Corporate Governance in 21 Century

...

Agency Cost: The agents(such as management) chosen by the principal (such as shareholders) may not act in the best interest of the shareholders and may want some part of the pie from the shareholder’s wealth for their own personal gains. These are hence the costs that must be paid to the agents so that they do their duty as well as possible. This way the interest of the shareholders and the agents can be aligned.

Board of directors: They are a group of individuals who are elected by the shareholders. They represent the shareholders to oversee the management of the company. Some of their basic responsibilities include hiring, compensating and firing of CEO and senior management team, developing and designing the system of corporate governance. They also need to use their expertise, contacts etc. in developing the company. Some other duties include:

- Adoption of a robust succession plan

- Establishing ethical behavior at the top

- Monitor the risk management system of the company

- Maintain communication with shareholders

- Establishment and implementation of government policies

To sum up, board of directors are elected by the shareholders so that they can increase the firm value and act in interest of the shareholders. Directors decide the vision of the company. The management on the other hand is concerned with implementation and bringing that image into reality. However what happens at times is that instead of benefitting the shareholders, at times the management is interested only in filling their own pockets. That’s the reason why corporate governance is so important. A look at the major failures in the past will make things even more clear.

2.2> Major Corporate Governance Failures

Period

Company/Group

Major Causes of Failure

1991

BCCI-Bank of Credit and Commerce International (UK)

- International Bank founded in Karachi(Pakistan) in 1972 by a Pakistani financier Agha Hassan Abedi

- Faulty Business practices-criterion for lending was proximity with the founder rather than ability to pay

- Unauthorised Deals, over expansion

- Poor Auditing - Compromised interest. PWC (UK) did not inform PWC (US)

- Illegal transactions - drug money laundering operations

- Weak regulation - No single country had overall regulatory supervision over its operations. Funds diverted to arms dealers, dictators and terrorist groups.

2001

Enron

- Faulty model of revenue recognition - Enron adopted the merchant model under which the entire sales value was reported as revenue instead of agent model where only trading and brokerage fees rather than full transaction value is recognized as revenue.

- Enron’s Board of Directors failed to fulfill their fiduciary duties towards the shareholders.

- Excessive Compensation to executives. Focus on short term earnings and high volume deals. Extensive stock options to executives.

- Many of the employees witnessed the wrongdoings of top executives, and some whistleblowers came forward but no heed was paid to them.

- Lastly, Enron outsourced external auditing for the function which was supposed to be performed by the internal audit team. It should instead have established a functional internal audit mechanism. Also its external auditor acquiesced in the application of fraudulent financial reporting and questionable accounting.

2005

WorldCom

- Started in 1963,the company forayed into wireless and broad band services. Bursting of the telecom bubble in 2001 resulted in fall in company’s revenue, stock prices and mounting debt.

- In 1985 Bernie Ebbers became its CEO .He was found guilty in March,2005 of accounting scandal of $ 11 billion. He dominated the Board .Board did not make proper review of acquisitions and approved personal loans to Ebbers.

- Large acquisitions were opportunistic rather than long term strategic plan

- Misclassification of revenue costs as capital costs: Over the five quarters leading up to July 2002, WorldCom was guilty of “misclassifying” almost $4 billion of telecoms maintenance costs. These maintenance costs were misclassified as capital spending that could be depreciated over several years, not one.

2009

Satyam Computer

Services

- Scant regard for accounting and ethics. Avoiding payment of taxes, cooking books, and pay offs.

- Ineffective Board despite majority of independent directors

- Audit Committee’s failure-did not heed to Whistle blower Joseph Abraham’s expose

- Accounting manipulations-false invoices, inflated bank balances, fictitious bank accounts

- Insider Trading-Offloaded their shares to invest in real estate

- Dubious Role of rating agencies

2.3.1> Need for Corporate Governance in the 21st Century:

Why do we need corporate governance at all? Aren’t the corporates prudent and ethical enough? The table given below tries to answer this question.

Global Competition

- Increased exposure due to globalization

- Efficiency, quality and governance practices to be at par with international standards

- Role Models-Infosys, Wipro, Tata Motors etc.

Scams in India

- Harshad Mehta-1991-92

- Bhansali Scam-1992-96

- Ketan Parekh scam

- Satyam Computers

...