Reasons for Corporate Governance failures


By

Ms. Shruti Mehta
Lecturer
Ms. Rachana Srivastavaare
Lecturer
Skyline Institute of Engineering & Technology
Greater Noida
 


Abstract:

Corporate governance is the set of processes, customs, policies, laws, and institutions affecting the way a corporation is directed, administered or controlled. Corporate governance also includes the relationships among the many stakeholders involved and the goals for which the corporation is governed. The principal stakeholders are the shareholders, management, and the board of directors. Other stakeholders include labor(employees), customers, creditors (e.g., banks, bond holders), suppliers, regulators, and the community at large.

This article reveals various reasons for failure of Corporate Governance, Corporate Governance conists of, various examples of Corporate Governance Failures like Enron, Satyam, Cadbury, Wal-Mart, Xerox and why Corporate Governance failed in such big organizations. Article also describes various mechanisms of Corporate Governance like (1) Company's Act (2) Security law (3) Discipline of capital market (4) Nominees on company board (5) Statutory audit (6) Codes of conduct etc. Some factors that influence the Corporate Governance like Owernership structure, Structure of company board, Financial structure, Institutional Environment etc. Various systematic problem in Corporate Governance and Recent Corporate Governance failures.

Key words: Corporate Governance, Governance, Satyam, Enron, Wal-Mart, Mechanism,
Polly Peck and Coloroll

Corporate governance is a multi-faceted subject. An important theme of corporate governance is to ensure the accountability of certain individuals in an organization through mechanisms that try to reduce or eliminate the principal-agent problem. A related but separate thread of discussions focuses on the impact of a corporate governance system in economic efficiency, with a strong emphasis shareholders' welfare. There are yet other aspects to the corporate governance subject, such as the stakeholder view and the corporate governance models around the world.

There has been renewed interest in the corporate governance practices of modern corporations since 2001, particularly due to the high-profile collapses of a number of large U.S. firms such as Enron Corporation and Worldcom. In 2002, the U.S. federal government passed the Sarbanes-Oxley Act, intending to restore public confidence in corporate governance.

Factors influencing corporate governance

1. The ownership structure

The structure of ownership of a company determines, to a considerable extent, how a Corporation is managed and controlled. The ownership structure can be dispersed among individual and institutional shareholders as in the US and UK or can be concentrated in the hands of a few large shareholders as in Germany and Japan. But the pattern of shareholding is not as simple as the above statement seeks to convey. The pattern varies the across the globe.

Our corporate sector is characterized by the co-existence of state owned, private and multinational Enterprises. The shares of these enterprises (except those belonging to a public sector) are held by institutional as well as small investors. Specifically, the shares are held by

(1) The term-lending institutions
(2) Institutional investors, comprising government-owned mutual funds, Unit Trust of India and the government owned insurance corporations
(3) Corporate bodies
(4) Directors and their relatives and
(5) Foreign investors. Apart from these block holdings, there is a sizable equity holding by small investors.

2. The structure of company boards

Along with the structure of ownership, the structure of company boards has considerable influence on the way the companies are managed and controlled. The board of directors is responsible for establishing corporate objectives, developing broad policies and selecting top-level executives to carry out those objectives and policies.

3. The financial structure

Along with the notion that the structure of ownership matters in corporate governance is the notion that the financial structure of the company, that is proportion between debt and equity, has implications for the quality of governance.

4. The institutional environment

The legal, regulatory, and political environment within which a company operates determines in large measure the quality of corporate governance. In fact, corporate governance mechanisms are economic and legal institutions and often the outcome of political decisions. For example, the extent to which shareholders can control the management depends on their voting right as defined in the Company Law, the extent to which creditors will be able to exercise financial claims on a bankrupt unit will depend on bankruptcy laws and procedures etc.

Mechanisms of corporate governance

In our country, their are six mechanisms to ensure corporate governance:

(1) Companies Act

Companies in our country are regulated by the companies Act, 1956, as amended up to date. The companies Act is one of the biggest legislations with 658 sections and 14 schedules. The arms of the Act are quite long and touch every aspect of a company's insistence. But to ensure corporate governance, the Act confers legal rights to shareholders to

(1) Vote on every resolution placed before an annual general meeting;
(2) To elect directors who are responsible for specifying objectives and laying down policies;
(3) Determine remuneration of directors and the CEO;
(4) Removal of directors and
(5) Take active part in the annual general meetings.

(2) Securities law

The primary securities law in our country is the SEBI Act. Since its setting up in 1992, the board has taken a number of initiatives towards investor protection. One such initiative is to mandate information disclosure both in prospectus and in annual accounts. While the companies Act it self mandates certain standards of information disclosure, SEBI Act has added substantially to these requirements in an attempt to make these documents more meaningful.

(3) Discipline of the capital market

Capital market itself has considerable impact on corporate governance. Here in lies the role the minority shareholders can play effectively. They can refuse to subscribe to the capital of a company in the primary market and in the secondary market; they can sell their shares, thus depressing the share prices. A depressed share price makes the company an attractive takeover target.

(4) Nominees on company boards Development banks hold large blocks of shares in companies. These are equally big debt holders too. Being equity holders, these investors have their nominees in the boards of companies. These nominees can effectively block resolutions, which may be detrimental to their interests. Unfortunately, the role of nominee directors has been passive, as has been pointed out by several committees including the Bhagwati Committee on takeovers and the Omkar Goswami committee on corporate governance.

(5) Statutory audit

Statutory audit is yet another mechanism directed to ensure good corporate governance. Auditors are the conscious-keepers of shareholders, lenders and others who have financial stakes in companies.

Auditing enhances the credibility of financial reports prepared by any enterprise. The auditing process ensures that financial statements are accurate and complete, thereby enhancing their reliability and usefulness for making investment decisions.

(6) Codes of conduct

The mechanisms discussed till now are regulatory in approach. The are mandated by law and violation of any provision invite penal action. But legal rules alone cannot ensure good corporate governance. What is needed is self-regulation on the part of directors, besides of course, the mandatory provisions.

Systemic problems of corporate governance

  • Demand for information: A barrier to shareholders using good information is the cost of processing it, especially to a small shareholder. The traditional answer to this problem is the efficient market hypothesis (in finance, the efficient market hypothesis (EMH) asserts that financial markets are efficient), which suggests that the shareholder will free ride on the judgements of larger professional investors.
  • Monitoring costs: In order to influence the directors, the shareholders must combine with others to form a significant voting group which can pose a real threat of carrying resolutions or appointing directors at a general meeting.
  • Supply of accounting information: Financial accounts form a crucial link in enabling providers of finance to monitor directors. Imperfections in the financial reporting process will cause imperfections in the effectiveness of corporate governance. This should, ideally, be corrected by the working of the external auditing process.

Recent Corporate Governance failures

As we have discussed before, the creation of corporate regulation is often linked to perceived failures of corporations and their management to behave in the way society expect them to. Corporate governance is not an exception to this trend, and, as with accounting, different countries may well experience difficulties at different times. For example, the development of British codes of best practice, which began with the Cadbury Committee, can be related to governance scandals such as Polly Peck and Coloroll in the late 1980s and early 1990s. However, the wave of corporate scandals, mostly in the USA, at the turn of the century has been marked not only by the number of cases but also by the effect they have had on investor confidence and market values worldwide.

The combined impact of various US corporate scandals caused the Dow Jones Index to drop from a high for 2002 of 10,632 on 19 March to 7,286 on 9 October, wiping out trillions of dollars in market value. Investor confidence in the fairness of the system and the ability of corporations to act with integrity was ebbing. According to a poll in July 2002, 73 per cent of respondents said that Chief Executive Officers (CEOs) of large corporations could not be trusted (Conference Board, 2003). Amongst the many negative effects of this was a worsening of the pension funding crisis caused by the dramatic drop in the value of pension fund assets. It also increased the cost of capital and caused a virtual cessation in new securities offerings. The International Federation of Accountants (IFAC) claims that while there has been a lot of strategic guidance for business, there has been too little said about the need for good corporate governance. These authors emphasize the fact that successful companies were visionary companies, with a long track record of making a positive impact on the world. They did more than focus on profits; they focused on continuous improvement. They took a long-term view and realised that they were members of society with rights and responsibilities.

However, the long-term view is something of a rarity in many companies. A critical factor in many corporate failures was:

  • Poorly designed rewards package
  • Including excessive use of share options (that distorted executive behaviour towards the short term)
  • The use of stock options, or rewards linked to short-term share price performance (led to Aggressive earnings management to achieve target share prices)
  • Trading did not deliver the earnings targets, aggressive or even fraudulent accounting tended to occur. This was very apparent in the cases of Ahold, Enron, WorldCom and Xerox (IFAC, 2003).

Adelphia manipulated its earnings figures for every quarter between 1996 and 2002 to make it appear to meet analysts' expectations. Some of the better known cases of financial irregularities are summarised in following table.

Company

Country

What went wrong

Ahold

NL

earnings overstated

Enron

USA

inflated earnings, hid debt in SPEs

Parmalat

Italy

false transactions recorded

Tyco

USA

looting by CEO, improper share deals, evidence of tampering and falsifying business records

WorldCom

USA

expenses booked as capital expenditure

Xerox

USA

accelerated revenue recognition


In terms of corporate governance issues, Ahold, Enron and WorldCom all suffered from
  • Questionable ethics
  • Behaviour at the top
  • Aggressive earnings management
  • Weak internal control
  • Risk management
  • Shortcomings in accounting and reporting

Corporate governance failure at Enron

EVERY time you turn a stone, another worm creeps out. That seems to be the story of the Enron debacle. Not a day goes by without a new expose of wrong doing in the company that one begins to wonder if there is anything in our systems and structure of an enterprise that can prevent such a catastrophe.

Enron is an excellent example where those at the top allowed a culture to flourish in which secrecy, rule-breaking and fraudulent behaviour were acceptable. It appears that performance incentives created a climate where employees sought to generate profit at the expense of the company's stated standards of ethics and strategic goals (IFAC, 2003). Enron had all the structures and mechanisms for good corporate governance. In addition, it had a corporate social responsibility task force and a code of conduct on security, human rights, social investment and public engagement. Yet no one followed the code. The board of directors allowed the management openly to violate the code, particularly when it allowed the CFO to serve in the special purpose entities (SPEs); the audit committee allowed suspect accounting practices and made no attempt to examine the SPE transactions; the auditors failed to prevent questionable accounting.

The use of questionable accounting and disclosure practices, their approval by the board and their verification by the auditors arose from a variety of forces, including:

  • Pressure to meet quarterly earnings projections and maintain stock prices after the expansion of the 1990s
  • Executive compensation practices
  • Outdated and rules-based accounting standards

complex corporate financial arrangements designed to minimise taxes and hide the true state of the companies, and the compromised independence of public accounting firms.

Corporate governance failure at Wal-Mart

It has co-filed a shareholder proposal over concerns that Wal-Mart Stores Inc, the US supermarket group, is failing to comply with its own governance standards. Karina Litvack, head of governance and sustainable investment.

  • Despite strong policies on paper, Wal-Mart has struggled to implement its standards across its US business.
  • 'Weaknesses in internal controls have eroded the company's reputation as an attractive employer and are adding fuel to the fires of Wal-Mart's critics.
  • Its failure to deliver on these policy commitments is inhibiting Wal-Mart's ability to expand into new domestic markets.
  • Over 'the past several years', it has become increasingly concerned by signs of failure in internal controls that have led to government investigations and class action lawsuits by employees.
  • Allegations include requiring employees to 'work off the clock' -- during breaks and after shifts -- systematic discrimination against women, and alleged questionable tactics to prevent workers from voting for union representation.
  • It got off to a promising start in 2005 with expectations of a dialogue with the independent directors on the audit committee. But when this simply withered on the vine, Wal-mart had little choice but to bring concerns about internal controls, labour violations and the erosion of the company's reputation to fellow shareholders.
  • Company was not interested in engaging in a productive discussion about how it builds and supports a compliance culture and, as a result, they have joined an international group of large filers led by the New York City Employees' Retirement System to file a shareholder proposal.

Corporate Governance failure at Satyam

It is one of Corporate India's worst unfolding chapters, What could be the reason behind such a huge collapse? The top level management failed to estimate the intensity of the gangrene in the organization. Questions also arise on the role of the auditors,and how such a magnitude of financial fraud could have gone unnoticed. Corporate governance is a field which constantly investigates how to secure and motivate efficient management of corporations. It has began as a corporate governance issue back in December has now turned into a major financial scandal for the ages in India. The shares of Satyam Computer Services has plummeted more than 90% in trading at the NYSE today, a stark reminder that investors must always cover their backs or else get racked even by the big names in the industry. NYSE today halted trading in Satyam Computer at its bourses in the US as well as in Europe after the Chairman disclosed financial bungling at the Indian IT major.

A business will always have two sides, its not necessary to gain profits everytime, but to sustain in the market the integrity is vital. Every day in some or the other place there is a merger or an acquisition happening, but due to the projected image the co-players in the market are dropping out their plans of taking over Satyam.

Undoubtedly there will be intense focus directed at the other Indian IT Services companies as well.The Satyam corporate governance failure may also make its competitors bolder in terms of acquiring market share created by its fallout, provided the indutsry can regain the trust of the same investors that Satyam has deceived.

From this necessarily brief review of the evidence, and particularly of the sources of failure in financial firms, draw some tentative conclusions. It is important to recognise, however, the evidence base for firm recommendations on corporate governance in financial institutions is thinner than one would like, and certainly not robust enough to offer a standardised set of recommendations valid at all times and in all places.

Principal conclusions are:

  • First, that people are more important than processes. Many of the failed firms, or near failed firms which we have encountered, had Boards with the prescribed mix of executives and non-executives, with socially acceptable levels of diversity, with directors appointed through impeccably independent processes, yet where the individuals concerned were either not skilled enough for, or not temperamentally suited to, the challenge role that came to be required when the business ran into difficulty.
  • Secondly, and in spite of first conclusion, there are some good practice processes worth having. Properly constituted audit committees, and Board risk committees can play an important role, as long as they are prepared to listen carefully to sources of advice from outside the firm.
  • Third, and this is a foundation stone of the FSA's approach, a regulatory regime built on senior management responsibilities is absolutely essential. In some of the cases we have wrestled with, senior management did not consider themselves to be responsible for the control environment and indeed, in the old pre FSA regime, were able successfully to claim that they were not responsible even if the business failed. So our regulation is built on a carefully articulated set of responsibilities up and down the business. It is important that they are not unrealistic. We do not expect the CEO to check in the bottom drawers of each of his traders for unbooked deal tickets. But we do expect the CEO to ensure that there is a risk management structure and a control framework throughout the business which ought to identify aberrant behaviour, or at least prevent it going on unchecked for any length of time.
  • One consequence of this senior management regime, fourth point, is that regulators must focus attention on the top level of management in the firm. For the major firms we regulate we insist that our supervisors have direct access to the Board, and that they present to the Board their own unvarnished view of the risks the firm is running, and of how good the control systems are by comparison with the best of breed in their sector. Unfortunately, we find some resistance to this approach. The management of some of our firms want to negotiate the regulators assessment, so that when it reaches the Board it is an agreed paper and sufficiently bland to cause no debate. Well-structured Board, and a confident management, should welcome an independent view, even expressed at the Board level, which they may challenge and contest if they wish. And non-executive directors should find it helpful to see a knowledgeable view of the institution which does not come from or through its own senior management.
  • Fifth and penultimate point may not be a popular one. Boards should take more interest in the nature of the incentive structure within the organisation. I am not talking solely about the pay of the CEO, important though that is to get right - as some firms in Britain have recently discovered. Talking about ensuring that the incentives within the firm, and pay is a very powerful one, are aligned with its risk appetite. A number of our most problematic cases have their roots in a misalignment of incentives.
  • Lastly, no corporate governance system will work well unless there is some engagement on the part of shareholders. Boards are responsible to shareholders. That is the received wisdom in Anglo-American capitalism, at least. But if those shareholders are not prepared to vote their shares, and show little interest in business strategy, then that accountability is somewhat notional, and unlikely to be effective. Certainly regulators cannot hope to substitute for concerned and challenging shareholders, though in some senses they may complement them.

Corporate Governance Failure at Cadbury

Adrian Cadbury, successor to and chairman of the Cadbury Schweppes confectionary group

Mr. Cadbury's visit and interactions with Indian industry triggered the first serious discussions on the subject of corporate governance. All in all, it seemed like a promising new way of looking at the evil that was single promoter-run firms in India then, who, among other things, ran their companies like fiefdoms and were loath to give up control even if their shareholdings were low.

Recognise that it was a not so competitive environment, the grip of the license raj was still fairly firm and companies and their promoter/founders could pretty much do what they wanted, with public money. The real pain of liberalisation was yet to set in and the Infosys way of boardroom discipline was some way from making its presence felt.

History it seems is repeating itself. Indian companies have exposed themselves to billions of dollars worth of forex derivative contracts over the last few years. Precise numbers are hard to come by and will perhaps never will. What is clear is that companies have taken financial risks they could or should have avoided.

What is clearer is that there was no compelling reason to take these risks. And to that extent, it's a failure of corporate governance and must be treated and then addressed as such. There is of course the other issue of how the Institute of Chartered Accountants or the accounting regulator figuring out how to treat derivative losses as they stand on scores of balance sheets today.

How did it happen? Companies have been steadily stepping up their exposure to currency swaps and the like for at least four years now. Over time, as the stock markets (which bolster sentiment) have held their own and the prospect of any downside risk appeared more and more distant with every passing day, chief financial officers (CFOs) of companies have got braver.

If a company entered into, let's say, a transaction to convert a local currency borrowing into the Japanese yen or Swiss franc borrowing through the swap route, then the company is inducing a risk into the system where there is not.  No two ways about that.

Managements ought to have, in the interests of corporate governance, clearly informed their boards of all foreign exchange exposures, the risks arising out of that and the measures to mitigate them were something to go wrong.

Moreover, under the relevant Securities & Exchange Board of India regulations, in the absence of an applicable standard in India for derivatives, the companies' Audit Committees should have examined international standards and disclosed the losses in the Governance report and indicated that these would have been provided for had the country adopted international standards as applicable.

Its possible many companies did keep their boards informed and made the appropriate references in their balance sheets. Though this does seem unlikely, even if they did, no one was watching. It's also possible that some companies are in violation of law. Either way, shareholders must perhaps shoulder some part of the blame.

To conclude is another Enron waiting in the wings? Not quite but it does raise some fundamental questions on what companies do with their shareholders' funds. It's also about how when the good times roll, everyone forgets to look at the figures closely. There is something in the original Cadbury committee definition of corporate governance. "Corporate governance is the system by which companies are directed and controlled."

Getting down to the details of governance, we can focus on five issues

Chairman and CEO: It is considered good practice to separate the roles of the Chairman of the Board and that of the CEO. The Chairman is head of the Board and the CEO heads the management. If the same individual occupies both the positions, there is too much concentration of power, and the possibility of the board supervising the management gets diluted.

Audit Committee: Boards work through sub-committees and the audit committee is one of the most important. It not only oversees the work of the auditors but is also expected to independently inquire into the workings of the organisation and bring lapse to the attention of the full board.

Independence and conflicts of interest: Good governance requires that outside directors maintain their independence and do not benefit from their board membership other than remuneration. Otherwise, it can create conflicts of interest. By having a majority of outside directors on its Board.

Flow of information: A board needs to be provided with important information in a timely manner to enable it to perform its roles. A governance guideline of General Motors, for instance, specifically allows directors to contact individuals in the management if they feel the need to know more about operations than what they are being told.

Too many directorships: Being a director of a company takes time and effort. Although a board might meet only four or five times a year, the director needs to have the time to read and reflect over all the material provided and make informed decisions. Good governance, therefore, suggests that an individual sitting on too many boards looks upon it only as a sinecure for he or she will not have the time to do a good job. 

Reference:

1. For a good overview of the different theoretical perspectives on corporate governance see Chapter 15 of Dignam, A and Lowry, J (2006) Company Law, Oxford University Press ISBN-13: 978-0-19-928936-3

2. Corporate Governance International Journal, "A Board Culture of Corporate Governance, Vol 6 Issue 3 (2003)

3. Crawford, Curtis J. (2007). The Reform of Corporate Governance: Major Trends in the U.S. Corporate Boardroom, 1977-1997. doctoral dissertation, Capella University.

4. SSRN-Good Corporate Governance: An Instrument for Wealth Maximisation by Vrajlal Sapovadia

5. Bhagat & Black, "The Uncertain Relationship Between Board Composition and Firm Performance", 54 Business Lawyer)

6. National Association of Corporate Directors (NACD) Directors Monthly, "Enlightened Boards: Action Beyond Obligation", Vol. 31Number 12 (2007), Pg 13. 

7. Theyrule.net

8. Hovey, M. and T. Naughton (2007), A Survey of Enterprise Reforms in China: The Way Forward. Economic Systems, 31 (2): 138-156.

9. Business for Development: Fostering the Private Sector . OECD Development Centre. Paris: OECD Publications, 2007 (149-152).

10. Nicolas Meisel, Governance Culture and Development (Paris: OECD Publishing, 2004) SourceOECD, 27 July 2007

11. Corporate Governance in Development: The Experiences of Brazil, Chile, India, and South Africa. ed. Charles P. Oman. OECD Development Centre and CIPE, 2006.

12. Nicolas Meisel, Governance Culture and Development (Paris: OECD Publishing, 2004) SourceOECD, 27 July 2007

13. The Disney Decision of 2005 and the precedent it sets for corporate governance and fiduciary responsibility, Kuckreja, Akin Gump, Aug 2005

14. TD/B/COM.2/ISAR/31

15. "International Standards of Accounting and Reporting, Corporate Governance Disclosure". UNCTAD.
 


Ms. Shruti Mehta
Lecturer
Ms. Rachana Srivastavaare
Lecturer
Skyline Institute of Engineering & Technology
Greater Noida
 

Source: E-mail March 18, 2009

          

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