"Material adverse changes, which raise substantial doubt about its ability to continue as a going concern" is one example of a fairly innocuous phrase which can have profound implications for a corporation’s survival. It is an auditor’s going concern qualification – something chief financial officers are becoming increasingly familiar with as the recession tightens its Darwinian grip on debt-laden corporations.
According to research firm Audit Analytics, more than 23% of public company filings made in the US for fiscal years ending between June 30 and December 31, 2008, included a going-concern qualification. But just how often is an auditor’s going concern qualification likely to appear in Asia?
A recent paper from the World Bank suggests a worrying trend. The bank says that the rollover of maturing debt, especially for commercial banks and corporations within emerging markets that either have no, or limited, access to domestic capital markets, constitutes a key risk to their survival. The bank estimates that over $1 trillion in emerging markets corporate debt will mature in 2009 and much of that has been extended by international banks which, under pressure from the governments which have bailed them out, are no longer lending across borders.
The result is that Asia faces a unique problem: while anecdotal evidence suggests that the overall level of corporate debt in Asia is at a historical low, the corporate debt that does exist is problematic because corporations could face severe difficulties in refinancing it over the next few years. Indonesia’s central bank, for example, said in February that $17.4 billion of corporate debt will mature in 2009 in Indonesia alone. Indonesia’s finance minister has publicly voiced her concern at the likely difficulties in rolling all that debt over.
We are, in fact, already seeing signs that this problem has surfaced. India’s Business Standard reported at the end of last month that Wockhardt, the pharmaceutical company, had joined the growing list of Indian companies entering into an institutionalised workout programme in order to restructure debt accumulated through over-expansion. The number of companies entering this programme reportedly rose by 300% in 2008-2009, indicating the worsening repayment capability of Indian companies. Fitch Ratings recently released a special report which identifies Asian corporations’ particular reliance upon continuing good banking relationships as key to being able to refinance debt maturing in 2010. It does point out, though, that if banking systems in Asia become stressed, leading to constraints on the availability of credit, current lending practices could change with larger, higher-rated corporations being allowed to refinance, while smaller, weaker corporations, or those already in distress, are being allowed to go to the wall.
The table below, from rating agency Standard & Poor’s, shows emerging market corporate defaults outstripping Europe in 2008. It also hints at the lag between the Asian financial crisis in 1997-98 and its effects, with the number of corporate defaults peaking four or five years later, in 2002. While past performance is, of course, not necessarily a guide to the future, Asia’s recent history certainly points towards the seeds of corporate default having already been sown by events in 2008 and 2009, with a harvest to be expected any time between 2010 and 2013.
As Fitch notes, all this data point to the need for pro-active debt management. This, of course, is not novel; it is something Asian CFOs should have been doing for the past few years - locking-in cheap credit when it was available, with an eye to stewarding their corporations safely through the inevitable change in the corporate cycle. Few CFOs seem to have done this, however; or we would not be seeing the oncoming crisis of debt maturity in Asia. Perhaps, as a result, the role of the Asian CFO will now undergo the kind of microscopic scrutiny which is a feature of litigation against directors and officers. The results could prove an uncomfortable reality check for many Asian CFOs.
The classic statement of the standard of skill to be expected of a director, namely that he or she need not exhibit a greater degree of skill than may reasonably be expected of a person with his knowledge and experience, can be found in an English case which is now almost 85 years old. Times have of course changed since then, as has society’s view of what can generally be expected of the modern corporation’s directors and officers. These expectations were more recently summarised in a US case decided in 1981, where the judge said that directors had a duty to:
- familiarise themselves with the fundamentals of the business in which their corporation is engaged;
- be (and stay) informed about the activities of their corporation;
- monitor their corporation’s affairs and policies;
- familiarise themselves with the financial status of their corporation, by regular reviews of its financial statements;
- enquire further into matters revealed by a review of their corporation’s financial statements.
Society’s expectations have continued to develop and the law on directors’ duties has become more exacting. In particular, as acronyms such as CEO, CFO, COO, GC and, more recently, CIO and CRO have multiplied, so the courts have shown themselves willing to apply standards of skill and care which are specific to the functions filled by people who have professional qualifications. The functions of CFO and GC (general counsel) are particularly susceptible to these standards, because they are routinely filled by individuals who are either certified public accountants or qualified lawyers.
The Australian case of ASIC v Vines is a good example of how the liability of a CFO, as the corporation’s primary financial adviser, might be assessed. In Vines, the court accepted that the core responsibilities of a CFO extend to:
- the financial operation of the corporate group
- supervision of the preparation of financial statements
- compliance with accounting standards
- the provision of accurate financial information to management, the board of directors and the corporation’s wider stakeholders, such as regulators and the investment community.
These responsibilities are likely to prove something of a circular problem for CFOs in Asia. A system of internal controls which enable the timely capture and transmission of information likely to have a material impact on the corporation’s financial statements is a pre-requisite for the provision of accurate financial information. Yet, if the internal controls aren’t there (and Vines suggests that it is the CFO’s job to ensure that proper internal controls regarding the financial operation of the corporation are in place), it is difficult to see how any CFO could be confident about the accuracy of the financial information he or she is responsible for feeding to the management, the board of directors and the corporation’s stakeholders.
Deficient internal controls have featured in 85% of the securities class actions filed in 2008 against Asian corporations listed on the New York Stock Exchange or on NASDAQ. While this may be explained by Asian corporations finding it difficult to comply with the scrutiny that goes with a US listing, the root of the problem is more complex. Asian corporations are very good at demonstrating the appearance of a system of corporate governance that ticks each box on a compliance checklist. The reality seems to be, however, that few Asian corporations have good corporate governance practices genuinely embedded within their culture. Information is power within many Asian corporations, and where power is often concentrated within the family that controls the corporation and a few trusted outsiders, information does not freely circulate. Satyam Computers Services is a recent, prime example of this problem.
If the approach in Vines is applied across Asia (and there is no obvious reason why it should not be), few CFOs will escape legal responsibility for inaccurate financial information produced as a result of deficient internal controls they have neglected to tackle. We need only look to the US for evidence that the courts, which are happy to shield directors and officers from being second-guessed by a corporation’s stakeholders, have also consistently deprived directors and officers of the protection of the business judgment rule where there is evidence of a “sustained or systematic failure” to exercise reasonable oversight.
In the years of litigation which are likely to follow the current financial crisis, a going concern qualification could well be seen as a final warning to a CFO of the need for pro-active debt management. For some CFOs, a workout programme or insolvency will be an inevitable result of their neglect, over the years, to implement a system of internal controls which could have provided them with timely and accurate financial information. Those whose job it is to recover losses suffered by the corporation’s stakeholders, or to discipline those responsible for an outcome which, with the exercise of reasonable care and skill, could have been avoided, are likely to demonstrate little sympathy.
Have another one for the road ahead. This hangover may be one that some Asian CFOs never quite shake off.
Steven Dewhurst is an insurance partner at Stephenson Harwood in Singapore.
FinanceAsia and AsianInvestor are hosting a conference on Distressed & Troubled Asset Investing at the Island Shangri-La hotel in Hong Kong today and tomorrow (April 28-29). Speakers include Ed Altman, professor of finance at NYU, and Charles Dumas, chief economist and head of world service at Lombard Street Research. Those interested in attending can still register on-site at a rate of $1,725.