Khaya Sithole: Steinhoff – a gang of desperate adventurers?

Over 142 years ago this month, the City of Glasgow Bank reported its financial results for 1878. In its disclosures from 30 September 1878, the bank indicated that for each £100 share held by investors in the bank, the market share was £236. This reflected a great sense of confidence in the prospects of the bank by various investors. According to documents stored in the National Library of Scotland, just 48 hours after these disclosures, the secretary of the bank instructed his managers “to close the doors, pay nothing, close off your books, prepare lists of assets and liabilities, pay salaries due, and allow the young men to return home”. 

This instruction became the major milestone in a series of activities that led to the collapse of the bank. As we now know, the collapse of CGB was a major moment in the history of modern capitalism and continues to shape modern-day practices.

Long before CGB collapsed, the questions relating to how banks ought to be funded and capitalised dominated the policy conversations. To better understand the root cause of the CGB collapse, one needs to appreciate the corporate and banking landscape of 19^th century Scotland. Primarily, the relations between shareholders, management and depositors. Because, unlike the modern-day corporate architecture, the banking system back then was underpinned by unlimited liability; no external oversight and no regulatory oversight. 

The unlimited liability model simply meant that if a bank’s liabilities ever exceeded its assets; the shareholders would be liable for the shortfall. In other words, depositors could suffer no harm in the event of a banking failure. The primary motivation behind depositor protection was simply that the risk aversion associated with depositors was such that if a risk existed that they could lose their deposits they simply would not deposit their money into a bank. On the other side of the ledger, making the shareholders liable for any shortfalls had multiple consequences.

Firstly, the idea that they might be liable for shortfalls provided an incentive for shareholders to elect “men of virtue” to be managers of the bank who could be trusted to run its affairs properly. The threat of being liable for massive shortfalls in the event of a collapse, however, meant that shareholders found it more desirable to keep the bank’s balance sheets within “manageable” levels simply because the more modest the balance sheet, the lower the potential shortfalls that might have to be covered. 

As a result, the Scottish banking system in particular gravitated towards a wide range of banks with modest balance sheets rather than big banks with large exposures. Lastly, the fact that liability was unlimited simply kept the number of potential shareholders to a pool of men and women of “means”, whose asset holdings could withstand any liabilities associated with their bank holdings.

Days before its collapse, CGB had a shareholder register of 1819 individual and institutional shareholders. But such was the scale of the losses at the bank that very few could meet their full obligations to cover the bank’s shortfalls. The reason for the shortfall — a fraud perpetrated by its management — exposed the perils of limited oversight and apathetic directors with no appreciation of fiduciary responsibilities. 

Having started off being managed by “men of virtue” since its founding in 1839; the bank had found itself gradually being left in the hands of “mediocrities and men of straw” who had little capacity for running the bank. It was against this backdrop that the bank found itself unduly exposed to a few high-risk clients to whom it had lent out significant amounts of money. Four clients in particular, accounted for 75% of the loans that the bank had issued. Such clients had such poor credit profiles they were aptly described by The Times newspaper as “gangs of desperate adventurers”.

The response to the CGB collapse had profound effects on the community of Glasgow but an even greater effect on banking, auditing and corporate structures. The most important reform precipitated by the CGB collapse related to the move towards limited liability for banks. Throughout the first half of the 19^th century, banks had no unilateral right to operate as limited liability companies. Up until 1858, a bank needed a state charter to operate with limited liability.

By 1858, of the 150 banks registered throughout the United Kingdom, only five had exercised that option. The reluctance for the other banks stemmed from the idea that as soon as the bank adopted limited liability, it simply passed on the shortfall risk to depositors rather than shareholders. This simply escalated the risk that depositors would simply switch to a bank which kept the shortfall risk in the shareholder hands rather than the depositor hands. As a consequence, banks that adopted limited liability had to maintain higher levels of capital in order to assuage depositor anxiety and hopefully keep some deposits.

When CGB collapsed, the scale of the losses meant that most of its shareholders surrendered their entire estates to cover their share of the shortfall. Even then, only 14% of the shareholders eventually made good on their obligations with the remainder reduced to various levels of distress, penury and ruin. This immediately created the impression that the risk of holding shares in an unlimited liability bank had become so high that only those who were remarkably wealthy could sustain an appetite for investing in banks. Unsurprisingly, this ushered in a wave of switches by other banks from the unlimited liability regime to the limited liability model that prevails throughout the corporate landscape today.

This paradigm shift immediately gained traction and by 1889, just 10 years after the CGB collapse, only two of the 124 banks registered in Britain had unlimited liability. Remarkably though — and perhaps ironically — this shift also led to the concentration in banking that prevails to this day.

This was simply because of the fact that once unlimited liability was removed there was a greater appetite for bank balance sheets to expand through acquisitions. Given the fact that shareholder losses were now capped at what each individual had invested and nothing more, it meant that shareholders no longer had to worry about the size of potential shortfalls and hence could allow bank balance sheets to be as large as possible. The effect of that thinking is prevalent even today where the banking system is dominated by a few major players and an assortment of smaller players.

Steinhoff liability 

This model of capping shareholder losses through the limited liability regime was once again in focus this year when Dorothea de Bruyn took on Steinhoff and its directors. De Bruyn — a pensioner who had invested up to R80 000 of her funds into Steinhoff —  found herself worse off after the discovery of “accounting irregularities” at the company in December 2017. De Bruyn — like most Steinhoff shareholders, lost the bulk of her investment as the share price collapsed by over 95%. In seeking relief, De Bruyn approached the courts seeking a ruling that would hold the company and its directors liable for the losses and the losses suffered by other small investors. In De Bruyn’s position, the investment decisions made by many like her were materially influenced by the representations made by the company, its directors and its auditors. The realisation that such representations were false, then should entitle her and others to recourse against the company and its directors.

In his judgment, delivered in June 2020, David Unterhalter reiterated the complexity that exists in the question of fiduciary duty and the rights of shareholders. The essence of the current legal position is simply that directors owe their fiduciary duty to the company and not to shareholders. As a result, shareholders cannot sue directors for losses suffered by them as a result of the loss in the value of a company. Although it is acknowledged that share price fluctuations and loss in value are an inherent risk associated with investing; the question of whether losses that emanate from explicitly fraudulent conduct like the actions of Markus Jooste, should be viewed differently, is an important consideration. 

Last week, I was able to put the question to Professor Mervyn King during a lunchtime webinar about corporate governance issues in South Africa. In King’s view, the court case reinforced the long-established position that fiduciary duties are owed to a company rather than shareholders. As a result, the legitimate litigant in such a case would be the company itself.

In the Steinhoff case, the limitations of this legal position are obvious. For the company to be able to lodge its case against those that have caused it to suffer losses, it would rely on its directors to do so. At Steinhoff however, all the critical role-players — including the directors — existed within a spectrum of complicity. In the aftermath of Jooste’s resignation, the reconstituted board contained all the directors that had not only overseen Jooste’s global corporate adventurism, but also had material financial interests in the business itself. 

Christo Wiese, the dominant shareholder with more to lose than anybody else, remained as chairperson for one more week until common sense prevailed. His successor — Heather Sonn — acceded to the chair and did a steady job of trying to unravel the mess, until, over two years later, it emerged that she also had transactions that created possible conflicts. She immediately resigned. The executive team was made up of insiders who — as luck would have it — had financial interest in the form of options which meant that they would have to make the call on whether the company needed to sue, with the understanding that their own financial interests were at risk.

The sum of these factors, simply means that the possibility of disaffected shareholders obtaining any form of relief in the Steinhoff saga, remains elusive not through lack of effort but rather through the limitations inherent in the legal and corporate systems. The irony of the De Bruyn case is that, had it succeeded, it would have meant that shareholders — whose liability is currently limited to what they invest — would have received compensation for the lost value of their investments. 

The challenges associated with that is the question of when are losses to be regarded as natural consequences of the investment world, versus those losses engineered by custodians of a business that would warrant shareholder compensation? Getting the answer to that — particularly when so much of the information would be under control of the directors — would be the new challenge to the architecture of capitalism. 

What I suspect would have happened in the interim, is that just like the men of wealth used to stay away from investing in banks because of fears about unlimited liability, very few directors would be willing to sign up for any fiduciary duty if the concept of shareholder compensation were to be adopted. The tragedy of where we are is that — just like in Victorian times — it is the innocent investors and bystanders whose losses are explicit and unrecoverable. Jooste, and his gang of adventurers, remain at large. And for as long as the only legitimate litigant remains the company itself, Jooste will remain at large for a long time to come.

Khaya Sithole — chartered accountant, academic and activist — writes regularly for the M&G and discusses the issues raised in his columns on his Kaya FM show, On The Agenda, every Monday from 8pm to 9pm