Introduction and explores the reasons for why corporate collapses

Introduction

This report gives a summary of how corporate governance is influencing
the current world of business and explores the reasons for why corporate
collapses are still ubiquitous. Also, a study based on how the principles and theories
that explain corporate governance in a wider aspect are implemented and how it
is related to shareholders as well as stakeholders of the company. The limitations
of the codes and regulations put forward by different committees and countries are
evaluated in this report. Finally, some recommendations on how effectively
corporate governance can be implemented and sustained in the longer run for
best practice of accountability and overall organizational performance. 

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Corporate Governance

“I cannot accept your canon that we are to judge Pope and King
unlike other men, with a favorable presumption that they did no wrong. If there
is any presumption it is the other way against holders of power, increasing as
the power increases… Power tends to corrupt and absolute power corrupts
absolutely” this letter from Lord Acton (1887) (cited in Oll.libertyfund.org. 2017)
to bishop Creighton defines the relevance of corporate governance in todays
corporate world. The king and the pope in the above quote could be compared to
the chairman and CEO in todays corporate world, where they are assumed to be
fair and just to both the shareholders and the stakeholders. However, practically
this does not hold true all the time and good corporate governance practice
monitors the check and balance between the aims of the corporates and both, the
shareholders and stakeholders.

According to the Cadbury committee (1992) “Corporate governance is
the system by which companies are directed and controlled. It encompasses the
entire mechanics of the functioning of a company and attempts to put in place a
system of checks and balances between the shareholders, directors, employees,
auditor and the management”. The underlying theme of corporate governance from
all sources describes the measures that ensure accountability of the top level
corporate management as well as the senior managers in the organization and implementation
of policies and measures to reduce the principal-agent problem. Corporate
governance plays a balancing role between the shareholders’ value and the
stakeholders value, by prioritizing and outweighing one another based on the strategies
and values adapted by each company.

Code of practice and corporate collapses

The creation of corporate governance codes and rules from time to
time is generally related to corporate collapses starting from Polly Peck, bank
of credit and commerce international and Maxwell communications corporation in
the late 1980’s and early 1990’s. The collapse of Polly Peck was a reminder to
keep check and balance in the working of the financial institution, here in
this particular case being the concentration of power on an individual who had
made fund transfer from London account (Polly Peck) to offshore accounts in
turkey and Northern Cyprus. This was due to the lack of board control and
oversight of this individual. These collapses led to the formation of the committee
on the Financial Aspects of Corporate Governance, commonly known as the Cadbury
Committee. The aim of the committee was to build up “the lack of public
confidence in financial reporting and the ability of auditors provide the
safeguards sought and expected by users of company reports would undermine
London as a major financial center” (Cadbury 2002).

Recommendations put forward by the committee were mainly focused with:

·        
Division
of responsibility at the head of the company

·        
Inclusion
and majority of independent non-executive directors

·        
Formation
of audit committee   

The committee’s focus was to increase the accountability of top
level management, transparency of the working and accounting practices to
safeguard and build back public confidence in the financial reporting of
corporates to all stakeholders. This was made clear by the committee in the
report stating that “focus on the control and reporting functions of boards of
directors and on the role of the auditors, although it recognized that it also
has contribution to make to the promotion of good corporate governance”
(Cadbury 1992). This was not the end of code or regulations with respect to
corporate governance, rather this was the basis on which many further reviews
were made by future committees, such as the Greenbury Committee 1995 which
dealt with the accusations concerning the level of executive directors
remuneration paid and the Hampel Committee 1998 was constituted to complement
and clarify the Cadbury and Greenbury report, which emphasizes on non-executive
directors. On doing an analysis or evaluation of these committee, it can be
seen that although there had been an emphasis on non-executive directors in the
reports, they fail to provide a clear and comprehensive guideline and
definition of the same. 

By the early 2000’s there came the next milestone for negligence in
corporate governance, known as the biggest audit failure, Enron, where “It
appears that performance incentives created a climate where employees sought to
generate profit at the expense of the company’s stated standards of ethics and
strategic goals” (IFAC, 2003). The poor financial reporting and accounting
loopholes helped mislead the board of directors and the audit committee from
comprehending the billions of dollar debts incurred by the company from its
failed deals and projects. But, the fact of the matter being that Enron had in
place all the policies and structure for good cooperate governance including
human rights and a corporate social responsibility wing. But at the end, the
implementation of these policies and unfettered power in the hand of the chief
executive is one that characterized Enron’s management. The recommendations put
forward by the Cadbury committee were willingly violated such as the audit
committees allowing unusual accounting practices to be overlooked and remain
unquestioned. Following the failure of Enron, the United States passed a federal
law called “Corporate and Auditing Accountability, Responsibility, and
Transparency Act” commonly known as The Sarbanes–Oxley
Act of 2002.

Sarbanes–Oxley Act of 2002 like the Cadbury committee, was due to
the corporate collapse of Enron, Tyco International Plc. and WorldCom which
deteriorated shareholders and investor’s confidence in the financial reports
and demanded an overall checkup of the regulatory system. The recommendations
focused mainly, like previous codes of practices on improving the accountability
and transparency which can be seen by the usage of section 302 and section 404,
respectively. Section 302 requires senior management to certify the accuracy of
financial reports thus imparting accountability to higher-level management.
Section 404 puts responsibility upon the managers and auditors to establish internal
control and reporting techniques which provides more transparency on the
working and internal structure of the organization which IS a very costly
implication. “a deeper question that Sarbanes-Oxley does not address is whether
we can (or indeed should) legislate for human greed” (Henry, 2011, p. 415)

Implementing internal controls has a downside of having high cost incurrences,
because of which there was a loss of initial public offerings from the American
stock market to the London stock exchange. Later, in 2006 US treasury secretary
Henry Paulson was assigned to review the Sarbanes-Oxley act, to which no
changes were made and suggested that the government would want to look into the
rules being enforced, such as ‘high standard of integrity and accounting’ along
with ‘innovation, growth and competitiveness’. However, the financial crisis of
2007-08 which led to the collapse of major financial institutions suggests a
more robust regulation practices for the financial institutions (Henry, 2011,
p. 415, 416). The biggest sign was the Enronization of Lehman Brothers (Kirkendall,
2017), this being the collapse of Lehman Brothers, where the Lehman executives were
subjected to the provisions in the Sarbanes-Oxley legislation enacted after
Enron’s bankruptcy that imposed criminal liability on executives who had falsely
certified “the (i) accuracy of the financial statements and (ii) absence of
deficiencies in internal controls regarding the preparation of the financial
statements which proved the point of the act but failed to prevent the
collapse.”(www.businessinsider.com,
2010)

Concepts and theories

Even with the extensive list of codes of practices and rules set in
place by different countries and committees the collapse of companies still
occurs to date, mainly due to the lack of proper division of responsibility
among the chairman and the top-level management (directors and mangers). Their
roles and influences in the corporate collapses can be explained by some
theories and concepts like principal-agent framework, conflicting sights of the
shareholders theory and stakeholder’s theory and how their interplay becomes
the cause of collapse for the corporates.

The principal-agent theory comes into
effect, because of the separation of ownership and control of the company
between principal (shareholder) and the agent (manager), respectively. There
occurs divergence of interest between the principal and the agent since there
is “no contract, however precisely drawn, can possibly take account of every
conceivable actions that an agent may engage in.” (Henry, 2011, p. 400). This
leads to a high agency cost (cost associated from mangers abusing their
position) and reduces the confidence amongst the principal and the agent which
in turn have a negative impact on the company. In the case of Enron, the
directors (agent) had a legal obligation to follow through to the investors (principal) but as explained not all the activities of the
directors could be covered under the legal obligations, the diversion of
interest between both and lack of alignment was the final reason for the
collapse of Enron. The principal-agent theory is a suitable analysis tool which
when used properly can identify when and where the interests of investors and
mangers are diverging and thus could be kept in balance and control.

Conflicting views between the shareholders and stakeholder’s
theory contributes another major reason for the collapse of the corporates
in today’s setting. Shareholder theory was explained by Friedman (1962, p. 133)
as “there is one and only one social responsibility of the business-to use its
resources and engage in activities designed to increase its profit so long as
it stays within the rules of the game, which is to say, engages in open and
free competition without deception of fraud.” On the other hand, Freeman, R.E
(2009) states that “Stakeholder Theory is an idea about how business really
works. It says that for any business to be successful it must create value for
customers, suppliers, employees, communities and financiers, shareholders,
banks and other people with the money. It says that you can’t look at any one
of their stakes or stakeholders if you like, in isolation.”.

The underlining distinction between both theories is that
stakeholder theory calls for the interest of all the stakeholders (including
shareholders) to be considered even if it reduces the profit of the company,
whereas the shareholders theory disregards other stakeholders except
shareholders to maximize profit of the company. There has been
misinterpretation at both ends by considering that shareholders theory
specifies only attaining profit and thus neglecting the part of legal and
nondeceptive means mentioned together with it and similarly in stakeholder’s
theory by assuming that the theory does not demand a company to focus on
profitability.

Farepak case study could explain the impact of stakeholder and
shareholders consideration. In the year 2006, more than 150,000 people had contributed
few pounds a week to the savings club of Farepak in return for a voucher at the
end of the year to spend on Christmas present. These savers were not given what
they were promised due to the inability of the parent company European Home
Retailer (EHR) to secure further credit form their bankers. EHR was
diversifying into many markets which made huge losses over the years, EHR
accounts had suggested that they were struggling from 2003 onwards. Banks
rejected the credit since the liability over weighed the assets of the company,
but several dividends were paid out and others such as EHR’s managers,
directors and family shareholders came out the with the least credit. The
question remains whether the poor savers (customers) were supposed to know that
EHR has diversified and made a huge loss before they invested few pounds every
week, even though the company is not legally obliged to compensate them, but in
the long run it may not have been wise to neglect these stakeholders
(customers) for short term benefits. (Henry, 2011, p. 401-403)

The interplay of how the shareholder & stakeholder’s theory
relates to the investors, the management in an organizational structure have
been summarized below in the matrix.

From the above made analysis both theories on a standalone basis
have their own misinterpretations and constraints, but a balanced mix of both could
and will be the solution for properly defining and segregating the role of the
chairman and the director for the efficacious running of any corporate.

 Limitations

Some of the limitations of corporate governance that have led to
the collapses of corporates around the world can be summarized as;

·        
Ownership-Management
separation which has been explained by the principal-agent framework is limited
from considering every aspect of that relationship for instance, although there
is a legal obligation by the agent to the principal, all the activities of the
director cannot be covered under these obligations.

·        
Flow
and asymmetry of information, another byproduct of principal-agent theory where
agent (managers) have greater access to information which may not be properly
coordinated or transferred to the principal (shareholder).

·        
Lack
of common codes and practices among corporates in different countries and
within the same country are causing many disparities and misinterpretation,
since it is widespread and tougher to collate.

·        
Deceptive
financial statements have been the main cause for the collapse of many
companies in the past and continue to occur, such as establishing complex
network of subsidiaries and cross-shareholding, despite various corporate
governance codes being implemented.

·        
Cost
of compliance for adopting the standards, rules and regulation laid by some federal
corporate governance laws have proven to be burdensome and expensive for
corporations, for example, the internal controls proposed by the Sarbanes-Oxley
Act 2002.

Recommendations

Considering the limitations of corporate governance and the vast
number of corporate collapses, recommendations listed below could be utilized
to improve corporate governance and the behavior of senior management within
corporations.

·        
Chairman
and CEO; Separation of roles for the chairman and the CEO is recommended to
eliminate concentration of power, which could lead to dilution of boards
influence over management in countries that do not already require this.

·        
Codification
of the codes and rules; As mentioned in the limitation due to widespread and
segregated rules and regulations from country to country, a unified and
complete code of practice should ideally be shaped and accepted worldwide.

·        
More
scrutiny of company strategic plans for legitimate value creation, to prevent internal
(senior management) forces from compromising long term interest for short term
benefits.

·        
Balance
between principal and agent; Properly communicated and agreed upon incentives
could align their goals and interests. These incentives need not always be
financial in nature thus creating a balance between the principal and the
agent.

·        
Centralized
flow of information; Everyone in the same hierarchical command should have easy
access to required information in a simple manner so it is easy to understand. Easy
access to information by the board members would create a more transparent
accountability system within the corporation thus improving the confidence of
the shareholders in the company.  

Conclusion

Over
the years the traditional mode of operation has changed drastically, following
which the code of practice has adopted itself to meet the demand. But the
questions that is to be answered is whether we need to wait for another
corporate collapse to produce newer codes of practice or rather foresee the
need of the industry and create a unified universally accepted principles-based
code of practice which can meet the need of the current era till it is required
to be changed in the future