Corporate governance principles can help boards spot fraudulent activities

Steinhoff directors were largely kept in the dark due to limited powers afforded by German regulations

The recent Steinhoff accounting irregularities saga that led to the demise of one of the jewels of Africa has lifted a corporate veil on the extent to which companies have embraced corporate governance principles and the effect the board structure has on the value of a company.

Steinhoff’s primary listing in Frankfurt and registered head office in Amsterdam enabled the company to use the Dutch Corporate Governance Codes. The company has a two-tier board structure comprised of management and supervisory boards, in line with these codes. This board structure in not used in other markets such as the US, UK and SA. The preferred structure in these markets is a unitary board system, where all board members are elected at one time.

The two-tier board structure Steinhoff adopted is not consistent with the recommendations of the King Code on Corporate Governance, which strongly advocates a unitary board structure, to the extent that in the recently published King IV Codes, the reference to “board” from King III has been changed to “governing body”, in line with Mervyn King’s assertion on the need for strong governance, citing the change in the business landscape over the years and the embedded uncertainties that have befallen market economies globally.

When looking at the performance and value creation by companies as cited in the King IV Code, the governing body must:

● Lead the value creation process by appreciating that strategy, risk and opportunity, performance and sustainable development are inseparable elements. Ensure that reports and other disclosures enable stakeholders to make an informed assessment of the performance of the company and its ability to create value in a sustainable manner.

The onerous responsibility of the board of directors to have intimate knowledge of what is happening at company level was lacking at Steinhoff. Such knowledge would have enabled the board members to be effective while carrying out their duties and asking the right questions. However, due to limited powers afforded to the supervisory board by the German regulations, weak emphasis on the strength of the board by the Dutch Governance Codes made it possible for some board members to be in the dark as to what was happening at Steinhoff.

This is consistent with what former Steinhoff chairman Christo Wiese alluded to when questioned in Parliament a few weeks ago, when he said the accounting scandal that befell the company “was literally a bolt out of the blue”. According to Wiese’s testimony, trust at Steinhoff reigned supreme over the tenets of good corporate governance, inquiring minds and professional scepticism that board members should possess at all times.

● Play an oversight role in organisational changes that have an effect on the operational and strategic direction, including leverage decisions and the amount of debt companies should carry on their books.

It should be inconceivable to look at the structure and composition of a board of directors without analysing capital structure decisions taken by management.

However, the agency problem arises when the co-operating parties share different goals.

The agency theory is directed at the ubiquitous agency relationship in which the principal (shareholders or board) delegates work with the agent (management).

One of the problems that can occur in agency relationships is that shareholders or members of the board find it difficult to verify management decisions because of information asymmetries between the two parties. In the case of Steinhoff, one can infer that the information asymmetries led to Wiese taking on more debt to increase his shareholding in the firm and the supervisory board not questioning management’s decisions for embarking on an aggressive acquisition growth strategy that was too erratic, mainly funded by debt and had no clear post-acquisition operational implementation plan. It is quite telling that this never discouraged Steinhoff’s creditors from extending lines of credit, term loans, acquisition finance and growth capital.

Agency cost of managerial discretion is most likely to occur because of management’s inclination to reduce inherent business risks through sophisticated corporate actions and business restructuring mechanisms. The performance pressure managements are subjected to when the company has taken on large amounts of debt is considerable.

A highly levered company has a higher probability of defaulting on its debt obligations. In most instances, businesses often conclude that gearing is the best form of capital finance without mentioning that it increases the business risk.

Admittedly, the remedy of this management practice is a strong, well-capacitated and independent board of directors whose duty is carried out by nothing other than good corporate governance principles where high ethical and moral standards are maintained.

● Comprise a diverse range of board members who are empowered to and capable of asking tough questions.

How a company board is constituted has a huge effect on firm value and the future sustainability prospects of the business. A company’s response to corporate governance can be attributed to the muscle or timidity of its board.

Do shareholders appoint board members who will soon turn into a bunch of “yes-men” who lack courage to scrutinise and interrogate management practices? To what extent is the diversity of thought in these board committees embraced? And what about diversity in terms of race, colour, culture and gender?

The notable economists Quamrul Ashraf of Williams College and Oded Galor of Brown University have claimed in one of their studies that diversity stimulates economic growth and homogeneity slows it down. It is incumbent upon each company to promote diversity of thought at board level.

If enthusiastically embraced and promoted, diversity is most likely to have a positive effect on the value of the business.

A well-structured and constituted board of directors has the potential to increase the value of the firm because of the following:

● Power within the company is decentralised and not vested within a selected few board members who will dominate and bulldoze other members for the duration of their board term. This will ensure business continuity and serves as a platform for all committee members to analyse and interrogate management practices and their decisions.

● Diversified company boards allow constant change of ideas with the sole purpose of maximising company value. This opens board committees to fresh ideas on a regular basis on how best to respond to corporate governance principles to ensure the business is a responsible corporate citizen.

● Different sections or executive board committees will depend on one another and work together to co-ordinate their activities. This reduces improper practices by the executives, who might otherwise lobby for protection from shareholders on their improper business conduct, to the detriment of the minority shareholders

● The atmosphere of trust at board level is likely to be strengthened and fellow board members are likely to encourage this as it has positive prospects to the growth of the company.

Company boards are key drivers in achieving excellence and a well-strengthened board, including the subcommittees, serves as a platform to engage management on their processes, including the decision-making and the extent to which these decisions affect the longterm sustainability of the business. Efficient company boards are most beneficial to investors and the company itself, even more when such boards are filled with high-calibre members who have due care and skills.

Shareholders need to appoint board members who will share the purpose and desire to grow the business, steer the company towards a socially and environmentally responsible state and, most importantly, embrace transformative policies such as affirmative action, employment equity and broad-based black economic empowerment, to mention but a few.

A well-structured and constituted board of directors minimises net agency costs and other inefficiencies and strengthens its ability to deal with under- or over-investment problems.

In addition, the principles of good corporate governance are not compromised but promoted, including transparent risk reporting across all lines of business. Management committees also need to understand the critical role they ought to play in ensuring the companies they lead are environmentally, economically and socially responsible. Due professional care, professional scepticism and honest and transparent reporting must be promoted. The absence of these tenets renders businesses susceptible to fraudulent activities and/or corporate actions that do not promote the interest of stakeholders.

Lastly, any improper conduct by management has a direct and immediate effect on the value of the business, as illustrated in the case of the Steinhoff accounting irregularities saga, to the detriment of all stakeholders, including employees, equity holders, debt and bondholders, and the economy at large.

A well-structured board of directors serves as an effective instrument and a good measure of corporate governance.

The oversight role the board of directors and its subcommittees play should never be limited to signing off meeting attendance registers and correcting spelling errors in the reports tabled for discussion. They are duty bound to conduct a thorough analysis of management decisions and processes.

HOW A COMPANY BOARD, AND ITS MEMBERS, IS CONSTITUTED HAS A HUGE EFFECT ON FIRM VALUE AND THE FUTURE SUSTAINABILITY PROSPECTS OF THE BUSINESS