Insolvency processes centre on the rights of the insolvent company’s creditors. Corporate governance is the system of rules, practices, and processes for a company to follow, including mechanisms that keep companies (and their directors) accountable to shareholders, creditors, and other stakeholders.
For a SME, whose corporate governance may centre more on accountability to its shareholders and creditors, one might expect a reduction of financial risk. This article explores the relationship between corporate governance and insolvency, for a SME enterprise.
Corporate Governance Scope Considerations
Initially, corporate governance mechanisms favoured shareholders with the object of shareholder wealth maximisation. However, pursuant to the Organisation for Economic Co-operation and Development (known as OECD), corporate governance is now recognised to be a guide of a company’s relationships with its stakeholders generally – going beyond shareholders.
For the corporate giants and listed conglomerates in the likes of Coca-Cola, Cadbury, and Apple, who have wider consequences from their operations (such as unethical labour, deforestation, and pollution), it may make more sense to have such broad ESG, charitable, or cultural commitments benefitting wider public stakeholders. For them, this may also still increase sales or customer confidence, and contribute to shareholder wealth. The drastic shift in the direct focus from shareholder wealth maximisation to wider stakeholders is therefore less of a risk. However, for a SME, corporate governance mechanisms would more appropriately centre on corporate governance mechanisms that centre on shareholders and creditors, to reap any financial or solvency benefits.
The Role of Corporate Governance at the Onset of Insolvency
At the onset of insolvency, corporate governance structures can significantly influence how effectively a company navigates financial distress. Sound governance practices may include clear decision-making processes, transparency in financial reporting, and accountability mechanisms for management actions. These elements can provide early warnings of financial trouble, allowing for timely interventions.
During the initial phases of insolvency, Directors must act in the best interests of creditors rather than shareholders, as per the fiduciary duty shift established in case law.[1] This duty compels directors to consider the impact of their decisions on the company’s solvency and the interests of its creditors.
Corporate Governance for the Management of Insolvency
Effective corporate governance can be crucial in managing insolvency. It can ensure that the company’s operations are conducted in a manner that maximises value for creditors and other stakeholders, or prevents abuse of directors of company assets and authorities which would be the subject of voidable transactions, clawbacks, or director’s duties breach claims in insolvency.[2] Mechanisms can be adopted into a company’s constitution, or simply by instilling customs in its company culture, employment policies, or regular training and development.
Some corporate governance mechanisms to consider may be:
1. Board Composition and Independence
A board composed of directors who are diverse in skills and experience, and who are independent in majority, can provide objective oversight and decision-making. The presence of independent directors is associated with better monitoring and less opportunistic behaviour by executives. An audit committee with members independent from the board, to ensure financial oversight, might be considered.
2. Transparency and Communication
Transparent financial reporting and open communication with stakeholders can help maintain trust and mitigate the negative impacts of insolvency. The UK Corporate Governance Code emphasises the importance of regular, meaningful dialogue with shareholders and stakeholders, which can be critical (particularly in light of the abovementioned established case law in New Zealand).
3. Risk Management
Robust risk management practices enable a company to identify, assess, and address financial risks promptly. The Turnbull Report (1999) highlights the need for boards to maintain a sound system of internal control to safeguard shareholders’ investments and the company’s assets. Conducting an internal and comprehensive risk management framework with regular assessments.
4. Compliance Management
Ensuring timely and accurate financial reporting, monitoring cash flows and liquidity, establishing a strong code of conduct and ethical standards, and implementing compliance programs to ensure adherence to these.
5. Executive Compensation
Implementing performance-based compensation or clawback provisions in the event of misconduct.
Impact on Solvency and Financial Health
Probably already obvious from the above, good corporate governance can directly influence a company’s financial health and solvency. By promoting prudent financial management and ethical behaviour, strong governance can help avoid risky practices that might lead to insolvency, or transactions or conduct that will attract negative action in an insolvency process. In contrast, poor governance can exacerbate financial distress. Failures in oversight, inadequate risk management, and lack of transparency can lead to mismanagement and financial irregularities.
The Guidelines
Reputable guidelines and references for corporate governance mechanisms to adopt, include:
- OECD Principles of Corporate Governance: a comprehensive set of principles aimed at improving corporate governance globally, covering rights and equitable treatment of shareholders, and the role of stakeholders in corporate governance.
- UK Corporate Governance Code: a well-regarded code from the Financial Reporting Council (FRC), with guidelines on board leadership, effectiveness, accountability, remuneration, and relations with shareholders.
- Turnbull Report: guidance for Directors and practical advice on implementing and maintaining sound internal control systems within companies.
- Coso Framework: the Committee of Sponsoring Organisations of the Treadway Commission (COSO) provides a widely used model for evaluating internal controls for risk management.
- IFC Corporate Governance Methodology: the International Finance Corporation (IFC) methodologies, useful for emerging markets.
- Cadbury Report: the report of the Committee on the Financial Aspects of Corporate Governance (1992) sets out recommendations on the arrangement of company boards and accounting systems to mitigate corporate governance risks and failures.
Conclusion
The relationship between corporate governance and insolvency is significantly relevant to a company at all times; during a company’s solvent trading, on the onset of any insolvency, and can prevent recovery actions taken during an insolvency process. Corporate governance mechanisms can provide a framework for financial stability and accountability, reducing the risk of insolvency. By promoting transparency, ethical behaviour, and sound risk management practices, businesses can better safeguard the interests of creditors and other stakeholders. By adopting governance mechanisms, companies have an in-built guidance to deter and manage insolvency in a way that is in-line with the expectations in insolvency law.
[1] For example, Fatupaito v Bates [2001] 3 NZLR 386 (CA), Re South Pacific Shipping Ltd (in liq) (2004) 9 NZCLC 263,670 (HC), and BTI 2014 LLC v Sequana SA [2022] UKSC 25.
[2] Including those duties listed in sections 131 to 137 of the Companies Act 1993.
