Essay title - Capital Financial Bankruptcy: Corporate governance
Introduction
A major component of bankruptcy and fraudulent activities is forecasting what a company’s future cash flows are likely to be, or what they would have been at an earlier point in time. This is due to the misuse of some companies’ funds by some of its executives. Investors are deeply concerned by the violation of trust and fraudulent activities by their management team.
In Corporations, the Chief Executive Officer (CEO) has always been blame for most business failures. Global News has created much speculation especially when CEOs have been seen now led away in handcuffs. As a result, mistrust has become one of the biggest fears for stakeholders and shareholders.
Corporate governance has always brought about much discussion because there are many areas where executives and investors do not agree, since their visions often differ. However, corporate governance is important to both managers and investors. The major reason for this is, in the case of investors, they lose a lot of capital. On the other hand, in the case of managers, businesses are often left to struggle when executives do not do what is expected of them, which is to maximize shareholders profits legally.
Corporate governance is a group of institution and control mechanisms which protect the suppliers of capital to a business, particularly suppliers of equity capital, the shareholders, who have residual protection after other claimants have been satisfied (Grossman 1995). Effective corporate governance helps to ensure that the interest of the shareholders’ are protected. Competition in the market place helps to provide an incentive for managers to deploy capital efficiently. A weak system impedes the flow of savings into investment and increase risks that cause corporate assets to be used unmanageably.
Stephen Overall (2003) highlighted the fact that ‘…In 2002 alone five of the top 10 bankruptcies that have taken place occurred in that single year…’
(FT Management, 2003)
Reports today show that high profile financial failures such as Enron have sound an alarm for the level of mistrust in the corporate sector and have left investors extremely cautious. The major causes of concern that causes conflicts arise from an “infectious greed” which has rise up at the highest level of businesses creating a burden of concern of moral ethics for shareholders.
The first pressure of improvement was the financial sector alarmed by the bad reputation and the negative influence which could affect the domestic financial market and the economy as a whole. The Code Best Practice represents the essence of the principles which are discussed in the Cadbury Committee report. They believed that companies’ best interest is to comply with the code and that it would become standard in well run companies.
Within most Corporations, some executives have been found with their hands in the ‘cookie jars’. On January 23, 2006 in the UK, Livedoor chief Takafumi Horie and three senior executives broke Japanese laws of security. Most often auditors and shareholders have left these same executives known to be involved in mishandling company funds and enhancing their personal wealth to go unnoticed. They move go on with their lives as though they have done nothing wrong, frequently continuing their dishonest acts on new jobs. Additionally, because their ‘crimes’ went unpunished young managers see it as a lucrative method of uplifting themselves and so gravitate to this trend as well.
The public suspicions that there is plenty of opportunity for mischief in large public companies have been raised, affirming Adam Smith (1776) warning. “The directors of [joint stock] companies, however, being managers rather of other people’s money that of their own, it cannot be well expected that they should watch over it with the same anxious vigilance [as owner]…Negligence and profusion, therefore must always prevail, more or less, in the management of the affairs of such a company.”
Increasing pressure for social responsibility was ranked second in a Financial Times/PricewaterhouseCoopers survey of the views of 750 Chief Executive Officers on the most important business challenges for companies in 2000 (Financial Times, 2000).
Klapper and Love (2002) find the effect of CG on firm performance may vary depending on the country specific level of investor protection. More specifically, firms with relatively good governance practices are likely to be more highly valued by investors in countries where investor protection is generally poor.
The aim is to show a linkage of weak stock return with managerial opportunism to determine whether, or not they look after their own personal interest or in the process of maximizing shareholders wealth end up not following the business plan in the interest of the organization. The focus will be on the board, non-executive members, audit committees, and the governance principles, Organization for Economic Co-operation Development (OECD), Sarbanes-Oxley Act (SOX), New York Stock Exchange (NYSE), the Code of Best Practice and at the same time, cite companies that have fallen victims to poor governance approaches.
The neoclassical theory of investment, as first formulated by Modigliani and Miller (1958) derives strong predictions from an elegant and simple model. It assumes manager maximizes the wealth of their shareholders because they invest until the cost of capital equals the marginal returns on investment.
The pressure of the American financial system encouraged countries like the UK to find different ways of injecting greater dynamism into their financial markets. This things like upgrading the importance of shareholder value and embracing the market for corporate control as a means of imposing discipline on publicly quoted companies.
The results of the stock market crash followed by companies such as WorldCom and other corporate scandals are results of such influence.
Corporate scandals in the UK highlighted some of the same issues that the US faced during post-Enron; the role of boards of directors as monitors of management, the independence and effectiveness of auditors and the adequacy of external regulation. Product market provides an incentive for managers to deploy capital efficiently, but only effective corporate governance can ensure that interests of shareholders are protected. Weak corporate governance impedes the flow of savings into investment, and increases the risk that corporate assets will be used sub-optimally.
Proper corporate governance must be based on sound judgment and on an understanding of the respective power and accountability of the different elements involved. This goal cannot be achieved unless all relevant information is available. This concept is a means of achieving sound business judgment, which, in turn, is a tool of judicial review used in analyzing executive conduct. If the CEO, the non-executive directors (NEDs) and the board of directors use their independent judgment, proper governance will prevail. Where the use of good judgment and high ethical standards is doubtful chances are that corporate governance will be ineffective and this will question accountability. The application of good judgment is fundamental to provide confidence in the relationships between management, shareholders and owners. Confidence is essential in improving a business performance as well.
The activities of the Cadbury, Greenbury and Hampel Committee are impressive. Unlike the U.S., where improvements in corporate governance can generally be traced to legislation or litigation; the British efforts at self-governance offers an attractive alternative model. In the U.K. it appears that improvements in corporate governance have arisen largely because business leaders have tried to address the business problems. They realized and are motivated by the fact that by “enhancing” their corporation’s governance they could avoid more regulation by the government; therefore, self-reform would be more suitable to business environmental needs. They reached the conclusion that intervention from the government would diminish the abilities of corporation to develop independent business free from state interference, therefore they pursued there objectives voluntarily.
Investors now have a big role to play in ensuring that the companies in which they hold shares are well governed. But they represent only one of a number of mechanisms, some internal to the company and others external, which can contribute to improved corporate governance. The strength of governance procedures and their influence on the way managers of companies behave, vary in the UK and the US. The differences are reflected in this project of how they are tackling corporate governance.
Evidence suggests that “slack structures” can affect the performance of companies in a given country, and that scandals can contribute to reduced stock price. The main hypothesis tested is developed in chapter 5 and describes the methodology employed to measure the returns of stock price and the risk of the company in the market place. A questionnaire was also carried out to seek to understand the way in which management viewed themselves and shareholders of the company. The data acquired are interpreted and discussed in sections used are discussed in chapter 5 and 6. The results regarding the effects of corporate governance on a firm’s performance are presented in sections 4 and 6. Conclusions are drawn in the final chapter. Appendices detailing data sources, variables and governance concepts are used along with a questionnaire to help in forming the outcome of this paper.
Literature Review
This review focuses on the concepts of corporate governance within businesses. Research was done from the relevant books, various articles, newspapers, journals, the worldwide web, and data from seminars, conferences regarding the topic of discussion and from interviews conducted with Directors.
What is Corporate Governance?
Corporate Governance is ‘…the ways in which businesses are directed and controlled’ (Atrill 2003). Corporate governance defines the relationship, the distribution of rights, accountabilities and responsibilities between the board of directors, shareholders and other stakeholders. They decide the rules and procedures with the aim of better implementing the objectives according to which the company is directed. It is a mechanism, which was developed to give guidance as to how a company should run its short and long term plans.
Shann Turnbull (1997) working paper on Corporate Governance states that the definition of corporate governance quoted by Tricker (1994) is focused on the board room but extends the scope to include ‘owners and others interested in the affairs of the company, including creditors, debt financiers, analysts, auditors and corporate regulators.’
These concerns reflect the need for a company’s financial reports to be of a high standard. The United Kingdom has now adopted its own International Financial Reporting Standards (IFRS). All listed European Union companies in 2005 needed to adopt this for their consolidated financial statements. However, the task of changing from one set of accounting practices to IFRS was not an easy job. There was a lot of significant disclosure requirement that will result in material financial reporting differences (Ernst & Young 2005).
Independent and non-executive members must be selected to sit among the board of director with a strong level of financial literacy in order to decrease the problems associated with agency problems. There must be a level of “full disclosure”, the consequences of full disclosure exist in the regulatory provisions and professional statements with which companies are expected to comply fully.
Monks and Minow (1991) share the view that a more effective board of directors and better corporate governance must lead to better corporate performance. A strong and proficient board of directors will ensure increased competitiveness compared with businesses without such boards. The aim is to ensure the compliance of the boards’ role as an adviser to the CEO and management and to see that the business has the strategy and organization needed to develop the performance shareholders expect.
These issues are very important since in some cases, self-arrangements between directors and executives who are well acquainted exist. The board is the key organ in the business for developing better governance and thus reducing conflicts. It is the means of communication between the stakeholders and shareholders, which prevent disaster. Without an effective board, the business performance will be in turmoil and unethical practices may precipitate economic crisis.
Governance and its Roles as a Business Organisation
It should be clear that the governance problem where finance is concerned is very severe, but not hopeless. The need to get governments to focus on their role as a facilitator is a necessary step towards greater success. Furthermore, an Audit Committees has a crucial role to play in the assessment of a companies’ financial statement.
Governance represents a key challenge for effective leadership to cultivate optimal results in market economies experiencing a vicious cycle of corruption and scandals.
Paul Steiger (2005) argued that ethical decision making is sometimes harder for institutions than for individuals, and that the “slippery slope” of corporate ethics scandals often starts with small mistakes that lead to bigger ones. “Sarbanes-Oxley and good corporate governance often don’t provide answers to many ethical questions”, he further stated.
“There is no doubt that audit committees can play a major role in bringing about greater accountability by companies and in restoring confidence in financial reporting.” (Lindsell (1992) p. 104)
“[Audit committees can] help directors meet their statutory and fiduciary responsibilities, especially as regards accounting records, annual accounts and the audit.” (Collier 1992)
Many philosophers consider ethics to be the “science of conduct”. More so, explain that ethics includes the fundamental ground rules by which we live our lives. Philosophers, since in the time of Socrates and Plato have been discussing this issue for many centuries.
Enhancing shareholders wealth must be the board of directors’ number one priority apart from maximizing profits. Plato (427-347 BC) Greek Philosopher says ‘…Good people do not need laws to tell them to act responsibly, while bad people will find a way around the laws...’ He emphasized the importance of trust and sound judgment, which he saw as vital commodities in good business practice. (Web 1)
Carly Fiorina, chief executive of Hew-lett Packard expresses the same view when she said ‘…Good leadership means doing the right thing when no one’s watching.’
Whereas Peter Drucker stated that ‘…Decisions are not made well by acclamation, they are made well only if based on the clash of conflicting views, the dialogue between different points of view, the choice between different judgments. One does not make a decision unless there is a disagreement…’
Douglas McGregor’s Theory X and Theory Y stated that ‘…Trust is a delicate property of human relationships. It is influenced far more by actions than by words. It takes a long time to build, but it can be destroyed very quickly…’ (FT Management 2003)
Corporate Governance is essentially leadership in that it affects the livelihood of the business and its shareholders. No person or institution will trust a corporation if its managers are known, or suspected, of misusing funds for improper purposes and corrupting the economic system. In a broader sense, international investors require confidence that the financial system and structures are secure and have credibility.
Moreover, good governance is that measure of trust mentioned, and it deals with proper accounting procedures followed, with executives being held accountable when things go wrong.
Rules and Regulations
In instances where management can manipulate accounting numbers to transfer wealth, accounting standards can assist in reducing agency costs by minimizing the scope of such manipulation. Empirical evidence from agency theory found that management manipulates accounting numbers to benefit from the contracting process. (Houltusen el al. 1995)
In order to achieve a robust and healthy financial system, organizations and committees have been formulated.
The OECD principles provide a structure through which companies may enhance their transparency and accountability, and thus improve their performance and access capital. They address issues such as the rights of shareholders; the equitable treatment of shareholders; the role of stakeholders; disclosure and transparency; and the responsibility of the Board. The OECD (1998a) principles, refers to the elements of good governance; the corporate governance framework (OECD, p. 16)“should promote transparent and efficient markets, be consistent with the rule of law and clearly articulate the division of responsibilities among different supervisory, regulatory and enforcement authorities.”
The International Accounting Standards (IAS) is known for its accurate, reliable and timely accounting. Information is fundamental for efficiency and financial stability. The practical effectiveness of many standards relies heavily on the quality of the underlying data and associated accounting and auditing practices.
Another relevant body is the International Standards on Auditing (ISA), under the International Federation of Accountants (IFAC). Crookedness is found especially when trying to fix the books, and this creates the need for greater consistency, transparency and comparability of financial information. The ISA aims at providing consistent, high quality and comparable audits based on (IAS) and other standards of a high international accepted quality. To achieve orderly capital markets around the world, corporations must provide investors and creditors with relevant, reliable, and timely information. Accounting, auditing, and the structure of corporate governance that they operate within are essential components in the flow of information to capital market participants. Furthermore, all practices work hand in hand with each other to ensure that best practice is operated within the organization.
The Smith Guidance (2005, p. 9) on Audit Committees helps to review “financial reporting issues and judgments”, these were implemented to aid with interim reports, preliminary announcement, financial statements and any formal statements for companies.
Conforming to rules are the most difficult situations faced by managers today. It is very difficult to formulate hard and fast rules that cover every contingency. In particular, this applies in differing business and geographical contexts, where differences in cultural expectations and standards may render an activity or behavior acceptable within one country but unacceptable within another. This can be a particular problem for multinational organizations with bases in a number of different countries that fall under different regulations. This is where corporate governance principles may play a significant role, which superimposes on businesses an additional set of criteria against management and their behaviours. A number of standards or guidelines may, however, be formulated by the management and the organisation. They must be consistently applied and be seen to consistently apply if management is to conform to company policies.
Corporate Governance and Fraud
There are several areas of according to Madsen and Shafritz (1990), that explains “managerial mischief” which includes illegal, unethical, or questionable practices of individual managers or organizations, as well as the causes of such behaviours and remedies to eradicate them...’ Good governance entails all matters of dealing with dilemmas that have no clear indication of what is right or wrong.
The other areas of business is the ‘moral mazes of management’ and this includes ethical problems that managers must deal with on a daily basis, such as potential conflicts of interest, wrongful use of resources, mismanagement of contracts and agreements, etc.
Corporate governance is used to describe proper business management but it is also being mentioned when trying to explain any actual failure or other disappointment in corporate performance. An essential component in the quality of a company’s effectiveness is the good sense and integrity of executives, who should have keen and inquiring minds and be able and ready to spend time mastering the essentials of their brief.
Even in a well run company a ‘bright scoundrel’ can succeed in outsmarting the governance system. When executives are greedy and choose to enjoy the fruits of their dishonesty, when the boards of directors or another controlling system do not set out an efficient scrutiny mechanism, a fraud is likely to be committed. Therefore, stringent financial measures to assure transparency are essential.
Recently a release from the Wall Street Journal (2004) reported that the ‘…Chairman and Chief Executive Jeffrey J. Steiner and other Fairchild executives and board members are accused in the lawsuit of breaching duties to the corporation, wasting Fairchild assets and enriching themselves at shareholders’ expense.’
Arthur Levitt (2002) stated that ‘…If a country does not have a reputation for strong corporate governance practices, capital will flow elsewhere. If investors are not confident with the level of disclosure, capital will flow elsewhere. If a country opts for lax accounting and reporting standards capital will flow elsewhere...’
It must be clear that proper governance will be accompanied by asking tough questions systematically. A high level of understanding and the motivation to inquire will accompany effective management. Without this, fraudulent acts would continue to occur and corporate governance would be cited again as an example of mismanagement.
- Procedures in the UK
The weaknesses in markets for corporate control and the insufficient dependence between under-performance and the probability of takeover imply that shareholders’ confidence will frequently be lost (The Journal of Financial Economics, 1996). As such, procedures need to play a crucial part in the performance of the firm.
The United Kingdom is well known for its financial procedures around the world; therefore, there are many committees and boards to assist with accountability, transparency, disclosure, audit and governance. Words such as Sarbanes-Oxley, Code of Corporate Governance and Accounting Disclosures are well understood amongst investors within the UK.
The first and most significant code on the financial aspects of governance was by the Cadbury Committee, from which two other committees, the Greenbury and Hampel Committee were created. The incorporation of the recommendations of the three committees appears as the Combined Code in the London Stock Exchange rules. (The Combined Code, 1998)
The Committee suggested that companies’ annual reports should contain a statement on how they apply corporate governance’s principles. The principal requirements of the Combined Code are as follows: half of the board should be non-executive directors. A majority of the non-executives should be ‘independent of management’ and ‘free from any business or other relationship which could materially interfere with the exercise of their independent judgment.’ (The Combined Code, June 2006) Companies must appoint a nomination committee. The Code repeats Cadbury and Greenbury’s recommendation regarding the presence of independent non-executive directors on the audit and remuneration committees, but emphasizes that all of its members must be independent non-executives. Another important requirement of the new code is that the directors must be re-elected every before three years.
Creating these committees has proven to be effective, the London Stock Exchange, the CBI and the OECD improving corporate governance, transparency and accountability shows just how serious and important this issue is. The activities of the Cadbury, Greenbury and Hampel Committee are impressive. Unlike the US, where improvements in corporate governance can generally be traced to legislation or litigation, British efforts at self-governance offer an attractive, alternative model. In the UK, it appears that improvements in corporate governance have arisen largely because leaders have tried to address business problems. They realized and were motivated by the fact that by enhancing their companies’ governance they could avoid more regulation by the government, therefore self-reform would be more suitable to the business environmental needs. They reached the conclusion that intervention from government would diminish the abilities of corporation to develop independent business free from state interference and therefore they pursued these objectives voluntarily. (OECD, 1998)
The creation of the three committees speaks for itself. The bringing together of the resources of the London Stock Exchange, the CBI, the Institute of Directors, leading institutional investors and accountants, concentrating on improving the corporate governance and accountability, makes a declaration of the seriousness and importance of this issue. These mechanisms brought substantial progress in several areas of corporate governance. The report on compliance with Code of best Practice details measurable improvements by listed companies in the nominating process, the determination of executive compensation the identification of leading directors, better financial controls and better communication with shareholders. (Cadbury Committee, 1992)
With the experience of almost sixteen years it seems that such codes are effective, both in assisting boards of directors to direct their companies well, and in providing the vital measure which guards against mismanagement and fraud. This brought substantial progress in several areas of CG and details measurable improvements by listed companies for better financial controls and better communication with shareholders. The reliance on best practice and the existence disciplinary sanctions ensures that companies will follow and comply with high governance standards. The codes reflect needs, including the interests of companies’ management, shareholders, institutional investors and other stakeholders. The codes provide solutions to new governance issues as they arise. (Hamper 1998)
The efforts reflect matters that are relevant and important to everyone in corporations and seem to have achieved good results across the UK. The reactions in the business environment are positive. This can be seen by the fact that companies adopt a written code of conduct under the recommendation of Cadbury Committee. Today’s companies understand the importance of clarifying responsibilities. By knowing what is expected, it will be easier to deal with problems. As a result, the directors know their duties to act on good faith when standing as the controlling body of the company. The reasoning that lies behind these codes of conduct is to ensure that openness will be maintained in the company. Openness will secure transparency and transparency is the key instrument to deter unethical action and to promote high governance standards.
Procedures in the US
Recent accounting scandals and white-collar criminal prosecutions, fines and penalties reflect that corporate governance is still very unsettled.
The central point of the new reforms is the role, responsibilities and composition of the board committee and disclosure of corporate policies. The (2004) New York Stock Exchange (NYSE) listing standards calls for directors on the board of listed companies to be free of any material relationship with the company. See Appendix 1 for NYSE listing standards.
The role of securities analysts and investment bankers, who make buy and sell recommendations on company stocks, that provide company loans, handle mergers and acquisition provide opportunities for conflicts of interest.
The board needs to confirm that the individual qualifies as “independent.” The listed companies must publicly disclose the individual. This was implemented because in relation to board failures, BOD and audit committees were charged with establishing oversight mechanisms for financial reporting on behalf of investors. Scandal identified board members who either did not exercise their responsibilities or did not have the expertise to understand complexities of the business. And in many cases the audit committees were not independent.
All listed company need to adopt and disclose corporate governance guidelines that address the responsibilities of the board committee, access to management and independent advisors, performance evaluation of the board etc. Moreover, each listed company must adopt and disclosure a code of business conduct and ethics for their directors and officers. They must contain compliance standards and procedures that facilitate operations and rules and regulations, this of course includes illegal and unethical behaviour.
The Sarbanes-Oxley Act (SOX) was created in 2002 in response to the accounting scandals include those affecting Tyco International, Adelphia and Peregrine Systems to name a few. These scandals cost investors billions of dollars ($500bn) when the share prices of these companies plummeted. SOX have now been renewed with 11 titles/sections for all U.S. public company boards, management and public accounting firms. It now requires the Securities and Exchange Commission (SEC) to rule on requirements and compliance of the new law.
The Public Company Accounting Oversight Board (PCAOB) a quasi-public agency is sat up to regulate, inspect and discipline accounting firms in the role of auditors to public companies. It looks at the independence, corporate governance, internal control and financial disclosure. There is also a board to register auditors and to defend the processes and procedures for compliance of audits, inspecting etc which relates with specific mandate of the SOX.
Governance and Management
For management seeking to balance the interest of various stakeholders a number of conflicts materialize. Profit becomes a motive rather than an objective, a measure of how well businesses actually perform their fundamental objectives. It can be recognized also, that not all well governed companies automatically succeed in the marketplace.
Management believes in economic terms, and long-term profitability that they are the measure of prosperity. There are executives who are faced with conflict between duty and self-interest; they may stand on both side of a business deal or they may be able to benefit personally from certain transactions. (Harvard Law Review, 1990)
If a motivated management judges every action purely on the bases of economic grounds, and therefore rewards are based on short-term economic performance ignoring all social and moral issues of fairness. Then, quite certainly he will aim to maximise the economic returns of the corporation, even at the cost of social or ethical values or serious consequences like the business destroying itself.
Shareholders need to fulfill their duty of governance and accountability because there are duties and responsibilities beyond profits (Williams, 1979). Shareholders appoint the board who are there to work with management, as management should be expected to respect its board and carry out the policies.
Good management is concern for the future of the corporation, achieve profits, have the interest of its shareholders and other ethical goals. By contrast, when management fails to take into consideration/account its social responsibility, it will be unable to foresee its ‘client’ needs and the company’s performance after a while will decline. In such cases, the board should step in as a guide and steer management.
In aid to improve performance, shareholders/board must ‘effectively’ monitor management decisions, but be careful not to intervene directly in the day-to-day management activities. Holzach (1983) stated that ‘…a good board should have its nose in and its hands out, understand thoroughly the time commitment. If you cannot bring something to the party, do not come…’
Sir Adrain Cadbury says that it should ‘…be crystal clear where the line between direction and management is drawn…’
The board needs to possess the ability to differentiate between right and wrong and have the courage to stick to its principles. An effective board must not fear confrontation with management, strong characteristics is not the only quality a board should possess; but realistic modesty as to what it can achieve is also called for.
Bevis once concluded that ‘more modesty is about the claimed contribution to corporate performance [and that] any particular form of corporate governance provided is highly recommended.’ (Journal of Portfolio Management, 1995)
Importance of Board Governance
The board must concentrate on how they perform when the company enters into difficulties or is already in this position. Even in peaceful days and normal conditions, they have an important role: it must ensure that high standards are kept. Effective governance will ensure healthier performance even in global economic crisis. When there are conflicts, the more effective board is the one that has curiosity and confidence to ask tough probably complicated questions and insist on getting clear answers. To reiterate the point above, the Higgs Report (January, 2003) on Suggestions for Good Practice shows how pivotal it is for Board member to be effective while carrying out their duties.
An inquisitive attitude is the essential ingredient for a board, which often wears two hats: that of expert consultant to the executives and that of the accountable shareholder agent. It is important as shareholders’ agent they be inquisitive. They need to be capable of pulling their weight in damage limitation and other conflicting situations.
If they do not compromise the principles, they can escape mistakes and become well- informed, accountable watchers of the company affairs.
Accountable watchers of the firm are mostly well-informed boards. They will provide helpful judgment and constructive review of the company’s policies and governance schemes. Time must be made for them to set performance goals and deadlines and they should be free to reassess the executives’ skills frequently.
The most significant step toward a better performing board and effective governance is the role of outside directors. The key principle is that these outside directors will be fully independent of the executives and their only affiliation with the company will be as a director. This measure provides an opportunity for boards to exert greater influence on the company’s operation as a task rather than to manage.
The boards’ role must be clearly defined as discussed earlier as the company must be obliged to allow directors access to the relevant information, by knowing that it will face harsh sanctions if it does not carry these obligations. Once accomplished, directors can no longer escape responsibility by arguing that management laid down hurdles and blocked their way in completing their duty.
When directors come to the realization that their duty is complicated and requires considerable skills, incompetent candidates will be deterred from applying for the role as directors. Moreover, lesser dishonest acts are likely to be reported and high standards with better performance will be achieved.
Two important roles of corporate governance are firstly the creation of dynamic enterprise that will be economically robust. This will be achieved by the objective allocation of energy for the establishment of leadership, management and direction and secondly, the role to guide the company in fulfilling transactions with integrity, accountability, responsibility and honesty in order to yield prosperity for the firm.
McKinsey in association with Institutional investors discovered that “large private money managers, especially those looking for long-term value are willing to pay a higher stock price for companies with good, independent board governance.” (McKinsey Quarterly 1997) If CEO and owners expect to build a strong and stable business with long-term visions, they need to endeavour to establish the best board for the business and not for their own personal interests.
LEGISLATION DEVELOPMENT FOR CORPORATE GOVERNANCE IN THE UK/US
This chapter focuses on the general regulations both in the UK and US and how they relate to corporate governance issues in companies. The legislation for both US and UK shows how they have tailored their regulatory system to try to combat weak corporate governance.
Corporate Control Markets
In a perfect and efficient market, it is assumed that there is no need for mandatory intervention. Market forces, if left alone will bring about the most efficient solutions. Therefore, mandatory government intervention assumes an imperfection in the market place which prevents the market from adopting the most efficient solutions on its own. The voluntary nature of corporate governance development in the UK and US affirms the argument that market forces will strive to adopt the most efficient solutions.
In the UK the median size of the large voting shareholders block is 10%.
Mayer stated that the concentration of control is considerably smaller in the UK than it is on the Continent. No individual investor therefore exerts dominant control; instead it can only come from coalitions of investors.
The situation is that financial institutions, especially pension funds and life insurance companies, hold a majority of shares, followed by directors with companies and individual investors holding the smallest portion of the voting shares.
Historically in the UK, the regulation of financial institutions led to dispersed holding of shares that allowed for takeovers. As a result, an active and efficient market for corporate control evolved. In theory, when a company is mismanaged and their managers act in a manner which is clearly for their personal benefit, such as by consuming excessively, earnings will decrease. Consequently, this causes the company’s share price to decline. Such a decrease in the share price exposes the company to the risk that a group of competing managers will purchase a large block of the company’s shares, take over the company and replace management. In practice, the target for hostile takeovers does not present this disciplinary mechanism, instead, the hostile bids focuses more on performing companies. Even though the situation is not the same in theory, the market for corporate control is still efficient because the turnover of management in the ‘threatened companies’ is very high.
In July 2002, President Bush signed the Sarbanes-Oxley Bill (also known as the Corporate Oversight Bill) into law. It imposed a number of corporate governance rules on all public companies with stock traded in the US. Finally, in November 2003, the New York Stock Exchange (NYSE) and NASDAQ adopted an additional set of corporate governance rules that apply to most companies with stock listed on these markets. American Stock Exchange (AMEX) joined in with similar rules in December 2003.
Severe scandals over the decade of companies such as Tyco, HealthSouth, Xerox, Shell Antilles and Guiana’s limited and Barings Bank have caused many firms to admit to having some financial problems of their own. Some firms started to experience major stock price declines as a result of announcing misstated financial reports (e.g. Agrawal and Chadha (2005). Companies such as Worldcom and Enron were forced into bankruptcy because of misstatements. Lawsuits were even held against them by their relevant stakeholders. (Palmrose and Scholz 2004)
Regulation Mechanisms
Many thanks should be given to the collapses of corporation, epitomized by the likes of Enron, because the United States and the United Kingdom begun to embark on programs geared to solve the problems in their legal system relating to weak governance.
Both the US and the UK in the last decade have shifted the profile of shareholders from private investors to institutions, as mentioned previously. A shift to pension and mutual funds has the savings of tens of thousands of ordinary people. Gone are the days when institutional investors are dormant, they are now very popular in Europe.
The main institutional investors then to be pension funds and insurance companies, including: ‘ABI’ – Association of British Insurers; ‘NAPF’ – National Association of Pension Funds; ‘PIRC’ – Pension Investment Research Consultants. As part of their call for better governance, they have pushed for truly independent directors, for top executive compensation to be correlated with a company’s performance and for confidential voting in annual shareholders meeting.
Institutional investors have an important role in promoting corporate governance. This can be accomplished by concentrating on advising companies that seem to be performing poorly, to reconsider their operating strategies, or protesting against apparently exploitative senior officers and by conveying their demands for improved management directly to the boardroom. (Chernoff 1996)
The Higgs Report have allowed under the Institutional Shareholders Committee (ISC) code of activism, institutional investors to intervene in the affairs of under performing companies “when necessary”.
The ISC best practice approach (2002) was an attempt for the introduction of stringent government legislation to impose a statutory duty on institutional investors to intervene in corporate governance. They increasingly play major roles in companies ensuring their shares are well governed.
Representing only a number of the mechanisms, some internal to the business and other external, which may contribute to improved corporate governance. The strength of those mechanisms, the influences on the way managers of companies behave vary in different countries, depending on institutional arrangements and ownership structures. These differences are reflected in different ways by which countries are tackling corporate governance.
The NYSE corporate governance rules introduces a range of new mandatory requirements concerning board structure to reflect generally accepted best practice in corporate governance. It deviates from the traditional U.S. state based mode of constitutional law as essentially “facilitative”, while some provision in SOX are listed as disclosure provision it was argued that the impact of the provisions will mandate compliance.
Regulatory mechanisms are there to encourage corporations who hold shares to comply. In addition they are guidelines for shareholders providing them with power to establish collective actions. Institutional shareholders need to adopt rules as a mechanism of scrutiny for examination control over the company’s governance in order to achieve a high level of performance.
Control Systems
Scandals both in the US and the UK involving corrupt analysts, excessive pay and auditing games have stimulated a cry for more transparency in accounting and for greater checks and balances.
Americans have been trying for years to get European businesses to adapt to their US transparency model. However, in light of the Arthur Anderson scandal corporations should not count on it. According to Marco Becht (2002) a German Economist and executive director of the European Corporate Governance Institute in Brussels ‘…Enron is helpful in making people realize that even more improvements are needed…’
SOX allowed for tough corporate governance rules would apply to all listed companies on the Stock Exchange (NYSE), NASDAQ, and American Stock Exchange (AMEX). SOX have since been summoned with new rules and regulations issued by the Securities and Exchange Commission; and as mentioned above in section 2 the PCAOB helps to regulate the accounting system. Among their many provisions, the new law and the stock market rules together require that the board of a publicly traded company be composed of a majority of independent directors and the board’s audit committee, consist entirely of independent directors and have at least one member with financial expertise. They also impose restrictions on the types of services that outside auditors can provide to their audit clients.
SOX warrants strong audit committees and for them to be manned exclusively by outside directors and appoints the audit clients. It bars auditors from several non-audit services for their audit client. This proposal will solve the issue of conflicts of interest for the auditor. It also gives clarity about the quality of the auditing processes. Breedan (2003)
The British reform looks very different from the American one. The focus of the government in the UK was built more on voluntary compliance with no statutory codes of conduct rather than on corporate governance issues. The current approach has developed from cases like Maxwell and Polly Peck from which the Cadbury Code in 1992 was articulated. The rationale behind the committee was to examine the reliability of UK reports, accounts and the credibility of the audit statements attached to them.
In 2003 the Higgs committee created a concept of “explain or comply” by which all listed companies are expected to follow. If ignored, they are expected to explain to shareholders the reason(s) why and in some circumstance non-compliance is justifiable (Higgs Report 2006). Improvement to the corporate governance practices is through the code of conduct.
As explained above the market mechanism and the self-correction are not effective enough to secure corporate governance in the UK. The current situation of the dispersed shareholders, have caused loss of power and influence from the point of view of the shareholders, who lack incentive and face substantial collective action problems when mismanagement and governance problems are identified in a specific company in which they are invested. Consequently, the weakness in the market for corporate control and the insufficient dependence between under-performance and the probability of takeover imply that the shareholders’ confidence will frequently be lost.
Self-regulatory codes seem inevitable after this current state. The main advantage of self-regulatory is its flexibility. Unlike legal statutes and regulations it is not mandatory and interferes less with the company’s decision making process. The codes are used as a supplementary device whose effectiveness is measured by market pressure.
Internal Control
The board of directors is the most internal control mechanism. In the UK all listed companies need to have a balance of independent directors on their boards. The job of the executive director is in charge of running the corporation, while the non-executive directors have the responsibility for monitoring the executive director activity whilst providing advice. The idea of meeting regularly is to reduce and correct any issues before they spiral at a low cost because they have access to the firms’ information.
Professor Brudney (1982) stated that of the roles of the board and internal directors three are most vital; and they are efficiency, social responsibility and monitors of integrity. The Cadbury Codes U.K. stressed the importance of directors as a check on managers’ misconduct which has arisen from the lost of public confidence in the financial reporting system. The Hampel Committee focuses on the board’s efficiency performance.
A part of the Cadbury Code states that the board should set “values and standards” of the company. (UK Code July (2003) A.1)
The Combined Code of corporate governance play a similar role to the SOX, however greater resource are dedicated to the enforcement of the securities law in the UK rather that in the US (Jackson & Roe (2007)). The Alternative Investment Market claims that their spectacular growth in listings coincided with the SOX legislation. SOX created two separate section which are civil provision (under Section 302) and criminal provision (under Section 906). Section 302 mandates a set of internal procedures to ensure accurate financial disclosure. The officers responsible must certify that they are “responsible for establishing and maintaining internal controls” and “have designed such internal controls to ensure that material information relating to the company and its consolidated subsidiaries is made known to such officers by others within those entities, particularly during the period in which the periodic reports are being prepared.” 15 U.S.C. § 7241 (a)(4) the officers must “have evaluated the effectiveness of the company’s internal controls as of date 90 days prior to the report” and “have presented in the report their conclusions about the effectiveness of their internal controls based on their evaluation as of that date.” Id..
Section 404 affirms the responsibility of management to produce an “internal control report” as part of each annual Exchange Act report (15 U.S.C. § 7262). The report must affirm “the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial report.” 15 U.S.C. § 7262(a)
Under section 302 and 404 the SEC was directed by Congress to promulgate regulations enforcing the provisions above.
The Higgs Report (2003) recommended strengthening requirements regarding the composition of boards, IoD, and recruitments of directors and audit committees in their “comply or explain” regulatory model, rather than prescriptive government legislation. This was also incorporated into the Combined Code.
In the U.S. the approach was through self-regulatory organizations and federal legislation and regulation. However, in 2002 the approach was more legislatory ruled with a higher level of mandatory governance standard.
Reform / Mechanisms
The creation of London Stock Exchange, CBI and Institute of Directors, leading institutional investors and accountants concentrating on improving corporate governance and accountability, makes a declaration of the seriousness and importance of this issue. The unification of the most important bodies made the framework of self-regulation an effective tool in the process of implementing the concept of corporate governance. This mechanism brought substantial progress in several arrears of corporate governance. The report on compliance with the Code of Best Practice details measurable improvements by listed companies in the nominating process, the determination of executive compensation, the identification of leading directors, better financial controls and better communication with shareholders.
With self-regulation being around for more than 10 years, it will be seen that such codes are effective, both in board assistance and in ensuring corporations are well run and in providing the important measure with guards against mismanagement and fraud. The reliance on best practice and the existence of market discipline ensures that companies will follow and comply with high governance rules, and standards. The Codes reflect market needs, including the interest of companies’ management, shareholders, institutional investors and other stakeholders. The Codes provide solutions to the new governance issues as they arise.
There have been arguments that by making compliance compulsory, less well intentioned companies which otherwise would not comply with the Codes, will no doubt follow the Best Practice or will face litigation. The U.K. appears to have no need for a rigid framework of legislation in order to raise governance standards because of the effective mechanism of market forces whereas in some emerging markets it is more fundamental. In such countries the law is required to set a foundation to corporate or professional behavior, but in the U.K the requirements are for promoting best practice beyond lawful practice. The OECD shares this view because their report states that “the design of corporate governance relationships and practice should be left to market forces: corporate governance should remain, basically, decisions by individual actors”.
The self-regulatory regime is quite impressive. The effort to reflect matters that are relevant and important to everyone in a corporate market seems to achieve good results. The reactions in the business environment are positive. This can be seen as more companies adopt a written code of conduct under the recommendation of the Cadbury Committee. Companies see the importance in clarifying employee responsibilities and duties. As a result, directors know their duties to act on good faith when standing as the controlling body of the company. The reasoning which lies beneath these codes of conduct is to ensure that openness will be maintained in the company. Openness will secure transparency, which is the key instrument to deter unethical actions and to promote high governance standards.
COMPANIES IN TROUBLE / SCANDALS
This section attempts to show some corporations both in the UK and US, which have fallen into trouble because of their lax corporate governance system. It will also give examples of top directors and individuals in companies who have been caught to have failed the system of governance which have created problems for the market and the economic system.
Signs of arising crisis
Acknowledgement while can be given to the Cadbury Code and the SOX as milestones in the development of the Corporate Governance. Scandals are still happening more than ever, even with extension to some of the code principles such as Competence (which includes education and training), Trust and Empowerment.
It is common in public companies for outside directors to be chosen by the CEO or management and consequently be under obligation to them, because they put them thereand could remove them. Moreover, the nominated directors follow the objectives of that person. This is worrying, especially because this process is managed without any clear involvement or support by shareholders.
Generally small shareholders are distinguished as remote from management. When a company has shown growth and increase in profit, most have been pleased to have enhanced their financial position, and therefore have allowed management, supported by the board to run it freely and function with minimum public scrutiny.
The “Maxwell Affair” when Robert Maxwell invaded his employee’s pension funds, some shareholders begun to be discontented with their anonymity and attempted to organize themselves into a formal association that would give them a chance to exercise power over management.
One of the biggest U.S. stock market crashed due to corporate governance was in early 2000 at $15 trillion US Dollars, the Market Capitalization had fallen by around $7 trillion that’s 45%. Investors lost nearly half of their life’s savings and pensions. (The Economist 2002 September 7th p. 14)
People Scandals
Argenti (1976) explained that managerial characteristics and mistakes are seen as determinants of business failures.
Controllers of firms may make deliberate choices in ways to maximize their objectives. Once their primary goal is to maximize personal wealth, then this goal is relatively easily achievable given the regulatory and legal environment in which they find themselves, they have no reason to introduce good governance practices that will contradict, thus they will try to take advantage of the weak laws and regulations and of their poor enforcement.
Nick Leeson acted for three years without management taking any precautions to prevent him from trading and running a back office operation. The executives were motivated by the fast profits, letting Leeson do whatever he wanted so long as he generated the earnings for Barings Bank (Journal of Derivatives, 1995). This sort of managerial misconduct caused the business to suffer a financial loss of $1.4 billion reflecting clearly a breach of trust.
Despite Robert Maxwell’s previous convictions and image, authority figures allowed him, since no prevention were made from him, to invade his employees’ pension funds, even though directors knew what was happening (DTI Investigation, 1971).
Conrad Black
Former media tycoon and chairman of Hollinger International Conrad Black started his six and a half year prison term in February 2008 for fraud and obstructing justice. He owned the Daily Telegraph and about 400 other small papers in North America and had a personal wealth of about £175m. Hollinger International his holding company was listed on the New York stock exchange in 1996. In June 2003 the shareholders asked for an internal investigation to be done on Black and other directors, of which Black resigned as chief executive in November 2003.
Money stolen from Hollinger shareholders financed Black’s extravagant lifestyles; he owned apartments in Park Avenue New York, one of which was for the sole use of their servants, mansions in Toronto, Palm Beach, and even a luxury house in Kensington, west London. According to Bower (2006) ‘…the important thing about Conrad Black is that he has never felt that he needed to obey the rules. One of the reasons he stole so much was that he genuinely felt the rules did not apply to him…’
In January 2004, he and David Radler former president were sued by Hollinger International to return $200m (£99m) in unauthorized payments and Black was sacked as chairman. He later counter sued for defamation of character. Hollinger International accused Black of stealing more than $1.2bn, and their investors along with the Canadian regulators filed lawsuit against him.
The SEC filed civil charges against him and Radler; Radler pleaded guilty in September 2005 and agreed to testify against others involved in the alleged $60m (£25.5) fraud.
In November 2005 Black was charged with 11 counts of fraud, one for obstruction of justice (when he was caught carrying out boxes from his office) and racketeering. He was later fined with $125,000 and was ordered to forfeit $6.1m.
Bower, who helped to expose Black’s extravagance in his book Conrad and Lady Black, say that ‘…Conrad Black is a very arrogant man. He will not like the idea of mixing with people who are poorer or less intelligent that he is. He will find that very hard to deal with…’
The Blacks in a single day spent $2.6m (£1.3m) on a diamond ring and $604,000 (£302,000) on an antique brooch. Yet over a six year period billed his company $1.4m (£700,000) for staff wages alone. Now he is in prison, the daily rates for inmates is from 23 cents (12p) an hour for unskilled workers and for skilled workers the “first grade” pay rate is $1.15 (£55p) an hour. Hence for him that will amount to about $290 (£145) a month, not at all what he could survive on outside prison.
Scandals in Corporations
Corporate scandals both in the UK and US represent a defining moment in corporate governance rules and norms. A prevalent assumption is that a major factor is the inadequacy of the US and UK board of directors.
In some companies, shareholders do not have direct say in the decisions taken by management. Even though they are the owners of the shares, because in large corporations, the number of shareholders can be enormous and they are predictably anonymous to the management. With the exception of voting usually only once a year, otherwise therefore they have no ways of exercising real control. Hence, the distance between the shareholders and management is often great.
Frictionless Business was the slogan for Peregrine Systems, Inc., that is until they became prone to an accounting scandal in 2002. In 2003 they were charged with “fraud” by the US SEC for falsifying sales and exaggerating revenues, by hiding losses as ‘goodwill costs relating to acquisition’. Management was selling off Peregrine stock, as a result of an audit by BMC a party interested in buying the company. Shareholders lost an equity valued at $4 billion dollars.
Further scandal was seen in the case of Enron. Reports released by Enron bankruptcy examiner, Harrison J. Goldin, “auditors at KPMG and PricewaterhouseCoopers turned a blind eye to problems at Enron on deals they helped set up in the Cayman Islands.” (Caribbean Net News 2003)
Goldin investigated financial institutions involving Enron’s special purpose entities.
In his investigation, it was discovered, that Andrew Fastow, Enron’s former Chief Financial Officer, used the partnerships of LJM Cayman LP and LJM2 Co-Investment LP to distort Enron’s financial statements. Evidence proves that he improperly reaped “personal benefits” from Enron’s dealings with them.
According to Goldin’s report, (Web 2), the firm ‘Enron’, “committed professional malpractice and was grossly negligent in preparing and providing opinions”, which were provided by PricewaterhouseCoopers, was causing Enron to “sustain significant monetary damages.”
However, these revelations came at a time when allegations recently surfaced concerning a possible conflict of interest on the part of KPMG past auditors of another insolvent Cayman company, National Warranty Insurance. Partners of KPMG in the Cayman were subsequently appointed by the Cayman court as liquidators of the company, which went into bankruptcy leaving a million customers in the US without the extended vehicle warranty cover they had paid for.
Audit committee is made entirely of shareholders, executive managers and their colleagues. Naturally, given the composition of corporate boards in this region the desirability of an audit committee comprising independent board members would have to be judged within the context of the effectiveness of minority shareholder representation on the board of directors as well as the potential impact on the capital markets.
The performance of the Corporation is important, accountability; transparency, disclosure and morale are all crucial aspects.
Global Corporation Scandal
We have seen over the years significant changes especially with trillions of pounds and dollars in capital flowing around the globe in search of investment. Shareholders have launched a campaign for more transparency and better run companies in gaining strength across emerging markets and even teaming with investors from different countries.
Stanley Dubiel head of governance research at RiskMetrics Group one of the largest US based proxy research firm stated that “there is a strong desire on the part of many companies to attract capital from international investors.”
The link of the global financial market is very important because the Asian financial crisis in the late 1990’s reminds us, due to the capital market collapse in the US. Shareholders may fight for more transparency and independence but many small economies are still dominated by “the old money family that are extremely powerful, especially in companies with weak corporate governance laws and unrealized accounting disclosure.” “They have tiny financial stakes, but huge voting power with multiple votes per share.” (Randall Morck)
Regardless of the rules, some businesses abroad fail to put corporate governance regulations into practice. While the UK may have fought independent directors, the directors often have hidden business and family ties to companies, says Guillen leading expert on corporate governance issues in Europe. As a result Shareholders have lost billions with regards to business scandals as in the case of Royal Dutch Shell.
Royal Dutch Shell
In a report prepared by the Group Audit Committee (GAC), Shell Group outlined that the former top executives were aware of reporting problems for 10 ½ years before notifying anyone. Shell has overstated oil and natural gas reserves. The report to the GAC has exposed deficiencies in their past reporting practices and the way in which Shell have dealt with such issues. Emmanuel Dubois-Pelerin, Credit Analyst of Standard & Poor Ratings Services from the audit report commented that the document ‘…highlights areas of durably weak corporate governance, with significant digressions from Securities and Exchange Commission rules’ (Oil & Gas Journal Vol. Iss. 16; pg. 20).
Shell has been falling behind its competitors and as a result has given misrepresentative figures to cover this up. Shell now has only 14.5 billion barrels of oil and gas, while BP has 14.5 billion, Exxon Mobil with 21 billion. There is concern of how they manage to “cook the books” with phony numbers and has created an outlook of deception and backbiting at the top (Wall Street Journal, June 2004).
Instead of informing investors of the shortfalls of the corporation, executives played up the strength of the company. This has lead to the company lost of many shareholders because it is poor reporting structure and the level of accountability. Eric Knight, Managing Director of Knight Vincke Asset Management, a corporate activist fund, and Ted White, Director of Corporate Governance has both criticized Shell of a lack of transparency during the review in a letter (Financial Times, May 2004).
Shell chief executive Jeroen Van der Veer job was to rebuild trust after the scandal. If this is measured in profits, then they recently announced (January 2008) a record profit of $27.6bn (£14bn) up from $25.4bn in 2007. Shell shares have crepted 0.5 per cent higher to £17.52 (Financial Times, January 2008).
Economic Scandal
The recent economic slowdown, disastrous accounting scandals and with the looming threat of a double-dip recession business capital expenditures are being scrutinized more specifically. Executives are under pressure to justify significant expense and demonstrate how the cost will improve the bottom line in the near future. Indeed, transparency and the return on investment have become the new buzz words.
The US economy out-performed the UK for years; the reasons for this acceleration in productivity growth can be linked to the invalidity of their financial market. The American financial system was ensuring that entrepreneurs with promising projects had easy access to capital, and that resources were swiftly transferred from slow growing to fast-growing sectors of the economy. In England additional pressure to make these changes came from the growing influence of American institutional investors as shareholders in English companies.
The recent financial crisis was precipitated by the US housing market bubble. This came from an era of credit expansion based on the US dollar as an international reserve currency. Furthermore, the culmination of a super-boom arose from credit and involved many misconceptions. Financiers failed to recognize the willingness to lend and the value of the collateral. Ease of credit generates demand that pushes up the value of property, which in turn increases the amount of credit available. The bubble started when people buy houses in the expectation that they can refinance their mortgages at a profit.
The intervention of the financial authorities of liquidity injection and stimulating the economy in any way possible whenever the credit expansion run into trouble have created a system of asymmetric incentives which is known basically a moral hazard have allowed for greater expansion of credit. This creates a safe haven for the financial market which prevents it from break down. The US deficit of 6.2 per cent of gross national product (2006) was a signal. Globalization however, allow for the UK/US to suck up savings of the rest of the world and consume more than it produced.
The authorities aided and abetted the process by intervening whenever the global financial system was at risk. In the UK four executives members of the FSA have resigned because they failed to do their jobs properly. The boom got out of control when new products became too complex for authorities to calculate the risks and started to rely on the risk management of the banks. It seemed to all fall down from there, because the agencies who provide the rates were referring to the originators. As a result it all went terribly wrong.
In London the FTSE 100 suffered their biggest one day fall since September 11, 2001 and the US Federal Reserve cut their interest rate to 3.5% the biggest for 25 years to try to saves the economy from a recession.
Methodology
Data Collection and Sample
This study is based mainly on a questionnaire survey that looks at corporate governance practices at the business level. The survey results are used to examine the effectiveness of governance practices and are used to test the link between the quality of corporate governance in relation to stock prices and managerial opportunism.
Healthier corporate governance is supposed to lead to better corporate performance by preventing the expropriation of controlling shareholders and ensuring better decision making. In expectation of such an improvement, the stock price may respond instantaneously to news indicating better corporate governance. However, quantitative evidence supporting the existence of a link between the quality of corporate governance and firm performance is very little. On the basis of the questionnaire survey, this study attempts to assess the existence of such a link. The corporate practices revealed in the survey responses have to be scored and an appropriate analytical model has to be used. Prior literature stops at this stage and interprets the association between accounting discretion and poor governance quality as evidence that lax governance structures engender excess managerial opportunism (e.g., Becker et al. 1998, Gaver et al. 1995, Chen and Lee 1995 and Guidry et al. 1999, Frankel et al. 2002, Klein 2002, Menon and Williams 2004).
The philosophical principles that have been acquired in this study are based on a positivistic approach. The role is to test theories and provide materials for the development of laws. It advocates the application of the methods of the natural sciences to the study of social reality. Pugh (1983), as in this study, describes the research task as entailing the collection of data to base propositions that can be tested.
The neoclassical theory of investment, as first formulated say by Modigliani and Miller (1958), derives strong and refutable predictions from an elegant and simple model. Assuming that managers maximize the wealth of their shareholders, they invest until the point where their cost of capital equals the marginal returns on investment. Since the cost of capital is the same for internally and externally raised funds, investment levels are independent of how they are financed, and for the same reason, the returns on investment are predicted to be the same for all companies, abstracting from differences in corporate risk.
Strong corporate governance is greatly associated with firms’ performance as measured by Tobin’s q (measured as the ratio of market value to book value of a firm). Although the score for shareholders’ rights alone does not show any significant association with business performance, scores for board effectiveness and overall scores (average scores for shareholders’ rights and board effectiveness) turned out to be significant. (Sauaia & Castro Junior, 2002)
Hypothesis
A hypothesis was established to show the relationship between stock prices and the quality of governance as evidence consistent with managerial opportunism and effectiveness. An attempt to show a reflection on the relationship between performance and governance quality representing: (a) management opportunism because of agency problems in the firm; or (b) companies that do not have appropriate levels of corporate governance procedures and guidelines in place suffer the consequences which relates to managerial opportunisms. The quality of governance is important in controlling the economic determinants of the firm influence and its opportunities. Analysis was made on the basis of the overall stock prices of the companies and the overall market betas. Generally, emphasis will be on how the company is rated in the market, looking at the businesses portfolios.
In appendix 4 and 5 a sample was measured using companies from the US Dow Jones and UK FTSE 100 to calculate the market betas. A Pearson correlation coefficient is used to measure the rank of two variables at one time in two series, and can be used to encapsulate the direction and strength (positive or negative) relationship of the two variables. A rank from 1-41 was used for the FTSE and 1-47 was used for the DOW Jones against the firms, the rank of course showing how best or worst the companies governance structures are, 1 being the best and 41 / 47 being the worst, (# 1=highest and rank # 41 / 47=lowest).
For the Pearson’s correlation, ordinal variables are coded by categories. An assessment of the companies’ stock return was used in the process to determine the ranking. The hypothesis sets out to test where there is a link between good governance and stock returns (Stock Ranking). To test this, data was taken from the companies’ financials in aid to calculate the coefficient intervals and the hypothesis. A firm’s effectiveness may be estimated as a function of corporate governance, stock return and beta.
In order to test the strength of the correlation relationship, two sets of data will measure how tightly ranked the data is. Pearson’s rank correlation coefficient takes a value between -1 and +1. A positive correlation is one in which the ranks of both variables increase together. A negative correlation is one in which the ranks of one variable increase as the ranks of the other variable decrease. A correlation of +1 or 1 will arise if the relationship between the two variables is exactly linear. A correlation close to zero means there is no linear relationship between the ranks Altman (1991). Put simply in calculating the Pearson correlation, 1.0 would mean that the rankings are in perfect agreement; -1.0 would mean that they are in perfect disagreement and 0 would mean that there is no relationship between the variables.
The same sample of companies was calculated using a regression statistical analysis to help calculate the beta of the market. A beta of 1 indicates that the security’s price tends to move with the market. Moreover, it is a measure of a stock’s volatility in relation to the market. The market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that sways more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock’s beta is less than 1.0. High beta stocks are supposed to be riskier and provide a potential for higher returns; low-beta stocks pose less risk and have a lower returns.
The beta (β) is a statistical measure of market risk on a portfolio. Beta offers a clear, quantifiable measure, which makes it easy to work with. Variations on beta depending on things such as the market index used and the time period measured. Betas are fairly straightforward to understand, it is a convenient measure that can be used to calculate the costs of equity used in a valuation method that discounts cash flows. Traditionally beta is used to estimate the elasticity of a stock portfolio’s return relative to the market index. A beta of 0.7 means the total return of the security is likely to move up or down 70% of the market change; 1.3 means total return is likely to move up or down 30% more than the market. Beta is referred to as an index of the systematic risk due to general market conditions that cannot be diversified away. (Web 3)
http://www.specialinvestor.com/terms/132.html
Many utility and energy stocks have a beta of less than 1. Companies were chosen to show whether their stock prices fluctuate as a result of weak governance consistent with managerial opportunism or vice versa. The formula used is Bg = Bu + Bu (1 - T) B / Vs. The tax on group profits on ordinary activities for US standards is 25% and for the UK standards the tax is 30%. If you think about risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk. In this instance i.e., technology companies where price bounces up and down more than the market. Flannery and James (1984), Kane and Unal (1988) and Saunders, Strock and Travlos (1990) It is hard not to think that stock will be riskier than, say, a safe-haven energy and utility company like utility stock with low betas.
Data Analysis
A Ten-Factor Matrix (see appendix 2) was used to highlight and summarize the most recent and highly debated issues in corporate governance globally. Further analysis of the Ten Factor Matrix shows there is an application of corporate governance principles to Stock Exchanges. In the United States and Britain and many others countries shown in the Matrix, shareholder activism have been playing a significant role in corporate governance development. Klapper and Love (2002) found that the quality of firm-level corporate governance is likely to be lower in countries with weak regulatory systems.
In the US shareholder activism is mild, the rights of shareholders are severely constrained between Annual General Meetings, making it difficult for institutional investors to gain access to the board if it does not wish to co-operate. One of the few options available is to organise a very costly proxy fight, which on average have a positive effect on the share price. Other forms of US shareholder activism are voting campaigns and voting initiatives. In voting campaigns, investors vote against proposals by the management, while in voting initiatives investors put proposals of their own to the shareholders in Annual General Meetings. While the latter is the most common form of institutional activism, neither appears to have a significant effect on share prices. This can in part be explained by the nature of the most active investors, public sector funds, which are often dominated by union members or other public sector institutions. They often table proposals which do not necessarily aim at increasing shareholder value but follow other political interests and consideration. In addition, many of the US institutional investors are asset management divisions of large financial institutions that conduct business with the firms concerned, and are therefore reluctant to antagonise the management of those firms.
In the US institutional investors are in a strong position as they can wield pressure through the media. In the UK however, it is growing fast. There have been a number of cases where institutional investors went public in situations where they were dissatisfied with the directors’ actions and negotiations that went wrong. In the cases of ‘Farnell Electronics’ and ‘Standard Life’ take over deal, institutional investors felt that Farnell were taking unnecessary risk by having debt to pay for the deals. When the transaction was approved ‘Standard Life’ sold its holdings, which resulted in a drop of its share price. In the case of the Granada Group the other interested party, the issue was for the ED personal contracts. There were criticism of the disclosure and the transparency approach which was taken, resulting in a large number of proxy votes against the reappointment of the non-executive director and member of the remuneration committee.
UK institutional investors tend to be more interventionist than the US. Hence, UK boards of directors are more exposed to investor pressure on such issues as the composition of the board, the appointment of new directors, and executive pay. UK boards also tend to have a balanced mix of inside and outside members, whereas in the US it is not uncommon for the chief executive (who is usually also the chairman) to be the only full-time manager on the board. Jonathan Rickford points out in this volume, the British system is in some respects more shareholder friendly than that of the US, not least because of the ability of shareholders to call an Extraordinary General Meeting with 10% of the share capital, and remove the board with a plurality of the votes.
The current trend of board sizes around the world is also shown in this Matrix. While the practical consideration of board sizes is very important, the theoretical implication deserves closer analysis. According to Herman (1991), large boards are ‘weak’ since these boards made in-depth discussion unlikely, and increased the prospect for diversity and fragmentation. According to a survey of 503 large companies carried out in 2000, the average board in that year had 9.2 directors, of which 4.9, or 53%, were non-executive; the corresponding figure in the mid-1980s was 35 per cent. The number of companies which had separated the positions of chairman and chief executive was just under 90 per cent. This issue was addressed in the most recent of the UK’s corporate governance inquiries, carried out by Sir Derek Higgs in 2003. The main thrust of the recommendations in the Higgs report was to improve the effectiveness and quality of boards, to ensure that at least half the members of the board were genuinely independent, and to impose a stronger obligation on companies to separate the posts of chairman and chief executive.
Table 2 shows an analysis of block and institutional investors. Lin et al. (2000) in their analysis of UK market reactions to director appointments, find positive market reactions in smaller firms when affiliated directors (including appointees of blockholders) are appointed to the board. Denis (2001) found that whilst blockholders seek to increase firm value, they may also attempt to enjoy benefits not available to other shareholders. Holmstrom and Tirole (1993) find that such blocks can reduce the liquidity of a stock and the supply of company information to the market. Bethel et al.’s (1998) results suggest that activist blockholders may be of benefit in influencing corporate governance, however, there is evidence that these blockholders may become as self-serving as the management they are supposed to monitor. The results of Bethel et al. and the arguments of Mehran (1995) suggest that greater distinction amongst different types of blockholders may be required, in a similar fashion to the distinction made between different types of company directors. The results of this section can be found in table 2.
Increasingly both in the UK and the US investors, funds, banks, and other financial institutions have been basing their decisions not only on a firm’s outlook, on its reputation and governance. The increased tendency to access capital, domestic and foreign, has been signaling key business players that the time for corporate governance reform is more urgent now than ever.
Hypothesis Analysis
Appendix 4 and 5 presents the estimation results of the relationship between stock rank and managerial opportunism in firms. Contemporaneous betas are estimated using rolling time series regressions of excess stock returns. Then estimated stock returns are used to predict the one-period a head cross-section of stock returns by regressing individual company (or portfolio) returns on their betas to estimate market risk premia. Results are combined across different cross-sectional regressions by averaging estimated risk premia.
Beta expresses the important exchange between minimizing risk and maximizing return. This means it is one time as volatile as the overall market. If the market were to provide a return of 10% on an investment, we would expect the company to return 20%. On the other hand, if the market were to decline and provide a return of -6%, investors in that company could expect a return of -12% (a loss of 12%). If a stock had a beta of 0.5, we would expect it to be half as volatile as the market: a market return of 10% would mean a 5% gain for the company. Moreover, the FTSE beta is 0.749 (see appendix 5) and the DOW Jones is 0.928 (see appendix 4), FTSE companies beta is calculated as the standard tax for the UK is 30% for businesses.
Bg = 0.749 + 0.749 (1 - 0.30) x 1.70 = 1.64
A regression analysis was created to calculate the beta of companies on the DOW Jones, a beta of 0.93 was obtained from the Regression Statistics. A tax need to be calculated against the beta, in the US the tax is 25%. Bg = 0.93 + 0.93 (1 - 0.25) x 1.75 = 2.15
If the betas are <1, the market increases or decrease the share will increase or decrease by less. If the market is doing good, the share will perform less well; if the market does badly the share will do less badly, and if the beta value is >1, then the shares will rise or fall by more than the market rise or fall. As the market does well, the investment does better than expected, and vice versa. High beta values are aggressive; the company outperforms the which ever way it goes.
On the analytical framework described above, results are presented and evaluated on the determinants of corporate governance quality and the relationship between managerial opportunism and governance quality; ranking for stock returns and governance quality is given in appendix 4(a) and 5(a). A correlation coefficient of stock rank and companies with managerial misconduct is shown in appendix 4(a) and 5(a) to show if there is a relationship between corporate governance and stock return.
The estimates for appendix 4(a) and 5(a) show the Stock Comp as rank stock return minus the rank position in the market.
The correlation in exhibit 4 above shows there is a positive relationship between stock returns and the quality of governance, as it is not minus, so I can say I am 0.77 confident, hence it can be stated that the degree of correlation used supports the hypothesis testing a positive relationship.
This of course meaning that I am sure the hypothesis testing stock returns against the quality of governance is correct, and that the stock ranking for companies is 76 and 77 out of 100. Furthermore, it also reflects the reliability of the sample obtained for use in this study. Moreover, from the hypothesis tested it an be established that there is a positive linkage.
Limitations
Some of the limitations that were experienced whilst undertaking this project are that:
- There was limited access to auditors information on independence on boards, (books, theories, journals, etc.) regarding CG.
- Data gathering was economically distressing and sometimes tedious since I had to follow up on emails sent by telephoning the participants.
- It was quite a lengthy and costly process to try to contact and adequately communicate with those involved.
All the necessary steps to ensure that the ‘rules’ of ethics are adhered to are taken into consideration. Information given in confidence or to which the author was exposed to, will not be printed without consent. The author will also ensure that due acknowledgement will been given in the bibliography and references to all sources of information/data be they printed, electronic or personal.
FINDINGS, DISCUSSION AND ANALYSIS
The project contains key levels of insights learned from the research carried out through several business corporations conducted by questionnaires and other relevant data obtained solely for this study. The findings from this research show an indication that corporate governance, while faced with already critical issues is still yet to be taken seriously by implementing stricter penalties to the culprits who are caught to break corporate procedures. The issue remains very important where companies operate in the ever-increasing regulatory environment.
Some of the companies interviewed operate in the heart of CG environment, communicating with management and shareholders and committing to ensure that there is a strong level of confidence in the markets. However, from a country perspective the regulatory and legislative issues are much more severe.
Methodology and Sample
The theory for this study was identified before the research because now more than ever we are seeing a trend in managerial opportunism in different companies around the world. Therefore, researchable questions have been compiled. This is consistent with the nature of deductive research, considering the theory in a particular domain; the hypothesis was formulated with empirical scrutiny. After testing the hypothesis, referrals were made to the findings of the theory that prompted the study and the last step involved induction. Inductive research comes before the theory and then the theory is generated from the results of the research (Bryman & Bell, 2003).
Surveys were carried out which referred to the method of data collection that utilizes questionnaires (see appendix 1). Surveys are among the most popular data collection methods in business studies.
A survey was conducted during a two-month period with 33 participants from companies both in the UK and the US. The range of respondents participated in the survey were CEOs, CFOs as well as other members of management, which included finance directors and non-executives members. Information was collected from accountants and consultants alike to share some real insight on the issue of governance and performance.
Awareness of Corporate Governance and its Principles
An understanding of governance is important, and was appropriate for the core of the research. Cadbury Code of Best Practice paved the way in order to help monitor the financial aspects of corporate governance in the UK and the SOX in the US. Survey result suggests that there is room for an understanding of the governance principles and improvement in communicating the procedures of corporate governance. In both countries, governments need to recognize the importance of corporate governance rules by ensuring that the legislative system is much firmer. The OECD and are continuously striving to establish best practice procedures as well as the NYSE.
The IMF has produced a Code of Good Practices on Transparency in Monetary and Financial Policies and there have been standards and codes in Accounting, Auditing, Banking Regulation and Supervision, Bankruptcy, Insurance Regulation, Payment System and Securities Market Regulation, and Corporate Governance. Many deals which would have been classified hostile years ago, due to the evolution of director’s duties through the litigation process, are now granted by incumbent managers through generous options packages that vest upon the change of control.
The American Stock Exchange (AMEX), the Securities Exchange Commission (SEC) or Department of Justice (DOJ) has called for new governance rules as part of their listing requirements and for enforcement for any financial misrepresentation or manipulation found in the US (Karpoff, Lee and Martin (2007)).
The Public Company Accounting Oversight Board (PCAOB) in the US has been introduced to supervise the audit committees. It will be a challenge for all businesses to accept and respond to the mechanisms. An example was of Enron’s long-time auditor, the Big 5 accounting firm Arthur Anderson criminal indictment. The need for reinforcing good CG practices at levels is much needed. Resource constraints prevent regulators from pursuing cases of manipulation. Resource constraints prevent regulators from pursuing cases of earnings manipulation; the greatest deterrent effect is for regulators to target egregious violators and cases likely to generate media coverage Agrawal and Chadha (2005).
While in the UK shareholders’ activities is growing and is very strong, in the US increased shareholders participation was muted in the US 2002 reforms (Chandler and Stine (2003). This has created controversy in the US regarding participation of shareholders in US board nomination Bebchuk (2003). Although it has now been abated, it is likely that the general issue of shareholder participation in corporate governance will continue to be contentious (Bebchuk (2005). The rights of shareholders are severely constrained between AGM, making it very difficult for institutional investors to gain access to the board if it does not wish to co-operate. It also gives insight to the hypothesis showing that managerial opportunism or no weak corporate governance practices in-fact affects the quality of performance.
The UK Combined Code on Corporate Governance (July 2003) contains main and supporting principles and provisions. The existing Listing Rules require listed companies to make a disclosure statement in two parts in relation to the Code. In the first part of the statement, the company has to report on how it applies the principles in the Code. In future this will need to cover both main and supporting principles. The form and content of this part of the statement are not prescribed, the intention being that companies should have a free hand to explain their governance policies in the light of the principles, including any special circumstances applying to them which have led to a particular approach. In the second part of the statement the company has either to confirm that it complies with the Code’s provisions or - where it does not - to provide an explanation. This ‘comply or explain’ approach has been in operation for over ten years and the flexibility it offers has been widely welcomed both by company boards and by investors. It is for shareholders and others to evaluate the company’s statement.
Studies show that domestic and international investors, creditors, multilateral institutions, and international organizations are pressing for better corporate governance. The reward for good corporate governance is a prosperous economy with a citizenry that supports economic growth. A survey by McKinsey and Company (1997), found that investors are willing to pay a premium for companies that demonstrate sound corporate governance systems and it serves to stir the importance of corporate governance on a global scale.
Board/Non-Executives Directors Effectiveness
The board of directors is the central point of corporate governance mechanism that shareholders entrust to monitor and to provide strategic guidance to the management of a corporation. Corporate governance refers to performance and structures, and is an exertion of influence over managerial decision-making. The decision makers in the firm would be the board of directors and therefore the composition of board is critical and critical to the firm’s performance, thus helps enable a better return on investment, as we saw that better governance structures creates better returns for the firm from the hypothesis tested. The Anglo-American model objective of the board is to maximize the value of the firm or the interests of all shareholders. Good boards provide a crucial link with the outside world, enabling the corporation to claim and protect “its shares of external resources” by legitimizing the company in the eyes of key resource holders (Langevoort 2001).
The survey reveals that boards meets less than quarterly and had more than 11 members. Section A.1.1 of the Code of Best Practice (2003) states that the board should meet sufficiently regularly to discharge its duties effectively. There should be a formal schedule of matters specifically reserved for its decision. Every company should be headed by an effective board, which is collectively responsible for the success of the company.
According to a survey of 503 large companies carried out in 2000, the average board in that year had 9.2 directors, of which 4.9, or 53%, were non- executive; the corresponding figure in the mid-1980s was 35 per cent. The number of companies which had separated the positions of chairman and chief executive was just under 90 per cent. There was also a high rate of compliance with the Combined Code on the composition of audit and remuneration committees.
It appears that management is more skeptical than CEOs/CFOs and NEDs. 37% of management (vs. 29% board members) does not believe that the board is effective in curtailing an independent view on the performance of management. Furthermore, 40% of management think that the board is not effective in ensuring that corporate governance and risk management procedures is implemented as opposed to 27% of the board. Realistically the board role includes strategic performance, which entails approving strategy, checking progress in execution and for adjustments and changes. Hence, when boards are more than 12 members they spend much time debating company issues rather than setting the board strategic objectives and reviewing management performance.
Board size and composition are important determinants of board effectiveness. The size should be large enough to secure sufficient expertise on the board, but not so large that productive discussion is impossible and free riding among directors is prevalent Salmon (2000). A board is likely to be less effective in substantive discussion of major issues (Jensen 1993; Lipton and Lorsch 1992) and suffer from problems among directors in their supervision of management (Hermalin and Weisbach 2001). A board should have a mix of inside/executive and outside/independent directors with a variety of experience and core competence if it is to be effective in judging the management’s performance objectively.
For the purpose of board independence, a substantial share of boards should consist of independent directors. The Chairperson of boards should be someone other than the CEO and is also believed to enhance the board’s independence on the ground that the roles of supervisor, though the separation might result in side-effects that could have a detrimental effect on firm performance. It should be argued that because of the agency problem and the conflict of power between management and controlled owner, there is a need to separate the two positions. If the same person held these two positions, they would be unable to control the company’s actions effectively and independently as this is the essence of corporate governance. Although the board appoints outside directors, which are required to ensure the proper management of the business, the reality is that in most changes the elected directors are related to management and the electors.
Code Provisions A.3.1 (2003)
The Importance of Non-Executive members
Findings suggest that there is room for improvement in the way non-executive members are selected for boards. Citation in appendix 2 highlights that the norm ‘of’ selection is for boards to be made up of CEOs/CFOs colleagues and existing members of the organization, and this not good governance practice.
Corporate governance structures were lacking in several areas. In most circumstances, the board of directors and the related committees (where they existed) contained no independent members and if they did for example, while all the committees may have been independent one of the members was not independent. In such cases, the board and related committees do not meet regularly and disclosure on related party transactions was usually insufficient.
The NYSE stressed that listed companies must have a majority of independent directors. ‘Effective boards of directors exercise independent judgment in carrying out their responsibilities. Requiring a majority of independent directors will increase the quality of board oversight and lessen the possibility of damaging conflicts of interest.’ (NYSE: Section 303A (2003))
The OECD principles clearly calls for ensuring the integrity of essential reporting and monitoring systems which the board is to set and enforce clear lines of responsibility and accountability throughout the organization. The board will also need to ensure that there is appropriate oversight by senior management. However, if it is made up of “drinking buddies” then this may not be the case and clearly not a great example of good governance, as in the case recognized by the Delaware Court of Chancery in In re Oracle Corp Derivative Litigation (DeMott (2005) and for example the NYSE governance rules, where the CEO, Jodee Rich and two of the non-executives directors, James Packer and Rodney Adler attended the same exclusive private boy’s school. Even when directors technically qualify as “independent,” there are a range of familiar scenarios that can erode genuine independence, an example loyalty to an appointer on the board; which may result in conformity of ideas and approach; backgrounds and social circles (Cox and Munsinger 1985). Helland (2006) found that directors of corporations facing lawsuits from managerial opportunism do not suffer a net loss of their board seats, only in cases where the SEC inquires and for cases in the top quartile.
The board of directors is the ultimate decision making body of an organization and thus plays a crucial role in many areas including corporate governance, hence non-executives members are integral for these purposes. An effective board should entail ethical, skilled and critically thinking individuals who will contribute special expertise to the company. The US Blue Ribbon Report states, “Most importantly, the board overall should consist of a majority of independent directors… (and) the rationale supporting the call for a majority of independent directors … (is) that independence is crucial to ensuring that the board fulfills its objective oversight role and holds management accountable to shareholders”. (p. 21-22)
The composition of the board is one of the most crucial issues of corporate governance. As a result, best practice requires that the majority of the individuals on the board should be genuinely independent. The independent board majority is a key mechanism to assure shareholders that their company will run competently in its own interests and consequently in the best interests of all shareholders. Evidence shows that boards dominated by independent directors are more effect in performing specific task, such as the removal of CEOs for underperformance (Weisbach 1988), than in general monitoring and advisory role.
The Code of Best Practice Section A3 states that the board should include a balance of executive and non-executive directors (and in particular independent non-executive directors) such that no individual or small group of individuals can dominate the board’s decision taking. While section 4.2.1 [R] states that the Management Board shall be comprised of several persons and have a Chairman or Spokesman. Terms of Reference shall regulate the allocation of areas of responsibility and the cooperation in the Management Board.
The majority (67%) of respondent in the report saw the significance of non-executive members on boards. However, (75%) of the organization surveyed have less than five independent members on their board. A key finding for this question is that a very small amount of respondents saw that non-executive did not enhance business performance at all.
Risk Management Policy
Risk management includes a wide range of corporate policies that describe the standard of conduct required of staff and specific internal control systems designed around the particular characteristics of firms’ activities.
The sample size chosen limited the possibility of finding statistically significant differences between industries and types of companies, which suffered from lack of risk management. In addition, no significant difference in governance scores was found between larger and smaller firms. However, with the financial crisis, corporate boards are found too often filled with company insiders, friends of the dominant shareholders or the CEO with conflict of interest issues. Outside directors played a minor role. As a result, boards tended simply to “rubber stamp” management decisions, rather than effectively performing their proper monitoring and supervisory functions.
The use of outside directors for Chairman positions and for key positions on committees were found to be absent in most companies. In addition, boards are now encouraged to appoint independent committees in areas such as risk management and financial reporting. The difference in management and the board’s point of view applies to the effectiveness of risk management clearly. Board members (62%) believes that it is vital to the organization while (23%) CEO/CFO thinks otherwise which could mean that they are more concerned with the financial risk of the business as the CFOs ‘primary’ focus of concern is to the financial responsibility of the company. Accountants and Consultants whom have a greater understanding also hold the view that the policies and implementation of risk management is imperative.
While the board agreed and are more positive about governance and risk issues in their organization they seem not to be fully aware of the procedures and policies in place in their own firms. CEOs and CFOs have stated that their companies have a clear policy in place, which identifies and assess risk; however, it was found that in these said companies there are no officers appointed with the responsibility for risk assessment. Findings also suggest that smaller companies do not have the capital to invest in risk management procedures and even so, larger companies did not have a specific individual assigned to the management of risk. A clear cost-benefit analysis of this proposal is still outstanding. Overall, the effective functioning of the internal mechanisms, of which the board is the most important, is more cost effective than ex-post failure mechanisms – hostile takeovers, proxy fights and lawsuits. These not only require expensive advisors, but divert director’s time away from their main duties.
More than half of the respondents saw that the policies of risk management contributes to better performance, 47% of non-executive members believes that risk management contributes to business growth, hence better performance.
Its is imperative for the purpose of returns to the company, as we saw from the hypothesis testing that there is a link between good governance structures and stock prices, which helps in securing in further investments for companies as investors are much more willing to pay more for companies which practices good governance.
This chapter has highlighted the major issues affecting business performance in relations to corporate governance. It presented information that was generated from the survey, with reference to the appendices and the hypothesis. The next chapter attempts to conclude the project.
Management and Shareholders Issues
Agency problems and the conflict of power between the roles of the board of directors and company management should be enough for the separation of both roles. If the same person held these positions, he would be unable to control the company’s actions effectively. The company should separate the chairman of the scrutinised body and the company’s general manager, the operational part of the company. This is the essence of corporate governance and one of the most important decisions.
There should be a clear division of responsibilities at the head of the company between the running of the board and the executive responsibility for the running of the company’s business. No one individual should have unfettered powers of decision. (Code of Best Practice 2003 Section A2) The number of companies which had separated the positions of chairman and chief executive was just under 90 per cent. There was also a high rate of compliance with the Combined Code on the composition of audit and remuneration committees.
The results from the questionnaire showed that more than half did not think that separation mattered. Adding that in a scenario where the shareholders regard one person as qualified for the two positions, there was no reason why the company should not be allowed to approve such a nomination. If the company would benefit from it, there was no room for objection. In order to keep the status quo in a public company, when the controlling owner wishes to be the chairman and the CEO at the same time, there is a possibility of escaping the rule.
Managing a business through the mode of corporation allows one to exploit its uniqueness. On one hand, shareholders benefit from the service of skilful directors and managers who are responsible for the business operations of the company. On the other shareholders invest in that company, taking the risks of investment. The division of roles is made possibly by the limited liability granted to shareholders. The effective operation of the company gives shareholders ability to invest in risky business activities.
In a company owned by many shareholders, where each individual shareholder owns only a small part of the corporation, the shareholders do not possess the power to control effectively the direction and management of the corporation (Garrett 1999).
In practice, the business’s directors/managers control the manner in which the company is managed. This separation creates an opportunity for the directors of the company to promote their own personal interests over those of the shareholders. The directors’ preference for their own personal interests can be expressed through inefficient management. This phenomenon has been labeled the “agency problem” Jensen & Meckling (1976).
The 21st Century brought with it the era of corporate leadership, which seem to fascinate us all. Governance appears to be one of the most exciting topics in the business sector, judging by numerous books and articles by distinguished experts such as Schleifer, Vishny, Adrain Cadbury and Kevin Keasey.
Directors of corporations are a representation of shareholders, meaning they must be frequent contact with shareholder concerns and wishes at all times. Brancato (1997) argued that shareholders identity can and should be determined by the board action, as these owners are whom the board is an agent. The directors’ moral duty is to the shareholders, not to the company-particularly since ‘the company’ so easily comes to mean current company management and, in any event, can actually conflict with one’s obligation to shareholders.
It is vital that those who represent Shareholders have set principles, which will codify roles in terms of adding value, fulfill, and stick to the relevant disciples to carry out the process and its relationships to those, involved. If the principles and codes are not upheld management will provide the board/shareholders, with whatever they wish the board to deal with - reflecting a management that is not govern. In such cases, the representatives of shareholders need to define its relationship to management thus showing strong owner representation.
Conclusion
Governance is primarily concerned with the “formation of rules and institutions which provide a predictable and transparent framework for the conduct of public and private business and to promoting accountability for economic and financial performance” (World Bank 1992).
The first law of nature is self-preservation, maybe it is for this reason that management will seek to satisfy their own personal objectives before the objectives of shareholders. If bearing in mind that generally there is a separation between management and the owners in case of companies. The objective of management usually center around themselves (i.e. the members of the board of directors) more specifically the objectives are measured in terms of maximizing their own wealth and status.
The expression of these objectives is displayed in many forms in reality. For instance, they provide themselves with very lard remuneration packages filled will (perks) in addition to a basic salary such as entertainment allowances, free accommodation, foreign travel, large spacious office equipped with the most expensive gadgetry, cars etc.
Management however, must be aware of the fact that satisfying their personal objective usually means reducing their satisfaction of shareholders objective, who are the owners of the corporation. They must also bear in mind the fact that these owners/shareholders possess the power to remove them from their offices and not reappointing them at the next Annual General Meeting. As a result, management should be sensitive to the expectations of shareholders since their jobs depend on it - (many companies management attempt to “satisfice”). That is to say, they try to ensure that the objectives of shareholders are satisfied to a reasonable extent before attempting to satisfy their own personal objective. It should always be born in mind that there would always be a trade off between the satisfaction of shareholder’s objective and that of any other stakeholder group.
The research showed that there was a positive relationship between the governance assessment of the companies’ managerial opportunism and stock prices. The top ‘1’ ranking companies (average stock price of 0.038 for the DOW Jones and 0.055 for FTSE) were significantly more profitable than the bottom ranking ‘41 and 47’. Similarly, the research found that the profitability of the top companies was significantly better than that of the bottom companies using ROA margin. The research established a clear relationship between the quality of corporate governance and better performance.
Most of the governance ranking research provides support for the proposition that good corporate governance improves performance. (Larcker et al., (2004)) The governance ranking research overall supports the proposition that good corporate governance enhances performance. The opinion-based research reviewed in this paper also supports the proposition that there is a link between a company’s corporate governance and its performance.
As discovered, society expects proper governance but it is vague of the concepts, procedures and principles that come along with it. Clearly, some concepts of governance would curb development as well as encourage it too as the call for quality governance is much long overdue.
The call for quality governance is based on the premise that accountable officers make better executives. Executive corporate governance is not just about creating a disciplinary device in the firms. Its aim is to find a balance that will allow the corporation freedom to execute transaction as it desire, and to ensure the existence of controlling mechanism over the management of the company, to secure the interest of shareholders.
In order to create a best fit we must take into account the interest of all parties and recognize that each party has their obligation. This may sound clear, but bear in mind that each country has a different culture with different economic forces. What seems to be perfect in texts books in reality can be inappropriate.
Therefore a more pragmatic approach is needed, an approach that can implement different provisions that may seem suitable to each system. It can be an advantage when studying from mistakes and applying the correct methods as we go along. A country, which desires to build a strong and healthy economy cannot ignore the forces; and an organization which seeks to achieve better performance can not allow mistakes to go unnoticed. The concept for adopting corporate governance principles must be the requirement of the specific economy as a whole. The policy makers must not be led by the needs to satisfy some group’s personal interests. In my view this is the effective way to create the right corporate governance principles which will lead by the vision of improving the firm and the economic environment.
It should be recognized that trust, integrity, and morale are important characteristics of executives today. When trust and integrity becomes a criteria in the governance of corporation, shareholders and stakeholders will then feel safe knowing that there resources will not be abused.
The size of the island creates difficulty to have independent audit committees and non-executive board members because in some countries everyone knows you, or knows someone who knows you. They attended the same schools, have prior employment relationships or are among the same committees and associations, hence this is the reason why it is so difficult for executives, auditors and other members of the organization to disassociate friendships with business relationships. This ‘cloud’ creates discomfort as the outcomes of such close relationships are left to be tested.
Regular reports from management can provide information on each of these issues. In addition, an internal audit process, independent of management who reports either to the board of directors or audit committee can assist directors in ensuring that policies and strategies are being implemented in an appropriate manner. Strong accounting standards strengthen the hand of shareholders resulting in higher returns on both reinvested cash flows and new equity issues, this holds more or less regardless of a country’s regulations.
Directors have significant obligations and responsibilities; failure to meet these obligations can be detrimental. In the context of the financial service legislation, directors and senior officers need to face serious personal sanctions for business failure and malpractices. In the United States, for example, there has been increasing success with respect to litigation filed against directors for mismanagement.
Re-vamping corporate governance adequately will not happen overnight. Many leaders tend to believe that by fine tuning a few procedures here, adopting a few rules there, and hiring corporate relations specialist is adequate. They even tend to think including a few sentences on corporate governance in annual reports is enough. A Jamaican firm placed a statement on its corporate governance in its Initial Offer Document, yet the said company failed to report on its corporate governance in its first Annual Report as a listed company, clearly showing no commitment for governance.
The efforts towards strengthening the awareness and practices of governances will be a hard task. An agenda must be implemented by the leaders to try to educate and communicate the importance and the advantages of good governance. The task of training individuals and disseminate knowledge in aid to promote conformance is long overdue.
There is no one corporate governance model that fits all. The affairs of the firm should be conducted and communicated, where necessary, to shareholders, in a manner rendering absolutely no doubt about integrity and capabilities of its directors and managers. Frequent and transparent financial and other information should be available and accessible to all shareholders and investors. All regulatory requirements, information specific to shareholders should be generated and disseminated in a timely manner, and be understood by all.
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