A company may invest in another company for many reasons, to make a strategic partnership with a customer or supplier, to pave the grounds for a merger or acquisition , to make a strategic partnership with a supplier or a customer, and so on.
These investments are unusual for most businesses and substantial planning is done before the investments are actually made. In principle, the ultimate objective of these investments must always be the same: to maximize the wealth of its shareholders. But what if it isn't?
The management of a company may invest in another company to the detriment of its shareholders and to its personal advantage. For instance, a director who is a minority shareholder in one company may extend interest-free loans to another company in which he is a majority shareholder, and later have these loans written off.
If abuse by management in inter-corporate investments is not checked then it would lead to lack of confidence in investors, which inevitably affects the investment climate and economic progress. That inter-corporate investments can be made against the interest of the shareholders, and that such investments are unusual, requires specific regulatory checks and balances.
Inter-corporate investments are regulated by the well-known Section 208 of the Companies Ordinance, administered by the Securities & Exchange Commission of Pakistan (SECP). We have a number of precedents of abuse of shareholders' resources through inter-corporate investments and Section 208 has long been a subject of heated debates. Recently it has been amended to make it less cumbersome for the companies. The objective here is to critically evaluate this law and recommend ways for improvement.
Section 208 divides companies into two categories, associated and not associated. Then it places restrictions on investments in associated companies and makes the directors of the investor company personally accountable for non-compliance.
In simple terms, two companies become associated if any of the following is true:
a) one company is a subsidiary of another; b) a person controls more than 20 per cent voting shares in both companies; c) brother companies are under common management or control, say a common director.
If two companies are associated then the following apply:
i. All investments in associated companies must be made with a prior approval from shareholders by a special resolution. A special resolution is passed in a general meeting with a minimum of 75 per cent votes cast in favour.
ii. The required rate of return on investment, whether in the form of debt or equity, should not be less than the borrowing cost of the investor.
iii. The terms and conditions of these investments cannot be altered without a special resolution.
iv. In case of violation, all guilty directors of the investor are liable for making up the losses and can be fined up to Rs 1 million each.
Section 208 does not apply to a banking company, any other financial institution approved by the SECP, a private company which is not a subsidiary of a public company, and a company whose principal business is the acquisition of shares, stock, debentures or other securities. Banks and financial institutions are excepted because their very business is investing in other companies and specific laws for regulating their investments are in place. Private companies are excepted because money of public at large is not directly involved.
Recent amendments and a Apparent rationale: Recently, the Companies Ordinance has been amended and the following have been changed:
i. Companies had previously to take an additional approval from the SECP if the aggregate investments in associated companies exceeded 30 per cent of the paid-up capital and free reserves of the investor company. This requirement has been done away with because investments are essentially a commercial and not a regulatory decision. Once there is adequate disclosure of the investment and it is approved by shareholders, approval by the SECP is unnecessary. Moreover, taking this approval wasted the time of both the investor company and the SECP.
ii. In the list of exceptions to Section 208, one addition has been made. This is a company whose principal business is the acquisition of shares, stock, debentures or other securities. Adding this exception was considered necessary probably because otherwise the scope of the Section is needlessly widened to institutions like mutual funds if they became associated with the investor company.
iii. The minimum quorum of a general body meeting of a public listed company, in which a special resolution is passed has been raised to 10 members from previously 3 members, representing at least 25 per cent of the voting shares. This increase in minimum quorum increases protection to shareholders as it makes it difficult to pass special resolutions by only a few members.
While the recent amendment has removed some of the unnecessary pains in Section 208, weaknesses of fundamental nature remain.
Fundamental weaknesses: Following are the fundamental weaknesses in Section 208.
i. The underlying approach is flawed because it focuses on suspicion of unfair gains made by the management rather than on the potential of losses to the shareholders. An investor company may place one of its directors on the board of the investee company to safeguard its investment. Placement of a director would make the two companies associated but it'd offer greater protection to the shareholders of the investor company rather than creating conflicts of interest.
Moreover, in cases where directors make malafide investments, losses to the shareholders might not be accompanied by direct economic gains to the directors. Directors may approve these investments to benefit friends or relations or simply be incompetent in assessing them.
ii. The scope of the Section is limited to investments in associated companies and not to all inter-corporate investments. It is probably assumed that investments in associated companies are more likely to have conflicts of interest than not-associated companies. This is a questionable assumption. The conflicts of interest in inter-corporate investments are too complex to be captured by a narrow definition of associated companies. It is also easy to keep two companies technically not-associated when practically they are under the control of the same persons.
An individual is deemed to have controlling influence on shares if shares are held by him, his spouse, or minor children. The shares might be kept in the names of different members of a family, other than spouse and minor children to get around the law.
iii. Within associated companies, Section 208 coves only those investments that are made after two companies have become associated. That is it excludes the investments before the companies became associated and also those investments that made the companies associated. Past cases show that the investments following under Section 208 were often less than those beyond falling outside its purview because of this technical loophole.
iv. It ignores the fundamental differences between investment in the form of debt and equity and treats them in the same way. You can't have a pre-specified rate of return on ordinary shares.
Due to these fundamental weaknesses, Section 208 has limited ability to do what it is supposed to, i.e. provide protection to the shareholders and can end up doing what it is not supposed to, i.e. hampering investments.
Conclusion: Corporate law is subject to the economic needs of its time. Our society is corrupt and checks and balances in corporate governance are weak. Under such conditions, some regulation of intercorporate investments is necessary but it has to be based on a clear and rational framework.
The conflicts in inter-corporate investments are a shade of the overall conflicts between shareholders and management. This conflict is primarily created because shareholders do not know as much as the management and there is insufficient accountability of the management. Companies are owned by shareholders and they are the ultimate beneficiaries or the affected of a company's performance.
Regulators should not and cannot perform the job of the shareholders; they can only facilitate the shareholders in doing their job. It remains the responsibility of the shareholders to stay informed of what their companies are doing. Therefore, the problem of abuse in intercorporate investments is best resolved by disclosure and management's accountability by shareholders rather than direct legal restrictions on the investments.
The SECP has substantially enhanced the disclosure requirements through SRO 865(I)2000 for passing a special resolution in favour of investments in associated companies. This SRO and recent doing away with SECP's approval of such investments are steps in the right direction. More, however, needs to be done to fix the problems in regulating inter-corporate investments.
Recommendations: I'd like to recommend the following:
(i) The scope of the Section be broadened to all intercorporate investments made by companies on which the Section applies.
(ii) The focus of the Section be on disclosure so that the potentials gains and risks for the shareholders of both the investor and the investee company can be judged. There shouldn't be any pre-specified minimum return on equity investments.
(iii) A prior approval be required by a Special Resolution for all investments beyond 5 per cent of the paid-up capital and free reserves of the investor company. No approval for smaller investments be required to avoid lack of flexibility to management.
(iv) The disclosure requirements on lines of SRO 865(I)2000 apply to all inter-corporate investments including those within the 5 per cent threshold.
(v) Directors continue to be severally and jointly liable for loss on investments made in violation with fines up to Rs 1 million.
