Is corporate governance the panacea for finance company ills?
The downfall of several licensed finance companies (LFCs) in recent years and the arrest of its directors earlier this year created fresh ripples of anxiety amongst the public as to the stability and sustainability of finance companies.
In January 2021, the State Minister of Finance, Money and Capital Markets and Staten Enterprises Ajith Nivard Cabraal announced that nearly Rs. 62 billion had been deposited during the last six years in six failed finance companies.
It was merely months ago that a notice of cancellation of the licence under the Finance Business Act, No. 42 of 2011 was issued to Sinhaputhra Finance PLC by the Monetary Board of the Central Bank (CB) which was later extended an opportunity to implement the proposed capital augmentation plan within the timeframe stipulated.
In addition, public notices published in national newspapers in October last year by the Department of Supervision of Non-Bank Financial Institutions cautioned that as at end September 2020, a further nine out of the 38 LFCs were non-compliant with the minimum capital adequacy requirement and had been given time extensions to rectify the non-compliance.
As cautioned by the CB via public notices in newspapers from time to time, the CB does not have a legal authority to guarantee deposits of LFCs. However, all LFCs are required to insure their deposit liabilities with the Sri Lanka Deposit Insurance and Liquidity Support Scheme (SLDILSS) established by the CB. Currently, the maximum compensation of Rs. 600,000 per depositor, per institution will be paid by SLDILSS in the event of a suspension/cancellation of any LFC. The public has been further informed that no other instruments other than “deposits” will be covered under SLDILSS.
Accordingly, CB cautions that regulation and supervision of the CB does not necessarily prevent the failure of any financial institution, including LFCs since the management of LFCs are vested with the ultimate responsibility to operate them in a safe and sound manner while complying with regulatory and supervisory requirements of CB.
The above situation leads to some very interesting questions:
- Is the public duly advised to exercise due care when making deposits in LFCs to ensure the safety of their funds and also to refrain from depositing funds in unauthorised institutions/persons?
- Does the current disclosure requirements imposed on LFCs suffice to assist the public in making informed decisions?
- Will the tightening of capital thresholds of LFCs be a risk mitigation to save the depositors?
- Is the general public financially literate to understand the disclosures/ announcements made by LFCs to ascertain their credibility and sustainability?
It is in this backdrop that a Consultation Paper on Proposed Direction on Corporate Governance was issued by the CB in December 2020 for public comments.
The rationale to introduce the New Direction, according to CB, was “to articulate sound principles of good Corporate Governance among LFCs in order to keep pace with the latest developments of best practices of good governance”.
Further, according to CB, existing directions on Corporate Governance applicable for LFCs and SLCs provide some forbearances when compared to the Corporate Governance principles applicable to banks. Therefore, the proposed direction envisages to strengthen the corporate governance principles among the non-banking sector.
At present, four Directions
relate to the corporate governance aspects of LFCs:
Finance Companies (Corporate Governance) Direction No. 03 of 2008 Finance Companies (Assessment of Fitness and Propriety of Directors and Officers Performing Executive Functions) Direction No. 03 of 2011 Finance Companies (Corporate Governance- Amendment) Direction No. 06 of 2013 Finance Business Act (Amendment to Corporate Governance) Direction No. 04 of 2020 In these circumstances, it is noteworthy to examine the provisions of the Consultation Paper and some of the key changes proposed therein.
Board Charter
As per provisions contained in section 2 of the Consultation paper, heavy emphasis is placed inter alia, on the composition, role, responsibilities, limits on related party transactions and managing conflict of interest which shall be developed and implemented through a Board Charter.
In this regard it should be noted that the matters to be covered in the Board Charter have more or less been prescribed by the directions currently in force. Hence ensuring compliance (or rather monitoring) to the same by the responsible stakeholders is of paramount importance rather than merely adopting a manual of best practices.
The Consultative Paper plays a thrust on the composition of the Board of Directors and the independence of Directors and mandates an increase in the number of independent Directors for a minimum of one fourth in the current directions to three or one third of the total numbers of directors, whichever is higher.
It also stipulates the Chairman of the Board Audit Committee and Integrated Risk Management Committee to be an independent director as against a non-Executive Director mandated under the current directions.
The Consultation Paper also makes specific reference to “cooling off periods” for directors, CEOs or Key Management Personnel (KMPs) of LFCs.
Role and Responsibilities of the Chair and CEO
The Consultation Paper further emphasises on the division of responsibilities between the chair and CEO to ensure a greater balance of power and authority with specific focus on the role of the CEO.
Sub Committees of the Board
A significant change referred to in the Consultation Paper is the enhancement of requirement for board sub committees based on the asset base of the LFC. For the purpose of specifying the requirements for board committees, LFCs are divided into two categories based on their asset base:
- Category A – more than Rs. 20 billion
- Category B – less than Rs. 20 billion
LFCs falling within Category A shall establish a Board Audit Committee (BAC), Integrated Risk Management Committee (IRMC), Nomination Committee, Human Resource and Remuneration Committee and Related Party Transactions Review Committee and ensure that a monthly meeting shall be held for BAC and IRMC.
Further common chairmanships are not allowed in the BAC and IRMC in case of category “A” LFCs. In case of category “B” LFCs, at least the BAC and IRMC shall be established and at least quarterly meetings for all sub committees. Chair of BAC and IRMC shall be independent. Common chairmanships are allowed in sub committees.
Compliance function
A very welcome change proposed in the Consultation Paper is the importance and independence assigned to the compliance function. As per the proposed amendments, it would be necessary for the Integrated Risk Management Committee to establish an independent compliance function to assess the LFCs regulatory compliance and appoint a dedicated compliance officer with sufficient seniority who is independent from day-to-day management shall carry out the compliance function to ensure that there shall not be ‘dual hatting’ in case of category “A” LFCs.
Group governance
Group governance has also been given much emphasis in the paper under consultation setting out separate detailed responsibilities for both holding and subsidiary companies.
Ethics and whistleblowing
Another interesting provision in the Consultation Paper is the requirement to adopt a Code of Ethics which provides guidelines on appropriate conduct and disallowing activities such as fraud, money laundering, bribery and corruption, etc. Emphasising the need for a corporate culture with strong governance focus, LFCs have also been mandated to establish a whistleblowing policy to ensure that legitimate concerns can be objectively investigated and addressed.
Conclusion
As set out in the preamble of the Consultative Paper issued by CB, effective Corporate Governance is critical to the proper functioning of the financial institutions. Governance weaknesses at financial institutions play a significant role in the failure of financial institutions as evidenced globally during the global financial crisis and in Sri Lanka during recent failures of LFCs. Hence the primary objective of any corporate governance initiative should be to safeguard stakeholder’s interest and with respect to financial institutions shareholder interests are secondary to depositors’ interests.
It is no doubt that Sri Lanka’s finance and leasing sector will face added pressure for consolidation as deadlines for the implementation of tougher capitalisation requirements approach in 2021 coupled by a challenging operating environment. It is predicted that post moratorium, Non- Performing Loans may reach an astronomical high of 20 per cent.
Hence tightening the loop holes and streamlining the internal processes particularly to safeguard the public is crucial at this juncture although it would add additional pressure of compliance to LFCs.
Nevertheless, as already quoted, good corporate governance, on its own, will not protect finance companies from fraud or excessive risk taking. However, only good corporate governance can ensure that finance company owners and managers are not hiding skeletons.
A concerted and focused financial literacy initiative encompassing all sectors of the public to educate them on the exercise of due care when making deposits to ensure the safety of their hard earned investments may be the need of the hour to supplement the efforts of the CB in promoting good governance.
(The writer is an attorney-at-law with over 30 years banking experience with NDB Bank PLC and SDB Bank PLC).