In our newsletter we will publish number of articles on various issues of corporate governance emerging as either new practices or practices that are gaining more importance and in need for streamlining. These emerging practices are included in a new book under the title of “Corporate Governance – Effective Performance Evaluation of Board and Emerging practices in Corporate Governance”. The book which is authored by Saleh Hussain, will be published in February 2014.We are starting publishing of these articles with “CORPORATE GOVERNANCE IN REAL ESTATE BUSINESS”.
We hope that you find the article of some use and your comments are welcome.
The real estate sector had its glory days in the beginning of twenty first century and peaked in most of the countries of the world between 2000 and 2008. This was eight years of real upward change that left millions of people around the world in an unprecedented state of wealth. It was certainly a worldwide phenomenon and very few countries did not ride the wagon.
Real estate developers, investors and investment bankers mushroomed around the world with projects that varied from mega development plans for shopping malls, recreation centres, housing and other speculative projects.
In the United States, the mortgage loan business relating to the financing of housing projects took different forms and selling and buying of those mortgages from one investor or bank to another became just a normal thing to do. The whole USA woke up to the realization that the same house loan changed hands but nobody knew exactly how many times. By the middle of 2007 and early 2008 the problem of those loans started to knock the doors of regulators and by the time they realized the magnitude of the problem, the financial crisis hit hard in 2010 compounding the devastating effect to those involved in mortgage loans from house owners and banks to investors.
The rating agencies were active in assigning high rating grades to the instruments that dealt with mortgage loans, although they did not really grasp how some of those instruments worked.
The financial crisis forced millions of people around the world out of jobs leaving governments to deal with finding solutions and putting in place rescue plans to prevent their economies from total collapse. The USA was the first to resort to such plans, albeit at the expense of taxpayers.
Worst was the fact that good number of house owners who had availed themselves of mortgage loans lost their jobs and were unable to repay their agreed upon instalments which resulted in multiple defaults under the resale and repurchase agreements of those loans.
The investment in real estate development projects around the world was subjected to a different set of problems. Developers, investors and investment banks developed plans to finance real estate projects and in the process inflated the price of the properties by many times. Accordingly, the financing to purchase offered real estate projects was very inflated in terms of cost. When the financial crisis hit the prices went down as a good number of projects around the world were either not completed or not sold as planned. There were huge defaults by borrowers and investors and governments and regulators found themselves helpless.
I am quite certain that million litres of ink were spread over a trillion of sheets of papers around the world with an analysis of what happened and what action needed to be taken to reduce the bleeding. Therefore, we are not trying here to repeat what the gurus and specialists had already concluded. What we wish to do here is to look at the governance side of the real estate business. Was there good governance, was it followed and did the regulators pay the right attention?. We will not cover the mortgage loans here but we will concentrate on real estate investment and role of investment banks in governing the business.
Typically the investment banks in our part of the world, which had only started to surface in the late nineties of the last century and expanded in number and size in the early part of this century concentrated their business activities investing in real estate. Only a handful looked at other investments outside the real estate domain such as private equity and buying into companies, developing them and selling them and in the process making some hefty returns for their investors and for private and corporate clients. Those who concentrated their business in real estate, including development projects, ended entering mega transactions and committing huge sums of moneys some of their own and the majority of it belonging to their clients.
While the price of real estate continued to rocket upward, they rode the wave allowing their wealth to grow rapidly too. When caught out by the financial crisis between early 2008 and 2010 the executives realized that they left their clients up in the air with losses and frustration. The investment officers too found out, a little bit late, that they had failed miserably to put in place a governance structure for the investment business they had undertaken. The absence of a good corporate governance structure was not limited to the investment banks themselves only but included all the special purpose vehicles that they had established to own and manage the real estate business and projects they entered into. The following are the main issues of governance that were ignored or not observed or even monitored:
As banks and investment houses entered into more real estate projects the need to establish new special purpose vehicles “SPVs” to hold each real estate investment became a necessity. Therefore many of those SPVs were established around the globe. Each of those vehicles was subjected to the laws and regulations prevailing in the countries in which they were established. Hence, the banks and investment houses ended up with a good number of those vehicles and in general lacked the skill and expertise to comprehend what it takes to govern them. This led in many instances to ignore or avoid the governance requirements of those vehicles. In some countries, particularly in the Middle East, the corporate governance practices were either weak or non-existent which compounded their difficulties. The lack of governance of the SPVs led to mounting problems for those who established them and caused huge losses to the investors concerned.
Corporate governance requirements for SPVs in most of countries are not much different to all other types of companies. They call for a dedicated board independent of management and proper and adequate policies and procedures that take into account the audit and control aspects of the operations of these vehicles. Boards of those SPVs needed to also establish Board committees to enhance the work and the supervision of the Board.
Typically the requirements of any corporate governance code vis-à-vis SPVs are no different than those applied on owners’ companies. The owners of those vehicles instead of complying with international best practices opted for manning the Boards of those vehicles with either their own executives or executive members of their main Boards depriving in the process the Boards of those vehicles the appointment of independent directors. In fact, in certain cases, the CEO of the owner’s company became Chairman of so many of those vehicles, to all intents and purposes, turning them into an executive club. The problem was created either due to the absence of clear directives from regulators or the inexperience of executive management.
The result of such actions was that those vehicles lost the benefit of actual independency, internal audit and control. This in turn led to mismanagement of the affairs of those vehicles and the subsequent loss to the owners and investors.
It is therefore expected, that the regulators, some of whom had already started issuing the necessary governance guidelines for the SPVs, to further tighten the loose ends and pay more attention. Applying the normal corporate governance requirements will be the most appropriate course of action to ensure that the representation on their Boards meets standards of audit and control.
One of the issues that faced the operation of the SPVs was the appointment of executive members of management by the owners to their boards and even management. In certain cases, the conflict of roles and interest of those executives was an impediment to the success of the SPV. On one hand, the executive might look to their appointment on the Boards of the SPV as a pleasant cause for additional income that is most welcome. The more Boards of these SPVs they sat on the more money they earned. Hence, the more the merrier. Mind you, this was happening at the peak of real estate investments boom and profits of investors and owners were rocketing. That was a good recipe for greed and ignoring the governance aspects of SPVs. A Very heavy price was paid by investors for such ignorance when the real estate business collapsed.
Emerging change would cause the regulators and investors to expect the following to happen: