1. Introduction…………………………………………………..4
1.1
Background
Information………………………………....4
1.2
Definition of Corporate Governance……………………4
1.3
Importance
of Corporate Governance…………………..4
1.4
Corporate
Governance Theories………………………....5
1.5
Corporate
Governance Codes……………………………5
2. Corporate Governance Mechanism………………………….6
2.1
Corporate
boards………………………………………….7
2.1.1 Corporate
board Structure…………………………...7
2.1.2 Role
of corporate board……………………………..8
2.2
Institutional
Investors……………………………………9
2.2.1 Role
of Institutional Investors ……………………..9
2.3
Other Corporate Governance Mechanisms…………...10
3. Case Studies………………………………………………...10
3.1
Enron…………………………………………………….10
3.1.1 Background………………………………………..10
3.1.2 Enron’s
Failure of Corporate Governance………..11
3.2
Reckitt Benckiser………………………………………12
3.2.1 Background………………………………………..12
3.2.2 Failure of Corporate Governance…………………12
3.3 Satyam………………………………………………….13
3.3.1 Background………………………………………..13
3.3.2 Failure
of Corporate Governance ………………..13
3.4
WorldCom……………………………………………..14
3.4.1
Background……………………………………….14
3.4.2 Failure
of Corporate Governance………………...14
4
Recommendations…………………………………………15
5
Conclusion…………………………………………………17
6
References…………………………………………………18
Introduction
1.1 Background of Corporate Finance
Many
scholars, economists, and other professions consider 2007- 2009 global
financial crisis as the worst financial crisis ever since the great depression
of 1930. The period characterized by the collapse of many financial
institutions, massive bailouts, the economic downturn and finally the great
recession was primarily attributed to the failure of corporate governance. As
much as this was a low point in corporate governance, it also showed its
importance not only to individual firms but to the world economy as a whole
(Tricker & Tricker 2015). Never before has the notion that corporate boards
and institutional investors are the most important corporate governance
mechanisms in the firms with important implications for the sustainable
long-term success of the firm been so vividly seen. From time immemorial as
humans, we have always learned from our mistakes and the 2007-2009 was an eye
opener especially to corporate governance (Lebedeva et al 2016). Before I can
explain further on the notion, it is important to learn the basic aspects of
corporate governance.
1.2 Definition of
Corporate Governance
Corporate
governance in simple terms refers to the set of rules, processes, and practice
through which a company is controlled and directed with (Solomon 2007). It
involves balancing the interests of the organization with the interests of
other parties such as the government, investors, lenders, suppliers, the
community etc.
1.3 Importance of
Corporate Governance
When
executed properly, corporate governance can help a company avoid certain risks
such as lawsuits, fraud, and misappropriation of funds. In addition to that,
good corporate governance helps in boosting the organization’s brand and
reputation to the media, investors, suppliers, customers and the society as the
whole. Furthermore, cooperate governance protects the financial interests of
the individuals involved with the company such as the shareholders and the
employees as explained by (Vitez, 2017).
1.4 Theories of
Corporate Governance
Corporate
governance can be defined in many ways but when it comes to analyzing it, we do
it through a framework of different theories. One of those theories is the
agency theory which looks at the shareholders as the principals and the
executives that have been hired to run the business as their agents. Another
theory is the stewardship theory which looks at the executive as the stewards
of the shareholders with both parties sharing the same goals. In addition to
that, we have the resource dependent theory which considers the board as to be
in existence so as to provide resources to the management with the aim of
achieving the overall objectives of the business. Stakeholder theory comes from
the assumptions that it is not just the shareholders who have an interest in the
company but other parties too such as suppliers, the government, creditors
among others (Farrar 2008). This means that this parties too can be affected by
the success or failure of the business. Other theories of cooperate governance
include transaction cost theory, political theory, and ethical related
theories.
1.5 Corporate
Governance Codes Introduction
The
code of governance over the years have originated for various reasons or in
response to various circumstances. The first major release was in 1992 by Sir
Adrian Cadbury popularly referred to ‘Cadbury Code’ titled “the Financial
Aspects of Corporate Governance”. Following serious revisions over the years,
the code is nowadays administered by the Financial Reporting Council. The
Organization for Economic Co-operation and Development (OECD) developed the
first internationally influential codes back in 1999 following a business
advisory committee that was led by Irra Milstein.
Boards
that govern companies are influenced by several documents which include but not
limited to articles of incorporation, by-laws, corporate governance guidelines,
committee charters, and codes of conduct. When it comes to the United States,
various federals laws such as the Sarbanes-Oxley Act of 2002, the Dodd-Frank
Wall Street Reform and Consumer Act, federal laws as well as federal security
laws in addition to regulations, rules, and guidance from SEC are used. These
documents are meant to be used for the purpose of best practices and flexible
working standards to safeguard the various parties that have an interest in the
organization. In short, they basically outline the interaction between the
board and management outlining the structure and the behavior of the board. The
codes are normally contributed to by various individuals including investors,
accounting firms, regulators, banks, corporate governance interest
organizations, academics, and stock exchanges, among others.
Corporate
Governance Mechanism
Policies,
control, and guidelines are vital for an adequate corporate governance
mechanisms. An effective corporate governance mechanism will consist of a
number of various mechanisms. The first level consists of internal mechanisms
which monitor the business from within and take corrective measures when the
business stray away from its set objectives. They include reporting lines that
are clearly defined, systems that measure performance and systems for the
smooth operation of the business. The next level is the external mechanisms
which are controlled by those outside the business and serve the objectives of
outsiders such as the regulators, government, financial institutions, and trade
unions among others. The objectives of the external mechanism include proper
debt management and legal compliance by the company in question. The last level
consists of an audit of the entity’s financial statements by an independent
auditor who generally works to serve both the internal and external parties
that are involved with an organization to ensure that their interests are
guided and that the management is doing everything properly. They also act as a
second opinion to back up what the management is saying.
2.1 Corporate Boards
The
board generally consist of groups of individuals elected or nominated by
shareholders in the annual general meeting. The board of directors normally act
as a bridge between the company and the shareholders -it decides as a fiduciary
with the aim of protecting the latter’s interests. This is the norm with a
Public company even though nowadays most non-profit making organizations and
private companies also have a board. Their main mandate is to make policies for
corporate management and also to make decisions on major issues that affect the
company.
2.1.1 Corporate Board
Structure
The
structure of the board of directors is mainly guided by the company’s bylaws
which sets out the structure, number of members, how often they meet etc. The
most important element is that it should be able to balance both the interests
of the management and
Shareholders. The
duties are regulated by the statutory laws, federal statutory laws, listing
standards, common law and shareholder activism and litigation.
The
membership of the board normally constitutes independent directors, senior
company executives, non-independent directors such as former senior executives
of the company among others. Nasdaq rules require the majority of the board
members to be independent and in they constitute up to 75% or more of the
boards in 93 of the top 100 US companies. Most boards consist of 8 to 15 members.
There are no age and nationality restrictions although in recent years gender
balance has been emphasized.
2.1.2 Roles of the
Corporate Boards
The
board's primary role as discussed earlier is the fiduciary duty to safeguard
the finances and the legal requirements of the entity. They do this by ensuring
that the entity in questions does all that is required of it by the law, and
the funds are properly used. Another role of the board of directors is setting
up the mission and vision of the organization. In addition to that, they ensure
that the management adheres and work towards achieving them. Over sighting the
activities of members of the organization such as executives is another role of
the corporate board. The board ensures that the management adheres to rules and
regulations and do their work as prescribed. Other roles of the board of
directors come up in the annual meetings where-by, they announce the annual
dividends, oversee the appointment of key executives and amend the by-laws
where it is necessary (Dimopoulos
& Wagner, 2016).
Other
roles of the corporate board include setting up the strategy for the company
for long-term survival, short-term gains and future exploration of
opportunities that are likely to arise. This might also include setting up the
structure of the company to ensure efficiency. The board, however, does not
take part in the day to day running of the organization and thus serve another
role of delegating the duties to the management. The board should also monitor,
control functions and set up compensation plans for the executives. Last but
definitely not least, the board helps in acquiring resources for the
organization while ensuring continuity.
With
great power comes great responsibilities. The board must always use their powers
for the right reason and do what is required of them by the shareholders of the
company. The board must always carry out whatever they do in the full interest
of the company, and in case there is a conflict of interest then the interests
of the company should always come first. They must also carry out their task
with due care minding the interests of both the shareholders and that of the
employees. Other responsibilities of the board include acting as the court of
appeal in case there are disputes, accessing the performance of the firm and
enhancing the organization’s overall public image and brand name.
2.2 Institutional
Investors
An
institutional investor is a person, persons or organization that pools money or
provides funds to purchase securities, other investment assets, property or
originate loans. They include financial institutions such as banks, Insurance
companies, pension and hedge firms, investment advisors, commercial trusts and
mutual funds. For a firm to grow, it requires resources inform of money which
is provided by these institutional investors who get profits and interests as
compensation for their troubles in taking the risk. The returns should exceed
the fees and expenses of the investments and is compared against treasury bills
which are considered to be risk-free.
2.2.1 Roles and
Responsibilities of Institutional investors
The
best thing about institutional investors is the fact that they have expertise
and knowledge to monitor the health and progress of the business. With this
knowledge, they can provide the best advice the organization and also control
the tendency of the management to put their interests first as opposed to the
interests of the company. This active monitoring helps reduce misappropriation
of funds and other forms of fraud (Gillan & Starks 2002, pp. 275-305)
The
institutional investors can act as a source of stability in hard times as was
the case in the coal crisis in India recently. By offering additional funds,
the institutional investors increase their stake and say in the company thus
can push for better corporate governance. Another aspect related to this is the
fact the institutional investors have a louder voice compared to minority
investors. Most of the time when minority shareholders raise their concerns on
corporate governance, they will rarely get addressed or at times get thwarted
by the minorities which are not the case with institutional investors.
2.3 Other Corporate
Governance Mechanism
Other
parties that are involved in corporate governance include the shareholders
themselves who have the biggest interests as the main contributors of capital,
the employees who get their incomes and job security from the good governance
of the company, the government which gets taxes from the organization and the
society as a whole which benefits from job creation, income distribution,
corporate social responsibility activities of the firm among other benefits.
Case
Studies
3.1 Enron
3.1.1 Background
The
story of Enron was not only the largest bankruptcy case at the time but also
the biggest audit failure. This was cited by many as the biggest corporate
governance failure especially on the part of corporate boards and institutional
investors.
Enron
was founded in 1985 by Kenneth Lay who also triples up as the chairman and
chief executive officer. This was after merging Houston Natural gas and
Intermonth. Other key people involved with Enron included: Jeffrey Skiing who
was the C.O.O, Andrew Fastow who was the CFO and Rebecca Mark-Jusbasche who was
the once a vice chairman.
From
1995 to 2000 Enron was in fact named America most innovative company by
Fortune. In the mid-2000s at its peak, the shares of Enron were trading at
$90.75 per share. By the end of November 2001, they were trading at less than
$1 per share. This was when the shareholders filed a $40 billion lawsuit. Enron
filed for bankruptcy on December second, 2001 with assets worth $63.4 billion
making it the biggest bankruptcy scandal ever in American history at the time.
At this stage, the shares were going at $0.26 per share.
3.1.2 Failure of
Corporate Governance in Enron
Lack
of due care and skill from the board was one of the reasons why Enron failed.
As submitted by S.Watkins, Kenneth Lay who was Enron’s chair, could not get
what was being said to him in regards to the company having questionable
accounting practices. This also showed lack of proper communication between the
board and the executives. This was further elaborated by Jeffrey McMahon, the
new Enron’s president who said it was virtually impossible to challenge the
authorities at Enron. A culture of intimidation had also developed at the
company with the likes of Ms. Watkins fearing to lose their jobs. The board
literally failed in its role of directing. This showed some sort of conflict of
interests where they were more than happy to receive high compensations without
asking serious questions which would have led to a decrease in their personal
bonuses. The management who carried out the day to running of the Enron
misrepresented information by allocating Enron’s debts to its dubious partners.
This also showed the lack of proper internal controls at Enron (Carberry & Zajac 2017, p.15134).
The
corporate investors also failed to properly supervise the company and advice
accordingly. For example, according to an economist at Enron, it was important
it was all mind games as it was important for the employees, investors, and
analysts to believe that the stock will bounce back. Other corporate investors
such as the two trustees of Enron’s 401(k) plan failed in their duties as they
did not warn the plan participants despite a memo detailing the accounting
malpractices. The institutional investors also had all the knowledge and
expertise but failed to utilize them- they just sat back and believed whatever
they were told.
3.2 Reckitt Benckiser
3.2.1 Background
Reckitt
Benckiser is a British multinational that produces consumer goods to do with
hygien, health, and home products. The name comes from the merging of a United
Kingdom company Reckitt & Coleman and Benckiser NV that was based in the
Netherlands back in 1999. The most well-known products worldwide include Dettol
and Strepsil.
Reckitt
Benckiser acquired Korean Oxy brand in 2001 which had been using
polyhexamethathylene guanidine (PHMG) in a product since 1996. In 2011, PHMG
was banned by the Korea Centers for Disease Control and prevention after a
published report showed a link to lung damage and report. Several reports also
came out supporting the Korean report, and at the height of this in 2016 a coalition of consumer groups came out for
the total boycott of Reckitt Benckiser products after it had been linked to
more than 500 deaths from a BBC report.
3.2.1 Failure of
Corporate Governance Mechanism in Reckitt Benckiser
In
the case of corporate governance, the management and directors fail as a whole
in doing their duty of due care and skill when acquiring the Korean Oxy brand.
They had a duty to investigate and know what is in the product. They put the
company’s financial interests before the safety of the consumers. In addition
to that, several attempts were made by the board and management to suppress
investigations instead of taking corrective measures.
Even
though this was mostly a failure by the management and board, institutional
investors also had the power to ask questions. Despite the various reports,
they were silent till there was outrage in the mass media.
3.3 Satyam
3.3.1 Background
Satyam
was India’s fourth largest computer service company in India which has a
population of over 1 billion. It was even listed on New York Stock exchange in
2001 with revenues exceeding $1 billion. The founder, M. Raju Ramalinga who was
also the chair was a highly regarded person in the business often gracing all
the major corporate events. In 2008 Satyam won the coveted prize of the Golden
Peacock Award for compliance issues and Risk Management in corporate
governance. In 2009, M. Raju confessed that the company’s accounts had been
falsified by a massive $1.47 billion (Bhasin 2005). In the same year, Satyam
stock was banned from trading on the New York Stock Exchange, and the Golden
Peacock Award stripped off. Mr. Raju was later convicted together with other
senior members.
3.3.2 Failure of
Corporate Governance Mechanisms
The
board at Satyam failed in their primary duty of due care and monitoring the
activity of the business as they did not notice the discrepancy. This was so
evident that the first order was to appoint a temporary board. The board also
put their interests first at the expense of the company for financial gains as
confessed by their chairman.
Despite
the amount that falsified being that large, the auditors who were Price Water
House Coopers failed in their auditing duties as they did not report anything
amiss despite having all the expertise and experience. They were even fined $6
million by the US stock exchange for not following the code of conduct and
auditing standards in when offering their services to Satyam. Institutional
investors also failed to raise questions or properly examine the financial statements.
Furthermore, with their expertise, they should have pushed for compliance with
the corporate code of governance.
3.4 Worldcom
3.4.1 Background
Before
filing for bankruptcy protection in 2002, WorldCom was the second largest long
distance phone company in the United States. With assets totaling over $104
billion, $30 billion in revenues and over 60,000 employees WorldCom filed for
bankruptcy protection on July 1, 2002. The company later wrote down more than
75% of the total assets with over 17,000 of the workers losing their jobs. Over
the period between 1999-2002, WorldCom had deliberately overstated their income
before tax by over $7 billion which was the main reason behind the falling from
grace to grass. It is currently known as Verizon business or Verizon enterprise
solution after being acquired by Verizon Communications and is slowly
rebuilding and being integrated into the parent company.
3.4.2 Failure of
corporate Mechanism in WorldCom
The
biggest failure of WorldCom was the fact that the board had failed in its
structuring role. Over the years, it had acquired a lot of companies with even
one accountant confessing that they would get calls from people they did not
even know existed. The departments were also not even properly structured for efficient
working and were very decentralized. For example, the finance department was in
Mississippi; the network operations were in Texas, the human resource in
Florida and the legal department in Washington DC. This provided a challenge of
communication as each department developed their ways of doing things. Apart
from that, the difference in management style and the culture that was
developed of not questioning seniors was a discouragement for employees who
wanted to correct any issues that arose. In fact, there was a deliberate
attempt by the management to hide vital financial issues as explained by Buddy
Yates, the director of general accounting who was told he would be thrown
outside the window in case he had shown the numbers to the auditors by Gene Morse,
a senior manager. The employees also put their self-interests above the
interest of the company as loyal employees were often compensated above the
company’s approved salaries and bonus packages by Ebbers and Sullivan. The
biggest failure was the board however as they failed terribly in all their
roles and responsibilities including due care, supervision, bridging the gap
between management and shareholder among others.
In
the case of institutional investors, they also failed terribly. No one raised a
question on the structure of the firm or why the firm was highly decentralized.
The increase in the salaries and compensation for the ‘loyal’ employees in the
finance and accounting department should also have raised questions.
Institutional investors should have also used their expertise to confirm the
information that was being provided to them.
Recommendations on Improving the Quality Of
Corporate Governance
Corporates Boards Should Meet Regularly: The
corporates boards do not take part in the day to day running of the business,
but they have a supervisory role. To carry out the tasks effectively, they need
to meet more often (Christensen et
al 2015, pp.133-164)
Division
of Responsibilities: The duties and responsibilities of a firm should be properly
defined and allocated within an organization. This will help in reducing
conflicts and also knowing who is liable and for what. This will also help
enhance effective communication within an organization.
Stronger
Internal Controls: Controls in an organization should start from within for
effective corporate governance. The controls include the supervision of
seniors, physical controls, controls among others.
Transparency:
Corporate governance is all about transparency. Transparency does not mean
revealing the companies but being honest in its activities. In case there is a
loss it should be stated and corrective measures to correct it taken,
Proper
succession planning: One of the best attributes is that its life is not limited
to that of the owners or directors. A proper succession plan should, therefore,
be set in place to ensure that the values of the company that encourages proper
corporate governance are passed from one generation to the other within the
company
Proper
training of directors: The directors of the company are the eyes of the society
and shareholders in the business. They need to be properly trained to carry out
their tasks effectively as is required of them. Another option is to select a
board of directors that is highly qualified in the different fields that the
business is engaged in.
Independent
members increase: Any organization that is interested in improving its
corporate governance should try as much as possible to increase the list of
independent parties in its running. The independent parties with no direct
relation can view the business from a better neutral point (Klapper & Love
2002, pp.703-728)
Conclusion
It
is crystal clear from the discussions above that the corporate governance
mechanisms such as corporate boards and institutional boards are the backbone
for the survival of any company. From the cases discussed above, we can see the
consequences of bad corporate governance and the fact that it does not matter
how big the company is. In addition to that, there is a failure the many bodies
that are meant to supervise corporate governance. Corporate governance board
needs to do more than just take the words of corporations. It is an
understatement to say that corporate governance should be a priority, it should
actually be a prerequisite.
View Corporate Governance Research Question
View Corporate Governance Research Question
References
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