Governance challenges for SMEs Tony Stumm Carter Newell, Brisbane

Governance challenges for SMEs

Tony StummCarter Newell, Brisbane

What is the current environment for SME’s?

• General economic conditions, cash flow pressures due to difficult retail trading conditions.

• Considerable financial uncertainty and lack of business confidence.

• Rising numbers of business closures, corporate collapses and bankruptcy.

• Tighter lending conditions.• Margins being squeezed.• Concerns on both existing and future markets.

What is an SME?

• Family businesses or close knit business structures - varying definitions.

• Small enterprise = 10 to 100 employees.• Medium enterprise = 100 to 500 employees.• Annual turnover up to $10M qualifies as SME.• Corporations Act guidance section 45A. A large

proprietary company must meet two of these three tests:– Consolidated annual revenue of $25M or more; and/or – Consolidated gross assets of $12.5M or more; and/or– 50 or more employees.

• A small proprietary company is the converse.

Problems affecting SME’s in Australia

• Findings of CPA Australia and Canada July 2010 Report.• SME’s need access to funds.• Cut unnecessary red tape. • Straight forward tax system.• Reduced consumer spending restricting margins.• Compliance fatigue.• Improved basic management needed.• Ability to respond.

Special characteristics of SME’s

• Lack of financial and human resources, including managerial resources.

• Limited personnel in comparison to larger companies.• Lack of strategic vision and long term planning.• Outmoded work planning practices.• Reliance upon owners.

2012 PWC Family Business Survey Challenges

• The results of PWC’s 2012 Family Business (World) Survey show that family firms are robust, vigorous and successful – they’re ambitious, entrepreneurial, and delivering solid profits, even in the continued uncertain economy.

• These businesses are making a substantial but under-valued contribution to stability and growth.


Unique characteristics:•“When you are a privately held company you have the ability to change the direction rapidly and do not have a board of directors that dictates what you have to do”. (USA)

•“We have a more autonomous decision-making capacity and especially more flexible management”. (France)


• “In a family owned business you tend to think on a long term basis, not a short term basis. You tend to think about your business over generations and not just only based on profits” (Austria).

• “A lot of our customers like doing business with us because we have good values. We can adapt more readily to customers’ needs because we are so flexible” (USA)


• Even more crucially, family businesses often face difficulties accessing significant levels of new capital to fund expansion.

• The three issues identified by most respondents were market conditions (54%), competition (27%) and government policy and regulation (27%).

• The recruitment of skilled staff and shortages of labour have become more acute challenges than they were in 2010.


• 59% of survey respondents cited price pressures as a likely future issue.

• Anticipating and addressing regulatory requirements and changes are a particular concern.

• “Corporate governance standards are an issue – if we want to grow then our standards will need to be up to speed with international best practice – in India the majority are not up to speed”. (India)


Unexpected Data:•Taken overall, more non-family members on the board, a figure which increases to 75% for firms with turnover of more than $100m.•“Family businesses do not place enough importance on proper procedures and governance”. (Middle East)


• “[We need to] bring outsiders onto the board of the company, and learn how to deal with that. Also the organisation of internal processes to streamline our operations. In other words, the professionalization of management”. (Brazil)

• Fewer than half of family businesses plan to pass the business fully (ownership and management) to the next generation.


So what are family businesses looking for?•Family businesses – like all businesses – want to see a reduction in red tape, a more stable economic environment, low interest rates, a more flexible labour market, further incentives for employment and training, a more consistent tax and regulatory framework, and investment in infrastructure.


• Around 97% of all private sector business in Australia are SME businesses.

• SME’s provide around 50% of Australians with employment.

• SME’s have corporate governance needs – but different to those of public companies.


• Financial management tools and understanding.• No suitable model for adapting ‘big business’ corporate

governance to SME’s.• On going affordable access to professional advice.• Sound, affordable, planning i.e. for expansion,

succession planning.

What can Corporate Governance do for SME’s?

• SME perception:• Why do SME’s need more rules?• What protections does Corporate

Governance provide?• What are the cost benefits?• Corporate governance won’t improve profits.

Corporate Governance challenges for SME’s - Insolvency Issue No. 1 – Insolvency•Without regular data retrieval and reporting, i.e. financial management tools, insolvency can be a real problem.•SME’s need to be conscious of “tell tale” signs indicating financial stress on a business that can lead to insolvency.•Difficult trading conditions heighten need for vigilance.

What is insolvency?

- Inability to pay debts when they are due for payment.

The “tell tale” signs of insolvency

• Discussed in detail in ASIC Regulatory Guide 217 and ASIC Information Sheet 42.

• Limited cash flow (including reasonably projected cash flow) to pay debts and commitments (including future commitments) a classic symptom.

• Frank assessments are required.

What if an SME collapses due to insolvency?

• A director of a company has a duty not to allow their company to trade whilst insolvent.

• If their company collapses and is liquidated, the liquidator can recover against directors the value of all debts incurred whilst the company traded whilst insolvent.

• There is “relation back” of personal liability on directors to the date found to be the insolvency date.

• Section 588E – deemed insolvency because of improperly kept financial records.

Other consequences for corporate insolvency

• Civil penalty against directors i.e. fine up to $200,000.

• Disqualification from being a director.

• Possible criminal offence where insolvency caused by dishonesty of a director (penalty up to $220,000 or imprisonment up to 5 years or both).

Defences (see section 588H)

• Reasonable grounds to expect solvency.• Reasonable grounds to believe a competent and

reliable person providing reliable information about the solvency of the company.

• When the debt was incurred, the director did not take part in the management of the company, due to illness or some other reason.

• The director took all reasonable steps to prevent the company from incurring debts.

Seeking forgiveness

• Section 1318 of the Corporations Act allows the Court to absolve a director from liability. Recent example: Stakeman Pty Ltd v Carroll 2009.

Does D&O Insurance or Company Indemnity help?• For an insolvent company, any indemnity rights which

a director has against the company are typically worthless.

• Provided the director didn’t wilfully breach the duty to prevent a company becoming insolvent, D&O cover should respond.

• Civil penalty order and compensation not covered by D&O.

• Directors can take out statutory liability insurance as protection.

Corporate governance challenge for SME’s – financial literacyIssue No. 2 – Financial Literacy•Ability of directors to interpret financial statements and data plus basic understanding of accounting standards needs improvement.•Recent survey findings highlight above as a significant issue.•The National Safety Council case was the first “wake up” call.

Corporate governance challenge for SME’s – financial literacy

• The Centro case left many observers wondering about directors’ liability for inaccurate financial statements.

• The implications suggest financial literacy of many directors (SME’s or otherwise) needs improving.

How does financial literacy improve?

• Education at high school level a recent ASIC initiative.• Training initiatives of CSA, AICD, CPA etc.• TAFE short courses.• Difficulty with imposing mandatory learning or testing.• Financial literacy an issue for:

– Consumers.– Retirees.– Australia.

Corporate Governance Challenges for SME’s – Personal Taxation LiabilityIssue No. 3 - Personal Taxation Liability•The ATO has a collection hit list for SME’s: GST, super contributions and PAYG tax payments.•Generally SME’s have concerns about the consequences of a tax audit.•Personal exposure of SME directors to unpaid superannuation guarantee amounts and unpaid PAYG tax is a big issue, particularly since June 2012.

Increasing directors’ liability from 29 June 2012

Before 29 June 2012 After 29 June 2012

Director penalty notice regime in place affects directors of companies who did not pay PAYG withholding tax to ATO. They became personally liable for the amount that should have been paid plus penalty.

Liability extended to make directors liable for unpaid superannuation guarantee amounts for employees.

Director needs to be given 21 days notice of recovery action after penalty notice given to the director. Director could pay or appoint an administrator or liquidator to the company within that 21 day notice period.

Directors have 3 months from incurring PAYG or superannuation guarantee payment to either pay or put their company into administration or liquidation. Directors become liable if the amount is unpaid after 3 months or within 30 days after becoming a director.

Increasing directors’ liability from 29 June 2012

• Defence continues where a director can prove they were not involved in the management of the company due to illness and all reasonable steps to ensure that the company complied with its payment obligations were taken.

Corporate governance challenge for SME’s – tax audit

Issue No. 4 – Tax Audit•Even though small SME’s may not need to prepare financial statements, all company SME’s need to keep proper written financial records (s286).•ATO is empowered to check compliance with tax legislation and to examine records.•Data matching by ATO highlights a risk of a ‘tax audit’.•ATO applies ‘industry benchmarks’ to determine targets.•Actual tax payable plus penalties can be the outcome.

Corporate governance challenge for SME’s – risk management

Issue No. 5 – Risk Management•Many SME’s have identified ISO 9000 and ISO 9001 as a desirable quality management system to implement.•Benefits: Improved customer products or services, reduced costs, improved competiveness.

Corporate governance challenge for SME’s – risk management

• Improved record keeping (accounts), minutes (directors’ and shareholder meetings), material considered at meetings including reports can act as a means to activate some defences for directors.

• Broader risk management is sometimes lacking with some SME’s. E.g. disaster planning from power shut down, computer malfunctions, fire, flood.

Possible outcomes for SME’s with good financial management

• Makes business easier to sell. Buyers usually impressed, value readily seen.

• Makes a ‘buy out’ plan from management more likely to happen.

• Creates good basis for investing equity funds and investing in the business.

Possible outcomes for SME’s with good financial management

• Creates a good starting point for taking a suitable business to an IPO listing.

• Transparency created makes a succession plan easier to implement.

• Could reduce D&O insurance premiums.

Corporate governance issues for SME’s – independent advice

Issue No. 6 – Independent Advice•The ASX Corporate Governance Principles recognise the principle of listed companies having a majority of independent directors.•For SME’s this is a challenge because:

– Suitable candidates with some appetite for risk and with inadequate compensation are hard to find.

– Personal liability of directors is a deterrent.

Corporate governance issues for SME’s – independent advice

The alternatives are:–Contracted advisers, based on hourly rates, fixed fees or retainer arrangements.–Mentors (who tend to be volunteers at the not-for-profit level).

Corporate governance issues for SME’s – government intervention

Issue No. 7 – Government Intervention•SME’s were assisted by the ‘simplification reforms in the 2003 amending Act to the Corporations legislation by introducing ‘The Small Business Guide’ (SBG) (s111J).•The SBG gives a general overview of the main rules in the Corporations Act affecting ‘Pty Ltd’ companies.

Corporate governance issues for SME’s – government intervention

• ASIC issues regulatory guides, Information Sheets assisting small businesses and is leading a financial literacy campaign.

• Isn’t there scope for ASIC to draft a fundamental guidance document encouraging SME’s to at least adopt basic financial management and risk management guidelines as a best practice ideal for SME’s to voluntarily adopt?

Conclusion

• Plenty written and said about corporate governance for SME’s.

• The most telling argument for some corporate governance for SME’s lies with SME directors protecting themselves from personal liability in an SME insolvency.

Conclusion

• Theoretically, SME directors can adopt self help without regulatory or legislative intervention. Financial management and risk management are desirable corporate governance initiatives for SME’s.

• No studies appear to have been done to indicate that the lack of corporate governance for SME’s needs a government response.

Corporate Governance will not stop the collapse of SME’s

• Different forms or levels of corporate governance can be voluntarily adopted by SME’s from those adopted by larger public companies.

• It may be desirable, given ASIC’s role and initiatives, for ASIC to consider release of a discussion paper where some guidance is given to SME’s about worthwhile corporate governance initiatives that SME’s could voluntarily adopt.

Documents

Governance challenges for SMEs Tony Stumm Carter Newell, Brisbane