Personal lawsuits signal warning for independent directors

 

Fund managers, retail investors and independent directors have been watching the outcome of a large payout for shareholders in a recent class action suit. It was the first ever collective investor action, where over 55,000 shareholders won a court-ordered payout of approximately US$385 million (RM1.61 billion).

Most fund managers who pay attention to issues like this would agree that this payout is significant, even on a global scale.

The payout is not only a big win for shareholders. It has also set a precedent that independent directors will not be easily let off when implicated in corporate wrongdoing.

The court ruling has sent a very strong message, not only to executives but also to independent directors. Fraudulent activities in a company will not be tolerated in some markets, and will come at significant personal cost to not only the perpetrators. Independent directors can no longer assume that only the executives will be liable when committing fraud.

The scam took place between 2016 and 2018, before Covid-19 hit. The issue became apparent when there was an admission that the cash position in the accounts was overstated by US$4.6 billion.

Initially, the company blamed the cash balance overstatement on an “accounting error”. Then it was discovered that false transaction records were connected to the company’s misreporting. Investors were so angry and frustrated with the corporate deceit that they came together to form a legal challenge.

This was not any old unknown company that had misled investors, but a company that was included in one of the most widely-followed indices, the MSCI Emerging Market Indices.

Most investors know what happens when a company is included into an index, as well as when a country’s overall weighting in the index is increased.

Most astute investors had anticipated at least an additional US$100 billion inflow into the country sub-portfolio due to the increased change in the asset allocation to this index. Unfortunately for many foreign investors, there are many companies included in indices that fall into trouble.

What was most interesting in this case was the following ruling:

1. The company’s former chairman, vice-chairman and four executives were found to be personally liable for systematic fraud.

2. The court sentenced the chairman to 12 years in jail and a fine for manipulating the stock market, failing to disclose material information and bribery.

3. The vice-chairman (a family member) and a total of 10 executives were also handed time in jail and fined.

Market observers know that the maximum penalty for fraud cases was amended in 2020; the previous amount was considered too low (at US$94,000) to be a real deterrent. Now, misconduct attracts personal liability with the highest penalty increased to 50% of the ill-gotten gains. This is all part of the reform agenda that some countries in Asia are looking to adopt.

4. The bigger message for the markets was the court ruling that all five independent directors (most of them academics) were held personally liable for between 5% and 10% of the total compensation. This works out to be a staggering personal cost of between US$19 million and US$38 million.

Most board members know that the fees earned by directors aren’t that high. On average, the compensation for independent directors only comes up to around US$31,000 per annum. This ruling has been a huge wake-up call to all independent directors that they can be held personally liable in some jurisdictions as the gatekeepers for shareholders’ interests.

This ruling sent shudders through the markets. We have witnessed at least 20 companies announcing the resignation of their independent directors. The reasons cited for their departure? Personal matters.

As this Asian nation is just one of several countries pushing to weed out corporate corruption, this ruling is clearly a message to independent directors that it is high time for them to improve the execution of their fiduciary duties and to make more effort to analyse companies’ processes and declarations that are made to the market and investors.

Many independent directors in Asia will say that they are not truly independent, and have little autonomy in carrying out their roles. However, with this ruling setting a new standard, this cry is likely to fall on deaf ears in the courts.

Independent directors who don’t read their minutes, who don’t want to object or stand up for shareholders and even stakeholders, should start to consider if sitting on a board is worth the risks brought about by their inattention.

With this case precedent of holding independent directors personally liable, it will no longer be fashionable to say that you are a board director or a director of an international company, as the risks of what the various jurisdictions may be farming out are likely to more than offset the glamour or the remuneration that has been received for your “independence”. - FMT

The views expressed are those of the writer and do not necessarily reflect those of MMKtT.