Of Nails and Finance Companies...

Those who remember nursery rhymes will recall that for want of a nail the horseshoe was lost, then the horse, the rider, the battle and ultimately the kingdom. The rhyme has been recited for hundreds of years preaching the value of thinking through the logical progression of actions and equally tracing back through events to find the real cause. Might it be that the rhyme is as relevant today to the recent collapse of several New Zealand finance companies as it was to medieval battles in merry old England?

The collapse of these companies has seen calls from various quarters for counter measures such as increased trustee powers, more regulation and compulsory ratings by reputable rating agencies. Certainly one can appreciate the proper motives behind these measures. However from a governance point of view one can argue that these measures, while reclaiming the shoe, horse and rider, still leave out the nail itself.

In all the commentary on the collapses, a focus on the effectiveness of the relevant boards of directors has not been apparent. Boards of directors are ultimately accountable for the survival and performance of the companies they direct. The direction provided by, and the decision making of a board should be the first object of enquiry when a company fails. Directors have unique access to all company information on a more timely basis than for any trustee, regulator or rating agency and they are uniquely placed to act on this information before any other party. The question becomes then how directors in these companies should act best to avert collapse.

Care needs to be taken when making assessments. While fraud, negligence and carelessness may have characterised some board performances, there may also have been alert and informed boards simply being side stepped by a large market movement.

Formal requirements under companies and securities legislation are clear. Investors and shareholders are entitled to rely on the legal responsibilities of directors and those directors, if in breach of their duties and obligations, should bear the full cost. An active regulator is important in this regard as shareholder and investor led actions can be frustrated by lack of resources or combined purpose.

Quite apart from the formal requirements however, there exists the issue of a board’s decision making performance. An effective board of a finance company knows the risks of lending to higher risk and longer term borrowers while borrowing from fluid, risk averse and shorter term lenders. It is aware of both duration and liquidity mismatches between dollar investors in the company and real estate, property and chattel based borrowers from it. The effective board will also be finely attuned to the business cycle, aggregate demand across market sectors and the costs of credit as a margin above risk free lending.

An effective board will therefore always insist on rigorous and timely reporting covering such matters as asset quality, rollover schedules and liquidity management. Whenever any matter occurs which should put a board into a state of alert then the effective board will step up its surveillance and oversight. Contingency plans such as stand by funding, daily reporting and the ability to manage redemptions will be in place. The extent to which a lack of contingency planning has been at play in recent collapses, despite board vigilance, might be a separate issue.

While good decision making cannot guarantee survival or success, it can make it much more likely. The law does not require infallibility on the part of boards as hindsight is always a harsh critic, but it does require that the decisions are assessed at the time they are made and against legal standards.

So what governance questions can potential shareholders or investors ask of finance companies seeking their savings so as to reduce the risk of a poor investment?

Who are the directors? What has been their relevant experience not just as directors but as managers and business people? What are their qualifications? Are they members of professional bodies such as the IoD? Have they been accredited as a director by the IoD? Have they successfully directed companies through tough times before?

What is the quality and transparency of board processes? How are the directors selected, appointed and evaluated? How independent is the board and what is the degree of shareholder concentration at board level? Is there an independent audit committee? How regular and comprehensive is the board’s shareholder/investor communication programme and how receptive is the board to shareholder or investor enquiry? Some of the recent troubled companies might have emerged positively from these questions while for others the questions might have provided warning of unacceptable risks.

In either case there can be no guarantees but assuredly if the horse shoe is properly nailed then more often than not the kingdom can be saved.