Question

Luangwa Mineral Resources is a State Owned Enterprise (SOE) that was in past managed parastatal before being privatize after liberalization of the Zambia economy. The privatization of the firm was decided because the firm had been run down and was not performing well as expected. Further the firm accrued huge liabilities and was running losses consistently. After being privatized the new owners (majority shareholders 75%) re capitalized the firm by investing $160 million to improve operation and clear outstanding debts. The new Board of Directors brought in goods expertise and knowhow which greatly improved the way the company was managed. The company was turned around within Three years and become profitable and as a result government was able to receive its share of profits. The company remained profitable until a regime changed policy that now required government to own majority share in a bid to accrue more benefits for the state. The changes in policy meant the minority foreign investors could not control decision making within the company as now government took more control of the affairs. The Government appointed a new board and new management took over. The company in a span of four years since these changes has reached a stage where it is now failing to meet its obligations. It has accrued huge debts and has started making losses due to poor decision making regards operations. Audits reports indicated that miss application of resources to non-value adding activities, poor cash flow management, over employment and abuse of company resources and board members (Chairperson) and management staff. It was reported that in previous quarter the board had spent $1.0 million on workshops, travel allowances and meetings alone much of the money obtained through an overdraft with a local bank. This was done at the expense of procuring a critical component of the production process that only costed $150,000. Consequently production was shut down for six months. This has led to wide spread uproar in the media and among concerned stakeholders and the company’s board and corporate governance system has been questioned. Among the many expectations from stakeholders is the effectiveness of the board through composition of members, integrity and ethical values of board members and ability to critically analyses the company’s long term sustainability Required: i. Discuss the objective and importance of Corporate Governance in general to the operations of an organization. (6 Marks) ii. Identify and discuss the Agency Problem issues in this case study that may have led to the current situation how this can be rectified. (10 Marks) iii. Discuss how Corporate Finance can be applied in guaranteeing the company’s long term financial sustainability while balancing wealth maximsation.

Answer 1

Answer i.

Importance: Every firm operates with an objective of Wealth maximisation of its shareholders. However, the time proven principles have been violated due to compliance risks and influence by the management, which at many times leads to poor decision making and thus, loss of wealth for the investors. This prevents the firm from achieving its primary goals, and leads to abuse of power and misgovernance. Thus, making it necessary for the firm to have of Corporate governance in the organization.

Objectives:

For a firm-

1. There should be a board that is properly structured. This ensures that it sits at the top and decision making is fair and appropriate

2. There should be independent directors that support the function

3. Practices of the board are transparent

4. Appropriate disclosures to the shareholders time to time so that they are informed of any management issues

5. Board has to monitor management at regular intervals

For the markets-

1. It increases public trust in the markets and the financial system, so that more investors can come forward

2. Investors are protected by these rules

3. Shareholders keep the position of power it is their money that is being used to bring up the business to scale

ii. Agency Problem- Though the management is expected to act in interest of shareholders, it does not.

This is apparant in this case. When the government took majority ownership of the company, the board of directors stopped functioning properly and appropriate expertise was not utilized. The managers, though they should have acted for the company, they did not do so.

This is due to the separation of control and ownership in the organization. This was the major agency problem red flags :-

- The management of the firm was appointed by government, which took over control and replaced previous management. Thus, interest of minority shareholders was ignored.

- Deliberate spending on non profit activities and possibilities of money laundering.

- Clear indication of misuse of resources by the management including abuse of staff

- Over spending on travel, workshops by the management instead of revenue spending activities

Rectification:

1. Identify the flaws in formation of board of directors and immediately correct them

2. Appropriate number of independent directors to be kept

3. Put necessary compliance controls and disclosures for investor awareness

4. Thorough independent audit of the firm and removal of the management and staff that is not acting for the shareholders

5. Putting forth better appraisal system

iii. Corporate governance keeps appropriate tabs on the stakeholders so that the compliance stands and there is no conflict of interest among shareholders. By placing appropriate measures, we ensure that the management acts in the shareholder's interest and there is an independent decision making that does not involve individual benefit. This will lead to wealth maximization in the following ways-

1. Appropriate number of independent directors will lead to unbiased decision making

2. Transparent board will help in keeping the focus on the things that matter- i.e. maximisation of sharerholder's wealth

3. No foul play by the management, leading to the clean work environment, and consequent wealth maximisation

4. Investor confidence maintained. They will keep expecting the firm to perform better!

5. Protection of minority shareholders rights. Usually, the majority shareholders can exercise significant control. Appropriate governance will ensure the minority rights are also protected.

To sum up, a company that has poor corporate governance is susceptible to frauds and mis manangement as history has proven. Good standards, on the other hand, lead to the company keeping its focus on wealth maximization.