The Related Party Loan at the Finance Company
Lanka Capital Finance PLC is a licensed finance company regulated by the Central Bank of Sri Lanka, listed on the CSE, with total assets of LKR 58 billion. Its capital adequacy ratio is 10.4% against a regulatory minimum of 10%, and NPLs have risen from 6.1% to 9.8% in 12 months. In June the board approved a LKR 450 million three-year loan to Hela Estates (Pvt) Ltd. A director, Mr Perera, did not attend the meeting but had lobbied fellow directors beforehand; his spouse owns 60% of Hela Estates. The credit committee paper described the borrower as 'a diversified group with strong collateral' but did not mention the director's interest. The loan was used to repay an overdraft at another bank. By December, Hela Estates had missed two instalments; the collateral is a 20-year-old hotel with a forced-sale value of LKR 180 million. The director signed the board minutes as a true record at the next meeting, without disclosing his interest. The external auditor has asked for the related party disclosures.
1. Identify the directors' duties engaged and analyse Mr Perera's conduct and that of the other directors.
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Mr Perera had a conflict because his spouse owns 60% of the borrower. Under the Companies Act and general law, a director must act in good faith in the best interests of the company, avoid conflicts, disclose any interest in a transaction, and not use his position for personal advantage. He should have disclosed before the board discussion, abstained, and not signed the minutes as a true record without noting his interest. Lobbying fellow directors beforehand does not cure the conflict.
The other directors also failed. The credit paper omitted the related party interest, described the borrower generically, and did not test repayment capacity; the loan refinanced another bank's overdraft, a warning sign. The board approved LKR 450 million against collateral with a forced-sale value of LKR 180 million, when capital adequacy was only 10.4% against a 10% minimum. That is not a prudent credit decision. The duty of care and skill requires directors to understand the risk and ask for the missing information.
2. What should the board do now about the loan, disclosure and regulatory notification? Consider the position of depositors and creditors.
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The board should immediately classify the loan, suspend further drawdowns, obtain an independent valuation, and take recovery action. It should notify the Central Bank of Sri Lanka as the regulator and make an immediate CSE disclosure if the information is material; the external auditor's query must be answered accurately. An independent committee should review related party transactions and the credit approval process.
If the company is near breach of capital adequacy, the directors must consider the interests of depositors and creditors, not only shareholders. They should take restructuring and capital-raising advice. Mr Perera should be removed from credit decisions, and the board should consider recovery from him and notify its D&O insurer. The board should also review whether the minutes were misleading and whether the annual report disclosure is complete.
3. What liability and audit committee failures arise, and what remedial steps should the audit committee take?
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Potential consequences include breach of directors' duties, regulatory action by the CBSL and SEC/CSE, and possible disqualification. The Companies Act imposes duties and liability for improper use of position and false statements; the exact cause of action depends on the facts. The audit committee should have reviewed the related party transaction and the adequacy of disclosures. It failed to do so and did not challenge the credit paper.
The committee should commission a forensic review, update the conflicts register, and ensure that related party approvals are independently validated. It should meet the external auditor without management present and review the loan loss provision. It should also report to the board on whether the director's conduct should be referred to the regulator. Remedial steps should be minuted and tracked, not left as recommendations.