Legal Case Studies

The Race towards Good Governance: The Steinhoff Case

Good governance refers to the principles and practices that promote effective, accountable, transparent, and inclusive decision-making and management within a company.

However, businesses have been succumbing to governance scandals. The term "governance scandal" refers to a situation where there is a significant breach or failure in the governance practices or mechanisms of an organisation. It involves a violation of ethical standards, regulations, or legal requirements, often resulting in negative consequences for the organisation and its stakeholders.
A governance scandal typically involves misconduct, fraud, corruption, or other unethical behaviours that undermine the principles of good governance, such as transparency, accountability, and integrity. The case of De Bruyn v Steinhoff International Holdings N.V. and Others ( Steinhoff Case) is an example of a case of governance scandal in South Africa.

Steinhoff Case Facts: In December 2017, it was discovered that Steinhoff engaged in accounting irregularities, which resulted in the company's stock price plummeting by 62% and wiping out billions of dollars in shareholder value. This resulted from intercompany loans that misrepresented the profits the company made. Steinhoff owned numerous retail brands and they moved money through intercompany loans to inflate its numbers. Steinhoff overstated its profits and assets, creating fictitious transactions, and hiding debts through complex financial structures. It was estimated that Steinhoff had inflated its profits by more than $7 billion over several years.
The fallout from the scandal was significant, as it not only affected shareholders such as pension funds but also led to job losses and financial distress for many employees and suppliers. Steinhoff faced multiple lawsuits and regulatory investigations in various countries, including South Africa, Germany (where the company had its primary listing), and the Netherlands (where it was headquartered).

Governance failures: The Steinhoff Case offers an extreme case of financial statement fraud. The governance issues in the Steinhoff case were wide-ranging and had a significant impact on the company's operations.

The key governance issues in the scandal included:
1. Accounting Irregularities: The primary issue in the Steinhoff case was the extensive accounting irregularities and financial manipulation that occurred within the company. These irregularities involved overstating profits, creating fictitious transactions, and concealing debts. Such practices violated basic accounting principles and undermined the accuracy and reliability of financial statements.
2. Lack of Transparency: The scandal revealed a lack of transparency within Steinhoff's operations. The company failed to provide clear and accurate financial information to investors, stakeholders, and regulatory authorities. There was a lack of disclosure regarding related-party transactions, complex financial structures, and the true state of the company's financial health.
3. Weak Internal Controls: The case highlighted significant weaknesses in Steinhoff's internal controls and risk management processes. The company's internal control mechanisms were unable to detect or prevent the fraudulent activities that took place. This raised questions about the effectiveness of the company's governance framework and its ability to identify and mitigate risks.
4. Questionable Corporate Structure: Steinhoff had a complex corporate structure involving numerous subsidiaries and related entities spread across different jurisdictions. These structures made it difficult to assess the company's financial position accurately and allowed for the manipulation of financial statements and transactions.
5. Inadequate Auditing and External Oversight: The scandal also exposed deficiencies in auditing practices and external oversight. Steinhoff's external auditors failed to identify the accounting irregularities and did not raise sufficient red flags. This raised concerns about the quality and independence of the auditing profession and the effectiveness of external oversight mechanisms.
6. Governance Failures at Board Level: The case revealed governance failures at the board level. There were allegations of inadequate oversight and accountability by the board of directors, including insufficient questioning of management, lack of independent directors, and potential conflicts of interest.

The governance issues in the Steinhoff case led to significant financial losses for shareholders, damaged the company's reputation, and raised broader concerns about corporate governance standards in South Africa and beyond.
The scandal exposed weaknesses in corporate governance practices, auditing standards, and regulatory oversight. It raised questions about the effectiveness of internal controls and the independence of external auditors.

Lessons from the Steinhoff Case: This case provides several important lessons for businesses, investors, regulators, and the broader corporate governance landscape.
1. Accurate financial reports: Companies must ensure that their financial statements reflect the true state of their affairs. The case also emphasises the importance of transparency to avoid negative consequences.
2. Strong Internal Controls and Risk Management: It is also important for companies to develop and implement robust internal controls and risk management processes. This will assist in identifying and mitigating the risks of fraud, financial manipulation, and unethical practices.
3. Appointment of Boards: It is also equally important to ensure that companies appoint Boards in terms of the Companies Act 71 of 2008. Boards actively challenge and question management, exercise oversight, and ensure that appropriate governance practices are in place.
4. Auditing Committees: The Steinhoff case highlights the need for stronger auditing practices and external oversight thoroughly, independent audits, and report any irregularities promptly.
The Steinhoff scandal serves as a stark reminder of the importance of transparency, accountability, and ethical conduct in the business sector to implement governance practices to achieve good governance.

Three Hats of a Business Owner: Shareholder, Director, and Employee

Running a successful business requires wearing multiple hats and juggling various roles. As an owner of a small or growing business, one must assume the responsibilities of a shareholder, director, and employee. However, the duties and responsibilities of each role differ in activities, and in terms of the legislation that governs them.

a. The Roles and importance of distinguishing between them:
i. Shareholders: Shareholders are individuals or entities that own all or a portion of a company's shares. As a business owner, wearing the shareholder’s hat entails:
• providing investment in the form of capital: Shareholders always bear the risks associated with their investments;
• decision-making powers: these are normally found in the Memorandum of Incorporation (MOI). Shareholders have voting rights on matters such as electing directors, mergers, or acquisitions; and
• receiving a share of the company's profits in the form of dividends.

ii. Directors: Directors are involved in overseeing the management and operations of the business, often representing shareholders. As a business owner, the roles of the director include:
• strategic planning of setting the company's long-term goals, formulating business strategies, and evaluating their implementation;
• providing guidance and supervision to the management team, embodying responsibility for the company's overall direction; and
• ensuring that the business operates ethically and in compliance with applicable laws and regulations.

iii. Employees: Employees:
• actively engage in the day-to-day operations of the organisation;
• contribute their skills, knowledge, and expertise to carry out specific tasks and responsibilities within the company; and
• must stay updated with industry trends, acquire new skills, and adapt to changes to maintain their effectiveness as employees.

It is vital to note that business owners in some instances may wear these three hats simultaneously. Wearing these hats simultaneously requires balancing long-term strategic thinking, overseeing operations, and actively contributing to the organisation's success. A successful business owner understands the importance of fulfilling each role effectively, and recognising the unique responsibilities and perspectives associated with each hat to reach long-term success.

b. Separation of duties:
As established above, shareholders, directors and employees have distinct roles and responsibilities. Duties of directors, shareholders and employees should therefore be separated. The benefits of separation of duties include:

i. Accountability and transparency: The separation of duties among shareholders, directors, and employees is essential for ensuring accountability, transparency, and the smooth operation of a business. Each role has distinct responsibilities and functions that contribute to the overall governance and success of the organisation as discussed above;

ii. Best interests of the company: Having a clear separation of duties prevents any single entity from having complete control over decision-making and operations. Shareholders, directors, and employees provide different perspectives, expertise, and interests, which helps ensure that decisions are made collectively and in the best interest of the company. Furthermore, maintaining a clear separation of duties among shareholders, directors, and employees is important to prevent conflicts of interest;

iii. Managing risk: Separating duties also plays a crucial role in managing risk. By dividing responsibilities, the organization can implement internal controls and safeguards to prevent fraud, errors, or misuse of resources. For instance, separating financial responsibilities among different employees reduces the risk of fraudulent activities going undetected;

iv. Legal compliance: Separating duties helps companies meet legal and regulatory requirements. Compliance with laws and regulations is critical to avoid legal penalties, reputational damage, and loss of trust from stakeholders. Clearly defined roles and responsibilities enable companies to demonstrate their commitment to ethical practices, integrity, and adherence to applicable laws; and

v. Clear separation of duties endorses trust and confidence from different stakeholders such as investors, customers, and suppliers.

c. Important documents:
The separation of duties among shareholders, directors, and employees is typically established and documented through various legal and governance documents. Here are some of the key documents used to define and formalise these roles:

i. Memorandum of Incorporation:
The starting point for each registered company is the Memorandum of Incorporation (MOI). It is a key document required during the process of registering a company and is governed by the Companies Act 71 of 2008.
• The Memorandum of Incorporation (MOI):
o is a legal document that outlines the constitution and internal governance rules of a company;
o includes important aspects such as name and registration details, the nature of the business, the share capital of the company, types of shares, procedures for convening and conducting shareholder meetings, powers, duties, appointment, and removal procedures for directors; and
o provides a framework for the company's internal governance, helping to ensure compliance with applicable laws, regulations, and best practices.
It is important for companies to carefully draft and tailor their MOI to suit their specific needs and governance requirements.

ii. Shareholders agreement:
Shareholders are not only governed by the MOI but they are also governed by their shareholders’ agreements. These are contracts between the company and its shareholders that define the rights and obligations of each party.
• The agreement may address matters such as share ownership, voting rights, dividend distribution, restrictions on share transfer, and dispute resolution mechanisms.
iii. Employment contracts: Employment contracts are essential documents for the relationship between the employer and the employee. Employment contracts outline the roles, and responsibilities of employees.
• They specify the tasks, reporting lines, performance expectations, and compliance requirements for employees, ensuring clarity regarding their duties.
• Companies must set out clear job descriptions.

iv. Letters of appointment: letters of appointment are formal documents issued by companies to individuals who are appointed to certain positions or roles within the organisation.
• These letters serve as written evidence of the terms and conditions of the appointment and the respective rights and responsibilities of the appointee.
• Letters of appointment are important in establishing the contractual relationship between the company and the individual and typically include the following key elements:
o position or title;
o terms and conditions of appointment;
o remuneration and benefits; and
o if applicable, provisions related to a probationary period.
Letters of appointment are legally binding documents that establish the rights, obligations, and expectations of both parties. It is important for both the company and the individual to carefully review and understand the terms outlined in the letter before accepting the appointment.

d. Compliance with different legislation:
Shareholders, directors and employees are required to comply with certain legislative requirements.

i. The Companies Act is
the primary regulatory framework for registered companies in South Africa. The Companies Act specifically sets out the legal framework for corporate governance and the rights and responsibilities.
• The Act sets out the rights and protection afforded to shareholders; and
• directors’ fiduciary duties to act in the best interests of the company, and exercise reasonable care, skill, and diligence. In terms of this Act, directors may be held personally liable for breaches of their duties.

ii. The Basic Conditions of Employment Act (BCEA): The BCEA sets out the minimum standards for employment conditions, including working hours, leave, remuneration, and termination of employment. responsibilities, including fraudulent or reckless conduct.

iii. The Employment Equity Act (EEA):
The EEA promotes equality and prohibits unfair discrimination in the workplace, particularly regarding race, gender, disability, and other protected characteristics.

iv. The Labour Relations Act (LRA):
The LRA governs collective bargaining, dispute resolution, and the rights of employees to join trade unions and engage in protected strike action.

v. The Occupational Health and Safety Act (OHSA):
The OHSA sets out regulations for ensuring the health and safety of employees in the workplace.

It is vital for business owners to ensure that they comply with these laws as failure to comply might result in financial penalties, imprisonment and a damaged reputation of the company.

It is recommended that business owners obtain legal advice on how they can wear these three hats prior to registering a company, and then regularly for any updates.