Corporate Governance: It's Your Responsibility Too – Some Inconvenient and Uncomfortable Truths

Hate to Be Contrary But You Have A Responsibility for Corporate Governance

Warning:  This post contains some inconvenient and uncomfortable “truths” about your responsibility for corporate governance.  To make corporate governance work, you actually have to do something more than whinge about the failings of others.  Or issue calls for vague enhancements to corporate governance like calling on firms, auditors, regulators, and others to “step up their games”.     

Corporate governance generally focuses on roles and responsibilities of the board of directors, external auditors, and regulators.  Shareholders’ roles and responsibilities are not sufficiently discussed.  You can see this in the “founding document” of corporate governance the Cadbury Report (1992) which was sparked by perceptions of corporate misgovernance in Robert Maxwell’s companies. 

Typically the role of shareholder is summarized in a single sentence:  

“The shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place.”  

This post argues that there are clear defects in that formulation and more importantly shareholders’ responsibilities exceed those outlined therein.  If corporate governance is going to be built on this slender reed alone, should we expect brilliant results?  

First to the defects. 

As a practical matter, the shareholders’ role in “appointing directors and auditors” is generally to vote on the candidates proposed by the board of directors.  Often there is a nominations committee of the board generally structured to be “independent” of executive directors (e.g., senior management) that recommends candidates to the full board (which includes executive directors).  There’s a great deal of reliance on “independence” of the nominating committee here.  

In general boards have not demonstrated a lot of “independence”, but perhaps they are when we're not looking.  Or perhaps not.  The full board then decides whether to approve the candidate.  There’s a potential conflict of interest in this arrangement. The full board includes executive directors.  Management may therefore have a significant role in hiring those who are supposed to monitor its performance.   

But there’s more.  

Generally the board only recommends a single candidate for a position.  If there are 6 director slots open, shareholders get to vote on six candidates. If it’s time to appoint auditors, one firm is proposed. Shareholders have all the choice given voters in “democratic” elections in one-party states.  On a positive note for shareholders, a “no” vote doesn’t usually lead to unhappy consequences. In either case it is “take it or leave it” which probably explains why the directors’ recommended candidates win, except in extreme cases.   

There are two reasons for this state of affairs. 

1. As a practical matter how would shareholders—usually an unwieldy large number--select potential board members or auditors?  Do they have the skills, contacts, knowledge?  How would consensus be achieved among shareholders over their competing candidates?  If consensus cannot be reached, there could be a plethora of candidates which could be as problematic as having only one candidate. 
2. While individual shareholders generally have a right to nominate directors, the directors’ candidates have a much easier road to election.   If you look at a typical US proxy, shareholder resolutions are included in a separate section with management arguments as to why these should be rejected. When a hedge fund or other professional investor wishes to get its own slate of directors elected, it typically hires third parties to draft, print, and mail its own proxy to each shareholder.  Why does it incur this not inconsiderable expense? It doesn’t believe that management will give its slate a fair shake in the management proxy.  It can’t wait until the meeting to propose directors and make its case because “management” proxies will already have been voted for directors and most shareholders skip the AGM.  They do give management representatives the right to vote their shares, but realistically are management representatives going to vote for the insurgent slate of directors?   
3. In some jurisdictions, if a shareholder owns 10% or more of the stock of a company, that shareholder can name a director and there is no requirement for other shareholders to support.  Differences in cumulative versus non-cumulative voting rights also affect the election of directors.  
4. But in general shareholders’ oversight through the election of directors is more theoretical than real. 

Given the very practical limitations on shareholder selection of directors and the numerous cases of board “failure” in corporate governance, including by ostensibly “independent” directors, shareholders need to do more to protect their interests and to foster good corporate governance.   

This is key because people are the critical variable in good corporate governance.  It wasn’t Enron’s corporate governance structure that caused problems at Enron. It was people. 

Let’s run through what the “more” shareholders must do by way of questions.  

These will allow you to check just how real your commitment to corporate governance is.  Are you Augustine of Hippo or St. Augustine of Hippo?  

Do Corporate Governance Principles  Inform Your Investment Behaviour?

Let’s assume that indeed you are firm believer in corporate governance. Or at least claim to be whenever there is corporate governance failure. 

Among the good practice principles you endorse is that the roles of chairman and chief executive officer be separated and that the chairman be an independent director, not an executive of the firm. Do you refuse to invest in corporations where the roles are combined? 

Suppose your principles also include a requirement for strong risk controls and non-manipulation of markets.  If your bank holdings include one that like Sea World has “whales”, do you refuse to invest or divest your holdings?      

How many of your firmly held corporate governance principles can a firm violate before you take concrete action?   

Remember that the road to corporate governance failure is a slippery slope.  It begins with a first bending of one rule and eventually the breaking of more.  If the firm is highly profitable, can you easily justify poor corporate governance?  Sure they lost US$ 6 billion but they still made a profit. 

In applying your corporate governance principles, do you allow yourself more slack that the CEO of a firm?  You wouldn’t tolerate his breaking even a single rule, but you can let your own principles slide a bit and perhaps even quite a bit, depending on profitability.  

Do You Perform Proper Due Diligence Before Investing?

Do you read more than the glossy pitchbook they give you?  Consider more than the cut of their suits and flash of their MontBlanc cuff links?  Read beyond the gushing appellation “Goldman Sachs of the GCC” or similar in the local press.   Or a shrieking recommendation delivered by Brother Jim on the TV?  

Does that due diligence include checking on corporate governance?  And situations that might cause corporate governance to fail, i.e., distressed financial conditions? 

Do You Know How to Perform Due Diligence Properly?  

Have you bothered to learn how to do due diligence on an investment?

Do you know the tricks used to enhance the presentation of performance in sales pitches?  When you were presented with financial performance, did you check what standards were used for reporting?  A good rule:  No GIPS no investment.  Were there model portfolios included?  Projections to the past:  “Using our strategy on a proforma basis, over the past 10 years we would have earned an IRR of 35%”.  What they don’t say is:  Of course, we didn’t, but it sure looks good.  And if we pick the right time period, we can find a sweet spot IRR.”  

If they're lying to you or stretching the truth in their pitches, what should infer about their ethics and their corporate governance?  

Do you know a bit about financial statements so you can at least spot if cashflow is not in line with reported income?  Would you have noticed that despite Dubious Gas’s reported income, the KRG and Egypt weren’t paying DG what they owed it?  

Understand that under accrual accounting, there can be different methods of recognizing the same transactions both on the balance sheet and the income statement? 

Do you know what the role of auditors, regulators, stock markets are? And what reliance you can or cannot put on them to look after your interests?  

Know what to look for in corporate governance structures, if you're looking for one that is complete and well-structured?  

Do you know the “red flags” of corporate distress?  As stated in my previous post, unless a firm is set up as a criminal enterprise, corporate misgovernance is more likely to occur when management is dealing with a serious problem than when things are going well.  

Some practical examples, before investing in one of Abraaj’s funds, did you look to see where their parent, the management company, etc were incorporated?  Did you understand that offshore companies in the Cayman Islands and other similar jurisdictions are lightly regulated (first euphemism of this post and in a long time)?  Did you ask why? A plausible answer might have been tax planning, but the flag of light regulation should have caught your eye.  

Did you ask for audited financials?  A good but not necessarily foolproof way to check if the firm is in financial distress.  The sort of “occasion of sin” that might lead to corporate misgovernance.   It's also a good way to check on the business performance.  If the funds they manage are performing well, that is, have a flow of exits and good returns, the bonanza of carried interest fees should show up here.  

But they might have told you: “No PE firm publishes financials.  We’re a partnership.  Our partners don’t want their remuneration disclosed.”  Did you know that Charterhouse Capital Partners and associated companies publish financials and that you can obtain a copy at Companies House?  You don’t get individual details but you get an aggregate number.  

Ask about performance of their funds?  If you had asked about their flagship “infrastructure” fund (IGCF) you might have noticed rather dismal performance as Arkad has pointed out. The delay in closing the “sale” of Karachi Electric might have caught your eye. You might have noticed that the GOP wasn’t paying K-El.  Or that K-El had been in Abraaj’s portfolio for some time. Might you have wondered about their wisdom in plunking down a whale-sized amount to invest in power in the subcontinent?  Or wondered what made this investment different from others in the subcontinent?  Enron Dabhol.    

If you looked at that fund’s investments, you might wonder, as Sabah Al-Binali did, why a Private Equity firm was buying listed stocks and what this meant about their stated investment mandate and adherence thereto.   Assuming it was a pure private equity fund, if they won't keep to the mandate, what other promises might they not keep?

What Post-Purchase Investment Monitoring Do You Perform? 

The Abraaj scandal came to light because a few investors saw something that raised red flags and they acted on that information.   

Do you read the company’s financials and investor presentations carefully and not just rely on company press releases or puff pieces in the press for your monitoring?   Local press analysis often being little more than a regurgitation of the press release.  

Do you look for changes in behaviour or reporting by the firm that are red flags of potential problems? 

Do You Exercise Your Corporate Governance Rights?  

Do you attend the annual shareholders’ meeting?  Ask questions you have from your post-purchase monitoring?  Listen to the questions of other shareholders and management’s responses?  React and participate? 

Where there are proxy materials, do you actually read them?  Do you vote your proxy?  Do you do more than “tick” yes on the management recommendations?    

In some jurisdictions there aren’t proxies. Some of this information is in the audited annual report.  Or in separate corporate governance reports.   

If you've got a problem with information provided have you ever complained in the AGM (with auditors, representatives from the MOIC or equivalent, and directors present) that information in financials and disclosures is insufficient.  Ever make similar complaints in writing to your stock market or local regulator about insufficient, unclear or misleading disclosures?    

CONCLUSION 

At this point I imagine that some of you are thinking.  

But this is hard work. It’s unrealistic.   We don’t have the skills or time to do all of this. The auditors, the board, the regulators should do their jobs properly and we won’t have to.  Quite!  Police and neighbors should be keeping watch to prevent burglaries.   I shouldn’t have to lock my door. 

Or wait just a minute, AA.  Are you seriously arguing that if we do this, there won’t be corporate misgovernance?  

No!  But you may make it harder.  You may create an environment that encourages other shareholders to take similar actions.  

You may deliver a very clear message to board members that you are watching.  Auditors, regulators, the MOIC may be awakened to action.

On the other hand, you can decide that this is too much and not really your responsibility. You can remain among the sheep. That entitles you to bleat on-and-on about corporate misgovernance whenever you’re sheared.   

Corporate Governance -- Easier Said Than Done

In the wake of the distress at Abraaj, there have been the usual calls to enhance corporate governance.  

As the title above indicates, AA has a contrarian view.  

In particular, I want to address two assumptions that seem to be held regarding this topic: 

1. If only we adopt certain measures, we can greatly reduce and perhaps even eliminate instances of corporate misgovernance.  
2. When corporate governance fails, the tendency is to blame third parties never oneself.  This “shifting” of responsibility seriously detracts from enhancing corporate governance. 

Corporate governance or lack thereof is the result of the interplay of three factors:  

1. Governance systems 
2. People 
3. Situations 

GOVERNANCE SYSTEMS 

The primary focus in the pursuit of good governance appears to focus on establishing systems, perhaps because the difficulty of controlling the primary factor in corporate governance—people— is realized to be difficult. 

These systems are designed to: 

1. Establish “rules of the road” for conduct generally in the form of codes of conduct or ethics.   
2. Create organizational structures and limitation of personal authority/segregation of duties to (a) prevent individuals from exercising unfettered control over the corporate entity and (b) provide multiple review mechanisms to “catch” bad behaviour that has slipped through the ethical and  organizational “nets”.  

Rules establish standards of conduct.  Basically, these can be summarized as follows.  Don’t cheat, lie, or steal from the company’s owners and other stakeholders.  Don’t use your position to take advantage of the company’s owners or other stakeholders.  Discharge your duties as a faithful agent. Pretty simple and obvious “stuff”.   Presumably, this is the sort of moral sense we’d expect from board members, officers, and employees of a firm.  

And well might ask why do we need to tell people to be ethical unless we assume we’ve hired some pretty low lives.  Does any ethical person think it’s right to steal or lie?  

So if they’re so self-evident, what’s the need?  

1. Ideally they provide clear unambiguous rules of conduct.  If insider trading is properly defined, to use one example, then there is little room for debate on what constitutes insider trading.  They also provide an inventory of responsibilities. 
2. They can address gaps or ambiguities in the law or governmental regulations.  Also they can hold the board, officers, and employees to higher standards than mandated by the law or government regulations.  
3. If crafted properly, they provide a legal basis for the termination of employment or other service.  If you find a “bad apple” you’ll want to get him or her out of your barrel ASAP.  

Examples of organizational structures and procedures (exercise of authority) are segregation of duties, including management of key review functions, dual control, requirements for independent directors, an independent chairman, etc. 

Review functions are both internal and external. Internal review includes internal audit, compliance, risk management, etc.  External review includes external auditors, including requirement for rotation of firms or audit partners; government regulation (chiefly for financial sector entities).

In some cases firms or governmental regulatory agencies have “whistleblower” programs for individuals to report inappropriate behaviour.  

But these measures while necessary are not sufficient.   

And unless there are glaring deficiencies, the benefit of adding additional measures is often likely to be marginal.  Using AA’s wayback machine, here’s a post from 2009 which shows that sometimes enhancement to existing measures can be theoretically useful.  

PEOPLE

No matter how good the system, if those charged with implementing it don’t follow it for whatever reason, corporate misgovernance can occur.  People are the critical variable. 

To set the stage, some examples of system failures due to people:  

1. Wells Fargo had a fairly developed whistleblower program.  It received numerous complaints about unauthorized opening of customer accounts and credit cards.  There was no discernable impact on firm behaviour.    
2. Enron had a 65 page corporate ethics manual, which if it were followed to the letter, would have prevented much, if not all, of its inappropriate behaviour.  
3. For more examples, take a look at the Breeden report on Hollinger International.  Richard C. Breeden, former head of the US SEC, and his law firm have prepared other reports on corporate mis-governance, e.g., MCI,  WorldCom.  

Typically, an attempt is made to address the “people issue” by establishing “fit and proper” criteria for owners/partners of unlisted firms, board members, and senior managers; limitations on numbers of boards board members may serve on; requirements for a number of independent-of-management board members; and possession of relevant skills and experience. 

Enron had a distinguished Board: 15 independent directors, including a former regulator, a former British MP, a distinguished former accounting professor who served as head of its audit committee.  

If you were looking for the ideal board which on its face has all the “right” people–qualified with years of practical experience and as outsiders ostensibly independent—and every Corporate Governance box "ticked", Enron’s Board would be a very strong contender.  Yet, as per press reports, Enron’s Board “suspended” the Company’s Code of Ethics to allow the CFO to be a shareholder in an Enron-related offshore entity.  Articles here and here.  

Enron’s Chairman/CEO had a reputation for promoting corporate governance and ethics.  See the first page of the Enron Code of Conduct.   Read his stirring speech at a 1999 the University of St Thomas in Houston. 

What went wrong? 

People are not perfect.  

Laziness, self-interest, incompetence, a propensity to “go along to get along”, fear of displaying one’s ignorance, etc. are typical traits that lead to governance and other problems.  Add to that an increasing sense of entitlement at the senior that one deserves more and more.  In short human nature.

Efforts to fundamentally change human nature do not have a track record of success.  Nor do those that focus solely on changing behaviour.  

The Soviets brought the power of the state to bear in an attempt to create a new and better Soviet man.  Jamal Abdul-Nasser and his colleagues a new Egyptian, freed from the legacy of colonialism, and what was perceived to be the dead hand of tradition.  Various religions have sought to modify behaviour and have wound up neither achieving widespread practice of right thought, right speech, or at a minimum right action.   

Those working on corporate governance enhancement have to recognize (a) the limitation of the perfectability of man and (b) that enhanced systems will not solve the people element in corporate governance problems.   

That doesn’t mean that one doesn’t try, but that one needs to have a sense of practical limitations.  In short we will not eliminate corporate misgovernance.

SITUATIONS 

In extreme cases, corporate entities are set up as “criminal enterprises” from inception.  Systems may be put in place but there is no intent to adhere to them.  

In noncriminal corporations, there is an intent to adhere to control systems.  Much corporate mis-governance occurs in response to distressed circumstances.  These situations are the real tests of ethics.  

It’s easy to be ethical when the money is rolling in and the corporation is doing well.  

AA has not once been tempted to rob a 7-11.  But if my imagined investments in Dubious Gas went to zero (my entire portfolio), I lost my job, and couldn’t access money, I might like Jean Valjean steal to feed my family.   

The same in the corporate world.  

If an investment firm had an ongoing cash shortage and needed money to continue operations but couldn’t get it immediately from legal sources, might its managers decide to temporarily “borrow” some client funds to bridge a cashflow problem that they’ve persuaded themselves is a temporary state of affairs?  

No doubt making the argument that preserving the firm also preserves clients’ assets, doesn’t disrupt financial markets leading to economy-wide problems.  And also considering carefully the impact of failure on their reputations as well as the loss of the perks of their positions.  

It’s in these cases that people will try to subvert systems.  Often they can do so and do so for a long time.  

Interestingly, when corporate misgovernance occurs, opprobrium is generally directed at those whose misgovernance is followed by collapse of their firm.  

In other words, the market seems distinguish between two situations: “successful” misgovernance (not bad) and “unsuccessful” misgovernance (unconscionably bad).  

Misstating financials is considered a fairly serious breach of corporate governance.  

At the outset of the Latin Debt Crisis, all US money center banks and some large regionals were insolvent based on a proper valuation of their Latin Debt.  Not a single one of these banks produced accurate financials.  The Government and external accountants either were woefully ignorant of the true state of affairs or colluded in the charade.  Eventually, the banks were able to work their way out of insolvency with a helping hand from the US government.  

Enron mis-stated its financials.  Lehman misstated elements of its financials.  Sunbeam as well.  All crashed and burned.  The Boards and senior officers of Enron, Lehman, Sunbeam and other companies were pilloried for corporate malfeasance.    Their auditors were charged with dereliction of duty.  In one case a major auditing firm was destroyed.

On the other hand not a single word of opprobrium was directed at the banks or their auditors over the Latin American debt crisis.  

What’s the takeaway here?  

1. For non-criminal firms, one can’t predict the response to corporate distress.  What level of distress will cause the system to bend and then break?  To cause normally ethically sound people to relax and then abandon their standards of conduct?  How can one devise a governance system that prevents that from occurring?  
2. Some corporate mis-governance is apparently good, i.e, if the firm survives.  It’s a natural response of someone in a distressed situation to imagine all sorts of “good” reasons to justify breaking the rules.  

RESPONSIBILITY SHIFTING 

A general reaction to corporate governance problems is that management failed, the board failed, the auditors failed,  regulators failed.  Indeed, they may have.  

But there is additional culpability.  What about other stakeholders and market participants?  If they adopt this very convenient view that they are innocent victims, then corporate governance is the responsibility of others. If one has no responsibility, then one need take no action, other than complain about the turpitude, avarice, and incompetence of others.  

The next post will deal with the apparently inconvenient and uncomfortable responsibility of other market participants to promote corporate governance.

AA Providential Warning – US Way of Life and Future Under Attack -- End of Civilization As We Imagine It

Another Public Service from AA

Who monitors the news so you don’t have to?  And reports serious stories you need to know?  

AA of course.  

What follows is clearly a three tinfoil hat level threat. And that's why I'm using both digital and old media to sound the alarm tocsin. 

Despite the title, this post is not about TISVP, though there’s no reason that it wouldn’t be him in the background.  Or that it would be him in the background.  

As reported in The Guardian, Larry Fedora, head coach of the University of North Carolina football team, sounded the warning:  

“Our game is under attack,” Fedora said on Wednesday at the ACC’s preseason media day in Greensboro. “I fear that the game will get pushed so far to one extreme that you won’t recognize the game 10 years from now. And I do believe that if it gets to that point, that our country goes down, too.” 

Fedora illustrated the point by recalling a conversation he’d had several years ago with a three-star Army general who attributed the success of the US military to football.  

“I had a question for him: What is it that makes our country, our military, superior to every other military in the world?” Fedora said. 

“He was like: ‘That’s easy, we’re the only football-playing nation in the world. And most of our troops have played the game at some point in their life at some level and the lessons that they learned from that game makes us who we are.’”  

That's football, not soccer!  You can call you game "football" but you'll never have a military superior to ours as the picture below demonstrates.

The story may also explain the peculiar features of American “thinking” to those confused by what they see happening in the former colonies.

 

 Strong Virile Football Playing American General Comforts Weak Soccer Playing European Officer

The “Art” of the Deal – How to Have a Successful Negotiation Each and Every Time

Gradually It's Getting Clearer What All the Mirth Is About

Asian analysts seem to have reached consensus that the above picture definitely dates from July and not May of this year.  Debate still continues whether the date of the photo is 12 July, 16 July, or 17 July.  

Did you ever wonder how the dealmeisters are able to have a “fantastic” record of successful negotiations? 

Side comment:  “fantastic” in the previous sentence is used in the first two senses of this definition.  

AA has for some time. Just recently his eyes were opened when America’s #1 DealMeister successfully negotiated a comprehensive precedent-shattering agreement with the formerly bad leader of the formerly bad Democratic Peoples’ Republic of Korea.  

Uniformed critics and other purveyors of “fake news” criticized the agreement as lacking real detail and commitment.  With what appeared recently to be push back by the North Koreans, these critics were emboldened further stating that “Kim will never give up his nukes”.  

In a masterstroke that saved the deal and no doubt silenced critics, according to press reports, the US President announced to what was no doubt an appreciative and rapt audience:  

“We have no time limit. We have no speed limit,” Trump said at a meeting with members of Congress on Tuesday.” 

Appreciate the pure genius of this.  

Strike a deal that doesn’t contain specific required actions but merely states some platitudes.   Then have no deadline for implementation.   It’s hard to imagine even a serial breaker of previous deals, like the DPRK, walking away from a deal like this.  

Please no snide comments that a deal without specific performance or time frame isn’t a contract.  

You may be wondering why an ostensibly financial blog like SAM is commenting on a political agreement.  Well, the simple answer is that this principle could be applied to finance.  

Worried about Abraaj or some other duff borrower repaying a loan to you?  Buy their zero coupon perpetual bond.  You’ll sleep as sound as the folks in South Korea or Japan do these days after the NK nuclear threat was eliminated!

Dubai Islamic Banks - You Can't Tell The Banks Without A Scorecard

A Stroll Down Memory Lane Courtesy of GN's Wayback Machine

GN has changed the picture to DIB.

Just be careful where you get the scorecard from.

AA had to check his spectacles several times today while reading the Gulf News’ article on Dubai Islamic Group  “DIB Group net profit up 14% to Dh. 2.4b”.  

First on the "Top News" Page of the Business Section  above the article on DIB was this picture of Noor Islamic Bank.  

1. Over four years ago (January 2014 to be precise) Noor dropped the word “Islamic” from its name, favoring the punchier “Noor Bank”.   
2. Second, Noor Bank is not part of the Dubai Islamic Bank Group.  NB is owned by various shaykhly personages and government entities, including some rather prominent ones within GN’s home news beat, the Emirate of Dubai.  I guess if you’ve seen one redwood or one Islamic Bank, you’ve pretty much seem them all, even if one (NB) is the self-described “Financial Icon of Dubai”.  
3. As an aside, even though it’s a scant 10 years since NB was founded, based on its status as the FIB (Financial Icon of Dubai), AA for one is ready to bestow the appellation, the “Deutsche Bank” of the GCC on NB. Will GN or Al-Khaleej join me? 

Second, and much more importantly, the following comment caught my eye (italics AA):  

“Non-performing financing ratio and impaired financing ratio improved to 3.3 per cent and 3.2 per cent, respectively, highlighting the quality of new underwriting.

No details on what the levels were at 30 June 2017 or at December 2017 in the GN.  

But AA has your back.  

From DIB's 2018 press release, as of 31 December 2017, the NPA and IFA ratios were 3.4% and 3.2% respectively.  And there has been progress from 2016 as well.

From DIB’s July 2017 press release on 1H earnings, we learn the NPA ratio was 3.6% but there's no information on the IFA ratio.  

Clearly DIB is making progress.  

But if one is touting the fact that new underwriting over the past 12 months or 6 months was of a “high quality” and this reduced the NPA and IFA ratios, does that mean that DIB is admitting that in the past when DIB made loans a good number of them went south within 6 or 12 months of underwriting?  

That would be some really unfortunate careless underwriting.

July 2018 The US - Russian Summit A Moment in History

Courtesy of The Sun, UK.   Gulf News has yet to post a video.

A great start.  Sunglasses off.   

Wink, wink, nudge, nudge, say no more.

AA Explainer: Whay Are There Basic Difficulties in US - Russian Relations and Summits

TISVP

Why are there basic difficulties in US- Russian summits and relations between the United States of America and the Russian Federation?

Here's an "AA Explainer" to help you understand why.

Since the President of the Russian Federation began wearing reflective sunglasses to summit meetings, his American interlucutors, especially those from one particular US political party, have had trouble looking into his soul.

And, if you assume that when they look into the sunglasses, they are able to see their own souls, it's got to be quite a disturbing event.

Dana Gas Restructuring: The “Art” of the Deal

Unconstrained Mirth at the Announcement of an Imagined Successful Negotiation  

Asian analysts are divided on whether the picture is from 13 May or 12 July of this year.  As you’ll recall, Dana Gas announced its “successful” restructuring on the former date, “accretive to all stakeholders”.  On 12 July the conclusion of another allegedly fantastic deal was announced.  By at least one account (Twitter?) this one “irrevocably sealed” with a handshake. 

Early on in its negotiations with creditors, DG adopted a rather pugnacious strategy, reminding AA of the “hit them back harder” strategy advocated in a business book published first in 1987 by a self-proclaimed dealmeister under the same title as this Blogpost. A remarkable coincidence!  Hence, this remark.  

Let’s review how DG was able to apply this “winning” strategy and negotiate a “fantastic” deal with its creditors. 

On 3 May 2017 DG issued a press release stating that it would commence restructuring negotiations with its sukuk holders because its cash flow problems made full repayment of principal on 31 October 2017 impossible as it needed to conserve cash.  

On 17 May 2017 the creditors announced that they hired advisors for the restructuring.  DG announced that it hired its own set of advisors on 5 June. 

Subsequently, on 6 June 2017, in a conference call with sukukholders DG announced a set of principles which it later codified in a 13 June press release:  

1. Illegality:  Due to changes in interpretation of Shari’ah, the existing sukuk was no longer compliant with Shari’ah or UAE law. Consequently, DG in good conscience could not make any payments, including the upcoming profit payments in May and October 2017. 
2. New instrument:  To be Shar’iah compliant.  
3. Tenor:  4 years with bullet repayment.  
4. Profit Distributions (Interest): Less than half of the 9% rate on the sukuk with provision for unspecified amount to be paid in kind (PIK), i.e., additional debt.  
5. Prepayment:  At company’s discretion with no prepayment penalty. Something not usually granted on a fixed rate debt instrument.  

DG also advised that it had asked the eminent courts of Sharjah to rule on the legality of the existing sukuk.  

This was the company’s first offer. Like anyone else negotiating in the suq, including the suq al mal, probably an opening offer intended to start negotiations with the expectation that that final terms would differ.  

In quick order thereafter the company advised that it had obtained restraining orders in Sharjah, the Cayman Islands, (effective 13 June), and the UK (apparently effective June 16) preventing the sukukholders’ agents from taking action against the company to enforce their rights.  Rather quick action given DG’s announcement that it hired advisors on 5 June.  

On 27 July DG advised the sukukholders that its “previously contemplated offer” (apparently the 13 June “proposal”) “is now off the table, and that the Company is pursuing litigation driven outcomes” as per its 31 July press release.        

What happened?   

According to an apologia for DG published by Al-Khaleej newspaper –available on DG’s website--under the title “Dana Gas has, from the outset, been transparent and sought fair solutions for Sukuk holders and has been justified in its actions to protect all of its stakeholders.”  Move over Gulf News you've got a strong competitor in local "journalism".

What rather sad and unprofessional behaviour by the sukukholders forced what was no doubt DG’s reluctant hand?  

In Al-Khaleej’s words:  

”However surprisingly (and unlike previous and normal practice) the committee refused to even meet and instead, in a very unusual and hostile ill-advised step according to Houlihan Lokey, one of the leading international financial advisers specialising in debt restructuring, the Company received threatening letters and a draft default notice that would have greatly harmed both the Company's ability to secure its outstanding cash receivables and realise the value of its enormously valuable assets; and negatively affecting all stakeholders including the Sukuk holders themselves.” 

First, a shout out to the phrase “its enormously valuable assets”.  Those would be the ones that over a rather prolonged period have been unable to generate an acceptable ROA or ROE, even ignoring risk, to say nothing of generating cash in a timely fashion.  

Second, earlier like Al-Khaleej I believed that HL was one of the leading international financial advisers specializing in debt restructurings.  Taking Al-Khaleej’s quote of HL at face value, my opinion has changed. I’m guessing that it’s more likely they were experts in restructuring church and charitable organization debts where more genteel creditor behavior is more likely to be commonplace.  In purely commercial deals creditors can be quite hostile when an obligor announces its inability to pay--an event which highlights the manifest failure of the lenders’ or investors’ underwriting of the deal at inception.   

In general debt restructurings are not pleasant affairs.  AA has been regaled by his elder brother and other equally reliable sources with stories of irate creditors verbally abusing the obligor and its advisors as lacking integrity and business sense, threatening to call a default and “destroy” the borrower.  And generally behaving “shirty”.  

In one case an unsecured creditor threw a rather heavy object at an obligor’s outside advisors when that advisor had the temerity to note that unsecured creditors were lower in legal priority of payment than secured ones.  In another case where an aggressive creditor rejected an initial restructuring proposal with a string of profanities directed at a former senior US government official who had returned to his lawyerly and advisory roots.  

Even more so if the obligor is a serial defaulter as is the case with Dubious Gas.  On top of that the company raised a rather preposterous defense against payment after having promised in the sukuk not to challenge the legality of the instrument.  See  Page 108 "Events of Default" (c) in the Prospectus.  

To add insult to injury DG prepaid other creditors in preference to the sukukholders sometime prior to 11 May.  Some cash is more worthy of preservation that other cash, I suppose.  A reasonable creditor would seem justified in ascribing manifest bad faith to the obligor. 

No wonder the creditors made the threat they did.  More here.  A perhaps rougher elbowed group of creditors would have called default immediately.   

Finally, according to the Al-Khaleej account, the threatening letter was sent on 23 May 2017.  On 6 June the company conducted a conference call with sukuholders.  Not a meeting in person, but a meeting nonetheless.   No doubt the sukukholders were less than enthusiastic about DG’s proposal as would be “normal practice”, especially given DG's less than good faith behaviour outlined above..  

Whatever the case here, subsequently, DG was quick off the mark (especially if advisors were hired on 5 June) with a blitz of legal actions. To boot the eminent courts of Sharjah seemed squarely on its side.  DG had seized the initiative from DG’s creditors.    A providential prepayment of other bank obligations prior to 11 May 2017 reduced the risk of creditor contagion.   

From all the above, it sure looks to AA like DG was preparing to take a hard line well before the 23 May “threat”.  

But DG has more up its sleeve, according to Bloomberg, DG also noted that the assets in the Trust--primarily, the company’s fine Egyptian assets--had dismal returns. DG have well-established track record in this field and were clearly speaking from experience and expertise.  DG noted that if it were to unwind the sukuk ab initio (because of its illegality) and recast the “profit payments” in excess of the assets true return as principal repayments it would then owe the sukukholders only USD 55 million.  On the other hand were it to covert the sukuk to equity in the fine Trust Assets, the sukukholders would owe DG some USD 150 million.  You will perhaps note an apparent contradiction between asserting these fine assets generated minimal returns and a valuation of some USD 850 million.  Such are the mysteries of “Islamic” finance and GCC finance.   For more on DG’s strategy/threat see my post here.  

Given the propensity of the eminent courts of Sharjah to see things DG’s way, including allowing the company to pay a dividend in the midst of a debt restructuring and in contravention of the UK High Court’s ruling, and basically refusing to apply other foreign court decisions on DG, it doesn’t seem unreasonable that they would see things DG’s way on this topic as well.    

One side note, investors who bothered to read the sukuk prospectus would not have been surprised by the actions of the eminent courts of Sharjah.  

Let’s take a look at the fantastic deal that DG secured for itself from an apparent position of strength and a no-nonsense take-no-prisoners approach.   

1. Tenor:  Three years instead of DG’s originally proposed four years.  Commencing from October 31, 2017.  
2. Profit Rate: 4% instead of the company’s 3% rate.  A partial win, but note that the average life of the sukuk has been shortened dramatically by the down payment and promised prepayment, though as structured the latter does not appear to be mandatory. 
3. PIK – No PIK.  
4. Principal Repayment:  No bullet repayment. DG will use USD 385 million of its cash to make a principal payment on signing.  Assuming sukukholders are smart enough to sign up for Tranche A (immediate payout at a discount), the principal amount of the sukuk will be reduced from USD 700 million to USD 420 million, roughly a 36% reduction.  
5. Prepayment:  Another USD 105 million prepayment no later than 31 October 2019, 15 months from anticipated signing in August 2018.  If made, the prepayment will reduce the sukuk to USD 315 million or 55% of the original USD 700 million.  If DG fails to prepay, the profit rate will increase to 6%.  Failure to pay appears not to constitute a default.  
6. Additional Obligations:  Promise to use all net free cash from NIOC settlement or sale of the fine Egyptian assets to buyback sukuk under certain undisclosed terms.  Neither the NIOC settlement nor the proceeds from the sale of the Egyptian assets are collateral.  Both of these are potential but probably not highly probability future events (assets).  A sale of the fine Egyptian assets has probably been harmed by DG’s trash talk about their multi-year disappointing performance not to mention the whiskers on the associated receivables. Recent moves by the USA to apply financial pressure to Iran could reasonably be expected to frustrate an NIOC payment if settlement were reached.  What is notable here though is that DG has accepted an obligation to use the NIOC settlement as a source of prepayment even though it is not part of the Trust Assets.   
7. Dividends:  Ability to pay 5% of paid-in-capital as dividends subject to certain undisclosed minimum cash maintenance requirements.  Potentially a stake into the heart of the sukukholders’ repayment prospects if this is not structured properly.  

It doesn’t seem that DG’s hard-nosed “clever socks” strategy has resulted in any real benefit to the company in terms of the restructuring unless we assume that a less confrontational negotiating style would have resulted in repayment of the full amount upon signing as well as board and senior management members pledging their first born offspring to the sukukholders.  

Not only did DG not get its wishes, but also DG has committed its cash windfall from the KRG settlement to repayment of the sukuk.    

But there’s more. 

Real damage has been done to the company.  

The cash drain is happening at the time when DG asserts it needs cash for needed development of its operations.   DG's clever socks strategy has burned a lot of bridges.  

Existing creditors and potential creditors with half a brain (note that caveat) have probably been alienated; though DG may be able to “bank on” bankers’ and investors’ chronic ADD and the rather large bloc of creditors and investors with little credit skills or sense.  See the Abraaj saga for examples of the latter.  

There is another lesson here.                   

If you’ve found what appears to be a clever business strategy in a book, check out the bona fides of the author before you act.  What is the business track record of the author? Is the author a true "captain of industry"?  Or been involved in serial shipwrecks?  

If you also see the author, even if he or she claims to be a billionaire, hawking steaks, wine, or dubious educational institutions on the TV, it may be a testament to his or her (a) less than stellar track record in business and thus (b) lack of real business acumen.  

After all, how many successful businessmen or women engage in such peripheral activities when they could earn additional billions in their more lucrative mainframe pursuits?  Lloyd Blankfein hasn’t come around to Chez Arqala offering gardening or pool services.  Warren Buffet isn't doing reality TV.

When reality collides that violently with image, it’s probably wise to heavily discount the advice. 

It's also wise to ensure a sound understanding of the correlation of forces.  If conditions are not good, even a "wise" strategy can fail.