committee undertaking the role of the Board Credit Committee (BCC) without the proper structures in place including having an INED chair the BCC as per Prudential Guidelines. There were allegedly no notices for or minutes of meetings for a BCC from as far back as 2006. Someone was asleep at the wheel over at the banking supervision unit. The lack of INEDs until February 2014 should also have raised a slap on the wrist from the regulator. But it doesn’t appear to have. The only redemption here is that the regulator eventually stepped in, and quite likely because there was a new sheriff in that town.

Whether that amount of money is feasibly recoverable is something for the courts to determine. And directors should not try and draw comfort that they can ask the companies whose board they sit on to put in indemnification provisions in the articles of association or in their appointment letters. Section 194 of the Companies Act 2015 specifically voids any provisions that a company may make to exempt directors from any liability that attaches from negligence, default, breach of duty or breach of trust. However, companies are permitted to purchase Director and Officer (D&O) Liability Insurance to provide that specific indemnity from negligence etc. But there’s a catch. The same Companies Act does not allow D&O cover to provide indemnity (i) against fines from criminal proceedings, (ii) fines from regulators for non-compliance, (iii) defense of criminal proceedings and, finally, (iv) defense of civil proceedings brought by the company itself in which judgment is given against the director.

Therefore even if the Imperial directors had D&O cover, such cover busts two out of the four prohibitions above, viz (ii) and (iv) since the company is the plaintiff in the civil suit.

What’s the moral of this sordid story? Being a director of any company is risky business. Being a director on a board full of business buddies is even murkier business, the kind that requires one to keep a set of adult diapers on hand as they undertake the flight of their lives.
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Twitter: @carolmusyoka[/vc_column_text][/vc_column][vc_column width=”1/3″][/vc_column][/vc_row]

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Chasing The Truth In Parliament

[vc_row][vc_column width=”2/3″][vc_column_text]Last week, an unlikely source in the form of a Parliamentary Committee helped to unseal the tightly held lips of the Chase Bank’s board of directors. The directors had been summoned to assist the Committee to understand the challenges that faced the Bank, resulting in the same being placed under receivership by the Central Bank of Kenya. This was an opportunity for the board to give its side of a controversial story, a tale that has as many versions as there are heads to the Greek mythical hydra. The story caught my attention for one reason only: The directors called the auditors professionally ignorant. Actually let me quote the exact statement here: “The Musharakah Agreements for each of the SPVs clearly show Chase Bank’s 99% interest in the Musharakah assets. Deloitte’s insistence on treating this as a normal loan or advance can only be labelled as professional ignorance at best.” Part of the dispute between the auditors, Deloitte in this case, and the board of directors has been on the treatment of a series of real estate transactions either as internal loans to a key shareholder (according to the auditor) or as Musharakah assets (Islamic financing terms according to the directors). So I pored over the submissions made by the directors in their vigorous defence of these assets.
Banking is premised on the fact that there are depositors who want a safe place to put their money, and there are borrowers who require to borrow funds for consumption. The bank is simply an intermediary. In the case of Islamic banking, the institution applies Sharia compliant procedures in the booking of those deposits and loans. The key point here is: there must be a customer. Period. Finito. Whether it is mainstream or Islamic banking there must be an individual or an entity who is the customer. But the directors state thus in their parliamentary submissions:
“Subsequently, Deloitte rejected the Musharakah Agreements and Deloitte insisted that the Musharakah properties be charged to the bank, thus effectively classifying the SPVs as Loans and Advances rather than Islamic investments as documented. These loans would then become technical insider loans, as the shares in the SPVs were held by the two directors, albeit held in trust for the Bank. Chase Bank’s Management emphasised to Deloitte that treatment of the Musharakah assets as Loans and Advances would be in contravention of not only the principles of Islamic banking (and therefore a breach of trust with Islamic depositors), but also of Section 12(c) of the Banking Act and
would incorrectly treat these as an insider loan. It was evident that Deloitte were simply not interested in appreciating the nature and substance of the Musharakah Assets or the principles of Islamic banking.”

I scratched my head and read the report twice over. At no point did the directors say who the ultimate customer was. I mean, a bank doesn’t wake up and decide to give a loan out to a customer, whether Islamic or otherwise. Why was there no attempt to say that this was an unfair treatment of a yet-to-be-named customer who had borrowed from the bank in good (Islamic) faith? That the assets were bought in the name of the SPV is not in doubt. That the SPV has two Chase directors as the shareholders is not in doubt. But where the shareholders were holding the shares “in trust” for the bank is where it starts to get “grab-a-bag-of-popcorn” interesting. The directors fail to mention if a “deed of trust” was provided to the auditors as evidence of that understanding between Chase Bank on the one hand and the SPV shareholders on the other. I mean, one doesn’t assume trust falls off the back of the Kisumu express train, it must be documented somewhere, right? The directors beat their Islamic financing drum further by dragging in the regulator into their drama: “On 26th July 2012, Chase bank wrote to the Director of Bank Supervision at CBK requesting CBK to revise the Central Bank Prudential Guideline on Publication of Financial Statements and Other Disclosures to accommodate Islamic products and
specifically:
(i) the Islamic Banking Income received to be reflected separately in the Profit and Loss
Account;
(ii) The Islamic Banking Expenses also to be reflected separately in the Profit and Loss
Account;
(iii) The Islamic Banking investments or Financing Activities as a separate Asset line in the
Balance Sheet;
(iv) The Islamic Deposits or Liabilities as a separate Liability item in the balance Sheet; and
(v) A separate Off Balance Sheet line item for Islamic banking.
The CBK has not objected, in the absence of any changes to the Prudential Guidelines, to the classification and treatment in any of its reports to the Bank.”

I have to admit, that this submission by the directors stumped me. If you wrote to the regulator and asked to be reporting Islamic Banking products separately, and the regulator did not object, then why do your 2014 and 2015 financial accounts not reflect the same? I zoomed across to the only fully-fledged Islamic Banks in Kenya, Gulf African Bank and First Community Bank (FCB) websites to see how their Islamic assets are recorded. Their professionally competent auditors in the name of KPMG and PriceWaterhouseCoopers (PWC) respectively reported loans as “financing activities (net)” exactly as Chase had requested the CBK to do in (iii) above. (It’s noteworthy that PWC audited the FCB accounts in 2014 but the 2015 published accounts are silent on who their auditors were) If Chase directors had knowledge as far back as July 2012 on how “Musharakah Assets” should be recorded on the balance sheet why wait until June 2016, or four years later, to call their auditors professionally ignorant? And why are the Islamic depositor funds not separately recorded yet the directors have vigorously highlighted the potential breach of trust for the Islamic depositors if Musharakah Assets are treated as loans and advances?

The Chase Bank saga is a case study of corporate governance failure, weak internal controls, questions on the auditors’ scope and depth of review and a passionate to almost rabid love for the brand by its most loyal customers. But on the back of all of that are innocent depositors who must always remain in the minds of all bank directors whose oversight role gets heavier with each passing day.

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Twitter: @carolmusyoka[/vc_column_text][/vc_column][vc_column width=”1/3″][/vc_column][/vc_row]

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Confluence of Political and Economic Risks

I recently dined with a European diplomat who asked the ubiquitous question that foreign residents in this country like to do: “What do you think will happen at the next Kenyan elections?” Before I tell you what I answered, I have to state categorically and most unequivocally that I am neither a political analyst nor commentator. I do, however, occasionally comment on the confluence of politics and economics as often happens invariably. That confluence is particularly necessary in the banking industry, where I spent many happy years, when analyzing credit risk of a customer for a term loan of not less than five years.

Within the duration of that loan such a customer is bound to cross the Kenyan election cycle. Depending on the nature of the customer’s business, the company is likely to have difficulties in loan repayments due to cash flow constraints occasioned by poor sales, deplorable debt collections or, heaven forbid, destruction of the company premises therefore impacting on the ability to produce the goods and services that are being procured. My answer to the diplomat saw him imperceptibly swallow and he leaned forward in interest.

“There will be bloodshed in 2017 as the historical patterns demonstrate it.”

“What do you mean?” he whispered.

“In banking, we look at historical behavior as a strong barometer of what future behavior is likely to portend. To understand our history of political violence, you have to start in 1992 when the first multi party elections were held,” I began. “In that year, you had an incumbent who was running against a very strong and credible opposition. That was when Kenya endured the first of several bloody episodes of tribal clashes.” I went on. “In 1997, the same incumbent was running for his second and last term as president. He had the benefit of the state machinery behind him, as well as a fragmented opposition. This time, the political waters were muddied in the coast region, where the pre-election clashes were largely centered. The coastal tourism economy very nearly collapsed and the hotel industry underwent massive bankruptcies.”

“Well what do you make of the peaceful election in December 2002?” the diplomat asked. “Doesn’t that destroy the pattern of electoral violence?”

“Actually, therein lies the pattern,” I responded. “Every time an incumbent is stepping down, there has been a peaceful transition in Kenya. It happened in 2002 and in 2013. But whenever there’s been an incumbent fighting to maintain the status quo, there has been bloodshed; ergo 1992, 1997 and 2007. The 2017 elections are a status quo event. The pattern will be the same.” My lunch partner mulled over this for a few minutes and promptly changed the subject.

In 2008, a few banks took advantage of the politically instigated clashes in the beginning months of the year to blame the growth in non-performing loans. Some of this was not entirely true and was a slick way of reporting previously suppressed bad loans. But you’d think that the regulator would have cottoned on to the games being played. It didn’t. It is not difficult to see why, when you look at the kind of pedestrian analysis the banking supervision department at the Central Bank of Kenya (CBK) undertakes. In the recently released 2014 Bank Supervision Annual Report, the Central Bank dedicates the monumental amount of three sentences to analyze the 2014 asset quality of the entire banking industry. I will pick two of the three sentences as an illustration:

“ The lag effects of high interest regime in 2012/2013 and subdued economic activities witnessed in the period ended December 2014 impacted negatively on the quality of loans and advances. As a result, non performing loans (NPLs) increased by 32.4% to Kshs 108.3 billion in December 2014 from Kshs 81.8 billion in December 2013.”

When your non-performing asset book increases by a third, it requires a fair amount of explaining beyond the vanilla high interest rates and subdued economic activities reasoning. There should be a fairly robust amount of granularity around the specific industries driving the poor performance of loans. It is an open secret that the central government endured inordinate cash flow challenges in 2014 that impacted key suppliers of services, particularly in the construction industry. This would invariably have a knock on effect to the suppliers of construction companies such as cement, cable and ballast for example. But this is what should be of concern as we hurtle towards an election cycle in the next two years. The retail loan book across the banking industry is the single largest loan segment with 3.6 million accounts grossing Kshs 516 billion and accounting for 26.6% of total loans in the market. This is ahead of trade at Kshs 375 billion (19.3% of total loans) and manufacturing at Kshs 237 billion or 12.2% of total loans. Retail loans, codified by the CBK as personal/household loans, are consumer loans and in this market represent the largely salary check off loans that pepper many banks’ unsecured loan offers. It’s highly likely that the bulk of these loans are used to purchase consumer items such as cars, furniture and electronics rather than investment in income generating activities. A political event such as post election violence, followed by an economic downturn caused by reduction in productive capacity of Kenyan companies will lead to retrenchments. You can also never underestimate the capacity of cheeky borrowers to take advantage of politically volatile environments to stop repaying loans due to destruction of work places and such like sob stories. I saw it happen in 2008.

A notable risk therefore sits in the banking industry come 2017: any delays in government payments (partly occasioned by tax collection difficulties on the part of Kenya Revenue Authority) together with probable election related violence will negatively impact bank loan books. Don’t be surprised if you find difficulty getting an answer on your loan application that year. Your bank is just not that into you in an election year.

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Twitter: @carolmusyoka