[21-12-2009]

Group I

[Muhammad Saeed Babar Reg. # MM073003

M Asim Ullah Reg. # MM081023
Shahat Khan Reg. #
Ashfaque Habib Reg. # MM073007]

[BORROWING POWERS OF DIRECTORS OF

PUBLIC LIMITED COMPANY]

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Borrowing Powers of Directors of
Public Limited Company
Introduction
Corporate governance is to ensure that a system is in place to protect the
individual as well as collective interests of all the stakeholders in a company.
In this respect the role of Board of Directors becomes very important
because by its very nature a company is an artificial juridical person in the
sense that it can sue and can be sued. But it works through its directors who
are its eyes, brain and muscle. Directors are the persons who run day to day
affairs of the company and possess the first hand information about every
aspect of its operations. Directors are also in the best of position to
determine its future course i-e set objectives, formulate strategy, devise
operational plans etc. Shareholders are the owners of the company who
provide capital to the company for its operations but do not run its affairs
and delegate this function to professional managers. These professional
managers may also be shareholders of the company. This separation of brain
and capital poses agency problem and dual role of directors, shareholders as
well as directors creates conflict of interest with other stakeholders such as
outside shareholders.

In the wake of recent financial crises and recent past failure

of Enron, Worldcom and Parmalat, a heated debate is going on the role of
directors and the board in the governance of corporate world. Much of the
debate is centered round the structure of the board, integrity of the financial
reports, auditing, shareholder activism, corporate governance rules and
regulations etc. A very little attention has been given to the concept
of borrowing powers of the directors. One of the elements of the powers
enjoyed by the directors is that these may be misused and abused as well. If
these are being misused, it means due care and necessary diligence has not
been taken care of and if these are being abused, it means these are used
for the purposes other than the benefit of the company. In these both cases,
the tendency or some inclination to misuse and /or abuse powers can lead to
disaster. As a precautionary measure, there is a need to put some checks on
the use of powers enjoyed by the directors. One of the powers given to
directors or used by the directors on behalf of the company is borrowing
power. There is no restriction on the borrowing powers of the directors in
Articles of Association and neither there is any law that restricts this power.
However, there are rules and regulations for the lenders that prohibit them
to lend in case of borrowing beyond a certain percentage of equity but
generally there is no restriction on borrowers.

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As directors manage a corporation for and on behalf of the shareholders who
own it, it is critical that any regulatory and legal requirements placed on
directors do not seriously compromise their goal of maximizing shareholder
wealth. Directors’ behavior influences the efficient operation of corporations.
If directors are subject to undue transaction costs in protecting themselves
from personal liability, these costs will ultimately be passed onto, and borne
by, the corporation itself. On the other hand, if directors are permitted to
operate completely unfettered by regulation and a degree of shareholder
control, investor confidence in the corporate may potentially be undermined.
In this regard, it is clear from past experience, particularly in relation to the
corporate collapses as mentioned above, that the conduct of directors
through corporations can have a significant impact on public perceptions and
market confidence.

While regulatory requirements are usually placed on directors as a means of

protecting investors, or the general public, such protection may well be
achieved at the expense of investors themselves. Accordingly, it is vitally
important that any measures put in place as a means of promoting investor
protection are properly assessed from an economic perspective to ensure
that they do not ultimately act to the detriment of shareholders as a whole.
To promote investor confidence and thereby facilitate expansion of capital
market, investors need to be satisfied that they have sufficient opportunity
for redress against a corporation and its directors in clear cases of negligent,
reckless or fraudulent conduct. However, directors who effectively control
the corporation must not feel so over-burdened with a fear of responsibility
that their decision-making is seriously constrained. Regulation in the area of
directors’ duties and shareholders’ rights invariably involves a fine balance
between maintaining investor confidence and encouraging commercial
enterprise. In the interests of maximizing shareholder wealth and economic
growth, directors need to be encouraged to take enterprising decisions.
However, these decisions must be taken in the interests of the company and
be challengeable if they are not bona fides and well informed.

In the backdrop of above deliberations, it is important to thoroughly evaluate

the possibility of check on the borrowing powers of the directors. This paper
shall examine the all possible ways in which such a check can be placed and
a critical analysis of each alternative shall be put forward. Finally, a
recommendation shall be made whether such a check is required or not and
if required what necessary amendments in Company Law are required.

Root Cause Analysis of Corporate Failures

A variety of complex factors created the conditions and culture in which a
series of large corporate frauds occurred between 2000-2002. The
spectacular, highly-publicized frauds at Enron, WorldCom etc. exposed

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significant problems with conflicts of interest and incentive compensation
practices. The analysis of their complex and contentious root causes
contributed to the passage of Sarbanes–Oxley Act in 2002. In a 2004
interview, Senator Paul Sarbanes stated:

“The Senate Banking Committee undertook a series of hearings on the

problems in the markets that had led to a loss of hundreds and hundreds of
billions, indeed trillions of dollars in market value. The hearings set out to lay
the foundation for legislation. We scheduled 10 hearings over a six-week
period, during which we brought in some of the best people in the country to
testify… The hearings produced remarkable consensus on the nature of the
problems:

1. Inadequate oversight of accountants

2. Lack of auditor independence

3. Weak corporate governance procedures

4. Stock analysts’ conflict of interests

5. Inadequate disclosure provisions, and

6. Grossly inadequate funding of the Securities and Exchange

Commission.”

Response
In line with the findings of the Senate Committee, Sarbanes–Oxley Act was
enacted in 2002. The Act requires from the management and the external
auditor to report on the adequacy of the company's internal control over
financial reporting (ICFR). Under Section 404 of the Act, management is
required to produce an “internal control report” as part of each annual
Exchange Act report. The report must affirm “the responsibility of
management for establishing and maintaining an adequate internal control
structure and procedures for financial reporting.” The report must also
“contain an assessment, as of the end of the most recent fiscal year of
the Company, of the effectiveness of the internal control structure and
procedures of the issuer for financial reporting.” To do this, managers are
generally adopting an internal control framework such as that described
in COSO (Committee of Sponsoring Organizations of the Treadway
Commission). The Public Company Accounting Oversight Board (PCAOB)
approved Auditing Standard No. 5 for public accounting firms on July 25,

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2007. This standard superseded Auditing Standard No. 2, the initial guidance
provided in 2004. The SEC also released its interpretive guidance on June 27,
2007. It is generally consistent with the PCAOB's guidance, but intended to
provide guidance for management. These two standards together require
management to:

1. Assess both the design and operating effectiveness of selected internal

controls related to significant accounts and relevant assertions, in the
context of material misstatement risks;
2. Understand the flow of transactions, including IT aspects, sufficient
enough to identify points at which a misstatement could arise;
3. Evaluate company-level (entity-level) controls, which correspond to the
components of the COSO framework;
4. Perform a fraud risk assessment;
5. Evaluate controls designed to prevent or detect fraud, including
management override of controls;
6. Evaluate controls over the period-end financial reporting process;
7. Scale the assessment based on the size and complexity of the
company;
8. Rely on management's work based on factors such as competency,
objectivity, and risk;
9. Conclude on the adequacy of internal control over financial reporting.

Corporate Culture in Pakistan

In the context of Pakistani corporate culture where listed companies are
mostly controlled by families, shareholder activism as suggested by the
Combined Code of CG is not possible. It is also not possible to wholly rely of
the Board of Directors since all the directors are from the same controlling
group or do not have necessary independence. Neither there is any culture
of non-executive directors and nor there is any concept of independence.
Since, the majority of listed companies are controlled by families; therefore,
their boards are dominated by strong personalities. Auditors are also out of
question because of their conflict of interests mainly due to non-audit
business and long time continuously auditors of the company. In these
circumstances, we are left with only one option and that is mandatory law
provisions to check any misuse of powers.

The Companies Ordinance 1984 states:

“Sec. 196(2) The directors of a company shall exercise the following powers
on behalf of the company, and shall do so by means of a resolution passed at

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their meeting, namely. —
(a) to make calls on shareholders in respect of moneys unpaid on their
shares;
(b) to issue shares;
(c) to issue debentures or participation term certificate, any instrument in
the nature of redeemable capital;
(d) to borrow moneys otherwise than on debentures;
(e) to invest the funds of the company;
(f ) to make loans;
(g) to authorize a director or the firm of which he is a partner or any partner
of such firm or a private company of which he is a member or director to
enter into any contract with the company for making sale, purchase or
supply of goods or rendering services with the company;
(h) to approve annual or half-yearly or other periodical accounts as are
required to be circulated to the members;
(i) to approve bonus to employees;
(j) to incur capital expenditure on any single item or dispose of a fixed asset
in accordance with the limits as prescribed by the Commission from time to
time;

(k) to undertake obligations under leasing contracts exceeding one million

rupees;

(l) to declare interim dividend; and

(m) having regard to such amount as may be determined to be material (as
construed in Generally Accepted Accounting Principles) by the Board-
(i) to write off bad debts, advances and receivables;
(ii) to write off inventories and other assets of the company; and
(iii) to determine the terms of and the circumstances in which a law suit may
be compromised and a claim or right in favor of a company may be released,
extinguished or relinquished:”

Code of Corporate Governance issued by SECP in Pakistan provides

guidelines regarding the responsibilities, powers and functions of board of
directors. Here is a reproduction.

“RESPONSIBILITIES, POWERS AND FUNCTIONS OF BOARD OF DIRECTORS

(vii) The directors of listed companies shall exercise their powers and carry
out their fiduciary
duties with a sense of objective judgment and independence in the best
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interests of the listed company.
(viii) Every listed company shall ensure that:

(a) a ‘Statement of Ethics and Business Practices’ is prepared and circulated

annually by its Board of Directors to establish a standard of conduct for
directors and employees, which Statement shall be signed by each director
and employee in acknowledgement of his understanding and acceptance of
the standard of conduct;
(b) the Board of Directors adopt a vision/ mission statement and overall
corporate strategy for the listed company and also formulate significant
policies, having regard to the level of materiality, as may be determined it;

Explanation: Significant policies for this purpose may include:

1. risk management;

2. human resource management including preparation of a succession

plan;

3. procurement of goods and services;

4. marketing;

5. determination of terms of credit and discount to customers;

6. write-off of bad/ doubtful debts, advances and receivables;

7. acquisition/ disposal of fixed assets;

8. investments;

9. borrowing of moneys and the amount in excess of which borrowings

shall be sanctioned/ ratified by a general meeting of shareholders;

10. donations, charities, contributions and other payments of a similar

nature;

11. determination and delegation of financial powers;

12. transactions or contracts with associated companies and related

parties; and

13. health, safety and environment

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A complete record of particulars of the significant policies, as may be
determined, along with the dates on which they were approved or amended
by the Board of Directors shall be maintained.

The Board of Directors shall define the level of materiality, keeping in view
the specific circumstances of the listed company and the recommendations
of any technical or executive sub-committee of the Board that may be set up
for the purpose;

(c) the Board of Directors establish a system of sound internal control, which
is effectively implemented at all levels within the listed company;
(d) the following powers are exercised by the Board of Directors on behalf of
the listed company and decisions on material transactions or significant
matters are documented by a resolution passed at a meeting of the Board:

1. investment and disinvestment of funds where the maturity period of

such investments is six months or more, except in the case of banking
companies, Non-Banking Financial Institutions, trusts and insurance
companies;

2. determination of the nature of loans and advances made by the listed

company and fixing a monetary limit thereof;

3. write-off of bad debts, advances and receivables and determination of

a reasonable provision for doubtful debts;

4. write-off of inventories and other assets; and

5. determination of the terms of and the circumstances in which a law

suit may be compromised and a claim/ right in favor of the listed
company may be waived, released, extinguished or relinquished;

(e) appointment, remuneration and terms and conditions of employment of

the Chief Executive Officer (CEO) and other executive directors of the listed
company are determined and approved by the Board of Directors; and
(f) in the case of a modaraba or a Non-Banking Financial Institution, whose
main business is investment in listed securities, the Board of Directors
approve and adopt an investment policy, which is stated in each annual
report of the modaraba / Non-Banking Financial Institution.
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Explanation: The investment policy shall inter alia state:

1. that the modaraba / Non-Banking Financial Institution shall not invest

in a connected person, as defined in the Asset Management
Companies Rules, 1995, and shall provide a list of all such connected
persons;

2. that the modaraba / Non-Banking Financial Institution shall not invest

in shares of unlisted companies; and

3. the criteria for investment in listed securities.

The Net Asset Value of each modaraba / Non-Banking Financial Institution

shall be provided for publication on a monthly basis to the stock exchange
on which its shares/ certificates are listed.

(ix) The Chairman of a listed company shall preferably be elected from

among the non-executive directors of the listed company. The Board of
Directors shall clearly define the respective roles and responsibilities of the
Chairman and Chief Executive, whether or not these offices.”

Proposals on how to restrict boards from

imprudent or irresponsible borrowings
As discussed above, in Pakistan majority of listed companies are managed by
controlling shareholders who are close family members. Other investors in these
companies are in minority. According to section 196(2) of Companies Ordinance
1984, directors can exercise borrowing powers of the company by means of a
resolution at board of directors meeting.

Code of Corporate Governance also allows directors to exercise all powers on behalf
of the company and only binds them morally to do this “with a sense of objective
judgment and independence in the best interests of the listed company.”
Further, it asks to maintain “A complete record of particulars of the significant
policies, as may be determined, along with the dates on which they were
approved or amended by the Board of Directors.”

Practically, there is no check on the directors regarding imprudent decisions.

Following are the three proposals to redress the situation.

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Proposal 1
There should be a maximum limit on the borrowing powers of directors such as a
certain percentage of net equity. That limit should be prescribed in the Company
Law.

The obvious advantage of this limit on borrowing is that this limit will itself take care
of the excessive borrowing to hide the mismanagement by the directors. The
directors of a company shall not be able to borrow beyond this limit.

The disadvantage is that sometimes directors have to borrow heavily to capitalize

on an opportunity. Obviously heavy borrowing will increase the risk level for the
company but at the same time it can be said that no risk no profit. Sometimes
opportunity is there but the company does not have enough funds available to
capitalize it. Therefore, this limit on borrowing at times may be detrimental to the
concept of maximizing shareholder value. Another disadvantage in this limit is that
law provides general guidelines. Law provisions cannot cover every situation and all
the possible scenarios. Such a limiting provision may seriously hamper the growth
of corporate sector in the country.

Proposal 2
There should be a provision in the Articles of Association of every listed company
that sets a maximum limit on the borrowing powers of directors such as a certain
percentage of net equity or total assets.

The advantage in this proposal is that it gives flexibility on case to case basis rather
than one solution fit all situations like law provision. Another advantage is that while
giving certificate of incorporation regulators can verify that the borrowing limit is in
line with the industry standard or not. This pre-checking will definitely protect the
interests of the stakeholders.

The disadvantage in this proposal is that sometimes directors genuinely and for the
benefit of the company and its stakeholders need to go beyond the limit prescribed
in the Articles but cannot do so. This would be a very serious impediment in the way
of maximizing shareholder value. Even if the shareholders in AGM allow them, they
have to go a lengthy procedure to avail the opportunity – amendment in Articles of
Association – and by the time they are through the opportunity may have gone.

Proposal 3
There should be a system of internal controls that plug the loop holes and
strengthen the decision making procedures thereby reducing the chance of
imprudent borrowing.

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It is highly recommended that following provisions in the Companies
Ordinance 1984 should be inserted to comply with mandatorily by all listed
companies.

The board should include a balance of executive and non-executive directors

(and in particular independent non-executive directors) such that no
individual or small group of individuals can dominate the board’s decision
taking.

There should be a formal, rigorous and transparent procedure for the

appointment of new directors to the board. This procedure should be
reported along with the compliance report of Code of Corporate Governance.

The board should maintain a sound system of internal control to safeguard

shareholders’ investment and the company’s assets.

The board should establish formal and transparent arrangements for

considering how they should apply the financial reporting and internal
control principles and for maintaining an appropriate relationship with the
company’s auditors.

The board should maintain a clear procedure for whistleblowing so that

anyone within the company or outside the company is able to blow the
whistle of any irregularity at an early stage.

Section 404 of the Sarbanes–Oxley Act may be adopted in true spirit that
requires management to produce an “internal control report” as part of each
annual report. The report must affirm “the responsibility of management for
establishing and maintaining an adequate internal control structure and
procedures for financial reporting.” The report must also “contain an
assessment, as of the end of the most recent fiscal year of the Company, of
the effectiveness of the internal control structure and procedures of the
issuer for financial reporting.”

Provision should be inserted for criminal penalties for violation of any of the
above provisions. Here, section 802 of the Sarbanes–Oxley Act may be
adopted.

Provision should be inserted for criminal penalties for retaliation against

whistleblowers. Here, section 1107 of the Sarbanes–Oxley Act may be
adopted.

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Recommendation to SECP
We recommend to SECP that Proposal 3 may be adopted. The recommendation is
based on following:

Borrowing Powers of Directors and Corporate Failures

The analysis, subsequent passage of the Act and its requirement as
described above shows that borrowing power of the directors per se has
nothing to do with the bad performance of a corporation. Rather bad
performance and subsequent sudden collapse was the result of factors other
than the borrowing powers of the directors. Heavy borrowing was done to
hide the imprudent investment decisions. Mainly, these factors were:

1. Ineffectiveness of the board

2. Weak internal controls

3. Weak risk management

4. Lack of independence of external auditors

5. Insufficient financial information disclosure

6. Conflict of interests’ of directors, analysts and auditors

The Combined Code on Corporate Governance 2008 has something to say

about directors’ role. Here is an excerpt:

“Good corporate governance should contribute to better company

performance by helping a board discharge its duties in the best interests of
shareholders; if it is ignored, the consequence may well be vulnerability or
poor performance. Good governance should facilitate efficient, effective and
entrepreneurial management that can deliver shareholder value over the
longer term.

The Code is not a rigid set of rules. Rather, it is a guide to the components of
good board practice distilled from consultation and widespread experience
over many years. While it is expected that companies will comply wholly or
substantially with its provisions, it is recognized that noncompliance may be
justified in particular circumstances if good governance can be achieved by
other means. A condition of noncompliance is that the reasons for it should
be explained to shareholders, who may wish to discuss the position with the
company and whose voting intentions may be influenced as a result.

In relation to the requirement to state how it has applied the Code’s main
principles, where a company has done so by complying with the associated
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provisions it should be sufficient simply to report that this is the case;
copying out the principles in the annual report adds to its length without
adding to its value. But where a company has taken additional actions to
apply the principles or otherwise improve its governance, it would be helpful
to shareholders to describe these in the annual report.

If a company chooses not to comply with one or more provisions of the Code,
it must give shareholders a careful and clear explanation which shareholders
should evaluate on its merits. In providing an explanation, the company
should aim to illustrate how its actual practices are consistent with the
principle to which the particular provision relates and contribute to good
governance.

In their turn, shareholders should pay due regard to companies’ individual

circumstances and bear in mind in particular the size and complexity of the
company and the nature of the risks and challenges it faces. Whilst
shareholders have every right to challenge companies’ explanations if they
are unconvincing, they should not be evaluated in a mechanistic way and
departures from the Code should not be automatically treated as breaches.
Institutional shareholders should be careful to respond to the statements
from companies in a manner that supports the ‘comply or explain’ principle
and bearing in mind the purpose of good corporate governance. They should
put their views to the company and be prepared to enter a dialogue if they
do not accept the company’s position. Institutional shareholders should be
prepared to put such views in writing where appropriate.

Companies and shareholders have a shared responsibility for ensuring that

‘comply or explain’ remains an effective alternative to a rules-based
system.”

Two very important points emerge from the reading the above excerpt that
are relevant to our discussion:

1. The Code is not a rigid set of rules. Rather, it is a guide to the

components of good board practice distilled from consultation and
widespread experience over many years. While it is expected that
companies will comply wholly or substantially with its provisions, it is
recognized that noncompliance may be justified in particular
circumstances if good governance can be achieved by other means.

2. Companies and shareholders have a shared responsibility for ensuring

that ‘comply or explain’ remains an effective alternative to a rules-
based system.

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Laws cannot cover everything and every situation. These are broad
guidelines much like control charts having lower and upper limits within
which different behaviors are acceptable. It is the intention that is required
because laws can be circumvented when required. Therefore, both
guidelines as well as intention to implement the guidelines in true spirit are
required to avoid financial fraud.

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