As part of his PhD research Dr. Keith Fairhurst analysed data extracted from business rescue plans and business rescue documents published during the business rescues of 104 privately owned South African companies that had entered business rescue since 2011. A focus of the analysis was the amount of shareholding held by management and the board composition of the companies. The variables studied included, fraction of total equity owned by management, total number of directors, number of independent directors and the existence of board duality. Board duality is the term used to describe the situation where the CEO and Chairman of the board are the same person.
For the sample studied the average board size was 1.89 directors and the average number of independent directors per company was 0.02. These are somewhat alarming statistic because it is commonly understood that a predominance of independent directors is a good corporate governance practice. A further alarming statistic that was revealed is that out of the 104 cases studied only 2 had independent chairpersons on the board.
Both of these statistics are at the opposite end of the scale of what is proposed as good practice in King III, King IV and the UK’s combined code. Furthermore in previous research, board size has been shown to correlate with the incidence of distress (larger boards correlate with a lower incidence of distress) and board diversity has also been shown to be associated with the prevention of distress.
The research showed that on average 93.8% of the equity of the 104 companies was owned by the management of the companies. This is significant in light of other research that confirms, that where management owns a significant portion of equity in a firm, then they may see the firm as existing for their own utility maximization exclusively. Such management may take decisions that are not aligned with the best interests of the firm, particularly if the firm is financially distressed. Furthermore these circumstances may result in shareholders resisting implementation of good governance policies and practices, and also resist the appointment of a robust and independent board. This may not be a problem while a company is healthy and meeting its debt obligations. However, should a company become distressed then the lack of indpendent oversight becomes an obvious problem.
So if one of the prime roles of the board is to monitor management, the board must be independent of management, with the CEO not acting as the board chair. The board must also be large enough that it will be difficult for management to control the board. This research shows convincingly that this is not the case for private firms in financial distress in South Africa and should be of particular interest for creditors. Creditors of privately owned firms that are in financial distress cannot expect any independent oversight of management decisions and actions. Once a firm has reached this point, the creditors will have to rely exclusively on legal processes to protect their exposure as the firm’s reputation is also unlikely to be very good. Legal processes include all the remedies provided for under formal business rescue “Chapter 6 Business Rescue and Compromise with Creditors” (Companies Act 71 of 2008, 2011).
In summary management of privately owned companies in financial distress are likely to be more oriented towards protecting their personal utility position than serving the interests of the company and it is likely that management inertia will result in a worsening of the financial position. Thus it would be advisable for creditors, particularly those that are unsecured, to take swift and bold action.
It follows that a robust and independent board could be very beneficial to creditors but the incumbent managers who are also the shareholders are unlikely to promote this. Therefore the providers of credit or the insurers of providers of credit to privately owned companies could consider actively encouraging robust corporate governance practices in the companies who make use of the credit, long before there is any hint of financial distress. After all, once a company is in financial distress it may be too late.