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Low Corporate Governance for Controlled Companies Part II

[vc_row][vc_column width=”2/3″][vc_column_text]Last week I demonstrated the interesting phenomenon of stock market investors who were willing to buy shares, and, in some cases, at a high price to earnings ratio, of companies that had openly stated that they were not interested in having independent directors, having a committee to nominate directors or a committee to review compensation terms for management. One more thing, these companies had little to no shareholder rights. Amongst the egregious governance dodgers are the little known Google (or rather, Alphabet, its parent), Berkshire Hathaway and Facebook.

ISS Governance, an independent corporate governance rating agency, gives NYSE and NASDAQ traded companies a quality governance score based on four pillars: audit and risk oversight, board structure, shareholder rights and Compensation. On a graduating scale of 1 to 10 with the latter being the lowest score and therefore demonstrating higher governance risk, Facebook’s governance score is a resounding 10! It gets a good score of 2 for audit but everything else slides into governance oblivion when board structure rated a 10, shareholder rights rated a 9 and compensation rated a 10.

How do these companies do this? Their capital structure typically has two classes of shares: Class A and Class B. So the owners of a private company who wish to go public to raise present or future capital, or help establish price discovery for the value of their shares, can still maintain tight control over decisions, while diluting their ownership using a dual class share structure. In a case like Facebook, Mark Zuckerberg owns only 18% of the common stock but has over of the 50% voting power, largely by structuring the class B shares that he owns to have ten times more voting power than the regular class A shares. According to a Forbes magazine May 2012 article titled “ Facebook Ownership Structure Should Scare Investors More Than Botched IPO”, these kinds of structures are fairly commonplace in Silicon Valley with the likes of Google, LinkedIn and Zynga. It is also noteworthy that other big brand names like Nike, Ralph Lauren and Estee Lauder have similar structures.
According to Investopedia, the common practice is to assign more voting rights to one class of shares than the other to give key company insiders greater control over the board and corporate actions. These super voting share structures are also good defenses against hostile takeovers where a party can purchase a significant quantity of shares on the open market as to demand a seat at the board table.

Controlled companies are able to do this because NYSE and NASDAQ rules permit these structures for as long as there is full disclosure at the Initial Public Offering stage, and further ongoing filing disclosures. These disclosures should state exactly what corporate governance standards the company is failing to comply with. Thus the American stock investor has to be savvy enough to research the share structures of the companies they wish to purchase before rocking up at the Annual General Meeting and making a fool of themselves demanding to see compensation policies for senior management and all that independent director nonsense that good corporate governance dictates.
But why should the ordinary Kenyan business owner care about all of this? Were such structures permissible on this side of the pond, then it’s fairly safe to assume that we would see more family owned businesses view the Nairobi Stock Exchange as a viable option for capital raising and price discovery without the requisite nuisance value that external shareholders are viewed to bring. A good example would be the supermarket chains such as Nakumatt, Tuskys and Naivas. Or the big local manufacturers like Bidco and Menengai Oil. The flip side of the argument is that without good corporate governance, the current cash flow issues clearly facing Nakumatt’s management would severely infect investor perceptions of other family owned businesses with opaque board structures and have a knock on effect on their market valuation. Controlled company structures require tightly run management practices that stand the test of economic vagaries. With only about 6% of American companies having these kinds of structures it demonstrates that it takes a special kind of owner to convince external shareholders to just forget about governance and put your money where our mouth is!
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Twitter @carolmusyoka[/vc_column_text][/vc_column][vc_column width=”1/3″][/vc_column][/vc_row]

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Shadow Directors

Maneno Ltd is a Nairobi Stock Exchange Listed company in the business of manufacturing consumer products. The founder, Michael Monga, was a well-respected businessman with multiple interests in various industries some of which interests have led to obvious potential conflicts. As Monga was quite alive to the effect of negative publicity on his business interests, he often appointed proxies to the boards of companies in which he was a substantial owner. Maneno Ltd had three such directors, who were senior employees in Monga’s other companies. Monga, being a very shrewd player, was also careful to select independent non-executive directors that could be prevailed upon to play ball where required.
Due to a fairly loose enforcement regime, cheap imports of the same consumer products that Maneno manufactured had started to flood the Kenyan market and management were spending valuable time firefighting with the relevant government agencies. Prudent past management had ensured that a significant amount of cash had been set aside and invested in money market instruments in anticipation of a strategic plant expansion that had been planned in the 5 year strategy. Monga instructed his three directors to support the Managing Director’s board paper recommending an interim dividend. That seemed strange as the financial projections indicated that the company was going to make a loss that year due to shrinking sales. The paper was approved and a special dividend was paid. The company went ahead to make losses and the following year a hefty final dividend was declared that essentially wiped out the healthy cash reserves that Maneno had been holding. As sordid stories go, within no time Maneno was bleeding cash, as management was unable to stem the effect of cheap imports versus their own locally manufactured products in an aging plant with high labor costs. The company filed for insolvency within two years of the final hefty dividend payout.
What potential remedies exist for the minority shareholders who were held at glorious ransom by the corporate shenanigans of Michael Monga? Both Kenya and Uganda have recently revamped their company laws from the archaic 1948 UK Companies Act that formed the basis of local company law. Uganda passed the Companies Act 2012 and Kenya followed suit with the Companies Act 2015 both of which laws essentially aligned company law with modern norms such as the concept of a shadow director. Company law defines a shadow director as someone who has not been formally appointed as a director but in accordance with whose directions or instructions the directors of a company are accustomed to act.
If you’re struggling to picture one, think of a multinational company in Kenya, whose board is regularly instructed by “group” via the managing director, on when to declare dividends or when to postpone making critical provisions on their financial statements. It can also be the finance director of a Kenyan company that has regional subsidiaries and demands the same financial behavior of the subsidiary boards. [It bears noting that the Tanzanian Company Act 2002 does not expressly define shadow directors.] It can be a cabinet secretary who regularly issues instructions to the board of a limited liability company with significant government ownership. In the Maneno Ltd example, Michael Monga is a classic example of a shadow director. Not only was he giving express instructions to the non-executive directors, but he also ensured that he indirectly controlled the board through the appointment process. For all intents and purposes, Monga was the board.
Company law recognizes that while de jure directors (directors by law) have fiduciary duties to the company including the duty to act in the best interests and promote the success of the company, de facto directors (directors in fact) also owe the company fiduciary duties and can therefore be held accountable for their acts in the same vein as the directors on record. This premise was established in the 2013 landmark United Kingdom case of Vivendi SA and Centenary Holdings Ltd versus Murray Richards and Stephen Bloch. In the case, as succinctly summarized on the Helix Law website, a shareholder of a company in trouble used his influence to make the sole director of the company pay him a salary and other money from the company, without providing any benefit or services back. These payments were made while the company was insolvent. The company went into liquidation and its receiver claimed compensation from the shareholder claiming that a) he was a shadow director b) a shadow director owed the company fiduciary duties as if he had been formally appointed as a full de jure director and c) the shareholder had breached those duties. A Burges- Salmon blog on the shadow director subject matter summarized the court’s findings thus: On the first issue, the court found that the sole director was accustomed to acting in accordance with the shareholder’s instructions and therefore the shareholder satisfied the test for shadow directorship. On the second issue it was found that in giving instructions to de jure directors, a shadow director assumed responsibility for a company’s affairs. However while a shadow director’s duties were not statutorily provided for, the consequences of being found to be a shadow director must evidence Parliament’s perception that a shadow director could bear responsibility for a company’s affairs. The court also observed that a shadow director’s role in a company’s affairs might be just as significant as a de jure director, and that public policy pointed towards statutory duties being imposed on shadow directors.
What does this mean for Michael Monga and many like him?
Company Law now provides extraordinary personal consequences to the shadow director including: a liability to contribute to the company’s assets following the company’s insolvency, disqualification from being a director of any company in Kenya following the company’s insolvency as well as criminal sanctions and personal liability for violations of director’s duties.
As a parting shot, while de jure directors may rely on Directors and Officers insurance cover, the shadow director is most definitely not covered under the same. If you sit on a Kenyan or Ugandan board, now would be a good time to look over your shoulder and find those shadows.
[email protected].
Twitter: @carolmusyoka[/vc_column_text][/vc_column][vc_column width=”1/3″][/vc_column][/vc_row]