Does corporate management have an obligation to foresee financial crises and its consequences?

As the current financial crisis engulfed the economy, a number of large Lithuanian companies, previously considered as financially stable and profitable business entities, suffered huge losses. These losses mostly affected the interests of creditors, employees, as well as shareholders that did not participate in the management of the particular company.

The bankruptcy of AB flyLAL-Lithuanian Airlines, the restructuring of one of the biggest Lithuanian contractors UAB RANGAâ€'IV, and the restructuring of the largest Baltic agricultural company AB Agrowill Group and its inability to duly repurchase its debt securities are just a few examples. The managements of these companies argue that at issue were the soaring losses, mostly due to the changes in prices and demand (increase in jet fuel prices, decrease in real estate prices and demand), as well as the global financial crisis in general. However, such risks resulting from price changes are inherent to each company and the downturn of these large companies cannot be based solely on the financial crisis, but also on the competency of its board members and directors to ensure the implementation of effective risk management policies. Their ability to effectively oversee the risk management function is critical to the success of any company.

In order to satisfy the trust and confidence given by the shareholders, the board members and directors should implement the duties established in the Lithuanian Civil Code. Among these fiduciary duties is the obligation to act with duty of loyalty and duty of care. A company should be managed with the degree of diligence, care and skill which an ordinarily prudent person would exercise in a like position and under similar circumstances. Moreover, directors should follow due process in adopting material decisions and make all material information reasonably available to them. In general, these duties also require proper risk management policies.

First, in order to properly implement risk management policies, potential price risks should be fully identified. The directors should gather due and full information on the market conditions, forecasts, and possible price changes. Proper execution of these duties may require financial expertise or even seeking expert advice.

Diverse financial articles and analyst reports emerged even in 2007 warning the global financial community about the unfolding financial crisis. Among the main reasons for their concern were the high debt numbers, relaxed standards for availability of credit to the less-than-creditworthy, opaque new financial instruments that made such credit available (mostly credit default swaps), and the large increase in real-estate values, just to name a few. In the spring of 2008, due to the increased rates of default in housing mortgage contracts and due to the lack of confidence and the impossibility to value the market price of diverse financial instruments in the United States market, the market for short-term lending ceased and banks stopped issuing credit.

It was evident that sooner or later all these circumstances involving systemic risk in the global financial system would affect the Lithuanian economy. Moreover, the Lithuanian situation was even more daunting because, during the last decade, Lithuania enjoyed huge economic growth and the steep downgrade in the financial cycle should have been anticipated.
Of course it would have been difficult to determine the global scope of the financial crisis, but the managements of the large Lithuanian companies at least had to be aware of and identify the potential financial risks, such as changes in credit availability, consumer spending and decrease in demand.

Second, once the possible price risks were identified, the decision to manage such risks should have been adopted. The market may propose diverse possibilities for the directors to manage the price risks (hedging with derivatives, avoiding the activity that gives rise to loss, insurance, or diversification of activities or securities portfolio).

Even if the company may claim that it had identified the potential risks but was not able to fully manage them, it may be argued that a company, in particular a publicly traded company, should publicly disclose such information. The Lithuanian securities laws require companies to disclose any material event which is related to the activities of the company which is, or should be, known to the company and may have a large effect on the market price of its securities. Not managing the price risks is undoubtedly an issue of concern for the company’s shareholders. Such a decision, in particular if it relates to excessive risks and long-term behavior of a corporation, undoubtedly is material to making an informed investment decision.

To conclude, the duty of loyalty and the duty of care require the management of a company to ensure the implementation of effective risk management policies, which means that the management should have foreseen and identified the largest potential risks of the financial crisis and should have taken necessary measures to mitigate such risks. Moreover, if the company was not able to manage, or had decided to assume these price risks, it had to ensure that the shareholders and investors were provided with all material information, especially if it could jeopardize the total value of the corporation.

Gintare Stalenyte is an associate advocate at Jurevicius, Bartkus & Partners, a member of Baltic Legal Solutions, a pan-Baltic integrated legal network of law firms including Glikman & Partnerid in Estonia and Kronbergs & Cukste in Latvia, dedicated to providing a quality “one-stop shop” approach to clients’ needs in the Baltics.