Amidst the pandemic, the companies’ boards of directors have had to make many decisions of material significance. They would continue to take many crucial decisions as the economy resurfaces; soon, it is hoped.
But decisions that directors own and how those calls are made are primarily hidden from stakeholders.
This guide is intended to reduce, if not eliminate, the likelihood of directors’ decisions being questioned down the road.
A hasty and objectively reckless decision can be a commercial success. The joyous stakeholders shall have no reason to sue the directors and no loss for which to hold directors’ liable. However, if the same reckless decision had been an economic disaster, the shareholders would sue directors for negligence. If negligence is proved, they will be liable for heavy penalties – financial and repetitional.
There are no foolproof or flawless decisions in the market. However, directors can utilise some excellent practices to ensure that they are not held negligent or accused of not acting in the company’s best interests.
Briefly, the advice for directors is to Reason, Record, and Report.
Understanding directors’ liability
Generally speaking, shareholders judge directors based on their commercial success, while the laws assess directors based on their decision-making process.
“A good director in the eyes of the law is not the one whose company records the highest profit or stock price.”
A good director is one who:
- Deliberated over the decision,
- Considered all relevant information,
- Weighed options,
- Took professional advice where required, and
- The majority of all intended to do what’s best for the company.
Overall duty to assess the solvency of the company
Before discussing specific situations, the author assumes that directors have and they regularly assess the companies’ solvency status. By assessing the solvency, the author is not referring to accounting ratios for balance sheet solvency (current assets over current liabilities) or cashflow solvency (divide your company’s total cash flow from operations by its total liabilities).
The line between financial distress and insolvency is blurry, and one may not know at which side they might find themselves. The starting point is to ask:
- Does the company have positive equity (that is, do assets exceed liabilities)?
- Is the company able to pay off debts as they come due?
- Does the company possess adequate capital to operate?
Why is it important?
In short, depending on the jurisdiction, to carry on trading through a company that has no reasonable prospect of avoiding insolvency is:
- A crime,
- Exposes directors to a heap of mess, such as personal liability for repayment of debts,
- Being disqualified by the law to take on directorships and other respectable roles, and
- Mentally and physically exhausting.
Therefore, before using this guide, the directors must be satisfied that they operate a solvent company.
Situation no.1 Issuing New Shares.
When a decision to issue shares is taken, the level of justification on record will depend on how many directors on the board are also shareholders.
Typically, at different stages of the decision-making process, directors should be minded to reason, record and report answers to the following questions:
- Why is funding required?
- Why is the company not taking debt? Or shareholder loan?
- Why at this price?
- Does the company even have a plan, or are we throwing good money after bad?
- Is this all an elaborate scheme to dilute shareholding?
How do we address the questions before they are asked?
- Why is funding required?
In the present market conditions, funding is probably required because the company is strapped for cash. If the funding is required for temporary working capital needs, credit facilities are precisely for that purpose. If the trade receivables cycle is too long for the company to rely on credit facilities alone, address it in its report explaining why trade receivables are high, who those non-paying clients are, and the management’s plan of action.
A call for funding a few weeks after a thorough quarterly report is more likely to be met with shareholder motivation and not anxiety.
It does not matter whether the funding is needed to adjust a business model, pay off debt, or provide a temporary source of oxygen for the business; directors must disclose, document, and justify their rationale.
Because no matter where the funding comes from, if it doesn’t yield the expected commercial benefits, the directors will be forced to defend their decision.
When directors are also shareholders
Suppose the majority of the board consists of shareholders with the majority of voting power in the company. In that case, the directors must dissuade any notion that additional shares are to maintain or increase control of the company.
- Why at this price?
Suppose most directors are also shareholders who will subscribe to new shares. In that case, a professional should evaluate the share price and disclose it to the shareholders before the offer to subscribe is made.
Whenever shareholding board members want to issue new shares for a significantly lower price, they must:
- Have a professional valuation to back up the price.
- Share a business plan or report to resuscitate with the shareholders.
- Tell the shareholders why the board did not try to Issue shares through private placement, where a third party investor will buy the shares of a distressed company at a very low share price to make a long term profit.
Now the share issue process.
Follow the proper procedure and place on record a justification for issuing additional share capital at every step of the process.
Call a board meeting.
The directors should hold a meeting, and the minutes must reflect the deliberations that took place and led to the decision to issue new shares.
Offer to Subscribe
The offer to subscribe, which is sent to existing shareholders, must disclose the purpose of the share issue. Contain information about the issuing price and the usage of capital to be raised.
Situation No. 2: Executive Compensation Packages
Do not surprise shareholders with annual financial statements, which show:
- There is no money for dividends.
- Trade receivables aren’t paid.
- Sales declined.
- The company overall did not do well.
- Banks might ask shareholders to give new personal guarantees to keep the facilities, and the directors took a million dollars each as their remuneration for the great job done.
Directors who actively communicate with shareholders, and report them thoroughly and regularly, assure shareholders that those appointed to take care of their companies are doing their job. When you communicate, you show you are earning your remuneration.
Call a meeting to discuss remuneration during the pandemic
Directors must reason and record why they are entitled to receive the remuneration they have declared.
The lesson is this: try to prevent disputes, but take all necessary actions to protect your actions if a dispute occurs.
Prevent – effective quarterly reporting will maintain shareholder confidence, and
Protect – recording the discussions when setting the remuneration will be compelling evidence in courts that the directors were not acting for selfish purposes.