Legal tools for regulating self-dealing

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Julius Chikomwe

THE law has a combination of preventive, corrective and punitive legal tools for regulating self-dealing. These include internal remedies under the Companies Act (Chapter 24:03), delictual remedies and remedies under common law. A brief discussion on each of these remedies will now follow.

I. Internal Tool(s) Under the Companies Act

The Companies Act (Chapter 24:03) has a statutorily-enacted model company charter, under Article 85 of Schedule I of the Companies Act commonly known as “Table A”. The model charter makes disclosure by an interested director mandatory. Failure to comply with Article 85 of Table A rules renders such a transaction voidable at the instance of the company. So, for those companies that adopted Table A as part of their company charter, this remedy would be part of their artillery against self-dealing.

 

Criminal Remedies

A director who acts in breach of his fiduciary duties for his own benefit and to the detriment of the company may also be criminally liable under Section of 186 (4) of the Companies Act(chapter 24:03). Liability under this section is punishable by a fine, imprisonment or both.

 

II. Common Law remedies

 

At common law, a director stands in a fiduciary relationship to his company. A fiduciary relationship comes into existence when a person controls the assets of another or holds power to act on behalf of another. Thus directors, as fiduciaries, have a duty to act in good faith towards the company, to exercise their powers for the benefit of the company and to avoid conflict of interest between their interests and those of the company. This is an invariable rule that provides the best form of protection against expropriation of shareholders by directors of the company. Under it, damages suffered by a company following a self-dealing transaction are recoverable and the transactions may be set aside unless the transaction is ratified by the company after full disclosure.

III. Delictual remedies

Essentially, delictual liability is concerned with damages suffered by a person as a result of a wrongful act or omission of another for which that person is entitled to compensation in terms of our common law. Directors owe their companies the duty to act with care and skill. Alternatively stated, directors are expected to demonstrate an acceptable degree of diligence. A breach of the duty of care and skill renders directors liable for damages on the grounds of negligence. Directors may thus be held liable in an unfair self-dealing transaction if they fail to exercise reasonable care, skill and diligence in their handling of self-dealing transactions.

Why remedies have been of little practical benefit to companies and their shareholders

It must be understood that self-dealing is an “economic” crime. Consequently, aggrieved companies and their shareholders expect that to be meaningful, remedies for unfair self-dealing should at the very least, deliver “economic justice”. “Economic justice” is a phrase that the writer coined to describe a remedy that can effectively restore to the company, what it would have lost through self-dealing. Yet as can be seen from this discussion so far, there is no clarity as regards what the law values more among these three: criminal punishment, recovery of damages (and in appropriate cases – disgorgement) or inaction?

The lack of priority in the law among the three possible courses has made “economic justice” the least likely course of action to be resorted to in cases regarding directors’ self dealing. It would seem that our corporate governance system has made it possible – if not tempting – for company directors to choose inaction instead of asserting the right of recovery, let alone to demand disgorgement of profits.

Rather, there is wide-spread general reluctance by corporate boards in this country to institute proceedings for the recovery of self-dealing damages and disgorgement of the profits that interested directors would have made. Although no scientific research has been undertaken to date, the consensus among accountants, lawyers, economists and corporate governance practitioners is that the general reluctance is due to the following reasons:

First, company directors have reputational disincentives for not enforcing recovery. Company directors are generally averse to the unfavourable publicity that accompanies such a process. Their view is that adverse publicity that attends to such a course of action could cause their names and that of their company, to take a beating in the process. Indeed, these fears may not be entirely unjustified. The market justifiably views less favourably, companies and boards under whose watch self-dealing would have occurred. This is regardless of the sophistication of the perpetrators or their methods. The market does this for a good reason: it is precisely the responsibility of the company’s board of directors to come up with appropriate mechanisms for detecting and defeating self-dealing by the company’s insiders.

Second, it is considered reckless and perhaps irresponsible for individual directors to put their valuable reputations at risk while pursuing a collective benefit or one that belongs to the company. In circumstances where rational company agents have to choose among inaction, shared rewards or individual punishment, they will predictably choose inaction. By so doing, directors conveniently shift the risk of damage to their names by foregoing the option of recovery. After all, inaction would be more attractive to them because it is costless to them as individuals.

Third, there is a general belief that by going after self-dealing directors, a company might upset the culture of privacy and fraternalism that characterizes relationships among corporate leaders, especially in a relatively small market such as ours, where the density of close relationships is very high.

Fourth, there is also the argument that company directors, as rational individuals, would want to avoid, as it were “legislating against themselves”, by setting precedents by which their own conduct may be judged in future.

Fifth, even if self dealing cases were to find their way to courts, there are reasonable fears that without enough numbers of disinterested and vigilant directors, recovery may still be defeated because of informational asymmetries that exist between insiders and shareholders. Our system of litigation is adversarial and because of this, the party with superior information has advantages over the party that has inferior information. Information symmetries between insiders and shareholders could therefore be exploited to land a guilty insider a “not guilty “verdict which but for possessing superior information, they would not have secured.

Readers would have by now realised that corporate insiders are a distinct class of people with common interests and shared fears. Because of this, and in light of the foregoing reasons, company directors may be unwilling to set precedents that may be used against them in future.

Conclusion

Raising Zimbabwe’s standing on the “Corporate Governance Perception Index” is the collective responsibility of all stakeholders: Government – it is responsible for building a favourable economic environment in which businesses can compete, recover, grow and compete; labour – expects that the “ecosystem” will create more jobs and decent wages; investors – they expect that their investments will realise both capital growth and yield steady incomes, and lastly, government and the rest of society – they expect companies to be efficient vehicles which besides contributing to the fiscus, will produce goods and services at reasonable prices. Society expects business to do its part in contributing towards the eredicating problems that confront us today, not least of which is the problem of directors’ self-dealing.

We could overcome the inaction that has characterised corporate directors’ general disinclination towards recovery and disgorgement to date by making recovery mandatory and not a discretionary option as is presently the case.

It has been argued that in order for our economy to improve, confidence needs to pick up first and the market will follow. I believe markets and confidence may not recover until our corporate governance does recover!

Julius Chikomwe is a Harare Corporate & Finance Lawyer. This Article was written in his personal capacity. He can be reached on jc@wsc.co.zw.

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