Internal and External Aspects of Corporate Governance 9780415776417, 9780203865293, 2009021335, 0415776414, 0203865294

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Internal and External Aspects of Corporate Governance

Ahmed Naciri

Internal and External Aspects of Corporate Governance

Routledge Studies in Corporate Governance

1. Corporate Governance Around the World Ahmed Naciri 2. Behaviour and Rationality in Corporate Governance Oliver Marnet 3. The Value Creating Board Corporate Governance and Organizational Behaviour Edited by Morten Huse 4. Corporate Governance and Resource Security in China The Transformation of China’s Global Resources Companies Xinting Jia and Roman Tomasic 5. Internal and External Aspects of Corporate Governance Ahmed Naciri

Internal and External Aspects of Corporate Governance

Ahmed Naciri

New York

London

First published 2010 by Routledge 270 Madison Ave, New York, NY 10016 Simultaneously published in the UK by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN © 2010 Ahmed Naciri

Typeset in Sabon by IBT Global.

All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark Notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe.

Library of Congress Cataloging in Publication Data Naciri, Ahmed. Internal and external aspects of corporate governance I Ahmed Naciri. p. cm.-(Routledge studies in corporate governance; 5) Includes bibliographical references and index. ISBN 978-0-415-77641-7 (hardback: alk. paper)- ISBN 978-0-203-86529-3 (ebook) 1. Corporate governance. I. Title. HD2741.N33 2010 658.4'2-dc22 2009021335

ISBN10: 0-415-77641-4 (hbk) ISBN10: 0-203-86529-4 (ebk) ISBN13: 978-0-415-77641-7 (hbk) ISBN13: 978-0-203-86529-3 (ebk)

This book is dedicated to all those who lost all their life savings and/or retirement securities because of others’ greed. It is a reminder that our way of doing business can be changed and ought to be and unfairness should be disturbing and decried by each one of us, especially if we are benefiting from it.

Contents

List of Comprehensive Cases List of Appendices List of Tables List of Figures Abbreviations Acknowledgments Preface

ix xi xiii xv xix xxi xxiii

1

Corporate Governance and Corporate Strategy

1

2

Corporate Governance: The Voluntary and the Legal Frameworks

21

3

The Board of Directors and Corporate Governance

53

4

The Standing Committees of the Board of Directors and Corporate Governance

84

5

Internal Control and Corporate Governance

108

6

Risk Management in Corporate Governance

130

7

International Financial Reporting and Corporate Governance

151

8

Financial Auditing and Corporate Governance

179

9

Credit-Rating Activities and Corporate Governance

206

10 Financial Markets and Corporate Governance

225

11 Corporate Governance in Less Developed Economies

242

viii Contents 12 Corporate Governance Requirement of Trust

261

13 Corporate Governance: the Road Ahead

281

Notes References Index

303 305 325

Comprehensive Cases

1.1

Adam Smith, The Wealth of Nations

20

2.1

The Sarbanes-Oxley Act

51

3.1

New York Stock Exchange Statement of Corporate Governance Practices

83

4.1

Microsoft Corporation Audit Committee

107

5.1

Internal Control Guidance for Directors on the Combined Code

129

6.1

Harvard University Risk Management System

150

7.1

IFRS Financial Statements

175

8.1

Royal Bank of Canada, Report of Independent Registered Chartered Accountants

205

9.1

Credit-Rating Agencies Around the World

224

10.1

The Madoff Ponzi Scheme

241

11.1

The Global Corporate Governance Forum

259

12.1

The Theory of Moral Sentiments

280

Appendices

7.A

Consolidated Balance Sheet at 31 December 200X

175

7.B

Consolidated Income Statement for the Year Ended 31 December 200X

177

Consolidated Cash-Flow Statement for the Year Ended 31 December 200X

178

7.C

Tables

3.1

The Most Significant Responsibilities of the Chairman of the Board

67

Measures to Be Taken by the Board for Ensuring an Appropriate Corporate Governance System

76

3.3

Strategic Planning Process

76

3.4

Risk Identification and Management

77

3.5

Internal Control

78

3.6

Oversight of Communications and Public Disclosure

78

4.1

Airframe KLM, Board of Directors Committees

87

4.2

Audit Committee Financial Information Review

93

4.3

Audit Committee Duties With Regard to External Audit

93

Audit Committee Actions With Regard to Monitoring Internal Control

95

4.5

Nomination Committee Duties

99

4.6

Remuneration Committee Duties

102

4.7

Potential Standing Committees

104

5.1

Common Categories of Control Activities

121

5.2

The Process of Information Identification, Capture, and Distribution

123

Risk Table

141

3.2

4.4

6.1

xiv Tables 6.2

Examples of Risk Measurement

141

7.1

Recognition Criteria for the Elements of Financial Statements

165

7.2

List of Adopted IFRS

166

7.3

International Accounting Standards (IAS)

166

7.4

International Financial Reporting Interpretations (IFRIC)

168

International Auditing Standards Adopted by the IAASB

169

7.6

The Use of IFRS by Jurisdictions

171

8.1

Report of Independent Registered Public Accounting Firm

193

Big Four Accounting Firms’ Global Revenues for the Year 2007

202

Examples of Credit Ratings by the Three Largest Credit-Ratings Agencies

213

9.2

Ratings Criteria, Agencies Versus Banks

215

10.1

New York Stock Exchange Regulations: Statement of Corporate Governance Practices

231

7.5

8.2 9.1

Figures

P.1

Trust-mistrust zones.

1.1

The fi nancial hurricane.

5

1.2

Four failure stories of fraud.

6

1.3

Classification of corporate governance defense mechanisms.

11

Corporate governance defense mechanisms’ assumed objective.

13

1.5

Internal control objectives.

14

1.6

The fi nancial decision-making triangle, IEM model.

16

2.1

Agency causes.

23

2.2

Agency consequences.

26

2.3

International initiative in corporate governance.

29

2.4

World Bank governance framework for development.

29

2.5

OECD 2004 corporate governance principles.

31

2.6

Requirements for ensuring the basis for an effective corporate governance framework.

32

Shareholders’ rights respect and key ownership functions.

33

2.8

Shareholders’ equitable treatment.

35

2.9

Stakeholders’ role enhancement mechanisms.

37

2.10

Disclosure and transparency.

37

1.4

2.7

xxv

xvi 2.11

Figures Global corporate governance forum’s approach to improving governance.

41

2.12

Sarbanes-Oxley main provisions.

45

3.1

The board and directors’ common legal responsibilities.

59

3.2

Criteria for selecting appropriate officers.

61

3.3

Functions of the board and directors.

63

3.4

Directors’ specific functions.

70

3.5

Requirements for an efficient board of directors.

74

3.6

Criteria for maintaining board of directors’ efficiency.

75

3.7

Legal and fraudulent corporate authority hierarchies.

81

4.1

Corporate governance managers.

86

4.2

Executive committee main roles in the organization.

90

4.3

Nomination committee main duties.

98

4.4

Compensation committee main duties.

101

5.1

Internal control main objectives.

110

5.2

Roles and responsibilities in internal control within the organization.

112

5.3

Components of internal control.

115

5.4

Specific control factors for an appropriate environment.

116

5.5

Internal control monitoring process.

126

6.1

Risk management process.

132

6.2

The board of director’s responsibilities in risk management.

135

6.3

The organization’s risk profi le.

137

6.4

Risk management strategies.

144

6.5

Risk management monitoring model.

145

Figures xvii 6.6

Integrated program of risk management.

148

7.1

IASB structure for adopting IFRS.

153

7.2

The IASB’s standards-setting process.

155

7.3

International assurance and auditing standard board structure for adopting ISA.

158

7.4

The IAASB’s standards-setting process.

159

7.5

The conceptual framework.

162

7.6

The elements of fi nancial statements.

163

8.1

Financial statement fraud schemes.

182

8.2

The market fraud trap.

185

8.3

The audit process.

187

9.1

Corporate-ratings principle.

207

9.2

Credit-rating process.

211

9.3

Credit-ratings main users.

214

9.4

Income statement and types of risk.

223

10.1

Dow Jones Industrial Average, February 25–March 2, 2009.

228

10.2

Takeover premiums.

235

12.1

Joint board and management gains from trust.

273

12.2

The mistrust zone.

276

12.3

Trustiness zone.

277

12.4

Optimal BMTR.

277

13.1

The risk return trade-off and fraud.

283

13.2

The market for safe passes.

294

13.3

The actors of the fi nancial chaos.

300

13.4

The power shift in corporate governance.

301

Abbreviations

AASB AICPA APB AR AICD BCBS BIS BMTR CASC CPAB CEO CFO CG CGRR CICA CPAAOB CSA CLO COSO CRA CR DR EBT EBIT EC ED FASB FSAP FSF GAAP GAAS GCGF

Australian Accounting Standards Board American Institute of Chartered Public Accountants Accounting Principles Board Audit Risk Australian Institute Company Directors Basel Committee on Banking Supervision Bank of International Statement Board Management Trust Relationship Canadian Accounting Standards Committee Canadian Public Accountability Board Chief Executive Officer Chief Financial Officer Corporate Governance Corporate Governance Regional Roundtables Canadian Institute of Chartered Accountants CPA and Auditing Oversight Board Canadian Securities Administrators Chief Legal Officer Committee of Sponsoring Organizations of the Treadway Commission Credit Ratings Agencies Control Risk Detection Risk Earnings Before Taxes Earnings Before Interest and Taxes European Community Executive Director Financial Accounting Standards Board Financial Sector Assessment Program Financial Stability Forum Generally Accepted Accounting Principles Generally Accepted Auditing Standards Global Corporate Governance Forum

xx

Abbreviations

IAASB IAPS IAS IASB IDA IFAC IFRIC IFRS IOSCO JSLC MR MD&A MENA NASDAQ NED NSG NYSE OECD PCAOB PIOB ROSC SAC SEC SOE SOX SRO TSX UQAM

International Auditing and Assurance Standards Board International Auditing Practice Statement International Accounting Standards International Accounting Standards Board Investment Dealers Association International Federation of Accountants International Financial Reporting Interpretations Committee International Financial Reporting Standards International Organization of Securities Commissions Joint-Stock Limited Company Misstatement Risk Management Discussion and Analysis Middle East and North Africa Region National Association of Security Dealers Automated Quotation Non-Executive Director National System of Governance New York Stock Exchange Organisation for Economic Co-operation and Development Public Companies Accounting Oversight Board Public Interest Oversight Board Reports on the Observance of Standards and Codes Standards Advisory Council US Securities and Exchange Commission State-Owned Enterprises Sarbanes-Oxley Act Self-Regulatory Organizations Toronto Stock Exchange University of Quebec in Montreal

Acknowledgments

This book would never come to being without the encouragement and the assistance of many people. I would like to express my thanks to my family and to Miguel Rojas, Guilene Fontaine, Terry Clargue, Abdelillah Bakiri, Lorn Switzer, Michel Nadeau, and many others. I am also indebted to many organizations whose materials help conceive this book: the Organization for Economic Co-operation and Development (OECD), the World Bank (WB), the Corporate Governance Forum (CGGF), the United States General Accounting Office (US-GAO), the American Institute of Chartered Public Accountants (AICPA), the Committee of Sponsoring Organizations of the Treadway Commission (COSO), the International Organization of Securities Commissions (IOSCO), the Financial Accounting Standards Board (FASB), the International Accounting Standard Board (IASB), the International Federation of Accountants (IFAC), the European Commission (EU), the Royal Bank of Canada (RBC), Abrema Corporation, the Riotinto Corporation, Harvard University (HU), University of California (UC), the New York Stock Exchange (NYSE), Public Companies Accounting Oversight Board (PCAOB), Reports on the Observance of Standards and Codes (ROSC), Public Interest Oversight Board (PIOB), and many others.

Preface

Unfortunately, current events tend to confi rm Galbraith’s assertion “that the world of fi nance let itself to be understood only if we admit that maximum admiration go to those who open the way to big catastrophes.”1 Indeed, the current fi nancial crisis is nothing else than a direct consequence of doubtful executive behaviors encouraged by environment and dominated by frauds, accounting number falsifications, huge embezzlements ($40 billions in the Madoff case), and excessive executive pay (that skimmed an average of $100 a working minute for the year 2007). Such misdemeanors have ended up weighting heavily on business relations, market conditions, and economic growth. Further, by becoming the normal standard of modern corporation scenery, such business deviations have created a devastating turmoil that is still spreading and intensifying, and consequently investors have lost any confidence in corporate disclosure and market mechanisms and tend to see the current crisis as something really quite new and different from any crisis that was experienced before. Managers were indeed to blame, but they were used as scapegoats to bigger and more dangerous offenders; as it happens, the major market players like large investors, auditors, rating agencies, fi nancial institutions, and even monitoring agencies and, for sure, they all bear direct responsibility for today’s chaos. Indeed, none of them seems to have done its job appropriately, and each did not resist the temptation of turning its activities from instruments of production of goods and services to relentless short-term profit-generating machines. The thirst for easy gain and the propensity for fraud have progressively changed their activities into a market for safe passes, where complaisant certifications and proofs of compliance with rules can be acquired for generous fees. Obviously, as for managers, many of these market major players have crossed the mistrust line and they ought to be sued and punished instead of being compensated, as it seems the case with some of these so-called rescue programs. After all, should a liar be believed when he promises not to lie anymore? Would it be because of the strong ties that link the capital to politics, that architects of the current economic disaster not only seem to be compensated but also often maintained in commands, despite voices that are calling for their immediate replacement? Instead of going after real delinquents, some

xxiv

Preface

people are blaming for the fi nancial chaos we are currently enduring, the free-market system that is by far the most ingenious human creation. Major market players are to blame instead; they have seriously interfered with its normal functioning, and it ought to be protected from them and “provocative as it may sound in today’s febrile and dangerous climate, freer and more flexible markets will still do more for the world economy than the heavy hand of government” (The Economist, 2008b). Adepts of Friedman theory still believe that corporations have only one responsibility: maximizing their shareholders’ wealth, and should not, therefore, try to do good actions with others’ money. They still challenge the idea that businesses can do well and do good at the same time. Such poisonous beliefs can, however, be misleading: first, corporations are there because society enables them to exist and second, the appropriate question that should be asked is: can businesses be conducted honestly? In face of the crisis we are currently in, the answer can only be yes and, at least, it should. Corporate governance is the path to be followed by businesses and other organizations to ensure their alignment toward such objective and should indeed be looked at as systemic process, having some of its mechanisms rooted in organizations themselves; but others, much impacting, are originating from outside. For a corporate governance initiative to succeed, it is primordial that all classes of mechanisms of governance work efficiently, but it is also required that a clear and precise social orientation toward honesty and trust is taken. As we know, dishonesty and mistrust are not new in human relations, but that is also the case for trust and honesty. Of course, some rebalancing of regulations is needed, particularly where innovation outpaced gappy supervisory regimes. Although laws and regulations may prove to be useful in signaling the direction society would like to see its businesses take, they always prove insufficient in establishing trust and honesty, especially when promulgated out of urgency. In all cases, laws and regulations should deal with principles not rules. Besides, the legislature is divided between its desires of saving individual self-interest, supposed to keep business activities running, and making sure that such self-interest is pursued within ethics and trust boundaries. Self-interest does not, however, limit itself to money: it may include reputation and other social value. Only a change of attitude can present any hope; even if attitudes are over time learned opinions and don’t change unless a major event occurs, change can be initiated from the current crisis and this opportunity should not be missed; it should rather be seized to bring more attention to ethics and honesty in doing business. Anyway, the recent euphoria for easy gains has prompted swindles to the advanced scene of corporate management; after misappropriating corporate and small-investor wealth, they are requiring that cost of their misconduct to be externalized on those who are not responsible for them. Some of the victims have lost their life saving in such adventures and others all their retirement benefits. Malfeasants ought to be stopped, sued, punished,

Preface xxv and replaced by more honest managers. Indeed, it was forgotten that trust in business is first about excellence and high achievement rather than malfeasance. The fraudulent corporate hierarchy of authority that seems to be instituted, which has marginalized honest managers and excluded them from corporate strategic decision making, should be reverted. And this may constitute a real test to the current crisis resolution. Indeed, the degree of the hegemony of a system can be measured by its tendency to persist in error. It is the time to react and ask whether modern managers were, at all, taught trust and honesty and whether we adopted a culture that tolerates and even justifies business abuse of trust. Our educational programs are also to blame; they should reflect such business ethical orientation. Till very recently our business schools seem to prompt students to wealth maximization regardless of the means used. The current fi nancial chaos, which has taken years to build up, may also take years to cure. The objective is not to completely eradicate mistrust, because this may prove to be impossible, but rather to make a critical mass of managers to cross back the line to the trust zone as represented in Figure P.1. Indeed, “we will often ashamed by the best of our actions, if people know all motivations that produce them.” (La Rochefoucauld, 1834) Corporate governance internal and external mechanisms covered in this book should be looked up as powerful operating instrument that can help improve corporate behavior and introduce more ethics to business transactions and relations. This book also calls for everybody’s participation to this noble task in these crucial times, because after all our fi nancial system cannot be other than the reflection of our current collective values and beliefs. It reminds those among us requiring honesty today from the fi nancial system that we should also ask ourselves, Are we honest enough to save the system or does “the unfair hurts us, only when it does not benefit us?” (Vauvenargues).

Figure P.1

Trust-mistrust zones.

1

Corporate Governance and Corporate Strategy

Wealth creation always precedes wealth distribution and requires autonomy, freedom to prosper but more importantly good governance (accountability) to sustain and develop. Autonomy and freedom to undertake may prove worthless in isolation and only an accountable and transparent autonomy, as suggested by corporate governance, would seem to be the panacea. Corporate governance is seen in this book as all the principles, mechanisms, and processes that are used to govern organizations ethically. Today and in the aftermath of serious embezzlements in major corporations throughout the world due to failures of diligence, ethics and accountability, that is, corporate governance, are becoming a powerful means of value creation (Gompers, Ishii, & Metrick, 2001). Indeed, “corporate governance has a role of vital importance to play one that is often not fully understood” (Oman, Fries, & Buiter, 2003). Most corporate governance works have, however, concentrated on immediate governance mechanisms like board structure and committees. On the other hand, most of the literature on the subject had originally taken a narrow view that aimed at ensuring that fi rms are mainly operated in the interests of shareholders. As commonly underlined, however, the theoretical justification for such a view is based on the existence of a perfect and complete market and in this is something that cannot be encountered in most countries. Consequently, these assumptions are far from being reasonable (Allen, 2005). In such case, a broader view of corporate governance, one that focuses on ensuring that society’s resources are used efficiently, may prove to be more appropriate. This chapter emphasizes the necessity of dealing with corporate governance in a systemic way, underscoring interactions between its diverse components and emphasizing its multiple impacts on corporate strategy and free-market value.

CORPORATE GOVERNANCE MECHANISMS’ INTERCONNECTION The dynamic complexity of corporate governance can only be surrounded by bringing together a range of mechanisms, and at the same time assessing

2

Internal and External Aspects of Corporate Governance

their impact on organization’s strategy and market value. Indeed, such understanding needs to go beyond immediate mechanisms, like board structure or its members’ independence, to address larger issues like the impact of governance on the socioeconomic environment in which organizations operate. Defense mechanisms against weak corporate governance are diverse; some of them are internal, others institutional or operational, and others external. They are all connected, however, and all share the same impact on corporate destiny and they each bring different strengths to the task. For the sake of clarification and although not universally shared, wealth maximization hypothesis will be used throughout the book and as “Arianne’s thread” to explain and connect all organization actions in the area of corporate governance. It should always be remembered that corporate governance is more about organization values and value creation and should be considered as a strong tool for building efficient entities, whether public, private, or state owned.

THE CORPORATION The group of people authorized to act as an individual1 and called “corporation” existed in one form or another in most ancient and Middle Ages civilizations. Mankind had indeed early discovered the virtue of such organizations and was able to use them for the common human well-being and progress. Corporate adventure as an organized system of doing business really departed around the fourteen century, when corporations were then established under frameworks set up by governments of the time, and for the purpose of undertaking tasks which appeared then to be too risky or too expensive for individuals and even for governments themselves to assume (Wikipedia). The efficient use of the corporate concept, in the centuries that follow, by colonial powers to reinforce colonial ventures gives the corporation yet another breath. The corporate concept reached, however, its highest status only during the nineteenth and twentieth centuries, when corporation became almost the only legal form of doing business and that sometimes controlled countless wealth and even economies. One reason for this remarkable development and expansion resides in the specific rights and privileges granted from the start to the corporation for the purpose of allowing it to play efficiently its expected role, mainly political, at the beginning it became economic overtime. The limited liability and perpetuity rights were but a few of the privileges, but they have unsuspected deep fi nancial ramifications. They have drastically changed the fi nancial scenery on earth. The limited liability right, for instance, allows anonymous trading in the shares of the corporation and simplifies it, as well, by freeing the corporation from its creditors’ consent for new share issues. The limited liability right, on the other hand, actually limits the amount any investor can lose or pay for his participation in a company’s capital stock. The limited liability right

Corporate Governance and Corporate Strategy

3

has had a real determinant impact on the financial scenery, allowing corporations to raise a tremendous amount of money by combining funds from different shareholders who do not necessarily knowing each other. Their number is therefore greatly increased and so the amount they are likely to invest and simultaneously their risk are also reduced, thus adding volume, liquidity, and accessibility to exchanges. The perpetuity principle, on the other hand, allows corporate structure and corporate assets to exist beyond the lifetimes of any one of its stakeholders or agents. Consequently, more stability and capital accumulation can be expected and the fi nancing of larger sized projects and over longer terms have become possible, due to the fact that larger amounts of capital are becoming available for investment. The corporation was able to skillfully take advantage of the granted special status and the corporate model was suggesting, till recently, that individual well-beings do not necessarily confl ict with each other and therefore the corporation should not be moved by any social consideration. Consequently, neither the unthinkable accumulated volume of wealth nor the high level of concentrated power should be seen as problems. Opportunism in business relationships was then put at the forefront of economic analysis (Smith, 1817), at a time it was still strongly believed that society can last only if every individual cares for others and is convinced that social order depends on his altruist behavior. Smith’s model was, however, often misunderstood, in a sense that although individuals deliberately seek personal interests and use every means to reach them, they are supposed also to have made sure that personal interests are pursued within the boundaries of ethics. Moreover, the means of realizing individual objectives are deemed to be legally permitted, if only economically efficient individuals acting in such a manner will actually contribute to the improvement of the common welfare. Although in some situations individuals may indeed help others while helping themselves, mankind seems to be generally compromising on moral and social values whenever monetary interests are involved. Business efficiency and business ethics often prove to be unconceivable, and modern businesses have instead learned how to subjugate heterogeneous means of wealth maximization, resulting in de facto opportunistic corporate attitudes that are based on frauds, tricks, and hypocrisy with regard to conformity to the rules. Such orientation has been building up slowly but surely for so long, and it seems today almost impossible to imagine corporations behaving differently. Being often freed in the twentieth century from much monitoring constraints, corporations became jealous of their independence and were constantly, strongly, and fiercely opposing any risk of sovereignty loss. In this regard corporations have actually adopted a rushing-ahead strategy, combining cleverly processes’ innovation, transactions’ sophistication, accounting number manipulation, and so on, whose sole objective is information opacity. Confusing investors and consumers was not enough for modern corporations; their managers learned also how to interfere with corporate democracy.

4

Internal and External Aspects of Corporate Governance

In a relatively very short period of time the corporate form became the dominant form of business all over the world, and also in a much shorter period of time corporate managers took over its complete destiny at the expense of shareholders. The discipline dealing with the authority within corporations is known as corporate governance and is concerned with the way managers behave themselves while running corporations, supposedly belonging to shareholders. Consequently, corporate governance goes beyond that of regulating shareholders–management relationships to cover other issues to be discussed in this book. As corporations play a crucial role in modern economies that rely intensively on such private organization for securing savings, regulating investments, and securing incomes, good corporate governance is becoming an essential requirement to an extensive and growing segment of the population and a major issue for public-policy makers. Such interest for governance was exacerbated by the unfair economic and social harms recently and overtly caused by notorious corporate embezzlements. Ultimately this crisis may have, after all, a positive effect if it succeeds in making policymakers become more sensitive to the necessity of good corporate governance in business dealing and making them aware of its major contribution to fi nancial market development, investment, economic growth, and social stability. This crisis may also prove to be beneficial if, for their part, organizations better understand how good corporate governance may contribute to their competitiveness and prosperity. It is also susceptible of making investors realize the role they can play for ensuring good corporate governance practices within corporations they own.

THE EXPLOSIVE COCKTAIL OF CORPORATE COMPLICATIONS AND MARKET SOPHISTICATIONS Corporate privileges would have no value if an appropriate market was not tailored and created specifically for them. For this reason, corporate advances and sophistications were accompanied, hand in hand, with the fi nancial market development and sophistication and these changes have had profound implications for corporate governance (Bradley, Schipani, Sundaram et al., 1999). The result was a new fi nancial order, mainly characterized by a vast volume of fi nancial transactions, but also doubtful opportunities of frauds, a kind of fi nancial hurricane that is impossible to master, at least till now, as represented in Figure 1.1. Indeed, corporate specific characteristics have contributed to exchange development and to exchange transactions explosion. By creating new fi nancial instruments such as options, derivatives, and exchange indexes, the exchange fuels the fi nancial hurricane even more by adding fuel to the fi re process. Market exchange operators became voracious and can hardly wait for an event to occur; they tend to anticipate them along with their eventual return in a foolish race for profit, creating more often false

Corporate Governance and Corporate Strategy

Figure 1.1

5

The financial hurricane.

expectation that result in many unnecessary deceptions. Major fraudulent transactions, although involving corporations, are now of a macro nature and are taking place at the market level. A recent round of fi nancial frauds is seen as the natural and inevitable consequence of a trend which was building up for so long now. Inevitably the market becomes the master governance system (Clarke, 2005, p. 1410). “Ironically, the blunt truth is that recent accounting scandals and broader phenomenon have made corporate managers more accountable to the market” (Coffee, 2002) and less to shareholders or citizens. Consequently, the corporation has become the privileged field for fraud and misappropriation that are both difficult to detect and to predict, due mainly to market sophistication. Corporations’ gain of power and their lobbying activities for regulations dilution has rendered them difficult to monitor, and engaged them in an interdependent complex system of confl icts of interest.

THE GLOBALIZATION OF FRAUD AND MISTRUST Corporate regulations’ strength coupled with corporate expansion and management power explosion can only lead to mistrust behavior proliferation. The most notable corporate frauds were initiated from economically advanced environments but should not divert us from the fact that other economies seem to have experienced their own share of misfortune and surely deserve their own share of blame. The truth is that “the dangers that accompany deception and abuse of trust loom large around the globe”

6

Internal and External Aspects of Corporate Governance

Figure 1.2

Four failure stories of fraud.

(Frankel, 2006). Four fraud failure stories tell it all: Satyam, Enron, Salomon Brothers, and Madoff. (see Figure 1.2). Enron is the fi rst major corporate fraud to be known to the public and concerns the nonrespect of corporate governance and market inefficiency that allowed Enron management to create a virtual company with virtual profits. This involved a combination of aggressive accounting, off-balancesheet deals, employee intimidation and adviser bribing, and market manipulations. Satyam Systems, a global IT company based in India, also joined, beginning in 2009, the list of notorious companies involved in fraudulent fi nancial activities. It undertook accounting improprieties that overstated the company’s revenues and profits and reported a cash holding of approximately $1.04 billion that simply did not exist. Like many others fi nancial institutions, Salomon Brothers expanded aggressively into property-related investments, including so called subprime mortgages—loans to people on low incomes or with poor credit histories. Salomon traders were also caught submitting false bids to the US Treasury in an attempt to purchase more Treasury bonds than permitted by one buyer. Finally, Madoff used a giant Ponzi scheme to rob a long list of sophisticated investors. “For years, it seems, the returns paid to investors came, in part at least, not from real investment gains but from inflows from new clients. It might still have been going on, were it not for the global fi nancial crisis” (The Economist, 2008a). All four fraud cases were fi nally caught in what we call here the market

Corporate Governance and Corporate Strategy

7

liquidity trap. Indeed, the market can temporarily be fooled by fraudulent assertions, but in the long run it always requires a cash flow at the level of the assertions, and as Warren Buffett put it, “Only when the tide goes out is it clear who was swimming naked.” The fi nancial sector, which was intended to protect against fraud and crisis, is no exception either. For the critics of modern fi nance, Bear’s swift end on March 16th was the inevitable consequence of the laissez-faire philosophy that allowed financial services to innovate and spread almost unchecked. Fraud has been rampant in the sale of subprime mortgages. Spurred by pay that was geared to short-term gains, bankers and fund managers stand accused of pocketing bonuses with no thought for the longer-term consequences of what they were doing. Their gambling has been fed by the knowledge that, if disaster struck, someone else—borrowers, investors, taxpayers—would end up bearing at least some of the losses. (The Economist, 2008b) Investment banks have become real debt machines trading heavily for themselves. “Goldman Sachs is using about $40 billion of equity as the foundation for $1.1 trillion of assets. At Merrill Lynch, the most leveraged, $1 trillion of assets is teetering on around $30 billion of equity” (The Economist 2008b). As should be expected, any trivial decrease in assets values will wipe out investors. Frauds and high economic crime rate globally (PricewaterhouseCoopers 2007 survey) and that “nearly one of two companies fell victim to economic crime in the last two years.” The cost of fraud is difficult to assess. “Fraud is big business internationally. Reported losses are in excess of US$ 1 billion and no country is immune to the depredations of a fraudster” (KPMG, 1999). As for many economic concepts, the corporate concept is a two-sided coin, with positive and negative sides. Corporate governance is the means by which the negative side can be discouraged from occurring when the coin is fl ipped. The situation underscores, however, the fact that those responsible for guaranteeing corporate governance and trust in the fi nancial system failed to do their job by not detecting frauds, and sometimes contributing even to their initiation. “Such drastic failure to discourage and deter fraudulent behaviors was as unforgivable as shocking and frightening” (Frankel, 2006). It is then only a matter of fairness to require some minimum level of good governance from corporations, as it is also a matter of economic growth, democracy, and social justice.

CORPORATE GOVERNANCE Corporate governance deals with the way managers govern themselves, but most importantly it is a matter of personal conviction and values. To fully understand the concept of governance, a brief history will be helpful. The

8

Internal and External Aspects of Corporate Governance

word itself comes from the old French gouvernance, meaning government. It quickly crossed the English Channel, losing, however, its letter u and becoming “governance.” While keeping the same meaning, the term has been shelved for many centuries. The way it is used today appears like a three-note melody. It all started at the end of the eighties, when international organizations, faced with repeated failures of their structural adjustment programs, were searching for ways out; that have decided for its use again. Seriously disillusioned, World Bank officials incriminated political frameworks in developing countries and called for upstream action directed on the mode of government. Status of international agencies expressly prohibits them from interfering in the political system of their clients, while such systems have a determinant impact on the success of structural programs. The term governance was called to the rescue. Denominated in technical terms, it allows circumventing political issues. The World Bank, for instance, defines governance as “the way in which power is exercised in the management of social and economic resources of a country for development.” Such a definition is made instrumental by imposing a set of four requirements, easier to define than to implement: (i) Establishing a state of law that guarantees the security of citizens and law enforcement; (ii) Setting a good public administration that requires proper management and equitable public spending; (iii) Underscoring responsibility and accountability, which require that managers are accountable for their actions before the citizens; and (iv) Requiring a transparency that allows each citizen to access and use pertinent information. The restructuring orientation of the World Bank model will inspire most corporate governance legislative initiatives that follow, especially the Sarbanes-Oxley Act of the United States (Sarbanes-Oxley, 2002). By the end of the 1990s, many Asian countries were facing a severe fi nancial crisis and again, international experts saw a governance crisis caused by a lack of business ethics and effective transparency. The Asian fi nancial crisis of 1997 has actually placed governance on the agenda of the Organisation for Economic Co-operation and Development (OECD), which published its governance principles in 1998, dealing with: (i) (ii) (iii) (iv) (v) (vi)

Responsibilities of the board; The basis of an effective framework for corporate governance; The right of shareholders; The fair treatment of shareholders; The role of shareholders; and The fi nancial disclosure and transparency.

The OECD initiative was focused on developing and transitional countries, and it took the implosion of Enron and the subsequent black series

Corporate Governance and Corporate Strategy

9

of corporate scandals to bring the message home to the economic powers of the world. It became obvious that these scandals were not just random acts of frauds and that most of them were in fact perpetuated within the legal systems and were sanctioned by the systemic failures of their own corporate governance systems. Corporate scandals and renowned malfeasances also highlighted the dramatic consequences of weak governance in organization and gave it a much higher priority. Considered as the most restrictive piece of legislation in American history, the Sarbanes-Oxley law is direct and immediate response to corporate scandals. It underscores the following corporate fields: (i) Stewardship; (ii) Responsibility and accountability in the organization; and (iii) Organizational transparency. Although Sarbanes-Oxley focuses only on flaws in the system, it has profound echoes all over the world. Sarbanes-Oxley and similar national legislations that follow were put into practice by exchange guidelines and security commissions, and were significantly transformed into highly lucrative business opportunities by accounting and legal fi rms. The Sarbanes-Oxley act gave rise to a new form of business management tools like internal control, risk management, and so on, rooted in governance principles originating from different horizons, whether from international organization or national legislations. It is believed that corporate governance may significantly be affected by relationships among participants of the corporate governance system. The following have their voice in the process (OECD, 2004): (i) Controlling shareholders, whether individuals, family holdings, bloc alliances, or similar corporations acting through a holding company or cross shareholdings, can significantly influence corporate behavior; (ii) Institutional investors, as owners of equity, are increasingly demanding and ask for a voice in corporate governance in some markets; (iii) Individual shareholders, whereas they apparently do not seek to exercise governance rights, may be highly concerned about obtaining fair treatment from controlling shareholders and management; (iv) Creditors may also play an important role in a number of governance systems and can serve as external monitors over corporate performance; (v) Employees and other stakeholders play an important role in contributing to the long-term success and performance of the corporation; and (vi) Governments establish the overall institutional and legal framework for corporate governance. The role of each of these corporate governance participants and their interactions may vary widely among countries and regions because the listed

10

Internal and External Aspects of Corporate Governance

relationships are subject, in part, to laws and regulations and to voluntary adaptation and, most importantly, to market forces. Legal and academic efforts to curb bad governance have emanated especially from the United States and they have naturally focused on safeguarding the American system. The American environment conditions cannot, however, be necessarily encountered in other regions of the world, where family property and public sector preponderance are the rule. Generally, corporate governance has a wider implication on economic and social well-being. First, it provides performance measures to achieve business success, and second, it ensures the accountability and transparency for equitable distribution of wealth. It should also aim to “ . . . holding the balance between individual and communal goals” (Clarke, 2005). Recently abuses to corporate governance were on the rise and, at the same time, the barriers to discourage frauds have been decreasing (Balkan, 2004). More deceiving, those who are responsible for guaranteeing trust in the fi nancial system, that is, auditors, rating agencies, investment bankers, boards of directors, lawyers, accountants, and so on, were used as facilitating instruments. It is only recently that governments, under extreme public pressure, were forced to act, and different defense mechanisms against weak corporate governance were suggested. In seeking the best way to restore the lost trust in the financial system, various legislative bodies look to different means to ensure improved governance behavior. Many mechanisms cohabitate, however, with the law and regulations, as suggested by Figure 1.3. Some of them are internal (institutional, operational, or informational); others are external, but none is cost free and all share the same objective, that is, the increase of organizational efficiency and ethic. Restoring faith in market and corporate governance by investors has become an extremely sensitive issue, especially in an era of a global securities exchange. For this reason, crucial initiatives were undertaken to ensure that capital continues to flow into the business sphere through reinforcement and investors’ confidence in markets and institutions and their ability to accurately assess the value and potential of investments. Institutional corporate governance defense mechanisms are those imposed by law with regard to corporate internal structure. They mainly concern shareholders’ meetings, boards of directors, and its committees, while operational corporate governance defense mechanisms are endogenous to the organization and are mainly embodied in both the risk management and the internal control systems of the organization. External corporate governance defense mechanisms, on the other hand, are those exogenous to the organization, like external auditors, the market for corporate ownership, specialized rating agencies, and even cultural values. The most shared objective of corporate governance defense mechanisms, regardless of their group of belonging, seems to be embodied in the respect of shareholders’ interest, and such objective is supposed to be reached through the maximization of the market value of the corporation. Although such a view is challenged by many, it still constitutes the dominant paradigm.

Corporate Governance and Corporate Strategy

11

LEGAL

INSTITUTIONAL

EXTERNAL

CORPORATE/GOVERNANCE DEFENSE MECHANISMS

OPERATIONAL

Figure 1.3

INFORMATIONAL

Classification of corporate governance defense mechanisms.

By themselves, however, none of these mechanisms of corporate governance defense has been completely effective. Institutional mechanisms alone are not strong enough to ensure honesty and efficiency within the organization. Laws and legislation imposing specific governance models on their own have not been successful either. The corporate governance system will be given a better chance to work if each class of corporate governance mechanisms is meant to be supportive of the others and when actors adopt an ethical attitude toward business. Together they may form a whole, a kind of “diversified” package, whose purpose is to ensure efficiency and ethics within the organization and ultimately maximize the market value of shares. The relative weight of any component in the package may vary, however, with the nature of relationships among people and environments, and as their balance changes, their impact on corporate governance efficiency may change as well.

HOW CORPORATE GOVERNANCE ENHANCES ORGANIZATION VALUE Finance views of corporate governance emanates from the strong belief that shareholders’ interests are best served by actions that maximize share prices in the short run, mainly because this view fi rmly assumes that today’s price

12

Internal and External Aspects of Corporate Governance

of shares fully reflects the market’s best estimate of the value of all future profits and growth that will accrue to the company whose share is involved (Blair, 1995). Other views of corporate governance exist. The market myopia view, for instance, questions the ability of today’s stock prices to be a reliable enough guide for future value and return from the company’s investment, to the exclusive focus of managerial consideration. The social responsible company view believes that corporations do not exist solely to provide returns to shareholders. Instead, corporations must serve a large social purpose. The idea that corporations should have some social purpose, beyond maximizing shareholder wealth, is making its way. It is currently more commonly believed that corporations should exist to create wealth for the whole society. Accordingly, the aim of corporate governance mechanisms and the responsibility of corporate directors are undergoing a certain shift in their purposes, and companies are more and more expected to work for a broader goal that may include shareholders’ wealth maximization, indeed (Blair, 1995). As underlined in Figure 1.3, all corporate governance defense mechanisms, whether institutional, operational, informational, or external, share the same goal: maximizing shares’ market price (Agrawal & Knoeber, 1996; Shleifer & Vishny, 1997). Although, as already mentioned, this is not the only view, recent research conducted by McKinsey & Co. (cited in Deloitte, 2004) found that: (i) Fifty-seven percent of institutional investors recognize that good corporate governance determines the increased/decreased value of their holdings in a company; (ii) Up to 41% of investors, depending on their country of origin, are willing to pay a premium for good governance; and (iii) Companies can expect, by moving from worst to best in corporate governance, a 10–12% gain in their market valuation. Finance theory would argue that this can only be done by reaching an optimum risk-return trade-off. Seeking a desired interpretation of accounting numbers, managers can actually effect investors’ impressions by acting on transactions’ timing or by restructuring them (Daily, Luehlfi ng, & Phillips, 2001; Godfrey, Mather, & Ramsay, 2003; Healy & Whalen, 1999), but not when markets are really efficient. Especially that market price (shareholders’ wealth) during any given period is related to market return, and as such could be impacted by financial reporting (Chayaler, 1995). Indeed, it was found that policies of managing income numbers, such as net income, revenues, or dividends, may affect market returns. They are also found to be significantly correlated to market prices and market returns; they can therefore have a significant effect on market price (Bitner & Dolan, 1996). This conclusion indicates that market values of corporations are positively affected by their gross margins, growth rates, and profits. Figure

Corporate Governance and Corporate Strategy

13

1.4 underlines the fact that institutional, operational, and informational governance mechanisms all aim to ensure a management quality that optimizes the trade-off “risk-return” and that aims to market value maximization. Such mechanisms are not, however, free from cost and should be backed up by appropriate value-added policies. The rationalization behind such affi rmation is that governance mechanisms are supposed to improve the corporate ability to gather funds, thus reducing operating and fi nancial risk and consequently lowering the rate of return required by investors or cost of capital. Given the scarcity of research on the subject, and even if logically we can expect governance to have a positive effect on the value of organizations, we are still unable to prove it. One of the reasons might be the poor defi nition of the weakly structured theoretical landscape surrounding governance. Although delegated to the board of directors, the responsibility of corporate governance belongs to the shareholders’ meeting. It is then crucial for shareholders to be ensured of the efficiency and credibility of the board. By seeking effective corporation governance, the board of directors and its different committees should not care only about the increase of the organization market value but also about how such an increase is actually achieved. In other words, the board should make sure that the road followed for attaining this purpose goes through ethics and of others’ respect, and this can be done by choosing the appropriate structure. Indeed, an organization will create more wealth for itself and

CORPORATE GOVERNANCE INTERNAL MECHANISIMS

INSTITUTIONAL

EXTERNAL MECHANISMS

OPERATIONAL

INFORMATIONAL MARKET EXPECTATION

Figure 1.4

Corporate governance defense mechanisms’ assumed objective.

14

Internal and External Aspects of Corporate Governance

for society as a whole by adopting ethical strategies, securing the organization a reputation of integrity. The board should also put in place the appropriate structure, the one which will favor good organizational governance. The board should look for the appropriate institutional structure that will help to align the interests of shareholders and managers and supply proper incentives for the board and management to act in the interest of the company and its shareholders. Such structure should encourage collaboration and discourage confrontation. In an increasingly globalized economy where competition is intense, good governance can make a difference. At the operational level, market value maximization can be reached by having in place efficient operational corporate governance mechanisms, especially a well-performing internal control system, including an appropriate risk management system and an efficient reporting system. The internal control is the system intended to help the organization to reach its objective in the most efficient and transparent way. In our view, the objective of the internal control system should go beyond this classical objective of ensuring information quality in order to embrace organization efficiency. This can only be achieved by controlling revenue, costs, and processes. It should also be capable of identifying promptly material weaknesses in internal control and taking corrective steps. Securing the market with regard to efficiency, risk mastering, absence of fraud, and fi nancial information quality can only enhance market value, as indicated by Figure 1.5. From Figure 1.5 a number of conclusions can be drawn with regard to the relationship between operational corporate governance mechanisms and market risk-return expectations and market value: First, for a corporation to be capable of efficiently managing its costs, it should have in place an appropriate process whereby the control of various costs of doing business is assured. Costs management is never done, however, in isolation; it is usually performed in conjunction with revenue and profit management. Often, in order to enhance revenues and profits, managers may

REVENUE-COSTS MANAGEMENT

TRANSPARENCY

INTERNAL CONTROL

RISK MANAGEMENT

Figure 1.5

Internal control objectives.

MARKET EXPECTATION

Corporate Governance and Corporate Strategy

15

deliberately accept incurring additional charges. Costs and revenue management is generally a strategy result; it usually stems from management’s belief that value increase for customers and lower costs of products and services are parts of an integral strategy of value maximization. Second, as a corollary for an efficient internal control system is an efficient risk management. Although risk management will be discussed at length in the following chapter, we can already say that it involves prudent risk taking for the sake of profitability. It is believed that the market privileges a stable and sustainable rate of return for every dollar of risk taken, while the organization is ensuring investment in its businesses to secure its future growth objectives. Practically, such an aim is reached through the thorough analysis of the various risk elements to which the corporation is exposed and the assessment of the impact and the likelihood of each one of them. By acting this way, the corporation is obviously hoping to certainly meet market expectation of return stability and growth. Risk management and internal control systems appear to be but two faces of the same coin. While risk is the possibility that the corporate return can be adversely affected by an unexpected event or action, internal control is the process by which the organization makes sure risks are kept at their lowest level possible. Management needs, therefore, to effectively balance risks and controls. Control procedures should be tailored in a way that risks can be brought back to levels with which management is comfortable and accept exposure. Internal controls and risk management policies are more efficient when proactive, value-added releaser, and cost-effective. Performing efficiently and managing risk intelligently may not be enough if it is not brought to the attention of investors in the marketplace. In order to be able to inform and convince investors, individually and collectively as a market, about the effectiveness of its internal control (risk management and revenue-cost management), organizations need to have in place an efficient and transparent reporting system. As we know, investors express their appreciation of the organization through their required rate of return, translating into market price in exchanges. Such required rate of return usually incorporates an informational risk component, associated information asymmetry (Barry & Brown, 1986), which can be reduced by the adoption of a reporting strategy, based on transparency (Botosan, 1997; Dye, 2001). Doubt with regard to fi nancial reporting quality will surely impact the overall risk of the organization and consequently will increase investors’ required rate of return. Corporate governance informational quality depends, however, on the state of other internal mechanisms (Healey & Palepu, 2001). Figure 1.6 allows the full understanding of the importance of corporate transparency. In the IEM model exposed in Figure 1.6, “I” goes for investor, “E” for the organization (enterprise), and “M” for the market. The EM axis describes information flows, the IM axis describes the assessment or valuation process, and the IE axis describes the decision-making process. Figure 1.6

16

Internal and External Aspects of Corporate Governance

shows that, like a beam of light emitted by a pocket flashlight, the information emanating from the firm (EM) will be taken into consideration by the investor, and therefore reflected on the value of shares (MI), only if the mirror, represented by the market, does not warp this reality, that is, only if information is transparent. The initiative for disclosing information lies within the corporation; the filter of transparency is required by law, regulation, culture, and ethics to be aimed at ensuring the quality and availability of such information, as well as keeping the market from becoming a warped mirror. For so long fi nancial transparency of organizations was limited to complying with laws and standards. Today, information is considered transparent only if there is no impediment to its harmony. Transparent information is therefore information that is accessible, comprehensive, of high quality, relevant, and reliable (CICA, Chapter 1000). Efforts made to defi ne information and its qualitative characteristics have mainly come from accounting-standard agencies, which deal with problems very early. Information is qualified as relevant when it is able to affect the decision made by its user, whereas its quality and reliability concern its solidity, as well as its ability to represent the economic reality.2 Nonetheless, recent events have shown that transparency is more than this; it also entails honesty and fairness. It is admitted today that good behavior in terms of transparency can only be judged on the basis of the described qualities. Even though it was temporarily neglected, the ethical dimension of transparency has long been present in academic debates. The Accounting Principle Board (APB), for example, defi nes the term useful information as information aimed at a general goal of ethics and “justice” and which is accepted as such by society as a whole. The APB goes even further. It places the objectives of ethics and relevance on an equal footing. From this viewpoint, the APB is close to the European view of transparency and appears to be moving away from the viewpoint of the Financial Accounting Standard Board (FASB), which, for practical reasons, stresses relevance (FASB 2), bringing along with it the International Accounting Standard Board (IASB). For the FASB,

I Decision

Evaluation

E

M Efficiency

Transparency Information

Figure 1.6

The financial decision-making triangle, IEM model.

Corporate Governance and Corporate Strategy

17

the relevance of information can be summed up by its capacity to make a difference in the decision-making process, helping its users analyze past, present, and future events to confi rm or correct forecasts (APB4). Whenever transparency is lacking, it means the organization is able to work the flashlight as it likes and therefore is able to change colors as it wishes, red, white, or blue, depending on circumstances. At the other extreme, the market works as a reflector, and its reflection will be far from being faithful, if the light signal emanation from the corporation is a fake. Transparency and efficiency are thus the two pillars of fi nancial disclosure. Complementary and interdependent, these two notions can only be dealt with in concert. Efforts toward transparency must therefore be aimed at both ethical information disclosure mechanisms and improvement of markets’ ability to faithfully reflect the information received. Unfortunately, recent events show that neither of these two conditions is being yet fully met.

EXTERNAL CORPORATE GOVERNANCE MECHANISMS External corporate governance mechanisms, on the other hand, are mechanisms originating from outside the corporation, but which might have similar effect on corporate risk and efficiency, by forcing management to obey rational management rules. Market for corporate control, for instance, given the possibility of ownership transfer it allows, may force corporate managements to behave efficiently (to run the company in shareholders’ best interest, i.e., maximizing return and minimizing risk) as well as ethically. The failure to do so, on the part of management, may be seen as an investment opportunity. It indeed provides potential bidders with a profitable chance for acquiring undervalued badly managed companies and replacing their ineffective managers. Rating agencies, whose role is assessing how likely a debt issuer is to make timely payments on a fi nancial obligation, may also have a proficient effect on corporate governance improvement. By their ability to assess organizations’ creditworthiness, credit ratings are often considered as indicators of organizations’ distress risk, or bankruptcy. Rating agencies can, therefore, be considered an external corporate governance mechanism. International fi nancial reporting standards (IFRS) can also have a significant impact on corporate governance improvement around the world. Indeed, international accounting harmonization, through the universal use of IFRS, has an unchallenged positive effect on financial transparency and consequently on corporate governance in most parts of the world. IFRS can be considered as efficient external corporate defense mechanisms. Most corporate governance mechanisms are very quick to accuse their limit, and trust is called upon as a last recourse, mainly in specific situations: fi rst, whenever numerous solutions to a single problem are suggested, but in a way that it is impossible to make a rational choice; second, in situations where formal structures cannot explain individual

18 Internal and External Aspects of Corporate Governance behaviors; and fi nally in cases of contractual arrangement incompleteness, where all the possibilities cannot be covered by contractual provisions. Whereas agency theory emphasizes formal mechanisms and contractual provisions based on rewards, sanctions, and monitoring, trust emphasizes informal mechanisms, requiring solely good faith. Trust and other social values can play, in most environments, a significant role as external mechanisms of corporate governance. Corporate governance defense mechanisms, whether institutional, operational, or external, have a similar impact on corporate risk and return. Institutional and operational mechanisms have a direct effect on corporate governance, whereas external mechanisms have indirect effects. All mechanisms will, ultimately, encourage the corporation to meet market expectation with regard to risk and return. Corporations, however, do not have a direct levy on market value. They have to go through processes of signalization, charm, and conviction, but they can also set benchmarks to show the market the seriousness and the soundness of their endeavors. Our discussion assumes the existence of such mechanisms as: (i) efficient markets; (ii) diffuse shareholding; and (iii) corporate gigantism, and so on. Such conditions can be met, however, in very few but leading environments. Most environments are captive of their history and would accuse different environmental conditions such as: (i) family property; (ii) transactions based on the personal relation and word given; and (iii) preponderance of an inefficient public sector. We believe that our conclusions can fit any environment with the appropriate adjustments to the local conditions, with regard to cultural values, market advances, economic development, and the like.

OVERVIEW OF THE BOOK Most corporate governance reforms impacted by the Sarbanes-Oxley Bill of the United States deal mainly with its internal mechanisms, undervaluating somehow its external mechanisms. This book deals, in a systemic approach, with internal and external mechanisms of corporate governance, while underscoring their interdependence. This overview chapter helps us highlight in a more explicit way the novelty of our approach and the vision of the traditional and emerging agenda in the corporate governance subject area. It assumes that all corporate governance defense mechanisms share but one objective: optimizing ethically the efficiency of the organization in order to maximize its market value. Chapter 1 introduced us to the world of corporations and corporate governance. It also emphasized the common objectives shared by all corporate governance mechanisms, whether institutional, operational, reporting, or external, which is value maximization of the organization through ethics and efficiency. Such objective will constitutes the main theme throughout the book.

Corporate Governance and Corporate Strategy

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Chapter 2, “Corporate Governance: The Voluntary and the Legal Frameworks,” shows that two conventional approaches of corporate governance have been proposed, the voluntary contractual approach and the legal approach (the imposed approach). It emphasizes their limits and underscores the supervisory role played by the international organizations. Chapter 3, “The Board of Directors and Corporate Governance,” stresses the fact that most recent corporate governance legislations, guidelines, and reforms focus on reorganizing and formalizing the board of directors’ structure and introduce new standards of accountability in order to provide the board with the necessary conditions for the success of its role. Chapter 4: The standing committees of the board of directors are given a wide range of responsibilities and functions. The high emphasis placed on the committees’ system for resolving board issues can probably be explained by its practical benefits, although it may also present some problems. Chapter 5: Internal control indicates that the shortest way for an organization to achieve its objective is by having in place an efficient internal control system that can help in achieving performance and profitability targets, preventing loss of resources, ensuring reliable fi nancial reporting and compliance with the law. Chapter 6: Risk management underscores the fact that risk taking activity is unavoidable for organizations and that those that do not take risks may actually be failing their responsibilities. It is therefore an obligation for organizations to manage effectively their risks. Chapter 7, “International Financial Reporting and Corporate Governance,” expresses clearly the need for international comparability and advocates international convergence. It explains how international fi nancial reporting standards (IFRS) may impact corporate governance quality. Chapter 8: Audit systems make it clear that the responsibility of publicly disclosed fi nancial statements, quality, and completeness lie in the board of directors’ hands. The board usually entrusts such a task to one of its special committees (called the audit committee), which in turn can use an external auditing service to help execute the job. Chapter 9: Credit rating, fi nancial institutions, and corporate governance explain how credit ratings are used by investors, issuers, investment banks, broker-dealers, and governments. It also discusses the economic role of credit ratings in corporate governance. Chapter 10: Financial market and corporate governance suggest that markets for corporate control represent the historical development of the capital market and represent a distinct type and can actually have a tripleaction effect on corporate governance improvement. They act as an external counseling, remunerating, and disciplinary mechanisms. Chapter 11: Corporate governance in less developed economies suggests that in developing and emerging countries the potential importance of corporate governance was long ignored and should be dealt with in the most serious way, given that economic development is subjected to it.

20 Internal and External Aspects of Corporate Governance Chapter 12: Corporate governance requirement of trust reminds us that fi nancial systems are suffering extremely from weak trust in business relationships. Trust seems to be called upon only as a last recourse, mainly in specific situations. Chapter 13 regrets that fi nancial authorities fail to look at the current corporate governance failure as a whole system failure and argues that as long as this is not done, it will be difficult to fi nd an appropriate solution to this problem.

CONCLUSION As a rule, sound corporate governance practices help increase the flow of capital and lower its cost for companies that need to fi nance their investment in real assets—human and technological as well as material and, thus, contribute to the economic development of a country (Claessens & Tzioumis, 2006). This awareness generally reflects the necessity of moving successfully from heavily relationship-based to effectively rules-based systems of governance. This book intends to look at corporate governance in a systemic way, underscoring the interrelations existing between its diverse components, and stressing the requirement to tailor it to the specific needs of each economic environment, including the developing and the emergent. In any case, “corporate governance must no longer confine its analysis to the relationship between managers, boards and shareholders. The narrowness of this focus is a major contributing factor to the present round of corporate scandals of which Enron is the most emblematic” (Deakin, & Konzelmann, 2003), and it should always be remembered that “that business ethics at its core is about excellence and high attainment rather than misdeeds and malfeasance” (Paine, 2003). Things seem to be changing for the better and it is up to those in charge to change the current chaos to an opportunity. The fi nancial system is surely due for change and change does not occur smoothly. It is hopeful this opportunity would not be missed.

COMPREHENSIVE CASE 1.1

Adam Smith, The Wealth of Nations You can fi nd a discussion of Adam’s Smith book The Wealth of Nations in Wikipedia at: http://en.wikipedia.org/wiki/Wealth_of_Nations. Adam Smith’s work, from 1776, helped create the discipline of economics “with its conjuring of the invisible hand, self-interest, and other explanations of market forces that have influenced academics, governments, and business leaders ever since (Cullen, 2006).” Discuss Smith’s main contribution to economic thought.

2

Corporate Governance The Voluntary and the Legal Frameworks

Except for minor restrictions preventing negative effects of monopolistic positions or unfair competition, efforts were constantly made to maintain corporate environments free from constraints of all kinds. Yet in the absence of adequate supervision, companies were not necessarily inclined to adopt appropriate behavior, as evidenced by the recent wave of corporate scandals. Although history is full of examples of abuses of all kinds and it would be unreasonable to expect a different outcome today, the fi nancial system has, however, never been so seriously affected as by the recent spate of weak corporate governance. The academics were the fi rst to trigger the alarm and seek appropriate solutions to corporate governance breaches; their endeavor remained limited, but the ferocity of the recent scandals has also forced the legislature to act. Consequently, two conventional approaches of corporate governance have been advanced, the voluntary contractual approach (Jensen & Meckling, 1976) and the legally imposed approach (SOX, guidelines of international organizations). Regulatory changes brought on by recent corporate reforms have broadly redefi ned the roles and responsibilities of most of the participants in a public company’s governance. This chapter examines each of these approaches, while emphasizing their limits and stressing the supervisory role played by the international institutions.

THE CONTRACTUAL/VOLUNTARY CORPORATE GOVERNANCE FRAMEWORK It is more commonly admitted by now that companies with good governance systems in place are usually able to ensure the market that there exist within them sound systems of authority sharing and operation controls. It is, however, commonly feared that when a sound corporate governance system is lacking and interests of management and stakeholders are not in line, “agency problem” may occur. Agency theory (Jensen & Meckling, 1976) has strongly impacted business thinking for decades, with regard to the nature of the relationships between stakeholders and the management; and this is what is termed as agency relation, also defined as a contract under which

22

Internal and External Aspects of Corporate Governance

one party (the principal) engages another party (the agent) to perform some service on his/her behalf. It is easy to understand that within the provisions of such contractual relationship, the principal will likely be delegating some of his decision-making rights to his agent. This, of course, is in line with the belief that the structure of authority within the organization is actually a succession of authority delegations: (i) shareholders delegating to the board, (ii) the board delegating to the CEO, and (iii) the CEO delegating to other high-ranking officers of the organization. Given the heavily delegating character of the organization, one can then understand that agency problems will arise mainly from of the impossibility of perfectly contracting for every possible action of any delegated agent. His decisions, by the way, will finally affect not only his welfare but also the welfare of the principal who delegates him the necessary authority to do the job. The main agency challenge in a corporate governance framework and at least the most impacting emerges from the difficulty of finding ways of inducing managers to act in the best interests of their shareholders. The seriousness of such challenge is hopefully supposedly reduced, as specific managerial incentives are discovered and used to induce managers to respect the shareholders’ wealth-maximizing rule in their decision making (Jensen & Meckling, 1976). As with any cost, agency costs will inevitably be captured by financial markets, and will ultimately be reflected in companies’ share prices. Agency costs can then be seen as the market value loss to shareholders, arising from divergences of their interests from those of corporate managers. Agency problems have multiple origins and lead to diverse consequences. Management can, for instance, “use pre-commitment to dividend payments to mitigate the agency conflict due to poor governance” (Kose & Knyazeva, 2007).

AGENCY ORIGINS Agency theory focuses on aligning the potentially confl icting interests of owners and managers. From an agency perspective, managers cannot be trusted and this may prove to be an extreme hypothesis; consequently, boards have to actively participate in corporate strategic choice and ensure management monitoring if shareholders’ interests are to be protected against management’s self-interests (Kiel & Nicholson, 2003). As underscored previously, agency problems would always occur whenever contractual relations involve confl icts of interest between partners, and this seems to be always the case, but also because contractual agreements have their own inherent limitations, because it will always be impossible to contract for all possible scenarios entitled for every contractual relation. Many management actions are naturally susceptible to giving rise to some agency limitation. This section will discuss only agency causes of agency problems, which seem common to us (Figure 2.1).

Corporate Governance Earnings Retention

Moral hazard

23

Time Horizon

AGENCY ORIGINS

Managerial Risk Aversion

AGENCY PROBLEMS

Figure 2.1

Agency causes.

The causes of agency problems may stem from different origins and those are called moral hazard, earning retention, time horizon, or managerial risk aversion. The first explanation of moral hazard in agency relationships assumed the case of a single manager who owns the entire company, and suggests a model that explains how such manager’s incentive to enjoy private perquisites increases with the decline in his ownership proportion in the company’s equity (Jensen & Meckling, 1976). Even in cases where the manager is seeking value maximization as he should, he may still do it his own way; he may still opt for investments that best accommodate his own personal skills, competency, and preferences, while maximizing shareholders’ wealth. Several reasons may justify such behavior: such strategy may increase manager’s job safety and will make it difficult and costly to replace him in the organization; it will further increase his negotiating power; and finally, it will supply him with a golden opportunity of extracting higher levels of remuneration (Shleifer & Vishny, 1989). Because increasing firm size seems to go hand in hand with increasing fi rm’s contracting nexus complexity, larger firms are therefore expected to suffer more from moral-hazard problems and consequently endure additional cost increases (Jensen, 1976). It is also expected, however, that in larger and more established firms, moralhazard problems can be overshadowed by free-cash-flow considerations, as it is believed that when managers have free-cash-flow funds at their disposal, their thirst for private perquisite consumption is tremendously increased whenever they have a sense that monitoring the way corporate funds are used is becoming difficult or even proving to be impossible (Jensen, 1986). Earnings-retention agency conflicts were also widely debated in the literature, and since management compensation structure seemingly increases with the company size, it is easy to expect and even suspect management to have every possible reason to focus on size growth, rather than on the classical maximization of shareholders’ wealth objective (Jensen, 1986). The

24

Internal and External Aspects of Corporate Governance

reason is that size increase allows greater management prestige while at the same time giving it more power and permitting it much easier domination of the board. It consequently makes it easier for management to award itself higher levels of remuneration and compensation (Jensen, 1986). Whenever, however, the increase in the corporate size is made for diversification purpose, it is easy to see, as explained earlier, that the resulting fi rm specific risk reduction will also induce an improvement in manager’s job security, mainly by consolidating its skill and competency image. Earnings retention is also expected to be privileged by management for financing purposes, whenever internal profitable investment opportunities exist. Unfortunately, although earnings retentions may reduce the need for outside fi nancing and therefore reduce potential costs of raising new external capital, they may also reduce as well the constraining and efficient monitoring of the management, by the capital market. Most shareholders are generally expected to be more concerned with future cash flows of their company, while management may be more concerned with those cash flows that are matching their own terms of employment, and this inevitably will lead to the time-horizon agency conflicts. Consequently, short-term projects promising high accounting returns are expected to be favored by management, at the expense of longer term projects promissing positive net present values (Dechow & Sloan, 1991), and such investment term preference policy will be even exacerbated by management retirement proximity. This divergence in horizon objectives may also lead to managers using subjective accounting practices to manipulate earnings and other strategic accounting numbers, especially prior to leaving their office, aiming at the maximization of their performance-based bonuses (Healy, 1985; Weisbach, 1988). Management income objectives may not always conform to the classical portfolio diversification requirements. Whenever this happens it leads to agency conflicts of a special nature, namely, the managerial risk aversion agency conflicts. In such cases managers may seek to minimize their company’s risk through firm diversification for the sake of securing more compensation income. They will avoid, for instance, any investment decision which would increase risk and which may endanger their personal income (Bartlett, 2006). Managers would rather follow a diversification policy of investment which is susceptible to reducing the overall organization risk and in the same vein securing even more of their personal income. Such managerial risk aversion policy allows also management to ensure better job security at a lower cost. A perfect example of such managerial risk aversion strategy will be the indebtedness policy. Debts are definitely susceptible to reducing agency conflicts (Jensen, 1986). Risk aversion managers would, however, prefer equity financing, even when indebtedness is possible, mainly because debts increase the risk of bankruptcy and default would cause tighter monitoring. It is commonly suggested, however, that should shareholders wish to diversify their holdings they can do it themselves and at lower cost.

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Agency problems may, however, diverge by cultural differences. The most important agency problem in the United States, for instance, resides in the relationship between the management and the board, on the one hand, and external shareholding on the other. Within such a relationship, management strives toward the maximization of its own utility at the expense of external shareholding. In most others country, such as Japan or continental Europe, where corporate ownership is concentrated in the hands of major banks and other large fi nancial institutions or families, agency relations are quite different. Agency relations are also different in emerging Asian economies or the Middle East and North African (MENA countries), where ownership is typically concentrated in very few family hands. Family shareholding tries also to maximize its own utility at the expense of other stakeholders, through nondeclared intermediaries or by other means. In such cases major agency problems lie between ownership/ board control and minority shareholding. In other environments, such as the Chinese or Commonwealth of Independent States of the former Soviet Union, the most important agency problem is a multidimensional one. It exists between the state, as majority shareholder, and external minority shareholders, and the protection of minority shareholders’ rights constitutes one of the economic key considerations in those countries. From an agency theory point of view, management is a shareholder’s agent, as indicated previously, whose mandate is the maximization of shareholders’ wealth; and management is responsible to shareholders only, in cases of success, like in those of failure. Usually a new contract, a cost decrease, a profit increase, or a value improvement are all indisputable proof of good performance and the reverse is true.

AGENCY CONSEQUENCES Agency relations have their own associated costs. As indicated in Figure 2.2, they are traditionally divided into monitoring costs, bonding costs, and residual loss (Jensen & Mecking, 1976). Monitoring costs are embodied in all the expenditures engaged in by the principal in order to efficiently monitor his agent and to help respect the mandate and its spirit. Monitoring costs usually cover the cost of writing contractual agreements and the cost of auditing. Although such costs are initially carried by the principal, it is agreed that they will ultimately be assumed by the agent because his compensation is supposed to be adjusted to cover such costs. This is at least what is commonly suggested (Fama & Jensen, 1983). Most recent corporate governance national systems have dealt with certain aspects of agency monitoring, because they believed that monitoring activities may act as a powerful deterrent to managerial malfeasance. The US Securities Exchange Commission requires, for instance, that listed companies provide statements of compliance with the Sarbanes-

26

Internal and External Aspects of Corporate Governance AGENCY ORIGINS

AGENCY PROBLEMS

Residual Loss

Monitoring Costs Bonding Costs

Figure 2.2

Agency consequences.

Oxley Act provisions with regard to organization’s internal and external auditing activities. European corporate governance directives require the same, although with less conviction. Bonding costs are the direct consequence of the agent awareness of being the ultimate bearer of the monitoring costs. Consequently, he is likely to set up appropriate structures to avoid paying too much and he will try, for instance, to discipline himself and have in place an appropriate system allowing him to show the shareholders that he is acting in their best interests. The voluntary establishment and adherence to such systems have their own costs, however, and the agent is believed to accept to bear them, at least up to a certain level. These costs have come to be known as bonding costs. As part of bonding costs, we can mention the cost of the additional information to be disclosed to shareholders, but bonding costs are not all financial. Agent acceptance of bearing bonding cost is far from being irrational, and the agent will cease incurring them as soon as the marginal reduction in monitoring equals the marginal increase in bonding costs. We should, however, be aware that the cost of fully enforcing principalagent contracts would usually far outweigh the benefits derived from such endeavor, and, further, trying to fully contract for every state of nature will always prove to be irrational. Even in the unthinkable case where monitoring and bonding efforts are correctly made, this still would not guarantee that managers will act completely in shareholders’ best interest, and this gives rise to a certain opportunity loss to be suffered by shareholders. This is what is commonly called residual loss. It means that an optimal level or residual loss should be looked at, for it might be seen as a trade-off between overly enforcing contractual mechanisms and totally constraining management to respect them. Residual losses are consequently designed for the purpose of reducing agency problems.

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27

The contractual/voluntary agency corporate governance relationship explains how managers and shareholders may act to control agency costs, in order to maximize fi rm value, but such model seems, however, to be constantly contradicted by real life events. Some managers have quickly learned how to subjugate corporate objectives for their own benefit, despite constraining contractual agreements. They have, for instance, learned how to juggle numbers to maximize their own option plans, and so on. In such cases suboptimality in decision making has resulted and has often become the rule for some business spheres for a long period of time. Trillions of dollars were unfairly misappropriated (hundred of trillions of dollars for the sole year 2008) and this may continue. The extent of such losses has constituted a real threat to the whole fi nancial system, and has endangered the economic and socially accomplished progress. Governments fi nally came to the conclusion of the need to react by a “legally” imposed corporate governance model led by the US. Most governments of the world have reacted to the 2000 corporate financial crisis quite strongly. They issue their own corporate governance legislations, and this has had a profound effect on the way their corporations are today doing business and the way they will be doing it in the future. It is feared, however, that the huge volume of new rules and regulations companies are submitted to (due to the legally imposed corporate), may have gone too far and may risk hampering the freedom to undertake. Despite skyrocketing corporate governance regulations’ costs, the risk of corporate misconducts was not quelled. The legal approach to corporate governance asks for the empowerment of board of directors supposed to monitor corporate managers, but also requires a strong shareholding, powerful independent auditors and credible credit-rating agencies. The legal approach is, advanced whenever public outrage is sufficiently high, when “the regulation is more brittle and less supple than would be ideal” (Roe, 2004), it is usually opposed .

LEGAL CORPORATE GOVERNANCE FRAMEWORKS Various legislative bodies around the world were seeking the best way of restoring the seriously threatened trust in the international fi nancial system, and they experiment with different legal means of ensuring sound governance. Public legislators are, however, divided between, on the one hand, their desires of maintaining alive self-interest that is supposed to keep the free market running. Indeed, “it is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own self-interest (Smith, 1993)”; on the other hand, their duty is to keep the market free from frauds and manipulations. Frauds are very evasive issues. Like moving sands in a swamp, you see them only once we are in, and for this reason vigilance should be the rule. All recent governance

28 Internal and External Aspects of Corporate Governance legislations share the same objective of ensuring that stock prices are protected and that investors will still be able to accurately assess corporate shares’ potential and therefore investing in them. Simultaneously, international agencies doubled their effort to convert developing countries to the ideal state of good governance. The fi rst formal tentative step to counter corporate governance abuses came from the Organisation for Economic Co-operation and Development (OECD). Under pressure from investors that had seen their investments crash and retirement funds melt away, the OECD was requested to develop a set of principles of corporate governance, and in May 1999 a set of principles of corporate governance was adopted and they constituted the fi rst international standard in the field (OECD 1999 principles). OECD’s initiative was originally concentrated on developing transition economies, but Enron’s implosion and the subsequent corporate scandals imposed the issue on the world scene and “market supervisory and regulatory institutions have come under greater pressure to upgrade their control procedures; stock exchanges were required to strengthen their listing conditions” (Bishop, 2004). On the other hand, transworld reforms were suggested and often imposed and quickly enacted across the globe. As major legislative pieces, both the OECD corporate governance principles and the SOX are worth being presented and understood, since they have and are having a profound impact on all similar legislation across the globe. It worth mentioning, however, that truth in laws and regulators has never been a reliable defense against fraud (Forbes, 2009). The next section is devoted to the presentation of the international principles for corporate governance and to other international initiatives and the following will be devoted to the discussion of the SOX.

INTERNATIONAL CORPORATE GOVERNANCE GUIDELINES The so-called “Washington Consensus,” under which Washington—and institutions under its influence, like the International Monetary Fund and the World Bank—pushed developing countries to open up their economies (Fukuyama, 2008) has also resulted in international initiatives in corporate governance. Figure 2.3 presents some of these initiatives. Most international initiatives of reforming corporate governance in the world emanate originally from the World Bank, which is indeed implicated either directly or indirectly in all international governance initiatives. In 1988 the World Bank expressed its serious disillusionment with the successive pitfalls of its adjustment programs for developing countries and its officials incriminated the then established political frameworks for the developing nation clients; They require good governance from them and described it as “the way in which power is exercised in the management of

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29

International initiatives

ROSC

World Bank OECD

Regional Roundtables

Financial Stability Forum

Global Corporate Governance Forum

Figure 2.3

International initiative in corporate governance.

social and economic resources of a country for development (The World Bank).”1 Four requirements (Figure 2.4) were considered necessary to render the concept of governance instrumental, as understood by the World Bank. This set of requirements will later constitute the World Bank governance framework and also the fi rst ever governance framework to be suggested. As a fi rst requirement, the World Bank framework calls for the establishment of a state of law that guarantees the security of citizens and ensures the enforcement of the law; the second requirement requires the existence of a good public administration, capable of listening to its citizens and convinced of the benefits of an efficient management and rational and equitable

WorldBank Framework

State of law

Good public administration

Figure 2.4

Transparency

Responsibility & accountability

World Bank governance framework for development.

30

Internal and External Aspects of Corporate Governance

public spending policies. In order for the previous requirement to materialize, it is assumed that not only responsibility and accountability within public administration must exist, but also that civil servants are accountable for their actions before their citizens. The last requirement underlines the fundamental role of transparency which should allow each citizen easy access and the use of pertinent information. As most international organizations did, the World Bank has also adopted the OECD principles (discussed later) as its benchmark instrument and part of its member countries’ surveillance procedures, mainly the Reports on Standards and Codes (ROSC). The World Bank initiative can legitimately be considered as the ancestor of all initiatives that follow in the field, and also seems to have inspired them deeply. Regardless of the fact that some may have seen in the World Bank governance framework a kind of a nostalgic FriedmanReagan neoliberal model and an instrument of market globalization, it seems to have succeeded, in some way at least, in empowering an increasing the number of developing countries taking care of their own economic destiny.

THE ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT CORPRATE GOVERNANCE PRINCIPLES The Organisation of Economic Co-operation and Development (OECD), the largest international club of developed countries, has felt the need for developing its own corporate governance principles (OECD principles) that were originally endorsed by OECD ministers in 1999, mainly under the unsustainable pressure exercised by the wave of fi nancial crises that swept across emerging economies in 1997/8. The last round of high-profi le corporate failures has even reinforced further the OECD in its belief and encouraged it to continue its efforts toward the global improvement of corporate governance. Consequently, at the beginning of the 2000s, the OECD undertook a reexamination of its principles adopted in 1999, to consider the latest developments. Indeed, by the year 2004 it published a revised version of its principles (OECD 2004 principles), which “have since become an international benchmark for policy makers, investors, corporations and other stakeholders worldwide (Johnston, 2004).” The OECD principles seem to have advanced the corporate governance agenda around the globe, and an increasing number of countries seems to be using them today, or are in the process of, for specific guidance in their legislative and regulatory reform initiatives. These countries are increasingly convinced, suggested, or warned that the seriousness with which organizations and institutions observe basic principles of good governance will be significantly impacting for investment decisions in these countries, by external investors. Of particular interest is the relationship that seems to link corporate governance practices to the much needed access to

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31

international capital markets. If this happens, local companies will be able to access fi nancing from a much larger pool of capital than locally possible. Heading most international organizations and with the backup of the World Bank, the OECD sets two specific conditions to countries willing to reap the full promised benefits of the global capital market: they should fi rst make sure their corporate governance arrangements are credible and well understood by the international fi nancial community; and second, they should adhere to a set of internationally accepted governance principles— as it happens, the OECD principles. Even, however, in the rare cases where corporations of a given country do not rely primarily on foreign sources of capital, it is still suggested that the adherence to a set of good corporate governance practices will still continue to be of higher priority, because of its alleged benefits. First, a set of good corporate governance practices will help improve the confidence of domestic investors; second, it will reduce the cost of capital; third, it will sustain the good functioning of fi nancial markets; and fi nally, it will induce more stable sources of fi nancing. A single best model of good corporate governance does not seem to exist, however; works carried out in both OECD and non-OECD countries seem to point to some common ground that may underlie good corporate governance practices and it was used by the OECD to build its principles, as summarized in Figure 2.5. The OECD 2004a corporate governance principles is composed of six chapters and together they represent a serious attempt to strike a balance between the Anglo-Saxon model and other non-Anglo-Saxon existing models. While the Sarbanes-Oxley Act concentrates on the board and the quality of financial reporting, the OECD-2004 concentrates on shareholders’ protection. OECD2004 first chapter addresses the “basis for an effective corporate governance

2(&' Board Responsibilities

Disclosure & Transparency

Stakeholders' Role

Shareholders' Treatment

Basis for an Effective CG Framework

Figure 2.5

OECD 2004 corporate governance principles.

Rights of Shareholders 

32

Internal and External Aspects of Corporate Governance

framework”; the two following chapters address the “rights of shareholders” and “the equitable treatment of shareholders,” while the last three chapters focus respectively on “the role of stakeholders in corporate governance,” “the role of the board,” “disclosure and transparency,” and finally “the responsibilities of the board.” The following will discuss each one of the six chapters, composing the 2004 OECD corporate governance principles.

Ensuring Basis The OECD principles rightly underline the importance of ensuring the basis for an effective corporate governance framework. They specify that an appropriate corporate governance framework should aim at the following objectives (OECD, 2004a): (i) The promotion of transparent and efficient markets; (ii) The consistency with the rule of law; (iii) The clear articulation of the division of responsibilities among different supervisory, regulatory, and enforcement authorities. More practically, the OECD 2004 principles also warned that while developing an effective corporate governance framework, four principles are also required., as indicated in Figure 2 6. For a corporate governance framework to be effective, it fi rst should have a clear orientation, one that promotes market efficiency. While, however, such market efficiency is desirable for most environments, it is illusionary to expect to encounter it in most economic environments of the world today. More precisely: (i) The sought governance framework “should be developed with a view to its impact on overall economic performance, market integrity and the incentives it creates for market participants and the promotion of transparent and efficient markets” (OECD, 2004);

The Basis for an Effective CG Framework Orientation

Empowerment Consistency

Responsibility

Figure 2.6 Requirements for ensuring the basis for an effective corporate governance framework.

Corporate Governance

33

(ii) It should be consistent, meaning “the legal and regulatory requirements that affect corporate governance practices in a jurisdiction should be consistent with the rule of law, transparent and enforceable” (OECD, 2004); (iii) It should clarify responsibility, meaning that “the division of responsibilities among different authorities in a jurisdiction should be clearly articulated and ensure that the public interest is served” (OECD, 2004); and (iv) It should fi nally empower actors, meaning that “supervisory, regulatory and enforcement authorities should have the authority, integrity and resources to fulfill their duties in a professional and objective manner. Moreover, their rulings should be timely, transparent and fully explained” (OECD, 2004).

Rights of Shareholders and Key Ownership Functions The 2004a corporate governance principles strongly defend that one main objective of corporate governance framework should unmistakably be the protection of the shareholders and the facilitation of the exercise of their rights. Steps to be taken in order to achieve shareholders’ rights protection are summarized in Figure 2.7. It is the view of the OECD that the protection of shareholder rights should be intended to allow shareholders the full exercise of their rights. In this regard the OECD 2004 principles underline specifically the fact that shareholder rights should encompass basic rights such as securing efficient methods of registration of ownership; transferring or conveying shares; obtaining on a timely and regular basis relevant and material information on the corporation; participating and voting in general shareholder

Shareholders Rights & Ownership Functions

Shareholder rights

Shareholder participation Ownership rights

Capital structure

Market for corporate control

Figure 2.7

Shareholders’ rights respect and key ownership functions.

34

Internal and External Aspects of Corporate Governance

meetings; electing and removing board members; and having a share in the profits of the corporation. Shareholders should further be placed in a position where they can easily exercise their ownership rights, that is, they should, for instance, have the right to be sufficiently informed and particularly to participate effectively in fundamental corporate change decisions such as: “amending the statutes, articles of incorporation or similar governing documents of the company; authorizing additional shares issue; and authorizing extraordinary transactions, including the transfer of a substantial part or all assets that in effect result in the sale of the company” (OECD, 2004a). It is worth mentioning that the OECD 2004 principles requirements go beyond the corporation to include institutional investors acting in a fiduciary capacity. These institutional investors are also required, fi rst, to disclose their overall corporate governance and voting policies with respect to their investments, and this includes the procedures that they have in place for deciding on the use of their voting rights; and second, to disclose how they manage material confl icts of interest that may affect the exercise of key ownership rights regarding their investments; All shareholders, however, should be permitted to consult with each other on issues concerning their basic shareholding rights as defi ned in the OECD 2004 principles, subject to exceptions to prevent abuse. All the rights and means of protection would be worth nothing if shareholders are prevented, in some way or another, from taking part in the corporate decision making. For this reason OECD 2004 principles specify that “shareholders should have the opportunity to participate effectively and vote in general shareholder meetings and should be informed of the rules, including voting procedures that govern general shareholder meetings” (OECD, 2004a). For such a function: (i) They should be supplied with sufficient and timely information concerning the date, location, and agenda of general meetings, as well as full and timely information regarding the issues to be discussed and decided at the meeting; (ii) They should have the opportunity to ask board questions, including those relating to the annual external audit, to place items on the agenda of general meetings, and to propose resolutions, subject to reasonable limitations; (iii) They should effectively take part in key corporate governance decisions, such as the nomination and election of board members; (iv) They should be able to make their views known on the remuneration policy for board members and key executives. Further, the equity component of compensation schemes for board members and employees should be subject to shareholder approval; (v) They should fi nally “be able to vote in person or in absentia, and equal effect should be given to votes whether cast in person or in absentia” (OECD, 2004).

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35

OECD 2004 principles also deal with the tricky subject of arrangements in capital structure, at risk of keeping shareholders from exercising their rights. Consequently, disclosure is required for capital structures and arrangements (see Chapter 2) that may enable certain shareholders to obtain a degree of control which is disproportionate to their equity ownership. To protect shareholders even further, OECD 2004 principles deal with issue of market for corporate control and welcome its existence and development. They require markets for corporate ownership to be adequately functioning in an efficient and transparent manner. They advocate that “the rules and procedures governing acquisition of corporate control in the capital markets, and extraordinary transactions such as mergers, and sales of substantial portions of corporate assets, should be clearly articulated and disclosed” (OECD, 2004) so that investors are allowed to understand their rights and recourse. It is also required that transactions must occur at transparent prices and under fair conditions protecting all the shareholders’ rights and according to their respective class. OECD 2004 principles fi nally exclude all antitakeover devices that may be used to shield management and the board from accountability and transparency.

Equitable Treatment of Shareholders Dealing with the issue of equitable treatment of shareholders, OECD 2004 principles specify that “the corporate governance framework should ensure the equitable treatment of all shareholders, including minority and foreign shareholders” (OECD, 2004a). Figure 2.8 summarizes shareholders’ equitable treatment actions as required by OECD 2004 principles.

Same class same rights

Equitable votes Impediments elimination

Insider trading prohibition

Minority shareholders protection

Figure 2.8

Shareholders’ equitable treatment.

36

Internal and External Aspects of Corporate Governance

As can be seen from Figure 2.8, OECD 2004 principles set up a number of milestones regarding shareholders’ equitable treatment. We can learn, for instance, that: (i) All shares within any series of a class should carry the same rights and all investors should be informed about the rights attached to their shares; (ii) Classes of shares which might be negatively affected by any changes in voting rights should be consulted for approval of such changes; (iii) Minority shareholders should be protected from abuses by controlling shareholders; (iv) Cross-border voting impediments should be eliminated; (v) Equitable treatment of all shareholders is required for general shareholder meetings processes and procedures; (v) Cast votes should neither be unduly difficult nor expensive; (vi) Finally, insider trading and abusive self-dealing should be prohibited and members of the board and key executives should be required to disclose “whether they, directly, indirectly or on behalf of third parties, have a material interest in any transaction or matter directly affecting the corporation” (OECD 2004a).

Role of Stakeholders in Corporate Governance One major innovation of OECD principles resides in their fi rm willingness to protect shareholders’ interests, as well, other stakeholders’ interests and to favor cooperative corporate agency relationships within the organization. It is specified in this regard that “the corporate governance framework should recognize the rights of stakeholders established by law or through mutual agreements and encourage active co-operation between corporations and stakeholders in creating wealth, jobs, and the sustainability of fi nancially sound enterprises” (OECD, 2004a). Figure 2.9 underlines means by which stakeholders’ role in corporate governance can be enhanced, according to OECD 2004 principles. In order to respect stakeholders’ rights, the corporation should, as a fi rst step, make sure such rights are established by law or set up through mutual agreements, and second that they are respected, as it should ensure that performance-enhancing mechanisms for employee participation are encouraged. Similarly, whenever stakeholders have to act in the corporate governance process, they should be supplied with all the needed relevant and reliable information and this has to be done on a timely basis. The corporation should also ensure stakeholders, including unions with appropriate and formal communication channels, allowing them to freely communicate to the board and other interested parties their concerns about illegal or unethical practices in the corporation.

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37

Enforcement of creditor rights

Stakeholders' legal contractual rights

respected Performance enhancing mechanisms encouraged

Free communication about illegal practices

Access to relevant information assured

Figure 2.9

Stakeholders’ role enhancement mechanisms.

Disclosure and Transparency Disclosure and transparency is the favored governance issue of most legislation and guidelines. OECD 2004 principles are no exception. They state that “the corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the fi nancial situation, performance, ownership, and governance of the company.” Components of an effective corporate disclosure and transparency system, as imagined by the OECD 2004 principles, are summarized in Figure 2.10.

Addressing environment reaction

Materiality

Ace. Standards Quality

Easy access to information

Auditing Quality

Figure 2.10

Disclosure and transparency.

38 Internal and External Aspects of Corporate Governance We can see from Figure 2.10 that the OECD principles widen disclosure defi nition to include other information components, besides those encompassed by the traditional fi nancial reporting system. Disclosure, in the view of the OECD 2004 principles, covers material information on a number of elements such as: (i) (ii) (iii) (iv)

Financial and operating results of the company; Company objectives; Major share ownership and voting rights; Remuneration policy for members of the board and key executives, and information about board members, including the CEO, their qualifications, their selection process, and whether they are considered as independent; and (v) All other information of special interest, such as related party transactions, risk factors, or governance structures and policies.

A number of specific requirements were also imposed to the described fi nancial information: (i) They should be prepared and disclosed in accordance with high quality GAAP and other nonfi nancial disclosure standards and should be audited; (ii) An annual external audit is required in order to provide an objective and independent opinion with regard to the quality of the financial reporting; (iii) A knowledgeable external auditor should be hired for the audit purpose and should be accountable to the shareholders and owe a duty of care to the company in the conduct of its audit mandate; (iv) Channels for disseminating information should, for their part, provide for equal, timely, and cost-efficient access to relevant information; (v) The corporate governance framework should fi nally be complemented by an effective approach that addresses evaluations performed by analysts, brokers, banks, rating agencies, and others that is relevant to decisions by investors.

Responsibilities of the Board Like most legislation that has inspired, OECD 2004 principles concede a strategic and pivotal role for the board of directors, within the corporate governance process. They state that “the corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders” (OECD, 2004a). Although board of directors will be discussed in the next chapter, we can already summarize its role by quoting the OECD 2004 principles. The board of directors is required to fulfill certain key monitoring functions, including:

Corporate Governance

39

(i) Reviewing and guiding corporate strategy, major plans of action, risk policy, annual budgets, and business plans; setting performance objectives; monitoring implementation and corporate performance; and overseeing major capital expenditures, acquisitions, and divestitures; (ii) Monitoring the effectiveness of the company’s governance practices and making changes as needed; (iii) Selecting, compensating, monitoring, and, when necessary, replacing key executives and overseeing succession planning; (iv) Aligning key executive and board remuneration with the longer term interests of the company and its shareholders; (v) Ensuring a formal and transparent board nomination and election process; (vi) Monitoring and managing potential confl icts of interest of management, board members, and shareholders, including misuse of corporate assets and abuse in related party transactions. OECD principles have gained broad recognition. Unfortunately the assumptions on which they were based can be encountered only in very few developed economies (market efficiency, corporate structure, etc.), but again what are the chances such a model can be successfully implemented elsewhere?

OTHER INTERNATIONAL CORPORATE GOVERNANCE PROGRAMS Led by the World Bank and the OECD, the international community was easily converted to the benefit of sound corporate governances systems for organizations and has emphasized the significance of its role in strengthening the international fi nancial architecture. In a world of integrated capital markets, it is becoming obvious and plausible that any serious fi nancial crisis faced by any individual country, depending, however, on its weight in the world economy, will imperil the whole international fi nancial stability and from there stems the rationale for minimum international governance standards. Such standards can rightly be considered as basic public goods that would benefit both individual national systems and also the overall international environment. It is even constantly advocated that international governance standards would enhance international transparency, as well as multilateral monitoring and surveillance (World Bank, 2007). At the national level, international standards provide a benchmark that can help identify vulnerabilities as well as guide policy reform. To best serve these objectives, however, the scope and application of such standards need to be assessed in the context of a country’s overall development strategy and tailored to individual country circumstances. Such enhancement of the international efficiency can be achieved by fi rst better identifying weaknesses and avoiding involved fi nancial vulnerability; by fostering market

40 Internal and External Aspects of Corporate Governance efficiency and discipline; and fi nally by ultimately contributing to a global economy, which is hopefully more robust and less subject to crisis. Several international forums were set up aimed at the achievement of such objectives, namely, the Financial Stability Forum (FSF) for international fi nancial stability, the Global Corporate Governance Forum (GCGF) for institutional framework improvement for development, Corporate Governance Regional Roundtables for promoting policy dialogue between the public and private sectors in developing countries, and the reports of the observance of standards and codes or ROSC for observance of selected standards relevant to private and fi nancial sector development and stability. They all will be presented in the following sections.

THE FINANCIAL STABILITY FORUM Although, its scope is much larger than corporate governance issues (http:// www.bis.org/publ/joint14.htmhttp://www.bis.org/publ/joint14.htm), the Financial Stability Forum (FSF) participates decisively in enhancement corporate governance around the world. It met for the first time in April 1999 and brings together, since then on a regular basis, national authorities responsible for fi nancial stability in significant international fi nancial centers, international fi nancial institutions, sector-specific international groupings of regulators and supervisors, and committees of central bank experts. The FSF is intended to promote international fi nancial stability through information exchange and international cooperation in fi nancial supervision and surveillance. It mainly seeks to coordinate the efforts of these various bodies in order basically to promote international fi nancial stability; and to improve the functioning of markets and reduce systemic risk. It is worth mentioning that OECD 2004 principles were designated by the FSF as one of the 12 key standards for sound fi nancial systems. The 12 key standards for sound fi nancial systems can be seen at the FSF Web site.

THE GLOBAL CORPORATE GOVERNANCE FORUM (GCGF) In yet another international corporate governance initiative to promote global, regional, and local initiatives that aim to improve the institutional framework and practices of corporate governance, a number of governments gave voluntary contributions to create a joint World Bank–OECD Global Corporate Governance. Housed in the joint IFC/World Bank Corporate Governance and Capital Markets Department, it has undertaken work in developing countries and helped to fi nance the OECD roundtables, based on OECD principles. The GCGF is a multidonor trust fund cofounded by the World Bank Group and the OECD aimed at the promotion of sustainable economic growth and poverty reduction within the framework of agreed-upon international development targets.

Corporate Governance

41

The forum contributes to the efforts of the international community to promote the private sector as an engine of growth, reduce the vulnerability of developing and transition economies to fi nancial crises, and provide incentives for corporations to invest and perform efficiently in a socially responsible manner. It fosters cooperation with various corporate governance programs and plays a coordinating role among donors, founders, and other relevant institutions (GCGF, 2008). The forum seeks to address the corporate governance weaknesses of middle-income and low-income countries in the context of broader national or regional economic reform programs. The forum has an extensive program to support corporate governance reform in developing countries. Strengthening corporate governance is an essential part of creating the necessary climate for investment and economic development. Sound corporate governance practices can inspire investor and lender confidence and spur both domestic and foreign investment. The forum focuses on practical, targeted corporate governance initiatives at the local, regional, and global level. The GCGF’s approach is summarized in Figure 2.11.

Country's Need

GCGF's Response

Define reform priorities through policy dialogue

Raise Awareness. Build Consensus

Ensure reform is underpinned by analysis

Sponsor Research

Draw on international expertise & networks

Disseminate Best Practices

Support implementation of reforms Technical Support. Capacity Building

Figure 2.11 Global corporate governance forum’s approach to improving governance. Built from data obtained in the site: http://www.gcgf.org/ifcext/cgf.nsf/Content/Home, as accessed February 7, 2008.

42

Internal and External Aspects of Corporate Governance

To ensure defi ning reform priorities through policy dialogue, the GCGF suggests raising awareness and building consensus through the organization of meetings, briefi ngs, policy papers, and dialogue. To ensure that reform is underpinned by analysis, the GCGF suggests sponsoring research, through analysis, validation, research papers, and so on. For drawing on international expertise and networks, the GCGF suggests disseminating best practices by using case studies, focus reports, and guidelines. Finally, in order to support the implementation of reforms, the GCGF suggests using technical support and capacity building, via training programs, toolkits, and so forth.

CORPORATE GOVERNANCE REGIONAL ROUNDTABLES The World Bank and the OECD also have a formal program of cooperation on corporate governance, which is designed to promote policy dialogue between the public and private sectors in developing and emerging markets. The OECD 2004 principles of corporate governance are again used as the conceptual framework for the project. Regional roundtables on corporate governance have proven to be an efficient way to maintain a continuous framework for policy dialogue and multilateral exchange of experience, drawing on the OECD Principles of Corporate Governance as a reference. The roundtables, organized in cooperation with the IFC/World Bank Corporate Governance Department, assure an inclusive approach, building on close partnership with the most important constituents in the respective countries and regions (OECD, 2008). The fi rst phase of the roundtable process included the drafting of regional white papers, setting out priorities and recommendations for the region. The current phase focuses on policy design, implementation, and enforcement. The roundtables are carried out with the support of the Global Corporate Governance Forum, cofounded by the World Bank and the OECD to advocate support and disseminate high standards and practices of corporate governance in developing and altering economies. As of today we can count up to five regional roundtables (OECD, 2008): (i) Asian Corporate Governance Roundtable; (ii) Eurasian Corporate Governance Roundtable; (iii) Latin American Corporate Governance Roundtable and Companies Circle; (iv) Russian Corporate Governance Roundtable; and (v) South East Europe Corporate Governance Roundtable. The OECD has also more recently initiated policy dialogue programs on corporate governance in three other regions: China, the Middle East, and

Corporate Governance

43

North Africa and Africa (http://www.oecd.org/document/9/0,3343,en_2 649_34813_2048457_1_1_1_1,00.html). The overall goal of the corporate governance roundtables is to assist decision makers from the private and public sectors in the region in their efforts to improve corporate governance. Its objectives are to promote better governance in the regions, to improve the understanding of corporate governance and assist in developing policy responses, to promote an ongoing dialogue on corporate governance experiences between private and public sectors, to monitor and evaluate progress in the regions, to identify possible needs for technical assistance and match supply and demand in this area, and to inform the international community about national and regional reform initiatives

REPORT OF THE OBSERVANCE OF STANDARDS AND CODES, ROSC In an unprecedented international move in the area of corporate governance, the International Monetary Fund (IMF) has invited the World Bank to embark on a joint pilot exercise preparing “Reports of the Observance of Standards and Codes” (ROSC). In this exercise, the two institutions are undertaking a large number of summary assessments of the observance of selected standards relevant to private and financial sector development and stability. These assessments are being collected as “modules” in country binders constituting the ROSC. Under this modular approach, the fund takes the lead in preparing modules in the area of data dissemination and fiscal transparency. Modules for the fi nancial sector (monetary and fi nancial policy transparency, banking supervision, securities market regulation, payment systems, and deposit insurance) are mostly derived as by-products from a parallel program called Bank-Fund Financial Sector Assessment Program (FSAP). The World Bank, on the other hand, has been asked to take the lead in three areas covered by ROSC: (i) Corporate governance, (ii) Accounting and auditing, and (iii) Insolvency regimes and creditor rights. Concerning the ROSC initiative, 12 areas are identified and associated standards considered useful for the IMF operational work as for the World Bank. And both used them “to help sharpen the institutions policy discussions with national authorities and in the private sector” (ROSC). Precisely, the World Bank is charged with evaluating OECD Principles of Corporate Governance implementation and such assessments are considered main components of the ROSC program, whose objective is to identify weaknesses that may contribute to a country’s economic and fi nancial

44

Internal and External Aspects of Corporate Governance

vulnerability. Each corporate governance ROSC assessment is performed in three steps: (i) It reviews the country’s legal and regulatory framework; (ii) It reviews practices and compliance of a country’s listed companies; and (iii) It assesses the framework relative to an internationally accepted benchmark. Toward this objective, the World Bank has established a tailored program to assist its member countries in strengthening their corporate governance frameworks. The objectives of this program are: (i) Raising awareness of good corporate governance practices among countries and public and private sector stakeholders; (ii) Comparing countries’ corporate governance frameworks and companies’ practices against the OECD Principles for Corporate Governance. These principles have been advanced in five main areas: ensuring the basis for an effective corporate governance framework; the rights of shareholders and key ownership functions; the equitable treatment of shareholders; disclosure and transparency; and the responsibilities of the board; and (iii) Assisting countries in developing and implementing their action plans for improving institutional capacity, with a view to strengthening their corporate governance frameworks. International organization governance initiatives seem to be fruitful and, as of December 27, 2007, more than 85 countries have undergone the ROSC program. Although a national initiative, the other major corporate governance reform is the Sarbanes-Oxley Act. The SOX will be presented in the next section.

THE PROVISIONS OF SARBANES-OXLEY (SOX) The controversial and impacting Sarbanes-Oxley Act (SOX) was passed by the US Congress in 2002. It was intended to bolster public confidence in capital markets, and it imposes new duties and significant penalties for noncompliance on public companies and their executives, directors, auditors, attorneys, and securities analysts. The full implications of the SOX legislation are governed by the Securities and Exchange Commission and the Public Company Accounting Oversight Board. Consequently, most of the provisions of the law only apply to public companies registered with the Securities and Exchange Commission, their auditors, and securities analysts.

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45

SOX is designed to protect investors, mainly by: (i) Improving the accuracy and reliability of corporate disclosures. SOX calls for greater personal accountability for both the chief executive officer (CEO) and the chief fi nancial officer (CFO); (ii) Providing for new levels of auditor independence; (iii) Requiring additional accountability for corporate boards; (iv) Increased criminal and civil penalties for securities violations; (v) Calling for increased disclosure regarding executive compensation, insider trading, and fi nancial statements; and (vi) Mandating certification of internal audit work by external auditors. SOX provisions are so impacting that it is considered to be the most significant change to federal securities laws in the United States since the New Deal. “Every publicly traded company in the U.S. has experienced its impact, included but not limited to changing the way the firm interacts with its external auditors, the requirements for anonymous “whistle-blowing” mechanisms, and the composition of the corporate board of directors” (Bloom & Naciri, 2007). SOX has inspired and impacted all similar legislations across the globe. The main provisions of SOX are summarized in Figure 2.12.

Public Company Accounting Oversight Board

Enhanced Financial Disclosures

Auditor Independence

Analyst Conflicts of Interest

Figure 2.12

Commission Resources and Authority

Corporate Responsibility

Studies and Reports

Sarbanes-Oxley main provisions.

Corporate and Criminal Fraud Accountability

46

Internal and External Aspects of Corporate Governance

Public Companies Accounting Oversight Board Fundamentally, the reason the SOX introduces the Public Companies Accounting Oversight Board (PCAOB) is to oversee external auditing and corporate governance issues that potentially affect the reliability of financial reports. The SOX managers witness an increase in their corporate responsibilities with regard to the production of reliable fi nancial reports. SOX also specifies restrictions on the activities of external auditors to improve their independence from their audit clients. PCAOB is in fact responsible for inspecting auditing fi rms in order to ensure their compliance with SOX regulations and professional auditing standards. It has also the power and the responsibility for investigating potential violations of SOX regulations, PCAOB’s rules, and professional accounting standards. PCAOB has also the power of imposing sanctions and civil penalties on accounting fi rms, including their suspension from auditing public companies. PCAOB may refer these matters to the SEC and the Department of Justice for further legal action if it believes such action is needed. It is required to keep the SEC advised of it actions, standards, investigations, and disciplinary hearings and sanctions (Section 107 (d)). In particular, PCAOB must inform the SEC of a fi nal sanction against a registered fi rm or associated individual. While a violation of PCAOB rules is considered to be a violation of the 1934 SEC Act, the SEC has the power to decide to uphold or change the sanction as it deems appropriate. As a private entity, PCAOB, is composed of five full-time members who are fi nancially literate, each serving for five years. However, no more than two of its members can be CPAs, and none of them can be employed by public accounting fi rms. They are appointed by the SEC in consultation with the chair of the Federal Reserve Board and the secretary of the Treasury (Section 101). Among the duties of PCAOB are the following (Bloom & Naciri, 2007) (Section 103): (i) Register public accounting fi rms; (ii) Set standards on auditing quality, control, ethics, independence and report to the SEC; (iii) Inspect accounting fi rms; (iv) Undertake investigations and disciplinary actions; (v) Enforce the SEC Act of 1934. Public accounting fi rms that desire to audit a public company have to register with PCAOB and to pay both a registration fee and an annual fee. Issuing companies also pay an annual support fee to PCAOB (to Section 109 (d)). Foreign accounting fi rms that audit subsidiaries of US companies are also required to register with PCAOB (Section 106). The board performs annual inspections of registered public accounting fi rms auditing more than 100 issues, others every three-year period (Section 104). PCAOB is responsible for holding disciplinary hearings generally closed

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to the public. The board may sanction a registered accounting fi rm for failure to supervise an associated individual with respect to audit and quality control standards. PCAOB requires registered accounting fi rms to maintain their audit work papers supporting all audit reports for at least seven years. The board also requires a second partner review of audit work and audit report approved by registered fi rms involving quality control standards (Section 103). The lead audit partner and the review partner are required to rotate on an audit every five years (Section 203). The CEO, controller, CFO, or chief accounting officer must not have worked for the audit fi rm for one year prior to the audit in order to avoid confl icts of interest (Section 206). The audit fi rm must advise the company’s audit committee of alternative GAAP that it discussed with management, including the consequences of such practices and recommendations made for the company, and all other written communications, judged to be material, between the auditor and management (Section 204). The direct reporting channel between the auditor and the audit committee highlights the independence of the auditor from management.

Allowed and Forbidden Services A registered accounting fi rm cannot furnish the following services to issuing companies while serving as its auditor (SOX, Section 301). (i) Bookkeeping or other services related to the accounting implementation; (ii) Appraisal or valuation services, fairness opinions, or contribution-inkind reports; (iii) Actuarial services; (iv) Internal audit outsourcing services; (v) Management functions or human resources; (vi) Broker or dealer, investment adviser, or investment banking services; (vii) Legal services and expert services unrelated to the audit; (viii) Any other service that the board determines, by regulation, is impermissible. The board may, on a case-by-case basis, exempt from these prohibitions any person, issue, public accounting fi rm, or transaction, subject to review by the commission. However, auditors can provide tax services if such services are approved by the company audit committee. Thus, SOX forbids independent auditors from engaging in the consulting function. The underlying principle is that auditors must not audit their own work. The board also requires the auditors to assess the extent which the company’s internal controls facilitate the preparation of records that fairly reflect the transactions and fi nancial statements in compliance with GAAP. The auditor is also required to describe material differences in internal controls (Section 103).

48 Internal and External Aspects of Corporate Governance

Audit Committee Audit committees of corporations have considerably more responsibility under SOX than was the case before. Such committees must now consist entirely of independent directors, completely unrelated in any way to management. The committees are assumed to have at least one person who is a fi nancial expert with appropriate education or experience in fi nancial accounting, so as to be able to understand fi nancial statements, including the application of accounting principles to those statements, and to understand auditing, both internal and independent. SOX calls for the audit committee to identify “a fi nancial expert” and whether this person is independent. While a fi nancial expert is not mandatory, if the committee lacks one, it must explain why (SOX, Section 407). In some cases, the fi nancial expert on the audit committee actually chairs the committee, but that is optional, not a SOX requirement or recommendation. Also, it should be emphasized that the fi nancial expert has no greater liability than any other member of the audit committee. Additionally, audit committees hire, compensate, and if necessary dismiss the independent auditors. The audit committee approves of all their services provided by the auditors. The audit committee has to be especially concerned with overseeing management of the risk function in the fi rm, having the authority to hire independent counsel, among other advisors (Section 301). The committee must establish and adhere to specific procedures for confidential whistle-blowing about alleged wrongdoing. Overall, the audit committee is expected to provide independent oversight on all audit-related functions. The audit committee is responsible for selection, compensation, and oversight of the corporation’s external auditor. Thus, the audit committee, rather than corporate management, is the primary contact for a corporation’s external auditor.

Financial Statements Certification and Quality The Sarbanes-Oxley Act affects corporations that are required to report fi nancial information to the Securities and Exchange Commission, and the CEO and CFO of the issuer are required to certify the “appropriateness of the fi nancial statements and disclosures contained in the periodic report, and that those fi nancial statements and disclosures fairly present in all material respects the operations and fi nancial condition of the issue. Thus, SOX requires both individuals to certify that they have received the fi nancial reports, that the reports do not contain material misstatements or omissions, and that the reports fairly present the fi nancial condition and operating results of the company. The officers certify that the fi nancial reports comply with requirements of the Securities Exchange Act of 1934 and contain information that fairly presents, in all material respects, the fi nancial condition and results of operations of the issuer. No longer can such executives assert that “the fi nancial statements were not my responsibility, and I did what the auditors told me to do.” If the CEO and CFO

Corporate Governance

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knowingly and intentionally give a false certification, they are liable for damages under SOX (Section 302). The maximum penalty would be a fi ne not exceeding $5,000,000 and/or a prison sentence of up to 20 years (Title IX: White Collar Crime Penalty Enhancements). Should the issuer have to restate its financial statements due to material incompliance, the CEO and CFO are required to reimburse their company for bonus and incentives received and gains on sale of company securities for the one-year period after issuance of the fi nancial statements (Section 305). Additionally, insider trading by officers and directors, among other insiders, is prohibited during pension blackout periods (Section 306). Personal loans to executives of the company are prohibited (Section 402 (a)). SOX (Section 402) calls for an annual report by the issuer to include an internal control report—that is, to (i) State the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for fi nancial reporting; and (ii) Contain an assessment, as of the end of the issuer’s fi scal year, of the effectiveness of the internal control structure and procedures of the issue for fi nancial reporting. The corporation’s external auditor, in turn, must provide timely information to the audit committee about important accounting practices and policies adopted by corporate management and any discussion between the auditor and management about alternative practices or policies. Any disagreements between the auditor and management about these matters also must be disclosed to the audit committee. The corporation’s external auditor is also required to attest to management’s evaluation of the company’s internal controls. Each issuer also must disclose if it has a code of ethics in place for its senior fi nancial executives. The company is required to immediately disclose in Form 8-K any change in the code of ethics.

Internal Control System In its Section 404, SOX calls for both companies and auditors to independently assess the adequacy of internal controls governing the fi nancial reporting system and to report on those controls to the SEC. This aspect of SOX has created the most difficulty, in terms of time and costs, for corporations affected by SOX and their auditors to comply with. Prior to SOX, independent auditors relied in large part on the issuer’s internal audit function to assess such controls. Under Section 404, independent audits of the controls of the issuer are now mandatory in addition to the usual facets of the external audit. While audit billings of major CPA fi rms have skyrocketed as a result of SOX, these fi rms have faced significant staff shortages in attempting to conduct such audits. Despite these problems, SOX has

50 Internal and External Aspects of Corporate Governance emphasized the importance of maintaining internal controls throughout the organization. External auditor is also responsible for examining the client fi rm’s internal control system and verifying that the system is adequate to provide reasonable assurance of reliable financial reporting information.

Corporate Governance Approaches, an Evaluation The latest avalanche of scandals highlighted corporate governance weaknesses and naturally led to the question of whether governance principles (international agencies principles and guidelines, SOX) have reached their objectives. One thing is becoming clear: benefits from good corporate governance are now widely understood and shared. Approaches to corporate governance improvement, whether voluntary or prescriptive, share common objectives, mainly: (i) Increasing the role and authority of independent directors; (ii) Tightening the defi nition of “independent” director and adding new audit committee qualification requirements; (iii) Fostering a focus on good corporate governance; (iv) Giving shareholders more opportunity to monitor and participate in the governance of their companies; (v) Establishing new control and enforcement mechanisms. Corporate governance is not only dealing with frauds. It is also a fundamental prerequisite for improving economic performance, facilitating corporate access to capital, decreasing volatility in retirement savings, and improving the general investment climate. Being nonprescriptive, the success of international principles and guidelines will always rely upon the willingness of people implementing them and how they are actually applied in a given situation by the interested parties, governments, companies, shareholders, and stakeholders. International principles and guidelines should be able to reassure partners and constant dialogue should be sought. Legal systems like SOX have deeply impacted fi nancial reporting, internal and external control standard setting, and the overall corporate governance and still have unforeseen consequences in the organizations’ daily life. While it is doubtful that a legal approach to corporate governance has eliminated some corporate frauds by focusing attention on the problem and by vigorous enforcement of its provisions, the law is expected to be a significant deterrent. However, for all its imperfections and criticisms, it has served to enhance the quality and reliability of financial reporting. The law has strengthened, in most countries, the role of the audit committee and the auditor. In any case, more and more companies are pursuing improvements in corporate governance, based on the belief that this is the route to follow, consistent with their own self-interest—wealth maximization.

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Although there can be no worse system than no system, only the respect of principles should be regulated, not every action. Indeed, an excess of rules will always tend to undervalue moral values and personal commitments. Dishonest individuals will find in obeying the rules the kind of moral excuse to go ahead with their forfeit, and they will not disregard any effort or resources to get around rules. For this reason, only adherence to principles should be regulated and efficiently monitored and noncompliance should be severely and heavily reprimanded. Most famous fraudulent cases have occurred in environments most respectful of rules (Enron), and under regulators’ scrutiny (Madoff). Besides, delinquents usually make sure they have all the needed backup and protection from monitoring agencies and political spheres. Moreover, Warren Buffett’s adage that “Only when the tide goes out is it clear who was swimming naked” proves to be a burning event more than ever.

CONCLUSION Corporate governance reforms enacted to date have neither been wide nor deep enough, with insufficient regulatory bite and enforcement, depending on the environment, except for the US legislation. The main focus of reform has been either on developing mechanisms or on external accountability mechanisms, namely, the independence of auditors and other requirements of corporate transparency. Other mechanisms have been inadequately addressed and so far much remains to be done at both international and national levels. The overwhelming positive aspect about international governance principles and guidelines and governance legislations is the message they try to curculate, underscoring that corporate fraud and institutional mismanagement are not acceptable anymore and should not be tolerated. Their effect is deeply felt not only in the developed countries but also all over the world. Policymakers are now more aware of the contribution good corporate governance makes to financial market stability, investment, and economic growth. Companies better understand how good corporate governance contributes to their competitiveness. Interest in corporate governance goes, therefore, beyond that of shareholders in the performance of individual companies.

COMPREHENSIVE CASE 2.1

The Sarbanes-Oxley Act The objectives of financial reporting are to provide information that is useful to investors and creditors in their decision-making process. In order for the financial reporting process to be successful—that is, for the objectives

52 Internal and External Aspects of Corporate Governance to be accomplished—many participants play important roles. Among the participants whose roles are critical to the success of the fi nancial reporting process are company management, audit committees, external auditors, analysts and investment advisors, investors, regulators and oversight bodies, and accounting standard setters. The Sarbanes-Oxley Act (SOX) requires changes by many participants in the fi nancial reporting (SOX, 2002). The act introduced major changes to the regulation of corporate governance and financial practice. It sets a number of nonnegotiable deadlines for compliance. It is arranged into eleven “titles.” As far as compliance is concerned, the most important sections within these eleven titles are usually considered to be 302, 401, 404, 409, and 802 (http://www.soxlaw.com/).

Required: Highlight the most innovative requirement of the SOX and evaluate their impact on the daily corporate governance practice of corporations.

3

The Board of Directors and Corporate Governance

Recent corporate governance regulatory changes have tried to empower the board of directors and intensify its scrutiny of member directors. As protectors of shareholders’ interests, the board now attracts more expectations to the point where corporate governance seems to start with the board and end with the board. Consequently, having an efficient and independent board of directors, capable of enhancing the other governance defense mechanisms, is a must for any organization that is willing to enhance its corporate governance. The understanding of the board, its structure, its role, and its functioning is, therefore, a prerequisite for the proper understanding of corporate governance (Admati & Fleiderer, 1998).The board of directors is actually considered the backbone of the corporate governance and its institutional compliance guarantor. Fundamentally, management proposes a strategic plan that the board reviews, approves, and monitors (TSX Guidelines). Furthermore, the proper functioning of the board is more likely to reduce managerial excesses, and the efficiency with which boards discharges their responsibilities notably impacts country competitive positions. For this reason, it is required that the board must not only have the necessary authority, but should also be in a position where it can efficiently run the organization’s business; and such authority should, however, be exercised in a manner that it is consistent with the principles of efficiency and accountability. The latter statement may even be at the heart of any system of good governance. The boards of directors are these days subject to much acerb criticisms that are once again highlighted by corporate scandals; consequently, most recent reforms of governance are focusing on boards’ restructuring and empowering, and this chapter examines these crucial issues within the process of corporate governance.

CORPORATE GOVERNANCE RESPONSIBILITY The board’s function of monitoring the organization has evolved gradually over a relatively long period of time. During the period of widespreading of

54

Internal and External Aspects of Corporate Governance

the company’s form of business, people were convinced that the shareholders should have the supreme authority over their organization as well as the full monitoring of its management, and the board of directors should play only a modest role as the shareholders’ agent and under their complete control. At the beginning of the 1900s, a new era opened for the board, especially when the principle of authority sharing between the board and the shareholders began to receive significant attention. Later and rather quickly such principle became a rule that remained unchallenged. Today, everyone seems to agree that directors should be responsible for overseeing the organization management, and unless it is proven they broke the law, such function should remain theirs. Consequently, the implementation and the maintaining of a sound governance within the organization can only be the responsibility of the board of directors. Indeed, although it is legally supposed to be entrusted with shareholders, it is actually implemented within the organization by the board of directors and its various standing committees.

SHAREHOLDERS MEETINGS Shareholders’ meetings are at the heart of corporate democracy because it was believed from the beginning and in respect of the pure democracy that the “collective decisions should be made by those whose interest are at stake in a manner, that is proportional to their interest” (Beetham, 1994). Shareholders’ meetings constitute the privileged podium from which shareholders exercise their supreme control over the organization. Accordingly, most national corporate laws seek to ensure that shareholders’ meetings do not experience any undue restrictions and their access is assured to all shareholders. These laws also require that each issued share effectively qualifies its holder for one vote at the shareholders’ meetings. Shareholders’ meetings can be statutory, if indicated in advance in the organizational chart, or extraordinary, if convened for the discussion of a particular issue. The statutory annual shareholders’ meeting is held on a fi xed date, usually six months from the beginning of each fiscal year, and a number of important decisions having a direct impact on the future of the organization have to be made, including directors’ election, financial statements’ presentation, and auditors’ report discussion. The functioning rules for these meetings are typically set by most national laws and are commonly reflected in the corporations’ charts. Thus, issues such as notice, the quorum, minutes’ preparation, and so on, are specified in advance so that they cannot be subject to any blackmail or bargaining maneuvers. All shareholders’ meetings, other than those required annually by law, are unusual meetings, called special or extraordinary, and can be convened by the board of directors or by any shareholder or group of shareholders that can demonstrate the ownership of a specified number of shares. The functioning conditions of the special meetings are also specified in advance. Issues to be discussed at an extraordinary meeting of shareholders can only be those specified in the notice. The

The Board of Directors and Corporate Governance 55 various national laws generally require companies the prior specification of a number of questions concerning the conduct of special meetings of shareholders, as the accuracy of the date of the meeting, the required quorum, the conditions for proxy voting, the minutes’ preparation, and the like. Given the usually high number of shareholders that companies usually have, the legal authority of their general meetings can only be delegated to a small number of representatives called directors and that have to be elected at shareholder meetings. “Shareholders rely primarily on a corporation’s board of directors to protect their interests” (Tlaa, 2007), especially when no clear contractual protection of their interests is otherwise expected; and although their rights are associated with ownership, they can sometimes be challenged on the basis that “the property owner who invests in modern corporations so far surrenders his wealth to those in control of the corporation . . .” (Berle & Mens, 1932). The basic function of the board of directors resides in formerly and appropriately allocating, delegating, and monitoring authority within the organization, and this includes the delimitation of management authority and power. It is important to underscore here the fact that the delegations of authority should be located within the boundaries of the statutory limitations that usually specify responsibilities that cannot be delegated to management. Any nondelegated responsibility is, of course, deemed to automatically remain the board’s own. Overall, the strategic guidance of the corporation should be ensured by the corporate governance framework and “the effective monitoring of management by the board and the board’s accountability to the company and the shareholders” (OECD, 2004); and this is effectively reached when a number of key functions are fulfilled by the board, and this includes the reviewing and guiding corporate strategy, the preparation of major plans of action, annual budgets and business plans, the implementation of risk policy, the setting of performance objectives. and all management activities (OECD, 2004). In any case, a good corporate governance framework is one that covers the functions, responsibilities, and authority of the board, the procedures for selection of its members, as well as decision making on issues that can have an impacting effect on the value of the organization. The board of directors is regarded as the best instrument for the establishment of the organizational objectives, their implementation, and the organization performance evaluation (Monks & Minow, 1995). It is finally admitted that firms with greater agency conflicts may be forced, due to circumstances, to set up better governance mechanisms, particularly those related to the composition and functioning of the board and the independence of the auditor (Dey, 2008).

THE BOARD OF DIRECTORS A board of directors is no more than a group of individuals elected by the shareholders and that act for themselves or on behalf of other organizations and that are granted decision-making authority in the organization,

56

Internal and External Aspects of Corporate Governance

one that is separated and distinct from the authority and responsibilities of owners and managers. The board of directors imposes itself as interface between the organization’s external environment and its management. Significant changes are affecting public company boards since the beginning of the 20th century and cover board independence, committee independence, board size, interlocking authorities, director occupation and multiple directorships, and so on. In general, such changes are observable both in small and large companies, although, statistically significant in large fi rms only (Chhaochharia & Grinstein, 2007). The board, as the highest internal governance mechanism, has to concede enough freedom to the management to allow it all the necessary autonomy to run the organization and to secure shareholders’ efficient wealth creation, as it should protect the interests of all those participating in this same wealth-creation process. As underscored previously, all boards derive their authority from the shareholders’ meeting, but their individual structures and operating procedures may vary considerably, both among organizations and also from one country to another, depending on the historical evolution of each country. An organization director is always shareholders’ elected officer, entrusted by his colleagues with the management of the organization. Collectively, directors formed the board of directors, whose role is to provide entrepreneurial leadership of the company within a framework of prudent and effective controls which enables risk to be assessed and managed. The board should set the company’s strategic aims, ensure that the necessary fi nancial and human resources are in place for the company to meet its objectives and review management performance. The board should set the company’s values and standards and ensure that its obligations to its shareholders and others are understood and met. As general rule the board fulfi lls the following management functions. (ICAEW) It is clear from this definition that the board of directors plays an important role, not only for its classical role of monitoring the organizational operations but also in ensuring that all the necessary conditions to maximize shareholder wealth are in place. Typically the board of directors plays two main roles, one of decision-making nature and another of oversight nature (RBC, Charter of the Board of Directors).1 The decision function of the board implies the formulation of the company’s strategic objectives and basic policies, as well as the approval of a number of actions and decisions, in collaboration with the organization management. Ultimately, the board of directors’ responsibilities are focused on the overseeing of the development of the organization’s long-term business strategies and their monitoring and their implementation; within the framework of the corporate fi nancial and legal integrity; developing staff compensation and succession planning

The Board of Directors and Corporate Governance 57 policies; ensuring management accountability; and representing interests of shareholders (TIAA-CREF, 2007). Boards of directors seem, however, to be affected by the governance regime of the country of origin of the company (van Veen & Elbertsen, 2008). As a rule, the seriousness with which board members take their responsibility is the main guarantor of its efficiency, although board members’ emotions and feeling of concerned often constitute a source of energy that affects board work and task performance (Brundin & Nordqvist, 2008), but other elements can be impacting on the board.

Structure of the Board of Directors An important part of the literature on the subject of corporate governance is rightly devoted to the issue of the effectiveness of the board structure. Some countries have opted for what is called a “two-tier board,” meaning that the functions of supervision and management of the company are separate. Such structures consist of a management committee that is entrusted with day-to-day operations, and a board of directors that is mainly responsible for overseeing the management committee actions and strategies. Although the two-tier board structure is commonly encountered in companies with dispersed ownership, it is believed it may also be an optimal board structure in companies with concentrated ownership, where few large shareholders control the board. The benefit of such structure in such situation is to limit the interference of large shareholders and to control managers’ incentive without reducing large shareholders’ incentive to monitor them. The two-tier board structure can therefore represent a valuable board optional structure in environments where ownership is concentrated (Graziano & Luporini, 2005). In some other countries the so-called “unitary board” structure dominates. In such cases executive and nonexecutive directors cohabitate. In other countries there finally exists an additional statutory body, mainly for audit purposes (OECD 2004 principles). The impact of CEO duality on corporate performance is found to vary across industries, and such behavior is supportive of both agency theory and stewardship theory. It seems, however, that when firms are categorized according to their financial performance, CEO duality attracts positive and significant benefits only when corporate performance is low (Elsayed, 2007). In all cases, directors are elected by shareholders, for one-year terms or more, and may also be sitting on the board for other companies; and under some national laws, a proportion of board members must be representatives of the employees (PricewaterhouseCoopers, 2003). Regardless of the chosen structure, the key requirement is that the conduct of the organization control process and the review of its fi nancial report should significantly involve independent directors. Directors can be classified either as executive or independent directors; an executive director is one that is fully dedicated to the operation of the organization, while an independent director comes from outside the organization and his appointment is justified on the basis of his expertise or

58

Internal and External Aspects of Corporate Governance

personal commitment and/or investment. The “independence requirements should be interpreted broadly to ensure there is no confl ict of interest, and loyalty to shareholders” (TIAA-CREF, 2007). Independent directors are generally expected to show a more unbiased view and be more critical of the board’s decisions. It is suggested that the size of the board may affect its efficiency, and for this reason it should be limited to a dozen members (Herold, 1979). It is also believed that the board should be composed mainly of independent directors as it is also stated that each committee should not only be chaired but also mainly composed of independent members because it is expected to fi nd a positive impact of board independence on the company’s performance and a negative relationship between CEO duality and performance (Elgaied & Rachdi, 2008). A limited number of directors can not only build confidence within the organization but can also enable the board to act decisively whenever the situation calls for quick action. In all cases the directors’ nomination is a very sensitive issue and it is legally required that directors’ appointment as well as dismissal must be approved by the shareholders’ meeting. There is currently also a general consensus against appointing directors on the basis of the relationship they may have with the management of the organization and that all directors must be appointed on the basis of their experience, their integrity, or the proof of their expertise in the fields of specialization sought by the organization. Some organizations opt for a rotating board system, where only a fraction of the board members is eligible for election each year, as a precaution mechanism and for continuity reasons because this makes the integration of the new directors easier and allows quick dealing with special issues that might have impacting effects on corporate being. Given directors’ mandates for which they are elected, they are required to establish the appropriate structures allowing management to achieve organizational performance goals and refrain from fraudulent transactions. Therefore, directors must have the required experience and competency in the fields of the organizational activity they are expected to supervise. The board of directors exercises its authority through its meetings and by conforming to a number of specific operating requirements, in terms of quorum, convening, or minutes; but shareholders use their right to vote at shareholder meetings to ensure the accountability of the board and to affect the board decisions (Ferri, Ertimur, & Stubben, 2007).

The Legal Responsibilities of the Board The legal responsibility of the board of directors is a direct consequence of the choice made to do business under the legal corporate form. When a company is run by owners, the decisions are supposed to be taken in their interests and only when the management function of the organization is not ensured by owners that potential confl icts of interest may arise; and this is something most corporate laws try to reduce, by imposing specific legal

The Board of Directors and Corporate Governance 59 board structures and also emphasizing that the primary responsibility of the board lies in serving two main roles: (i) One major role of the board aims at representing shareholders and defending their interests. Indeed, shareholders have only the board to lean on for the defense of their interests. Effective representation of shareholders involves, however, more than willingness; it also requires the integrity, competency, and the reflex to make the right decisions. Indeed, incompetency may prove sometimes to be as harmful as dishonesty. (ii) The other major role of the board aims at identifying, in case of poor performance, the reasons for such weakness and eventually taking appropriate corrective actions. Unfortunately, even the most competent managers, acting with the best intentions, are not always immune to errors and/or fraud temptation. For this reason, most national corporate laws contain provisions making the board of directors and managers responsible for any wrongdoing, particularly with regard to their duty of trust, loyalty, and supervision (Nelson, 2008). Figure 3.1 summarizes the traditional legal responsibilities of the board of directors and administrators.

Shareholders' meeting

DIRECTORS

Duty of loyalty

Duty to quit

Figure 3.1

Duty of trust

Duty of concern

Duty of supervision

The board and directors’ common legal responsibilities.

60

Internal and External Aspects of Corporate Governance

Board function is essentially a matter of trust, and based on the duty of trust, for instance, the board must act in the best interests of those it represents, that is, shareholders. The duty of trust of directors should, as indicated, extend beyond integrity to encompass competency as well. Due to the fact that the organization is often operating in a wide social environment, the way it is managed can have a decisive effect on its ability to achieve its goal of maximizing. In accepting the position, an appointed director actually commits himself to defend the interests of the organization and place them above his own, and the main challenge for him is to fi nd a way of reconciling the maximization objective with ethics and social responsibility considerations. The duty of loyalty, on the other hand, means that the appointed director commits himself not to use his influence within the organization to achieve personal gains or privileges. It is also his duty to give due attention by his function. The duty of loyalty is not, however, just a matter of common sense; a director should not only take seriously his function but must also take all necessary steps to achieve its objectives, including the required time and the collection of information. The entire board of directors and its individual members are also expected to have the courage to resign when it becomes clear that they are no longer in the position to fulfill their task appropriately, and this is called the duty to quit one’s position. Real life is full of examples of such failure of duty to quit. It is commonly recognized that a change in management will be rendered necessary as a result of a persistent poor performance. It is also widely admitted that changes on the board should be made whenever the organization is showing a poor performance that goes beyond the responsibility of the management team. Such a change should, however, take into account continuity and smooth transition constraints. The duty of supervision requires that directors take their responsibilities seriously. This includes updating their knowledge of the organization and how it is managed, the sources of information needed, and the actions to be undertaken when problems arise. The fi rst step on the road to effective monitoring of the organization is the establishment of transparent policies, to be coupled with an effective an internal control system that is overseen by an audit committee and backed by a directors’ code of conduct. Second, the board should have clear procedures regarding decisions that require its approval and the type of information that should be regularly received. It is important to determine the ability of the board to prepare an agenda of meetings and to demand explanations from the management and have a clear picture of organizational performance. Directors must know not only what questions to be asked but also how to be persistent in order to get the right answers. In fact, at this stage directors’ competency is more than crucial.

Functions of the Board The OECD 2004 principles discuss with enough clarity the board and the directors’ responsibilities and Figure 3.2 summarizes their main features.

The Board of Directors and Corporate Governance 61

OFFICER SELECTION CRITERIA

Independence

Integrity

Sound business judgment

Figure 3.2

Professional ethics

Commitment

Criteria for selecting appropriate officers.

According to Figure 3.2, the board should meet a number of challenges, usually through its standing committees. The following are some functions to be filled: The most crucial element in board responsibility is by far the corporate ethical culture that should be monitored from top to the bottom. “Culture is the way people behave when they are not being watched. It is very organization specific and very unlike regulation which is procrustean” (Sudeep, 2008). The magnitude of any individual impact on the organization and its shareholders increases by his moving up on the organization hierarchy. On the other hand, the capacity of the board to change employees’ attitudes is impacting to the culture of the organization. Actually, the ability of the board to reinforce organizational culture will significantly depend on its capacity to shape the culture progressively, while moving to the highest level of the organizational chart. Indeed, the top of the fi rm has the upper hand in shaping its culture, and whenever the head crosses the line, this sends out an implicit signal to lower-level staff to knowingly or unknowingly act in a similar manner (Sudeep, 2008). Organization culture cannot be imposed, as surprising as this might be; it is, however, an individual matter that can be developed. Consequently, the board should know how to allow mangers and employees to appreciate it and discover for themselves its benefits. No regulation can substitute for the ability of the board having an appropriate and personal way of dealing with the organizational issues,

62 Internal and External Aspects of Corporate Governance although the presence of expert-independent directors on boards and committees may enhances fi rm efficiency and value (Kam & Li, 2008). The board of directors is also responsible for the organizational efficiency and governance practices and should make changes as often as required, through monitoring activities. Fulfilling monitoring duty, however, requires from the board a number of qualities (TIAA-CREF, 2007), for instance, being a model of integrity that inspires a culture of responsible behavior and high ethical standards; ensuring that the use of corporate resources is made for the sole corporate benefit; a strong internal control that discourages conflicts of interest is in place; and an external auditor is appropriately hired. That board should finally make sure that laws and rules provisions are respected by the organization. The board must ensure and protect the organization’s accounting and control systems integrity and oversee the disclosure and communication processes, including the insurance of independent audit and the establishment of an effective system of internal control and risk management. It must fi nally adhere to the compliance of laws and regulations within the organization. The board is responsible for adopting information guidelines that respond to the investors’ and stakeholders’ demands for information and the organization’s handling of matters relating to insider trading and applicable insider legislation. The board should also monitor and manage potential confl icts of interest, abuses of corporate assets, and transactions with related parties which might involve officers, directors, and major shareholders. The board is responsible for adopting information guidelines on responding to the investors’ and stakeholders’ demand for information and the organization’s handling of matters relating to insider trading and applicable insider legislation. The other most important responsibility of the board lies in the selection, development, and evaluation of the performance of managers. Ensuring a strong, efficient, and stable management team that possesses sound values is indeed critical to the success of any organization and the securing of its future. For this reason, the board should continuously monitor and evaluate the CEO and senior management and should establish a succession plan for the development of executive talents, thus ensuring continuity of leadership (TIAA-CREF, 2007). Besides being continuous, the CEO evaluation process should also be based on clearly defi ned corporate strategic benchmarks as well as personal performance objectives. There is actually no more frustrating position for staff than an arbitrary performance evaluation process; for this reason the fi nancial and nonfi nancial criteria used to evaluate executive performance should also be disclosed. Both the nominating and compensation committees, as will be discussed in the next chapter, should actively participate in the CEO evaluation and high-ranking managers’ succession planning. An appropriate succession plan should identify in advance high potential executives within the company and provide them with a succinct career development path. It should seek to develop senior managers capable of replacing the CEO whenever the need for change is felt. It is ultimately the board’s responsibility to take charge of

The Board of Directors and Corporate Governance 63 managers’ and directors’ selection, compensation, monitoring, and replacement, where appropriate, and align key managers and director remuneration to long-term interest of the organization and its shareholders.

Directors Directors are individual members of the board that are elected by the shareholders of the organization. When directors are owners and managers at the same time, they are called inside directors. When directors are managers, they are called executive directors. When they are not owners or managers, they are referred to as outside directors, but they are sometimes qualified as outsiders, disinterested directors, independent directors, or nonexecutive directors. Ultimately, the right directors are those securing to the organization the right performance. Consequently, directors are assigned specific functions toward the achievement of such objective, as summarized in the Figure. 3.3. (OECD 2004 principles).

Shareholders' meeting

BOARD FUNCTIONS

MONITORING ASSESSMENT

REVIEWING

NOMINATION & COMPENSATION

DISCLOSURE INTEGRITY CONFLICT RESOLUTION

Figure 3.3

Functions of the board and directors.

64 Internal and External Aspects of Corporate Governance Directors are commonly required to be constantly aware of a number of responsibilities and functions: (i) Directors must be aware of their fiduciary responsibility and must ensure that they operate the organization with diligence and care, on a fully informed manner and good faith and at all times, keeping in mind the interests of the organization and its stakeholders; (ii) Directors must be able to defend shareholders’ interests, while taking into account the interests of other stakeholders. Whenever a board’s decisions can affect differently many share classes, directors should ensure fair treatment to all shareholders; (iii) Directors should oversee the implementation, within the organization, of high ethical standards; and (iv) Directors must fi nally ensure the clear delineation of responsibilities and equitable sharing of authority within the organization. It becomes clear from the members’ qualities listing that the board plays a decisive role in corporate governance (Byrne, 1996; Millstein & MacAvoy, 1998; Seward & Walsh, 1996). Ultimately, it is responsible for maximizing shareholder wealth, while hopefully making sure that the path followed is ethical. Directors are indeed required to ensure that shareholders’ interests are not protected at the expense of other stakeholders such as employees, customers, suppliers, government, and the public. Directors do not need, however, to possess advance management expertise to play an effective governance role, except for being members of some standing committees of the board. The task for directors is to understand and approve organization policies and to monitor them at different stages of their advancement and achievement. It is often suggested, however, that directors with human capital such as prior management experience are among the most influential board members (Stevenson et al., 2009). On the other hand, directors who serve larger fi rms and sit on larger boards are more likely to attract additional directorships, and fi rm performance seems to have a positive effect on the number of appointments held by any director. It is usually warned that besides shirking their responsibilities to serve on board committees, multiple directors seem often to be associated with a greater likelihood of securities fraud litigation (Anonymous). Given, however, that directors usually hold only a small portion in the companies they manage and that legal rules and contractual previsions insulate them from liability for business failures, many are wondering what incentive can induce directors of public corporations to serve the interests of the shareholders (Stout, 2003).

Nonexecutive Directors With the general public losing faith in the activities of business executives, the role of the nonexecutive directors is increasingly gaining importance in

The Board of Directors and Corporate Governance 65 modern corporate governance. As defi ned previously, a nonexecutive director is one who is not involved in the management of the organization’s daily operations and does not form part of its executive management team. In addition, he is not an employee of the company or affiliated with it in any other way. An inside director, by contrast, is a director who also serves as an executive manager of the organization and also is called organization officer. The nonexecutive director provides both expertise and experience that an organization may not be able to afford on a full-time basis or where there is a specific need. There are two competing views of the executive directors’ roles on corporate boards. One view emphasizes the valuable information-sharing role of executive directors inside, whereas the other view emphasizes CEO influence over inside executive directors. Both views treat executive directors as a homogenous group (Masulis & Mobbs, 2009). The nonexecutive directors help the chairman of the board to insure that the executive directors are running the company for the benefit of its owners. Where, however, the chief executive is also the owner of the company, nonexecutive directors aim at ensuring that the company meets the requirements of corporate law and regulation, and they may also provide unbiased advice to the chief executive. The nonexecutive directors are supposed to be appointed based on criteria that should be both objective and of professional quality. The nonexecutive directors can actually add real value to any type of organization. They can act as the guarantors of the governance process, mainly by positively impacting the monitoring of the executive by constructively challenging and contributing to the development of the organization strategy; and by scrutinizing the performance of the management in meeting agreed goals and objectives; and finally, monitoring and where necessary removing senior management in succession planning (Higgs, 2003). In order to permit nonexecutive directors to do their job appropriately, they should be allowed to meet separately to discuss organizational issues among themselves, away from the organization officers. They need to be independent of mind as well as willing and able to challenge and question executives while maintaining a good working relationship (Higgs, 2003). The criteria of directors’ independence include: (i) Not having being employed by the company within the last five years; (ii) Not having any material business relationship with the company (directly or indirectly) within the last three years; (iii) Not receiving any remuneration other than the normal director’s fee (no involvement in share option or performance-linked schemes; not a member of the pension scheme); (iv) Having no close family ties with directors, senior employees, or company advisers; (v) Not having any cross directorships or significant links with other directors;

66 Internal and External Aspects of Corporate Governance (vi) Not being a representative of any significant company’s shareholder; (vii) Not having served on the board for more than 10 years. It is suggested that when an inside director becomes independent, then shareholder wealth increases; and inversely, when an independent inside director departs, then shareholder wealth decreases (Masulis et al., 2009). It is also underlined that voluntary appointment of independent directors is usually associated with improvement in both economic factors and managerial power. Independence seems, however, to decrease with managerial ownership and family control and to increase with the weaknesses of alternative corporate governance mechanisms and the severity of agency problems (Chaur et al., 2008). The corporate governance paradigm for boards of directors should actually be inverted: shareholder-owners should be in the majority and independent directors should be in the minority. Consequently, it is argued that corporate governance should be amended to facilitate the ability of these oversight shareholders to call meetings, which would serve as the most effective check and balance on management (Fogel et al., 2007). Directors’ independence positive effect is, however, challenged on the basis that companies may appoint independent directors who are overly sympathetic to management, “while still technically independent according to regulatory definitions” (Cohen et al., 2008) What disturbs investors more was and still is the inability of boards of directors to put an end to the massive fraud that occurred under their monitoring mandates. Investors are convinced that directors did not adequately do their job; they did not inquire enough, nor did they ask the tough, right questions. Some boards of fraudulent companies were actually considered among the best boards, just prior to their companies’ downfalls, yet they failed to detect outrageous frauds and stop them before they destroyed companies and broke through the financial confidence. Obviously, something went wrong at the top of these companies, and it surely has to do with the board members’ independence, no matter how impressive their backgrounds (Sharfman et al., 2008). The corporate debacles have certainly led to the enhancement of directors’ independence, but more than directors’ independence seems to be needed. It is found, for instance, that ties to others directors who meet outside of board meetings were more important predictors of collusive decisions and have more effect than ties across boards. Such fact underscores the importance of social dynamics factors in board decision making (Stevenson et al., 2009). It is also believed that boards of directors would be less prone to error if rules, other than independence, were in place requiring better monitoring in selecting board members (Sharfman et al., 2008). The issue is not so much an issue of independence, but rather the legitimacy and the credibility of the board members. Independence can be meaningful only insofar as it reinforces the legitimacy of a board and only then can the board have the authority and the right to oversee the management of the organization and only then can value be effectively added (Allaire, 2008).

The Board of Directors and Corporate Governance 67 THE CHAIRMAN OF THE BOARD AND THE CHIEF EXECUTIVE OFFICER The chairman of the board is elected among independent directors and has as his or her main role the insurance of smooth functioning of the board. The chairman should possess specific qualities; he must, for instance, provide counseling and advice, but above all he should demonstrate leadership in all aspects of his task. He is in charge of preparing the board meeting’s agenda, after consultation with the CEO and ensuring that meetings are run in an efficient manner. More specifically, the CEO should make sure that “the board is operating efficiently and fulfilling its oversight role adequately, acting in an advisory capacity to the CEO and to other officers and arbitrating relationships between management and the board” (RBC, 2008).

The Chairman of the Board The chairman of the board, at the top of the organization hierarchy, is required to demonstrate specific personnel qualities and leadership. Table 3.1 summarizes some of his most important responsibilities.

Table 3.1

The Most Significant Responsibilities of the Chairman of the Board

Management of the Board and Corporate Governance

Shareholder Relations

(a) Organizes the activities (a) Chairs meetings of shareholders. of the board of directors and committees, including (b) Facilitates the board’s efforts to create and efficiency evaluation. (b) Ensures that sufficient maintain practices that respond to feedback from time is allotted during board meetings for effec- shareholders and other stakeholders. tive decision making. (c) In consultation with (c) Ensures that board management, responds functions are effectively to shareholder concerns carried or efficiently regarding governance delegated. issues or other issues (d) Oversees the process relating to the board. for regular director peer review and supplements the formal peer review process by meeting with each director individually. (e) Participates in the orientation and mentoring of new directors.

Management Relations (a) Provides advice to the CEO on major issues. (b) Facilitates effective communication between directors and management, both inside and outside of meetings of the board. (c) Works with the president and chief executive officer to ensure management strategies, plans, and performance are appropriately represented to the board. (d) Participates as a chairman of selected committees. (e) Advises management in the planning of the strategy meeting.

Source: Adapted from Royal Bank of Canada: mandate for nonexecutive chairman of the board. RBC Web site, as accessed on July 22, 2008.

68

Internal and External Aspects of Corporate Governance

There are also several key qualities that are required from an efficient board chairman (Crocker, 2003): (i) First, he should have the required time to do the job, knowing that chair of board position requires more time than any director position; (ii) He is also required to be an efficient team builder and able to create a good working relationship with management; (iii) He should be a good delegator; his responsibilities are so wide that the only way for him to do the job is by delegating. The incapacity of the delegator is one of the biggest challenges met by board chairs; (iv) He should be comfortable with the process of running meetings. The way the board meeting is conducted is almost as important as what the board discusses; (v) He should be strategic, by being able to lead and keep the board focused on the high leverage issues, not minutiae; and (vi) He should be fi rm, by knowing how to take and keep control when any member disrupts effective workings of the board. As a rule, the chairman of the board must demonstrate a high level of integrity, high ethical standards in his own behavior, as well as provide a lead on corporate governance matters. Only then, therefore, can he inspire investors’ confidence. The ideal chairman spends significant time mentoring, developing, and advising his colleagues; he is team builder, empathetic and very effective. He encourages contributions from fellow directors and achieves consensus, yet he challenges and probes colleagues, especially the executive directors. He has an acute critical faculty and a critical thinking ability (Dulewicz, Gay, & Taylor, 2008).

The CEO As the chief executive officer, the CEO has the most important role in the management of an organization. He is the individual responsible for carrying out and implementing the strategic plans and policies as established by the board of directors, and he reports to the board. The main responsibility of the CEO is to defi ne the strategies and the objectives of the organization and submit them to the board. Shareholders usually mandate the CEO to guarantee them a return that maximizes the value of their shares, that is, a yield that would offset the risk taken. Shareholders’ sometimes excessive return requirement has induced some CEOs to engage in the doubtful business of fraud, which will be discussed in later chapters. The realization of legitimate shareholder return can, however, be done by creating an organizational environment that favors a sustainable value creation. The CEO must therefore assume full responsibility and accountability for the entire organization. Basically, the CEO is responsible for the following tasks (RBC, 2008) and that it can share with the other members of the executive team:

The Board of Directors and Corporate Governance 69 (i) Development of the management strategy for the entire organization and ensuring its approval by the board of directors; (ii) Defi nition of a performance-oriented business philosophy, based on ethics; (iii) Maintenance of a high level of spirit and motivation for managers and employees; (iv) Encouragement of the executive committee members, by setting up career advancement programs, fair delegation of authority and responsibility for individuals, and by clarifying strategic initiatives; (v) Development of a global management program, ensuring the effectiveness of the management team; (vi) Establishment of employee replacement plans and the ensuring of the continuity and the leadership required for the development of the organization; (vii) Fostering a customer-oriented climate; (viii) Acting as the fi nal decision maker on behalf of the board and by delegation; (ix) Ensuring that all transactions are conducted in compliance with laws, regulations, and codes of conduct, if any; (x) Working closely with the chairman of the board; and (xi) Ensuring that the purposes of board meetings are focused on the right issues. Modern corporate governance reforms require the CEO of listed companies to certify each year that he or she is not aware of any violation by the company of corporate governance standards, and this certification must be disclosed in the company’s annual report or, if the company does not prepare an annual report, to shareholders (NYSE Section 303A(12)(a)). The use of stock-based pay schemes seems to have induced some CEOs to manipulate earnings, and this calls for an increased need for board oversight. It is argued that whenever monitoring and compensation are separated through an audit and a compensation committee, the compensation committee may be willing to choose higher pay-performance sensitivity, as the increased cost of oversight is borne by the audit committee. In all cases, each board of directors should sets up an evaluation process for the CEO that does three things: it articulates the values and principles that underlie the company and defi ne its specifying nature; it defi nes a process to assess the match between those values and the behavior of its managers; and it reports on its assessment to its people and its investors. (Clark, 2003).

NOMINATION CRITERIA OF CORPORATE OFFICERS AND DIRECTORS The appointment of the organization managers and officers is a fundamental and constant process and can be considered as one of the most

70 Internal and External Aspects of Corporate Governance important tasks of the board and one of its main responsibilities. Manager nominating criteria should be recommended by the nominating committee and adopted by the board. They are intended to be used when considering potential candidates for the positions of board members. In this respect, education, competency, experience, qualifications and skills, and other personal characteristics of the candidates are to be considered by the board in the light of the existing and potential needs of the organization. The aim is to achieve a balanced board of directors, composed of members originating from diverse backgrounds and with appropriate expertise in the management of organizations. The criteria for selecting directors are summarized in Figure 3.4. Directors’ independence appears to be the most important criterion for effective director selection. As underscored in the previous section, a board of directors cannot exercise independent adjudication in the exercise of its responsibilities unless its members are independent. Most corporate governance legislations require that the majority of board members be independent as well as the composition of the majority of its standing committees. The audit committee, for instance, must be composed of independent directors only. To qualify for independence, however, a director should not have

DIRECTORS' FUNCTIONS

FIDUCIARY AWARENESS

SHAREHOLDERS' FAIRNESS

RESPONSIBILITY DELIMITATION

Figure 3.4

Directors’ specific functions.

APPLYING ETHICS

The Board of Directors and Corporate Governance 71 a relationship with the company, either directly or indirectly, and should not be partner, controlling shareholder, officer, or agent who has a relationship with the organization. Independence is crucial for the effective functioning of the board and the strengthening of its oversight role, including the supervision of all aspects of the management of the company’s activities. The board should therefore develop specific criteria for defi ning and delimiting its external directors’ independence. The Corporate Governance Listing Standards of the New York Stock Exchange (NYSE, 2002), for instance, stipulates that a director will not be considered independent if: 1. He is or was an employee of the organization over the past three years. 2. He is or a member of his immediate family is or was an officer of the organization over the past three years. 3. He is a current partner or employee of the external auditor. 4. He has an immediate family member who is currently a partner of the external auditor. 5. A member of his immediate family was in the past three years (but no longer) a partner or employee of the external auditor. 6. He concluded consulting contracts with the organization. 7. He holds other mandates of the board of directors that might affect its independence. 8. There were any interlocking directorships over the past three years between the companies related to the director and the company. The seizure of the independence of directors through the distinction between inside/outside directors is increasingly challenged; directors are instead classified as inside, outside, and gray-zone directors. With gray-zone directors meaning those directors although not employees or managers, are not effectively independent of the management team, because of business or family ties. Consequently, independent directors are defined as those directors who were appointed to the board prior to the incumbent CEO (Daily et al., 1994). Nominee directors should, however, demonstrate other personal attributes besides independence; they must be moved by integrity, honesty, and have established reputations for fairness, responsibility, and good judgment. They should demonstrate professionalism and adhere to ethical standards, allowing them to contribute effectively to organizational monitoring. Other factors may be considered by the board when assessing qualifications of nominee directors and this should include their understanding of management disciplines, organization activities, and the technology it uses. The level of education and experience of nominee directors are often considered important by the board, but also their personal achievement, their age, and sex. Increasingly, boards are aware that differences of views and confrontation of ideas can strengthen its capacity to function effectively. Thus, diversity begins to make its way in directors’ selection processes. In the case of mandate renewal, special attention should also be given to the

72 Internal and External Aspects of Corporate Governance historical performance of the candidates, such as past participation and contributions records to meetings and activities of the board. Nominee directors are also required to have the ability and willingness to commit sufficient time to the board activities. They are required to invest sufficient effort and time to understand the organization and its environment. All nominee directors must be evaluated with a view of harmonizing and developing an effective board of directors and with the aim of establishing teams that can best perpetuate organization traditions, the success of its activities, and defend the interests of its shareholders.

DIRECTORS’ CONFLICTS OF INTEREST Given that directors have control over the organization, on behalf of its shareholders, most legal systems circumscribe their activities to prevent them from overstepping their authority or putting themselves in a conflict-of-interest position. A conflict of interest occurs when a director’s personal interest hampers the interests of the organization or one of its affiliates. A conflict of interest may also take place when a director or an immediate family member receives unwarranted personal benefits, for the mere fact of his or her position in the organization or family link. Typically, directors are not allowed to compete with the organization or to take advantage of its opportunities. Legal systems also require that directors avoid any conduct which might reasonably be mistaken as creating an appearance of conflict of interest. Traditionally, legal systems have broken conflict of interest into several categories: (i) Conflicts of interest arising from transactions with the organization; (ii) Conflicts of interest arising from the use of assets of the organization; (iii) Conflicts of interest arising from being in competition with the organization; (iv) Conflicts of interest arising from the use without the consent of the organization opportunities and information; (v) Conflicts of interest arising from the lack of discretion in exercising authority within the organization; and (vi) Conflicts of interest arising from being bound to vote in a particular way at meetings. Theoretically, any director who enters into a transaction with his organization is putting himself in a position of conflict between his personal interest and his duty to the organization. Examples of confl icts of interest include: (i) The receipt loans or guarantees of obligations as a result of one’s position as a director; (ii) The involvement in an activity or business relationship which can interfere with current or potential organization business;

The Board of Directors and Corporate Governance 73 (iii) The acceptance of bribes or any other undue remuneration for services relating to the conduct of the affairs of the organization; and (iv) The acceptance or having an immediate family member accept donations from individuals or entities that deal with the organization. This is where the donation is made in order to influence directors’ actions, or where acceptance of the donation could reasonably create the appearance of a confl ict of interest. Conflicts of interest can either be financial or material and they can be apparent or potential. Corporate governance codes generally require that any director’s conflict of interest with the organization must immediately be brought to the chairman of the nomination committee and to the chairman of the board of directors. The board should then decide, after review, whether an action has to be taken. As a rule, the involved director, whether actual or potential, should not take part in the board’s discussions concerning his case. Conflicts of interest also include confidentiality, and directors are required to protect all organization nonpublic information at their disposal. Confidential information can be defined as any nonpublic information entrusted to or obtained by directors because of their position in the organization, and this includes: (i) Private information concerning the organization’s fi nancial and business position, prospects, or plans; (ii) Private information concerning possible fi nancial and business transactions; and (iii) Private information regarding discussions, deliberations, and decisions of meetings between directors or managers. Rules governing conflicts of interest should be strictly enforced, even in cases where they may be purely hypothetical. Directors may in fact be forced to repay all personal gains arising from conflict-of-interest transactions. Directors are not allowed to compete directly or indirectly with their organization. They are also not allowed to sit on the boards of competing organizations as their duties to each company would conflict with each other.

BOARD RESOLUTIONS A board resolution is a system adopted by the organization board of directors that authorizes the directors or management of the organization to undertake actions on its behalf. They can be placed before the board of directors by the board itself, by managers, or by shareholders. All organization resolutions must be passed by a majority of the board of directors meeting in session. Any resolutions which receive the board’s approval have to be recorded in the minutes of that board of directors meeting. Resolutions are intended to amend the organization by laws and regulations or to provide precise guidelines to the organization management on particular issues concerning the

74 Internal and External Aspects of Corporate Governance organization’s affairs. Board resolutions can deal with different organizational issues, such as approving major transactions, nominating new directors, hiring and dismissal of managers and employees, and the issue referring to standing committees for more review and study. Some organization transactions may also require resolution, issuing new shares or contracting new long-term debt, or any action that might change the organization’s ownership structure. The general operation of the business does not, however, require resolutions, since the original articles of incorporation of the organization should delegate it to directors and managers. All shareholders must receive specific notice indicating that the organization resolution has been passed by the board of directors, and all corporate resolutions which have been approved during the business year must also be presented to the shareholders’ annual meeting and the directors should be on hand to answer questions on the resolution. Resolutions should also be filed with the appropriate regulatory body in which the corporation has been registered. Occasionally the impact of a corporate resolution is so impacting that the organization will choose to present the organization’s resolution at the shareholders’ annual meeting for feedback by the shareholders before taking a fi nal decision on the resolution. This allows the organization to answer questions and build support (http://EzineArticles. com/?expert=David_Gass). As a basic rule, details of good corporate governance, such as holding meetings, adopting resolutions, and recording these events in corporate minutes, should never be neglected.

MAINTAINING BOARD OF DIRECTORS EFFICIENCY An efficient board of directors must meet a number of specific requirements, as shown in Figure 3.5. Because of its fiduciary responsibility, the board should be aware that its obligations extend beyond the interests of shareholders. The crucial role of the board of directors should in fact represent a source of

Fiduciary responsibility

Clear delimitation of responsibilities Fair treatment of shareholders

Figure 3.5

High ethical standards

Requirements for an efficient board of directors.

The Board of Directors and Corporate Governance 75 confidence for shareholders that should be ensured that the capital they provide to the organization will be protected from misuse and misappropriation by managers. Actually, shareholders’ protection and their equitable treatment have become key issues in recent years. In principle, the board should set the tone on ethics of the organization, not only through its own actions but also through the appointment and supervision of key executives and senior managers. In practice, however, the continued effectiveness of the board of directors requires a number of specific actions, as shown in Figure 3.6. The board has the responsibility of corporate governance within the organization, and this includes: (i) The establishment of a strategic planning process; (ii) The identification and the management of risks; (iii) The planning of management team succession and replacement and the evaluation of its performance; (iv) The communications, the disclosure, and the monitoring; (v) The internal controls; and (vi) The corporate governance.

BOARD EFFICIENCY CRITERIA

Governance Succession planning

Strategic planning

Risk identification

Figure 3.6

Disclosure & communication

Internal controls

Criteria for maintaining board of directors’ efficiency.

76 Internal and External Aspects of Corporate Governance The board must develop corporate governance policies and their implementation. Table 3.2 summarizes the functions of the board and states measures to ensure the existence of an appropriate governance structure. The measures specified in Table 3.2 must be reflected in the corporate governance guidelines of the organization, thus assuring that the board retains the required authority and has in place the necessary practices to carry out its task, that is, to review and evaluate the organization’s business operations and to make decisions that are independent of its management. The board should systematically and routinely review and develop practices to determine if they serve shareholders’ best interests. The strategic planning is also an area where the role of the board can have the greatest impact. Table 3.3 summarizes the functions of the board in this area. The strategic planning is exercised by the board of directors with respect to the formulation with management of fundamental policies and strategic goals and through the approval of certain significant actions, with regard to Table 3.2

Measures to Be Taken by the Board for Ensuring an Appropriate Corporate Governance System Measures

1

Developing a set of corporate governance principles and guidelines.

2

Establishing appropriate structures and procedures to allow the board to function independently of management.

3

Establishing board committees and defining their mandates to assist the board in carrying out its roles and responsibilities.

4

Setting expectations and responsibilities of directors, including attendance at, preparation for, and participation in meetings.

5

Undertaking regular evaluation of the board, its committees, and its members, and reviewing its composition with a view to the effectiveness and independence of the board and its members.

Table 3.3

Strategic Planning Process Measures

1

Supervising the formulation of the strategic direction, plans, and priorities of the company and annually approving the strategic plan.

2

Monitoring implementation and effectiveness of the approved strategic and operating plans.

3

Reviewing and approving the corporate financial objectives and operating plans and actions of the company, including capital allocations, expenditures, and transactions which exceed threshold amounts set by the board.

4

Approving major business decisions.

The Board of Directors and Corporate Governance 77 supervising the formulation, monitoring the implementation, and reviewing strategic orientations, plans, and priorities of the company. Other tasks of the board relate to corporate governance, senior management succession planning, and management performance evaluation. The supervision of the succession planning processes of the organization includes: (i) (ii) (iii) (iv) (v)

Senior manger selection; Senior manger appointment; Senior manger carrier development; Senior manger evaluation; and Remuneration of the chairman of the board, the CEO. and management team.

It was suggested that the ability of the board to better oversee the management of the organization can be significantly improved simply by the inclusion of independent directors (Fama, 1980; SOX, 2002; Weisbach, 1988). A board of directors is often the product of a specific culture, and its effectiveness presupposes the existence of an appropriate nomination committee in charge of identifying and recruiting competent members and capable of integrating the existing organizational culture. The board should ensure that the organization is able to respond to changing factors both inside and outside. It must have in this regard an effective system of risk management, as summarized in Table 3.4. It must ensure that appropriate mechanisms are in place to identify key risks and examine systems’ implementation and compliance. The board should be aware of the important role the internal control system can play as organizational effectiveness, reliability, and good governance mechanism. For this reason, it must, as shown in Table 3.5, fi rst consider the effectiveness of internal control, management, and information systems. Second, it must establish cultural values of the organization, as defi ned in policies contained in the code of conduct. Third, it must, examine the fi nancial statements of the organization, ensure compliance to standards of accounting and auditing, and contribute to the publication of annual reports. It must ultimately approve in advance dividends, capital allocations expenditure, and all transactions above a certain threshold. Table 3.4

Risk Identification and Management Measures

1

Ensuring that processes are in place to identify the principal risks of the company’s business.

2

Reviewing the systems that are implemented by management to manage those risks.

3

Reviewing the processes that ensure compliance with applicable regulatory, corporate, securities, and other legal requirements.

78

Internal and External Aspects of Corporate Governance

Table 3.5

Internal Control Measures

1

Reviewing the effectiveness of the company’s internal controls and the company’s management information systems.

2

Establishing the company’s values.

3

Reviewing the company’s financial statements and overseeing its compliance with laws.

4

Approving transactions exceeding threshold amounts set by the board.

A system of financial reporting and disclosure is a prerequisite for good corporate governance. It is beneficial to investors and other stakeholders in the organization. The quality of fi nancial reporting and transparency remain a responsibility of the board. Table 3.6 highlights the requirements for assessing the effectiveness of communication systems and fi nancial disclosure. This includes measures to collect feedback from stakeholders, supervision of the implementation process of full disclosure, and the time frame to review the processes and controls in connection with the assurance of the organization’s fi nancial statements. It is generally admitted in practice that the board is more likely to function effectively if the following conditions are met: (i) Directors are also shareholders, that is, they retain a large volume of shares; (ii) The board is determined to create long-term value; and (iii) The board is constantly on the lookout for efficient managers and talent. The board should regularly review the performance of the organization to ensure that there is good governance in the way it is managed. The most influential of the board actions, however, relates to its decisions at the strategic level. Such actions must be supported by the existence within Table 3.6

Oversight of Communications and Public Disclosure Measures

1

Assessing of communications effectiveness.

2

Overseeing establishment of processes for accurate, timely, and full public disclosure, including the company’s disclosure policy.

3

Reviewing due diligence processes and controls in connection with certification of the company’s financial statements.

The Board of Directors and Corporate Governance 79 the organization of a good planning process and strategic objectives. Such actions are also reinforced when the board is able to specify the methods to achieve those goals. Strategic planning success depends largely on the ability of the board to support the systematic implementation and the monitoring of the strategic planning. The board must be aware that a successful strategy will depend not only on the speed of its design and accuracy of its implementation, but also and more importantly on the organization’s ability to adapt its strategy to change. Although the board is an essential and decisive factor in the supervision of management organizations for their survival and good governance, its importance appears to have been diluted for some time. This can be explained by the lack of shareholders, who seem no longer taking their role very seriously, especially when it comes to choosing the right board members. Many individuals take part in the management of the organization and there is a risk in the variety of influences that can cause unintended overlap and even confl icting orientations. This could thwart the ability of the organization to pursue its main objectives of efficiency. It is important that the board is aware of these risks and takes the necessary steps to limit them. Effective monitoring by the board also requires that the allocation of responsibilities for supervision, implementation, and enforcement among different authorities be clearly defi ned so that the competencies of complementary bodies and agencies are respected and used most effectively. “The board should be large enough to provide expertise and diversity and allow key committees to be staffed with independent directors, but small enough to encourage collegial deliberation with the active participation of all members” (SEC, 2007).

DIRECTORS’ NOMINATION SYNDROME OF THE BROKEN LADDER Despite many national laws supposedly guaranteeing equal employment opportunity to all citizens, the boardrooms of their corporations are still overwhelmingly the subject of extreme discrimination; minorities, women, and common citizens are ashamedly excluded from boards of directors of corporations. The gap between women and ethnic minority representation in senior management and numbers in the wider population is particularly worrying. They are victims of what we qualify as the syndrome of the “broken ladder,” wherein the few last steps are missing in a way that no one can reach the boardroom if he/she is not pushed up from the bottom or pulled up from the top. In a word, any board pretender needs to have very solid ties to the ruling class because competency might not be enough and only ingratiating behavior may prove to be the strongest factor for obtaining board appointments. “To

80 Internal and External Aspects of Corporate Governance become a member of this elite club of senior managers and directors, it isn’t simply a question of whether you are able to do the job—other things come into play” (O’Hara, 2009). Indeed, a quick look through the landscape of corporate boardrooms in both developed and developing economies shows that many groups in society are still underrepresented in leadership positions in businesses around the word. A study by Catalyst, a nonprofit organization working to help women advance in business, found that women were particularly poorly represented in what are called “line positions”—jobs with profit-and-loss responsibilities. Those jobs are keys to advancing in the corporate world. Women account for only 6.4% of all line offi cers (CBC News, 2000). Only 0.8% of Japanese chief executives are women, compared with 10% in Britain and 23% in Sweden. Statistics on minorities are less common. Once they are allowed access, women and minority directors may join multiple boards at a faster rate, because they are more likely to hold advanced degree (Hillman et al., 2002). Although, there are wide discrepancies between developed and developing economies, the discriminating model is always the same. In every country an extremely select club controls boardroom access and women and minorities are particularly poorly represented. As a rule, individuals who lack privileged backgrounds have no chance to access positions of leadership in large companies. There also exists, for able individuals lacking privileged backgrounds, a subtle form of discrimination which will always keep them out of the boardroom. Companies led by a homogenous group of managers and directors may, however, risk becoming ineffective. Recruiting people from a variety of backgrounds to serve on governing boards can help companies to improve their efficiency. Diversity is indeed expected to encourage a greater range of ideas and increase the likelihood that board members will be able to exercise control over internal management to the benefit of shareholders. Although the process through which gender and ethnic diversity impacts fi nancial performance is subtle and complex, some functions of the board may benefit from diverse directors whereas other functions may actually suffer. Furthermore, the type of diversity appears to matter (Carter et al., 2007). Populating a corporate board with a homogenous group, however, may only result in a team unlikely to challenge upper management and do the job efficiently. This culture has persisted because of the tendency for boards to consist of a circle of “insiders” who are typically coming from a privileged class in society that has shared as education at elite institutions, family ties, political sphere, membership in exclusive social clubs, and upper-class backgrounds; and “this system perpetuates itself because of the widespread practice of appointing new board members on the recommendation of current board members” (Westphal et al., 2006), or under government pressures. Greater diversity both at the board level and within the management structure is needed, and some countries are

The Board of Directors and Corporate Governance 81 improving. “Chief executives need to walk into their boardroom, take a look around, and ask themselves: ‘Does this represent in any way, shape or form what I see around me when I walk around streets every day?’ Then they need to do something about it” (O’Hara, 2009). Such culture may even explain the corporate stagnation in many developing countries, and it might have been in developed countries “a factor in corporate decisions that have resulted in many negative outcomes for shareholders, including poor corporate performance, accounting scandals, and white-collar crime” (Westphal et al., 2006).

BOARD AUTHORITY USURPATION Large investors fi nd that it requires use of the board forum to express their view: they rather try to act directly on corporate managements, mainly by setting specific benchmarks of return and risk. Managers are actually pressed to manage reported earnings to meet large investors’ and analysts’ earnings and risk projections and requirements. They usually try to turn a loss into a profit or to ensure that profit does not decline. By imposing their law, large investors and analysts actually contravene the corporate legal structure of authority, as indicated in Figure 3.7. Besides being required to realize fi nancial performance, they are not in position to realize they are also forced to adopt their doubtful decision by their board of directors, and the best way to do it is to hire supportive directors. Finally, a fraud authority hierarchy is created in the corporation.

Figure 3.7

Legal and fraudulent corporate authority hierarchies.

82 Internal and External Aspects of Corporate Governance INTERRELATION WITH OTHER GOVERNANCE MECHANISMS The board of directors plays a pivotal role in corporate governance. As an integrated set of internal and external controls seeking the harmonization and the fairness of corporate operations, the board is seen as a crucial element in the corporate governance process. Basically, the board of directors plays two fundamental elements: decision making and oversight. The decision-making function is materialized by the formulation in collaboration with management of fundamental strategies; the oversight function is exercised through a review of management actions, adequacy of systems and controls, and the implementation of policies. The board of directors also establishes formal delegations of authority, limiting management’s authority and defi ning delegations. The relationship between the board and company performance is, however, seen to be indirect, but the board surely shapes the strategic direction of the company, sets company objectives, and evaluates business success, all of which could have a strong impact on company performance. The interface role of the board in the corporate governance mechanism can be understood by detailing the multiactions of the board in corporate governance. Specifically, board activities impact the corporate governance process in multiple ways: (i) First, at the level of the strategic planning process, the board supervises indeed the strategic formulation, monitors the implementation of strategies, and reviews and approves corporate objectives and plans. (ii) Second, the effect of the board is also sensitive at the level of the internal controls, because the board ensures the effectiveness of the internal control system and the well functioning of the risk management. It also reviews the company’s fi nancial statement and oversees their compliance with applicable audit standards and accounting and reporting requirements. (iii) The board’s impact on governance mechanisms is also felt at the level of compliance with law; it ensures that processes are in place for insuring compliance with law and regulations. (iv) Succession planning and evaluation of management performance is another area where the influence of the board is most impacting. The board supervises the succession processes and takes in charge the hiring and the compensating of high-ranking managers. (v) Oversight of communications and public disclosure are subject to strict board control; the board should assess the effectiveness and review due diligence processes and controls in connection with certification of fi nancial statements. (vi) The overall corporate governance is fi nally the board’s ultimate responsibility; it must develop a set of corporate governance principles and guidelines and establish appropriate structures and procedures to allow the board and its standing committees to function independently of management. It must set committees and defi ne their mandates and undertake their regular evaluation. It is therefore true to say that corporate governance starts and ends with the board.

The Board of Directors and Corporate Governance 83 CONCLUSION As the representative of shareholders, the board must play a crucial role in monitoring the management of organizations. In most cases, companies opt for a structure on two levels, which reserves to the board the responsibility for adopting the overall strategy of the organization and delegating all operational matters to the management team, appointed as monitors for this purpose. To fulfi ll its role, the board uses a number of standing committees composed mainly of independent members. Board of directors, despite being a vulnerable interface within the organization structure has, however, to ensure accountability and autonomy by fostering its own culture and this includes promoting constructive dissatisfaction, actively monitoring the fi rm’s risk policies and practices, insuring the necessary expertise in the areas concerned, and avoiding soft confl icts (Sudeep, 2008). The board is responsible for setting the ethical tone within the organization, not only by acting appropriately but also in the way it appoints and oversees highranking managers. “High ethical standards are in the long term interests of the company as a means to make it credible and trustworthy, not only in day-to-day operations but also with respect to longer term commitments” (OECD, 2004). Thanks to recent corporate scandals, boards are under severe criticism, and there is a serious urgency for a better understanding of all elements that determine board effectiveness. Academia has focused on a number of quantifiable characteristics, while practitioners lean toward elements that are not always underscored in the literature (Van Den Berghe et al., 2004). Public pressure for reform has seen its most powerful emanation in a new ‘enthusiasm’ for committees of the board composed of independent directors and seen as panacea for all corporate ails (Lumsden 2009). Board standing committees will be discussed in the next chapter.

COMPREHENSIVE CASE 3.1

New York Stock Exchange Statement of Corporate Governance Practices The best way to get a real flavor of the central responsibility of the board in the corporate governance process is by referring to the New York Stock Exchange regulation entitled “Statement of Corporate Governance Practices” (http://www.nyse.com/regulation/listed/1101074746736.html)

Required: Analyze the New York Stock Exchange Regulation entitled “Statement of Corporate Governance Practices” and discuss the implication of its different guidelines.

4

The Standing Committees of the Board of Directors and Corporate Governance

Given the wide range of responsibilities and functions the board is required to fulfill and that ask for advanced expertise, most corporate governance reforms require the board to be supported by a number of standing and specialized committees to help accomplish the task. As rule, the board is allowed to establish as many committees as needed and usually whenever an issue appears to be too complex and/or too important to be tackled by all its members. Such committees are usually chaired by a board member whose specific role is to be responsible in front of the board for the management and the effectiveness of the committee he chairs and to provide the necessary leadership to fulfill its mandate. The high emphasis placed on the committees’ system for resolving board issues can probably be defended on the basis of its practical benefits, although it may also present some problems. Nevertheless, the committees’ system is certainly becoming an important part of the organizational corporate governance dynamic. Especially the increased oversight and monitoring by the board through committees seems to lead to some increase in fi rm value (Brick et al., 2007). Thus, a number of standing committees that can be established by the board are discussed in this chapter.

STRUCTURE OF THE STANDING COMMITTEES OF THE BOARD The standing committees of the board of directors may be accurately described as subcommittees of the board. Such committees recommend policy for approval by the entire board and allow it to make full use of all the expertise, time, and commitment its members may have. By operating at the board level and not at the staff level, committees are meant to ensure diversity of opinions, but they should not, however, supplant individual responsibility of board members. They should be composed of two or three directors. Although listed companies may have several committees that have specifi c tasks to perform, small fi rms may decide to possess fewer committees. No matter the size of the company, while developing committees its board should respect a number of basic requirements:

The Standing Committees of the Board of Directors 85 (i) It should ensure and defi ne the specific needs to be entrusted to the projected committee; (ii) It should make sure that the directors constitute the majority of committee members; (iii) It should make sure that each committee has a specific mandate to address, and its members precisely understand such mandate; (iv) It should try, whenever possible, not having a same director chairing different committees; and (v) It should try to have nondirectors and relevant employees volunteer as members of committees; an exception is made for the audit committee. Committees’ functioning is similar in all of them and each committee should be, for instance, headed by a chairman to be held accountable for the management of the committee and its performance and must provide its committee with the necessary leadership to allow the fulfillment of its mandate. The committee chair should also fulfi ll any other role delegated by the board. Typically, he should chair committee meetings and ensure that it is well organized and running efficiently. Further, he should collaborate with the chairman of the board and the chief executive officer to determine the frequency of the committee meetings and prepare for the agenda. He should also select independent members of the committee and monitor their performance and oversee their responsibilities. He should report to the board with respect to the committee’s activities and make any recommendations deemed desirable by members. On the other hand, each committee must meet as often as required by the business activities or as claimed by any significant corporate and environment development. The committee chairman is the one who should determine, in consultation with members, the timing and frequency of the meetings, as he should prepare an appropriate agenda for this purpose, in consultation with other members but also with the board. The agenda and information on issues to be discussed must be communicated to members well in advance, thus enabling constructive discussions to take place during the meetings. The minutes of the meetings must be prepared under the responsibility of the committee chairman. Such minutes must generally be adopted at each meeting of the committee. Minutes may, however, be made earlier, if all members agree with the content. Minutes should be signed for adoption by the chairman, who should report to the board, usually at the earlier board meeting. The chairman of each committee should be responsible for setting the meeting agenda and objectives, in collaboration with the management and the board. The chairman and committee members must determine the frequency and duration of meetings in accordance with the organization bylaws. Each committee must conduct its own selfevaluation and report the results to the board of directors. It must also have its own charter, whose relevance should be evaluated periodically and the required changes be recommended to the board. Each committee member

86

Internal and External Aspects of Corporate Governance

should be appointed and removed by resolution of the board of directors. The appointed members should hold office from the date of their appointment until the next annual general meeting of shareholders or until their successors are appointed. Given that all committees are actually subcommittees of the board, it is unusual for any committee to act independently of the board. Typically, committees should discuss and present issues on which the board must vote. The increasing complexity of the issues addressed by the committees induces, however, the board to make greater use of committees, especially regarding technicalities and supervision issues. The most common standing committees of the board are summarized in Figure 4.1. Although their names may vary from organization to organization, they are generally: the corporate governance committee, the strategic

Shareholders' meeting

BOARD

Executive Committee & CEO

Corporate Governance Committee

Audit Committee

Strategic Comm. Nomination Committee

Risk Committee

Finance Committee

Other

Figure 4.1

CORPORATE GOVERNANCE

Corporate governance managers.

The Standing Committees of the Board of Directors 87 committee, the executive committee, the audit committee, the compensation committee, the nomination committee, and the fi nance committee. The board of directors may, however, entrust several functions to any single committee and may use different names for the same committee. It is also common to see the board adding new committees or removing some of the already existing ones, depending on its needs in fulfi lling its responsibilities. Each committee is supposed to fulfi ll the assigned mandate by the board, in accordance with the organization bylaws, the charter of the committee itself, and other legal requirements. Table 4.1 indicates that Air France–KLM has four board committees with specific missions: audit committee, remuneration committee, appointments committee, and strategy committee. Table 4.1 also defi nes the mission of each committee. Committees of the board are discussed each in turn in the following sections.

THE COMMITTEE OF GOVERNANCE One committee of the board that is gaining importance in these times of turbulent corporate behaviors is the corporate governance committee, which has the primary role of overseeing and enhancing the board organization, Table 4.1

Airframe KLM, Board of Directors Committees

Committees

Missions

Audit committee

The audit committee’s principal missions are to review the interim and annual consolidated financial statements in order to inform the board of directors of their content, to ensure that they are reliable and exhaustive and that the information they contain is of high quality, including the forecasts provided to the shareholders and the market.

Remuneration The remuneration committee is primarily responsible for submitting committee recommendations for the level of changes to the remuneration of corporate officers. It may also be asked to give an opinion on the compensation of the group’s senior executives, as well as on the possible policy for stock option plans for new and existing shares. Appointments The appointments committee is responsible for proposing candicommittee dates to serve as members of the board of directors as well as to replace corporate officers, particularly in the event of unforeseen vacancies. Strategy committee

The committee’s responsibilities include reviewing the strategic orientations of the group’s activities, changes in the structure of the fleet or scope of subsidiaries, the purchase or sale of aircraft-related or other assets, and the air subcontracting and alliance policy.

Source: http://www.airfranceklm-finance.com/board-directors.html.

88

Internal and External Aspects of Corporate Governance

procedures, and performance, along with ensuring the organization’s governance integrity and assessing governance development and practices in accordance with adopted policies, principles, and strategies. It makes recommendations on governance matters to the board of directors. Overall, the role of the committee of corporate governance usually includes a combination of responsibilities in the following organizational dimensions: (i) The alignment of operations of the board with the best corporate governance practices; (ii) The assessment of the effectiveness of the other standing committees of the board; (iii) The approval of the corporate statements in corporate governance; (iv) The determination of the independence of directors and monitoring compliance, and (v) The supervision of directors’ behavior on ethics and conflicts of interest. The corporate governance committee must report annually to the board on issues relating to corporate governance, including performance standards for directors, the size of the board and its structure, the charter and composition of all the standing committees of the board, and make the appropriate recommendations of proposals to shareholders, as required the corporate bylaws. As a general rule, a summary of each committee meeting must be circulated to each board member and the committee must report to the board at least once year on the status of its work at each regularly scheduled board meeting, and this should include the reporting on the board performance and the company’s governance. The chairman of the corporate governance committee should be appointed by the board of directors. He heads its committee in all aspects of its mandates and he is particularly responsible for effectively managing the affairs of the committee and ensuring the effective functioning of the organization. The corporate governance committee should be given the power to engage outside consultants and other advisors, as needed, to assist in carrying out its functions.

THE STRATEGIC COMMITTEE The board of directors generally entrusts corporate strategies issues to its standing strategic committee, whose main role is to support the board regarding policy and planned options and alternatives. The strategic committee also acts as a consulting body for the board of directors on the long-term strategic plans submitted by the management. Members of the strategic committee, which usually meet on a regular basis, should be chosen among independent members of the board, and furthermore its chairman is appointed by the board and has the primary responsibility to ensure

The Standing Committees of the Board of Directors 89 the proper functioning of the committee and act as its spokesperson and primary contact with the board of directors. In some organizations the chairman of the board also chairs the strategic committee. Members of the strategic committee may be removed and replaced and any vacancy must be filled by the board. Some specific responsibilities go back to the strategic committee; it must, for instance, be entrusted with the overseeing of the strategic development of the organization, the reviewing the long-term planning and budgeting processes, the evaluating and the recommending of the appropriate strategies, and the ensuring of organizational risk management and control. The strategic committee also takes part in decision making with regard to large organizational transactions, such as mergers and acquisitions (in some organizations this is entrusted with the fi nance committee), major research and development projects, and other projects that have a large impact on the future of the entity. The strategic committee should be given the required power to delegate authority and tasks to subcommittees or individual members whenever deemed appropriate in accordance with the organization bylaws. The pertinence of the strategic committee was, however, often challenged at the basis of two arguments: fi rst, it is believed that assigning strategy oversight to a single committee might invite less involvement by other board members; and second, that organization strategy should not be limited to a few directors because it is the responsibility of all the directors. Actually, it often advocated that not all board members have the passion for strategic thinking and do not also possess the vast expertise allowing them to deepen strategic issues. On the other hand, it is suggested that boards should look for diversity when searching for independent directors. Directors who lack experience in company’s sector or industry will be, however, of little help to the development of the strategies required for growth and shareholder value creation. Overall, setting up a strategy committee of the board may prove to be the best way to assess and contain risk associated with strategic execution.

THE EXECUTIVE COMMITTEE A clear defi nition of roles and the precise delineation of authority between the board and the executive committee are the very essence of corporate governance. The executive committee is composed of senior management and chaired by the chief operations officer (CEO). The executive committee should be given the power to act on behalf of the board of directors in all issues related to the organization management. The CEO should be allowed to decide on the allocation of responsibilities among members of his committee. He should be able to articulate the mission of the company, clarify its objectives and values, and act as its main spokesman. Figure 4.2 summarizes the main roles of the executive committee.

90 Internal and External Aspects of Corporate Governance

Executive committee

Strategy & risk manage.

Figure 4.2

Administration & control

Financial reporting

Executive committee main roles in the organization.

By reading Figure 4.2, it is easy to understand that the role of the executive committee is particularly important in many areas, whether strategic risk management, administration and control, or fi nancial disclosure, and so on. The executive committee is supposed to report directly to the board of directors on matters of strategic risk and internal control, and it is expected to provide an overview and demonstrate leadership. Further, it should be able to turn such organizational strategies into business plans, budgets, pro forma fi nancial statements, and fi nally into daily value-added transactions. This means that the executive committee should be constantly involved in all stages of strategic development and should be able to bring the necessary changes to the process. More precisely, executive committee responsibilities have to do with the following: (i) Risk identification. The executive committee must identify the major risks faced by the organization and discuss them with the audit committee and the board of directors in order to fi nd the appropriate solutions. This also includes the updating and the changes made necessary by the changing environment. (ii) Effective leadership. The executive committee must demonstrate strong leadership in managing the organization in the area of general administration and control. It must encourage a corporate culture that promotes ethical practices, integrity, and a positive work environment, as well as developing and maintaining an effective organizational structure capable of ensuring progress and the efficient replacement of employees and their progressive training. It is believed that such organizational style would be able to attract, retain, and motivate quality employees.

The Standing Committees of the Board of Directors 91 (iii) Internal control. The executive committee must design, implement, maintain, and evaluate periodically, in collaboration with the CFO, effective internal controls systems and procedures and must be able to provide reasonable assurance that fi nancial statements are presented in accordance with generally accepted accounting principles. It must also make sure that information on the organization is reported to the CEO through alternative channels within the organization and that any gap in controls and procedures is instantly reported to the audit committee. (iv) Current operation. It is the responsibility of the executive committee to ensure that the board is kept fully informed on all aspects of organizational operations, and on all significant issues relating to organization management. This includes the organization’s fi nancial position, performance of employees, relations with government agencies and regulators, and on any issue considered to be important for the future of the organization. Typically, the executive committee must ensure that communication and harmonious relations are always maintained with the board of directors. (v) Effective budgeting. The executive committee is responsible for preparing annual budgets for board approval. This is the time when main operating and fi nancial objectives are approved by the board and become benchmarks against which officers and employees’ targets are set and their performance measured. The board gives its consent to each year’s strategic plan, operating plans, and budgets, which are subjected to a detailed review. The executive committee is also expected to regularly review and evaluate its performance. (vi) Financial disclosure. The executive committee must play a decisive role in fi nancial disclosure and production of fi nancial reports and must be held accountable for their quality (SOX, 2003). The executive committee is also required to report to the board of directors and shareholders, in collaboration with the chief financial officer, on the reliability and relevance of fi nancial information reported by the organization. It should, in collaboration with the CFO, ensure that annual and interim reports contain no misrepresentations or fraudulent information and should ensure that the financial statements fairly represent the fi nancial position of the organization. It must also provide any certification required by law.

THE AUDIT COMMITTEE One major responsibility of the board of directors is to provide the organization with an efficient internal control system capable of constantly demonstrating its effectiveness and assets safeguard. Such a task is, however, entrusted to one standing committee of the board, called the audit

92

Internal and External Aspects of Corporate Governance

committee. In fact, most if not all corporate governance guidelines recommend that all publicly traded organizations must have an audit committee, and this has brought new expectations of audit committee responsibilities and effectiveness (Vera-Munoz, 2005). The audit committee is defi ned as A committee composed of independent, non-executive directors charged with the oversight functions of ensuring responsible corporate governance, a viable fi nancial reporting process an effective internal control structure a credible audit function, an informed whistleblower complaint process and an appropriate code of business ethic with the purpose of creating long-term shareholder value while protecting the interest of other stakeholders. (SOX, 2002) Currently most exchanges require listed company to have a minimum three-person audit committee composed entirely of directors that meet the independence standards and fi nancial literacy, at least for some of them. It is suggested, however, that while appointing fi nancial experts to the audit committee may improve corporate governance, their ability to do so is contextual (DeFond et al., 2004). It is obvious that the formal role of the audit committee is to assist the board in carrying out its monitoring function within the organization and the control over its operations, including its fi nancial reporting and compliance with laws and regulations. This actually encompasses several areas, such as: (i) Monitoring the integrity of fi nancial statements. The audit committee should monitor the integrity of the fi nancial statements of the company, and this includes its annual and interim reports and any other formal announcement relating to its fi nancial performance. Table 4.2 gives a listing of the reviews to be made by the auditing committee with regard to the monitoring of the fi nancial information. (ii) Monitoring external auditor activities. It is the responsibility of the audit committee to assess and make recommendations to the board, to be put to shareholders for approval at the general shareholders meeting, in relation to the appointment, reappointment, and removal of the company’s external auditor. The audit committee is in charge of overseeing the selection process for new auditors and their replacement in case of resignation. Some classical duties of the audit committee, with regard to the external auditor, are listed in Table 4.3. (iii) Monitoring internal audit activities: ensuring the independence of both the internal audit and external auditors and assessing their performance. Table 4.4 gives a list of some actions performed by the audit committee with regard to the monitoring of the internal control.

The Standing Committees of the Board of Directors 93 (iv) Reviewing internal control and risk management systems. One of the most impacting roles of the audit committee is the monitoring of the internal control and the risk management, to ensure that key risks are identified and adequately managed, and to review and approve the statements to be included in the annual report concerning internal controls and risk management. (v) Reporting. Table 4.2 No.

Audit Committee Financial Information Review Subject Review

1

The consistency of, and any changes to, group accounting policies on a yearon-year basis;

2

The methods used to account for significant or unusual transactions where different approaches are possible;

3

Whether the company/group has followed appropriate accounting policies and made appropriate estimates and judgments, taking into account the views of the external auditor;

4

The clarity and completeness of disclosures in the company’s/group’s financial statements and whether they are set properly in context;

5

All material information presented with the financial statements, including the operating and financial review and the corporate governance statement relating to the audit and to risk management;

6

A report on significant frauds reported to the group;

7

Where, following its review, the committee is not satisfied with any aspect of the proposed financial reporting by the company, it shall report its views to the board.

Source: SSL International PLC, Audit Committee Terms of Reference, at: http://www.ssl-international.com/Investor/CorpGov/Audit/Pages/default.aspx as accesed on March 15, 2009.

Table 4.3 No.

Audit Committee Duties With Regard to External Audit Duty

1

Approval of their remuneration, whether fees for audit or nonaudit services and that the level of fees is appropriate to enable an adequate audit to be conducted;

2

Approval of their terms of engagement, including any engagement letter issued at the start of each audit and the scope of the audit;

3

Assessing annually their independence and objectivity taking into account relevant UK professional and regulatory requirements and the relationship with the auditor as a whole, including the provision of any nonaudit services;

(continued)

94 Internal and External Aspects of Corporate Governance Table 4.3 (continued) No.

Duty

4

Satisfying itself that there are no relationships (such as family, employment, investment, financial, or business) between the auditor and the company (other than in the ordinary course of business);

5

Agreeing with the board a policy on the employment of former employees of the company’s auditor, then monitoring the implementation of this policy;

6

Monitoring the auditor’s compliance with relevant ethical and professional guidance on the rotation of audit partners, the level of fees paid by the company compared to the overall fee income of the firm, office and partner, and other related requirements;

7

Assessing annually their qualifications, expertise, and resources and the effectiveness of the audit process which shall include a report from the external auditor on their own internal quality procedures;

8

Assessing annually their qualifications, expertise, and resources and the effectiveness of the audit process which shall include a report from the external auditor on their own internal quality procedures;

9

Assessing annually their qualifications, expertise, and resources and the effectiveness of the audit process which shall include a report from the external auditor on their own internal quality procedures;

10

Meet regularly with the external auditor, including once at the planning stage before the audit and once after the audit at the reporting stage. The committee shall meet the external auditor at least once a year, without management being present, to discuss their remit and any issues arising from the audit;

11

Review and approve the annual audit plan and ensure that it is consistent with the scope of the audit engagement;

12

Review the effectiveness of the audit;

13

Review any representation letter(s) requested by the external auditor before they are signed by management;

14

Review the findings of the audit with the external auditor. This shall include, but not be limited to, the following: discussion of any major issues which arose during the audit, any accounting and audit judgments, and levels of errors identified during the audit;

15

Review the management letter and management’s response to the auditor’s findings and recommendations; and

16

Develop and implement a policy on the supply of nonaudit services by the external auditor, taking into account any relevant ethical guidance on the matter.

Source: SSL International PLC, Audit Committee Terms of Reference, at: http://www.ssl-international.com/Investor/CorpGov/Audit/Pages/default.aspx as accesed on March 15, 2009..

The Standing Committees of the Board of Directors 95 Table 4.4 No.

Audit Committee Actions With Regard to Monitoring Internal Control Action

1

Monitor and review the effectiveness of the company’s internal audit function;

2

Approve the appointment and removal of the head of the internal audit function;

3

Consider and approve the remit of the internal audit function and ensure it has adequate resources and appropriate access to information to enable it to perform its function effectively and in accordance with the relevant professional standards. The committee shall also ensure the function has adequate standing and is free from management or other restrictions;

4

Review and assess the annual internal audit plan;

5

Review reports on the results of the internal auditor’s work;

6

Review and monitor management’s responsiveness to the findings and recommendations of the internal auditor;

7

Meet the head of business assurance at least once a year, without management being present, to discuss their remit and any issues arising from the internal audits carried out. In addition, the head of business assurance shall be given direct access to the chairman of the board and the committee.

Source: SSL International PLC, Audit Committee Terms of Reference, at: http://www.ssl-international.com/Investor/CorpGov/Audit/Pages/default.aspx as accesed on March 15, 2009..

Doing its job by the auditing committee is not enough; the result should be reported to the board of directors, and the reporting responsibilities of the audit committee include: 1. The formal reporting of the committee chairman to the board on its proceedings after each meeting on all matters within its duties and responsibilities. 2. The audit committee recommendations to the board it deems appropriate on any area within its remit where action or improvement is needed. 3. The committee reporting to shareholders on its activities to be included in the company’s annual report. In order, however, for the audit committee to effectively perform its functions, it should given the following authorities: 1. It should have the power to require information from any employee or manager of the organization. 2. It should have the authority to obtain the required external legal assistance and professional advice, at the organization’s expenses. 3. It should have the power to invite to its meetings every member of staff and to proceed to its interview.

96 Internal and External Aspects of Corporate Governance A number of restrictions are, however, imposed on members of the audit committee; thus, they cannot, for instance, receive any compensation, except the reimbursement of the expenses engaged for doing their job, and the chairman of the committee must be an accountant or a fi nancial expert. Recent legislations on corporate governance have conceded much more authority to the audit committee regarding, in particular, its relations with the external auditor. The audit committee must, in this regard: (i) Make recommendations to the board for approval in general shareholders’ meeting, the appointment of external auditors and their dismissal, as it must also approve their remuneration and employment conditions. The most recent corporate governance reforms require audit committees of listed companies, the assessing annually of external auditor qualifications and performance; (ii) The audit committee should be responsible for ensuring the external auditor independence and should carry permanent monitoring of the external auditor activities, ensure its independence and objectivity, and should also take the necessary actions to guarantee the effectiveness of the complete auditing process, taking into account professional standards and regulatory requirements. This involves the development and the implementation of appropriate policies in respect to nonaudit services that the external auditor can provide, as well as the safeguard of the ethical orientation of the organization. The audit committee is also required to report to the board with regard to its activities and discuss annually, with the board, the performance of internal and external auditors in the implementing of audit plans; (iii) The audit committee must review the changes and amendments to be made to the accounting system and the financial disclosure policies. The audit committee must also examine the changes and amendments along with the desires and needs of the CEO and the internal auditor; (iv) The audit committee must meet at least twice a year, with internal and external auditors and without the presence of any officer or employee of the organization, on the one hand, and with employees of the company without the presence of external auditors, on the other hand. (v) The audit committee must have a written charter which should concentrate mainly on the goal of the committee and should include the required help to be given to the board, to ensure the integrity of the organization’s fi nancial statements, the compliance with the legal and regulatory requirements, the assurance of the external auditor independence, and the qualifications to monitor the internal audit function and external auditor performance. The audit committee must meet, on a regular basis, generally several times a year. The chairman, or any member of the audit committee, in consultation

The Standing Committees of the Board of Directors 97 with the chairman, should be empowered to call a meeting of the committee. A notice of each meeting should be sent to all members, indicating the place, date, and time and should also be accompanied by the agenda of the issues to be discussed during the meeting. The presence of independent fi nancial experts on the audit committee seems to enhance the usefulness of accounting earnings as a performance measure in compensating CFOs (Gore et al., 2007). It is, however, believed that the audit committee cannot fulfi ll its role of protecting investors unless it becomes a separate board elected by investors on a democratic rather than a plutocratic basis. It is suggested that an independent body elected by investors will provide better protection for them. It has other advantages, such as reducing board costs, protecting the reputation and integrity of directors, reducing the need for prescriptive stock exchange rules on board composition and structure, or prescriptive legislation on audit processes (Turnbull, 2007). Furthermore, it is believed that more principles-based standards need not result in less interfi rm comparability or have a negative effect on audit committee strength (Tsakumis, Doupnik, & Agoglia, 2009). In face of the current corporate crisis, it is still feared that more reforms should be undertaken if audit committees are to be able to strengthen the fi nancial reporting process (Cox et al., 2009). In summary, the audit committee must ensure the implementation and maintenance of internal control, fi nancial disclosure, and adequate risk management systems, including the prevention and the detection of fraud and errors. It must review and approve the appointment, the replacement, the transfer, or the dismissal of the internal and the external auditors. It should review the internal and the external auditors’ mandate, the annual audit plan, and the required audit resources and functions. Recent corporate governance reforms seem to have significantly increased audit committee roles and independence and contributed to auditor independence and audit quality. (Hoitash et al., 2008)

THE NOMINATION COMMITTEE Corporate governance reforms and exchange regulations also highlight the fundamental role of the nomination committee in the ethical functioning of organizations; they usually require each listed company to have a nominating committee composed entirely of independent directors, and such committee is also a standing committee of the board and its role is crucial for the proper functioning of the board and the strengthening of its independence and the quality of board member candidates. The nomination should be mandated to play a leadership role in developing good governance within the organization, mainly by ensuring the hiring of appropriate and efficient officers and managers. Figure 4.3 highlights the main functions of the nominating committee.

98

Internal and External Aspects of Corporate Governance

Nomination committee

Governance Structure

Independence

Figure 4.3

Governance Chart

Other

Nomination committee main duties.

According to Figure 4.3, the nomination committee oversees compliance with the rules of corporate governance relating to board member nomination, remuneration, and evaluation. A precise nominating committee performs a number of specific functions: (i) The nomination committee must formulate and design the appropriate governance structure of the organization and must oversee its implementation; (ii) It must oversee and monitor all matters relating to the independence of directors that might involve any potential confl ict of interest, just as it evaluates any change in status of a member of the board, and determine the propriety of his situation in light of this change; (iii) It must carry out a detailed examination of the structure of corporate governance, at least once a year, and recommend to the board the necessary amendments, as it must review the structure of the board on the size, composition, and independence and make recommendations on changes deemed necessary; (iv) It must proceed in search of qualified candidates and recommend to the board candidates for election or appointment. It takes part in the appointment of chairmen of various standing committees and

The Standing Committees of the Board of Directors 99 determines the number of members who sit on the board of directors; and (v) It should conduct the assessment of skills, knowledge, and experience already on the board of directors and, in the light of this assessment, a description of the role and capacity sought in candidates prior to identifying and recommending them. Periodically, the nomination committee should, in collaboration with the board of administration, evaluate the functioning of the board to identify major areas of concern. It must, on this occasion, assess the overall effectiveness of the board and the efficiencies of individual directors. It must have a say in the process of selecting directors and the ability to use specialized consulting services. Table 4.5 gives an idea about nomination committee duties in practice. Table 4.5 No.

Nomination Committee Duties Duties

1

Review and evaluate regularly the board structure, size, balance of skills, and composition and make recommendations to the board with regard to any adjustments that are deemed necessary;

2

Consider succession planning for directors and other senior executives, keeping under review the leadership needs of the company;

3

Prepare a description of the roles and capabilities required for a particular appointment, be responsible for identifying and nominating candidates for approval of the board to fill board vacancies as and when they arise as well as put in place plans for succession, in particular, of the chairman and the chief executive;

4

Review annually the time required from nonexecutive directors;

5

Ensure that on appointment to the board, nonexecutive directors receive a formal letter of appointment setting out clearly what is expected of them in terms of time commitment, committee service, and involvement outside board meetings;

6

Make a statement in the annual report about its activities, the process used for appointments, and explain if external advice or open advertising has not been used; the membership of the committee, the number of committee meetings, and attendance over the course of the year;

7

The committee should make recommendations to the board: on plans for succession for both executive and nonexecutive directors; on suitable candidates for the roles of senior independent director; on membership of the audit and remuneration committees, in consultation with the chairmen of those committees; on the reappointment of any nonexecutive director at the conclusion of their specified term of office; on the reelection by shareholders of any director under the retirement by rotation provisions in the company’s articles of association; and on any matters relating to the continuation in office of any director at any time.

Sources: http://www.ssl-international.com/Investor/CorpGov/Nomination/Pages/default.aspx as accessed on March 15, 2009.

100

Internal and External Aspects of Corporate Governance

The nomination committee should consist of a minimum of two independent board members and should preferably be chaired by the chairman of the board of directors. The nomination committee meets regularly and must keep minutes of its meetings. Its president is required to provide to the board a report of its activities and procedures.

COMPENSATION COMMITTEE Each CEO of an S&P 500 company made in 2007 (a crisis year, by the way) an average salary of $46,666 a day or $100 a working minute. And for this reason, in the eyes of the general public, executive compensation is the element of corporate governance that is most controversial and remains a major concern (Byrne, 1996b), and it should be given all the necessary consideration. The monitoring role of executive compensation is usually given to the remuneration or compensation committee of the board, and that was made mandatory by most recent corporate governance legislations. Such a role generally consists in identifying and awarding compensation to be paid to the executives of the organization and to report to the board for inclusion in the annual report. In family-owned and state-controlled fi rms, the remuneration committee seems to play a limited role on the pay-setting process, It, however, plays an impacting role in fi rms in which family members do not hold the top management positions and has a positive impact on the performance (Narasimhan et al., 2007). The compensation committee is subject to a number of operating rules. It must, for instance, be composed of three independent directors, and its chairman, who is appointed by the board, may also be revoked at any time by the same board. The committee must have full authority necessary to carry out its task and can delegate any part of it to one or more subcommittees as deemed appropriate. In this case, each subcommittee must include one or more members of the compensation committee. The compensation committee and its various subcommittees should be allowed to meet as often as needed to fulfill their tasks. The common responsibilities of the compensation committee are summarized in Figure 4.4. The tasks performed by the remuneration committee include: (i) The CEO and senior executives’ performance evaluation, in light of the organization fi nancial position and its objectives; (ii) The determination of the CEO and senior executives’ remuneration, based on their evaluation. In this regard, it must approve all wages, bonuses, incentives, and long-term incentives for executives and managers. It must also approve the overall amounts set and the methodology used for the determination of all wages, incentives, and bonuses for all employees other than executives;

The Standing Committees of the Board of Directors 101

Compensation committee

Evaluation of performance

Suggesting changes

Equity based compensations

Figure 4.4

CEO Compensations

Grants' approval

Compensation committee main duties.

(iii) The reviewing and recommending of equity-based compensation plans to the full board and the company’s approach to compensation; and (iv) The approval of all loans to executives. In order to be effective, the role of the compensation committee should report the board and should propose any action needed to improve the system. To this end, the compensation committee must be able to examine internal controls and recommend to the board any necessary changes. The compensation committee must fi nally have the authority to hire external consultants, which would help to fulfi ll its responsibilities professionally. Table 4.6 presents remuneration committee duties.

FINANCE COMMITTEE The fi nance committee is also a standing committee of the board and its role is to oversee all major fi nancial transactions undertaken by the organization. This committee must be composed of a minimum of two members and must be independent in their majority. All members should be recommended by the nominating committee and appointed and dismissed by the board.

102

Internal and External Aspects of Corporate Governance

Table 4.6

Remuneration Committee Duties

No

Duties

1

To review the framework of remuneration for executive directors and product group chief executive officers and its cost, and make recommendations to the board;

2

To determine the terms of service, including remuneration, for: (a) the chairman; (b) any director of Rio Tinto PLC and Rio Tinto Limited who is also a salaried employee of the company or any subsidiary; (c) any product group chief executive officer who is not an executive director of Rio Tinto PLC and Rio Tinto Limited;

3

To confirm management’s approach to remuneration and employment conditions strategy for any other employee of any group subsidiary whose employment constitutes a Band A, B, or C position;

4

To determine the pension arrangements, including widows’ arrangements, for those mentioned in (2) above;

5

To review any termination arrangements for those mentioned in (2) above;

6

To recommend share-based long-term incentive plans, or the discontinuance of existing plans, to the board;

7

To recommend to the board proposals for granting and, when necessary, exercising share options under the executives’ share option schemes;

8

To ensure that the company’s remuneration policy is consistent with management’s approach to developing future leaders;

9

To report on these matters and on any other matters referred to it by the chairman or the board, at the first convenient board meeting following the committee’s decision; and

10

To submit to the board a draft of the remuneration report required to be included in the company’s report and financial statements by relevant UK and Australian legislation and regulation;

11

The committee may seek external and internal advice on remuneration design and obtain external and internal remuneration surveys.

Source: Rio Tinto, at: http://www.riotinto.com as accessed on 10 October, 2008.

The fi nance committee should meet as often as necessary in coordination with the regular board meetings. The chairman of the committee must report annually to the board on the activities of his committee and its operating procedures. The fi nance committee is responsible for reviewing large projects with fi nancial management and should be granted the power to approve or reject, on behalf of the board, all large investment projects, business strategies, policies, and transactions relating to corporate fi nance, including the following: (i) Capital structure strategies;

The Standing Committees of the Board of Directors 103 (ii) (iii) (iv) (v) (vi)

Investment strategies; Investment programs; Mergers, acquisitions, and divestitures; Cash management programs and strategies; and Plans and strategies for managing exchange exposure and other risks.

The fi nance committee must have the authority and the necessary resources to fulfill its responsibilities, including the authority to hire independent fi nancial legal advisers. Like any other committee, the compensation committee must keep minutes of its meetings. It is suggested that fi rms with a fi nance committee of the board of directors or a CEO who has a fi nancial background tend to use lower levels of incentive-based compensation for their CFOs. Finance committees and CEOs with financial backgrounds seem therefore to provide stronger monitoring of the CFO’s fi nancial decisions (Gore et al., 2007).

OTHER STANDING COMMITTEES OF THE BOARD As a general rule, organizations’ boards can set up as many standing committees as they deem necessary to deal with issues requiring special care or special expertise. Some organizations may, for instance, opt for a risk committee, whose role is to approve, on a regular basis, the organizational risk and ensure compliance with policies and strategies recommended in this area by the board of directors. Other organizations may establish public policy committees, whose role is to review policies and programs, to ensure that the operations of the organization remain aligned with the expectations of their national government policies. Other organizations set up human resources committees, whose role is to support the board with regard to human resource policies to achieve strategic objectives. Corporate governance committees are also usually encountered; they are responsible for the oversight of governance within organizations. Their responsibilities include aligning the board governance best practices, but also discuss the relevance of ethical guidelines and the constant updating and monitoring of possible confl icts of interest and the ensuring of directors’ independence. An important share of the work of the governance committee is the monitoring of transactions with directors and shareholders. The sought objective is to provide a forum for monitoring transactions between the organization and related parties, making sure that they take place in normal business conditions. Other potential standing committees of the board are indicated in Table 4.7.

104

Internal and External Aspects of Corporate Governance

Table 4.7

Potential Standing Committees

Committees

Their Typical Roles

Board Ensure effective board processes, structures and roles, including Development retreat planning, committee development, and board evaluation; sometimes includes role of nominating committee, such as keeping list of potential board members, orientation, and training Evaluation

Ensures sound evaluation of products/services/programs, including, e.g., outcomes, goals, data, analysis, and resulting adjustments

Fundraising

Oversees development and implementation of the fundraising plan; identifies and solicits funds from external sources of support, working with the development officer if available; sometimes called development committee

Marketing

Oversees development and implementation of the marketing plan, including identifying potential markets, their needs, how to meet those needs with products/services/programs, and how to promote/ sell the programs

Personnel

Guides development, review, and authorization of personnel policies and procedures; sometimes leads evaluation of the chief executive; sometimes assists chief executive with leadership and management matters

Product/Pro- Guides development of service delivery mechanisms; may include gram Devel- evaluation of the services; link between the board and the staff on opment program’s activities Promotions and Sales

Promotes organization’s services to the community, including generating fees for those services

Public Relations

Represents the organization to the community; enhances the organization’s image, including communications with the press

Sources: http://www.managementhelp.org/boards/brdcmtte.htm#anchor486505 as accessed 11 September 2008..

FEARED COMMITTEES’ DISADVANTAGES The committees’ board system suggested by the most national corporate governance reforms is widely regarded as the more effective board system to deal with organizational issues and monitor their activities. It is, for instance, suggested that the boards perform two main functions, namely, setting CEO pay and overseeing the financial reporting process. The use of stock-based pay schemes, however, may encourage the CEO to manipulate earnings and this may call for an increased need for board oversight. Whenever the whole board is responsible for both setting CEO pay and overseeing the financial reporting process, it will be inclined to provide the CEO with a compensation scheme that is relatively insensitive to performance in order to reduce the burden of subsequent monitoring. When the functions are separated through the formation of committees, the compensation committee is willing to choose a higher pay-performance sensitivity, as the increased cost of oversight is borne by the audit committee. (Laux, 2008). One may, however, wonder how the

The Standing Committees of the Board of Directors 105 committee structure will fit in the context of the collective responsibility of members on which the board concept is built and also what are the limits of the concept of the committees’ board structure. Although the committees’ board system allows the board of directors to rely on more expertise, to gain flexibility and to claim more effective control over the organization, it also presents inherent drawbacks in the structure itself and they are equally important and must be considered. The following are of primary interest: (i) One of the main criticisms made to the committees’ structure is that it actually acts instead of the board, and this makes the board lose the traditional problem-solving advantage assumed in its collegial functioning, seeking the participation of all members in the decisionmaking process. The committees’ system is likely to make the organization lose the benefit of a range of managerial expertise that some of its members may possess, especially when selected and nominated in the most appropriate manner. (ii) The other major concern relates to the difficulty of determining the true control over various committees. Although they all belong to the board, they can often be niches of authority against the entire board. (iii) The third concern about the committees’ structure is the imprecision that may characterize the nature of the relationship of committees with managers, auditors, and other parties involved in the governance process. (iv) Another concern with the committees’ structure is the additional costs to be incurred to run committees and that are sometimes unnecessary. It is feared that board resources may be poorly used when committees are established merely for the sake of having committees. To avoid such a risk the board should agree to more supervision and monitoring on its own. (v) The fifth concern with the committees’ structure is the inappropriateness of any committee using internal managers for advice, both because a person’s loyalty will naturally lie with management and because they may be the very people the committee is supposed to be overseeing. (vi) The sixth concern involves the increasing liability of committees’ members: a very real risk that committee members may fi nd themselves subject to a higher level of responsibility. Having been responsible for overseeing specific issues and knowing that other managers are relying on the integrity of their work, they must be aware of the seriousness of their task, which is expected to be of the highest level of quality and much more complete. (vii) The seventh concern has something to do with the fear that the effectiveness of the board can be damaged by the diversity of committees that are ineffective, resulting in waste of time and resources. There is also a real danger that committee members may become frustrated and confl icted and feel their efforts are futile.

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(viii) The eighth concern points to the additional workload involved by the board, because of the existence of committees, mainly to coordinate the work of all of the committees. This often increases the management responsibility and the board can become deviated from its main objective if its various committees end up working apart from each other, without another board organ that integrates the various committees’ work. Overall, committees can be very helpful to the board if, however, each committee is carefully chosen and its task well defi ned. Committees should also be regularly reviewed to assess their effectiveness and validate their continuity.

INTERCONNECTION WITH OTHER CORPORATE GOVERNANCE MECHANISMS Most corporate governance reforms call for boards to establish a number of committees that are expected to add most value to the corporation. Committees may be of an ongoing nature, usually referred to as standing committees such as the audit committee, or may be formed for a specific short-term project or goal. The board committees are supposed to more effectively deal with complex or specialized issues and to use more efficiently directors’ time and expertise. Board committees make recommendations for action to the whole board for collective decision making. The three most common committees are audit, remuneration, and nominations committees. The audit committee impacts internal and external corporate governance mechanisms, because its aim is (i) To ensure that accounts fairly represent the company’s fi nancial position and performance; (ii) To monitor and evaluate the adequacy of internal controls; (iii) To review and agree on the audit plan; and (iv) To select the external auditors, appraise their work, and review their independence The remuneration committee can also play an important role in improving the overall governance in the organization by (i) Developing and determining policies and practices for remuneration of directors, the CEO, and senior executives and to disclose this to the market; (ii) Reviewing the remuneration and benefits of directors, the CEO, and senior management; and (iii) Adopting the remuneration report. The impact of the nomination committee is decisive because its responsibility is (i) To assess the board’s and organization’s needs in terms of skills, knowledge, and experience for directors, the CEO, and senior management and make recommendations to the board; (ii) To assess and review board performance and director development; and (iii) To ensure proper succession planning for the board and key executives.

The Standing Committees of the Board of Directors 107 The board may feel other committees are necessary for organization in specific industries. For example, a resources company may have an environmental committee, airlines may have a safety committee, and a charity may have a fund-raising committee. Implication in committees allows directors to deepen their knowledge of the organization, develop an expertise, become more actively engaged, and fully use their experience. Besides, the existence of committees may indicate to investors that the board is taking particular issues seriously.

CONCLUSION The massive number of recent corporate scandals in public companies has emphasized the need for enhancing oversight capabilities by the boards of directors and calls for greater expertise in monitoring businesses. It has prompted various reforms of corporate governance to focus on the system of standing committees of the board of directors and has imposed their setting in place. It seems even that that increased oversight and monitoring by the board through its standing committees has led to some increase in fi rm value (Brick et al., 2007). Numerous standing committees can be established by the board and each committee should be mainly composed of independent board members. The board’s ability to shape organizational governance through standing committees is supposed to be enhanced, as will its commitment to ethics. Some committees are almost unavoidable, whereas others may be of an optional nature. The audit committee, for instance, plays a key role in ensuring the quality of the entire financial organization, auditing, and internal control systems. The nomination committee acts as an insurance policy with regard to the appointment and the compensation of directors. Setting a committee is not, however, enough by itself to ensure the smooth running of an organization and the systemic governance framework. It is also necessary to back up each committee with the required assistance expertise through legal counseling and other professional help.

COMPREHENSIVE CASE 4.1

Microsoft Corporation Audit Committee You are invited to report to the Microsoft Corporation Audit Committee Charter and Responsibilities, at: http://www.microsoft.com/about/companyinformation/corporategovernance/guidelines.mspx, and you are required to underscore the major characteristics of such charter and to highlight differences, if any, with regard to what was advanced in the chapter.

5

Internal Control and Corporate Governance

Internal control has always been regarded as a priority strategic corporate governance defense mechanism and its role was further enhanced by the recent corporate governance reforms. Modern corporate governance legislation, for instance, requires the disclosure of three reports related to the effectiveness of a company’s internal control systems (SOX, 2002): the management’s report on the effectiveness of internal controls, the auditor’s opinion on management’s assessment of internal controls, and the auditor’s opinion on the effectiveness of internal controls (Lopez et al., 2006). Recent corporate governance legislation may actually be seen as the culmination of a century of development of internal control defi nitions, applications, and procedures, and they summarize such process development through their requirement of the internal control, its periodical review, and the annual report of its efficiency (Heier et al., 2004). Internal control is supposed to help the organizations to achieve their performance and profitability objective achievement in a most structured and effective way, to prevent loss and fraud, to ensure the reliability of its fi nancial disclosure, and to comply with laws and regulations, hence avoiding damage to reputation. Consequently, with an appropriate control system, the organization is supposed to be assured of accomplishing its goals with no surprises along the way. Although companies with more serious company-wide internal control problems seem to be of smaller size, younger, and weaker fi nancially (Doyle et al., 2007), internal control may prove to be beneficial to every organization, by encouraging them to stay alert and remain attentive to their environment. This chapter looks at the internal control as a value-added management tool and not as an administration burden and explains its functioning and extent.

WHAT IS INTERNAL CONTROL? The corporation is confronted with numerous aspects of corporate governance and the most challenging is how to translate governance principles

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into daily operations, especially with regard to the internal control system (Cattrysse, 2005). The best way to start, while studying the internal control, is to depart from the defi nition suggested by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), which sees Internal Control as a process, affected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories: (i) Effectiveness and efficiency of operations, (ii) Reliability of fi nancial reporting; and (iii) Compliance with applicable laws and regulations. (COSO, 2005) This defi nition allows us to focus our investigation of internal control on elements that seem to be more impacting. It should fi rst be emphasized that all managers and employees must be focused on the organization efficiency, reliability, and compliance with the rules and must constantly be checked for this purpose. The shortest way for the organization to meet such requirements is to establish an internal control system that is considered satisfactory by both internal and external interested parties in organization efficiency and that is constantly updated in the light of the changing environmental conditions. Reasonable assurance of the existence of such an effective control system must be given by the board and its standing audit committee. Such insurance actually aims to achieve specific goals in at least three ways. First, by seeking proof that the overall effectiveness of the company is constantly sought; second, by obtaining assurances that the internal control system is constantly functioning effectively; and third, by obtaining assurances that the overall personnel is familiar with its job and performs it effectively and that is subject to monitoring and in all fairness and objectivity. The reasonable assurance of the effectiveness of the internal control system is, however, accomplished in stages: the organization must fi rst carry out a deep examination of its entire internal control system to determine how it is actually operating and for the sake of implementing a new system in case of absence. It must then explore ways of improving the existing internal control system while making sure both internal management needs and the external environmental constraints are taken into account. It must fi nally assess the quality of the existing or the newly established internal control system, by determining to what extent it actually helps identify the major risks of fraud, mismanagement, waste, and management or operating abuses. It is crucial that the management team look at the internal control system as a process likely to affect, in a decisive manner, the effectiveness of all other organizational processes (including information systems) and personnel. It must be aware of the control

110 Internal and External Aspects of Corporate Governance possibilities offered by the internal control system, and it should particularly consider it as a strong operating tool whose results cannot only be tangible but also measured, monitored, and controlled. The objectives of the internal control extend, in fact, the protection of the organization’s resources, whether physical or intangible, to cover the prevention and the detection of frauds and embezzlement. The internal control can, therefore, play a key role in the implementation of good corporate governance, specifically when it encompasses the policies, processes, tasks, behaviors, and other aspects of organizations, mainly by facilitating its effective and operating efficient. The internal control also helps to ensure the quality of internal and external reporting and ensure compliance with applicable laws and regulations (Turnbull Report, par. 20). Figure 5.1 highlights the most important dimensions of the internal control process and identify areas in which it is expected to provide reasonable assurance regarding the achievement of organizational goals. We can see from the Figure 5.1 that the internal control addresses several aspects of the organization activities:

INTERNAL CONTROL

Risk management

Effectiveness and efficiency of operations

Reliability of financial reporting

Compliance with laws and regulations

Monitoring Substitute Figure 5.1

Internal control main objectives.

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(i) It fi rst addresses basic organization objectives: profitability, efficiency, and the safeguard of organization resources, mainly by dealing with the management of risks faced by the organization; (ii) It may even play a substitute role for the monitoring insured by the ownership structure, institutional ownership, the proportion of independent directors sitting on the board, and the proportion of accounting expert members of the audit committee (Michelon et al., 2008). (iii) It deals with the compliance of laws and regulations to which the organization is subjected and which avoids its legal suits and bad reputation. Management must be aware, however, that the effectiveness of the internal control system is everyone’s responsibility in the organization, and it is much more effective when built on the already existing management process; and (iv) It also deals with the preparation of the fi nancial statements and the assurance of their quality, in terms of reliability and timely disclosure. The internal control system also aims at ensuring that all fi nancial transactions carried out by the organization are recorded and that all of those registered are real, properly evaluated, constantly recorded, properly classified, periodically summarized and timely, and appropriately disclosed (AICPA, 2005). Since the 1970s, however, changes in economic, political, and regulatory environments and forces have been accelerating with a speed that some compare to the 19th-century industrial revolution, and this has affected significantly organizations’ internal control systems. It seems that organizations “ . . . are experiencing declining costs, increasing average (but decreasing marginal) productivity of labor, reduced growth rates of labor income, excess capacity, and the requirement for downsizing and exit” (Jensen, 2000). Although each organization seems to face its own unique set of internal control challenges, there are, however, evidences suggesting that corporate internal control systems were unable to deal effectively with recent economic changes (Jensen, 2000). Companies with more serious entity-wide control problems seem to be usually smaller, younger, and weaker fi nancially, whereas fi rms with account-specific problems tend rather to be healthy fi nancially but have complex, diversified, and rapidly changing operations. The internal control weaknesses determinants seem to vary based on the specific reason at the origin of weakness. Firm size and age are, for instance, strong determinants of staffi ng issues (Doyle et al., 2006). It is further suggested that a significant relation exists between audit committee quality, auditor independence, and internal control weaknesses (Zhang et al., 2006), and fi rms with larger audit committees, with greater nonaccounting fi nancial expertise, and more independent boards are more likely to remediate material weaknesses in internal control and in a timely manner (Goh, 2009). Internal control quality seems to have

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an economically significant effect, given that fi rms identified with material weaknesses in internal control have worse operating performance and stock returns (Tang et al., 2007).

INTERNAL CONTROL SYSTEM STRUCTURE When referring to our discussion on the board of directors in the previous chapter, we come to the conclusion that internal control is a process that must be initially designed by the board but that can only and should be implemented by the management of the organization, with the participation of the entire personnel. The primary role of internal control is to provide reasonable assurance regarding the achievement of the organization objectives in the three directions mentioned previously, that is, operational efficiency, reliability of fi nancial reporting, and compliance with laws and regulations applicable to the company (COSO, 2008). Given the magnitude of the internal control system, it must, however, involve everyone in the organization, and, further, its success is deeply rooted in such involvement and commitment. Figure 5.2 describes the main parties involved in the internal control system.

INTERNAL CONTROL

Board of directors

CEO

Other personnel

Audit Committee

Figure 5.2 Roles and responsibilities in internal control within the organization.

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From Figure 5.2 we can see that added to the fact that all employees of the organization must be involved in the operating of its internal control system, the internal control “melody” should receive a clear signal from the management, one that emphasizes the fact that internal control is something of high importance to be taken seriously. Further, all employees should also be apprised of their role in the building of the internal control and their interaction with other employees’ activities; they should fi nally have an appropriate means of communication allowing them to report to the management their personal appreciation and any breach of the control. The information dimension of the internal control is also important to external stakeholders and consequently the organization must maintain effective communication with customers, suppliers, shareholders, and regulators (COSO, 2005). It is the responsibility of the board of directors to ensure the existence of an internal control system within the organization and to constantly secure its effectiveness on behalf of shareholders. Practically, the board of directors is required to define the internal control policies and require regular evidences of its proper functioning. The findings and evaluation on the effectiveness must, however, be based on deep analysis. Unfortunately, most boards do not usually have the required advanced knowledge and expertise in the field. Board members should at least devote the necessary time and effort to making sure that the control system is operating appropriately and this does not seem often the case—not yet, anyway. In an attempt to resolve such weak monitoring of internal control, various recent governance reforms have suggested the so-called audit committee, exclusively entrusted by the board to ensure the existence and the proper functioning of the internal control and reporting systems (COSO, 2005). Despite the diversity in the monitoring of the internal control, it should be made always clear that the implementation remains, as outlined before, the full responsibility of the management team, particularly the CEO. On the other hand, internal and external auditors have a duty not only to monitor the whole process of internal controls but also to measure and attest its effectiveness. More than any other individual in the organization, the CEO must set the tone that will affect the integrity and the ethics of the whole internal control system. “The chief executive officer is ultimately responsible and should assume ‘ownership’ ” (COSO, 2005). The way it works in large organizations is quite simple: the CEO is fulfilling his/her duty in providing leadership and guidance necessary to its senior executives; and for their part, they assign responsibilities for the establishment of internal control to their respective personnel at lower levels. The situation may get more complicated, however, whenever we move to small size organizations, where the CEO is also owner of the company. Although, in such cases, its action on internal control is more direct, decisive, and suffers little delegation, it may also prove to be incomplete, due to the lack of expertise. Needless to say, some management teams have till today been able to continually evade controls, and this allows them to intentionally fake numbers and hidden

114 Internal and External Aspects of Corporate Governance data. A vigilant board of directors, particularly when it relies on an adequate system of internal controls and effective means of communication, may be the best bulwark against such fraudulent onslaught. Because accounting transcends all activities of the organization, it may also prove to be of precious help in strengthening internal control. It is actually expected that accounting and information systems play a decisive role in the success of the internal control, which are complemented by the intervention of the internal and the external auditors. They both take part effectively in the enhancement of the internal control; their activities are actually designed to assure the existence of controls and validate their required qualities. Ultimately, the internal and external auditors’ main role is to determine whether or not the controls do exist, are properly designed, implemented, and operating effectively and make recommendations for improvement where necessary. A number of other internal control contributors, other than the external and internal auditors, have to be mentioned, as they also contribute to the improvement of the quality of the internal control system of organizations. We can note, in this regard, lawmakers, regulators, customers, suppliers, fi nancial analysts, credit-rating agencies, the media, and the market. Although most of these external interested parties cannot act directly on the internal control of the organization, they can nevertheless exercise a positive pressure toward its improvement. Many national governance jurisdictions have enacted their own laws and regulations (SOX, 2002), as well as some international institutions (OECD, 2004), dealing with the internal control in organizations. They all call for a system of internal controls that provides reasonable assurance that the financial disclosure process is efficient. They are actually requiring that financial statements issued by the organizations be certified by a chartered external auditor. It is suggested that small size companies are more likely to be identified with an internal control weakness (Zhang et al., 2007). However, companies with larger audit committees, that is, with greater nonaccounting financial expertise and more independent boards, are believed to be more likely to remediate material weaknesses in a timely manner. The main objective is to achieve organizational and reliable financial information that enables managers and investors to take rational decisions, although recent accounting frauds may have impeded such desire, as we will see later in the book.

THE INTERNAL CONTROL PROCESS The internal control system can be broken down into five main and interdependent components (COSO, 2008). At the organizational structure, internal control refers to specific measures taken by the organization in order to achieve the defi ned objectives that are clearly explained. Figure 5.3 illustrates the dynamic and continuous aspect of the internal control system. It takes place in a control environment characterized by risk assessment, reporting, communicating and monitoring activities. For the internal

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INTERNAL CONTROL STRUCTURE

Environment of control

Risk assessment

Activities

Monitoring

Information & communication

Figure 5.3

Components of internal control.

control system to be functional, all its components must not only be efficient but must also be integrated to the organization operating system and be part of its control culture. Indeed, the internal control will gain in effectiveness whenever control activities are integrated into the operational infrastructure of the organization (AICPA, 2005).

Environment of the Internal Control One main responsibility of the board of directors with regard to internal control is to provide an appropriate control environment that is supportive and encouraging to the establishment and the maintenance of controls throughout the organization (US-GAO, 2002). Such control environment should involve integrity, ethical values, and competence on the part of all the personnel of the organization. It also means that there exists within the organization a philosophy and a management style, both distinguished by their rigor and the reward of efforts, and that are clearly expressed in the way the

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management assigns authority and delineates responsibilities. It is also characterized by the attention given to the monitoring and the guidance provided by the board of directors (AICPA, 2005). The control environment can therefore be regarded as the foundation of all other internal control system components and should be considered “as the trigger for the whole organization: influencing the control consciousness within the organization and among its staff” (COSO, 2005). The internal control describes the atmosphere in which components operate and perform their supervisory responsibilities and employees feel bound by organizational policies, procedures, and standards of ethics and good conduct. It also requires the existence of “an effective control environment, where competent people understand their responsibilities, the limits to their authority, and are knowledgeable, mindful, and committed to doing what is right and doing it the right way” (COSO, 2005). Internal control should also include appropriate mechanisms for immediate disclosure, at appropriate levels of management, of all identified significant gaps and other impacting control weaknesses. Such mechanisms should also be able to initiate corrective measures. Several factors affect the internal control environment and are summarized in Figure 5.4.

INTERNAL CONTROL ENVIRONMENT

Oversight Responsibility

Integrity & Ethic

Commitment to Competency

Human Resource Policies

Management's Philosophy

Assignment of Authority & Responsibility

Organizational Structure Figure 5.4

Specific control factors for an appropriate environment.

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The strengthening of the control environment of the organization remains primarily in the hands of the board of directors and the management, and they are expected to set the tone, for this purpose, mainly by adopting an inspiring control enhancing behavior. Thus, at the stage of control establishment policies and procedures, a written explanatory document should be prepared and communicated to all the personnel. It should promote the highest levels of integrity, personal standards, professional qualification, and leadership. In this document, the organization should seize the opportunity to emphasize its philosophy of authority and responsibility sharing that must be based on fairness, efforts recognition, and personal integrity. The most important elements of the control environment are highlighted in Figure 5.4 and are discussed in what follows (COSO, 2008).

Integrity and Ethical Values The success of the internal control system is dependent on the moral values of integrity and ethics that are adopted by the organization and imposed on all of the personnel. The integrity can only be introduced successfully to the organization when ethics is established and valued at the top of the organizational chart and carefully communicated to all employees and precisely when: (i) The management encourages a culture that emphasizes the importance of integrity and ethical values; (ii) The management quickly takes appropriate actions and measures once a breach of ethics manifests itself; (iii) The management discourages unethical conduct by establishing realistic and attainable goals, avoiding unnecessary pressures, and providing fair incentives; and (iv) The management always bases compensation, promotions, and reprimands on fair and objective criteria and achievement levels. The best way for an organization to promote ethics is to develop and seriously implement its own formal code of conduct, dictating well-defi ned appropriate behavior to all the staff and especially to the attention of senior managers. Further, as most serious attempts to ethics were actually performed by high-ranking managers, areas of confl ict of interest should be clearly and formally demarcated. Some organizations, for instance, make it mandatory for their employees and managers to periodically recognize such codes and even formally sign such recognitions. On such occasions, employees and mangers are sometimes given the opportunity, for instance, to answer questions, such as “Do they know what is acceptable behavior?” “What are the penalties that might be expected from an unacceptable behavior?” Or “How do they handle a situation when they witness a breach of ethics?” The complete process is set up in the hope of raising awareness of employees to the benefits of an ethical organization.

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The commitment to competency is yet another area where the human factor dominates the internal control process and imposes its mark. The organization must, therefore, be aware of such phenomenon by fi rst giving priority to an appropriate process of selecting, hiring, promoting, and compensating employees; second, by focusing on rationally identifying and clearly defi ning tasks when fi lling vacancies or fi rst hiring; and third, by the attention to considerations such as the required level of training and the extent of supervision of employees. Employees are, indeed, more efficient when they are properly trained. For this reason, management must provide employees with the necessary training and guidance to enable them to fulfi ll their responsibilities appropriately. It is only then that employees will be encouraged to maintain and improve their skills for the job. Management must adopt a managerial attitude and a business philosophy that encourages the success of an effective internal control. Management should therefore be credible in the eyes of all employees, who should be assured that competency and rationality in decision making is considered the key to organizational success and therefore takes precedence over all other considerations. The management should also make any decision only after consultation and in-depth analysis of risk and return and must always demonstrate an unwavering attitude in defending the organization’s interest, while remaining fair and equitable to all stakeholders. The effectiveness of the internal control environment also calls for an appropriate organizational structure, one that is required by its size, the nature of its operations, and its efficiency. This is the kind of structure that facilitates the flow of information throughout the organization and that is sufficiently flexibly adapting to the nature of the corporate operations and that must ensure that areas of authority and responsibility are structurally well-defi ned, clearly delimited, and officially communicated to all stakeholders. Such structure should be submitted to periodical evaluations and changes must be made when they are dictated by environment changes and other circumstances. Another key element enabling the organization to ensure an effective internal control lies in how the powers and responsibilities are assigned among senior managers and key employees. The appropriate assigning of authorities and the delegating of responsibilities to managers and the key personnel can have serious effects on the successful achievement of organizational goals, as evidence of the internal control effectiveness. All employees must be informed of their responsibilities and how their individual actions are closely related to the actions of others. This precaution is made effortless when the organization has a clear and precise job description that is constantly updated and should indicate clearly the degree of authority and responsibility delegated to each task. To be effective, an internal control environment requires the establishment consigned in writing of clearly described policies and procedures for recruitment, orientation, training, evaluation, promotion, compensation,

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and discipline of employees. When hiring executives or employees, routine checks must be conducted on applicants, according to predetermined hiring plans. Once hired, the recruits should receive appropriate training and follow-up. The responsibility for overseeing internal control goes back to the audit committee, whose role, as we already know, is to monitor and support controls’ operations and processes. This committee must examine the internal audit work closely and coordinate fi rmly the external audit activities. It must meet regularly to discuss major issues affecting operations control and performance and report to the board on the overall status of the internal control. The risk management cannot actually be separated from the internal control. Although this is widely addressed in the next chapter, we can already summarize its implications for the internal control. Risk can be defi ned as the possibility that the organization cannot achieve its set in advance objectives of profitability and efficiency. The risk assessment is carried out in two stages. First, through the identification and the analysis of relevant risks facing the organization while in pursuit of its objectives. Second, by taking all the necessary actions the effective monitoring of such risks requires. Consequently, objectives’ defi nition seems to be a prerequisite for any risk management system and by extension for any internal control system success. It is consequently important that at the highest level of the organization, objectives are presented in a comprehensive strategic plan. The risk management process ensures the organization goals are achieved in the following way: (i) By achieving operations’ objectives that are linked to the implementation of the core mission of the organization and its units, in terms of the efficiency of the integrated internal control process, including performance standards and safeguarding resources against losses; (ii) By achieving financial reporting objectives that are related to the preparation of reliable fi nancial statements, including fraud prevention and avoiding mishandling of fi nancial data; (iii) By achieving reliability objectives, by explicitly considering the possibility of misstatements due to fraud in risk assessment in fi nancial reporting; and (iv) By achieving compliance objectives that are related to adherence to laws and regulations applicable to the organization.

Control Activities Control activities are viewed as internal policies, procedures, techniques, and mechanisms that aim at ensuring that at least risk management guidelines are implemented and followed by all employees of the organization (US-GAO, 2002). As part of the organizational planning, control activities

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are essential to the management of risks threatening the organization’s resources. Control mechanisms include a wide range of transactions such as authorizations, verifications, reconciliations, reviews, security measures, and the production of appropriate documentation (AICPA, 2005). Control activities vary in different organizations. This happens for various reasons, such as differences in the internal control objectives, differences in the environment, level of organizational complexity, culture, or risks. The adequacy of internal control process depends on the activity choices and their effective implementation—if they are, for instance, appropriate and sufficient in numbers and if they are implemented correctly. Although control activities are very diverse, some are vastly common to most organizations and are recognized by the recent national governance laws that recognize the preventive and detective role played by the internal control. They all require organizations to establish risks of fraud assessment and examine related controls policies and procedures that help ensure that management decisions regarding risks and controls are met (SOX, 2003). Control systems may have different objectives and may be either preventive or detective. When, however, carried out properly and in a timely manner, all control activities aim to improve efficiency and facilitate risk management, or at least reduce it. Preventive controls activities attempt to prevent undesirable behaviors and events from happening. Examples of preventive controls include approvals, authorizations, verifications, reconciliations, reviews of performance, security of assets, segregation of duties, and controls over information systems (COSO, 2008). Examples of preventive controls are prior authorizations, verifications, reconciliations, performance reviews, securing assets, segregation of duties, and the various systems checks. Detective controls, on the other hand, are control activities designed to detect undesirable behaviors. They can provide proof of occurrence of such behaviors but cannot prevent them. Examples of detective controls are variance analysis, reconciliation of data, physical inventories, and the various audits. Preventive controls are important because they are proactive and focus on quality control. They are also important because they can provide evidence that control activities are carried out appropriately. Regarding the control over the fi nancial reporting, reliability seems to be the determining factor, and internal and external auditors are required to identify and test controls that are designed to mitigate the risk of manipulating figures, distort data on performance or risk. This involves, however, the use of personal judgment (SOX, 2002).

The Most Common Control Activities Management should focus on monitoring activities that can have the greatest impact on the fight against risks of fraud or breaches of trust and responsibility and that can jeopardize the attainment of the previously set

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organizational goals. The organization must seek both the general application and the common categories of control activities (US-GAO, 2002). (i) In terms of general application, any organization must have a system of formal control on all of its major activities. This includes policies, procedures, techniques, and mechanisms and must be evaluated regularly to ensure their continued relevance; and (ii) The common categories of control activities require that any organization must conduct regular monitoring of actual performance and compare the results with forecasts and the results of previous years. In addition, the organization must develop plans for periodic performance over the long term. Table 5.1 summarizes the common categories of control activities to be performed by the organization. Table 5.1

Common Categories of Control Activities

Category

Control Activity

Control over Human Capital

Company’s workforce should effectively be controlled to achieve results.

Control over Information Processing

Control activities suitable to information processing systems should be used to ensure accuracy and completeness.

Control over Physical Assets

Physical control over vulnerable assets should be performed to secure and safeguard vulnerable assets.

Control over Performance Measures and Indicators

Performance measures and indicators should be established and monitored.

Segregation of Duties

Key duties and responsibilities should be divided or segregated among different people to reduce the risk of error, waste, or fraud.

Control over Execution of Transactions Transactions and other significant events and Events should be authorized and performed by the appropriate personnel. Control over Recording of Transactions Transactions and other significant and Events events should be properly classified and promptly recorded. Control over Access Restrictions to and Accountability for Resources and Records

Access to resources and records should be limited and accountability for their custody should be assigned.

Control over Documentation

Internal control and all transactions and other significant events should be clearly documented.

Source: Built based on information from United States General Accounting Office (GAO) (2001) Internal Control Standards, August.

122 Internal and External Aspects of Corporate Governance Organizations must periodically perform a comprehensive high-level risk assessment of their information system (entity-wide security management program). They should develop plans that clearly describe wide security programs, policies, and procedures that support them. In addition, the responsibilities for security and information must be clearly defi ned. The organization should continually stay in touch with its security programs, monitor their effectiveness, and constantly make the required changes and must control the access to their information systems (access control). Also, organizations must classify their sources of information and establish the criteria for access to be provided to stakeholders. They must be able to identify authorized users of their information. Organizations must prevent or detect unauthorized access and should investigate any violations and take appropriate corrective and disciplinary measures required. Any change to the information system must be duly authorized. Also, the introduction of new software must be carefully tested and approved. Access to software should be restricted due to liability. Organizations must fi nally have an application control that covers the structure, policies, and procedures designed to ensure completeness, accuracy, validity, and authorization of all transactions during the application process. It should include both the routines contained in the computer programming codes, policies, and procedures associated with their uses, such as manual measures performed by the user to determine that the data are processed accurately by the computer.

Communications For an organization to master the control of its operations, it must have a system of relevant and reliable information covering both external and internal events. External communications enable and support the understanding and the execution of internal control objectives, processes, and individual responsibilities at all levels of the organization, whereas internal information is needed to facilitate the functioning of other control components identified, captured, used, and distributed in a form and time frame that enable personnel to carry out their internal control responsibilities. Information must, in all cases, be adequately identified, captured, recorded, and reported on time, to managers, investors, and other users. Today, managers can rely on a number of technological innovations in order to fulfill their responsibilities with regard to internal control (US-GAO, 2002). They can use information technology, sophisticated computer networks, and modern telephone devises, as well as integrated video conferencing, to collect and distribute information. The need to exercise an effective control over such systems has become paramount and depends on the size, the needed confidentiality of information, and the complexity of operations involved. Typically, relevant information must be identified, collected, and

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disseminated in a form and on a schedule that would enable employees to exercise their responsibilities. Communications forms should be broadbased and the management of information technology must assure useful, reliable, and continuous communications, and the appropriateness of information and communication systems to the entity’s needs should be considered. Published reports should deal not only with internally generated data but also with information about external events, activities, and conditions affecting the organization and deemed necessary to make an informed business decision. Effective communication also must occur in a broader sense and flow down, across, and up the organization itself. Table 5.2 describes the process by which pertinent information can be identified, captured, and distributed to the right people in sufficient detail. Forms of communication must be diversified and information management should be relevant, reliable, constant, and circumstantial. The published reports on information systems must address not only data generated internally but also external events data, activities, and conditions affecting the organization that are deemed necessary to the understanding of the internal situation. Generally speaking, effective communication must take place within the organization, and information must flow from top to bottom, but also from the bottom to the top, through the whole organization. Organizations should generally exercise two categories of controls on their information systems: general controls and application controls. The general controls consist mainly of activities to maintain the integrity of the system and the availability of the functions of information processing, network, and application systems. Applications controls apply to the treatment activities in computer centers to ensure the complete accuracy of treatment (US-GAO, 2002). These controls ensure that: (i) Appropriate tasks are carried out; (ii) Requests for correction of data are processed; (iii) Errors are noted to be corrected;

Table 5.2

The Process of Information Identification, Capture, and Distribution

1

Managers should receive analytical information that helps them identify specific actions that need to be taken.

2

Information should be provided at the right level of detail for different levels of management.

3

Information should be pertinent, summarized, and presented appropriately.

4

Information should be made available on a timely basis to allow effective monitoring of activities and to allow prompt reaction.

Source: Adapted from United States General Accounting Office (GAO) (2001) Internal Control Standards, August.

124 Internal and External Aspects of Corporate Governance (iv) Applications and functions are processed according to established schedules; (v) Backups are made at appropriate intervals; (vi) Recovery procedures for handling failures are implemented; (vii) Software development and change control procedures are consistently applied; and (viii) Actions of computer operators and system administrators are reviewed. Typically, the organization’s management must ensure that the necessary physical security and environmental measures required are in place to reduce the risk of sabotage, vandalism, and destruction of networks and treatment centers. It must also ensure that an effective internal communication is established within each location or working group that can have serious repercussions on all organizational operations. Thus, information systems should be constantly reviewed and updated in a constant effort to continually improve their usefulness and reliability. The process by which management can ensure good internal communication can be summarized as follows: (i) The existence of mechanisms allowing the free flow of information across the organization; (ii) The existence of an easy communication between functional activities; (iii) The assurance that no denunciation of fraud, misconduct, or circumvention of internal controls is subject to retaliation; (iv) The existence of mechanisms allowing employees to recommend improvements to the internal control; (v) The existence of recognition and reward system for good employees; and (vi) The existence of specific mechanisms permitting management to communicate frequently with supervision groups and the board of directors. As a general rule, the various laws controlling corporations require companies’ management to ensure that effective and reliable communication occurs with external groups that can have a serious interest in company’s business.

Monitoring Monitoring is the process by which management evaluates the smooth functioning of the internal control and its components; highlights deficiencies and communicates them in a timely manner in order that corrective measures can be taken. “Monitoring leads to the identification and correction of control deficiencies before they materially affect the achievement of the organization’s objectives” (COSO, 2005). This section will examine the role of the board of directors and management in the monitoring of the

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internal control. Both activities of monitoring and evaluation are taken into account (UC, 2004). The board of directors is responsible for defi ning the internal control process and assuring that it is adopted by the entire organization. It is also responsible for reviewing it periodically to ensure its effectiveness, based on reports provided by the management and audit committee. Such reports should not only cover any failure or weakness identified but also should offer a solution. Any effective internal control system essentially requires that there be effective and continuous communication between the board, the audit committee, and the management on issues relating to risk and control. When considering reports from management on internal control, the board must still take a number of precautions, such as: (i) The board of directors must compare management reports with the audit committee fi ndings on internal control; (ii) The board of directors should ensure that risks are taken into account and should assess how they are identified and managed; (iii) The board must evaluate the effectiveness of the internal control system in particular, in view of all the identified significant deficiencies and weaknesses; (iv) The board must determine whether the necessary measures were taken as quickly as necessary, to address important identified gaps and weaknesses; and (v) The board must consider whether the situation described in the submitted reports requires a greater monitoring of the internal control system. The board should also conduct an annual assessment of the overall internal control system in order to prepare its own annual statement on the subject. The assessment should focus on the issues addressed in the reports examined during the year but also any additional information of interest and any significant aspects of the internal control. The board should specifi cally, in its annual evaluation of internal control, focus on (UC, 2004): (i) Changes that occur since the last annual assessment in the nature and extent of risks and in the company’s ability to meet its changing external environment; (ii) The scope and quality of the management of risk and internal control and, where appropriate, the quality of work performed by internal audit function and the external auditor; (iii) The extent and the frequency of reporting the results of monitoring controls that can lead to a cumulative assessment of the quality of the internal control system and the efficiency by which the risk is managed; (iv) The impact of various failures and control weaknesses that were identified during the period; and (v) The effectiveness and reliability of the fi nancial disclosure of the organization.

126

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CONCLUDE

INTERNAL CONTROL MONITORING PROCESS

DESIGN & EXECUTION

REPORTING Figure 5.5 Internal control monitoring process. Sources: Adapted from COSO (2005) Internal Control–Integrated Framework, Volume III—Application Techniques (http://www.coso.org/publications/executive_summary_integrated_framework.htm), accessed on June 20, 2008.

Ongoing and Separate Control Activities Two major classes of monitoring activities of the internal control system can be encountered, namely, ongoing monitoring activities and separate or ad hoc monitoring activities A follow-up must be made during normal operations of the company and management should include regular operating and monitoring activities. These are called ongoing monitoring activities. They must also include comparisons and reconciliations and other measures taken to ensure that employees do their job properly. More importantly, the ongoing controls must seek assurances that managers and supervisors are aware of their responsibilities and of the necessity for control itself. During the monitoring activities, management is supposed to have a clear strategy to ensure effective supervision and be able to react quickly when problems arise. The evaluations’ activities should be used by organizations as a way to take a fresh look at their internal control systems. These are called separate monitoring activities. These assessments take the form of self-evaluation and examination of design control and direct tests; the focus must always be placed on the effectiveness of controls at a specific point in time. In addition, this type of surveillance also covers policies and procedures. The conclusions and recommendations should be brought to the attention of the management and, ultimately, the board of directors. INTERNAL CONTROL EFFECTIVENESS The effectiveness of internal control implies that managers examine its adequacy and understand how it allows them to accomplish the organization goals. They must also be able to say whether the methodology

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for assessing internal control is logical and appropriate and whether different assessments are carried out by the external auditor, having adequate ability and resources to accomplish its task with independence, and whether the organization has appropriate mechanisms enabling it to react promptly to any discovery of negative fi ndings. The effectiveness of the internal control system can be evaluated by the level of reasonable assurance that the board of directors and management are capable of providing, as regard to: (i) What extent operational objectives of the organization are met. (ii) Reliability with which the published fi nancial statements were prepared; and (iii) Compliance with which laws and regulations have been upheld. Management’s role in enhancing the effective functioning of the internal control system is crucial. Managers as well as auditors do not have to look at each piece of information to determine if controls work appropriately; they must focus their attention on high-risk areas. The use of sophisticated monitoring techniques, such as sampling, can provide a reasonable level of confidence that controls are working as planned. On the other hand, the market price seems to react to the internal control weaknesses. The information content of internal control weakness disclosures depends on the severity of the internal control weakness (Hammersley et al., 2008).

INTERCONNECTION WITH OTHER CORPORATE GOVERNANCE MECHANISMS Because it is the job of the internal auditor to help an organization to accomplish its objectives by introducing and implementing a systematic and disciplined approach to evaluate and improve the effectiveness of risk management, the internal auditor is being entrusted with an important role in the corporate governance process (Cattrysse, 2005). For this reason, recent national governance reforms usually focus on the crucial role played by the internal control in corporate governance and strengthening its enormous role in the organization. The reason is that the internal control allows the board of directors to be vigilant and gives it the means by which all other internal corporate mechanisms can be monitored and directed. Corporate governance is a combination of processes and organizational structures implemented by the board to inform and enable it to lead. They also monitor the use of the organization resources, management strategies, and policies for the attainment of organizational goals. The internal control with regard to corporate governance is widely regarded as one of the four pillars of governance, the other pillars being the board of directors, the management, and the external auditor. The internal control helps

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to assess organizational performance over time and continuously puts in place procedures for monitoring. It also ensures that managers know their responsibility for oversight and monitoring. In addition, fi ndings of ad hoc monitoring enable the identification of gaps that must be investigated. The control procedures ensure that the results of audits and other unfortunate discoveries are quickly assessed and that appropriate measures are taken to correct them. The internal control system is designed to provide reasonable assurance with respect to the effectiveness of virtually all the operational activities of the organization but also to be informed of the organization’s ability to take risks, to produce reliable information, and to ensure respect for the laws and regulations that affect the organization. Perhaps the greatest impact of internal control is its ability to affect favorably market price of the organization shares. Ultimately, an effective internal control system must enable a company to improve its performance, profitability, and achieve its objectives. Despite all the reasonable assurance that the internal control can provide, the concept of reasonable assurance is limited by the cost-benefit constraint induced by establishing control procedures. Improvement seems, however, to be in the way and the role of audit committees and auditors in the reporting of internal control deficiencies has being also upgraded following recent corporate governance reforms. It is suggested that a higher number of meetings of the audit committee, lesser proportion of “fi nancial experts” in the audit committee, and more auditor changes characterize fi rms that report weaknesses in their internal controls, in accordance with SOX, compared to fi rms with no weaknesses (Krishnan et al., 2005). While the internal control function is changing, consulting services are expanding, and with this expansion, however, comes a concern regarding the potential lack of objectivity for both internal and external auditors (Ahlawat, 2004).

CONCLUSION The managers of organizations have long sought ways to control their businesses. Internal control is implemented to maintain the organization toward efficiency and profitability while ensuring the achievement of its objectives and respect an atmosphere of minimization of risks. Internal control allows the management team to respond rapidly to any unexpected changes in economic conditions, competition, demand, and so on. Given that internal control is used to serve many important goals, more and more votes require generalization to all organizations and improving their operation. However, achieving operational objectives and organizational strategies may depend on factors outside the company, such as competition or technological innovation. These factors are clearly outside the internal control framework, which cannot control them. A very effective internal control cannot provide that information or feedback on

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the implementation of strategic and operational objectives, and it cannot guarantee their implementation. It also involves human actions that introduce the possibility of misjudgment. It may also be neutralized by collusion between employees or by constraints imposed by the directions. The internal audit function is evolving from its traditional oversight function to one that includes a broader advice and consultation role. On the one hand, internal auditors are becoming more involved in a wider spectrum of activities to add value to their organizations. On the other hand, economic pressures have forced many companies to consider outsourcing as an alternative (Ahlawat, 2004). In summary, a successful internal control is a process that achieves the most efficient combination of controls necessary to provide the highest insurance (lowest risk) that corporate objectives can be achieved reliably (KPMG, 1999).

COMPREHENSIVE CASE 5.1

Internal Control Guidance for Directors on the Combined Code The Combined Code on Corporate Governance, published July 2003, assesses the effectiveness of the company’s risk and control processes; it can be obtained from http://www.icaew.com/index.cfm/route/118905/icaew_ga/pdf. You are required to study the Combined Code on Corporate Governance and answer the question asked in its appendix and highlight their impacting effect on the quality of the internal control of organizations.

6

Risk Management in Corporate Governance

Firm value is supposed to be affected by risk in several direct and indirect ways, and for this reason an increasing number of companies are committed to risk management, considered to be one of their main objectives. It is actually argued that because of capital market imperfections, such as agency costs, transaction, or borrowing costs, “risk management at the firm level (as opposed to risk management by stock owners) represents a means to increase firm value to the benefit of the shareholders” (Bartram, 2005). It is also suggested that the risk is inherent to any corporate activity and companies that avoid any risk-taking activity may be not actually fulfilling appropriately their responsibilities to their shareholders. Basically, risk management is not about renouncing every risk but rather controlling those unavoidable risks in order to achieve stable and sustainable profitability for each dollar invested. Risk management needs also to allow for the achievement of a comprehensive strategy for growth, while taking into account market environment and market requirements. One notable innovation of recent corporate governance reforms is to have placed the risk dimension at the forefront of the management of organizations. It is, however, suggested that relation between risk management and agency conflicts may prove to be actually more complex than previously thought (Morelle et al., 2005). Boards of directors seem effectively to be moving from their current focus on internal control to a more comprehensive risk management program. (Brancato et al., 2007) and are increasingly convinced that risk management contributes to safeguarding the shareholders’ wealth and the company’s assets. The current serious crisis can actually be regarded as a failure of risk management within organizations. This chapter deals with risk management as an important component of the system of corporate governance.

THE CONCEPT OF RISK MANAGEMENT Companies are constantly faced with various categories of risks and must learn how to manage them, and this surely requires a specific culture and advanced skills. The aim is to respond effectively to potential, unpredictable,

Risk Management in Corporate Governance 131 and adverse economic, business, and fi nancial events that might affect the organization. Change and the uncertainty that always accompanies it are indeed the fundamental characteristics of today business activities. Unfortunately, such uncertainty and change usually translate into an escalation of the rates of return required by investors on corporation shares, and call for the need for greater transparency on the part of organizations. Coping with change and uncertainty, while safeguarding the organizations’ effectiveness, is becoming a major organizational challenge that most companies are facing today. Many benefits can be withdrawn, however, from managing the risk within the organization, and the fi rst advantage is expressed through the improvement of the certainty with which the company achieves its objectives effectively. In addition, risk management contributes to ensuring a sharper focus on priorities, strengthening the whole process of internal control, and emphasizing the integration daily practices of risk management. It is further often suggested that a risk management function is important for any organization and especially for those in the process of being redesigned or re-engineered for outsourcing reasons (Rosen, 2003). Indeed, “Few areas of corporate oversight are more important these days than the evaluation of the organization’s ability to manage risk” (Treasury Board of Canada, 2008). Like two sides of a coin, risk and control managements are virtually inseparable, and this means that “risks fi rst must be identified and assessed, then managed and mitigated by the implementation of a strong system of internal control” (Treasury Board of Canada, 2003). We can look at the risk as a specific uncertainty associated with current or future events and its management can, in the other hand, be seen as a specific process that includes appropriate mechanisms and relevant information ensuring that companies would not be unnecessarily exposed to avoidable uncertainties. It is also “a systematic approach to setting the best course of action under uncertainty by identifying, assessing, understanding, acting on, and communicating risk issues” (Treasury Board of Canada, 2001). Risk management is intended to contribute to the safeguarding of corporate assets and the prevention and detection of fraud and embezzlement of all kinds. Given that objectives of the company, as well as the environment in which it evolves, are constantly changing, this makes it difficult to manage risk and requires particular conditions as: A systematic, integrated but adaptable approach to risk management requires an organization to build capacity to address risk explicitly, to increase the organization’s and stakeholders’ confidence in its ability to achieve its goals. It contributes to better use of time and resources, improved teamwork and strengthened trust through sharing analysis and shares with partners. (Treasury Board of Canada, 2001) An efficient risk management system is usually the fruit of pertinent studies and regular evaluations that allow a deep understanding not only of the

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nature but also the magnitude of the risk involved, and there is a reward when it is successfully conducted, because company’s objective is more efficiently attained. For their part, the monitoring and the control activities involved in risk management have, as main objective, to secure such goal achievement. Risk management objectives include “those related to the achievement of a specific objective but also those fundamental to the viability and success of the company” (KPMG, 2008). Risk management can only be identified by highlighting the links between all kinds of risks confronting the company, and this adds a new dimension to it and requires that its process be considered as an integrated one. Any form of risk worth being managed, however, is proven only when its advantages overcome the costs involved. There is, however, no outperforming method to appropriately manage risk; even if a consensus does exist, requiring risk management should never be an isolated activity to be conducted by specialists only. Each organization can instead have its own approach to risk management, but the systematic process, described in Figure 6.1, appears to be necessary and may even represent one of the best practices today. According to Figure 6.1, risk management is carried out in stages and can be applied to the company as a whole or only to one of its departments. In any case, however, the process should be kept simple and a little formal. In small companies, for example, the owner must be able, on his own, to administer and coordinate the risk management activities of his company. Each step of the process suggested in Figure 6.1 is discussed in the following sections.

Risk Management Process

RISK OBJECTIVES RISK ANALYSIS RISK RESPONSIBILITY RISK STRATEGIES

RISK PROFILE

RISK MEASUREMENT Figure 6.1

Risk management process.

RISK CONTROL

RISK REPORTING

Risk Management in Corporate Governance 133 RISK MANAGEMENT OBJECTIVES The risk assessment activities include the development of clear and reasonable objectives that will guide employees, as well as delineate their responsibilities. It would also identify opportunities associated with the organization operation, the preparation of the financial statements, and the meeting of organizational goals and sought objectives. Risk identification is the basis for the determination of how risks should be managed. As for any management action, the development of the overall goals and objectives is fundamental to the success of the risk management process; it also constitutes its starting point. The company must therefore concentrate sufficiently on the goals and objectives of its risk management process; it should record them in writing and express them in terms that allow the measurement of their performance. It is commonly acknowledged that “for an entity to exercise effective controls, it must establish objectives and understand the risks it faces in achieving those objectives” (COSO, 2008a). In this regard, the guidelines must be sufficiently general, while being enough clear and precise, so that they can be embodied into the operational strategies. At the global level of the company, objectives and goals should be presented in a comprehensive strategic plan that should include a mission statement in the broadest sense, as well as in selected strategic initiatives. At the organizational units’ level, the goals and objectives must support the strategic plan of the company. These goals and objectives are generally classified into the following categories: fi rst, operational objectives that relate to the implementation of the core mission of the company and to the efficiency of its operations, including performance standards and safeguarding resources against loss or fraud; second, fi nancial disclosure objectives that relate to the preparation of reliable financial reports, including the prevention of financial fraud; and fi nally, adherence to laws and regulations objectives. The pursuit of the objectives must be clearly communicated to all managers and staff involved in risk management. Ultimately, the company must have an integrated management strategy, coupled with a risk assessment and the availability of resources necessary for their attainment. The objectives of risk management must, however, be developed rationally in order to safeguard their complementarily, and they are generally imposed by the organizational structure. It is important to emphasize that all levels of the organization should not only be involved in setting goals but also be committed to their achievement, as they should also be aware of the implications of their actions on the entire risk management process in order to avoid actions that may impede the progress of the organization. Note that risk management can be used for reasons beyond basic risk control, and other reasons may include offsetting CEO risk taking incentives and seeking improved operating performance (Westerman et al., 2004; Bartram, 2005).

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RISK MANAGEMENT RESPONSIBILITY The primary responsibility for the proper functioning of a risk management system lies within the management team, which must not only establish the system but also ensure that it functions effectively and on an ongoing basis. In small companies, the owner or principal manager can take over the whole process, whereas in large organizations “the board is ultimately responsible for determining whether management has implemented effective risk management (COSO, 2008b). The board of directors fulfi lls such responsibility, fi rst by controlling the risks the company faces and second by understanding how the management team deals with those risks that are critical to corporate goals. The board of directors usually oversees risk management through two of its standing committees, namely, the risk committee and the audit committee, as it also relies on the system of internal control of the company. If we remember our discussion on the chapter devoted to the board of directors, we note that any appropriate governance structure should be established by the board of directors, its risk committee, and its audit committee, as bodies responsible for overseeing and assuring the harmonious functioning of the risk management system as well as the development of risk management culture within the organization. Whenever necessary, the board should be able to seek specialists’ help and entrust them with specific aspects of risk management. It must ultimately determine whether the risk management system in place meets the needs of the company and also ensures that its members show a fi rm commitment to risk activities. It must fi nally guarantee that management is effectively applying its principles, belief, and conviction in managing the organization’s risks. It seems, however, that board willingness alone is not enough; it cannot induce enterprise risk management implementation. “Only boards with a separation of CEO and chairman, tend to favor more elaborated risk management” (Desender, 2007). One possible explanation is that CEOs might not favor risk management implementation and might withstand pressure from the board, especially if they are occupying the seat of the chairman. The board should, ultimately, ensure that the company has a clearly defi ned and documented risk management process. This should guarantee the adequacy of the organizational structure with regard to the proper flow of information and its communication with the executive committee and board of directors. Figure 6.2 summarizes the appropriate measures that should be taken by the board to ensure effective supervision of the risk management process within the organization. The role of the board in risk management activities can be summarized in four separate functions: (i) The board of directors has the responsibility for shaping and influencing culture of risk and control within the organization;

Risk Management in Corporate Governance 135

Board of directors & risk management

Shape Culture Ensure Framework

Undertake Review

Approve Limits

Figure 6.2 The board of director’s responsibilities in risk management. Source: Adapted from Royal Bank of Canada (2007, p. 83).

(ii) It must ensure that management has put in place the appropriate framework, policies, processes, and procedures necessary for proper risk management and assessment of its effectiveness; (iii) It must approve risk limits that require specific delegation of authority to management and it must fi nally review the overall policy of risk disclosure, major risk exposures, and specify exceptions. In many cases the internal audit committee plays a dual role of risk management and internal control as it is usually and specially designed to ensure that the organization has put in place risk policies, processes, and control mechanisms to manage risks and ensure compliance with laws and regulations, mainly by: (i) Ensuring that the risk profi le of the organization is consistent with its strategic objectives; (ii) Ensuring that appropriate policies and procedures and effective risk management systems are in place; (iii) Approving the policy implications of risk selection; (iv) Recommending, for approval to the board, transactions falling outside the authority of the management; (v) Reviewing the risk disclosure system, risk exposures and processes, and major risks; and (vi) Ensuring that all relevant information on risk is communicated in due course to the board of directors.

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The audit committee is responsible, on behalf of the board, for monitoring the integrity of fi nancial statements and should review and ensure the adequacy and effectiveness of the systems of risk management and of internal control, and should report to the board on their efficiency.

RISK PROFILE In order to manage their operations, companies must inevitably determine the level of risk they are willing to assume. Risk management has, therefore, become one of the main responsibilities of management teams, because it allows managers to act proactively to reduce unwarranted surprises. Failure to manage risks formally and knowingly may shed doubts about the organization’s ability to achieve its goals of efficiency and to comply with the established standards and laws. Recent corporate crisis has shown how true such an assertion can be. As noted earlier, companies may be exposed to a variety of risks and it is therefore impossible to identify and evaluate individually each one of them. Depending on the company, management must be able to identify both internal and external risks to which their organization is exposed, and to highlight their origins, using different assessment methods of risk exposures. The organization should, for example, develop an organizational risk profi le mainly intended to study both risk threats and opportunities but also consider corporate objectives and resources availability. The collection of relevant information at all levels of the organization is, however, necessary for the building of the risk profi le of the business. It allows all the organization personnel to fully understand the risks that concern them, and determine their likelihood and potential impact. Furthermore, the identification and evaluation of existing risk management mechanisms at the organization units’ level is another essential component of the risk profile of the organization. Typically, while preparing its risk profile, an organization should aim for the following objectives: (i) The identification of risk threats and opportunities through appropriate internal and external environment knowledge; (ii) The establishment of the current status of the risk management system; and (iii) The identification of the risk profile of the company, the main areas at risk, risk tolerance, and the ability of the organization to mitigate the effects of risks. The organization actually needs a rational and systematic approach to risk identification and management, one that is rigorous and at the same time sufficiently flexible to allow adaptation to environment changes. Such

Risk Management in Corporate Governance 137 approach must be chosen depending on the nature and the degree of the perceived risk. To capture the diversity and complexity of risks, the organization can, in this regard, rely on various risk management techniques, including: (i) Interviews and internal discussions, including questionnaires, reflections, self-assessments, deepening workshops, and so on; (ii) Analysis of strengths, weaknesses, opportunities, and threats; and (iii) External sources of information, including comparison with competitors, discussions with peers and external consultants, and so on. A systematic approach to risk management can improve the determination of the probability of occurrence of risks and contribute to manage them more efficiently. It may also help to adopt a common language for organizational risk communication, management, and coordination. Figure 6.3 allows a clarification of the various risks that the organization may be facing. The framework suggested in Figure 6.3 highlights the key risk profi le, which may face most businesses. The pyramid approach for determining risk profi le may also be used to help identify and categorize risks. Risks can, indeed, be classified vertically in a pyramidal form to reflect the degree of risk control exercised by the organization. The pyramid approach can help the company develop a common internal language and introduce supplementary discipline in managing risk. The risk pyramid must, however, be reviewed regularly to ensure that key risks are constantly identified, classified, and treated appropriately.

The least controllable Average controllable risks: strategic, reputation and operational Greatly controllable risks: market, liquidity, and Insurance Figure 6.3

The organization’s risk profile.

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The Least Controllable Risks Risks placed at the top of the risk pyramid are those that the organization considers difficult to control and expects to encounter many difficulties to manage, through conventional risk management methods, for example, risk limits, and/or portfolio diversification. Such a category includes regulatory, legal, and competitive risks. These risks have a “negative impact to business activities, earnings or capital” (Royal Bank of Canada, 2007, p. 99). Organizations can use codes of good conduct or corporate governance codes to establish “tone-at-the-top” risk management policies and establish integrity culture and therefore compliance with laws and regulations. These codes should place emphasis on fairness and thus make them override all other considerations, under all circumstances. Competitive risks, however, are associated with the inability of the company to build or maintain a sustainable competitive advantage on its markets and such risk can occur within or outside its traditional sector or national boundaries. The competitive risk gains, to be managed at the overall organizational level, should also cover the risk assessment of new products and services, the improving of existing products, alliances and acquisitions, and so on. The management and staff must constantly understand that the ability of an organization to adapt to the changing competitive environment will have a decisive impact on the overall financial performance of their organization.

Average Controllable Risks The average controllable risks, located within the second highest level in the risk pyramid, are those whose control is supposed to be manageable by the organization. This is the case of the strategic risks, the loss of reputation risks, and the operating risks. These are, in fact, risks relatively more easy to control than the previous category (the least controllable risks) at the top of the pyramid. They are, however, more difficult to control than the category that follows, those located at the base of the risk pyramid. The strategic risk can be defi ned as the potential of loss arising from the lack of strategies, or their inefficiency and inability to adapt to changes. Reputational risks are expressed through the potential of negative publicity, which the company may suffer from and which can be harmful to its market value, or liquidity. Finally, operational risks can be defined as losses resulting from inadequacy or failure of internal control processes in incorporating external events operating effects. As for all major risks, strategic risks are usually monitored, evaluated, and managed by the management, under the supervision of the board of directors. The overall strategy must normally be prepared by the CEO, in consultation with the board and conditional on its required approval. Each manager of an organizational unit is also responsible for the strategic risk management of his unit and to ensure that the chosen strategy is in

Risk Management in Corporate Governance 139 line with the overall organizational strategy. The unit manager must also be accountable for his actions in risk management to the CEO, who is required to report to the board as to how risks are identified and managed across the whole organization. Organization reputation is on the verge of becoming the most valuable organizational asset and is worth being defended. It is also becoming more essential to market valuation and value maximization of the organization. Reputation is, however, constantly subject to high fluctuation and the organization must be aware that such risk has to be managed along with other forms of risk, since they all have some impact on its future. As a general rule, organizations must have a clear reputation risk management policy, approved by the risk committee. The ultimate responsibility for the company’s reputation rests in the hands of the management, which must ensure that every employee contributes positively to the reputation enhancement, by ensuring that: (i) Ethical practices are followed at all times and at all levels of the organization; (ii) Interactions with stakeholders, customers, suppliers, and other parties are positive and cooperative; and (iii) Ensure that the organization complies with constant policies, laws, and regulations. The reputational risk is managed more efficiently when each individual works to improve the organization reputation. Organizations are also constantly exposed to operational risks, expressed in the mishandling of transactions, inadequacy of documentation, technology failures, theft, fraud, and embezzlements of all kinds. The impact of such risks can cause enormous fi nancial losses, penalties, and damages to corporate reputation. Operational risk management is fundamental to value creation and the organization operations running smoothly. The organization should ensure and maintain an operational risk management that transcends organization structures and hierarchies. Again, the task is usually entrusted to the risks management committee, which must establish processes, policies, and practices. The committee must also evaluate and report the results to the board of directors, and it can have recourse, whenever necessary, to specialists to help solve technical issues.

Controllable Risks The controllable risks are those over which the company exercises the maximum control and has the highest influence. They are located at the bottom of the risk pyramid. They cover a variety of risks, such as the liquidity or market risks. The organization is actually exposed to the liquidity risk when it is unable to meet its daily payments. It is exposed to market risk when the fi nancial instruments it possesses suffer a loss potential, due to changes in

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interest rates, variations in exchange rates, and movements in stock prices. Market risk can mainly be decomposed in interest rate risk and currency risk. Organizations must make sure they always have relatively easy access to the necessary liquidity for their daily operation, and this includes the necessary sum of money to meet their obligatory debt requirements. The process that ensures organizations adequate access to funds whenever they are needed is known as the liquidity management, and it is the responsibility of the fi nance committee. One of these responsibilities is to ensure that an effective liquidity structure is in place to properly measure and manage the liquidity risk. These needs can be assessed through the adoption of a conservative liquidity scenario, stating the liquidity amount that must be available at all times to ensure full coverage not only for payments coming due but also for forecasting operational liquidity needs. Cash requirements may be satisfied either by realizing that operating assets can be easily converted into cash or by efficiently managing cash flows. Corporations must also have emergency liquidity plans to address any unforeseen situation. The organization may also be exposed to market risk within its own investment portfolio, and that can be managed through a variety of processes, all aiming at the identification of specific risks and determining their potential impact. In this regard, the finance committee should regularly review the investment performance of the organization and assess the success of its portfolio management, whereas the risk committee must review and approve policies and limits of the risks taken. Typically, an organization should start new operations or expand existing ones only after assessing in depth their risks that are considered acceptable, and only when an appropriate risk management infrastructure is in place. Traditionally, the fi nance committee is responsible for managing market risks and must, for this purpose, periodically review and approve the market risk of the entire company. The organization may also be exposed to interest rate risk whenever its assets and liabilities reach different maturities. It then may be exposed to currency risk when it has investments abroad or when its assets denominated in foreign currencies are more or less important than its commitments in those currencies. A negative change in exchange rates may indeed adversely and significantly affect the net income and hence the overall return and stock price. Hence the need to minimize the impact of currency risk by managing effectively becomes a matter of necessity.

RISK MEASUREMENT In the hope of controlling risks, the company must determine how these risks affect its strategic objectives. It must consider for this purpose the degree of risk and the probability of their occurrence as well as their possible consequences on the organization and its environment. The terms probability and consequence take into account elements of uncertainty

Risk Management in Corporate Governance 141 and a wide range of risks. The risk matrix is a simple but effective way to illustrate the relationship between the probabilities and consequences of any risky event. Table 6.1 is based on the success determinants in achieving the overall goal of the organization to manage risk. It refers to the pyramid risks discussed previously and provides examples of risks, while emphasizing the relationship between their probabilities and their consequences. The use of the risk table is a simple and effective method of enhancing the likelihood and consequences of an event risk. Risk is rarely easy to measure in a precise manner. It is nevertheless possible to assess it, using several competing methods, through an integrated organizational approach. Table 6.2 gives an example of risk measurement based on qualitative and quantitative characteristics. The qualitative analysis is descriptive and aims at giving an overall level of risk. The use of score or percentage allows the classification of risks by their probability and consequences. The qualitative analysis is based primarily on digital data. Table 6.1

Risk Table

Consequences

Probability of Occurrence Low (distant) Moderate (possible) High (probable)

The least controllable risks Average controllable risks Controllable risks Source: Canadian Institute of Chartered Accountants at: http://www.cica.ca/index.cfm?ci_ id=17150&la_id=1, as accessed 24 January 2009.

Table 6.2

Examples of Risk Measurement Probability

Impact Negligible, Minor Moderate Major Catastrophic Score 1, 2, 3, and so on

Qualitative

Almost certainly Likely Possible Unlikely Rare Score 1, 2, 3, and so on Percentage probability

Quantitative

Ranges dollar Time horizon Percentage Hourly Person Daily Weekly Annually and so on Percentage of volume and so on.

Source: Canadian Institute of Chartered Accountants at: http://www.cica.ca/index.cfm?ci_ id=17150&la_id=1, as accessed 24 January 2009.

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Corporations can use a range of methods to manage their daily risks, such as risk indicators, data analysis and stress tests, and so forth. These indicators give an overview of the nature and level of risk exposure and changes underway. The events can also be placed in a centralized database, and once processed, they can more readily help understand the risks that arise. They can also provide a historical perspective of risk and establish a basis for measuring exposure and assessing efforts to cope with such risks. The sensitivity analysis can also be used to measure the impact of variations in risk factors such as changes in interest and exchange rates. They are designed to help isolate and quantify the risk exposure induced by macroeconomic changes. To do so, however, stress tests can be used to alert the management and the board to potential disruptive events’ exposures, whether of political or economic origin. Several types of tests can be used, including historical events of stress. The stress scenarios are reviewed and updated as often as needed to reflect events and hypothetical situations.

RISK ANALYSIS Once risks are identified, management should conduct analysis through a thorough review of their possible effects on the entire organization, allowing it to make more informed decisions. Risk analysis is dependent on the relevance of the organizational culture chosen, as well as on the clarification of strategies, the competence of employees, and the adaptation to change. The organizational risk management culture can be a major relief to a successful risk management. The way the management and the board of directors express their convictions with respect to the importance of risk management can have a direct impact on the behavior of the employees dealing with the risk. More importantly, the board must set the tone and influence the seriousness with which management addresses risk management. It is therefore crucial that the company possess an appropriate code of conduct, human resources policies, and systems of reward or punishment that support the risk management goals. This is to ensure that employees have the required knowledge and skills and are trained to adapt to change. Risk analysis should focus on clarifying strategies because they can completely change the outcome of risk management policies. It should enable employees to improve their knowledge and competency in risk management, given that this is obviously the driving force behind its success. The skill and competency of employees must guide the organization when choosing persons to be assigned to risk management. The competency refers here to the assessment of the risk management knowledge and processes, including how the system should work, or what constitutes a deficiency in this area. The availability of the required documentation on risk management can

Risk Management in Corporate Governance 143 be useful when controlling the process and updating knowledge. Management may consider a two-step process to place the right people in the right positions for risk management. The fi rst step is to establish the leadership of risk management at the management level. Those responsible for monitoring risk in this general direction must have a thorough understanding of the risks and possess the skills required for their management. Once the leadership of risk management is established, existing skills can be used depending on the degree of risk encountered (COSO, 2008b). Risk analysis should also focus on organization adaptability to changes within management as well as staff. Adaptation is, in fact, another important dimension of risk management. The organization must possess favorable mechanisms to risk anticipation, identification, and response to the risks imposed by changes in economic, regulatory, and operational environments. Priority must nevertheless be given to changes that can have a drastic and widespread impact on the overall entity. Special attention should also be given to the risks induced by the hiring of new executives and new personnel for key positions or as a result of a high turnover of employees in a given area. The introduction of computerized systems has changed the nature of risk management activities. There is, however, appropriate mechanisms to address the new constraints imposed by this phenomenon. The growth, as the decay, may be initiators of organizational change and may have a direct impact on risk management and strategies. The company has to review its risk management system whenever, for example, it starts a new production or abandons an existing one and, in general, whenever a major event upsets its daily routine. The risk management team and the entire staff, in general, should understand what is expected from them by being aware of the risks that arise in their area of responsibility and which may materially affect organizational goals. They should also be capable of mastering the controls that are important to manage or mitigate these risks. These expectations should not only be clarified and underlined in a code of conduct but also developed recognized and discussed at meetings, in performance reviews, or even be included in job descriptions. Moreover, the larger the organization the more such communication skills should be formalized (COSO, 2008b).

RISK MANAGEMENT STRATEGIES Each company defi nes its risk management strategy according to its proper needs, that is, according to its own risk tolerance and the risk tolerances of its key stakeholders. Available options must be evaluated on the basis of risk to be taken and the benefit to be gained. As indicated in Figure 6.4, risk management strategies are generally grouped into four broad categories: avoidance, transfer, mitigation, and acceptance.

144 Internal and External Aspects of Corporate Governance

Risk Management

Avoidance

Mitigation

Transfer

Acceptance

Figure 6.4 Risk management strategies. Source: Adapted from COSO (2008b, p. 18)

Risk avoidance is the decision not to take any risk and it seems therefore to be the answer to all types of risks. It has, however, its own price, as it also leads to a loss of opportunities that usually accompany the risk taking activities. The avoidance of risk may, however, be chosen knowingly and for strategic reasons, especially when the risk is considered to be too high compared to the potential benefit it may give. It can also result from a sustained aversion to risk. People are naturally suspicious of risk and may be affected in their decision, with regard to risk, by internal systems and organizational culture. Too much risk aversion may, however, act as an impediment to the organization growth and may lead to missed opportunities. Organizations can reduce loss possibilities by transferring their risk to others, but this can also be achieved using other means, such as fi nancial instruments transactions, insurance policies’ sales, or partnership establishments. The transfer of risk can be a useful strategy, particularly when the third party is more competent in managing risk. The implementation and the monitoring of significant success factors and key performance indicators is yet another means of achieving the risk decreasing goals. Checks prevention and detection techniques can help anticipate and manage, and significantly reduce, the likelihood of risk. These include internal controls and manufacturing and other process controls. An organizational culture of risk management can, of course, prepare employees in making informed decisions to mitigate the risks. Typically, risk management means that those who are in charge have the right strategies in hand to face the following choices:

Risk Management in Corporate Governance 145 (i) Strategic choices should be beneficial and allow the seizing of opportunities; (ii) Operational choices must ensure the availability of systems that are able to detect, correct, and manage the risks; (iii) Crisis choices should prepare the corporation to face eventual disasters; (iv) Choice flexibility should allow the set up of a business that can survive disasters, cost, and prosecution. All risks that are not avoided or transferred are assumed to be supported by the organization, and this also implies the acceptance of the implicated losses. Risk acceptance may, however, constitute a viable strategy whenever small risks are involved, that is, whenever the protection cost would overcome the loss to be endured.

RISK CONTROL Risk monitoring process includes information on risk analysis and the identification of appropriate measures to be taken while control is exercised. Actually, “the core of effective and efficient monitoring lies in designing and executing monitoring procedures that evaluate important meaningful controls over risks to the organization’s objectives risk management” (COSO, 2008b, p. 17). Figure 6.5 presents a model that can help in designing, implementing,

IMPLEMENT MONITORING

PRIORITIZE RISKS

IDENTIFY INFORMATION

IDENTIFY CONTROLS

Figure 6.5

Risk management monitoring model.

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Internal and External Aspects of Corporate Governance

and monitoring risk management. The model reiterates the importance of understanding risks and their mutual relationship and with controls. The monitoring of risk management begins with the understanding, deepening, and the prioritizing of risks within the organization. The prioritization of risks is used to identify the most significant among them by monitoring objectives and organizational levels. The second step is the risk ranking and it involves the identifying and the systematic scheduling, on a routine basis, of risks. The information obtained can impact risk decision making with regard to the type, the timing, and the extent of monitoring. The next step concerns the identification of controls in risk management or mitigation processes. Major controls are utilized to support conclusions in the internal control system or in its ability to function effectively. They often address one or both of the following characteristics: (i) Their failure could affect the whole corporation’s objectives but cannot reasonably be detected in time by other means; and/or (ii) Their management could prevent further control failures before they become significant or occur. Key controls identification helps to ensure that the organization commits resources where they can count more and produce the most value. The last step is identification of the information required for supporting the conclusion as to whether or not the risk controls have been put into place and are functioning as planned. This involves the understanding of how a risk management failure can occur and what information will be persuasive to determine whether it is working properly or not. The control involves the use of permanent monitoring procedures and/ or separate evaluations to gather and analyze persuasive information, supporting the conclusions on the effectiveness of internal control.

RISK REPORTING Risk information disclosure mechanisms aim to provide the management team, the board of directors, and investors with the necessary feedback with regard to the appropriate monitoring of the risk management. They provide the insurance that an integrated risk management is in place and it is operating effectively. An efficient risk disclosure facilitates learning and allows effective decision making, especially when considering successes and failures, best practices, and monitoring procedures. Corporations must evaluate the effectiveness of their risk management procedures on a periodic basis and disclose the results. They should also indicate the necessary adjustments to ensure sustained progress. There are three main types of risk reports:

Risk Management in Corporate Governance 147 (i) Reports prepared to the attention of internal managers and all staff; (ii) Reports prepared to the attention of the board of directors; and (iii) Reports prepared to the attention of stakeholders and outsiders, such as regulatory agencies. The management and the board of directors should receive risk management reports on a timely manner, and they should contain relevant and reliable information and describe progress towards goal achievements. They should also include indicators of change and other qualitative information such as customer satisfaction and employee attitudes. The board of directors should seek and obtain assurance that the organization has taken all the necessary measures toward the identification, the assessment, and the appropriate management of risks. The management team should develop a reporting process that meets the boards’ needs and requirements. Such a process must include written reports, presentations, and discussions. In addition, corporations that resort to external fi nancing are subject to additional and specific risk disclosure requirements. The most important are those relating to prospectuses and annual reports. The prospectus must, for instance, present and describe, in a detailed manner, risks that potential investors are expected to take and other risk coverage considerations, through a variety of factors, such as environment, operational issues, changes in pricing, labor relations, competition, and other factors.

IMPLEMENTING AN INTEGRATED RISK MANAGEMENT PROGRAM Acting on the basis of mere intuition, the risk management field would not guarantee success of results, because it does not protect against risk. An integrated program of risk management, as represented in Figure 6.6 is therefore necessary and its implementation should include the following: (i) The creation of a risk awareness culture within the organization, and every employee should have his/her responsibility for risk management clearly delineated; (ii) The establishment of specific risk management objectives and performance; (iii) The establishment of a structure of risk management; (iv) The communication and training on risk management; and (v) The implementation of policies and strategies in terms of risk management. To create a risk awareness culture, organization managers must show the way for the rest of the staff by unequivocally defi ning strategic objectives

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Internal and External Aspects of Corporate Governance

Risk Management Process

Culture

Structure

Objective

Communication & Training Implementation & Enforcement

Figure 6.6

Integrated program of risk management.

and focusing on values that they feel are most important. They actually must lead by example, making use of their leadership and efficient judgment. The integrated risk management program will, however, succeed only when risk management goals are aligned with those of the internal control. The risk management process should be initiated at the highest level of the organizational hierarchy. The management team must defi ne goals, prioritize, and clarify the steps in line with the predetermined program objectives. The risk management structure must take into account the business nature, its size, and the complexity of its organization. Thus, complex organizational structures should generally opt for formal risk management structures, where goals, objectives, policies, and procedures are contained in written document and the staff is officially assigned specific risk management tasks. Small organizations, on the other hand, should use instead relatively simple risk management structures that do not require the use of much resource. Each organization must, however, opt for procedures that best suit its needs but which define responsibilities, goals, objectives, and processes. The three measures that promote accountability at all levels of the company are: (i) The establishment of risk management responsibilities and their integration to other organizational responsibilities;

Risk Management in Corporate Governance 149 (ii) The integration of risk management to the organizational planning; and (iii) The promotion of competency in risk management by providing employees with the necessary tools, allowing them to align the risk management goals to those of controls. In every case, a good risk management system should ensure an efficient risk control throughout the organization. It should also lead to regular reviews of the risk management by the risk committee and the board of directors. Risk management policies, their assessment, and the active monitoring of internal and external risk events are also subjected to the risk committee scrutiny.

INTERCONNECTION WITH OTHER CORPORATE GOVERNANCE MECHANISMS Risk management may be closely linked to most other internal corporate governance mechanisms and play a major role in improving their effectiveness. It has, however, a privileged relationship with key internal control mechanisms for which it constitutes a major concern. Risk management represents the central theme of the internal control, whose objective is, above all, identifying risks and ensuring that everything necessary is done to make the risk management as effective as possible. Thus, risk management is closely related to internal control but may also affect several other corporate governance mechanisms. Consequently, a corporation possessing a solid risk management system increases its chances of having a good management team and effective personnel. Risk management encourages the corporation to emphasize the importance of leadership and employees’ managerial competency. It is also an effective management tool whose primary objective is to support the optimization of resource allocation and expenditure engagement. It is therefore supposed to encourage the value creation within the organization, encouraging managers and employees to be cautious and to continuously seek the learning of risk management. A sound risk management also allows the board of directors to exercise effectively its oversight role on the management team. The ultimate goal of risk management lies in the pursuit of shareholders’ value maximization while maintaining risks at their lowest levels. Aiming to meet market requirements, organizations try to impact market value of their shares through their risk management policies. Risk reduction can be achieved every time a transaction made by the organization has contributed to the reduction of its overall risk, increasing its market positive perception, and therefore, increasing its stock value.

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Internal and External Aspects of Corporate Governance

CONCLUSION Risk management arrays a special strategic significance in these changing times. It covers risk identification and presupposes the use of clear risk management strategies, a commitment to risk management at the highest level of the organization hierarchy, the delimitation of powers and risk management responsibilities, the existence of skilled employees, and having at their disposal the necessary tools for effective risk management and adaptability to change. A comprehensive and proactive risk management must be privileged, one that combines experience and knowledge and requires business units to take part in risk management and controls. The suggested system must be designed to promote a strong culture of risk management and ensure alignment with the corporate strategic objectives. Risk management can have an immense impact on the organization market value and on all the internal corporate mechanisms. In fact, the companies that manage their risks effectively are also able to achieve their objectives, mainly because they are able to identify their risk, to manage them, and respond in time. Many corporations having hard times these days could have avoided them, if only they took the precaution of having in place a serious risk management system.

COMPREHENSIVE CASE 6.1

Harvard University Risk Management System The risk management system of Harvard University can be found in the university’s 2007 annual report, p. 16. You are required to study carefully such system and to highlight its main features.

7

International Financial Reporting and Corporate Governance

The interest was clearly and early expressed for fi nancial information quality and comparability. This has made accounting legislators concerned with the quality of fi nancial statements preparation and disclosure. As a fi rst effort, and departing from such consideration, the majority of accounting regulator bodies throughout the world adopted precise professional standards for monitoring fi nancial reporting activities within their national boundaries. It has now become a generally accepted accounting principle, also referred to as GAAP. The objective of GAAP is precisely to ensure companies’ activities, comparability, reliability, and fairness in reporting over time. Corporate scandals in the year 2000 have exacerbated the search of transparency in fi nancial reporting. In a second impetus, and under the capital market globalization pressure, the need for international comparability has also strongly emerged as well as the need for international convergence. Some advanced accounting professions (the United Kingdom, United States, Australia, Canada, Ireland, but also Germany, France, Japan, Mexico, and the Netherlands) reacted to the need for international comparability in 1973 by creating the International Accounting Standards Committee (IASC). It later became the International Accounting Standards Board (IASB), aimed at elaborating and releasing international accounting standards for fi nancial reporting and promoting their use worldwide—a derivative of GAAP to be recognized throughout the entire planet. Such accounting standards are called International Financial Reporting Standards or IFRS. Standards elaborated before April 1, 2001, remain entitled International Accounting Standards or IAS. For its part, the International Federation of Accountants (IFAC) became a standard-setting body designated at the International Auditing and Assurance Standards Board (IAASB). This sets up international auditing standards. IASB and IAASB standards are gaining significant international ground and over 150 countries are proclaiming IFRS as their own GAAP, although some in the wording only. This chapter deals with international standards and how they may impact corporate governance.

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INTERNATIONAL FINANCIAL REPORTING STRUCTURE Two major international standard setting organizations share international accounting and auditing standardization activities: (i) The International Accounting Standards Board (IASB) for fi nancial reporting standards and (ii) the International Auditing and Assurance Standards Board (IAASB) for auditing standards. The IAASB is a standing committee of the International Federation of Accountants (IFAC). This section discusses the IASB and IAASB role in international accounting harmonization. Although other organizations play an impacting role in international fi nancial reporting harmonization, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) participates effectively in the improvement of internal control, and so on. The International Accounting Standards Board and the increasing international integration of the capital market have inevitably accentuated the need of international accounting standards and practices convergence. In 1973 the creation of what was once known as the “International Accounting Standards Committee” IASC was one of the outcomes of such dynamic and was the initiative of 10 national accounting professions. As early as 1987 the IASC raised its ambitions by seeking “to make comparable the accounts of any company throughout the planet,” conditional that the IASC completes, in a three-year period, a complete set of quality accounting standards, thus comparable to US GAAP (IASB, 2008). From the beginning, the IASC believed that alignment of international accounting standards (IAS), with “U.S. generally accounting principles” (US GAAP) would give him a competitive edge. The IASC efforts proved to be profitable in 1995 by concluding a historical agreement with the International Organization of Securities Commissions (IOSCO) under the auspices of the US Securities and Exchange Commission (SEC). Consequently, the use of IAS for all transnational listings becomes possible. The IASC doubled its activities since then and the small core of founders has been extended to include 16 member countries. The IASC also changed its name to the International Accounting Standards Board (IASB). It has taken full responsibility for accounting standard setting since 1 April 2001. The European Union decision to submit all its listed companies, including banks and insurance companies, from 2005 onward to IFRS fi nancial statements was the primary driver behind the significantly expanded use of IFRS. The new European Union–wide mandatory application of international fi nancial standards has had tremendous effect on accounting convergence. The Chinese adhesion to IFRS gives the IASB yet another opportunity to impose itself as “the” international accounting standard setter. The IASB structure for adopting IFRS has some specific features, as summarized in Figure 7.1. At the fi rst level of the hierarchy of the IFRS adoption process, we have the International Accounting Standards Committee Foundation (IASC Foundation) as a nonprofit organization dedicated to the development of

International Financial Reporting and Corporate Governance

153

TRUSTEES

IASC FOUDATION

IFRIC

SAC (Advice)

IASB

(Interpretation)

IFRS Figure 7.1 IASB structure for adopting IFRS. Source: Adapted from the IASB at http://www.iasb.org as accessed on 5 October 2007.

IFRS. The IASC Foundation is composed of two main organs: the trustees and the IASB. It has an International Financial Reporting Interpretations Committee (IFRIC) and a Standards Advisory Council (SAC). The Trustees of the IASC Foundation played a crucial role in the adoption of IFRS. They appoint members of the IASB and are also responsible for overseeing the entire international standardization process, while ensuring its funding. The entire responsibility of the IFRS standard setting remains, however, in the hands of the IASB, which is required to develop, in the public interest, “a single set of high quality, understandable and enforceable global accounting standards” (IASB, 2008), that is, IFRS. Their objective is to ensure transparency and comparability of information contained in the fi nancial statements. Other main responsibilities of the IASB reside in its obligation to cooperate with national accounting standards in order to advance international accounting convergence and harmonization. The IFRIC mission is “[to] interpret the application of International Accounting Standards (IAS) and International Financial Reporting Standards (IFRS) and provide timely guidance on financial reporting issues not specifically addressed in IAS and IFRS, in the context of the IASB Framework, and undertake other tasks at the request of the IASB” (Deloitte 2008a). IFRIC approves such interpretations, which are subjected to public comment. It then sends them to the IASB for consideration and approval as final interpretation.

154 Internal and External Aspects of Corporate Governance The financial statements are generally deemed to be in accordance with IFRS, unless they comply with the IFRIC interpretations (Deloitte 2008b). The Standards Advisory Council (SAC) is the forum where the IASB consults with individuals and national representatives concerned with the IFRS development takes place. As part of this consultation process, the SAC advises the IASB on a variety of issues, including the preparation of the agenda, adding to the draft calendar of meetings, changes in the priorities of projects, and changes to the priorities of the agenda. It also gives advice relating to projects under study, with particular emphasis on practical application and implementation, including issues relating to existing standards that warrant consideration by the IFRIC.

The IASB Due Process of Developing IFRS IFRS is developed through a process of international consultation, called “due process” (International Accounting Standards Board 2008, International Accounting Standards Committee Foundation 2006). The IASB due process is achieved in several steps, and always under the constant supervision of the trustees. They have, at any moment, the possibility to act in order to ensure compliance with the process. Figure 7.2 describes the whole process adopted by the IASB to develop IFRS. The legislative process of the IASB takes place in six steps: the due process approach to standard development is the one used by the fi nancial standard board of the United States and which is very popular. 1. The agenda preparation step is the starting point of the IASB standardization process and the IFRS development. It constitutes the opportunity to assess the appropriateness of the agenda items. Usually, at this stage, the IASB staff is asked to consider issues and identify those of interest as required by environmental change or at the other national standard setters, the SAC and the IFRIC. When deciding whether a draft agenda is to be retained, the IASB takes into account the following: (i) (ii) (iii) (iv) (v)

The relevance and reliability of the information for the users; The guidelines available; The possibility of improving the convergence; The quality of the IFRS to be developed; The resources available (International Accounting Standards Committee Foundation, 2006).

2. The IASB meetings constitute the second step of its standardization process; this step materializes through public discussions of potential projects. It has to decide the adoption of new exposure drafts after consultations on the agenda and priorities with the SAC, IFRIC, and other national standard setters.

International Financial Reporting and Corporate Governance

155

Agenda Decision Discussion Paper Public Consultation

Exposure Draft

Published IFRS

INPUT FROM: Advisory Council Working Group International groups, analysts; preparers; Audit technical partners Special interest groups Local standard setters

Feedback Statement

Jurisdictional adoption process

IASB two-year post- implementation review

Figure 7.2 The IASB’s standards-setting process. Source: Adapted from IASB AND THE IASC Foundation (2008). Who we are and what we do, at www.iasb.org, as accessed on August 27, 2008.

3. The project planning is the third step in the IASB due process. While the IASB may decide to add an item on its agenda, it may also decide to proceed with the development of an exposure draft, alone or jointly with another national standard-setting body. Whatever option is chosen, the procedure of due process is always followed and a working group has to be set up to monitor the exposure draft. 4. The development and the publication of a discussion paper is the fourth step of the due-process approach. The IASB usually publishes a discussion paper at this time dealing with the issue under study. Such

156 Internal and External Aspects of Corporate Governance publications are not, however, mandatory, although they can be very helpful in initiating discussions. They may also introduce new facts, clarifying points that remain obscure, and soliciting members’ early comments. If the IASB decides to skip this step, it should have reasons for choosing to do so. A classical discussion paper generally includes the following: (i) A comprehensive overview of the issue; (ii) Different possible approaches of addressing the issue; (iii) The preliminary views of the papers’ authors or the IASB and an invitation to comment. All discussions of technical issues related to the exposure draft should take place in public meetings. When a project is completed and has been approved, it is published as a discussion paper seeking public comment. 5. The development and the publication of the exposure draft is the fifth step of the due process. Whether the IASB decides to publish a discussion paper or not, it generally uses an exposure draft as a primary vehicle for public consultation. Unlike discussion papers, the exposure draft contains a proposal in the form of a standard draft or amendment to an existing standard. The development of an exposure draft begins with the IASB considering the following: (i) The issues and the recommendations emanating from the IASB research staff; (ii) The comments received on the discussion papers; (iii) The suggestions made by the SAC, the working groups, or the national standard setters. An exposure draft is then written, published, and submitted to the public for comments. The exposure draft is an invitation to comment on a draft standard or to react on a proposed amendment to an existing standard. 6. The development and the publication of any IFRS constitute the sixth step of the due process. Indeed, after resolving disagreement issues arising from the exposure draft, the IASB will decide whether or not to present its new revised exposure draft for public comment. If so, the IASB should: (i) Identify substantive issues that emerged during the comment period of the exposure draft, and have not been addressed before; (ii) Evaluate the evidences that have been considered; (iii) Assess whether the issues were sufficiently understood and actively seek the members’ views;

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(iv) Examine whether or not the various viewpoints were aired in the exposure draft and were properly taken into account, in the conclusions (International Accounting Standards Committee Foundation, 2006). 7. The IFRS development is the fi nal step in the due process. When satisfied with the quality of the exposure draft and its conclusions, the IASB, a vote on the exposure draft is generally conducted by the IFRIC. The IFRS is formerly adopted once the process is completed, all outstanding issues resolved, and IASB members voted in favor.

THE INTERNATIONAL AUDITING AND ASSURANCE STANDARDS BOARD The other major player in the international accounting and auditing arena is the International Auditing and Assurance Standards Board (IAASB): a standard-setting body designated by, and operating under the auspices of, the International Federation of Accountants (IFAC). The IAASB is subject to the oversight of the Public Interest Oversight Board (PIOB). Figure 7.3 summarizes the structure of the IAASB. The auditing standard process is headed by PIOB, formally established in 2005 to oversee IFAC standard-setting activities. The objective of the PIOB is to increase confidence in the investors and others that such activities, including the setting of standards by the IAASB, are responsive to the public interest. PIOB members are nominated by international institutions and regulatory bodies and as of the year 2008, IFAC has 157 members and associates in 123 countries. It also has jurisdictions representing 2.5 million accountants employed in public practice, industry and commerce, government, and academia. The role of the IAASB is “to issue international standards on auditing and assurance, quality control and related services, and to facilitate convergence of national and international auditing standards” (International Accounting Standards Committee Foundation, 2006). Standards elaborated by IAASB until now focus on three domains (International Auditing and Assurance Standards Board, 2008): (i) Elaboration of auditing standards; (ii) Follow-up of the process of adoption of auditing standards; (iii) Response to concerns regarding the application of standards in each activity. This is aimed to improve the coherence of standard practical application. The IAASB believes that if the public must have confidence in the information contained in the audited fi nancial statements, it must fi rst have confidence in the standards that govern their preparation and monitoring.

158 Internal and External Aspects of Corporate Governance

PIOB

IFAC

IAASB

ISA Figure 7.3 International assurance and auditing standard board structure for adopting ISA.

Similar to the IASB, the IAASB also follows a due-process approach to auditing standards development. Such process is summarized in Figure 7.4. “Input is obtained from the IAASB’s Consultative Advisory Group, national auditing standard setters and IFAC member bodies. Exposure Draft of proposed pronouncements are widely distributed for public comment and placed on the IFAC website. The IAASB follows a rigorous due process in the development of its standards and pronouncements” (International Auditing and Assurance Standards Board, 2008). The IAASB identifies items to be included in the agenda based on an examination of issues not only on auditing and quality of fi nancial reporting

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Research and consultation

Transparent debate Exposure for public comments

Consideration of comments received

exposure

ISA Affirmative approval

Figure 7.4

The IAASB’s standards-setting process.

but also from comments and suggestions received from interested parties. When a particular issue is gaining divergent views, the IAASB may hold a public forum or panel for their discussion. The procedure adopted by the IAASB ISA adoption process is achieved in steps: 1. The first step of the process is embodied in research and consultation. Once a new project is identified, a working group usually develops its positions on the basis of research and consultation. It is established with a mandate to develop a draft standard. The working group includes members of the IAASB, but also nonmembers showing interest or expertise.

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2. A transparent debate constitutes the second stage of the process. It is open to the public and covers the discussion paper on the proposed standard. 3. The third stage covers the IAASB exposure draft subject to public comment. The exposure drafts are expected to receive wide circulation because they are generally posted on the Web site of the IAASB. Public comments are solicited and the exposure period is normally 120 days, if not more. 4. The consideration of comments received on the exposure draft constitutes the fourth stage of the due process approach of the IAASB. Comments and suggestions received as a result of the exposure draft are considered at an open forum. If the amendments to the exposure draft are subject to further consultation, another review of the document is initiated. 5. The affi rmative approval is the fi fth stage of the IAASB approach. On this occasion the document is approved. The approval of the exposure drafts, their revision, and the standard releases are achieved through affi rmative vote of at least two-thirds of the members of the IAASB, as decided by the Public Interest Oversight Board.

THE INTERNATIONAL FINANCIAL REPORTING FRAMEWORK The main reason of a conceptual framework for fi nancial reporting is to allow rational and harmonious development of accounting and auditing standards. This development goes beyond any subjectivity and is clearly based on generally accepted accounting principles. The conceptual framework is a coherent system of interrelated objectives and fundamentals that prescribes the nature, function, and limitations of fi nancial reporting. The objectives identify the goals and purposes of fi nancial reporting and the fundamentals are the underlying concepts of fi nancial accounting and reporting. These concepts provide guidelines in selecting the transactions, events, and circumstances to be accounted for, how they should be recognized and measured, and how they should be summarized and reported. (FASB/IASB, 2006) To be consistent, standards should be rooted in fundamental concepts rather than in a scattered collection of conventions. “For the body of standards taken as a whole to result in coherent financial reporting, the fundamental concepts need to constitute a framework that is sound, comprehensive, and internally consistent” (FASB/IASB, 2006). The conceptual framework also helps accounting standard setters adopt standards and rules that are based on common principles, whether

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for current problem solving or in case of the resurrection of new ones. Although the accounting conceptual framework of the IASB is not an international standard in itself, it is, however, intended to serve as a guideline for resolving accounting issues that are not directly covered by the IFRS. The companies’ managements are specifically required to take into account the conceptual framework while preparing and presenting the fi nancial statements. This is especially true in the absence of standards or interpretations relating specifically to an accounting issue. IAS 8 also requires that each entity must use its judgment in the development and the application of accounting policies. This must, however, lead to information that is relevant and reliable. By taking such a stand, the IAS 8 actually requires companies to review their old previous defi nitions of the fi nancial statements components criteria. For example, recognition, measurement, assets and liabilities concepts, income, and expenditure should be considered within the new conceptual framework. For the fi rst time, in April 2001, the IASB has adopted its conceptual framework and currently works for its revision jointly with the FASB of the Unites States. In this new version, the conceptual framework is defi ned as a coherent system of concepts that flow from an objective. The objective identifies the purpose of fi nancial reporting. The other concepts provide guidance on identifying the boundaries of financial reporting, selecting the transactions, other events, circumstances to be represented, how they should be recognized and measured (or disclosed), and how they should be summarized and reported (the FASB-IASB joint project is presented in Financial Accounting Standards Board and International Accounting Standards Board, 2008). The aim of the framework is to defi ne the objective of fi nancial statements, identify the characteristics that defi ne the usefulness of information in fi nancial statements, and defi ne the basic elements of fi nancial statements and the concepts of accounting and valuation. It consists of nine elements, as shown in Figure 7.5. The conceptual framework is composed of the following components: (1) The raison d’être of fi nancial statements; (2) users; (3) accountability; (4) the objective; (5) the underlying assumptions; (6) the quality characteristics; (7) Items; (8) recognition of elements; (9) measuring elements. The fi nancial statement’s rationale (area 1 in Figure 7.5), according to the IASB conceptual framework, stems from the need to meet, at least annually, the informational needs of a wide range of external users. The users of fi nancial statements are composed of actual and potential investors, employees, creditors, customers, and governments. They employ fi nancial statements to assist them in their decision-making process (area 2 in Figure 7.5). They are actually interested in evaluating the ability of the companies to generate cash flow and to determine their certainty and their timing. The primary responsibility for preparing and presenting the fi nancial statements lies with the management teams. They are required to provide a range of users with the information on the companies’ fi nancial position

162

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1

9 8

2

THE CONCEPTUAL FRAMEWORK

7

4 6

Figure 7.5

3

5

The conceptual framework.

(area 3 in Figure 7.5). The main objective of fi nancial reporting, as we already know, is to enable existing and potential investors, creditors, and other users to make their decisions in all confidence (area 4 in Figure 7.5). The financial statements are based on specific assumptions, such as accrual-basis and going-concern (Financial Accounting Standards Board and International Accounting Standards Board, 2008). The accrual-basis assumption specifies that the effects of the transactions and other events are recognized when they occur, rather than when cash or its equivalent is received or paid. They are then reported in the fi nancial statements of the periods relative to them. Whereas the going-concern assumption underlines that the organization is presumed to continue its operations indefinitely (area 5 in Figure 7.5), the financial statements have also specific characteristics and attributes that are required for ensuring the usefulness of the information contained for investors, creditors, and other users. Four main characteristics are required from the useful financial information. These are (i) understandability, (ii) relevance, (iii) reliability, and (v) comparability. 1. Understandability requires that the information should be presented in a way that is easily understood by its users, who should have a reasonable knowledge of business, economic activities, and accounting and are willing to study diligently the provided information. 2. Financial information qualifi es for relevance when it is likely to influence economic decisions of its users, either (i) by helping to

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assess the possible economic impact on the organization of past, present, or future events, or (ii) by helping to confi rm or correct past evaluations. The relevance also includes several components such as the materiality. Information is called material when its omission or misstatement would signifi cantly impact the decision making of its users. Timeliness is another component of relevance because in order to be useful, information must be provided to users within the period where it is most likely to have an impact on their decision making. 3. The reliability of fi nancial information occurs when the information is free from material error and bias and that its users can be confident that it faithfully represents the events and transactions it is meant to represent. The information is not reliable when it is deliberately designed to mislead users or to orient their decisions. 4. Comparability in fi nancial reporting (area 6 in Figure 7.5) means that users must be able to compare the fi nancial statements of the same company over time and to identify trends in its fi nancial position and performance. The fi nancial statements should also be able to allow the comparison of different companies. Disclosure of accounting is essential to ensure comparability. The fi nancial statements describe the impact of financial transactions and other events, grouping them into categories based primarily on their accountants (area 7 in Figure 7.5). These categories are called elements of fi nancial statements. Figure 7.6 summarizes them.

COMPONENTS OF PERFORMANCE

COMPONENTS OF FINANCIAL POSITION

Asset

Liability Expenses

Equity

Figure 7.6

The elements of financial statements.

Income

164 Internal and External Aspects of Corporate Governance The fi nancial statements’ components can be classified as directly related to the company fi nancial position or directly linked to its performance. The elements directly related to the company’s fi nancial position are the assets, liabilities, and equity (Financial Accounting Standards Board and International Accounting Standards Board, 2008): an asset is a resource controlled by the company as a result of past events, and from which future economic benefits are expected. By contrast, a liability is a company’s present obligation arising from past events, including a settlement and resulting in an outflow of resources. The equity, fi nally, is the residual shareholders’ interest in the company’s assets, after deducting all its liabilities. The elements directly related to the company’s performance are the income and the expenditure (Financial Accounting Standards Board and International Accounting Standards Board, 2008). The income is defi ned as an increase in economic benefits during a single period. It is expressed as cash inflow, appreciation of assets, or decreased liabilities resulting from capital increases other than contributions from shareholders. In contrast, expenses are decreases in economic benefits during a single period. They take the form of outflows or depletion of assets or liabilities. The situation results in decreases in equity other than those caused by the transactions with shareholders. Recognition (area 8 in Figure 7.5) in the financial statements elements is the process of integrating of an item in the financial statements that meets the definition of an element and encounters the following recognition criteria: (i) It is probable that any future economic benefit associated with the item is to flow to or from the company; (ii) The cost of the item can be reliably measured on the basis of these criteria. Table 7.1 outlines the criteria for recognition of elements of fi nancial statements. Measurement involves (area 9, Figure 7.5) the assignment to the fi nancial statements elements, monetary amounts where they are to be recognized and reported. The IASB framework acknowledges that a variety of measurement bases are used today to a different degree and in varying combinations in fi nancial statements, including: (i) the historical cost; (ii) the current cost; (iii) the net realizable value; and (iv) the present value. The historical cost measurement basis is the most commonly used today; however, it is usually combined with other measurement bases. The accounting measure involves the assignment of monetary amounts where elements of financial statements should be recognized and reported. The conceptual framework of the IASB acknowledges that several bases of measurements are now employed in the financial statements to varying degrees and in varying combinations: (i) the historical cost; (ii) the current cost; (iii) net realizable value; (iii) the realizable value; (iv) the current value. The historical cost remains, however, the most commonly used measurement method today, although it is generally combined with other measuring bases.

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165

Recognition Criteria for the Elements of Financial Statements

Element of financial statements

Recognition criteria

An asset

is recognized in the balance sheet when it is probable that the future economic benefits will flow to the enterprise and the asset has a cost or value that can be measured reliably.

A liability

is recognized in the balance sheet when it is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably.

Income

is recognized in the income statement when an increase in future economic benefits related to an increase in an asset or a decrease of a liability has arisen that can be measured reliably. This means, in effect, that recognition of income occurs simultaneously with the recognition of increases in assets or decreases in liabilities (e.g., the net increase in assets arising on a sale of goods or services or the decrease in liabilities arising from the waiver of a debt payable).

Expenses

are recognized when a decrease in future economic benefits related to a decrease in an asset or an increase of a liability has arisen that can be measured reliably. This means, in effect, that recognition of expenses occurs simultaneously with the recognition of an increase in liabilities or a decrease in assets, for example, the accrual of employee entitlements or the depreciation of equipment.

Source: Financial Accounting Standards Board and International Standards Board (2008).

The reported fi nancial information is, however, subject to a number of constraints. First, it is confronted with the materiality constraint, where information is considered to be important only if its omission or misstatement can affect the decision making of its users. Second, information must also respect the cost-benefit rule, where the benefits of publishing a fi nancial information in the fi nancial statements must justify the costs associated with its publication.

OVERVIEW OF CURRENT INTERNATIONAL FINANCIAL REPORTING STANDARDS Originally, the IASB accounting standards were called the International Accounting Standards (IAS), and after 1 April 2001, they became International Financial Reporting Standards (IFRS). They include currently: (i) The International Financial Reporting Standards (IFRS), published after 2001; (ii) The International Accounting Standards (IAS), issued before 2001;

166 Internal and External Aspects of Corporate Governance (iii) The interpretations made by the International Financial Reporting Interpretations Committee (IFRIC) and published after 2001; (iv) The interpretations of the standing Interpretations Committee (SIC) issued before 2001. In addition, the IASB conceptual framework provides guidelines for the preparation and the presentation of the financial statements and describes some of the principles underlying IFRS. The IFRS also addresses such financial issues as the consolidated financial statements, the accounting for acquisitions, the goodwill, and so on. Tables 7.2 to 7.4 provide a complete list of all the IFRS, the IAS, and the IFRIC interpretations, in use until the end of 2007. Table 7.2

List of Adopted IFRS

IFRS number and title

IFRS number and title

IFRS number and title

Preface to International IFRS 3 Business Financial Reporting Stan- Combinations dards

IFRS 6 Exploration for and Evaluation of Mineral Assets

IFRS 1 First-time Adoption IFRS 4 Insurance of International Financial Contracts Reporting Standards

IFRS 7 Financial Instruments: Disclosures

IFRS 2 Share-based Payment

IFRS 5 Non-current Assets IFRS 8 Operating Segments Held for Sale and Discontinued Operations

Source: http://www.iasplus.com/interps/interps.htm, as accessed on January 21, 2008.

Table 7.3

International Accounting Standards (IAS)

IAS number and title • IAS 1 Presentation of Financial Statements

• IAS 2 Inventories

IAS number and title • IAS 15 Information Reflecting the Effects of Changing Prices Withdrawn December 2003 • IAS 16 Property, Plant, and Equipment

• IAS 17 Leases • IAS 3 Consolidated Financial Statements Originally issued 1976, effective 1 Jan 1977. Superseded in 1989 by IAS 27 and IAS 28

IAS number and title • IAS 29 Financial Reporting in Hyperinflationary Economies

• IAS 30 Disclosures in the Financial Statements of Banks and Similar Financial Institutions Superseded by IFRS 7 effective 2007 • IAS 31 Interests in Joint Ventures

(continued)

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Table 7.3 (continued) IAS number and title

IAS number and title

• IAS 18 Revenue • IAS 4 Depreciation Accounting Withdrawn in 1999, replaced by IAS 16, 22, and 38, all of which were issued or revised in 1998 • IAS 5 Information to Be • IAS 19 Employee Benefits Disclosed in Financial Statements Originally issued October 1976, effective 1 January 1997. Superseded by IAS 1 in 1997 • IAS 20 Accounting for • IAS 6 Accounting Government Grants and Responses to Changing Disclosure of GovernPrices ment Assistance Superseded by IAS 15, which was withdrawn December 2003 • IAS 7 Cash Flow State- • IAS 21 The Effects of ments Changes in Foreign Exchange Rates

IAS number and title • IAS 32 Financial Instruments: Presentation Disclosure provisions superseded by IFRS 7 effective 2007 • IAS 33 Earnings Per Share

• IAS 34 Interim Financial Reporting

• IAS 35 Discontinuing Operations Superseded by IFRS 5 effective 2005 • IAS 8 Accounting Poli- • IAS 22 Business Combi- • IAS 36 Impairment of Assets cies, Changes in Account- nations ing Estimates and Errors Superseded by IFRS 3 effective 31 March 2004 IAS 23 Borrowing Costs • IAS 37 Provisions, • IAS 9 Accounting for Contingent Liabilities and Research and DevelopContingent Assets ment Activities Superseded by IAS 38 effective 1.7.99 • IAS 10 Events After the • IAS 24 Related Party • IAS 38 Intangible Assets Balance Sheet Disclosures • IAS 11 Construction • IAS 25 Accounting for • IAS 39 Financial Instruments: Recognition and Contracts Investments. Superseded by IAS 39 and Measurement IAS 40 effective 2001 • IAS 12 Income Taxes • IAS 26 Accounting and • IAS 40 Investment Reporting by Retirement Property Benefit Plans • IAS 13 Presentation of • IAS 27 Consolidated and • IAS 41 Agriculture Separate Financial StateCurrent Assets and Curments rent Liabilities Superseded by IAS 1 • IAS 14 Segment Reporting • IAS 28 Investments in Associates Source: http://www.iasplus.com/interps/interps.htm, as accessed on January 21, 2008.

168

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Table 7.4

International Financial Reporting Interpretations (IFRIC)

IFRIC number and title

IFRIC number and title

IFRIC number and title

IFRIC D1 Emission Rights IFRIC D8 Members’ Shares IFRIC D15 Reassessment in Co-operative Entities of Embedded Derivatives IFRIC D2 Changes in Decommissioning, Restoration and Similar Liabilities

IFRIC D10 Liabilities Aris- IFRIC D16 Scope of IFRS 2 ing from Participating in a Specific Market—Waste Electrical and Electronic Equipment

IFRIC D3 Determining IFRIC D11 Whether an Arrangement Contains a Lease

IFRIC D17 IFRS 2 Group and Treasury Share Transactions

IFRIC D4 DecommisIFRIC D12 Service sioning, Restoration and Concession ArrangeEnvironmental Rehabilita- ments—Determining the tion Funds Accounting Model

IFRIC D18 Interim Financial Reporting and Impairment

IFRIC D5 Applying IAS IFRIC D13 Service Conces- IFRIC D19 IAS 19—The 29 Financial Reporting in sion Arrangements—the Asset Ceiling: AvailabilHyperinflationary Econo- Financial Asset Model ity of Economic Benefits mies for the First Time and Minimum Funding Requirements IFRIC D7 Amendment of the Scope of SIC 12 Consolidation—Special Purpose Entities

IFRIC D14 Service Conces- IFRIC D20 Customer Loysion Arrangements—the alty Programmes Intangible Asset Model

Source: http://www.iasplus.com/interps/interps.htm, as accessed on January 21, 2008.

OVERVIEW OF INTERNATIONAL AUDITING STANDARDS The International Auditing and Assurance Standards Board (IAASB), known until 2002 as the International Auditing Practices Committee (IPAC), is in charge of the publication of international auditing standards. It works as a standard-setting body under the auspices of the International Federation of Accountants (IFAC). As the global organization for the accountancy profession, IFAC is committed to protecting the public interest by developing high quality international standards, promoting strong ethical values, encouraging quality practice, and supporting the development of all sectors of the profession around the world. (International Federation of Accountants, 2008) The IAASB’s aim is to enact high-quality standards in auditing, insurance, inspection, and related services. This would improve the uniformity

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of auditing practices by professional accountants around the world and strengthen public confidence in the audit profession and better serve the public interest (International Federation of Accountants, 2008). Most legislation requires that the auditor’s report on the quality of fi nancial statements clearly indicate the layout used for preparing the fi nancial statements. The audit opinion must also state whether or not the fi nancial statements give a true and fair view of the fi nancial position of the company, in accordance with GAAP, GAAS, and the underlying conceptual framework. The audit opinion must also state whether the fi nancial statements are prepared in accordance with International Financial Reporting Standards (IFRS), in accordance with IFRS and a conceptual framework, or under a national framework, while indicating the extent of its compliance with the IFRS. Table 7.5 lists the international auditing standards adopted by the ISA of the IAASB. It should be noted that the ISA are published once they are Table 7.5

International Auditing Standards Adopted by the IAASB

Approved final ISAs, as of December 31, • ISA 230 (Redrafted), “Audit Docu2007 mentation” • ISA 240 (Redrafted), “The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements” • ISA 260 (Revised and Redrafted), “Communication with Those Charged with Governance” • ISA 300 (Redrafted), “Planning an Audit of Financial Statements” • ISA 315 (Redrafted), “Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and Its Environment” • ISA 330 (Redrafted), “The Auditor’s Responses to Assessed Risks” • ISA 540 (Revised and Redrafted), “Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures” • ISA 600 (Revised and Redrafted), “Special Considerations—Audits of Group Financial Statements (Including the Work of Component Auditors)” • ISA 720 (Redrafted), “The Auditor’s Responsibility in Relation to Other Information in Documents Containing Audited Financial Statements” ISAs awaiting Confirmation by the Public • ISA 560 (Redrafted), “Subsequent Events” Interest Oversight Board, as at Decem• ISA 580 (Revised and Redrafted), ber 31, 2007 “Written Representations” Source: International Federation of Accountants (2008).

170 Internal and External Aspects of Corporate Governance approved, and the Public Interest Oversight Board has confi rmed that the due process had been followed in their development. The IAASB also issues International Auditing Practice Statements (IAPS) providing interpretive guidance and assistance to professional accountants in applying the ISA and promoting good practices. The financial statements’ certification required by both the IAASB that the IASB can, if respected, represent a significant incentive for improving financial transparency. IFRS and ISA are expected to be followed by enhancing measures of the auditors’ independence and the strengthening of their responsibilities. The effectiveness of the external auditor generally includes the requirement of mechanisms of a particular order to make sure that auditors acting in public interest give neutral opinion on the quality and ethics of the reported information: they also require auditors to be subjected to some oversight body. International standards also require external auditors to be recommended by the audit committee of the board and appointed directly by the general meeting of shareholders. They also stressed the fact that auditors should have a professional duty to the company rather than to any person or group of its managers in particular.

INTERNATIONAL FINANCIAL REPORTING CONVERGENCE The high interest for IFRS has prompted many countries to adopt them as a means of convergence of accounting standards around the world, and this enables the IASB to have more success in its initiative of harmonizing international accounting. Many countries currently share such conversion vision; this is the case, for instance, of the Europe Union, most Anglo-Saxon countries traditionally used to US-GAAP (fundamentally close to IFRS), China, and many other emerging economies. Some countries have set themselves a convergence target; the Australian accounting legislation, for instance, requires the Australian Accounting Standards Board (AASB) to contribute to the development of a unique set of standards that is applicable around the world. This is also the case in Canada, where the Canadian Institute of Chartered Accountants (CICA) has also played a key role in developing IFRS. In general, the IFRS is rather similar to the Canadian standards and is founded on identical conceptual framework, and except for few minor differences, they cover the same subjects. The Canadian Accounting Standards Committee (CASC) has recently agreed upon a strategy for the adoption of IFRS in Canada. In the case of countries like Canada and Australia, the adjustments to IFRS are minimal and do not require big sacrifices. Elsewhere in emerging economies like China, the need for international capital has created an incentive for the adoption of IFRS that is seen as a kind of shortcut to the international fi nancial market, an “acquit de conscience.” It seems that the European Union, like China and many others countries, may appreciate American accounting standards quality, but have some problem borrowing them directly from the FASB. They prefer to (partially) use them

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under the heading IFRS, allowing the attainment of fi nancial goals without really believing in the alleged virtues of convergence. The review, however, of fi nancial disclosure systems of many countries that claim the adoption of IFRS shows that their accounting standards show significant differences with IFRS. China, for example, has simply decided to ignore any prerogatives in its IFRS that do not fit their needs. Countries such as Japan, Singapore, Hong Kong, and Thailand, deemed to have adopted IFRS, do not really respect them, while pretending compliance. Indeed, “no matter what can be said, no Asian country . . . can honestly demonstrate that its national accounting standards are conforming to IFRS” (Atkins, 2006). Table 7.6 summarizes the use of IFRS as main fi nancial disclosure requirements by companies (listed and unlisted), as of January 11, 2008, and where the auditor’s report indicates, therefore, that the fi nancial statements are prepared on the basis of IFRS. Although in most countries that have adopted IFRS a great amount of information is already publicly disclosed, at least on an annual basis, the adoption of IFRS may still further enhance the quality of financial reporting. This would be applicable only by improving its comparability as well as its transaction efficiency, and a strong disclosure regime is supposed to help attract capital and maintain confidence in the capital markets. Developing economies may also fi nd IFRS adoption beneficial, even if the majority of them are still seeing their needs not covered by IFRS. Table 7.6

The Use of IFRS by Jurisdictions

Grand Totals for Listed Companies Information, to the best of our knowledge, for 157 jurisdictions: • IFRS not permitted—32 jurisdictions • IFRS permitted—25 jurisdictions • IFRS required for some—3 jurisdictions • IFRS required for all—82 jurisdictions* • No stock exchange—15 jurisdictions* Of the 110 jurisdictions (25 + 3 + 82) that permit or require IFRS: • In 75 jurisdictions the audit report refers to conformity with IFRS • In 32 jurisdictions the audit report refers to local GAAP or to IFRS as adopted in the jurisdiction • In 1 jurisdiction the audit report for some companies refers to local GAAP and for other companies it refers to IFRS • For 2 jurisdictions we do have this information Source: Deloitte (2008c).

Grand Totals for Unlisted Companies Of the 157 jurisdictions in table: • IFRS not permitted—35 jurisdictions • IFRS permitted for all or some—34 jurisdictions • IFRS required for some—21 jurisdictions • IFRS required for all—28 jurisdictions • We do not have information—39 jurisdictions

172 Internal and External Aspects of Corporate Governance Most recently, the Securities and Exchange Commission of the United States has put on its agenda the issue of recognizing IFRS for foreign issuers, from 2014. If this materializes, it would be the greatest IASB success. A multiyear plan in several stages is, however, adopted, and this will take time before the issue is solved. A year ago, however, the US SEC issued a concept release allowing US issuers abroad to prepare their financial statements on the basis of IFRS (SEC, 2008). Indeed, one can “only imagine how much more it would be useful at an international level with people from various countries, cultures and backgrounds, coming to the table and trying to set common standards and converge” (Blanchet, 2001).

IFRS FINANCIAL REPORTING QUALITY AND CORPORATE GOVERNANCE According to the International Accounting Standards Board, fi nancial statements prepared in accordance with IFRS should include (IAS 1.8): (i) A balance sheet; (ii) Income statement; (iii) Either a statement of changes in equity or a statement of recognized income or expense (“SORIE”); (iv) A cash-flow statement. Appendices 7.A and 7.C include a set of fi nancial statements prepared on the IFRS basis, as required by IAS 1. The IASB has, however, recently published a revised version of IAS 1 on the presentation of fi nancial statements. This version contains significant changes compared with its previous version. The most important of these changes is the requirement that all entities should disclose changes in nonowner shareholders’ equity in a single comprehensive income or in two separate statements; a statement of income separate and a comprehensive income. The revised IAS 1 also calls for changes in the financial statements appellations: the balance sheet will become the statement of fi nancial position; the income statement will become the statement of comprehensive income; the cash flow statement will become the statement of cash flows. Even though companies are not required to use these new designations in their fi nancial statements, all standards and interpretations should be revised to reflect the new terminology. The revised IAS 1 is effective for fiscal years beginning on or after 1 January 2009 and early adoptions are allowed. The fi nancial statements’ disclosure is the means by which companies communicate to the market. Their fi nancial results and their main objective are to provide users with information that is useful to their decision-making process. For this reason, the data presented must be complete and reliable. It must actually allow the assessment of the cash-flow amounts, timing, and uncertainty. The information contained in the fi nancial statements should

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also be useful for managers and board members to enable them to make their decisions with full knowledge, on behalf of the owners. In recent years the increasing international capital market integration has inevitably heightened the need for convergence of accounting standards and practices. Joining the convergence trail, at least at the principle level, can be relatively easy and who would oppose virtue? Who would, indeed, oppose a system of fi nancial disclosure which would be effective and comparable, regardless of where we are on the planet, knowing, of course, that such a system is supposed to benefit investors and other stakeholders? It would be less expensive to implement and use it. It would facilitate the flow of capital and investment. The convergence in practice may, however, prove to be a very difficult task, especially when its alleged benefits can be realized only if many prerequisites are met. Particularly if minimal progress is not achieved at all levels of the information system such as accounting, standards setting, auditing, and so on. This is, of course, not the case everywhere in the world. For this reason, international standards would be differentiated by level of economic development.

FINANCIAL DISCLOSURE AND CORPORATE GOVERNANCE Putting aside the political considerations, no doubt the IFRS and GAAS adoption constitutes, for most countries, a significant advance in financial disclosure and governance. OECD guidelines underline the necessity of sound fi nancial reporting systems for corporate governance quality. They require that “The corporate governance framework should ensure that timely and accurate disclosure be made on all material matters regarding the corporation, including the fi nancial situation, performance, ownership, and governance of the company” (OECD, 2004, p. 22). The IFRS impact on the corporate governance quality can be assessed at different levels of the fi nancial disclosure: (i) on the conceptual framework level; (ii) in the fi nancial statements quality level; (iii) at the audit process level. The biggest advantage of the IFRS and ISA adoption can be withdrawn by some developing countries. Indeed, a regime that promotes genuine transparency can be an essential improvement component of manager monitoring. It can at the same time enable shareholders to exercise their rights with more confidence. Experiences from developing countries suggest that weak disclosure, coupled with the lack of transparency, can lead to a very costly management behavior, devoid of any ethical consideration and leading to a loss of market integrity and economic chaos. Shareholders and prospective investors need access to sufficiently reliable and comparable detailed information to assess the management performance and thus make informed decisions. The lack of information, like its opacity, can only impede investors’ ability to make rational decisions and would lead them inevitably to increase their return requirement. This will consequently induce companies’ capital cost increases. A disclosure system can have other advantages for

174

Internal and External Aspects of Corporate Governance

businesses, including contributing to the improvement of the public understanding of business, its structure, its policies, environmental performance and ethical standards, and its relations with the community in which it operates (OECD, 2004, Section V, Disclosure and Transparency). In the majority of developing countries, IFRS and ISA risk being of little help. Their financial information systems are still very basic. They lack the basic generalized billing systems and the underground economy is the rule rather than the exception. At a first step on the road to transparency, most developing countries need to generalize accounting system to all their businesses.

INTERCONNECTION WITH OTHER CORPORATE GOVERNANCE MECHANISMS A well-designed and executed fi nancial disclosure system is fundamental to all mechanisms of corporate governance, whether or not from internal or external horizons. The fi nancial disclosure is the window through which stakeholders can access information with regard to businesses and keep abreast of their performance and consequently the fate that awaits their investment. For this reason the fi nancial reporting reliability should raise no doubt. The fi nancial disclosure system can have, indeed, a direct impact on almost all governance processes. Such effects can be more easily seized following the disclosure process itself. At the level of the financial information production, the financial disclosure can be reliable only if an internal control system is established and effectively monitored by a second governance mechanism that is the audit committee. The adequacy of the job is certified by a third mechanism, which is the external auditor. At the disclosure itself, the information is used by a large number of users, both internal and external. Internally to the company, the board of directors and the shareholders would have been unable to exercise their oversight with reference to their business without the availability of reliable information. The managers themselves would have been unable to take the necessary operational decisions without an effective information system. Outside the company, the disclosure of quality and credible information is a value-added initiative guaranteeing lower fi nancing costs and better share valuation. It can affect the external image of the company by external credit-rating agencies, banks, and others. It is therefore clear that the financial disclosure plays a major role in corporate governance.

CONCLUSION The accounting harmonization defended by IASB has beneficial effects, although it seems systematically to exclude the developing countries. Most developing countries, as well as the so-called emerging markets that joined convergence, did it for their own reasons which do not necessarily fit with

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the prerogatives of convergence. Two reasons can explain such situation. On the one hand, most developing countries are not yet at a the level which will allow them to wholly benefit from IFRS and ISA; and on the other hand, the exorbitant costs induced by the provisions of convergence can be incommensurate with the ability of the majority of small businesses around the world and this usually calls for abstention. The situation requires easy application standards for developing countries and small businesses. Actually there is no worse system than “no system.”

COMPREHENSIVE CASE 7.1

IFRS Financial Statements Appendixes 7.A to 7.C reproduce income statement, balance sheet, and statement of cash flows prepared in accordance of IFRS, and you are invited to discuss the main innovations introduced by IFRS.

APPENDICES 7.A TO 7.C Appendices 7.A to 7.C present a set of fi nancial statements prepared on the IFRS basis, as required by IAS 1. Appendix 7.A

Consolidated Balance Sheet at 31 December 200X (IAS 1.46(b),(c), IAS 1.104 IAS 1.46(d),(e)) Note to financial statements no. Source

Assets Noncurrent assets

IAS 1.51

IAS 1.68(a) Property, plant and equipment

15

IAS 1.68(b) Investment property

16

IAS 1.69 Goodwill

17

IAS 1.68(c) Other intangible assets

18

IAS 1.68(e) Investments in associates

20

IAS 1.68(n) Deferred tax assets

10

IAS 1.69 Finance lease receivables

26

IAS 1.68(d) Other financial assets

22

IAS 1.69 Other assets

23

Total noncurrent assets (continued)

176 Internal and External Aspects of Corporate Governance Appendix 7.A (continued) Note to financial statements no. Source IAS 1.51 Current assets IAS 1.68(g) Inventories

24

IAS 1.68(h) Trade and other receivables

25

IAS 1.69 Finance lease receivables

26

IAS 1.68(d) Other financial assets

22

IAS 1.68(m) Current tax assets

10

IAS 1.69 Other assets

23

IAS 1.68(i) Cash and bank balances

46

IAS 1.68A(a) Assets classified as held for sale

12

Total current assets Total assets Equity and liabilities Capital and reserves IAS 1.69 Issued capital

28

IAS 1.69 Reserves

29

IAS 1.69 Retained earnings

30

IAS 1.69 Amounts recognized directly in equity relating to assets classified as held for sale

12

IAS 1.68(p) Equity attributable to equity holders of the parent IAS 1.68(o) Minority interest

31

Total equity IAS 1.51 Noncurrent liabilities IAS 1.69 Borrowings

32

IAS 1.68(l) Other financial liabilities

34

IAS 1.69 Retirement benefit obligation IAS 1.68(n) Deferred tax liabilities IAS 1.68(k) Provisions

35

IAS 1.69 Deferred revenue IAS 1.69 Other liabilities

36

Total noncurrent liabilities IAS 1.51 Current liabilities IAS 1.68(j) Trade and other payables

37 (continued)

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177

Appendix 7.A (continued) Note to financial statements no. Source IAS 1.69 Borrowings IAS 1.68(l) Other financial liabilities IAS 1.68(m) Current tax liabilities IAS 1.68(k) Provisions

35

IAS 1.69 Deferred revenue IAS 1.69 Other liabilities IAS 1.68A(b) Liabilities directly associated with assets classified as held for sale Total current liabilities Total liabilities Total equity and liabilities

Appendix 7.B

Consolidated Income Statement for the Year Ended 31 December 200X (Aggregating Expenses According to Their Function (IAS 1.8(b), IAS 1.46(b),(c)) Note to financial statements No

Source

5

IAS 1.81(a)

Continuing operations Revenue Cost of sales

IAS 1.88

Gross profit

IAS 1.83

Investment revenue

7

IAS 1.83

Other gains and losses

8

IAS 1.83

Share of profits of associates

20

IAS 1.81(c)

Distribution expenses

IAS 1.88

Marketing expenses

IAS 1.88

Occupancy expenses

IAS 1.88

Administration expenses

IAS 1.88

Finance costs

9

IAS 1.81(b)

Other expenses

IAS 1.88

Profit before tax

IAS 1.83

Attributable to:

IAS 1.81(d)

Income tax expense Profit for the year from continuing operations

10 IAS 1.83

178 Internal and External Aspects of Corporate Governance Appendix 7.C

Consolidated Cash-Flow Statement for the Year Ended 31 December 200X (This Illustrates the Direct Method of Reporting Cash Flows From Operating Activities) Note to financial statements no.

IAS 6.10 Cash flows from operating activities IAS 6.18(a) Receipts from customers Payments to suppliers and employees Cash generated from operations Interest paid Income taxes paid Net cash generated by operating activities Cash flows from investing activities Payments to acquire financial assets Proceeds on sale of financial assets Interest received Royalties and other investment income received Dividends received from associates Other dividends received Amounts advanced to related parties Proceeds from repayment of related party loans Payments for property, plant and equipment Proceeds from disposal of property, plant and equipment Payments for investment property Payments for intangible assets Development costs paid Acquisition of subsidiaries Proceeds from disposal of business Net cash (used in)/generated by investing activities Cash flows from financing activities Proceeds from issues of equity shares Proceeds from issue of convertible notes Payment for share issue costs Payment for share buy-back to: —equity holders of the parent —minority interests Payment for share buy-back costs Proceeds from issue of redeemable cumulative preference shares Proceeds from issue of perpetual notes Payment for debt issue costs Proceeds from borrowings Repayment of borrowings Dividends paid to: —equity holders of the parent —minority interests Net cash used in financing activities Net increase in cash and cash equivalents 381 561 Cash and cash equivalents at the beginning of the financial year 19,400 18,864 Effects of exchange rate changes on the balance of cash held in foreign currencies 55 (25) Cash and cash equivalents at the end of the financial year 46 19,836 19,400

Source

IAS 6.31 IAS 6.35 IAS 6.10

IAS 6.31 IAS 6.31

IAS 6.39 IAS 6.39 IAS 6.10

IAS 6.31

IAS 6.28

8

Financial Auditing and Corporate Governance

The agency relationship that binds the shareholders to the managers stems from confl icts of interest arising mainly from the information asymmetry benefiting managers. If further we consider that managers also seek to maximize their own interests, it becomes likely they will not always act in their shareholders’ interest, and the situation justifies the existence of the fi nancial audit as an incentive for getting managers to act in the best interests of shareholders. Thus, making managers’ behavior publicly known to outsiders through fi nancial disclosure will enhance corporate image and reassure investors. The primary responsibility of the quality and completeness of fi nancial disclosure goes primarily to the management team, even though several parties are actually involved in such process and in the forefront we have the fi nancial audit process. This chapter discusses the purpose and the principles governing the audit of the fi nancial statements and underlines the responsibilities and the roles of the parties involved.

OBJECTIVE OF FINANCIAL AUDITING AND THE FINANCIAL REPORTING FRAMEWORK The main purpose of the fi nancial audit is to ensure users of fi nancial statements regarding the reliability of these reports and their compliance with generally accepted accounting principles, laws, and regulations. The fi nancial audit is expressed through a professional opinion based on the quality of the publicly disclosed information as well as the effectiveness of the internal control on which this information is based. Users of fi nancial reports are therefore assured of the strength of the information contained. The external auditor of fi nancial statements must, therefore, be aware that users of the audited fi nancial statements are interested in information that would enhance their quality and increase their confidence as investors (PACOB, 2004). As discussed in previous chapters, the responsibility for overseeing the fi nancial disclosure process and the monitoring of the

180

Internal and External Aspects of Corporate Governance

internal control belongs to the board of directors. The board must oversee the prior establishment of an appropriate set of specific control rules and procedures and ensure their compliance. This task is usually entrusted with its standing audit committee, which has recourse to external auditor services to help carry out the work and certify its quality. Unfortunately, serious concerns are currently raised regarding the reliability of the audit process and external auditors’ objectivity, and this is seriously endangering the fi nancial statements’ credibility and integrity. Financial audit cannot be performed without an appropriate framework for information production and dissemination. Several conceptual frameworks dealing with the preparation and the presentation of fi nancial statements have been suggested, and their main requirements are tending to converge. This is the case, for instance, of the conceptual framework developed by the Financial Accounting Standard Board of the United States (FASB) or the one adopted by the International Accounting Standards Board (IASB). The conceptual frameworks would like to play for fi nancial reporting a role that is similar to that played by a constitution for a nation and is generally supplemented by other laws, regulations, and position papers that usually deal with the preparation and presentation of the fi nancial reports. An appropriate conceptual framework for fi nancial reporting requires many essential information attributes, such as relevance, predictive value, neutrality, and accuracy. To be relevant, fi nancial information must be able to make a difference in the mind of its user and to affect his decision-making process. This includes helping to assess the impact of past and present events on a company’s future cash flows. The information should also be helpful in correctly confi rming previous information interpretations. This is what is called confi rmation value. Financial information must also contain a certain predictive value in the eyes of its user, meaning it could be used to predict the future economic event effects on the company’s fi nancial position. Financial information is considered to faithfully represent the economic events affecting the company when able to capture their informational substance. This information should not be intended to influence the opinion of its user. When this is the case, it is called neutral (FASB, 1995). Financial information must be verifiable by providing users with the insurance of the accuracy in portraying events’ economic effects on the company’s cash flows. Verifiability actually happens when information is what it is actually supposed to represent, that is, “When the measures and descriptions are verifi able, and the measuring or describing is done in a neutral manner” (FASB, 1995). Additional information can also be required by the fi nancial disclosure system, for instance, the indication in the fi nancial statement of the underlying conceptual framework and the accounting methods used for recording transactions. Other critical clarifications can also be retrieved with regard to the quality and the reliability of the reported information.

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181

FINANCIAL STATEMENT FRAUD Financial statement frauds are typically committed by offenders with a relatively high level of education, and they are estimated in thousands of billions of dollars and, more seriously, the damage of frauds extends the monetary value to threaten the whole world economy.

Financial Statement Fraud, an Illness that has Developed Insidiously Many business events have contributed significantly to the recent fraud explosion; accrual accounting, tax avoidance, earnings management, executive compensation schemes, and the investors’ insatiability for return are among the most important. The fi rst organized assault to fi nancial statements’ integrity probably came with the generalization of revenue tax which incited individuals and companies to look for ways to avoid their obligations. Tax avoidance or tax mitigation can be defi ned as the legal use of the tax code to one’s own advantage in order to reduce the amount of tax that is payable by means that are within the law. By contrast, tax evasion is the general term used to qualify efforts for not paying taxes, using illegal means. Tax advisors were using the term as an alternative to the pejorative term tax avoidance, but tax regulations were also using it to distinguish tax avoidance, foreseen by the legislators from tax avoidance, which exploits regulations loopholes. At the turn of the 20th century, new phenomena exacerbated fi nancial statement fraud, the accrual basis accounting became more common, and consequently fraud protection gave ground to reporting issues that became a top priority to accountants, at the expense of fraud detection (Wells, 2000). It didn’t take long for some people to take advantage of this new environment, which is more favorable to fraud. For this reason the second half of the 20th century has been littered with spectacular fi nancial frauds and embezzlements of all kinds. The 1950s saw the birth of earnings management or creative accounting that refers to accounting practices that may follow the letter of GAAP but certainly deviate from their spirit. They are characterized by excessive complication and the use of novel ways of characterizing income, assets, or liabilities and the intent to influence readers towards the interpretations desired. Many techniques were invented for this purpose.

Earnings Management Techniques Earnings management has been under attack due to the recent corporate scandals and is viewed as detrimental to a fi rm’s reputation. Some still argue, however, that earnings management may be beneficial “because it improves the information value of earnings by conveying private information to the stockholders and the public” (Pornsit et al., 2008; Chalayer, 1995). It is

182

Internal and External Aspects of Corporate Governance

believed that fi rms with a high proportion of outside board members have more chance of reporting abnormal accruals being large enough to turn a loss into a profit or to ensure that profit does not decline significantly (Peasnell, Pope et al., 2005). Common techniques for earnings management can be grouped into three broad classes. The fi rst class of earnings management concerns the choice of the appropriate accounting method to be used in the preparation of the fi nancial statements. Indeed, most studies of earnings management generally assume earnings are managed through changes in accounting methods, through specific transactions such as debt defeasance or write-downs, and through discretion over accruals. Choosing a different accounting method gives rise to the most significant and most durable impact on earnings. The effect is also the most easily recognizable, given that changes in accounting methods are usually included in results. The second class of earning manipulations covers actions taken by managers to change the timing of expenses and, to a certain degree, revenues. Managers might, for instance, defer expenses for maintenance or research until the following period. This would have as a direct effect the boosting of earnings in the current period (see Figure 8.1). Fraudulent companies usually create fictitious revenues and the common way to do it is to account for sales that did not occur. The accounting transaction created is a credit to sales with an offsetting debit to accounts receivable, which boosts both assets and income. They may have recourse to fraudulent asset valuations. Although any asset can be fraudulently valued, the most frequent manipulations occur in inventory. Timing differences is

F i n a n c i a l s t a t e m e n t

Fictitious revenues f r a u d s c h e m e s

Figure 8.1

t ulen d u a Fr asset s tion alua V

Concealed liabilities & expenses Financial statement fraud schemes.

T diff iming ere nce s

Improper disclosures

Financial Auditing and Corporate Governance

183

yet another way companies overstate assets and income, by taking advantage of the accounting cutoff period to either boost sales and/or reduce liabilities and expenses. Also, companies may not properly disclose any material fact or concealed liabilities and expenses, because unfortunately it is all too easy to conceal liabilities and still have audit duplicates issued. After all, it is easier to audit something that is there rather than something that isn’t. Generally accepted accounting principles (GAAP) require adequate disclosure in the fi nancial statements of any material fact regarding the company’s fi nancial position. The third category of ways to manage earnings is characterized by a particular subjectivity in fact; the opportunity for judgment in accounting to affect earnings is evident in many areas and management opinion and impacts greatly the reported numbers (Alich, 2003). Examples of accounting areas where differences can arise are the choice of depreciation method, allowance for bad and doubtful debts, and stock valuation. And these on top of issues like accounting for futures, goodwill, and so on. The several decades old critical accounting literature highlights the inherent subjectivity of accounting information and calls for reform. It seems that “no authoritative guidance exists concerning the basis for assessing collectability or assessing the degree of significant doubt,” and “auditors apparently will tolerate sugar-bowling (over-reserving in good years and under-reserving in bad years) so long as companies don’t materially misrepresent results” (CICA, 1988). Obviously such situation gives managers enormous latitude in the matter of judgment, and they don’t always “err on the side of the angels,” and this turns into a nightmare the efforts made by anyone trying to understand the real significance of the reported accounting numbers. On the other hand, according to the signaling theory, manipulating earnings may provide companies’ managers with a mean for influencing people’s perception of their managerial performance. It is also argued that managers may wrongly believe that the stock exchange does not favor volatile earnings and they may strive to please it (Ronen and Sadan, 1981), especially that managers don’t need “to cook the books” to manage their earnings; accounting standards often allow them a lot of freedom. A riskaverse manager, who is precluded from borrowing and lending in the capital markets, may, however, have a strong incentive to smooth his fi rm’s reported earnings (Lambert, 1980; Dye, 1988). It seems that even within a market setting incentives exist for a manager to smooth income that is independent of either risk aversion or restricted access to capital markets. In fact, managers may rationally want to smooth reported income to a lower claim holder’s perception of the variance of the fi rm’s underlying economic earnings, and such action could even have a positive effect on a fi rm’s market value (Trueman et al., 1989), especially if it helps meeting analysts’ earnings projections. Anyway, recent research seems to indicate that managing earnings to meet expectation is a common behavior (Burgstahler et al., 2001). It seems that “the chance of abnormal accruals being

184

Internal and External Aspects of Corporate Governance

large enough to turn a loss into a profit or to ensure that profit does not decline is significantly lower for fi rms with a high proportion of outside board members” (Peasnell et al., 2005). On the other hand, it seems that “board and audit committee activity and their members’ fi nancial sophistication may be important factors in constraining the propensity of managers to engage in earnings management” (Xie et al., 2001).

THE MARKET FRAUD TRAP The most known examples of earnings management involve companies trying to meet analysts’ earnings projections (Barton et al., 2002; Brown, 2001; Matsumoto, 2002). Management is constantly under pressure to meet or better beat analysts’ earnings forecasts. Thus, in years when a company is not performing as strongly as forecast, it is tempting to try to take advantage of accounting loopholes to impact reported earnings. “Sometimes, it is also tempting to purge the balance sheet of unsightly accounts by transferring them to arcane, but related, legal entities” (Thornton, 2002). The situation is becoming even more constraining by the fact that investors are becoming unforgiving of fi rms that fail to meet these earnings expectations (Burgstahler et al., 2001; Skinner et al., 2001). It is, however, suggested that most executives prefer to report earnings that just meet, or beat slightly, analysts’ predictions (Matsumoto, 2002), and that publicly held corporations report small declines in earnings less often than small increases in earnings (Degeorge et al.; 1999; Hayn, 1995). Most common restatements of fi nancial statements concern revenues and assets (Palmrose et al., 2001). Overall, managing earning is not only a widespread behavior (Abarbanel et al., 2001) but also varies across fi rms as a function of previous optimism in fi nancial reporting (Barton et al., 2002). Fannie Mae, the US mortgage giant, has reported, for instance, during the period 1998 to mid-2004 extremely smooth profit growth and hit announced targets for earnings per share precisely each quarter. The company’s decisions, while they may not seem necessarily in violation of accounting rules, had the effect of overstating the fi rm’s capital resources and fi nancial position. Most resounding fi nancial statement frauds are actually trapped by the market and their authors are ultimately forced to admit their crime. Figure 8.2 describes the market incentive for fraud and how fraudulent companies get trapped. What usually starts as anodyne gap between operating numbers and those actually reported in fi nancial statements gets progressively out of control over the years. “It is like riding a tiger, not knowing how to get off without being eaten” would describe the situation the Satyam’s CEO, Ramalingam Raju, when, at the beginning 2009, his IT company, based in India, has just been added to a notorious list of companies involved in fraudulent fi nancial activities, one that includes such names as Enron, WorldCom, Societe

Financial Auditing and Corporate Governance

185

Fraudulent information

Dividend requirement

Share issues Figure 8.2

The market fraud trap.

General, Parmalat, Ahold, Allied Irish, Bearings, Kidder Peabody, and so on (Sudhakar, 2009). Indeed, what used to be a distraction in playing with accounting numbers becomes a nightmare when the market requires the translation of the false pretensions into earnings per share and dividends and fraudulent companies have but one solution: admitting the whole farce and seeking legal protection.

EXECUTIVE COMPENSATION AND OPTIONS BACKDATING Executive compensation describes how top executives of business corporations are paid, and this includes a basic salary, bonuses, shares, options, and other benefits for work on the board of directors. Over the past three decades, director remuneration has risen dramatically beyond the rising levels of an average worker’s wage. From 1990 to 2001, the share of equitybased compensation in total CEO compensation grew from 8% to 66%. Almost all of that was due to option programs that made relatively poor use of market information and were poorly designed (Clark, 2003). As suggested in the fi nancial literature, this creates a serious agency issue, especially with regard to risk management, and can give rise to conflicts of interest between managers and shareholders more notably when executives are remunerated in stock options. For this reason it is often argued that the risk management committee should be composed of competent and independent directors who hold no options to purchase the fi rm’s shares (Blanchard & Dionne, 2003). Amid the turmoil that amounts to trillions of dollars, chief executive officers of the fi rms most responsible for causing the crisis have still received generous pay. “The chief executive of a Standard & Poor’s 500 company made, on average, $14.2 million in total. Also in 2007, a crisis year, each CEO of the S&P 500 made an average daily salary of $46,666; the equivalent of $100 a working minute. This highlights the need for further reform to protect companies and their investors. (Executive Pay Watch, at: http://www.aflcio.org/corporatewatch/paywatch/). It is surprising to still see boards of directors controlling companies that are also responsible for the levels of their own pay, and although executive

186

Internal and External Aspects of Corporate Governance

compensation is at the core of a number of fi nancial statement frauds, it still is an area that has not had the kind of in-depth look it deserves. The best part of the story of executive compensation resides in the unfortunate habit taken by executives to have recourse to option backdating, a practice that involves setting the strike price of an option retroactively to a day when the stock traded less expensively. An option with a lower strike price is more valuable because it costs less to exercise and has a higher pop. Such practice raises a number of legal and accounting issues. The practice of backdating itself is not illegal, nor is the granting of discounted stock options, but the improper disclosures are. Most of the legal issues arising from backdating are a result of the grantor falsifying documents submitted to investors and regulators in an effort to conceal the backdating. It seems that the stock option backdating scandal is much more widespread than initially believed and “the deluge is growing daily, with a fresh batch of companies announcing stock option accounting problems with each passing day” (MacDonald, 2006). Companies also have a management compensation plan tied to the reported earnings figures and consequently may have a natural incentive to increase such reported income, since higher reported profit leads to higher compensation (Core et al., 2000; Ke, 2001); and whenever flexible accounting rules are permitted, “managers can shift income between years and thereby increase total bonus payoffs” (Revsine, 1991). For this reason managers prefer loose reporting rules over tight ones. Note that many studies have demonstrated a significant relation between bonus schemes and the accounting choices executives make. It is suggested that a decrease in option-based compensation reduces CEOs’ incentives to take excessively risky investments, resulting in improved profitability (Qiang et al., 2008). Similarly, requiring permanent reporting on internal control effectiveness is supposed to lead to higher control quality if management’s performance-related compensation is dominated by stock options (Zhang et al., 2006). The legislator began from the 1980s engaging considerable resources in reaction to the fraud threats. The National Commission on Fraudulent Financial Reporting (the Treadway Commission) was created for this purpose and has identified the several discrepancies in the system. The Committee of Sponsoring Organizations (COSO) has also issued a report calling for better internal control systems. The Public Oversight Board, for its part, concluded in a special report that “the public looks to the independent auditor to detect fraud, and it is the auditor’s responsibility to do so.” The whole process culminated in governments adopting specific laws confi rming auditor responsibility in detecting frauds. Having in mind the actual crisis, all these counterfraud efforts do not seem to have succeeded in eradicating frauds. Despite the fact that the determination of the actual cost of fraud and abuse may be difficult, if not impossible, because many frauds remain undiscovered and unreported, the total cost of fraud to the economy can be now estimated in the thousands of billions of dollars. Fraud is, however, as old as humanity; for instance, accountants “in the pharaohs’ courts were

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already charged with fraud prevention and detection” (Wells, 2000). We limit ourselves here to financial statement fraud schemes.

THE FINANCIAL AUDIT PROCESS The main objective of fi nancial audit is to detect frauds in fi nancial reporting for the protection of shareholder ownership and correctly informing them and the potential investors. Such objective can be traced back as far as ancient Egypt, where scribes were entrusted with the pharaohs’ bookkeeping; they mainly had the responsibility of inventorying stocks of gold, grain, sheep, and other valuable products. As expected, some of them could not resist the temptation of appropriating some their rulers’ assets. It was then decided for auditing purposes to have two scribes independently record each transaction. And the concordance of two scribes recording was synonymous with no problem. However, the death of the two always resulted in cases of material difference. “That proved to be a great incentive for them to carefully check all the numbers and make sure the help wasn’t stealing. In fact, fraud prevention and detection became the royal accountants’ main duty” (Wells, 2000). Fortunately, the modern fi nancial audit activity is far less risky and it is undertaken before the publication of the fi nancial statements. This is actually a multistage process. Figure 8.3 summarizes the main steps of such process (PCAOB, 2004).

Engagement Procedures

Planning and risk assessment

Internal controls testing

Audit report

Finalization

Figure 8.3

The audit process.

Substantive procedures

188

Internal and External Aspects of Corporate Governance

The “engagement procedures” step constitutes the starting point of the fi nancial audit process. This step encompasses the external auditor appointment as well as the agreement on the audit terms and conditions, which should include preliminary approval of nonaudit services. The next step, called “planning and risk assessment,” is when the external auditor must draw its preliminary conclusions with regard to materiality and the risk-occurrence probabilities. This step takes effect earlier in the business year and has two objectives. First, a better understanding of the company and the environment in which it operates; second, the identification of the key audit risks involved. These risks represent the possibility the audit would lead to a wrong opinion. The external auditor will work to control the process of eliminating all situations where one person could be both the decision maker and the decision executor. The external auditor generally should suggest appropriate plans and procedures to increase the rigor of the control process. The third step of the fi nancial audit process, the “internal control assessment,” is designed to evaluate the effectiveness of security control procedures. This is achieved by multiplying testing and transactions cross-checks. When internal control is considered to be adequate, this usually results in a significant reduction in the audit activities and decreases, at the same time, the cost involved. At the fourth step, the external auditor may decide not to perform tests on internal control mechanisms. Whenever he is convinced of their effectiveness and unreliability, he will adopt instead more constraining approaches or substantive approaches. If the external auditor is convinced of medium quality of internal control mechanisms, he will pursue a more thorough approach called “Substantive Analytical Procedures.” Finally, if he believes that internal control mechanisms are inadequate, an even stricter approach will be adopted called “Substantive Tests of Detail.” The substantive approach takes effect after the end of the business year and will aim to gather evidence, either confi rming or refuting the claims of the management team. This will compare actual figures to those disclosed in the fi nancial statements and ensure their reliability and compliance with GAAP and legal standards. The external auditor uses the analytical procedures approach whenever internal control is not considered good enough. He will then engage himself in fi nancial information cross-check and compare them to the nonfi nancial information. This will ensure that the numbers make sense and that unexpected or abnormal movements can be explained. Whenever the external auditor considers internal control mechanisms to be weak, he will then have recourse to the sampling of transactions affecting significant accounts and try to fi nd evidence confi rming such transactions as invoices, bank statements, and so on. The completion of the audit process constitutes the last step in the financial audit process. It takes effect at the end of the period and has several objectives. The fi rst objective is the preparation of a report covering

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everything related to the treatment of audit issues brought to the attention of the auditor during the conduct of the audit; second, the evaluation and verification of evidence obtained during the audit process; and third, the assertion of the type of opinion that should be indicated in the report, given the evidence obtained. Whatever the chosen approach, the auditor must maintain full independence from the management team so that his decisions are taken with their own merit in mind. The term audit risk (AR) generally describes “the risk of a material misstatement of a given fi nancial statement item that is or should be included in the audited fi nancial statements of an entity” (Australian Educational Research Pty. Ltd., 2008). It covers theoretically a spectrum of situations. These situations range from the case where there is complete certainty about the absence of any material error to situations where there is complete certainty of the existence of material misstatement. In real life, however, the audit risk will always be located between these two extreme situations and can be decomposed into misstatement risk, control risk, and detecting risk. (i) The misstatement risk (MR) describes the chances that the fi nancial statements were actually materially misleading before they were audited. Such a risk may be divided into two subrisk components: the “inherent misstatement risk” and the “control misstatement risk.” The inherent misstatement risk can be defi ned as the sensitivity of a statement to a hardware error. This is caused either by itself or when combined with other inaccuracies. The control misstatement risk can be defi ned as the risk of a material error, either by itself or when combined with other inaccuracies, and that is not susceptible of being prevented or detected and corrected in time. (ii) The control risk (CR) describes the possibilities that a material misstatement, in the fi nancial reports, will not be detected and corrected by the internal control prior to their disclosure. As for other risks, controls can be assessed at different levels of aggregation and at different stages during the audit process. (iii) The detection risk (DR) describes the probability that an error can escape the vigilance of the auditor. It relates to the nature, the timing, and the extent of the auditing process. This process is to be determined by the auditor in order to bring the audit risk to an acceptable low level. Usually, the higher the inaccuracy risk, as estimated by the auditor, the lower the detection risk that can be accepted and vice versa. Before, however, the auditor considers the audit risks, he must fi rst determine what he considers to be a material audit error and significant disclosure failure. Only then can he be in the position of assessing the level of audit risk and consider it acceptable or feasible. Note that the acceptable level of audit risk is the risk of a material fi nancial statement misstatement

190 Internal and External Aspects of Corporate Governance that is acceptable to the auditor; it is estimated by reference to the expected reliance on the audited fi nancial statements.

The Evaluation of the Effectiveness of the Audit Process The generally accepted auditing standards (GAAS) are published by several organizations such as PCOAB and the International Auditing and Assurance Standards Board (IAASB). They require from the external auditors the assessment of the risk that the client’s fi nancial statements may contain inaccuracies. They then design the appropriate audit procedures to reduce the chances that such errors may go undetected. Indeed, prior to any risk assessment, the auditor must fi rst determine what he considers to be an inaccuracy in fi nancial reporting. Only then will he be able to assess the audit risk and qualify it as low, moderate, or high. The overall audit risk (AR) can also initially be broken into two subcomponents: the risk that incorrect fi nancial information may fi nd its way to the unaudited fi nancial statements (RMM), on the one hand, and on the other hand the risk that such error remains undetected by the auditor (Goldwasser, 2005). This kind of risk can be expressed by: (1—Pad), where Pad represents the probability of auditor detection. RMM can also be broken down into two components: the risk that an inherent inaccuracy happens (RMM i) and the risk that such inherent inaccuracy will not be detected by the entity. It can be expressed by: (1—Ped), where Ped represents the probability of entity detection. Thus, substituting the two components of RMM, audit risk can be mathematically defi ned as follows: AR = RMM i *(1-Pad)*(1-Ped). The three components of audit risk: RMM i, (1—Ped) and (1—Pad) are referred to, respectively, as inherent risk (IR), control risk (CR), and risk detection (DR). This gives rise to the audit risk model of: AR = IR * CR * DR

(Equation 8.1)

Where • IR, inherent risk, is the perceived level of risk that a material misstatement may occur in the client’s unaudited fi nancial statements. This is within the underlying levels of aggregation, in the absence of internal control procedures. • CR, control risk, is the perceived level of risk that a material misstatement in the client’s unaudited fi nancial statements, or the underlying levels of aggregation, will not be detected and corrected by the management’s internal control procedures. • DR, detection risk, is the perceived level of risk of a material misstatement in the client’s unaudited fi nancial statements or underlying

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levels of aggregation. Since, however, detection risk (DR) consists of analytical procedures and tests of details, this can be decomposed in the risk of detection by nonanalytical procedures (RAP) and the risk of nondetection by tests of details (RTD): DR = RAP * RTD

(Equation 8.2)

Where: RAP is the risk of no detection by analytical procedures. RTD is the risk of no detection by tests of details. By replacing its value by DR (RAP*RTD) in equation 8.1, the latter can be rewritten as follows: AR = IR * CR * RAP * RTD

(Equation 8.3)

Auditing standards will also assume that auditors are capable of using equation 8.3 to design their audit procedures by assigning a value to low level AR, 10%, for instance. The audit risk formula then becomes: AR = IR * CR * RAP * RTD = 10%

(Equation 8.4)

The use of the audit formula expressed by equation 4 to plan audit procedures requires a number of prerequisites: the auditor should, for example determine the values of MR and CR. The problem of quantifying audit risk components is so imprecise that auditing standards setters have generally opted for combining control risks with inherent risks and treat them as a single factor usually designated as risk of a material misstatement (RMM). In essence, if they ignore the inherent risk factor altogether, the audit risk equation becomes: RMM * R AP * RTD = x%

(Equation 8.5)

This makes sense, because a company’s internal control should be designed to prevent or to detect the material errors that are likely to be the product of the inherent risks associated with the enterprise. The auditor is therefore instructed to focus on the effectiveness of the client’s internal controls. In practice, auditors complete long internal control checklists and test a few dozen of them. The problem is that this process only reflects a superficial understanding of internal controls. Even companies with relatively simple operations have been found to have several hundreds of controls. If these are defective, they could give rise to material misstatements. In large complex entities the number of critical controls could number in the thousands.

192 Internal and External Aspects of Corporate Governance FINANCIAL AUDIT RESPONSIBILITY Financial audit will express a clear opinion as to whether the fi nancial statements have been prepared in all aspects according to generally accepted accounting principles and the agreed-upon conceptual framework. The activity of fi nancial audit is to submit to an independent third party’s formal review, the fi nancial information disclosure system, and the financial statements. Such a review is ensured by the external auditor, under the supervision of the audit committee. In most countries external auditing of fi nancial statements is carried out by practicing accountants. The external auditor is required by the end of the process to publish an independent opinion as to whether or not the published financial statements are in conformity with GAAP and GAAS. The other major role of the fi nancial audit is the enhancement of investors’ confidence in the published fi nancial statements and also the reinforcement of their conviction that the fi nancial audit results in discouraging fraud and embezzlement of all kinds. The quality of fi nancial information is, however, closely linked to the quality of the internal control system, discussed in a previous chapter. This is referred to as The process designed, implemented and maintained by those charged with governance, management and other personnel. This will also provide reasonable assurance about the achievement of an entity’s objectives with regard to reliability of fi nancial reporting, effectiveness and efficiency of operations, as well as compliance with applicable laws and regulations. The term ‘controls’ refers to any aspects of one or more of the components of internal control. (International Auditing and Assurance Standards Board [IAASB], 2008, p. 14) It is the responsibility of the audit committee to maintain free and open communication channels with the external auditor and the management team, and this is supposed to insure that all parties involved in the financial audit fulfi ll their task properly. There are some evidences that internal audit is generally viewed as a complementary rather than as a substitute monitoring mechanism (Carey, Simnett, & Tanewski, 2006).

The Role of the Management Team in the Financial Audit Process The management team is in the forefront of the fi nancial audit process. It must not only implement the internal control mechanisms that are necessary for the fi nancial audit, but must also ensure that all fi nancial information is collected appropriately and distributed equitably among all parties concerned. It is also the management’s duty to keep this process alive and constantly updated in a way that ensures that its qualities are constantly saved and updated. It should be noted that the audited

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fi nancial statements and the external auditor’s opinion do not relieve the management team from its responsibility toward the preparation and the presentation of the fi nancial statements in accordance with GAAP and GAAS. As a general rule, the responsibility of the management team in terms of fi nancial audit includes: 1. The design, implementation, and maintenance of appropriate internal control systems required for the preparation and the presentation of reliable fi nancial statements are free from material misstatement that may result from frauds or errors; 2. The choice and the use of appropriate accounting policies and methods; and 3. The choice of accounting estimates that are reasonable, given the circumstances (IAASB, 2008). Most accounting standards and governance guidelines require management teams to formally certify the quality of the information contained in the published fi nancial statements. They now have to commit their own criminal responsibility with regard to their presentation in all material respects and fairness of the fi nancial position of the company. Table 8.1 reproduces an illustrative report on an audit of fi nancial statements Table 8.1

Report of Independent Registered Public Accounting Firm

We have audited the accompanying balance sheets of X Company as of December 31, 20X3 and 20X2, as well as the related statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 20X3. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). These standards require that we put into play the audit to obtain reasonable assurance as to whether the financial statements are free of material misstatement. An audit includes examining on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management. These will also evaluate the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to the above present fairly the financial position of the Company as of [at] December 31, 20X3 and 20X2, and the results of their operations and cash flows for each of the three years in the period ending December 31, 20X3, in conformity with U.S. generally accepted accounting principles. [Signature] [City and State or Country] [Date] Source: Public Company Accounting Oversight Board (2004).

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Internal and External Aspects of Corporate Governance

Management may have recourse to external consultant services to enhance internal audit. This is usually perceived by external auditors as a legitimate managerial intent to accurately assess the state of internal control rather than hide its deficiencies. “However, in case of high integrity management, the involvement of external consultants might be seen by auditors as inconsistent with prior evidence on the quality of internal control and thus might signal the existence of the additional risk factors of material weaknesses” (Blaskovich, 2007). On the other hand, auditor’s nonaudit services are sometimes seen as a particular and credible signaling means for the manager to convey information to the auditor. “In such case, a manager’s incentives to influence auditor’s information and the negotiation feature of the reporting process can create the appearance of a positive association between auditor’s non-audit services and less accurate fi nancial reports, even when auditor independence is not an issue” (Zhang, 2003).

The Role of the Audit Committee in the Financial Audit Process The other party deeply engaged in fi nancial audit activities is the audit committee itself, and its responsibility is threefold: it lies in ensuring the compliance with internal audit procedures, the choice of the external auditor, and the monitoring of its actions. The audit committee plays a key role in reviewing fi nancial information before their publication. This, however, will obviously happen only if members of the audit committee are knowledgeable of the fi nancial disclosure process. Some of them are even fi nancial experts (Sarbanes/Oxley). In order to carry out their responsibilities, audit committee members must pay greater attention to a number of technical issues such as the understanding of accounting principles, the knowledge of the estimates and judgments used in the preparation of the fi nancial statements, the compliance with GAAP and GAAS, the knowledge of the key performance indicators, and the understanding of the sensitive and complex fi nancial areas, such as fi nancial instruments and option schemes, and so on. In the case of companies operating under several laws, the impact of each law referring to preparation of the fi nancial statements must be highlighted, dealing especially with company’s risks and performances. The role and responsibility of the audit committee in the field of fi nancial audit therefore present several aspects. They cover the preparation of the fi nancial statements, the internal control efficiency, and the external audit monitoring. This includes the appointment and the communication with stakeholders. It seems that the relation between nonaudit fees and the likelihood of restatement is insignificant, and this may contradict independence concerns about nonaudit fees paid to entrenched auditors (Stanley, 2007). Furthermore, “external auditors appear to be more affected by client pressure and less concerned about internal audit quality and coordination

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when making internal audit reliance decisions at clients for whom significant non-audit services are also provided” (Felix et al., 2005). On the other hand, “weaker shareholder rights are commonly associated with poorer audit quality. Such inclination is not present, however, in regulated fi rms and this is because regulatory monitoring substitutes for external auditing and, hence, influences the association between shareholder rights and auditor choice” (Jiraporn, 2007). Finally, even audit committee meeting frequency seem to be associated with reduced levels of discretionary current accruals (Xie, Davidson, & DaDalt, 2001).

Financial Reports One of the main responsibilities of the audit committee is to ensure, on behalf of the board of directors, the effectiveness, fairness, and reliability of the fi nancial reporting process. This should also include the quality of the company and the results and formally communicating within and outside the company. The audit committee should therefore take all the appropriate measures to establish strategies aimed at efficiency in fi nancial reporting. It is important to review the annual fi nancial statements before their publication to be assured of their completeness and consistency. This could be compared with the information known to the committee members (PricewaterhouseCoopers, 2003). It is important that the review covers not only the fi nancial statements but also the notes to fi nancial statements as well as management clarification and comments. To carry out the efficient handling of the fi nancial statements review, the audit committee will obviously need to be familiar with the underlining conceptual framework. When companies use foreign markets for their fi nancing, they must also prepare their fi nancial statements in accordance with several sets of GAAP, or at least provide reconciliations of their own GAAP to GAAP of other environments. Fortunately, in order to enhance the comparability of fi nancial statements and fi nancial reporting harmonization, many countries are adopting or have already adopted International Financial Reporting Standards (IFRS). This has the effect of avoiding the use of a double set of GAAP or to undertake their costly reconciliations.

The Audit Committee Relationship with the external Auditors The other main concern of particular importance for the audit committee is the maintaining of a constant and regular channel of communication between the external auditor and the management team. The audit committee must consult with the auditors and management on issues regarding the adequacy and effectiveness of the accounting system and the fi nancial controls. Discussions with external auditors should focus on the following key elements:

196

Internal and External Aspects of Corporate Governance

1. The qualifications of the external auditor for the audit, including its independence and the appropriateness the methodology is suggesting; 2. The identification of the audit plan and the key audit risks; 3. The disclosure policy and the overall quality of the financial reporting; 4. All other issues considered of interest and brought forth by the auditors in connection with their mandate (PricewaterhouseCoopers, 2003). The accounting policies, methods, and choices must be accompanied by the appropriate explanations. The audit committee must have regular meetings with the external auditors at appropriate times as well as several times a year, not only at the time of the annual audit mandate. This should be done hopefully at the following steps of the audit process: 1. At the pre-commitment stage, in order to approve the scope of the audit mandate and discuss the external auditor independence requirement, and fi nally approve the letter of agreement of the audit mission; 2. At the planning stage, in order to clarify the auditing method to be used; 3. During the audit process itself. This will present an opportunity for the external auditor to inform the committee of all the important issues affecting the conduct of the audit; and 4. At the resolution stage of the audit mandate, to discuss the audit fi ndings. In general, the audit committee should be able to discuss problems and difficulties encountered, particularly management team cooperation and the reliability of its answers to the auditor’s questions with the external auditor throughout the audit process. Three key issues should be raised with regard to the quality of the external audit process. 1. The fi rst question to be asked is: if the external auditor had to prepare the audited company financial statements, would he have done it differently? 2. The second question to be asked is: if the external auditor was an investor, would he feel that he had received information in a timely manner, the necessary information, allowing him to gain a deep understanding of the critical fi nancial position of the company? 3. Finally, are internal control procedures in line with external audit procedures and if not, what are the differences and why? As a rule, the audit committee should be made aware regularly of the external auditor criticisms relating to the company’s audit policies and practices and other treatments of fi nancial information. In some countries, GAAS also includes specific provisions requiring communication between the

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external auditor and the audit committee. The audit committee is directly responsible for making recommendations to the board of directors on the appointment, the mandate renewal, the replacement, the compensation, the monitoring, and the independence safeguard of the external auditors. The audit committee is also responsible for solving disagreements that may arise between the management team and the external auditor with regards to the fi nancial disclosure process. The external auditor is nominated by the shareholders’ general meeting. This is done after having been appointed by the board of directors upon recommendation of the audit committee. All audit and nonaudit services provided by the external auditor must be approved by the audit committee. The audit committee at this time may delegate such task to the pre-approval of one of its members. The audit committee monitoring of the external auditor is required by most recent governance reforms (SOX), stating, for instance, that: 1. The external auditor must report directly to the audit committee and not to the management team, and that is the responsibility of the audit committee to determine the external auditor compensation. 2. All services provided by the external auditor must be pre-approved by the audit committee, including consulting services. 3. The external auditor must report the following: new accounting method, new application of GAAP, differences of opinion that may arise between the management team and the external auditor, weaknesses discovered during the audit, and other relevant issues relating to the audit process. This must be reported directly to the audit committee. 4. The external auditor cannot act as auditor and consultant for the same company simultaneously for a number of services related to accounting and other strategic management areas. The ultimate objective of the fi nancial audit is to allow external users of fi nancial statements to make decisions as rationally as possible. It also seeks to ensure that the fi nancial statements were prepared in accordance with GAAP and GAAS and approved accounting conceptual framework. The audit committee as representative of the board should make sure that internal control and external audit are performed appropriately and should maintain smooth and continuous channels of communication with the external auditor.

Consulting Services Most corporate governance reforms restrict the number of consulting services the external auditor can perform. They also charge the audit committee with the task of developing and recommending to the board of directors auditor hiring and auditing policies. The main responsibility of the audit committee must be to ensure that the audit does not suffer from the auditor’s

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lack of independence and absence of objectivity. Specifically, the audit committee must ensure a number of prerogatives including the insurance that the external auditor has the required knowledge and experience that make him a qualified supplier of audit and nonaudit services; the safeguards that were put in place to ensure that there is no threat to the auditor objectivity and independence resulting from the supplying of nonaudit services; that the necessary precautions were taken for ensuring that audit fees are appropriate and competitive and whether there is criteria for the assessment of auditor compensation. Typically, an external auditor cannot provide the following services to a client while serving as its auditor: 1. 2. 3. 4. 5. 6. 7. 8.

Bookkeeping activity and other accounting-related services; Internal audit outsourcing services; Valuation and appraisal services; Actuarial services; Management or human resources functions; Brokerage, dealership, investment advisory, and other financial services; Legal services and expert services unrelated to the audit; Any other service that the board deems incompatible with the audit activity.

It is, however, commonly accepted that auditors can provide tax services if they are approved by the audit committee of the company.

THE EXTERNAL AUDITOR An external auditor is hired by the shareholders’ general meeting on the board of directors’ recommendation and after being selected by the company’s audit committee. Three factors should guide the choice of the external auditor: objectivity, work performance, and competence (Krishnamoorthy, 2002). On the other hand, recent developments are tremendously impacting the role of the external auditor and greater responsibility is assigned to him (Holm & Laursen, 2007). This section deals with the external auditor and the audit environment.

External Auditor Role and Duties The external auditor is subject to a number of legal and professional rules and regulations with which he must comply. He is required, for instance, while fulfi lling his mandate, to demonstrate competency, professional skepticism, and ability to collaborate with the company’s audit committee and should report to the company’s board of directors. More specifically, the external auditor is subjected to a number of professional auditing standards or GAAS and other ethical requirements related to the audit. His

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commitment is carried out under the supervision of the audit committee, in full respect to corporate audit policies. This would include safeguarding policies against confl icts of interest and dependence to the management. The basic principles governing the external auditor’s role aim to ensure his credibility, integrity, and independence (COSO, 2008). They are summarized in the following: 1. The external auditor must demonstrate integrity by being direct and honest in all his audit activities. 2. He must be objective in his endeavor, in order not to let bias, confl icts of interest, or undue influence prevail over his own audit conclusions. 3. He must demonstrate professional competency and diligence. This is obtained by imposing upon himself the obligation to maintain knowledge and skills required to ensure that the clients receive the proper professional service to which they are entitled. 4. The external auditor must always aim at obtaining reasonable assurance that the fi nancial statements are free of material misstatement based on fraud, errors, or omissions. 5. He must respect the confidentiality of information revealed to him during the audit activity. He must not disclose any of it to third parties without specific permission from the company, neither use it for personal purposes nor to others’ advantage. The audit mandate must be planned and carried out with the necessary professional skepticism (AICPA, 2005). He is supposed to generally assume that circumstances exist that will cause the information contained in the fi nancial statements to be significantly deceptive and misleading. Such professional skepticism authorizes the auditor to use a permanent questioning and critical evaluation of audit evidence. Examples of the use of professional skepticism and critical thinking include a high sensitivity devoted to the selection as well as the nature and the extent of the documentation produced in support of transactions. It transcends the sensitivity paid to the need for corroborating the management team explanations and statements. It is expressed in actions, such as the introduction of new analytical methods or discussions with people inside or outside the company other than the management team (Office of Internal Audit, Northwestern State University, 2008). Fraud detection is a complex process. It makes professional skepticism a requirement during the whole audit process for several reasons: fi rst, for reducing the risk of exaggerating unusual circumstances; second, for avoiding overgeneralization of the audit fi ndings; third, for avoiding the use of erroneous assumptions in determining the nature, timing, and extent of audit procedures and the evaluation of its results. Accordingly, the management team representations cannot be considered as a valid substitute for conducting an appropriate audit, nor can they motivate enough evidence to draw reasonable conclusions on which the audit opinion can be based.

200 Internal and External Aspects of Corporate Governance The external auditor must submit his fi ndings in writing to both the management team and the board of directors and should attend the board meeting. During this time the annual financial statements are discussed and adopted. The audit report must include the audit issues that the auditor wishes to bring to the attention of the management team and to the board of directors. In general, the audit report should include information for assessing the risks that may threaten auditor independence or encourage conflicts of interest. This may refer to any information of interest that may affect the audit course of events and that has characterized the audit process. This includes management cooperation, the various discussions with the board and a list of corrections that were observed but not made, and so on. With regard to the fi nancial figure, information should also be provided in the audit report, including analysis of changes in equity, which are not included in the annual report. These are part of the auditor’s opinion, and they may contribute to a better understanding of the fi nancial position and the company. This is especially the case of the discussion of the nonrecurring items, the accounting policy choices when alternative choices are possible, and their special effects. It is ultimately the case for the discussion of the quality of the forecasting and the budgeting processes. Regarding the effectiveness of the internal control and the risk treatment, some information must be provided. This should include suggestions for improvement, quality assessment, gap identifications, and comments about the threats of risks to the company and how they should be presented in the fi nancial statements. Finally, the report should also give information regarding the respect of the legal provisions, texts of incorporation, professional standards, and regulations. In deciding to accept an audit term, the auditors normally base their decision on specific rules, and these may include an assessment of the management team competency, an assessment of its integrity, and reputation. Indeed, external auditors are allowed to refuse an audit term or withdraw for an ongoing one if, for example, the ethical requirements cannot be met or significant moral weaknesses are encountered, such as noncompliance with the laws and regulations. “The external auditors ought to recognize that they must be perceived as the experts regarding internal control and risk management and that this must be engrained as part of the service rendered, i.e. part of the value adding nature of an audit. At the same time they must improve the transparency of the audit standards and the communication processes of audit reporting” (Holm & Laursen, 2007).

The Reasonable Assurance The external auditor conducts its audit assignment in accordance with GAAS, in order to achieve reasonable assurance that the fi nancial statements are free of material misstatement, either because of errors or fraud. “Reasonable assurance includes the understanding that there is a remote

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likelihood that material misstatements will not be prevented or detected on a timely basis. Although it is not absolute assurance, reasonable assurance is, nevertheless, a high level of assurance” (PCAOB, 2004b, p. A13). Reasonable assurance is a relatively new concept. It relates to the accumulation of audit evidence needed for the auditor and enabling it to conclude that there were no inaccuracies in the fi nancial statements taken as a whole. The concept of reasonable assurance has a number of limitations resulting from the fact that the audit review is made on a test basis. This requires the exercise of professional judgment and also because internal control imposes its own inherent limitations, and fi nally, because the audit evidences are persuasive rather than conclusive. As noted previously, while seeking reasonable assurance, the auditor must maintain an attitude of professional skepticism in front of the management team and throughout the whole audit process. He must be aware that there are serious chances that management may override the control mechanisms and must recognize that auditing procedures that are effective for error detection may not necessarily be effective for fraud detection. Fortunately, the external auditor may use the audit guidelines that can help identify and assess the risks of material misstatements and fraud. These guidelines can be used to design appropriate procedures for their detection (COSO, 2008). This is the case, for example, of the International Standards of Auditing (ISA). The external auditor’s approach to form an audit opinion is pure value judgment regarding particularly the evidence collection and the conclusions formulation. Many other limits and reservations can be expressed with respect to the fi nancial audit process. These may affect the audit work, quality, and conclusions.

External Auditor Opinion on the Financial Statements The external auditors prepare audit reports to the audit committee. These reports can take different forms. They can be written or oral reports on all relevant issues, but they can also be a series of documents to be discussed at a meeting or even presentations or oral communications. Although these contents may vary, depending on the circumstances, the following questions must be addressed in all audit reports: 1. The audit reports should outline the general approach and overall scope of the audit process, including limitations and requirements; 2. The audit reports should clarify the choice made with regard to accounting method and policy changes and practices that could have a significant impact on the company’s fi nancial statements; 3. The audit reports must determine the potential effect on the fi nancial risks and exposures, such as pending litigation, which should be disclosed in the fi nancial statements;

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4. The report must confi rm the audit adjustments that have a significant effect beyond fi nancial statements, whether recorded by the entity or not; 5. The audit report should explain the material uncertainties related to events and conditions that may raise significant doubts about the ability of the entity to continue as a going concern; 6. The audit report should highlight any disagreements with management on matters that, individually or together, could impact significantly fi nancial statements or the audit report; and 7. The audit report must finally address all other issues contained in the audit process. The auditor should also formally report to the audit committee on a number of other issues, when required by law or regulations. It is also the responsibility of the auditor to determine if the reporting framework adopted by the management team for financial disclosure is acceptable, given the nature of the entity and purpose of its financial reporting. The auditor is required to produce, at the end of the audit process, a statement of auditing relating the quality of his work.

Who Guards the Guardians? Financial audits are usually performed by practitioners’ accounting fi rms. The reason is that not only the complexity and the specialization of the task require doing so but also the necessary level of knowledge makes it impossible for a nonprofessional to do the job. Audit activities are consequently dominated by a small number of large accounting firms which provide independent opinions on the fi nancial information published by companies. There are four big auditing fi rms, known as the “Big Four,” controlling the majority of audit activities of large listed companies, public institutions, international institutions, and multinational corporations around the world. The total revenue of the four major audit fi rms for the year 2007 came close to hundreds of billions of dollars. This is more than the annual national budget of many countries. Table 8.2 shows the extent of the concentration affecting the audit activity around the world. Table 8.2

Big Four Accounting Firms’ Global Revenues for the Year 2007

Accounting firm

2007 global revenue ( bn. of US dollars)

PricewaterhouseCoopers

25.2

Deloitte

23.1

Ernst & Young

21.1

KPMG

19.8

Source: PricewaterhouseCoopers (2008), Deloitte (2008), Ernst & Young (2008), KPMG (2008) and corresponding entries in Wikipedia (2008).

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The external audit of fi nancial statements is, however, a relatively recent phenomenon, because until the turn of the 20th century, companies were not obliged to submit their fi nancial statements to the review of an external auditor, nor were they obliged to submit annual reports to their shareholders. Later, however, and especially following the establishment of the United States Securities and Exchange Commission, the situation had drastically changed. Since then, not only did external audit become mandatory throughout the planet, but the fi nancial auditing standards and methods have evolved significantly. The safeguarding, by auditors, of shareholder interests as well as the other stakeholders of the modern publicly traded global enterprise is no longer efficient or effective; this is particularly true in the wake of renowned corporate failures and the recent trend is strengthening internal control procedures and risk management. Andersen, PricewaterhouseCoopers, and Deloite & Touche are auditors that witnessed the collapse of Enron, Freddie Mac, and Fannie Mae: virtually behind each renowned fi nancial failure there is a big accounting fi rm. So were they paid high fees (Deloitte was paid $49.3 million in fees in 2007) to cover up? After the numerous renowned corporate failures, one question topped investors’ minds: where were the auditors? “So where are all those expensive auditors who are paid a lot of shareholder money to catch such problems? Right now, just as in past accounting scandals, they’re reverting to type: they’re trying to run away or, at the very least, blame the accounting rules” (MacDonald, 2006; Basioudis et al., 2007). No surprise, therefore, that external auditors are increasingly facing intense criticism to be more efficient in conducting audits without compromising quality and effectiveness, and this can be achieved by strengthening objectivity, work performance, competence, and avoiding confl icts of interest (Krishnamoorthy, 2002). It seems that such common practice of companies hiring accounting and finance personnel from their external audit fi rms can have an impact on auditor independence (Zulkarnain & Shamsher, 2007). It should therefore be avoided.

THE INTERCONNECTION WTH OTHER CORPORATE GOVERNANCE MECHANISMS The management team is primarily responsible for the preparation of the fi nancial statements, and the external audit constitutes a major foundation of corporate governance. The objective is to ensure the fi nancial statements external users of their quality and reliability and that, therefore, they can be used in the decision-making processes as complete and credible knowledge. Given the overlapping of the fi nancial audit with many internal corporate governance mechanisms, it is easy to expect its effects to go beyond its technical requirements. It consequently extends to cover many other internal governance dimensions. An efficient fi nancial audit ensures the integrity of the fi nancial reporting as well as the reliability of its information gathering

204

Internal and External Aspects of Corporate Governance

and disclosure process. Additional to ensuring organization transparency, it may also be more focused on specific governance mechanisms, subsequently on the effectiveness of the internal control system and risk management. It may warn against governance threats, may suggest ways they can be tackled, and also calls for laws and regulations’ observance. Furthermore, when deciding to accept or refuse an audit term, the auditors normally based their decision on specific rules which may include assessing the management team’s ability, integrity, and reputation. The external auditors have the choice to change an audit assignment, if, for example, the ethical requirements cannot be met or significant moral challenges are encountered. At this time the external auditor can help strengthen corporate governance in organizations. This fact is accented by the requirement from the external auditor to maintain an attitude of professional skepticism throughout the audit process. The fi nancial audit fosters a culture of monitoring and an attitude of constant vigilance. It constitutes a guarantee that the fi nancial statements are free of material misstatement or fraud. Absolute insurance is certainly not of this world. Thus, a positive audit opinion would not ensure the entity survival into the future, nor would it protect against possible malfeasance.

CONCLUSION The fi nancial audit objective is to ensure the quality of financial disclosure and compliance with laws, rules, and regulations. The audit committee is mandated by the board of directors to ensure smooth functioning of the fi nancial audit. It has, therefore, a particular role in ensuring shareholders of the integrity of the auditing process and the internal control quality. Its success depends, however, on the ability and competency of its members. The audit committee is the body responsible for overseeing and monitoring relations with the external auditor and has the primary responsibility to make a recommendation to the board and hence to shareholders on the appointment, reappointment, and removal of the external auditors. It consequently sets the tone for the quality and the professionalism of the audit work. Although the external auditor can play a major role in enhancing corporate governance, public criticism is constantly on the rise. It reached a crescendo in recent days, following the recent fi nancial crisis. People are wondering how such large bankruptcies could happen to companies that were still to receive a positive opinion without reservation from the external auditor. The external audit process appears, more and more, like many human activities that are useful only because they exist and seem to have no purpose but to perpetuate themselves. It is difficult to live without them not because they are necessary to our lives but because, maybe, they were imposed to us.

Financial Auditing and Corporate Governance

205

COMPREHENSIVE CASE 8.1

Royal Bank of Canada, Report of Independent Registered Chartered Accountants The Royal Bank of Canada, Report of Independent Registered Chartered Accountants can be found at the Bank’s 2008 annual report (http://www. rbcwminternational.com/pdf/Rapport-RBC-2008.pdf). You are invited to study deeply this report and highlight the extent of external auditors, certification, and responsibility.

9

Credit-Rating Activities and Corporate Governance

Credit ratings (CR) can play a crucial role in fi nancial markets, by regulating issuers’ access and influencing investor behavior; they are assessments of the likelihood that an issuer of a debt will be unable to meet its financial obligations as planned, with regard to interest expenses on debt and reimbursement of principal. The credit-rating agencies (CRA) ultimately lead to a significant reduction in borrowing costs for issuers, which in turn increases the overall supply of venture capital and ultimately leads to greater economic growth. The credit-rating activities have benefited from the globalization of fi nancial markets and especially international banking regulations, which includes them in their requirements for the establishment of bank risk (Basel II). The CRA also allow greater access to capital markets to categories of borrowers who otherwise would have been excluded: universities, hospitals, municipalities, and so on. Banks play for their customers a credit-rating activity similar to those played by CRA for fi xed-return security issuers. The CRA and banks can significantly impact governance within organizations, and the effect can even be stronger for unlisted companies. The constant failures of big CRA to predict major corporate fi nancial crises are, however, shedding serious doubts on their reliability, credibility, and accountability. This chapter examines the economic role of rating agencies and bank ratings in corporate governance enhancement.

WHAT IS CREDIT RATING? The basic idea behind credit rating is to minimize the impact of information asymmetry characterizing the relation existing between issuers and investors regarding the credit quality of issuers (Elkoury, 2009). They also play an important role for investors by increasing the range of investment alternatives available to them, and, fi nally, they provide an “independent measurement” of credit risk that is easy to use and will supposedly improve the overall efficiency of the fi nancial market. As a rule, borrowers with high credit ratings will benefit from lower interest rates as a consequence

Credit-Rating Activities and Corporate Governance 207 of lower risk premium required by investors. The credit ratings are actually a mere production of professional opinion expressing views on the uncertainty surrounding the ability of fi xed-return issuers to repay debt. For this reason they are considered one of the outside “gatekeepers” who act as reputational intermediaries by evaluating issuers in order to protect outside investors (Pinto, 2006). CR is based on analysis of both qualitative and quantitative information and aims at determining the ability of issuers of fi xed-income securities to discharge their fi nancial obligations. Such obligations generally consist of two distinct components presenting different characteristics. Interest expenses or fi xed dividends are a form of rent on borrowed money and due at the end of each specific period of use. Their power is dependent on the amount of the credit volume, the level of the interest rate and the chosen term, and, of course, the total of all principal repayments made, which equals the total loan by the end of the term. The CRA play an important role in the modern capital market by expressing their opinions on the risk of fi xed-income securities that investors incur. The CRA provide views of credit for various fi xed-income instruments and that includes private loans, bonds, preferred shares, and other debt instruments. It is important to always remember that the information CRA developed is not subjected to any formal audit, that is, an audit that is conducted by a recognized auditor. CRA opinions are subject to change at any time, as they can be confi rmed, overturned, and even abandoned. Figure 9.1 outlines three basic principles underlying the CRA opinions. These are precisely the principles on which the stable rating philosophy is based. They include hierarchy and qualitative and quantitative considerations. Issuers’ performance, or their ability to cope with the burden of their debts, is generally affected by the changes in the economic environment. CRA address these environmental changes by relying on a stability rule while assessing credit ratings. They consider volatility as synonymous with increased risk. Issuers that are affected by cyclical environmental changes are therefore considered a weak CR. Since the objective of CR is to provide credit issuers with preliminary evaluation of the quality of their credit, CRA try to avoid opinions that can be affected by changes that are not induced

Rating Philosophy

Corporate Ratings Principles

Hierarchy

Figure 9.1

Corporate-ratings principle.

Qualitative & Quantitative Considerations

208

Internal and External Aspects of Corporate Governance

by normal economic cycles. They seek instead to adopt a smoothing of the long-term variations and even reconsider their CR whenever it becomes clear that a structural positive or negative change has a serious chance to materialize. In establishing their opinions, CRA carry out the classification of debt by issuer and use as a starting point the senior debt to be rated higher, and so on. CRA do not limit themselves anymore to the analysis of quantitative information available; they usually back them with qualitative information as well. The issuance of an opinion implies the assessment of the ability of the issuer to pay in the future; it must therefore combine qualitative and quantitative information regarding the issuer’s capacities. Although the issuer’s current performance is an important one, its future performance is even more important. CRA opinion also addresses credit quality, taking into account factors such as payback by the investor in case of default. If we assume, for example, that Moody’s ratings are used (see table 9.1) and that the CR assigned to an issuer is AAA, this means that the Moody’s believes that the probability that the issuer will be unable to repay its debt in full is next to nil. The probability of default increases progressively as one goes down the ratings scale. The objective of credit rating is relatively simple: it aims to “to provide, through a simple symbol system, objective and independent opinions of relative credit risk that investors can use as a supplement to, but not as a substitute for, their own internal credit research” (Pinkes, 1997). Given the statutory requirements for an advance rating before trading, CRA hold an intriguing intertwined position of quasi-public regulators (Jain et al., 2008), and this would have allowed them to play a major role in corporate governance improvement, if only conflicts of interest had been avoided. Indeed, their common failures to reflect the financial condition of numerous troubled issuers raised issues about their roles and regulation (Pinto, 2006).

THE ROLE OF CREDIT RATINGS Investors usually require compensation for any risk they may be induced to take and for fi xed-income securities this will always translate in a higher interest to be paid to them, and this will result in an increase in the cost of capital for issuers. For this reason, investors and issuers can take recourse to credit ratings to reduce the information asymmetry that exists in favor of issuers. The CR is in fact likely to reassure investors and issuers by allowing them greater access to information from various sources. With respect to the issuer ability to pay, this includes its fi nancial position, the market in which it operates, and so on. Issuers may, however, issue different categories of fi xed-income securities for this reason; the various securities issued by the same issuer may have different credit ratings, depending on their risk profi le. In general, credit ratings allow investors to be aware of the risks that threaten them in participating in a debt program. The sole presence of informed investors and issuers is capable of reducing uncertainty in indebtedness and consequently reducing the cost of capital accordingly.

Credit-Rating Activities and Corporate Governance 209 To establish credit ratings, CRA engage in careful analysis of current and future events that may impact the issuers’ credit risks in the future. They draw, for this purpose, information from various sources. Like securities analysts, with whom they share many similarities, CRA should refrain from any advice and they actually prefer to limit themselves to the assessment of default probabilities, thus avoiding the perilous situation of being contradicted by the facts. They allow, however, both greater access to venture capital and greater flexibility of funding. Credit ratings may also allow better monitoring of issuers and more frequent evaluation. They are consequently in a better position to effortlessly issue larger amounts of securities and under more favorable conditions. Credit ratings are widely used by investors; they help debt issuers’ access to a wide range of potential underwriters and they have seen their scope enlarge by market globalization. The CRA activities are not limited to developed environments; CR are often used in developing countries, by investors, whether local or foreign issuers. They are mainly used to assess the risk premium to be required on a given fi xed income security. Lenders traditionally insist on being compensated for the uncertainty surrounding a debt issue by requiring higher interest rates from issuers. CR may, however, contribute in reducing such uncertainty to the issuers’ benefit, thus reducing the cost of capital. By allowing the reduction of risk, credit ratings contribute to improving the efficiency of capital markets and increase its liquidity. As a matter of fact, disintermediation and market efficiency will always benefit the investors and issuers through agency fees being lower. The CR plays also another significant role, mainly by broadening investors’ investment horizons. Even sophisticated investors may not have all the needed skills or knowledge to interpret the accessible countless databases and analysis of investment. They may, more effectively, take recourse to CR to make rational decisions. The CR can open more investments to a wider variety of market segments and also allow investors to focus more time on other important elements of investment securities in their possession or acquire such interest rates. The provision of quality ratings is supposed to be at least partially sustained by the reputational concerns of the rating agencies.

CREDIT-RATING AGENCIES The global integration of fi nancial markets has brought some change to the CRA governance structures, and they now play a more important role than in the past. A prominent example is provided by the commercial credit-ratings agencies that have established themselves as influential gatekeepers of the international credit market. A problem with this form of intermediation is that when there are errors, ratings agencies can do considerable damage to borrowers and investors alike. Still, it is very difficult to hold rating agencies accountable. The standards of creditworthiness established by the rating agencies are supposed to be based on neutral

210 Internal and External Aspects of Corporate Governance expertise, on the one hand, but are often subject to mandatory enforcement by fi nancial market regulation, on the other; for this reason, “the resulting compliance without complaints reduces the possibilities for learning” (Kerwer, 2001). The CRA-assigned ratings are actually bankruptcy risk assessments. Several kinds of CRA can be encountered in key global markets; they significantly vary in size, work processes, specialization, and even in their defi nition of risk of default. This obviously makes comparisons between them almost impossible. Some CRA are regional in scope whereas others are international; few are approved by some monitoring authority and others are not. A few CRA dominate the international credit rating and perform the majority of rating transactions. They are Standard & Poor’s, Moody’s, and Fitch (3CRA). Although CRA may be encountered anywhere, as in countries like Nigeria, Peru, or the Trinity, their impact is still negligible compared to the activities of 3CRA, which operate on a global scale and generate most of their revenues by charging issuers for the CR they make freely available to the public. While small CRA generate their revenue primarily by offering subscriptions to issuers, all CRA also offer additional fi nancial consulting services to their customers, such as simulations that determine how the creditworthiness of issuers may be affected by specific events, as well as several other consulting services. Actually, Moody’s, Standard & Poor’s, and Fitch rating “serves as unofficial umpires in major league fi nance, helping investors and underwriters gauge what to buy and what to avoid. Many big investors aren’t allowed to even touch bonds that don’t have the blessing of a good credit rating” (Eisinger, 2007). In what follows, a short history of 3CRA is provided. Moody’s, for instance, was founded in 1900 and over the years of service, credit-ratings activities have been developed and expanded to cover the commercial paper market and bank deposits. Today, Moody’s Corporation is present in 18 countries and is composed of two subsidiaries, namely, Moody’s Investors Service and Moody’s KMV, producing more than one billion dollars in sales and employing more than 2,000 people. The credit ratings from Moody’s are among the most widely used in the world. Publications and professional advice of Moody’s reach over 3,000 schools and over 20,000 subscribers. Moody’s has actively built alliances with local creditrating agencies in the world. The creation of Standard & Poor’s dates back to 1860. Standard & Poor’s has also expanded its services over the years. It was acquired in 1966 by the McGraw-Hill Companies Inc., now a division of the McGraw-Hill Companies Inc., and has offices worldwide, providing financial advice, credit ratings, and many other services related to assessing the credit worthiness of companies. Fitch was founded in 1913; it began as a publisher of fi nancial statistics. Fitch quickly became the leader in providing essential financial statistics critical to the community through its publications. Today, Fitch provides credit ratings for companies and municipal bonds. Fitch merged in 1997 with the IBCA to increase its global presence in the banking sector and financial institutions and sovereign credits. Through

Credit-Rating Activities and Corporate Governance 211 this merger Fitch became French property and currently covers 2,300 banks and financial institutions and more than 1,000 companies. Because credit ratings are mostly opinions, the reputation of rating agencies is fundamental and 3ARC are aware of this fact and strive to establish a universal system and a structured methodology for the production of CR. In addition, agencies advocate that their activities are public and transparent and that all information relating to any rating decision is available for anyone wanting to consult them. The rating process, the symbols used, and the adopted methodology vary significantly within agencies. Some CRA use a process that focuses on analysts’ role in the process. Other CRA would opt instead for quantitative models, where the rating process is more mathematically oriented. In other cases, the process is homemade, and it is therefore kept secret. In the rating process, despite the diversity of approaches that are used, the majority of CRA seem to follow the same rating procedures and employ comparable instruments, at least at the level of form, and certainly not at the principles level. The CR are often based on the opinions of committees, usually consisting of at least one experienced analyst. The decision at the committee level is usually taken by a simple majority. Typically a CR takes shape in several stages; the process is described in Figure 9.2.

PRESS RELEASE

COMMUNICATION OF THE CR TO THE ISSUER

COMMITTEE ASSIGNMENT OF CR

Figure 9.2

Credit-rating process.

SENIOR ANALYST ASSIGNMENT

DATA COLLECTION

DRAFT(INTERIM) REPORT & CR RECOMMENDATION

212 Internal and External Aspects of Corporate Governance (i) A senior analyst is fi rst assigned the rating assignment. He is then entrusted with the responsibility for its preparation and its conduct and realization; (ii) The senior analyst collects the relevant information, originating from various sources; (iii) Based on the collected information, a draft (interim) report, containing a recommendation, is written; (iv) The interim report is submitted to the entire rating committee and ultimately assigned credit rating; (v) The issuer is informed about the rating committee’s decision and supplied with the report. The issuer will generally examine the facts and check for assurance that no private information is publicly disclosed. He can theoretically seek review of the rating, in case of disagreement. Although this is something CRA are usually very reluctant to concede, unless the issuer has new information or that he had discovered errors, omissions or inaccuracies occur; (vi) A press release is then communicated once the issuer’s comments are analyzed and changes, where appropriate, are made. It contains the CR and its justifications. The press release does not, however, constitute the end of the process; the CRA will generally continue to follow the issuer and periodically meet with its senior managers, although less frequently. The central element of the rating is the assessment of the default probability of an issuer to cope with debt obligations. CRA methods appear to diverge and the identification of common elements is difficult to achieve, since some elements of evaluation employed are purely qualitative and subjective, by nature, and there is no formal model for their rational use.

The Symbols of Credit Ratings The listings are simple and concise symbols used to express credit-quality opinions to the market. It is, however, important not to confuse symbols with opinions. Opinions generally contain more contextual information relating to securities which they aim to opine in the rating reports. They are usually expressed by a single symbol, like “AAA.” Table 9.1 shows examples of the credit-ratings symbols used by the 3ARC. When using credit-ratings opinions and symbols, we must always bear in mind that, no matter their quality, they do not necessarily guarantee against loss of investments. They are, at most, simple views on the relative probability of failure of an issuer and the loss of amounts invested. If properly understood by their users, they may, however, serve as a form of investor protection. Far from being elements of bankruptcy prediction, CR are rather risk measures very helpful in making up one’s mind. They express, however, probabilities that may never occur. Let’s assume the Moody’s

Credit-Rating Activities and Corporate Governance 213 Table 9.1

Examples of Credit Ratings by the Three Largest Credit-Ratings Agencies

Fitch

Moody’s

Standards and Poor’s

AAA: the best quality com- AAA: judged to be of the AAA: the best quality panies, reliable and stable highest quality, with mini- borrowers, reliable and mal credit risk. stable (many of them governments) AA: quality companies, a Aa1, Aa2, Aa3: judged AA: quality borrowers, a bit higher risk than AAA to be of high quality and bit higher risk than AAA are subject to very low credit risk. A: economic situation can A1, A2, A3: considered A: economic situation can affect finance upper-medium grade and affect finance are subject to low credit risk. BBB: medium class compa- Baa1, Baa2, Baa3: are BBB: medium class borrownies, which are satisfactory subject to moderate credit ers, which are satisfactory at the moment risk. at the moment Sources: Fitch, Moody’s, and Standard & Poor’s.

rating scale is used and that some issuer is given AAA rating. The chances of failure on its fi nancial obligations are lower (less likely) than those of another issuer with an Aa1 rating, which is even less likely than that of another issuer with an Aa2 rating, and so on. Unfortunately, the credit-rating opinions are far from being standardized: they do not mean actually the same thing for every CRA. Two main reasons can explain this divergence. First, defi nitions and symbol scales and methods used to produce them are often not comparable among agencies. Further, analysts’ opinions are subjective in nature and we cannot expect them to be identical. The value investors place in the credit ratings will therefore depend upon the reputation of the CRA itself. If, by misfortune, the reputation of a credit agency happens to suffer, investor confidence would suffer also.

Credit-Ratings Users Credit ratings are actually used by many market players and for various reasons. The main users of credit ratings are summarized in Figure 9.3. Users of credit ratings include: (i) Issuers appreciate credit ratings and, in many cases, are willing to pay for them because these credit opinions are likely to lower their cost of capital. Once reassured about the risks they face, investors usually require a lower yield on their investments;

214 Internal and External Aspects of Corporate Governance

FixedIncome Investors

Equity Investors

Credit Ratings Institutional

Figure 9.3

Issuers

Regulators

BrokerDealers

Credit-ratings main users.

(ii) Investors in fi xed-income securities also draw benefit from credit opinions and often use them to decide whether to purchase a fi xedincome instrument or not. They usually rely on credit opinions to assess the risk of investing in fi xed-income securities. They will, in fact, use CR as a proxy against issuers’ failure and at low cost; (iii) Equity investors often fi nd it also advantageous to use credit ratings in their decision-making process. Although credit ratings and share market prices do not always match, they are usually believed to point in the same direction. In effect, companies may suffer devaluation even though stock market listings remain high quality; (iv) Institutional investors seem to constitute the major buyers of fi xedincome securities. They often use their own analysts and lead their own credit analysis, but they also rely on the CRA credit opinions to confi rm their own assessments of issuers’ credit. They may also use credit ratings for several other purposes such as meeting specific requirements or face special investment restrictions; (v) As in the case of institutional investors, brokers and traders can also use CRA credit opinions to confi rm the conclusions of their own research and their recommendations. Similarly, bond analysts can use credit ratings in their overall evaluation of the quality of fi xed-income securities. Underwriters and investment banks also advise issuers to make a choice of the rating agency; (vi) Financial regulators appear to use the credit ratings’ opinions for a variety of purposes. Recently, for example, the Basel Committee on Banking

Credit-Rating Activities and Corporate Governance 215 Supervision has proposed that banks can use the credit-ratings symbols of CRA to determine capital requirements under the new Basel Accord. BANKS’ CREDIT-RATING ACTIVITIES A bank’s credit rating can also help establish a customer default probability, in meeting its fi nancial obligations toward the bank, by making the required payments in a timely manner, in addition to enable the bank itself to assess its risks with customers. Banks can, however, provide independent advice to investors and supply them with credit ratings. Compared to CRA ratings, bank ratings are relatively recent (Krahnen & Weber, 2001). Banks’ rating models were actually developed at banks, in a disorganized manner, which fi nally forced the Basel Committee on Banking Supervision (BCBS) to request the establishment of a harmonized system of bank internal credit-rating system. Basel II deals with the implementation in banks of effective risk management, covering the identification, evaluation, monitoring, and control of risk processes. The approach of the internal rating of the BCBS is recommended even for transactions with large companies for which banks can rely on external credit ratings. Table 9.2 compares internal banks’ internal credit-rating model to CRA’s models. Table 9.2

Ratings Criteria, Agencies Versus Banks

Standard & Poor’s

Moody’s

Typical bank

Financial risk: –Balance sheet –Financial policy –Return –Capital structure –Cash flow –Financial flexibility

Financial risk: –Cash flow –Liquidity –Debt structure –Equity and reserves

Economic situation: –Earnings (cash-flow return) –Financial situation (capital structure, liquidity, . . . )

Business risk: –Industry code –Competitive situation

Competition and business risk: –Relative market share competitive position –Diversification –Turnover, costs, returns –Sales and purchases

Business situation: –Industry assessment –Unique selling proposition and competition –Product mix –Special risks –Forecast: earnings and liquidity –Legal structure

Management:

Quality of management: –Planning and controlling –Managerial track record –Organizational structure –Entrepreneurial succession

(Quality) of Management: –Experience –Succession –Quality of accounting and controlling –Customer relationship –Account management

Source: Brunner, Krahnen, and Weber (2000, 8) and Krahnen and Weber (2001, 9).

216 Internal and External Aspects of Corporate Governance Table 9.2 shows great similarities between banks’ internal credit-rating model and the CRA models. All models are based on three criteria: fi nancial risk, business risk, and management quality.

CREDIT RATINGS IN CORPORATE GOVERNANCE The credit-ratings activities, whether emanating from banks or CRA, can play an important role in many international or local business transactions. CRA and banks attempt actually to take advantage of the large amount of information on issuers and borrowers, their economic environments, and fi nancial positions, aiming to allow investors to correctly assess the risk they are about to take. Users of credit ratings are numerous and employ them for a variety of reasons. From the point of view of corporate governance, credit ratings can be helpful in several ways (Pinkes, 1997), as previously discussed. Banks’ ownership of businesses varies among countries. In some countries, such as Germany and Japan, banks are the main owners of industrial enterprises, whereas in other countries, such as the United States, ownership of nonfinancial enterprises is prohibited. Regardless, however, of business ownership status, banks are able through their privileged relationships with their customers to significantly impact their management and governance. The presence of bank representatives on boards of directors can also increase the chances that the choice of corporate strategies will not be at the expense of creditors. Such a bank representation on the boards of directors is generally considered an effective external mechanism of corporate governance that could ensure the independence of the board. It is also a guarantee of the effective commitment from the board to take the right decisions regarding acceptable levels of risks associated with debt. The closer business relationship between the bank and companies allows banks to know more about the companies and their environments and assess risks in sight. Many investors use credit ratings as a benchmark for private setting of targets or limits of credit risk. A board of directors may, for example, stipulate that managers cannot transgress a listing limit. A pension fund may decide that its portfolio managers may acquire as bonds or other debt instruments a certain rating. Others may stipulate that managers cannot buy debt without credit rating and must limit their detention low debt rating to a small proportion of their overall portfolio. One factor involved in the rating is evaluating the management level of experience and competence of leaders. As indicated in Table 9.3, the production models of trading credits include a quality of management. The model Moody’s rating reflects the quality of management in terms of: (i) Planning and Control, (ii) Background management,

Credit-Rating Activities and Corporate Governance 217 (iii) organizational structure, and (iv) Succession of business. Lawmakers may use credit ratings or allow their use for regulatory purposes. Under the Basel II accord, for instance, the Committee on Banking Supervision allows banks to use selected credit ratings to calculate their net capital reserve requirements. By combining the feedback of external information with the credit rating, investors are intended to obtain a better understanding of management efficiency and corporate governance quality. The effect of credit ratings on corporate governance has traditionally been considered by testing the effectiveness of scoring models that include credit governance attributes. Three models were compared for this purpose (Ashbaugh, Collins, & LaFond, 2006): the fi rst model incorporating company’s specific features, the second model integrating governance attributes only, and a third model includes both governance and company’s attributes and characteristics. The introduction of governance attributes in the models’ credit rating seems to improve their explanatory power. Weak governance, such as a lack of independence of the board members or a lack of transparency in fi nancial reporting, may affect the credit-rating quality because they constitute evidence that creditor rights may not be respected. Another study compares the banking model to the 3CRA models (Grunert et al., 2005) and shows that credit ratings based on fi nancial and nonfi nancial information are more effective than models that take into account fi nancial factors only. The simultaneous use of fi nancial and nonfi nancial factors seems to produce a credit-risk measure that is more effective than if it was based on fi nancial factors. The results suggest that the quality of management positively affects credit quality (Kyereboah et al., 2006). It is suggested that in developing environments the study of the relationship between governance and performance would be more appropriate than the study of the relationship between governance and credit risk (Grunert et al., 2005). It follows that the separation of control function from those of management is the performance factor. It seems, on the other hand, that CEO incentives increase subsequent to credit downgrades and, to a much weaker extent, decrease after credit upgrades; and this favors a corporategovernance-based argument and suggests that rating agencies’ monitoring “complements equity-based incentive contracts to mitigate agency conflicts between managers and shareholders” (Kang et al., 2007). Recent fi nancial crisis is, however, shedding significant doubt with regard to the extent of CRA contribution to corporate governance enhancement, because the major agencies seem to have contributed substantially to the crisis by giving their highest rating (AAA) to most failing organizations and have also counseled them (Strier, 2008). Credit-rating activities today look like safe-passes transactions, allowing their holders to cross many regulatory barriers without really proving compliance with principles.

218 Internal and External Aspects of Corporate Governance CONCERNS REGARDING CREDIT AGENCIES There are several reasons for doubting credit ratings (Koresh, 2003), and problems were perceived with CRA ratings at all levels of the rating process (Hunt, 2006). Criticism has been especially directed towards the high degree of concentration of the industry. Promotion of competition may require policy action at national and international level to encourage the establishment of new agencies and to channel business generated by new regulatory requirements in their direction. (Elkhoury, 2008) The more common criticisms concern (1) disclosure practices (such as related to the assumptions underlying their ratings decisions); (2) potential conflicts of interest; (3) unfair practices; and (4) diligence and competence. CRA usually argue, in the little amount of gathered empirical evidence to support such criticisms, “the absence of such evidence does not indicate that the criticisms are invalid” (Frost, 2006). First, powerful tests related to potential confl icts of interest and alleged unfair practices are exceptionally difficult to design. Second, criticisms related to the adequacy of CRA disclosure practices have not yet been, but could be, investigated by empirical researchers. Third, many criticisms, particularly those focusing on the adequacy of CRA disclosure practices, diligence, and competence, are based on subjective benchmarks that are difficult to quantify (and that themselves are open to question). Empirical evidence does support the view that the large CRA dual roles of (1) providing timely information to market participants and (2) serving regulatory and contracting functions create confl icting evidence (Frost, 2006). But surveys on the use of agency credit ratings reveal that most investors believe that rating agencies are relatively slow in adjusting their ratings (Altman et al., 2003). The CRA are assumed to occupy a crucial position within the financial system. Their constant failure to predict major crises that have shaken the financial landscape since 1930 is jeopardizing their reputation. “Investors in Europe, who got slammed by unexpected defaults in securities backed by U.S. home loans, are particularly upset about the issue, and European securities regulators plan their own examination of the credit-rating agencies” (Zibel, 2007). CRA are often held responsible for amplifying aftermath financial crisis. Consequently, a number of concerns are often expressed with regard to CRA. It is, for instance, feared that CRA may establish special mechanisms that discourage newcomers, inhibit competition, encourage conflicts of interest, discourage transparency, and avoid accountability. All these concerns are addressed by the IOSCO code. It is argued that the very nature of the CRA market might make it difficult for new CRA to succeed, mainly because issuers usually desire ratings

Credit-Rating Activities and Corporate Governance 219 only from those CRA that are well established. Indeed, although there are some 150 CRA around the world, a very small number, around six agencies control 80% of the market. CRA can also be in a situation of confl ict of interest when they are in a position to press issuers to subscribe to their consulting services, possibly in exchange for favorable ratings. Some agencies even assign ratings to issuers who do not request them. The motivation behind unsolicited ratings is to press recalcitrant issuers to subscribe to credit rating. In fact, in addition to their coercive nature, unsolicited credit ratings present the major disadvantage of not involving the issuer in the rating process, depriving it of a crucial source of information. The CRA have been accused of using aggressive and dishonest tactics in performing unsolicited ratings and systematically reducing credit ratings for issuers who do not submit themselves to ratings. In this regard, the IOSCO code (IOSCO, 2003) recommends a number of rules limiting rating activities motivated by business relations between an issuer and a CRA or its affi liates. Another common criticism made against CRA resides in their lack of transparency about the methodologies used to conduct rating activities. To this end the IOSCO code recommends that the rating agencies disclose a number of fundamental elements that must be included in their individual code of conduct. Further, CRA are required to explain any deviations from such codes. The weakness of accountability on behalf of CRA is yet another area of weakness noted in the CRA. A mechanism to protect users against CRA rating errors and potential abuses of power does not exist. This is obviously unfortunate because CRA have initiated powers far beyond mere technical activity, to embrace the controversial field of security valuation. The introduction of some form of monitoring of rating activities proves to be necessary, given the high level of confl ict of interest that is exacerbated by the virtual absence of competition. Although confl icts of interest are common in other fi nancial market activities, they are particularly critical in the credit-rating market, mainly because of the virtual monopoly that seems to describe rating agencies’ activities. Moreover, issuers seem to be in weak positions because of their dependence on ratings Legislators were concerned about CRA activities, regarding particularly their reliability confl ict of interest, and are wondering if ratings should not be corrected (Section 702 of the Sarbanes-Oxley Act of 2002). Such concern has been amplified by the scandals of large companies that were still rated positively by CRA less than a week before their bankruptcy. The IOSCO code is one of those initiatives aimed at the improvement of governance of CRA. It aims to ensure the integrity, the quality, and the transparency of credit rating: (i) ensure quality and integrity of the rating process, (ii) remain independent and avoid confl icts of interest, (iii) assume their responsibility to market participants’ methodology through greater transparency and adequate treatment of confidential information provided by issuers (IOSCO, 2003).

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Actually, ratings are deeply embedded in fi nancial regulation, and for this reason the CRA have been handed an oligopoly they don’t seem to deserve, given the conflicts of interest they constantly have shown and the payments they receive from the issuers of the securities they rate. Furthermore, they are unaccountable because their ratings are deemed mere opinions and thus protected as free speech (The Economist, 2008). Appropriate solutions should be found and soon. Major CRA usually help their clients put together complicated mortgage securities before they receive an official ratings stamp, and this give-and-take can go too far and it is like a student who wants a B-plus on his term paper and his teacher sat down with him and helped him write an essay to make that grade (Eisinger, 2007). “In the case of credit bail out, loans were bundled and sliced into complicated debt instruments. The risk of these is gauged by credit-rating agencies which are paid by the very fi rms that created the securities and which make a lot of their money from advising on how to win the best ratings. Many of these structured debt instruments are bought by banks in other countries using off-balance-sheet entities for which they make little capital provision and about which banking supervisors know virtually nothing” (The Economist, 2007b). It’s becoming clear, indeed, that the ratings agencies were far from being passive raters, particularly in front of the overly optimistic ratings they give for risky packages, many of which are now blowing up. The ratings granted proved too generous, considering the state of the market, and to make matters worse the agencies were much too slow in downgrading (Eisinger, 2007).

SOME SUGGESTED SOLUTIONS Rarely has a process merited such highly unanimous criticism as credit ratings. Although CRA feel that such criticism was, in part, based on a misunderstanding, in an effort to head off new rules they have begun to think about changing the way they do business; but “such stabs at self-healing may not placate everyone” (The Economist, 2008). Indeed, most issues raised are not easy to solve, but some suggestions are commonly advanced: (i) Ending the regulatory dependence on ratings. The role of the state has diminished and more of its legal activities are being taken over by other institutions (Flood, 2005), and there is no rational argument in favor of maintaining the regulatory dependence on ratings users, who can indeed be left free to draw their own conclusions from paid studies and market data. Investors already have recourse to such process with regard to shares. Rating agencies are earning huge oligopolistic revenues offering opinions on the creditworthiness “of an alphabet soup of mortgage-related securities created by over-eager banks.

Credit-Rating Activities and Corporate Governance 221

(ii)

(iii)

(iv)

(v)

As the market blossomed, so did the agencies’ profits. Moody’s net income rose from $289m in 2002 to $754m last year. But did the fat fees lead to a drop in standards?” (The Economist, 2007a). Introducing more competition. Like any other area of business competition, ratings can only enhance efficiency and discourage conflicts of interest. It is feared, however, that “it might just as easily lead to a race to the bottom” (The Economist, 2008), as agencies race to offer issuers the best terms possible. Switching to an investor-pays system might seem the obvious solution, but it is not clear that enough investors would cough up to make the business viable. Some, perhaps many, would hitch a free ride as ratings leaked. Making agencies legally liable for their opinions. Indeed, recent corporate governance has introduced legal liability for CEO, CFO, and director, so why not for CRA? Why should such requirement scare CRA out of business, as it is commonly argued, if it did not scare others? A more practical approach might be to let the agencies get on with their housecleaning while introducing a reform borrowed from the accounting industry: a board, made up of industry types, investors, and academics, charged with policing the agencies’ analytical techniques and governance.

In any case, rating agencies would like to be seen as having embraced change, but they will need help in convincing the world that they mean it. They are claiming to be tackling their confl icts. Moody’s and S&P have built stronger walls between their analysts and salespeople. Both have vowed to review any rating issued by an employee who leaves to work for a client (The Economist, 2008). It seems, however, unreasonable to expect any fundamental change in the credit-rating activities. The SEC, for instance, recently issue a new proposal intended to increase transparency and reduce confl icts of interest in the CR. Such proposal may be most important for what it does not do because “it does not plan to forbid the ‘issuer-pays’ system, in which the rating agencies are paid by the parties whose products are being evaluated” (Hunt, 2008).

THE INTERCONNECTION WITH OTHER CORPORATE GOVERNANCE MECHANISMS The credit rating is an information process aiming at issuers’ risk assessment and emphasizing its dual fi nancial and business dimensions. It is therefore possible to explain the impact of credit ratings as an external mechanism of corporate governance, based on its effects on the risk management and the internal control, by examining the corporate risk structure. The company’s

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overall risk depends on its investment strategy, on the one hand, and on its indebtedness strategy, on the other hand. The simplest way to understand the relationship between credit ratings and corporate governance is to ride corporate leverage relationships. Generally speaking, any increase in investment in fi xed assets may increase corporate return, but also its operating risk. Similarly, any increase in indebtedness, usually to fi nance an increase in investment, can also improve corporate performance, but will also increase the company’s fi nancial risk. The two main components of company’ risk, namely, the operating risk and the fi nancial risk, can be identified by referring to the statement of income in Figure 9.4. It explains operating leverage, fi nancial leverage, and combined leverage especially and emphasizes their relationship with the risk components. Operational risk comes from the investment strategy of the company, which is imposed, in large part, on its industry. The company is still master of its choice for the other party; it may actually accelerate the process of replacement of fi xed assets or its delay and suffer the consequences. The operating leverage is assumed, even distracted, given the idea about the risk of exploitation. The operating leverage expresses the relationship between the turnover of a company’s earnings before interest and taxes (EBIT). The fi nancial risk stems from corporate indebtedness strategy. Even if debt level limits seem to exist by sector, companies are relatively masters of their funding decisions. Their ability to effectively choose the right level of indebtedness can impact their efficiency and decrease their fi nancial risk. Leverage can help in assessing the scope of risk and its weight on corporate performance. The fi rst risk component is the operating risk. It is usually described by the relationship between the corporation’s gross income and its earnings before interest and taxes, the so popular EBIT (gross income/ EBIT). Similarly, the company’s fi nancial risk can be expressed by yet another ratio linking company’s EBIT to its earnings before taxes (EBT) {EBIT/EBT}. A company’s overall risk can also be expressed through a more general relation, one linking gross income to EBT (gross earnings/ EBT). Company’s total risk is actually the consequence of both investment and indebtedness strategies. It is important to understand that an issuer wishing to secure a good credit rating will also manage effectively both its operating and fi nancial risks. The credit ratings can directly impact the quality of governance system, especially internal control and risk management systems. The ease with which a company is able to face its interest expense is tremendously affected by the stability of its operations. As a rule, any increase in debt or deterioration in indebtedness conditions will increase its risk of default. Operational risk can also have serious repercussions on the quality of the company debt and its ability to benefit from indebtedness (Callahan et al., 1989; Huffman, 1989). In fact, operating risk and fi nancial risk are negatively correlated (Myers, 1997). The fi xed assets, for example, which are a

1000 (100) 900 300

600 120 480

= Gross profit

(Less) Operating expenses

= Earnings before interest expenses and taxes, EBIT

(Less) Interest expenses

= Net earnings before taxes, EBT

(Less) Taxes (20%)

= Net profit after taxes

Income statement and types of risk.

(4000)

(Less) Variable costs (1000 units at $4)

Figure 9.4

5000

Sales revenue (1000 units at $5 each)

Financial leverage

Combined leverage

Operating leverage

Credit-Rating Activities and Corporate Governance 223

224

Internal and External Aspects of Corporate Governance

source of operating leverage, are also a source of fi nancial leverage, because of their ability to facilitate the debt fi nancing.

CONCLUSION When properly conducted, credit-rating activities can play a key role in improving corporate efficiency and corporate governance. There remains, unfortunately, a doubt about the reliability of credit ratings and how CRA perform their tasks. CRA are often subject to much criticism and the end of September 2008 events are not helpful in dissipating doubts. Judgment errors are common and so abuses of power are common in many CRA, which do not hesitate to use dubious methods to encourage the use of their ratings. They are often suspected of oligopoly and creating entry barriers to credit rating and also of confl ict of interest. So many unprofessional business conducts are damaging to investor confidence that is essential to the market survival. The critical situation is not limited to the credit-rating market; CRA suffer from a lack of leadership and power, which others on the fi nancial market can claim. They seem to be constantly lagging financial crises. Many initiatives are currently at work, and they aim to regulate CRA activities and even submit them to license. This, however, may create other problems. “Moody’s has downgraded Fitch, Fitch has cut Moody’s in retaliation, and Standard & Poor’s has put itself on negative watch.” This is how one 2008 conference speaker stated his talk, to raucous laughter, as reported by The Economist (The Economist, 2008).

COMPREHENSIVE CASE 9.1

Credit-Rating Agencies Around the World The list of rating agencies around the globe can be obtained from http:// www.defaultrisk.com/rating_agencies.htm. Very few among them seem to control the majority of the rating activities, enumerate them, and discuss the reason of their concentrated power.

10 Financial Markets and Corporate Governance

One main characteristic of modern economy is its ability to create free extended exchanges in products and services as almost the only means of making transactions. The invention of exchange markets has undeniably revolutionized the world of fi nance, by ensuring it much liquidity and unexpected fluidity. The recent development of market for corporate control is yet a further step that constitutes the latest historical development in the field. As a particular and distinct type of capital market, the market for corporate control allows transactions on corporate securities to be made on so huge a volume that they usually provoke shifts in corporate control. This makes corporations themselves become commodities susceptible of being bought and sold. This consequently provides an efficient incentive for improved corporate governance and enhanced management efficiency. Takeovers or their prospect, as corporate control transactions, are assumed to benefit shareholders and the corporation. Indeed, “evidence indicates that corporate takeovers generate positive gains, that target fi rm shareholders benefit, and that bidding fi rm shareholders do not lose” (Ruback et al., 1983). They may actually constitute a strong external corporate governance mechanism that has a multiple effect on corporate governance by acting as counseling, remunerating, and disciplinary mechanism. But the fi nancial market seems to have lost part of its gloss these days, thanks to many deficiencies discovered and the numerous frauds orchestrated. This chapter deals with fundamental issues of the market and the market for corporate control as a performing external enhancing mechanism of governance.

STOCK EXHANGES Corporations would not have flourished and expanded the way they did if stock exchanges were not invented to allow transactions on their securities to be assured at all times. A stock exchange is no more than an organized marketplace where companies’ securities can be bought and sold, through brokers that centralized the supply and demand of orders. Stock exchange development

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Internal and External Aspects of Corporate Governance

was so quick in some developed economic environments, where listed companies dominate economic activity and sometimes cover up to 80% of the whole economic activity (New York Stock exchange–listed companies, for examples). In developing and emergent economies, however, the proportion of exchange listed companies still very low and those companies have difficulties to grow and consequently other corporate financing mechanism need to be sought. Stock exchange markets present impacting advantages; they mainly allow organizations easy access to financing, by permitting them to issue their securities and ensuring investors of the liquidity of their investments. Typically, an issuing organization is allowed to sell securities to investors and promises them the payment of dividends or coupons and the retrocession of the residual value or the whole capital, depending on the security issued. Further, issued securities can be freely bought and sold after the date of issuance. Stock exchanges also present many other benefits, such as dividends payments, selling of securities, and so on. Over the years stock exchanges have tremendously evolved and have undergone constant innovations that have improved their liquidity and flexibility. Depending on their nature, exchange markets have micro and macro effects: (i) On the micro level, they allow organizations to easily raise capital for investment and growth through security issues and to expand more easily and diversify; and fi nally to benefit more efficiently from fi nancing. When savings are invested in securities, allocation efficiency of resources can only result. (ii) On the macro level, they allow funds that could have been consumed or kept idle to be mobilized and put to work as investments and this, of course, promotes business activity. They further extend investment horizon of such funds by ensuring investors of the recovery of their investment any time. Indeed, an investor would never risk investing its short-time savings if he is not assured of its recovery any time.

Market Efficiency Hypothesis (EMH) Exchange markets are assumed to operate efficiently and the efficient market hypothesis (EMH) states that it is not possible to consistently outperform the market by using the information that the market already knows (Fama, 1970). This means that stocks always trade at their fair value on stock exchanges, and thus it is impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices (investment dictionary). Traditionally three forms of the efficient market hypothesis are commonly stated: (i) weak-form efficiency, (ii) semi-strong-form efficiency, and (iii) strong-form efficiency, each of which has different implications for how markets activities. The weak form of efficiency actually excludes any possibility of making excessive returns by using investment strategies based on historical share prices’ behaviors, whereas the semi-strong form of efficiency implies that share prices adjust very rapidly and in an unbiased fashion to all publicly

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available new information. Consequently no excess returns can be expected to be earned by trading on that information. The strong form of efficiency fi nally implies that share prices reflect all the available information, both public and private, and no one can earn excessive returns by using such information. It was, however, empirically demonstrated that if barriers to private information become public, as with insider trading, the strong form efficiency may not be possible. The efficient market hypothesis actually maintains that securities are perfectly priced according to their inherent productive properties, the knowledge of which all market participants have equal access. The relevance of market-efficient hypothesis has actually benefited from the rise of computerized systems that allow analysis of stocks’ performance and corporations’ investments to become increasingly automated on the basis of strict mathematical or fundamental analytical methods. Given the high power and speed reached, some computers can now instantaneously process any and all available information, and even translate such analysis into an immediate trade execution order. Despite this fact, however, most decision making is still done by human beings, and for such they are therefore subject to human error. Even at an institutional level, the use of analytical machines is anything but universal. While the success of stock market investing is based mostly on the skill of individual or institutional investors, people will continually search for the reliable method of achieving greater returns than the market averages. After years, debate is still raging among stock market participants and observers as to whether the market is really efficient, that is, whether it reflects, as affi rmed, all the available information. Over time many scattered pieces of evidence have been identified and are inconsistent with the theory, and this makes more and more people reconsider their acceptance of the efficient market hypothesis and even the methodological procedures used for its demonstration (Jensen, 1978). There are at fi rst glance a number of deficiencies in the efficient-market theory (Bergen, 2004): First, the efficient-market hypothesis assumes that all investors perceive all available information in exactly the same way and at the same time. There are, however, different stock analysis and valuation methods and this presents some challenge to the validity of the market efficiency. “If, for instance, one investor looks for undervalued market opportunities while another investor evaluates a stock on the basis of its growth potential, these two investors will already have arrived at a different assessment of the stock’s fair market value” (Bergen, 2004). Consequently, one argument against the market efficiency is that since investors value stocks in a different way, it becomes difficult to know what a stock should be worth in an efficient market. Second, there should not exist, under the market0efficiency hypothesis, an investor that is able to attain greater profitability than another with the same amount of investment: with the identical information in their possession they can only achieve an identical return. We know, however, that there is a spectrum of market returns achieved by a large range of investors. “If no investor had any clear advantage over another, would there be a

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range of yearly returns in the mutual fund industry from significant losses to 50% profits, or more?” (Bergen, 2004). Third, the strongest market hypothesis is that no investor should be able to beat the market; consequently, the best investment strategy would simply be to place all of one’s money into an index fund. There are, however, many examples of investors who have consistently beaten the market (Bergen, 2004). It is, of course, unreasonable to expect the market to attain full efficiency all the time, because it takes time for stock prices to respond to new information released into the investment community, although for some exchanges stocks were found to adjust to new information released in less than 10 minutes (Dann et al., 1977). The efficient hypothesis, however, does not give a strict defi nition of how much time prices need to revert to fair value. Moreover, under an efficient market, random events are entirely acceptable but will always be leveled out as prices revert to the norm. Although we can mention a large body of evidence in support of EMH, we can identify an equal amount of dissension. The case of Warren Buffett having consistently beaten the market over long periods of time is often advanced against the efficient-market hypothesis. Buffett’s performance should in fact be impossible, according to the EMH. Detractors of the EMH also point to 2008 events where phenomenal stock market movements have been registered and great dismal dips were followed by unexpected huge rallies1 and emerging stock markets have lost more than half their value in 2008. Figure 10.1 relates the movement of the Dow Jones Industrial Average for five days, 26 February–2 March, 2009. Figure 10.1 indicates how the NYSE is nervous and such market bungee behaviors confront EMH opponent in their beliefs. Bungee jumps, in addition

7300 7200 7100 7000 6900

Dow Jones

6800 6700 6600 6500

25 Figure 10.1

26

27

28

Dow Jones Industrial Average, February 25–March 2, 2009.

Financial Markets and Corporate Governance

229

to being frightening, usually end up with security prices lower than when they started and “with their safety hanging by a thread” (The Economist, 2008a). It is, therefore, important to ask whether EMH undermines itself by requiring prices to respond instantaneously with the release of any new public information that can be expected to affect a stock’s fundamental characteristics. Consequently, if ever it allows for some kind of inefficiencies in this area, it may have also to admit that absolute market efficiency is impossible. Overall, market-efficiency hypothesis, which had gained much fame during the 1970s and 1980s, seems today to fall into disrepute as a result of market events and growing empirical evidence of inefficiencies (Stout, 2003).

STOCK ECHANGE AS CORPORATE GOVERNANCE–ENHANCING MECHANISMS When efficient, an exchange market allows shares to be traded freely and prices to reflect all publicly available information. It consequently permits investors to protect their investment through prices. Besides this universal role, stock exchange markets have three deciding functions in enhancing and developing corporate governance in organizations: a remunerating function, counseling and educating function, and finally a disciplinary function.

Stock Exchange as Corporate Governance Remuneration Mechanism Market-efficiency hypothesis is based on a fundamental principle called allocation efficiency, referring to a situation where scarce capital resources are allocated among investment projects in accordance with their respective return. Such principles allow security exchanges to act significantly as a means of compensating companies for the quality of their governance and management. Accordingly, allocation efficiency occurs when companies can obtain funding for the projects that are the most profitable, thereby promoting the race to the top and consequently an economic growth. A capital market is assumed to be efficient at its allocation level if it is also producing the right capital for the right projects and at the right cost. When such an objective is not achieved by a given market, there is believed to be a market failure. Several reasons may be at the origin of such failure and the followings situations are commonly blamed: (i) imperfect knowledge; (ii) differentiated goods and services; (iii) resource immobility; (iv) concentrated market power; (v) insufficient savings; (vi) externalities; and (vii) inequality of bargaining powers. They can most likely be encountered in underdeveloped exchange markets. There are, however, prerequisites to allocation efficiency that the market must meet. The market should undeniably be efficient at both information and transaction levels. Informational efficiency is said to exist when much is known by all, and transactional efficiency is believed

230 Internal and External Aspects of Corporate Governance to exist when transaction costs are reasonable and fair. When markets are both informationally and transactionally efficient, capital flows will direct themselves to the places where they will be the most effective, providing an optimal risk/reward scenario for investors. A fairly large amount of research and reports was published on the way the market reaches capital allocation efficiency that is supposed to be achieved in two different ways: fi rst, it is believed that markets classify projects on the basis of their risk-return trade-off and consequently more profitable projects on the risk-return plan will be supplied by capital fi rst. An investment’s return is therefore assessed by measuring how much risk is involved in producing that return, and is generally expressed as a number. The common risk measure is called beta, and expresses the systematic risk of a corporation, individual investment, or a portfolio. This is a kind of risk that cannot be eliminated through diversification. Second, markets are also believed to distinguish investments on the basis of their risk and return, and assign them a corresponding required return or cost of capital. Low levels of risk are commonly associated with low potential returns, whereas high levels of risk are associated with high potential returns. Accordingly, invested money can render higher return only if it is subject to the possibility of being lost, and vice versa. Because of this risk-return trade-off, investors in the market require less return from companies with less risk, and this means lower cost of capital for them. The way for companies to decrease their risk and therefore their cost of capital is by having in place appropriate internal control and risk management systems, and this may means a good corporate governance system. The resulting effect of any risk-decreasing policy will be, of course, an enhancement in market price of the company, which is usually expressed as the net present value of that company’s future cash flows. The appropriate discounting rate to be used for the present value computation is actually the company’s cost of the capital or what happens to be the same, the return required by investors from investing in the corporation given the level of risk. Therefore, the effect on company’s value of all its corporate governance policies and strategies, especially the efficiency and appropriateness of its internal control and risk systems, can be better understood by apprehending the way the company’s cost of the capital is computed. Modern fi nance suggests the use of a classical model of computation called the capital asset pricing model or CAPM, which is based on the relation between expected return (cost) and expected risk. The required rate of return by investors on any investment, any company, investment, or portfolio, according to the CAPM, should produce a return equivalent to the return of governments bonds, if its systematic risk is equal to 0. It should give a return equivalent to market index return if its systematic risk is equal to 1. It should fi nally give a return higher/lower by a premium of risk to market index return. Stock exchange markets can help inseminating corporate governance in listed companies through appropriate remuneration; they can also encourage corporate governance through education and counseling or sanctions.

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Stock Exchange as Corporate Governance Counseling Mechanism Listed companies usually have a wide range of shareholders and are consequently subjected to more rules and regulation, mainly imposed by governments and security exchange commissions. It is believed that both dispersed ownership and monitoring framework will generally tend to improve management performance. It is therefore expected that exchange-listed companies will usually have better management records than privately held companies. This is, of course, to forget that most renowned corporate failures come from some of the most important publicly traded companies. Nevertheless, security exchanges in most countries seem to play a helpful role in corporate governance improvement. They play a decisive counseling role by suggesting, sometimes imposing, corporate governance guidelines, to be endorsed by company’s board of directors. Table 10.1 summarizes the regulations of the most important stock exchange of the world, the New York Stock Exchange. Most exchanges have since also issued their own regulations. The London Stock Exchange, for example, offers specialized corporate governance workshops to corporate directors.2 Table 10.1

New York Stock Exchange Regulations: Statement of Corporate Governance Practices

1 The Board must affirmatively determine each director’s independence and disclose those determinations. 2 A majority of the directors must be independent. 3 Nonmanagement directors must meet at regularly scheduled executive sessions without management. 4 There must be a nominating/corporate governance committee composed entirely of independent directors. 5 The nominating/corporate governance committee must have a written charter that addresses: (i) the committee’s purpose and responsibilities and (ii) an annual performance evaluation. 6 There must be a compensation committee composed entirely of independent directors. 7 The compensation committee must have a written charter that addresses: (i) the committee’s purpose and responsibilities and (ii) an annual performance evaluation. 8 The audit committee must have a minimum of three members, all of whom must be independent. 9 The audit committee must have a written charter that addresses: (i) the committee’s purpose and responsibilities and (ii) an annual performance evaluation. 10 The company must have an internal audit function. 11 The company must adopt and disclose corporate governance guidelines. 12 The Company must adopt and disclose a code of business conduct. Sources: New York Stock Exchange (2007).

232 Internal and External Aspects of Corporate Governance

Stock Exchange as Corporate Governance Disciplinary Mechanism Corporations exist ultimately for the benefit of their shareholders, and if they are given the possibility to get rid of inefficient or bad corporate managers, even at the cost of selling their share at generally a greater that expected gain, they will appreciate and do it. Markets for corporate control may allow them just doing that, through takeovers. Market for corporate control can be a strong corporate governance disciplinary mechanism in successful takeovers and is susceptible to penalizing incumbent managers through job loss, displacement, or reduction of power. It can best be viewed as “an arena in which managerial teams compete for the rights to manage corporate resources” (Ruback et al., 1983). A takeover occurs when a change takes place in a corporation’s controlling interest through either a friendly acquisition or via hostile bids. Hostile takeovers aim at replacing the target company’s existing management and are usually attempted through a public tender offer. 3 Market for corporate control can be affected by events like the investment horizon of the shareholders. “Target fi rms with short-term shareholders are more likely to receive an acquisition bid but get lower premiums” (Gaspar et al., 2005). Companies held by shortterm investors have a weaker bargaining position in acquisitions. On the other hand, weaker monitoring from short-term shareholders could allow managers to proceed with value-reducing acquisitions or to bargain for personal benefits at the expense of shareholder returns (Gaspar et al., 2005). However, the gains created by corporate takeovers do not seem to come from the creation of market power and “with the exception of actions that exclude potential bidders, it is difficult to fi nd managerial actions related to corporate control that harm shareholders” (Ruback et al., 1983).

Forms for Corporate Control Several terms are interchangeably used to qualify a company’s control taken by another: mergers, takeovers, acquisitions. They are very similar, in the sense that they describe the combination in a single legal unit, of two previously separated entities. There are different ways for a company to acquire the control over another company. There is, for instance, the tender offer, where a company proposes to purchase some or all of shareholders’ shares in another company, and the price suggested is usually at a premium of the market price. Tender offers, however, may be friendly or unfriendly. Most Securities and Exchange Commission laws require any corporation or individual acquiring significant percentage of a company to disclose information to the Securities and Exchange Commission, the target company, and the exchange. The OECD principles indicate the following: The rules and procedures governing the acquisition of corporate control in the capital markets, and extraordinary transactions such as mergers,

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and sales of substantial portions of corporate assets, should be clearly articulated and disclosed so that investors understand their rights and recourse. Transactions should occur at transparent prices and under fair conditions that protect the rights of all shareholders according to their class. (OECD, Principle II.E) There is also acquisition where a company buys most or all of the target company’s ownership stakes in order to secure the control of the target fi rm. Acquisition transactions are commonly made as part of a company’s growth strategy whereby it appears more beneficial and more efficient to take over an existing fi rm’s operations and market compared to expanding by its own means and learning by its own mistakes. Acquisitions are often paid in cash, by remittance of the acquiring company’s shares, or a combination of both. They can either be friendly or hostile. Friendly acquisitions occur when the target fi rm expresses its willingness to be acquired, whereas hostile acquisitions don’t receive the target fi rm’s consent. The acquiring fi rm usually needs to actively purchase large stakes of the target company’s outstanding shares in order to secure a controlling majority and often offers a premium on the market price of the target company’s shares in order to entice shareholders to sell. Friendly takeovers occur when a target company’s management and board of directors agree to a merger or acquisition by another company. In such case, a public offer of shares or cash is made by the acquiring fi rm, and the board of the target company will publicly approve the terms of the transaction, which may yet be subject to shareholder or regulatory approval. This stands in contrast to a hostile takeover, where the company being acquired does not approve of the buyout and even fights against it. Hostile takeovers occur when an attempt is strongly resisted by the target fi rm. Hostile takeovers are usually bad news, because the employee morale of the target fi rm can quickly turn to animosity against the acquiring fi rm. The key determining factor in whether the buyout will occur is the price per share being offered. The acquiring company will offer a premium to the current market price, but the size of this premium, usually based on the company’s growth prospects, will determine the overall support for the buyout within the target company. A buyout occurs when a group of investors, rather than an existing fi rm, buys a company or one of its subsidiaries. In a management buyout the existing management buys its fi rm from the present owners. In one form of management buyout, the managers of a wholly owned subsidiary buy their fi rm from the group that owns it; hence it becomes an independent fi rm. When a company takes over or controls interest in a company, using a significant amount of borrowed money, this is called leveraged buyout or LBO. Often the target company’s assets serve as collateral for the borrowed money.

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Economic Fundamental of Markets for Corporate Control As indicated before, market for corporate control represents the most recent historical development of a distinct type of the fi nancial market, wherein the trading of corporate equity occurs on a very large scale and allows the change in the control of these companies. According to the OECD glossary (Khemani et al., 1993), the term market for corporate control refers to the process by which ownership and control of companies are transferred from one group of investors and managers to another. Similarly, the market for corporate control, often referred to as the takeover market, is a market in which alternative managerial teams compete for the rights to manage corporate resources (Ruback et al., 1983). The rationale for the economic function of markets for corporate control should be looked for within agency theory, which addresses the issue of how shareholders can be assured that once they invest their funds, management will not usurp their rights and neglect their interests. Since the 1930s, a decline was noticeable in shareholder control over management, as ownership stakes grew smaller and more dispersed among a large number of shareholders (Berle et al., 1932). Few incentives exist for fragmented owners to actively monitor management because the resources devoted to monitoring can be jointly appropriated by the bulk of “free-riding” shareholders” (Shleifer et al., 1997). Consequently, individuals have only one way out: diversify their portfolios and they usually prefer exit over voice in response to poor performance. Furthermore, small shareholders are rarely informed enough to make qualified decisions or appropriately monitor management. In essence, corporate control appears to undergo a serious failure that needs to be remedied to reduce agency costs. One major remedy is markets for corporate control (Shleifer et al., 1997). It seems that “the lower the stock price, relative to what it could be with more efficient management, the more attractive the takeover becomes to those who believe that they can manage the company more efficiently” (Manne, 1965). The theoretical innovation was to posit a strong relation between share prices and managerial performance and thereby to unearth a new market-based governance mechanism that is compatible with the exit preferences of small shareholders. As shareholders react to poor managerial performance through exit, the lower share prices create incentives for outsiders to accumulate control rights, replace the management team, and ultimately restructure the underperforming fi rm. These outsiders usually expect to recover their investment through an eventual share price premium. Markets for corporate control are mechanisms allowing sophisticated transactions to be used to take over control of a company’s shares. Open market block purchases, tender offers, negotiate share swaps, or contesting the control of proxy rights, are some of techniques used (Bittlingmayer, 1998). Most authors view markets for corporate control as an effective instrument for disciplining poor management performance. The overall

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threat of a takeover floating above managements’ heads places them under greater pressure and incites them to institutionalize feedback mechanism between corporate decision making and the stock market. Takeover risk also increases the scope for a shareholder voice, since unsatisfied shareholders’ exit leads to the threat of a takeover. Management may, however, react negatively to takeover threats by adopting costly defensive strategies to be discussed later. It is also suggested that managers of larger firms are less likely to be disciplined by the market for corporate control than managers of smaller fi rms (Offenberg, 2006). Evidences point out towards the possibility that takeover transaction may lead to significant premiums. To see how profitable mergers and acquisition can sometimes be, let’s consider the few renowned deals depicted in Figure 10.2. The takeover premium can amount to 70%, and considering an expanded time horizon, Ernst and Young suggests that the average takeover premium in the US is around 24%. That means investors in the takeover target make an average profit of nearly 24% by the time the deal closes (Tracy, 2005). It was also confi rmed that shareholders in successful takeover targets may realize substantial wealth increases (Jensen et al., 1983), indicating a potential for improved performance, which the previous management had failed to use. Two motives for takeover success were identified: efficiency gains and disciplining poorly performing management It was found that the performance of disciplinary targets, where top management depart following the takeover, was no worse than the market average but worse than their industry average. Nondisciplinary targets perform as well as their industry average. CEO turnover in target fi rms seems to increase following a takeover. This is consistent with the takeover market disciplining managers who fail to maximize shareholder wealth. Takeovers may also present

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the potential of severely damaging effects; they can, for instance, undermine trust and cooperative relationships among shareholders and managers, and by widening market influence, they may place issues outside the boundaries of negotiation and, by doing so, turn management decisions into de facto nondecisions (Bachrach et al., 1963). Well spotting companies and situations that are ripe for a takeover can be highly profitable (McClure, 2009), and the negligence to do so can cause extreme damage. Jean Coutu pharmaceuticals has, for instance, lost over 40% of its market value in its adventure of a missed takeover of Echer.

Impediments to Control Market Efficiency Efforts to reform corporate control markets have focused primarily on antitakeover laws, but today there is a broader perspective recognizing that fi rms have developed techniques that help them resist takeovers, even if they are in the interests of its independent shareholders. A common term for most measures taken by a company to protect itself against an unwanted or hostile takeover attempt is what is called “shark repellent,” also known as a “porcupine provision.” While the concept is a noble one, many shark-repellent measures are not in the best interests of shareholders, as the actions may damage the company’s fi nancial position and interfere with management’s ability to focus on critical business objectives. Some examples of shark repellents are poison pills, scorched-earth policies, golden parachutes, and safe-harbor strategies. Management and controlling shareholders can therefore have recourse to some specific long-term devices to deter or reject a proposed control bid, but they may also have recourse to short-term strategies to support share prices, thereby sacrificing long-term shareholders interests. The following are the commonly encountered long-term protective strategies used: (i) Special amendments, whereby a company includes special restrictions to its charter or bylaws that become active only when a takeover attempt is announced or presented to shareholders with the goal of making the takeover less attractive or profitable to the acquisitive fi rm. (ii) Poison pills are strategies used by target companies to discourage a hostile takeover, mainly by attempting to make its stock less attractive to the acquirer. It can adopt for such purpose two types of poison pills: (a) the “flip-in,” which allows existing shareholders (except the acquirer) to buy more shares at a discount, and (b) the “fl ipover,” which allows shareholders to buy the acquirer’s shares at a discounted price after the merger (The Free Dictionary). Here’s how they work: boards of directors create special rights that are similar to stock options or warrants that grant their holders the opportunity to, for example, buy, at a discount price, a number of shares, usually

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in relation to the number of shares they already owned. Such special rights apply only to those shareholders who do not attempt to take over the corporation (Edmonds, 2008). (iii) Golden parachutes, which occur when lucrative benefits given to top executives in the event that a company is taken over by another firm, resulting in the loss of their job. Benefits include items such as stock options, bonuses, severance pay, and so on (The Free Dictionary). (iv) Debts that are conceded to senior managers and/or controlling shareholders can discourage takeover attempts. Senior managers’ indebtedness allows managements to retain control over more resources without putting additional equity at risk. The main disadvantage in this case restraint is the risk of losing control through bankruptcy. In many countries, however, such a threat is weak. Legal frameworks are often dated and do not apply to contract and securities transactions. (v) Pyramid schemes, which generally involve using control of a publicly held fi rm to gain control of others, can also be used by large shareholders or managers to enhance their control over their corporation. Suppose fi rm one owns 50% of fi rm two. Under a pyramid scheme, fi rm one might use fi rm two’s assets to buy 50% of fi rm three. Firm one would then have effective control of fi rm three. Managers of fi rm one could also fortify their control of fi rm one by directing fi rms two and three to buy shares of it. In some environments the risk of hostile takeovers is minimized and the rights of the takeover bidder are restricted. Usually the shares purchased for control purpose have no voting rights within a certain period. This kind of rule makes it easier for management to defeat takeover bids, even if they prove to be in the interest of the fi rm and its minority shareholders. Tax considerations can, in some circumstances, also make control transactions fi nancially unattractive. This is the case when mergers and acquisitions are treated as taxable events involving realized capital gains or losses.

Markets as Corporate Governance Defense Mechanism Market share prices are often considered as a good indication of management’s efficiency in running corporate businesses, and market for corporate control is usually considered a dissuasive corporate governance mechanism. Generally speaking, investors or shareholders delegate substantial authority to professional managers who are hired to manage the company’s day-to-day business. Shareholders, however, may not always be in a position to monitor the corporation, particularly if there is a large number of shareholders involved. Under such circumstances, the company management may not necessarily make decisions that are in the interest of shareholders. Managers may choose to escape their legal duties by pursuing their own goals, at the expense of shareholders, such as avoiding

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risk, maximizing their pay and fringe benefits, or spending money on prestigious projects. Depending on the available information, share prices of the company will be valued low and this would create incentives for takeover by a more efficient group of investors. By taking control and subsequently changing management and/or management practices, the acquired assets will gains more value. In this way the market for corporate control seems indeed able to play an important role in reinforcing and promoting efficiency. Therefore: Markets for corporate control should be allowed to function in an efficient and transparent manner and the rules and procedures governing the acquisition of corporate control in the capital markets, and extraordinary transactions such as mergers, and sales of substantial portions of corporate assets, should be clearly articulated and disclosed so that investors understand their rights and recourse. Transactions should occur at transparent prices and under fair conditions that protect the rights of all shareholders according to their class. (OECD Principle II.E) Reputation and credibility are often insufficient to induce managers to perform honestly. Market for corporate control is believed to constitute the only and last incentive for managers to pursue diligently corporate efficiency and profitability, and it induces them to continually strive for greater efficiency and profitability. The failure to do so may provide potential bidders with the golden opportunity to acquire the ailing company and replace ineffective or opportunistic managers. In case of the fear of loosing their job following takeovers, managers may decide to behave irreproachably. Indeed, changes in corporate control through mergers, takeovers, acquisitions, divestitures, and the like enhance shareholders’ value by allowing the businesses to be transferred under the control of new owners who can put business assets to work more efficiently, or by transferring of majority control from emerging market targets to developed market acquirers (Chari et al., 2004). Some fi ndings, on the other hand, point to a significant relationship between top management turnover and performance during an active takeover period but no such relationship during an inactive period. It seems, in contrast, that performance-enhancing corporate restructurings persists following declines in performance, and regardless of whether these occur during an active or inactive takeover period. This may mean that the threat of takeover won’t be enough to ensure complete coherence between managerial actions and shareholder wealth (Ruback et al., 1983). This can be attributed largely to the costs of organizing takeovers, in particular the high bid premiums. Management may actively seek to reduce the probability of takeover since it may result in loss of personal wealth and reputation.

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Another school of thought, called the myopic market model, is far from convinced that the stock market may actually constitute a good indicator of corporate performance. Accordingly, the stock market is considered unable to cope with uncertainty and often misprices assets. As proof, it is underscored that share prices often change without any corresponding change in corporate fundamental values. Such price changes may simply result from analyst guesses or the psychological mood of market players and other investor prejudices (Keynes, 1936). Consequently, the market for corporate control is far from being fair and cannot be taken for an efficient disciplinary mechanism. The threat of hostile takeover may force managers to act at the expense of corporate wealth creation, distorting managers from corporate real objectives. For the myopic market model, the only appropriate corporate enhancement mechanisms are of internal nature. The takeover process and shareholders’ voting rights for short-term return should, therefore, be restricted. Evidences just mentioned are largely inconclusive concerning the effectiveness of the market for corporate control in disciplining corporate managers. It is generally seen as a last resort, only when target managers have been performing very poorly. This is perhaps attributable to the high costs and disruption associated with a company being taken over.

FINANCIAL MARKET AND NONLISTED COMPANIES Nonlisted companies constitute the bulk of companies around the world and, although their economic weight is rather limited, they constitute the biggest jobs supplier. In developing and emerging economies, and even in some developed countries, they tend to represent the dominant form of companies. Governance features and mechanisms characteristic of listed companies, like market mechanisms, may not be suitable for nonlisted companies. On the other hand, corporate governance issues vary not only from business to business but also across countries. For these reasons a specific chapter is devoted to corporate governance in nonlisted companies. The need to create effective internal and external mechanisms for nonlisted companies and for improving institutions to stimulate economic growth is becoming urgent.

INTERCONNECTION WITH OTHER CORPORATE GOVERNANCE MECHANISMS Financial markets impact tremendously all other corporate governance mechanisms in many ways: fi rst, the market, although not completely proven, seems to appreciate corporations with good governance system by upgrading the value of their shares. Indeed, a good corporate governance

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system is synonymous with efficiency and low-cost agency and therefore high return and low cost of capital. Unfortunately, the market was constantly kept from functioning efficiently by major market players that were acting in a way that qualifies them as “value subtractors rather than value adders. Their activities generate a reduction, rather than an increase, in the total benefits of all the other market players (themselves included)” (Vaknin, 2007). They have caused the market to suffer much failure in its role as corporate governance arbitrager. Second, the market can act as a rampart protecting against fraud by requiring fraudulent corporations a return at the level of their fraudulent pretensions. Whenever, however, a company reports earnings that are not backed by cash flows, sooner or later it fi nds itself trapped; short of liquidity, it has only one way out: admit its fraud and ask for bankruptcy. Third, market for corporate control allows inefficient manager replacement. This market is of major importance in corporate governance because it affects the incentives of managers and thereby the efficiency of the fi rm. Indeed, the presence of a well-functioning market for corporate control may deter managers from running the fi rm below its performance potential because that would make the fi rm vulnerable to takeover (Jensen et al., 1983).

CONCLUSION It is true that economic development creates demands for different types of fi nancial instruments to which the fi nancial system has usually responded almost automatically and therefore “where enterprise leads, fi nance follows” (Duisenberg, 2001). In addition to being crucial in supplying and reallocating capital in the economy, the fi nancial market plays a major role in improving organizations’ management and corporate governance. It compensates corporations with good corporate governance systems by upgrading the market prices of their shares and discourages fraudulent managers by requiring returns at the level of their lies. The market for corporate control, on the other hand, may prove to be an arena where alternative management teams compete for the rights to manage corporate resources. In small takeovers, management teams can, however, consist of a single proprietor (with staff) or a partnership of managers. Competing management teams are also commonly organized in the corporate form, especially in large takeovers (Ruback et al., 1983). Market credibility seems, however, to be seriously challenged these days by the doubts of some major players scarifying common interest for satisfying self-interest, and maximizing their benefit at any cost, particularly if such cost is externalized and supported by others. Although some market major player behaviors were made in most legality, they feed the market with much inefficiency and keep enhancing them, thus creating a vicious cycle of fraudulent prosperity that seems to be broken today.

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COMPREHENSIVE CASE 10.1

The Madoff Ponzi Scheme Defenders of market efficiency constantly explain its magic, and assert that no one could bit it, yet always somehow some one fi nd way to fool it. Madoff, for instance, frauds the market for over $40 billion in what he described as a giant Ponzi scheme: “For years, it seems, the returns paid to investors came, in part at least, not from real investment gains but from inflows from new clients. It might still have been going on, were it not for the global financial crisis. Redemption requests for $7 billion, by investors looking to pull back from turbulent stock markets, forced Mr. Madoff to admit that his coffers were empty—bearing out Warren Buffett’s adage that only when the tide goes out is it clear who was swimming naked” (The Economist, 2008b). Discuss how the Madoff Ponzi scheme and other similar frauds have impeded market efficiency.

11 Corporate Governance in Less Developed Economies

The debate on corporate governance was particularly confined to developed countries, where external corporate governance mechanisms are normally functioning: capital markets are more advanced and fi rms usually have dispersed shareholdings. The recent succession of corporate scandals fi nally compelled less developed countries to acknowledge the impacting effect of corporate governance practices on economic development. Indeed, the evolution of the country’s corporate structure and the forces driving corporate governance reforms over the past decade tend to point to some awareness within developing economies (Vaughn et al., 2006). It is feared that governance mechanisms recipes that have been suggested for advanced economies, including reactive and proactive law enforcement, may not help in the short- to medium-term horizons in less developed economies. It is suggested, at least in the short term, administrative governance may be a viable alternative to legal governance in LDE (less developed economies) stock markets (Pistor et al., 2005). The leading issue of corporate governance that arises in advanced economies concerns the legal and institutional framework likely to ensure good governance in organizations. The sought objective of corporate governance in developed economies is primarily to induce managers to act in the best interest of companies and their shareholders. Such considerations of corporate governance seem, however, not to reflect less developed economies’ specific needs where weak governance can have more ramifications, despite the fact that corporate governance is supposed to be important for the success of long-term development in all economies (Oman et al., 2003) and that “the critical role that corporate governance plays in fi nancial development and enterprise reform has been confi rmed by fi nancial crises, corporate scandals, and the long and difficult transition from plan to market” (World Bank). This chapter deals with issues of corporate governance in less developed countries.

WHO ARE THE LESS DEVELOPED ECONOMIES The less developed economies cover a wide range of countries translating deep cultural, political, economic, and legal differences. Some LDE

Corporate Governance in Less Developed Economies 243 countries are rich, whereas others are among the world’s poorest, and the number of formerly poor countries has recently undergone an extraordinary development (Aizenman, 2005). The major characteristic of LDE is embodied by the dominance of small-size companies that do not issue shares to the public for their fi nancing, that is, nonlisted companies that also coexist, side by side, with large family businesses, state-owned enterprises, and subsidiaries of foreign multinationals. A nonlisted company is actually one that is tightly controlled by a small group of owners, and whose shares are not traded freely on the stock exchanges, “either because the shares are held by very few persons or because they are subject to restrictions that limit their transferability” (Hansmann et al., 2004). Although companies and their managers from developing countries are progressively gaining a significant understanding of the crucial role played by corporate governance, they still appear, for a variety of reasons “reluctant participants, unable and/or unwilling to change effectively” (Jang et al., 2002) their behaviors towards corporate governance Despite such rejection or apparent inappropriateness of modern systems of governance for LDE, good corporate governance can actually prove to be extremely beneficial in many ways. First, a good governance system may present a potential for value creation to LDE (Durnev et al., 2005; Black et al., 2006); and second, by helping to channel private sector funds into profitable projects, corporate governance also contributes directly to the economic development of a country (Claessens et al., 2006). Unfortunately, appropriate legal and institutional structures that may permit the corporate governance issues to be resolved or even just considered seem to be lacking in many LDE, or are, at best, arbitrarily enforced. Adding to that, corporate governance mechanisms in developed economies cannot simply be extrapolated to emerging markets (Kouwenberg, 2006). This may be the reason why corporate governance is still considered a luxury that can be afforded only by those advanced economies, where companies are publicly traded in free markets and shareholding is dispersed. This should not, however, undervalue the essential role that can be played by good governance in any economic system, especially that corporate governance can act as an improving business management mechanism at both its institutional and operational levels. LDE should, therefore, fi nd corporate governance highly rewarding despite the delay they register in the area of governance. There can be no denying that the more successfully governed companies are also the better managed and will always be in a better position for easier funding: investors are believed to be requiring a risk premium from poorly governed companies for investing if only they are to invest. The tremendous efforts devoted by academic and monitoring agencies to the understanding of corporate governance in advanced economies have as equivalent only the scarcity and the insignificance of the initiatives emanating from the LDE, and the situation can be explained by the fact that corporate governance has long been ignored as a fundamental leverage for economic development until very recently (Oman et al., 2003). Things

244 Internal and External Aspects of Corporate Governance seem, however, to be moving into the right direction, mainly on the initiative of the international organizations, such as the World Bank or the OECD (see Chapter 2 [this volume] for more discussion of the role played by the international organizations in enhancing corporate governance in LDE). Indeed, corporate governance has its place in the development process of LDE, a place that proves to be even more critical than it was traditionally thought. Corporate governance can indeed be used as a facilitating instrument and also as a performance-generating element in organizations. It can create and maintain the incentives needed to focus manager efforts towards growth, efficiency, and ultimately added value; and besides, it is more likely to limit fraudulent managers in their unfortunate tendency to try to misappropriate corporate assets. The corporate governance proves to be a unique and unchallenged way of improving corporate responsibility and providing protection for investments and investors. It helps establish commitment mechanisms that ensure adequate return for shareholders (Shleifer et al., 1997) and, hence, it contributes to lowering the cost of outside fi nances for organizations. For this reason it is often suggested that better governance reduces the cost of both equity and borrowed capital (Ashbaugh et al., 2004; Sengupta, 1998). The unfortunate rhetoric that links corporate governance to economic advance, that is, to a situation where there are enough companies with enough shares widely traded in exchanges, must be strongly denounced. In fact, the spirit of corporate governance is at the heart of a major challenge facing most LDE today: how to move successfully from a relationship-based governance system to an institutions-based governance system (Oman et al., 2003). A relationship-based system is a system that is based on personal relations and where individual or group performance is a function of the privileged relationships they might have with the economic and political environment and the influence they may exercise. In some LDE, the situation has became so serious that citizens and companies can hardly realize any basic administrative act as basic as having a permit to build or a birth certificate without resorting to a relation or hiring an intermediary making money out of their privileged relations. Institutions-based governance is a rule-based system, where individuals and companies know the rules and can require their respect and it is, therefore, far more efficient because it discourages corruption and unfairness costs and concentrates collective efforts on production of goods and services for the common well-being. The impact of corporate governance appears, therefore, to extend well beyond the LDE’s business sectors in order to encompass all other economic sectors and to become a key national development issue. “The Latin American cases are instructive in this regard as governance mechanisms are being introduced in multiple guises along a continuum of private and public rules, amplifying the prospects of effectiveness” (Cally et al., 2002). There seems indeed to be progress when any LDE moves from an

Corporate Governance in Less Developed Economies 245 economic system focused heavily on personal relationships and family ties to another economic system based on rules. Due to their informal nature and the vagueness that surrounds economic systems based on relations, you can only expect them to be economically damaged and delayed in their social progress. The reason is simple: economic transactions’ sophistication, combined with relationships’ psychological complexity, makes it very difficult today to run an economic system based heavily on relations. Actually, modern economic systems call for a certain form of conceptualization and a minimal rational structuring that can only be ensured by rules-based corporate governance institutions that simplify the functioning of organizations and improve the institutional mechanisms that are essential to the success of sustainable development. Consequently, organizations’ transparency is improved and external fi nancing is more easily attracted. Besides, it will be always true that: The quality of a country’s governance institutions—of which those of corporate governance now constitute an integral part—matters greatly for development as a whole. In all countries, and for all segments of a country’s population, including the poor, the ability to move from heavily relationship-based to predominantly rules-based institutions of corporate, as well as public, governance is essential. (Oman et al., 2003) While opting for a governance system it should be, however, kept in mind that although most of the literature on corporate governance emphasizes that fi rms should be run in the interests of shareholders, this is an appropriate objective function only when markets are perfect and complete. In many emerging economies the situation is far from being the case: markets are rather imperfect and incomplete and it might be therefore necessary to look for alternative fi rm objective functions, such as pursuing the interests of all stakeholders. On the other hand, it may not be necessary to use optimally the law to ensure good corporate governance. “Other mechanisms such as competition, trust, and reputation may be preferable” (Franklin, 2005) and should be put to work.

NONLISTED COMPANIES IN LDE The fate of LDE is very closely linked to the effectiveness of their nonlisted companies and a typical nonlisted company is one whose shares are held by a large block holder, usually family, industrial conglomerate, or a state holder (Claessens et al., 2006). There are, therefore, a variety of nonlisted companies: family businesses, joint ventures, state enterprises, and privatized enterprises. All these forms of nonlisted companies are examined in the next sections.

246 Internal and External Aspects of Corporate Governance The predominant form of nonlisted companies is undoubtedly the family-owned companies and these are companies whose shares are held by members of the same family. Such companies are unique in many ways: fi rst, they have a limited number of shareholders; second, there is no stock market where their shares can be exchanged; and fi nally, the majority of shareholders is composed of family members involved in the company management and is effectively intervening in its functioning. Despite many commonalities, family-owned companies are far from constituting a homogeneous group, and their diversity is only limited by the variety of owner families. For their part, joint ventures are contractual arrangements between two or more parties, intending to perform a specific economic activity or reach a certain business objective. They adhere to joint ventures for multiple reasons: in order, for instance, to join their forces, to minimize the risk associated with a particular activity, or to expand or protect their competitive advantages. They also agree on the sharing of the joint venture’s profits and losses. In fact, a joint venture can take several forms; it can be a distinct business unit or collaboration between businesses. In the case of a collaborative joint venture, a high-technology fi rm may, for example, sign an agreement with a manufacturer to bring to life its idea for a product and market it; one part to the agreement provides the know-how and the second provides the means for realizing the project. The major concern that is usually expressed with regards to joint ventures has do with their ability to restrict free competition, especially when they are initiated by companies that are also current or potential competitors, and where they can be used as entry barriers to newcomers to promising markets. As sacred relics of a recent past, state-owned enterprises (SOE) still dominate the economic landscape in many countries. Public property was largely in use in the decades that followed World War II, and had become a major popular policy to address a broad range of market failures (Shleifer, 1998). The state-owned enterprises are legal entities created by governments to exercise some of their powers and put life in some of their projects, and they have often been suggested as an alternative to government regulations or to monitor or run sectors deemed strategic to economic development or social advance. In many countries, some sectors of national economies are also dominated by state-owned enterprises: rail transport, electricity, gas, and supply of basic commodities, especially in developing environments where they continue to serve the majority of individuals (Caprio et al., 2004). “A typical SOE is mandated to produce an output of reasonable quality to be sold at an affordable price. It also has fi nancial targets as returns on capital, profitability, taxes and dividends paid to the treasury” (World Bank, 2006). When the control of a state-owned enterprise is transferred to a forprofit private management system, we are in the presence of what is called a privatization process. Privatization can be realized by issuing shares in

Corporate Governance in Less Developed Economies 247 the stock exchange of a stated-owned company; it can also be performed by a sale of assets of an entire firm or only part of one, usually by auction; it can fi nally take the form of vouchers, consisting of distributing shares of ownership to all citizens, usually for free or at a very low price. Vouchers as a form of privatization have been used mainly in countries in transition of Central and Eastern Europe, such as Russia, Poland, the Czech Republic, and Slovakia. These vouchers can actually ensure citizens’ involvement in privatizations and give them a sense of participation. Of all the forms of privatization, share issues are the most common, because of their assumed benefits to privatization. Share issues are, for instance, expected to broaden and deepen domestic capital markets, increase liquidity, and improve the potential for economic growth. Unfortunately, privatizations often missed their targets, because their success also requires the existence of capital markets that are sufficiently developed to allow issued shares to fi nd enough buyers that offer appropriate prices. Despite their praiseworthy goal and well-intentioned restrictions, vouchers usually fall short of their objective, because at the end the widely distributed shares end up in very few hands, and this cancels their positive goal. Nonlisted companies, whether former state-owned enterprises or family-controlled fi rms, usually accrue serious governance gaps that are unique and are much more impacting than for listed companies, despite the current crisis they contribute to develop.

The Weaknesses of Corporate Governance in the LDE Nonlisted companies use different corporate governance mechanisms and are also created under different legal forms, varying between partnership and corporations, through limited liability companies. The choice of the legal form of the nonlisted company will also determine, to a large extent, the choice made for the internal corporate governance system. In most cases, the chosen legal form leads to a specific governance structure. Some legal forms can, for instance, allow owners to simultaneously ensure the management of the company and its control without having to resort to a board of directors. On the other hand, other companies of certain sizes may be required to establish a two-level corporate governance system, comprised of a management board and a board of directors. Even if corporate governance systems vary by country, several features of governance are common to all LDE. This is the case, for example, of the lack of market competition: in most LDE competition is, indeed, constantly hampered and market players have not enough incentive to provide goods and services as efficiently as might be expected from them, whether in quantitative or qualitative terms. The lack of fair and healthy competition has disastrous consequences, because it does a little to encourage wealthy families and government agencies to ensure that companies they run are well-managed, not to mention well-governed. As expected,

248

Internal and External Aspects of Corporate Governance

monopolies inevitably breed corruption and decisions are far from been taken for economic efficiency reasons but rather for political and personal considerations; and the situation inevitably leads to irreversible funds embezzlement, corporate assets misappropriations, and loss of opportunities for economic development. Like most developed economies, LDE seem also to suffer from doubtful behaviors of many powerfully vested interest groups. Those are circles that are well-rooted in local and national political structures and that dominate their economic development. The doubtful behavior of such powerful vested local groups can be considerably damaging and “it serves to weaken or undermine healthy proper functioning of markets as well as to weaken or undermine the development and consolidation of democratic political institutions” (Oman et al., 2003). Fortunately, improvement signs can be observed in many LDE and many of such doubtful links become increasingly subject of some kind of public interest., although not to the point where their survival is challenged. Powerfully vested interest groups continue indeed to benefit from generous government support and to enjoy protected oligopoly position. Aware of their undue privileges, family businesses have always taken the valuable precaution of being constantly represented in government spheres, either directly or by standing alliances. Such unfair public protection usually acts as a deterrent for anyone who might react against the insensitivity/arrogance of family-owned businesses and state enterprises. With market globalization, however, some of these monopolistic protections have crumbled, and many family-owned and state enterprises found themselves unable to compete in the international arena and they engage in yet more doubtful activities. The control of wealthy families and SOE over corporate assets in LDE that are lacking institutional integrity is common and usually has negative implications on corporate governance and adverse macroeconomic consequences and “a concerted effort to improve a country’s institutions is needed before diffuse ownership is desirable” (Morck et al., 2004). This situation is reinforced by ill-defi ned property rights and weak judicial systems in most LDE, inevitably leading to the systematic weak enforcement of contractual arrangements. Currently many LDE have corporate governance systems, codes, and regulations, although it is much more on paper and enforcement is often inadequate or lacking, although it is at the heart of any corporate governance efficient system and LDE citizens still have to wait to see any significant improvement. Another area that LDE are suffering from is the chronic lack of competent executives, which is believed to be initiated by the absence of competitive markets for managers, although family businesses and SOE seldom feel the need to hire managers on the basis of their competency, but rather on the basis of family ties or marriage links and political obedience. Monopolistic profitability of family-owned companies and SOE makes it impossible to judge the competency of their managers, and this extends to their board members, especially that owners usually exercise on their

Corporate Governance in Less Developed Economies 249 companies a complete control power, for which they are the most jealous. They, for instance, appoint and dismiss nonfamily board members and hire and fi re managers. Consequently, the board of directors and top managers are usually exposed to the mood of the controlling shareholder and hence efficiency can only suffer. This situation has naturally many negative repercussions: it makes shareholders lose the opportunity and the benefit of the separation of ownership from control, as required by all appropriate governance systems, and it also leads to another and much more serious problem which renders professional managers’ positions no longer affordable and consequently companies fi nd themselves run by amateur managers, whose only concern is keeping their jobs and doing whatever it takes to please the one who hired them. A little case is consequently made for directors’ independence. LDE companies are also suffering from their inability to have recourse to their fi nancing, to shares issues in stock exchanges. First, their small size naturally inhibits their need or their ability to raise fi nancing through issuing shares. Second, even companies that have reached the critical mass which may render possible shares issue fi nancing would voluntarily exclude themselves because of the availability of better alternatives offered to them and facilitated by their family ties. They may also not be interested in any sharing of control of their companies, which might be induced by any shares issue. Third, even in the rare cases where a family in control is in the presence of minority shareholders, the aversion to such shareholding is so strong that minority shareholders are left with but one choice: selling their shares. There actually exits in LDE a strong phobia for minority shareholders of all kinds and as a rule, LDE companies, even the largest that could use the stock market for funding, do not appear favorable to its use; their intimate relations with banks makes shares issue less attractive. Furthermore, many of these fi rms that may consider share issue as viable alternative are generally owned subsidiaries of conglomerates, often possessing their own banks. In such conditions, markets inevitably accrue very limited liquidity and activity. Boosting stock market in LDE can be seen as structural decision by nature and may represent the most crucial governance action to be taken by any LDE. The absence of shares block holders, outside families or state, is yet another issue in LDE, because family businesses as well as state enterprises cannot benefit from the contribution of block holders to the improvement of corporate governance. Indeed, blocks holders usually specialize in fields they invest in and therefore acquire a great expertise in certain economic sectors. They are, therefore, in a better position to effectively monitor the management of companies of their investment. The weakness of accountability and transparency is also an area of discord for family and state enterprises. Whereas listed private companies are supposed to be accountable to their shareholders and to be subject to strict fi nancial disclosure, family and state enterprises are required to be loyal to their owners, whether families or the state. The desire to be subject to the

250 Internal and External Aspects of Corporate Governance minimum disclosure requirements, coupled with excessive liquidity ensured by the fi nancial sector, encourages many family businesses and state enterprises to use the bank as the sole source of funding. Family- and state-owned companies in developing environments seem to adopt suboptimal strategies for fi nancing and investment decisions, but once such behavior is widespread throughout the whole economy, it discourages liquidity and weakens jobs creation and inhibits economic development. Further, where ownership is concentrated and especially where family members or state representatives “have important management positions (which is a common situation in developing countries), self-dealing resulting in expropriation of the value of minority shareholdings is all too common” (Dam, 2006).

GOVERNANCE INTERNAL MECHANISMS IN LDE Internal mechanisms of governance in LDE also suffer from diverse limitations, mainly because family or state owners do not lend themselves to any sharing of power within the organization under their control and such governance weaknesses differ, however, depending upon whether the company is family-owned or a state enterprise and if there is foreign ownership involved (Sytse, Rejie, & Rezaul, 2006).

The Internal Mechanisms of Governance in Family Businesses In family businesses, legal requirements and responsibilities of board members are usually confi ned in the incorporation legal texts of companies that commonly provide guidance for board members. In the private sectors, members of the board have duties to the company they serve and to its shareholders, although the exact nature of these rights varies across countries (OECD, 2004). Family businesses’ charters are, however, usually silent regarding internal corporate governance mechanisms, like the composition of the boards of directors, the internal structure, the corporate decision making, and the disclosure requirements. The other internal mechanism of corporate governance is embodied in the incentives and compensation schemes that are often offered to managers to motivate them to pursue value-added management policies and to discourage them from taking decisions that are not in the best interest of the company and its shareholders. Such mechanism is rarely used by family enterprises: despite recent abuses, it is, indeed, generally believed that the compensation scheme, as an important part of managers’ remuneration under the form of stock options, encourages them to benchmark their performance in line with owner expectations. They are also supposed to help prevent extremely risky managerial decisions and discourage potential manager opportunism. In most family businesses a particular culture of secrecy regarding business practices also dominates and it goes even beyond financial disclosure.

Corporate Governance in Less Developed Economies 251 For structural, cultural, competitive, and tax considerations, family-owned companies are rather reluctant to reveal any information relating to their businesses’ activities ,and they are even willing to pay the high price to avoid mandatory disclosures. Actually, family companies, being at the forefront of their business, their managers may feel more vulnerable than managers of private companies. To assess the financial health of any family business, one may have recourse to some exotic evaluation means other than the traditional analysis of the fi nancial statements and will have, for instance, to base his judgment on the luxury with which a family celebrates a happening—a wedding, for instance. Even in the few cases where disclosure does exist, another problem usually arises and it concerns the accuracy of the disclosed information itself and its updating. The accuracy of the disclosed information often depends upon the experience and the quality of auditors, whose independence is far from being ensured. By acting this way, family businesses seem to deprive themselves of an effective management tool, because mandatory disclosure may, in fact, help their managers to discipline themselves and rationally run the family businesses. There is an urgent need for nonlisted companies to be submitted to disclosure requirement of some sort. Venture investors, for instance, have developed contractual arrangements that not only give them immediate access to the family-owned company’s fi nancial statements but also force the company to reveal performance problems and other essential information to the investors (OECD, 2006).

Board of Directors in Family-Owned Companies Family owners are believed to have a longer investment horizon, better monitoring of management, and suffer lower information asymmetry. They are further supposed to have greater litigation and reputation cost concerns (Chen et al., 2008). A clear picture of the board of directors of companies under family control was given in 1971. It was shown that: Boards of directors operate in a working environment complicated by the psychological implication of family members working in the same organization—with and against each other. Members of a family bring into the business confl icts, rivalries, guilt feelings, ambitions, loyalties, prides, resentments, and interrelationships which are quite different from the characteristics of typical nonfamily companies. (Mace, 1971). Family members usually determine the course of action for the board and a number of interesting conclusions can be drawn (Mace, 1971): (i) Boards of directors of family-owned companies often have to serve as conciliators whenever divergence of views occurs among members of the ruling family;

252 Internal and External Aspects of Corporate Governance (ii) Board members of family-owned companies are generally used as sources of advice mainly to the ruling family, and incidentally to the chairman of the company, when he is not a family member; (iii) The family-owned company’s board of directors is sometimes called upon to serve as a kind of disciplinary organ for the president, when the chairman is not a family member, but rather a professional manager: (iv) The family-owned company’s board of directors is generally not involved in choosing a successor to the deceased or fi red chairman. This type of decision is usually reserved for family members, who are often jealous of such privilege. Family members typically consider it of extreme importance to appoint a chairman or terminate his mandate. It appears that in most family businesses the board does not fulfi ll its role as usually expected; it does not, for instance, set up corporate goals nor does it monitor the company’s management. Similarly, it does not take part in the appointment of the chairman whenever he is a family member. Familyowned companies’ board members are often confronted with two unique dilemmas (Mace, 1971): fi rst, directors are usually confronted with the inability of fathers in family businesses to objectively appraise the capacities, skills, and motivations of their sons who are candidates for the chairing of the family business—especially when the family in control owns a relatively small percentage of the outstanding shares and the balance is publicly owned. Second, directors are also confronted with the situation where some family businesses are also used as a supply legal vehicle for family members, for personal services, conveniences, and other luxuries, at company’s expenses, although part of the shareholders are not family members. Issues that confront the board members in family businesses are several times exacerbated; they usually receive a surplus of complications induced by emotional family relations. The magnitudes of family problems brought some to suggest the establishment of family councils, a kind of mechanism that can combine family considerations and business requirements and can take over arbitration of confl icts, thus preventing the disruptions of family business before they occur.

The Corporate Governance Internal Mechanisms in State Enterprises Governments around the world usually designate or appoint directly most, if not all, of the board members of companies they own. Board members of state enterprises have theoretically the same duties and authority as their counterparts in private companies. The state as the main shareholder may, however, have aims and purposes that sometimes differ greatly from those traditionally pursued by private companies and are often refl ected in the constituting legal documents of state enterprises or in specifi c performance agreements between governments and state-owned enterprise

Corporate Governance in Less Developed Economies 253 boards, and also in explicitly adopted regulations. In this regard, rights and obligations of board members, whether from private or state-owned companies, would appear fundamentally comparable. In practice, however, clarification of roles is dramatically missing in SOE. This lack of clarity can reasonably be attributed to the ambiguity of the legal status of SOE, with regards to policy objectives or simply to legislative gaps. What really makes the boards of SOE so different from those of private companies is the relationship linking the board with its controlling state shareholder, as well as the difficult sharing authority that implies. A number of functions should automatically belong to the board of directors (OECD, 2004). In practice, however, some of these functions are carried out by both the controlling state and the board of directors. Often, the monitoring of the performance of the SOE or the overseeing of the appointment process of senior managers, for instance, which should be left to the board of directors, is not. The board is commonly bypassed by the controlling state. SOE may also face many additional challenges that can seriously compromise their effectiveness. Unlike private corporations, SOE generally cannot have their board changed via a takeover or proxy contest, and neither can they go bankrupt. The absence of potential takeover threats reduces the incentives of board members and managers to drive towards the value maximization of their organization. Similarly, the dissipation of all risks of bankruptcy often introduces a lack of rigor in budget preparation and the absence of reasonable constraints to contain costs. Hence, two of the most important checks on underperformance are missing in SOE (Baygan-Robinett, 2004). SOE are also commonly subject to additional governmental monitoring; they are usually submitted to a trusteeship of several ministries and sometimes a specific organ is set up for this purpose. The problem with this type of additional oversight structure is the divergence of authority sources it creates and the diversity of views that has to be reconciled. Each source may, indeed, have different objectives and interest to defend. The result of such situation on the management effectiveness is invariably the same; it diverts the SOE from their original objectives. Even in the absence of flagrant abuse, this complex agency relation may present difficulties not encountered in the more straightforward agency relation. Managing multiple and potentially confl icting objectives is one of the central challenges encountered in the governance of the SOE. The SOE, however, also experience their own share of classical agency problems, especially those arising from the multiplicity of principals. The reason is that each governmental agency involved in the monitoring of an SOE has its own vision and its own targets for such SOE and each agency is also tempted to engage the SOE in the direction it privileges most. Even if the various objectives are perfectly legitimate, the overall impact of this competitive influence dramatically reduces accountability and weakens the incentives for managers and board members to look for efficiency, particularly that the lack of clarity can be the initiator of malfeasance.

254 Internal and External Aspects of Corporate Governance

Improving Corporate Governance of SOE The improvement of governance of SOE can have far-reaching consequences, because it may particularly ensure their profitability and thereby silence criticisms towards them and secure their survival. Such improvement in governance may also have a beneficial impact on private business sectors, which will be pushed to review their own governance mechanisms and management practices, and the whole economy will undergo significant improvement. Even when the SOE is due for privatization, good governance remains a key success factor of process (Coffee, 1999). It also improves privatizations’ outcome for the governments. The SOE governance challenges can only, however, be addressed through transparency, usually requiring a comprehensive national program where each SOE has to provide enough information to the public, including nonfi nancial information that relates to sensitive issues such as, for instance, transactions with related parties, changes to board membership and senior management nominations, and hiring of high ranking employees, and so on. It may also require an overall government ownership statement, where each agency involved with SOE draws an accurate picture of the SOE’s portfolio it holds. In addition, all SOE must have a system of internal controls overseen by the board and subject to an external audit. The problems of SOE governance could, of course, be significantly reduced by the mere appointment of professional managers and the hiring of competent directors. It seems, however, that companylevel governance and performance are lower in countries with weak legal environments, and this may suggest a significant impact of the legal system that should remain a priority for policymakers (Klapper et al., 2002) EXTERNAL MECHANISMS OF CORPORATE GOVERNANCE IN LDE External governance mechanisms are predominantly market based, but other external mechanisms coexist. They contribute to strengthening the governance structure of the entire enterprise and the enhancing of the effectiveness of its internal governance mechanisms. Players other than the market may also have an impacting role in this regard, such as creditrating agencies and banks. LDE face a fundamental dilemma. They need to develop fi nancial markets, and yet they lack the ingredients it takes to do so (Pistor & Chenggang, 2005).

The Market as External Governance Mechanism The market for corporate control is supposed to provide shareholders of listed companies with the opportunity to get rid of their underperforming or fraudulent managers. The threat of hostile share acquisitions of underperforming companies can affect their managers and discourage them from undertaking

Corporate Governance in Less Developed Economies 255 activities that might endanger business performance and consequently shareholder interest. It is, indeed, commonly agreed that whenever company performance is located significantly under the one required by the market, given a certain level of risk, this will lead to the emergence of hostile transactions on the company’s shares and that are large enough to cause a change in the company’s control and eventually to the replacement of its managing team. The market for corporate control is, however, inaccessible for unlisted companies, and this is also something minority shareholders in family or state businesses cannot have recourse to. The situation calls for replacement mechanisms to the market for corporate control in LDE that would protect shareholders against abusive managers. Such replacement process should aim to reinforce monitoring activities performed by banks, rating agencies, or creditors, but also by the rehabilitation of human values like trust and reputation. Indeed, trust and reputation concerns seem to be important to private funding, whether individuals or agencies. Effective nonlisted companies’ corporate governance systems will always be dependent on the awareness of actors, but also on the existence of governance mechanisms that are sufficiently sensitive to nonlisted companies’ specific problems. Always in the absence of market for corporate control, debt holders may play a proxy disciplinary role regarding underperforming managers. Since a higher leverage can potentially be seen as a strong warning of controlling shareholders, corporate governance and performance can actually be linked to fi nancial leverage whenever, for instance, a block holder wished to maintain control by not diluting existing equity with more equity; when the controlling block holder wants to signal to the outside capital market that corporate governance is sound and that the value of minority shares will not jeopardized; and finally, when a high level of debt will restrict the power of a controlling shareholder to extract private benefits of control, mainly because part of revenues will inevitably be diverted to interest payments (Hall, 2006). The stock market, as an effective external mechanism of governance, cannot usually be used against companies under family control. Indeed, the small size of the majority of businesses owned by families naturally limits their access to the stock market, if they do not voluntarily refrain themselves, thereby forgoing maximum benefit of issuing shares. Most family-controlled companies, having reached the critical size where public fi nancing by shares issue becomes a viable option, often abstain. They are actually capable of self-funding mainly through alliance and “lift returns” of all kinds, and those that are ready to make the jump to the stock market are unfortunately those who do not qualify. Consequently, they are generally boycotted by investors on the basis of their poor management and weak corporate governance. It is, however, argued that “contrary to current conventional wisdom—an active market for corporate control is not an essential ingredient of either company law reform or fi nancial and economic development” (Deakin et al., 2003). It is feared that costs of hostile takeover bids would jeopardize prospects for growth in LDE.

256 Internal and External Aspects of Corporate Governance LDE companies’ corporate governance can be improved only through the stock market. For this reason stock market development becomes a priority in LDE and it constitutes the foundation of any successful corporate governance reform. Market development, however, requires transparency and appropriate financial disclosure and this is something to which LDE family-owned companies are always opposed.

Other External Governance Mechanisms The credit-rating agencies, banks, and other institutional investors can contribute effectively to the improvement of good corporate governance in LDE. They may, for example, require nonlisted companies they are investing in to conform to standards of good practice in the course of their assessment of the risk involved by such companies. The so-called Basel II accord has, for instance, as its goal the improvement of the procedures for risk assessment by banks, and it is trying to accelerate the extension of such a strategy to some large nonlisted companies. Institutional investors can also enact the principles of good governance that contribute to the increased respect, integrity, transparency, and confidentiality within the company (OECD, 2006). For small nonlisted companies, the availability of a healthy banking system is of great importance and a major requirement for development and growth. For this reason, LDE regulatory agencies must be aware of the importance of the banking system and must also ensure its independence and good governance if it has to play a guiding role in the field. Indeed, how can the care of the sheep can be entrusted with wolves? Particular attention should be paid to the quality of supervision of the banking sector and the need to strengthen the governance of the overall fi nancial sector. Daily events may, of course, suggest that it is not only an LDE issue. The 2008 fi nancial crisis should remind us of the danger of letting banks overcome their traditional activities and bargain safety for abnormal returns. With regard to credit-rating agencies, there is no reason to expect their effectiveness to be dependent of the level of economic development and they should therefore play a crucial role in LDE. The way, however, credit ratings are assessed can often lead to false conclusions, especially when objectivity is lacking and whenever dependence is a rule. Again, the current fi nancial crisis is showing how credit-rating agencies can dramatically fail to assess adequately security issuers’ risk. Many developing countries and especially emerging economies have seen in the credit ratings some kind of a shortcut to their fi nancial markets’ development. They naturally opted for mandatory rating requirements for local debt instruments and have taken appropriate measures to create local credit-rating agencies that are submitted to licensing. The situation has proven to be disastrous in many cases.

Corporate Governance in Less Developed Economies 257 (i) First, the credit-rating mechanism was often used regardless to its usefulness. There is indeed a serious risk that credit scorings may be used not for the good reason, that is, for their intrinsic qualities, but rather for regulatory considerations. Given, however, that market discipline is often artificially removed from the process, the credit ratings in such circumstances are likely to increase rather than to reduce risks for investors; (ii) Second, government’s oversight of such rating licensed agencies provides little help to ensure the quality of their opinions and this casts doubt on their usefulness; and (iii) Third, when credit-rating agencies are licensed, users will have the tendency to shop for less expensive and less demanding credit-rating agencies, because all agencies are able to ensure meeting regulatory requirements by the issuer and gain access to the capital markets, even if it is for the wrong reasons. In view of such a race for mediocrity, credit-rating agencies will inevitably lower credit requirements and investment effort in research. While trying to create credit-rating systems, LDE must be aware of the danger of not ensuring the necessary conditions for their success. The credit-rating systems must be implemented for good reasons; otherwise they may be detrimental to the well-intentioned goals, and ultimately endanger the integrity of the rating process they seek to protect. Institutional investors such as pension funds and others institutions that act as a trustee on behalf of individual small investors, have an important role to play in strengthening good corporate governance and better protect the value of their investments. Private investors can also produce a similar effect on the quality of corporate governance. Venture capital associations, for instance, often enact principles that help increase integrity, transparency, and confidentiality within the companies they are investing in, and this is done by setting these principles in articles of association and shareholder agreements. Private investors can also make their investment decision conditional upon such registration.

THE FOUNDATIONS FOR AN EFFICIENT CORPORATE GOVERNANCE FRAMEWORK FOR NONLISTED COMPANIES Because governance framework is meant to identify and take advantage of internal and external corporate governance mechanisms, it is easy to understand that an appropriate legal framework will be able to motivate managers to comply with governance rules and standards. The availability of a legal, well-defined rules-binding framework would be the best way to introduce a governance culture into organizations. Countries with poor corporate

258 Internal and External Aspects of Corporate Governance governance need to start by enacting an efficient legal framework. Most legal frameworks usually ensure the following rights to shareholders: (1) The right to participate in the annual general meeting and the opportunity to ask questions; (2) The right to propose resolutions to shareholders; (3) The right to exercise shareholder’s vote; (4) The right to residual value; (5) The right to receive information on the affairs of the society; (6) The prevention of non-pro-rata distributions; and (7) The differences between classes of shares. Legal texts in most jurisdictions also contain provisions that guarantee minority shareholders the benefit of sharing in proportion to their participation in the capital stock of the company and keep the controlling shareholder from extracting undue profits. The effectiveness of company law depends, however, on the legal publicity and disclosure rules. The right to be informed must therefore prevail in legal texts. The other element that may help to establish good governance within organizations is the famous code of corporate governance. Although it may seem utopian to believe that most companies that have a code of corporate governance respect it, the recognized problem is only half solved. Most governance code models focused, however, on listed companies and can reasonably be extended to nonlisted companies. These governance codes may, at least, provide nonlisted companies with a biding formal framework that increases confidence and consequently investment opportunities.

INTERCONNECTION WITH OTHER COPORATE GOVERNANCE MECHANISMS The often encountered perception that corporate governance would be of little interest to economies that have no listed companies in sufficient numbers is misleading. The main reason is that corporate governance institutions are actually at the heart of one of the greatest challenges faced by all developing and emerging market economies: how to move successfully from corporate governance institutions that are heavily relations-based to rulesbased institutions. The combined and harmful effects of personal relationships and favoritism in LDE are expressed in expropriation of all kinds, rights usurpations, and corruption. They actually destroy all development efforts and allow every opportunity for growth to be missed. Virtually all LDE are undergoing a difficult transformation process in which corporate governance plays a key role. Such transformation process involves a profound change in economic policy and national governance. Economically, the transformation is from relatively closed and market-unfriendly systems. Politically, the transformation is from relatively undemocratic to

Corporate Governance in Less Developed Economies 259 more democratic systems. In both, the move is towards more functionally rules-based systems of governance, away from systems that were nontransparent and unaccountable and often heavily relationship-based.

CONCLUSION The mechanisms of corporate governance are used to determine what standards of corporate behavior a given society sees as acceptable and ensure its compliancy by companies. Many LDE have recently undertaken major economic reforms. Their fi nancial markets have also developed faster more than ever before and this is perceptible at the level of their size and the sophistication of the services that they provide. Such endeavors can, however, prove by themselves to be insufficient to create the kind of interactive dynamic that is needed for the long-term productivity and growth despite the result of experiences in LDE over the last decades that show that the voluntary codes and procedural remedies drawn from Anglo-American law, for example, do not seem to constitute the most effective way of channeling market forces to the improvement of corporate governance (Jordan et al., 2008). The political and economic reforms undertaken by LDE must, however, be maintained, but should be tailored to environmental needs in order to successfully advance the struggle against poverty and corruption and also to strengthen political democracy and economic modernization. Governance institutions that work effectively are more important for LDE even more than for developed countries. They are needed to overcome the market shortcomings and deficiencies. Recent fi nancial developments have had an impacting effect in LDE, including market development, governance, and regulatory issues. Reforms were initiated in light of the fi nancial crises that have taken place in those markets (Vatnick, 2007). Governance reform involves great efforts and deep changes in mentality, attitudes, and policies. The objective is to achieve a system of governance based on rules. The speed and sequence of the governance reform systems may vary from country to country and the degree of resistance it may encounter. Some countries are relatively more advanced in one or more governance dimensions than others. Almost all developing and emerging market economies are already in the midst of the difficult transitions to transparency, accountability, and rule-based governance institutions.

COMPREHENSIVE CASE 11.1

The Global Corporate Governance Forum The Global Corporate Governance Forum is a multidonor trust fund facility of the International Finance Corporation (IFC) that provides assistance

260 Internal and External Aspects of Corporate Governance to emerging markets and developing countries on corporate governance. Cofounded by the World Bank and the Organisation for Economic Cooperation and Development (OECD) in 1999, it promotes corporate governance initiatives at the local, regional, and global levels, deploying tools and guidelines drawn from international best practices. Visit the site of the Global Corporate Governance Forum, at: http:// www.gcgf.org/ and discuss how such initiative can help improving corporate governance in LDE.

12 Corporate Governance Requirement of Trust

Human societies have always recognized trust as a requirement for a wellfunctioning of human institutions. Being introduced in economic thinking by Adam Smith two centuries ago, the trust issue is today the subject of much debate. Very few human relationships are actually founded on what each one knows about the others and in a demonstrable manner only (Simmel, 1987). Trust seems, however, to be significantly denied its traditional rights during the 20th century and was given only little impacting role in business relations. It was called upon in specific situations only and mainly as a last recourse: fi rst, whenever economic theory suggests numerous solutions to a single problem, but in way that it is impossible to make a rational choice; second, in situations where formal structures cannot explain individual behaviors (Leibenstein, 1982); and fi nally, in cases where contractual arrangements are incomplete. Mercifully, the trust did not reach the stage where it is denied completely, although it was getting closer. It is recently, however, acquiring priority in corporate governance, due to recent corporate and fi nancial crisis. This chapter argues that trust and reciprocity, if they could be shown to exist in two-group exchanges (board and management), would pose a serious challenge to the common belief that managers are always ready to bargain corporate governance for their own self-interest.

TRUST IN BUSINESS RELATIONSHIPS One way of starting our discussion on trust is to relate the story of the so-called prisoner’s dilemma (Thuderoz, 1999). A husband and wife were arrested on a murder charge; they were jailed by the police in two separate rooms. The husband and wife can either plead guilty or not guilty, knowing, however, the consequence of their decision: if, for instance, the wife pleads guilty and the husband does not, the wife will be set free and the husband will be sentenced a 20-year jail term and vice versa; if, on the other hand, the husband and wife both plead guilty, they are both jailed for five years: if the two, however, plead not guilty, they will only be sentenced to

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one year imprisonment each. The husband and the wife should decide each separately for the appropriate strategy without knowing what the other partner would choose. The husband and the wife are each faced with a dilemma of (i) not pleading guilty and being jailed for only one year, but, at the same time, taking the risk of betraying the other spouse and seeing him or her imprisoned for 20 years, (ii) to plead guilty and to be freed, or (iii) to be jailed for five years, if the other partner confesses also. Each spouse has a real personal interest in confessing, that is, to betray the other partner in order to be freed. If, however, the two spouses adopt the same strategy, they will be jailed for five years, and this is, of course, a higher price, compared to what they would have got if they trusted each other and had pled not guilty. If each spouse, for achieving the common objective, pursues his/her interest only and consequently makes the other spouse support the cost of his/her defection, the common objective can either not be reached, will fail, or will prove to be of unbearable cost. In this situation, the pursuit of individual interest is confl icting with the mutual gain and ends up with the worse result possible, for partners. This case can be extended to other situations; it shows how mistrust and the pursuit of individual gain may oppose the pursuit of mutual gains and can bring the worst result for each partner (Thurderoz, 1999). Academicians are only beginning to understand the process of trust deterioration as an interorganizational phenomenon and there is the need for further work on the nature of trust (Audi, 2008; Mezgar, 2006; Laaksonen et al., 2006). Indeed, the relationship between ethics and trust is still ambiguous because “ethics can promote trust, whilst trust can simultaneously be abused resulting in unethical behavior” (Bew et al., 2004). Some empirical evidence indicates, however, that there must be a climate of trust before organizational activity can expand (Claire et al., 2007; Bell et al., 2002). Actually, it is commonly believed that nothing can threaten a business relationship more seriously than lack of trust. Trust can be seen as the essential ingredient upon which all real success depends. Trust cannot be taken for granted; it is rather an emotional skill, “an active and dynamic part of our lives that we build and sustain with our promises and commitments, our emotions and integrity” (Solomon et al., 2003). The capital markets that are a key element of the economic development seem also to have suffered from a lack of trust and trustworthiness. They seem to be broken today and repairing them is critically important to restore trust in business, and tinkering with the rulebook may not be enough. Restoring trust in capital markets require four qualities from participants: honesty, disclosure, transparency, and professionalism. Those qualities are missing, although they are needed

Corporate Governance Requirement of Trust 263 before any significant change in the prevailing lack of trust (Mills, 2003; Solomon et al., 2003; Axelrod, 1999). It is important to emphasize that where, for example, agency theory underlines formal mechanisms such as rewards, sanctions, and monitoring, trust focuses on informal mechanisms, requiring only good faith. “Trust can be defi ned as a fi rm belief in the honesty of another and the absence of suspicion regarding his motives or practices” (Moment, 2003). It is believed that what keeps all contemporary societies together, even more than mutual interest, is mutual trust. This suggests that trust and ethics are far from being a luxury, but rather an indispensable means for promoting economic development. The free market is, however, based on free relationships within a protective framework against fraud or force, and ethics cannot emerge unless people have the freedom to make coercion-free choices between alternative decisions. Given that the free market is based on freedom of choice, it is argued it can promote morality and character development—a key aspect of human flourishing. Commerce in a free economy not only requires but rewards virtuous behavior (Younkins, 2001). Some people do not recognize, however, any role for trust in business relationships. If they only knew that modern technology allows a single finger movement to destroy entire companies and to cause the life savings of many investors to go up in smoke. Trust cannot actually be dissociated from any human relationship and the one which is devoid of trust cannot be described as a relationship at all. It is certainly for this reason that in the long run trust in business relationships has traditionally and always been the key to their success. The lack of trustworthiness of some organization management has far-reaching consequences on the whole fi nancial system. The 2008 market downfall and financial crisis are, to a large extent, the consequence of investors’ loss of confidence in corporate managements and the numbers they produce. Such mistrust and suspicion of managers inevitably translate into the capital market access denial for businesses, and this ends up hurting all corporate stakeholders and the whole economy. Corporations need to protect and reinforce trust where necessary, because a lack of trust can particularly impede their functioning and growth (The Economist, 2008b). Although a great deal of current losses “will have fallen on the very wealthy, who can cope, many others, though, are not so well placed. And one class of investor will be especially badly hit: workers in defined-contribution, or money-purchase, pension schemes” (The Economist, 2008a). Unfortunately, one possible consequence of such a situation is that small investors will be discouraged from entering stock exchanges again or at least for some time to come. “ . . . Keep the money in the bank and the returns could be paltry and the capital eroded by inflation. Put the money in equities and the risk is that developed stock markets suffer the same long slow, grinding bear run as Japan”1 and just when market needs it least, “Bernie Madoff’s pyramid scheme takes financial fraud to new lows.”2 The $17 billion of investors’ funds that Madoff’s fi rm supposedly held earlier this year have

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all but evaporated and the hole could be as big as $50 billion. For years, the returns paid by Madoff to investors came not from real investment gains but from inflows from new clients. The affair has robbed an embarrassingly long list of supposedly sophisticated investors of their swimwear. Hundreds of banks, hedge funds, and wealthy individuals parked money with Mr. Madoff, impressed by the steady returns on offer: 10 to 15% a year, even in rough times, with barely a down month.3 Critics are now blaming the weak monitoring of the market for the fi nancial crisis that is tipping the economy into a deep recession but can intensive monitoring save from fraud? Trustworthy behaviors seem actually to be common and, more importantly, they can be predictable. Indeed, a variety of factors “can reliably increase, or decrease, the incidence of cooperation” (Stout, 2003). Two main currents of trust can be clearly distinguished: a trust mechanism as predictive risk reduction, on one hand, and trust as an instrument in which reciprocity is based on good faith, on the other hand (Koenig, 1999, p. 133). The trust is based on what an individual or group believes in respect of its relations with another person or another group. Such a belief ultimately brings each individual or group to act in the interest of another individual or group, with some kind of anticipation of reciprocity. The reciprocity in this situation has, however, forced obligation to be sensitive to the anticipation created in the other party. Trust as a combination of anticipation and mutual obligation gives cooperative relationship much flexibility, one which is actually difficult to encounter in formal relationships. A common characteristic to the numerous trust interpretations is expressed in their vulnerability and dependence dimensions, occurring whenever social exchanges entitled obligations that cannot be delimited by contractual arrangement. Usually the decision to trust depends on the action of the other party involved (Gambetta, 1988). But should this really be reassuring enough? Trust alone does not seem to be sufficient impulse for honesty. Recent history, however, also suggests that legislation alone is not sufficient to impose trust and reliability in business relations neither social values, the market or contractual arrangements. Each mechanism appears to be crucial to the success of the others mechanisms and seeks their support for its own success. The success or failure of contractual arrangement and legal requirements depends largely on the ability of parties to adhere to standards of fairness and respect social values. The exorbitant agency costs of contractual and legal arrangements, necessary for full monitoring of managers, exceed far beyond the benefits that can be drawn from them. In addition to the limitations and inabilities of the laws and regulations, mainly intended to strengthen corporate governance, it is also feared that their costs may be so high that they could threaten the effectiveness of capital market. Indeed, “while viewing the corporation as a nexus of contracts and as a voluntary organization based on cooperation and consent, trust can thus function as an axis that best fits corporate law, and also serves to justify it” (Bukspan, 2008).

Corporate Governance Requirement of Trust 265 “There is a circle of trust in the capitalistic economy, and to the extent that component of trust is lost, there will be a breakdown in the free enterprise system that affords opportunity for individual achievement” (Jennings, 2001). Trust seems, therefore, to be essential to economic prosperity and, hence, the agency theory does not exclude it altogether from its reasoning and even sees it as additional incentive mechanism. The agency theory suggests that contractual mechanisms are in place to fight against opportunism. They are likely to generate confidence between the parties, encouraging them to behave in accordance with their commitments. No matter, however, how well a contractual agreement is drafted, its success depends on involved parties’ ability to trust one another and whether they can work through their differences to resolve ambiguities without litigation or disruption. “There is neither law nor any written agreement that can guarantee performance under the terms of a contract” (Jennings, 2001). The success or failure of contractual agreements will depend largely upon the ability of the partners to respect fairness standards and candidly deal with each other. The trust can also be seen as a key strategic reductive cost element, although individuals seem to have a basic natural inclination to be honest. Other voices, however, are suggesting that trust has no place in business relations; they believe that the essential function of social institutions is not to build confidence but rather to limit the likelihood of opportunistic behaviors. In their view, individuals are much like calculators, and only a high penalty can dissuade them from behaving otherwise. The trust would, therefore, be linked to the existence of sanctions and encourage people to respect their commitments and to keep their promises. The contractual arrangements, as effective as they may be, cannot guarantee the trust, for which they are technical alternatives. They are not able to take account of other individual characteristics that discourage dishonesty beyond institutional and contractual arrangements. Trust, anyway, seems to have consequences that go beyond business relationships between individuals or groups. It is believed, for example, that the world we know today would not have been possible without individuals trusting each other, or at the very least a certain minimum level of trust should exist. Thus trust among economic actors is generally regarded as a key factor in achieving economic efficiency. Trust seems also to represent a central factor in the success of companies, and also in their ability to develop systems and complex processes. Group effectiveness may depend directly on the level of trust between its members, because trust can lead to lower transaction costs, simply by limiting the use of costly and sometimes excessive contractual provisions governing companies and their operations. In this case, efficiencies would certainly be improved. In such a context, trustgenerating cooperation appears to be able to increase efficiency by generalizing corporate internal relations based on trust (Alter et al., 1993) and to facilitate the smooth exchange of information leading to its faster flow (Powell, 1987). It is even strongly advocated that the fate of the capitalist

266 Internal and External Aspects of Corporate Governance economy is bound to trust (Jennings, 1998), and whenever the element of trust is lost, it follows a break in the free enterprise system that has yet provided so many opportunities and new value for so many generations and individuals. Indeed, not all countries endowed with abundant natural resources and talented workforce are developed economies. Some of these rich countries still face many hesitations on the part of investors, entrepreneurs, and citizens to commit funds in long-term investments. This can be explained by the lack of trust investors have in the integrity of governments and leaders to honor their promises and to behave honestly. Without trust, economic growth is offset by the reluctance imposed by uncertainty. It is believed that lack of trust has provoked “the implosion of America’s most storied investment banks, the vanishing of more than a trillion dollars in stock-market wealth in a day: (Fukuyama, 2008). Trust and other moral criteria can be crucial to economic growth (Jennings, 1998). “In today’s world, where ideas are increasingly displacing the physical in the production of economic value, competition for reputation becomes a significant driving force, propelling our economy forward” (Greenspan, 2007). All this looks particularly pertinent today. Trust, however, seems to work with trustworthy people only.

TRUST AND CORPORATE GOVERNANCE Trust appears to be at the basis of each corporate governance defense mechanism, besides law and regulations. Till now, however, no class of corporate governance defense mechanisms seems to have been fully effective without trust. The idea of trust in corporate governance relationships is far from new; Adam Smith, for instance, in the 1700s seemed to have laid down its foundation, by underscoring the fact that “Property rights continue to have a rightful moral legitimacy when used to secure the right of each individual as a stakeholder” (Smith, 1817). Indeed, whenever interests of management and stakeholders are not aligned, this leads frequently to what is termed as “agency problem.” Jensen and Meckling (1976) proposed the theory of the “contractual” and voluntary agency corporate governance relationship, where they discussed why problems arise within the nexus of corporate contracts that they described as characterizing the modern corporation. They also underlined how managers and shareholders may act to control agency costs for the sake of maximizing their company’s value. The contractual and voluntary agency corporate governance relationship model does not seem, however, to overcome real-life events. Some managers have quickly learned how to bargain corporate objectives for their own benefit, despite constraining contractual agreements. They have, for instance, learned how to juggle numbers to maximize their wealth through, for instance, their own option plans, and so on. Such suboptimal behavior in decision making has resulted and also become the rule, and trillions of dollars were unfairly

Corporate Governance Requirement of Trust 267 misappropriated. The extent of these losses has constituted a real threat to the whole fi nancial system, and it is continuing to endanger accomplished economic and social progress. Divergences of interest between managers and stakeholders arise because of the impossibility of neither completely covering the whole range of conflictive situations through contractual arrangements nor perfectly compensating managers for keeping them from corporate governance abuses. It is also generally believed that contractual agency costs of monitoring managers would far outweigh the benefits which might be derived from them. This situation made governments come to the conclusion of the need to react by legally imposing a structuring corporate governance system. “In situations where distrust abounds and problems with dishonesty create the need for mandated performance, our tendency is to create complex laws and rights designed to bring about the standards of fairness that gospel principles would dictate regardless of codified law” (Jennings, 2001). It is feared, however, that the huge volume of new rules and regulations that system has submitted companies to may have gone so far as to endanger the freedom to undertake. It also well may be that despite skyrocketing regulations’ costs, the risk of corporate misconduct will not be eradicated (Sarbanes-Oxley Act, 2002). Laws and regulation costs may fi nally prove to be so high as to also hamper capital market efficiency. They can also create appropriate conditions for the absence of a common fi nancial reporting language throughout the world. Like agency costs, legal costs ultimately will be captured by fi nancial markets and reflected in a company’s share price (Fama et al., 1983). It is then in the interest of management and board to minimize their amount, but how about if they can avoid them all together by adopting trustworthy attitudes? Contractual arrangements in business are themselves dependent upon honesty and trust and so the entire economic system, as pointed out previously. Investors, for instance, are willing to entrust their funds with businesses only because they trust that the borrowers/issuers will honor their obligations. Examples of the kind can be found by the hundred in business relations. Similarly, there is a serious reason to believe that a lack of trust in board management relationships may significantly encourage doubtful management behavior and diminish management chances for success. The positive effect of collaboration and confidence in board CEO relationships was recognized (Westphal et al., 1995, 1997). Many observers have noted that the level of trust the board can have in management is contingent upon the associate’s perceptions of the manager’s personal and professional qualities. In this they are doubtless right. It is, however, important to note that trust does not exclude monitoring. Indeed, “control mechanisms serve to focus members’ attention on organizational goals, while trust mechanisms promote decision-making and enhance cohesiveness” (Stiles et al., 2001). Trust in corporate governance can be decomposed in many levels (Ebersole, 2006).

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• First form of trust is the one the board of directors made in respect to managers’ technical skills and know-how. The board of directors is in fact seeking individuals whose level of competence inspires confidence. • Second form of trust is one the board places in managers with regard to their ethical conduct and character strength. The managers’ reputation is paramount; their honesty and integrity must also be perfect. • Third form of trust is one the board places in managers in respect to their skills and personal abilities. Managers must ensure that the board of directors not only believes what they say but must be convinced they will treat each issue with the utmost respect and confidentiality • Fourth form of trust is the one the board made with respect to the transparency of managers and their openness in business dealings. A lack of transparency on the part of managers can do much harm and greatly affect their business relationships, inside and outside the organization. • Fifth form of trust is the one the board places in managers requiring them to be “persons of their word” and accountable for all their actions within the company. A new and modern phenomenon makes trust even more important within the organization. Modern available technology grants individual extended autonomy and power based on their use. Thanks to such technology, largescale operations are now entrusted to mere individuals with the real power to do incommensurable damage. In fact, technology has ultimately put the destiny of organizations in the hands of a few individuals, and very rarely in human history have we witnessed the irrational behavior of a single individual destroying great institution of several thousands of his fellow men. Consequently, an urgent need for high level of integrity standards is felt dramatically for monitoring their use. Indeed, behaviors, standards, and control cannot remain at their level of the past, which can reasonably be confused with impunity. The appropriate use of technology requires, therefore, good judgment, honesty and discretion, and certainly not the blindness and ambition witnessed these recent years. Yet, what we are seeing today does not seem to point toward strengthening the role of integrity, but rather a deterioration in standards of morality. “We have declined from a level of choosing integrity because of our belief in its importance and its origins to a level of fi nding an ethical breach only when one is caught” (Arcement, 2008). It is true that that “a society without rules is a society that is on the brink of chaos and self destruction. Likewise, a society with the wrong kind of rules will ultimately suffer the same fate” (Arcement, 2008). Fortunately our modern societies seem to still have a lot of potential ethical enough to overcome the current devastating trend. “But, like a natural resource, our supply is getting lower and we must reverse this downward spiral otherwise a valuable fabric of human society will disappear” (Arcement, 2008).

Corporate Governance Requirement of Trust 269 The overall situation seems, therefore, to stress the urgent need to seek alternatives to both conventional approaches of corporate governance, particularly on board management relations. This chapter offers a third way of selecting managers by members of the council on the basis of their reliability.

BOARD MANAGEMENT TRUST RELATIONSHIP (BMTR) Currently, many important changes are taking place in the corporate field; a growing awareness is, for instance, developing among companies and legislators and concern is emerging among different stakeholders with regard corporate governance and how it should be tackled. Such changes are advanced against a background of legislative and contractual corporate governance approaches. They are advocating alternatives based on a new thinking, one that puts ahead collaboration and trust. The common belief is that an appropriate balance should be reached between the costs of the contractual and the legal approaches to corporate governance and aims they seek to reach, that is, trust has to be sought and encouraged in order to enhance corporate efficiency. Besides, mistrust and dishonesty are neither free from pecuniary costs nor from negative social consequences. Mistrust and dishonesty are indeed susceptible of destroying the very foundation of economic prosperity. After all, there actually will be no possible social organization if the given word can be taken back anytime and consequently nobody can be trusted and needless to say that quite few human relationships are founded on what each one of us knows, in a demonstrable manner, about the others (Simmel, 1987). Fortunately, trust seems still to pay and it even appears that the higher the level of mutual trust, the better performance is likely to result in organizations (Sako, 1998; Zaheer et al., 1998). Most corporate governance legislations underscore board responsibility in hiring and compensating management teams, along with the board impact on the corporate efficiency. “The board is responsible of the selection, compensation, monitoring, and, when necessary, replacement of key executives” (OECD 2004 principles, Organisation for Economic Co-operation and Development, 2004). Unfortunately, and as mentioned earlier, contractual agreements and legal provisions are proving to be inefficient in this regard and at best incomplete. In today’s business, indeed, it is difficult for the board to select efficient managers based on professional skills alone. Developing a trusting relationship with management is board key success. It seems that only acts of trust may allow board/management relationships to harmoniously last. Trust in board/management relationship has as objective the joint creation of wealth for all corporate stakeholders. Board and management are both expected to make the necessary contribution for the success of their relation (Dussauge et al., 1999) and such contribution is usually and broadly defi ned as sunk expenditures of capital but also of efforts.

270 Internal and External Aspects of Corporate Governance Trust, however, seems to work only with trustworthy managers; mistrusted managers may, indeed, see in the board/management relationship yet another utility-maximizing opportunity to be taken at the shareholders’ expenses. Further, the introduction of trust in board/management relationships does not necessarily make abstraction of all strategic considerations and more seriously uncertainty endures. Such uncertainty may last because of equilibrium multiplicity, especially for those managers willing to be responsive to trust demonstrations at higher levels of compensation only and also because of information incompleteness and asymmetry. The next section will show how trust can work in board/management relationship.

THE BOARD/MANAGEMENT TRUST RELATIONSHIP Trust is described in this chapter by a dynamic combination of two distinctive elements: (i) trustfulness of the board in the management and (ii) trustworthiness on the part of the management. Put together, these two elements will constitute the board/management trust relationship or BMTR.

Trustfulness Trustfulness can be expressed by the will of the board of directors to rely on the management team. It takes the form of a trust allowance that we call “π” and put under the responsibility of the nomination committee. On behalf of the board, the nomination committee may choose to use it, in whole or part, as an incentive for hiring new managers or compensating former managers, depending on their performance. The amount that the nomination committee will chose to award is dependent on its expectations with regard to management team performance and is represented by “ω.” One or more of the following scenarios may be chosen by the nomination committee: 1. The nomination committee of the board may choose, for example, to pay the management committee the whole allocation, thus demonstrating a maximum trustfulness in the management team, in this case, ω = π. 2. The nomination committee of the board may also decide to pay the management committee only part of the endowment, showing thus a partial trustfulness, in this case: 0 ≤ ω ≤ π. 3. The nomination committee of the board may ultimately choose not to pay the management team any compensation, expressing thus its deep concern with management team trustworthiness, in this case: ω = 0. The BMTR is resolutely a value-added process and it is assumed that any amount invested in trust activities by the company is supposed to produce a gain, that is, ω is to be multiplied by a certain multiplier greater than 1.

Corporate Governance Requirement of Trust 271 Experimental studies on the trust had normally been using a multiplier of 3 (Kreps, 1990; Berg et al., 1995; Ortmann et al., 2000).

Trustworthiness Trustworthiness is expressed here by the ability of the management team to be reliable in the eyes of the board of directors. It is materialized by the proportion of the BMTR gain (3ω amount) received by the management team and returned to the company, as act of trustworthiness and this takes the form of an additional value added to the company. The reliability of the management team can actually be measured by the extra monetary gain produced through the extra effort provided by the management team and motivated by the paid compensation. The management team, taking its responsibilities in the most honest way, eventually increases the company’s value beyond what can be expected in the absence of any compensation. The increase in value as a proportion of the overall BMTR gain is expressed by α. 0 ≤ α ≤ 100% as a percentage and can, however, take different values: 1. α may, for example, be equal to 0% of the total BMTR gain;4 this usually happens when the management team opposes a fraudulent behavior to the trust initiative. This is the situation where the management team would cash compensation and would not work accordingly. The company would not only lose the compensation granted to the management team, but also the expected increase in value which goes with it. 2. α may also be equal to 100% of the BMTR total gain, and this happens when the management team shows a complete reliability to the board. This is the case where the management team chooses to confront the board trust initiative by a total reliability and maximum performance (α = 1). 3. α may eventually be equal to a certain percentage varying between 0 and 100%, thus expressing specific levels of reliability of the management team. This is the situation where the management team chooses to work only for the equivalent of what it was paid for. For example, the management team deems it sufficient not to work more than the compensation paid to it, let’s say 30% of the total BMTR gain of 3ω, or 0.3(3ω). In this case, the gain for the entire company will exactly equate the compensation paid to the management team. The dominant belief is that the nomination committee will always take on behalf of the board decisions that conform to the trust and reciprocity requirements. An important feature of the BMTR is that different amounts of compensations can be paid to the executive committee. It seems plausible that the importance of such amounts will have a significant impact on trust reciprocity. At one extreme, the payment of 1% of π will indicate a very

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low belief in trust reciprocity; at the other extreme, a payment of 99% of π will express the company’s fi rm conviction in trust and reciprocity. From an evolutionary perspective, people with a predisposition to reciprocity and trust will be more willing to reciprocate and trust when they think their counterparts share the same values and conviction with regard to trust. The chapter assumes that the board of directors, as represented by its nominating committee and the management team are gain motivated and are also moved by trust motives, as a facilitator of trade and in compliance with the following: 1. The trust initiative of the board, with regard to the management team, is risky for the board; 2. With respect to all possible actions, board decisions with regard to trusting the management team are costly, but may end up being paid for by the company; 3. The company and the executive committee are, monetary wise, much better off in a trust relationship, compared to what they may have achieved as a profit if the board did not trust the executive committee. In any BMTR relationship, the conditions of trust may be summarized as follows: 1. Trusting the management team at the beginning of the relationship is risky for the company, as the management team may or may not react favorably to the board initiative; 2. For the BMTR to be beneficial, the management team must demonstrate reliability toward the board; and 3. To be equitable, BMTR must be a two-way road and the parties concerned must fi nd their interest. In addition, investment in the trust must produce a positive result. The next section will give a graphical representation of the board management trust relationship.

BMTR GRAPHICAL REPRESENTATION We will review the situation described earlier, where the board of directors and the management team took part in BMTR. The board participation takes the form of a choice made on the level of the compensation offered to the management team, to make it carry appropriately its agency mandate, that is, in the best interest of the shareholders (Jensen et al., 1976). On the management side, such participation materializes a wealth-maximizing strategy that can reasonably be attributed to the BMTR. The X axis in Figure 12.1 represents the gains that board of directors is expecting from the BMTR and the Y axis represents the corresponding gain of the management

Corporate Governance Requirement of Trust 273 team. This graphic is built on the assumption that the level of reliability of the management team (additional wealth creation) is described as α fraction of the BMTR overall gain. As indicated previously, the BMTR is supposed to be a wealth inducer process and for this reason the compensation awarded to the management team is tripled. It is in fact a classic working hypothesis that is often encountered in most experiment studies on trust (Kreps, 1990; Berg et al., 1995). Although it is generally accepted that the trust in business is risky, it is nevertheless established that it ultimately leads to significant gains that benefit all partners. Depending on its level of reliability, the management team will decide on the effort to provide and therefore the share to keep of the BMTR gains. We are talking here about the compliance with the company’s governance rules and the adherence to the maximization rule. This performance is actually measured by the additional gain realized thanks to the trust relationship. The proportion of the overall BMTR gain that is returned to the board by the management team is expressed by α, which may, for example, equate 0% in the case of fraudulent behavior on the part of the management team; it may also equate 100% in the case management complete reliability. It may finally equate a certain percentage ranging between these two extremes, thus expressing different levels of management efficiency. Figure 12.1 shows the overall gain from BMTR by board of directors and management team. It is built on the assumption that a specific amount ϖ is allocated to the nomination committee, allowing it to concede extra pay to a management team, based on some expected future performance

Management gain 3

π

Breakeven line (α=l 3) F (α =2/3)

(α = 1/2) Mistrust line (α=0)

G M

2 π

H π

J π

2 π

I

Board gain

3 π ω = 0.6 π

Figure 12.1

Joint board and management gains from trust.

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considered abnormal. In case of an extreme mistrustful attitude of the part of the management team, the board will not send any additional compensation and (ω = 0) (X = 0, Y = π) on the axis X. If, however, in a case of extreme trust on the part of the management team, the board would decide to send all the budgeted allocation, ω is then equal to ϖ (3 π = X, Y = 0). The basic rule is that for each amount ω transferred by the board of directors for the benefit of the management team, it will ultimately amount to 3 ω. The largest triangle FEI describes all the BMTR possibilities. While the triangle IEG represents positive gain BMTR opportunities for the board of directors, the triangle FEG represents negative gain BMTR opportunities. When the amount returned to the company is expressed as a fraction of the total amount received by the management team, that is, α (3ϖ) = α3ϖ, the following rules can be deducted: 1. The case where the management team holds all the money that is transferred, without acting accordingly, is represented by the FE segment. In this case, α = 0. 2. The situation where the management team returns only one third of the amount received, an amount equal to the initial endowment put at the disposal of the nomination committee for compensating management team high performance, is represented by EG segment. It allows the corporation to break even. In such case, α = 1/3. 3. The situation where the management team divides with the company in two equal parts the total amount received (3 π / 2) is described by EM segment and α = 1/2. 4. The case where α = 2/3 is represented by the EH segment. This is where the management team returned the 2/3 of the amount received. 5. The case where the management committee is interested in fully responding to the initiative of trust of the board of directors is described by the segment IE, and α is then equal to 1. The range of possibilities offered by the BMTR is therefore represented by the FEI triangle, and E may be regarded as the optimal solution: the Nash equilibrium in a collaborative environment, that is, the choice of nonregret, given the choice of the other party involved in the BMTR. Whenever the board of directors, through its nomination committee, decides to trust its management team, it actually puts at its disposal different trust level choices which are represented by the JK segment of the investment line ω, in the triangle FEI. Any trust decline on the part of board with regard to the management team drives the investment ω to the left until it reaches the point E, where the board trust of management is nil. Conversely, any increase of the level of board trust of management will push the investment line ω line to the right until it is confounded with the segment IF. At this level BMTR is actually maximized. It is important to underline the fact that it is the board of directors that decides of the level of trust to be involved in the BMTR. In a case of an overall

Corporate Governance Requirement of Trust 275 mistrust, it will not trust the management team, and its gain from the BMTR will be limited to the saving of the allocated compensation ϖ. In the most common case, where the board of directors trusts its management team, it will engage the whole allocation for compensating the management team and ω is equal to ϖ. Note that whatever the option chosen, the choice of the trust levels is limited to the segment SI. The best option is, however, achieved at 3ω. Whatever the level of investment in trust ω, the management team is, however, the one who decides on the sharing of the BMTR gains. It does this by choosing the level M, along the segment JK. The board may also opt for a sharing formula that is completely independent of the level of trust expressed by the board of directors. It will straddle the line EM and turn it around E. This line moves to the right when the reliability rate of the management team is growing and left when this rate decreases. In case of the total lack of reliability on the part of the management team, the EM segment is then confounded with the EF segment. Otherwise, that is, when the management team fully meets the board’s expectations in terms of trust, the EM segment is confounded with the IE segment. Figure 12.1 helps to focus on interesting information concerning the BMTR and draws some conclusions: • First, there appears to be a balance of mistrust which is described by point E; • Second, the management team may not see any advantage in responding positively to the trust advances of the board of directors, and may stick precisely by the segment EF; • Third, the management team may have interest in being fully trustworthy to the board of directors, by precisely locating itself along the segment EG; • Fourth, the situation where the management team opposes board of directors’ trust advances fairly and honestly is described by the segment EH. Indeed, along this segment both the management team and the company will withdraw an equivalent from the BMTR; • Fifth, there exists an optimal level of BMTR, where the management team and the company not only maximize their gains of BMTR, but they also ensure its equitable distribution; • Sixth, there is finally an interval of BMTR where the management team would be interested in responding with full trustworthiness to board of directors’ trust initiatives and this occurs along the segment IE. From previous observations, three distinct areas of BMTR cannot only be identified but also deserve to be highlighted.

The BMTR Mistrust Zone The triangle EFG in Figure 12.2 describes the area where the BMTR proves to be a bad choice for the board of directors. This area describes opportunities

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Management gain

F

Breakeven line (α' =1/3)

G

Board gain Figure 12.2

The mistrust zone.

for fraudulent behavior on the part of the management teams. Such frauds are believed to be even more harmful. In this regard, PricewaterhouseCoopers (2007, p. 18) states that “Most fraudsters tend to be risk-takers, or else very decisive, extroverted or career success-oriented individuals, traits that are also highly prized in management recruitment.” When facing such profi les of leaders, the board of directors should not lose time and money to convert them to an ideal of trust they certainly do not believe. The board of directors should instead devote its efforts to work more lucrative. Such area of potential mistrust is described by triangle EFG. The fraudulent leaders may not see things in the same way, and may rather consider the BMTR as yet another opportunity to maximize their own utility and will be ready to wait for the right moment to act accordingly.

The BMTR Trustiness Zone The triangle EGI depicted in Figure 12.3 represents the zone where BMTR will be paying. Within this triangle, both board and management will be gaining from BMTR; both of them will be better off. Not only each part will be gaining but also the overall gain will increase when investment in trust increases. This zone concerns managers whose needs are based on growth, fulfi llment, and self-achievement, and who are intrinsically motivated. They may

Corporate Governance Requirement of Trust 277

G

I

E Figure 12.3

Trustiness zone.

gain greater utility by accomplishing organizational rather than personal agendas. Likewise, managers, who identify with their organization and are highly committed to organizational values, are also more likely to serve organizational ends. This is a situation in which the managerial philosophy is based on involvement and trust.

The BMTR Optimal zone The EM segment in Figure 12.4 shows the region where the BMTR is maximized. The situation where the management team responds honestly and fairly to the board of directors’ expression of trust is described by the segment EH. Indeed, along this segment both the board of directors and the management team realize gains from BMTR which are respectively equivalent. This

(α =2/3)

E

E Figure 12.4

Optimal BMTR.

278 Internal and External Aspects of Corporate Governance is the optimal level of BMTR and where both parties not only optimize their gain from the BMTR but also ensure its equitable distribution. The preceding analysis allows us to realize that the board of directors is therefore in a position of adapting its employment strategies to their special performance-compensating reliability. For example, if the board of directors believes that management is likely to be unreliable, it will maximize the value of the company by renouncing any investment in trust within the management team. If, however, the board is convinced of the management team’s half reliability, it must be indifferent to the amount to be invested in BMTR, because the company value increase which may result from any initiatives will exactly equate the amount invested in trust. If, ultimately, the board feels its management team is of trustworthy, it will maximize the company value by maximizing its investment in trust. Indeed, all amounts invested in trusting the management team will be returned with a premium positive. These results are obviously interesting for the boards of directors because they may allow the right selection and the hire of appropriate management teams in accordance with well-established criteria based on well-defi ned psychological profi les, thus avoiding many pitfalls.

Ethics and Market Value The fi nancial research does not agree on whether the market can pay for ethics in business. The situation is, however, changing, and many signs are pointing toward the recognition of ethical behaviors as components of market valuation. First, recent resounding corporate crises have been instrumental in rending ethics recognized by market actors. Indeed, some of the largest and most prestigious companies have seen their well-fortified status tumbling down, due mainly to breaches of ethics and good governance. This situation is forcing companies to look for ways to shield themselves from extended ethics damages. It also appears that most companies, especially the largest, are beginning to fear the deterioration of their public image; 33% of companies among the Fortune 500 appear to be in this situation. Indeed, the fi ndings of the Weber Shandwick (2008) survey of 950 business executives in 11 countries indicates that the market seems to take into account ethics and reputation in its assessment of companies. Second, it seems that most companies, especially the largest, start fearing ethic reputation deterioration and damages (33% of the Global Fortune 500). Indeed, Weber Shandwick, with KRC Research, conducted in 2006 a survey of 950 business executives in 11 countries and explored the relationship between corporate responsibility and reputation management. The fi ndings of the survey seem to point out to the consideration by the market of ethics in its valuation of companies. Significant differences in reputation damage fears exist. The survey noted that European executives seem to

Corporate Governance Requirement of Trust 279 be more sensitive to ethics than their counterparts in North America and Asia. Whatever the region, Europe, America, or Asia, “executives consider fi nancial wrongdoing and unethical behavior the most significant threats to reputation.” Companies appear also to be more aware of the fact that ethics is an imperative to market expansions and conquests. They are now aware that ethical companies are able to more easily attract the best talent, the best employees and good customers, suppliers, and investors. The supposed benefits of ethics make it increasingly present in companies and give it the necessary legitimacy for its development. The Weber Shandwick study detects signs that companies are starting to go beyond their traditional fi nancial targets for ethics considerations. They are also demonstrating that management strategies with social flavor can produce positive and measurable impacts on profits. The companies’ success seems also to be more significantly dependent on their ethics: It’s life under a magnifying glass today for companies and their leaders. No ethical lapse, moral misstep or other corporate misdeed—real or perceived—goes unnoticed. CEO and corporate behavior are watched, critiqued and communicated around the world at breakneck speed by everyone from early morning news anchors and newspaper columnists to bloggers, chat room visitors and whistleblowers. (Weber Shandwick, 2008) Although ethics is often discussed and its failure seems to start to be feared, its consideration by the market as an important company evaluation factor is slow to spread.

INTERCONNECTION WITH OTHER CORPORATE GOVERNANCE DEFENSE MECHANISMS In the area of trust in business relations, a large gap separates the desirable from the possible, although trust seems to be a social value deeply rooted in most people, because of history and religion. Further, “As the global economy makes us more and more reliant on ‘strangers,’ and as our political and personal relationships become more complex, Building Trust offers invaluable insight into a quality none of us can flourish without” (Solomon et al., 2003). Trust appears, therefore, to be the basis of all human relationships and particularly of contract law, which serves “as the main legal bridge toward substantiating the social norm of trust” (Bukspan, 2008). Consequently, trust can impact all other corporate governance defense mechanisms, particularly contract arrangement and regulations.

280 Internal and External Aspects of Corporate Governance Contractual agreement and regulations play for fraud detection the role of night-vision lenses: you can only see where you direct your eyes and you miss the rest. Trust allows having a more complete view of the situation.

CONCLUSION Although the modern business world is modeled on the basis of opportunistic behavior, based on calculations and economic rationality and where trust has virtually no place and seems to be considered only as a last resort and in situations where there’s nothing to lose, this chapter concludes that board–management trust relationship seems a matter of choice. The manager team chooses to be reliable and their choice seems to be contingent on their trustworthiness, and the board also seems to choose to create a trust relationship, depending upon its perceptions of such managers’ trustworthiness. Consequently, the chapter underscores the importance of trust in board management relationships and emphasizes the fact that this will work only with trustworthy managers. Mistrusted mangers may see in the trust a means of their own utility-maximizing opportunity to be taken at the corporation’s expense. The determination of managers’ psychological profi les becomes therefore a serious business, and it may be proof of one of the most efficient ways to differentiate beforehand between trustworthy and mistrusted management behaviors. The trust has, however, little chance to establish itself as an important mechanism of corporate governance, unless a new cultural orientation, rewarding its use, is reintroduced.

COMPREHENSIVE CASE 12.1

The Theory of Moral Sentiments You can find a discussion of the Theory of Moral Sentiments in Wikipedia at: http://en.wikipedia.org/wiki/The_Theory_of_Moral_Sentiments. Smith’s conclusion from 1759 has tremendously contributed to modern economic thinking. In fact, moral sentiments presage the emerging field of behavioral economics (Ashraf et al., 2005). Smith believed that there were certain virtues, such as trust and a concern for fairness, that were vital for the functioning of a market economy. Discuss Smith’s argument in favor of trust in business relations.

13 Corporate Governance The Road Ahead

With the corporate world and the whole fi nancial system rocked by revelations of conflict of interest, undue political influence, malfeasance, negligence, frauds, and greed, new ideas need to be advanced to save the free market system (Emmons, 2003). This, the most ingenious system mankind has ever invented, is calling for reform. Venturing any serious prediction of the consequences of continuing crisis will surely prove to be hazardous, but one can wonder if the current crisis is not actually an unprecedented systemic failure; for this reason most observers are taken aback by the turn of events and are jaw dropped in astonishment. There is, however, a general consensus that the amplitude of the disaster requires a broader approach, and that it is important to think of what lessons should be learned for the future. We show in this book that corporate governance should be looked at as a systemic issue, rooted in human values—a form of puzzle having some of its components anchored in the organization, while others are originating from outside it and corporations are but mirrors of the conditions prevailing in society. When organizations are appropriately governed, it is suggested that the entire fi nancial system of governance will be operating efficiently and the reverse occurs in a contrary situation. One thing is clear: the actual crisis is seriously endangering the free market economic system by establishing a bona fide crisis of confidence and “historically, such a crisis has been proven to be extremely dangerous” (Moss, 2008). Unfortunately, analysis about governance crisis has frequently concentrated more efforts on the damages of the problem than on the possible cures or origins, and “thus, rather than advocating robust solutions, they tend to provide narrow answers to the identified problems” (Thomas, 2008). We tend to think of the current governance crisis as a detailed, uncontrollable force that no one understands, although this is actually a direct consequence of a specific decision-making process adopted by people who were individually making decisions to approve, pass on, and cover fraudulent transactions. This chapter discusses the real sources of the current governance turmoil, and suggests ethical corporate governance as a solution. It is possible, indeed, that the current crisis may take time to resolve and that “it will be a whole new ballgame that takes many years to play out” (Light, 2008).

282 Internal and External Aspects of Corporate Governance WEAK CORPORATE GOVERNANCE’S DISASTROUS EFFECTS Corporate frauds are incredibly evasive issues and like moving sands in a swamp, you would know they are out there, but you would not know when you are to face them. Fortunately, there are some precursor signs that allow for locating them in advance and that merit has to be considered. Corporate frauds have several disastrous effects; they can be of micro, individual, and macro origins. Corporate fraud’s micro effect concerns the corporation, mainly because frauds introduce into corporations a culture of greed, and a greed system does not tolerate any dissidence and consequently tends to neutralize any alternative management system. Frauds establish a kind of feudal regime, similar to those found in Middle Age states, and where the lord makes decisions without compromise or appeal. He, for instance, compensates and punishes, based on his prevailing mood, and it does not take much time for subordinates to adopt similar attitudes, which are forwarded to their own subordinates. Quickly, the organization is transformed into a wellstructured machine of greed that scarifies efficiency for personal interest, and quickly the entire organization is no more than an organized privilege system. Employees’ frustration usually translates into selfish priorities, where corporate objectives weigh little and the corporation fi nds it difficult to create wealth, for itself and for its shareholders or society, but only for its executives. Siemens, the German electronic giant, for instance, used to have three “cash desks” set up in its offices, and managers used to bring empty cases and fi ll them with cash to make payments to corrupt officials and politicians around the world in order to win contracts (The Economist, 2008a). What do you expect these “trustworthy” managers to do the next time they have the opportunity to fi ll up their suitcases again? Furthermore, corporate management should always worry whenever its core business is suffering from the decline in the ratio of its operating cash flow to income. Such a decline normally occurs when a company reports earnings that are not backed by cash flow and can be considered a forerunner sign of fi nancial troubles yet to come. When the fi nancial system fails, everyone suffers. At the individual level, there are people who were very, very well off one day and were virtually destitute the next because of frauds. Others lose their entire retirement funds and have to rely on state help later in life, but only where such help exists. Overall, although part of the burden of the fi nancial crisis is born by wealthy investors who may afford it, there seems to be throughout the world an externalization of costs of fraud on those who are not responsible for them and who are unable to cope with such burden. How many people lost their job and the dreams of decent lives which go with them? Hundreds of millions of new houses, all over the world, are empty and nobody to buy them. Hundreds of millions of workers are laid off, and everywhere good

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businesses are going bankrupt and jobs are being destroyed. “For the fi rst time since 1991 global average income per head is falling. Even as growth in emerging markets has come to a halt, the rich economies look set to shrink” (The Economist, 2009a). Above all, small investors were encouraged to enter market adventure without it being explained that whenever they enter the market, they are in fact selling a risk-taking service, whose price (return) is a direct function of the level of risk to be assumed. At the macro level, the fi nance theory suggests that when capital markets are efficient, in equilibrium, every risky asset must be priced so that it falls on the market line AMB in Figure 13.1. It is therefore easy to understand that fraudulent mangers will try to locate market price of the organization under their control, within the fraud zone. Consequently when an asset risk is known to investors, its required rate of return will also be known. The market suffers, however, from much inefficiency, as discussed in previous chapters, in a way that it is possible for any fraudulent corporation to report false information to investors, causing them to mistakenly overevaluate corporation shares, as in the graph in Figure 13.1, although its real value should be located at the point R, ending up thus not paying investors enough return for the risk taken. Complacent investors are therefore twice cheated. When a sufficient number of corporations drank from the toxic water of fraud and got trapped by the liquidity trap, investors got scared and confidence in the fi nancial system and its main institutions is weakened, and everybody suffered. One can only wonder why investors were not suspicious enough of the unnatural returns offered to them by fraudulent corporations. In the case of Madoff, for instance, some of his clients who put their faith in him

βa Figure 13.1

β =1

βb

The risk return trade-off and fraud.

284 Internal and External Aspects of Corporate Governance suspected that he was engaged in some wrongdoing, but not to the point that would endanger their investment. They thought he might be trading illegally for their benefit on insider information (The Economist, 2008b). The Stanford International Bank is yet another flagrant example of such cupidity; investors were hoodwinked over the safety and liquidity of uninsured certificates. The bank consistently offering rates well above those of other banks, sometimes more than twice as high (The Economist, 2009b). Sooner or later, fraudulent corporations are caught by what we call the market trap. Although the market has no way of verifying the veracity of the reported information by corporations, it has, however, an implacable protection mechanism: its requirement of a dividend at the level of the reported information, whether fraudulent or not, and what usually starts as a marginal fraud continues to grow over the years until it attains irreversible effects. Unable to cope with the lack of liquidity, fraudulent activities will have but one way out, which is bankruptcies (Enron, Satyam, Salomon Brothers, and the like), bringing with them, in despair, hundred of thousands of small and large investors. The tragedy is that throughout the world costs of frauds have been excessively externalized on those who are not responsible for them. Up until recently, hundreds of trillions of dollars of world wealth have already gone up in smoke. The Dow Jones, for instance, which was trading at about 13,000 in May 2008, was trading at around 6,500 this March 3, 2009. It is suggested that each point of the Dow Jones industrial corresponds to one trillion dollars. This is a loss that equates and even exceeds thousands of times the annual budget of half of the countries of the world. Talking about budget, the credit crunch has also deeply impacted most emerging and developing countries’ current accounts, and the huge expected deficits for 2009 need to be fi nanced but international capital has become scarce.

THE SOURCES OF THE PROBLEM The modern fi nancial system has been heavily impacted by Smith and Friedman’s thinking. Some two hundred and thirty years ago, Adam Smith strongly made the case for self-interest when he wrote that “it is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own self-interest.” Smith’s self-interest view does not limit itself to money, but was intended to include individual protection of reputation and its sensitivity to other social values. Friedman overbid some hundred and fi fty years later, by asserting “that corporations have only one responsibility: maximizing profits for owners,” especially that they are typically and fundamentally entrusted by their shareholders to accumulate wealth for them. Although this is true, businesses still have, at the very least, an obligation to comply with the law and the prevailing social morality and even the pure profit

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maximization rule may imply certain types of ethical behavior, because fi rms may worry about their long-term reputation. Neither Smith nor Friedman would advocate sacrificing long-term profits by acting unethically today (Glaeser, 2009). Many sides of the modern fi nancial model are undeniably admired, especially its performances, its liquidity, the depth of exchanges, and the huge amount of money that can be collected in markets, not to mention the relative success in enhancing economic democracy, by submitting the socioeconomic decision making to a larger number of shareholders. More than any other fi nancial system in history, the modern system allows more ease in performing a large number of fi nancial transactions. Such dynamism and possibilities for private wealth accumulation constitute a strong appeal for most investors around the world. The recent vibrant economy and unprecedented possibilities for private wealth accumulation have brought about some changes in corporate governance systems around the world, and this has even led some local elites in many countries to bargain some of their secular privileges in exchange for more extended opportunities. Such a revolutionary fi nancial model is today seriously surrounded by dangerous revelations of greed and malfeasance of all kinds, to the point where its survival is at stake. Let us be clear: the free market system, as exchange mechanism, has no new weakness that may explain the current crisis; it is the weak trustworthiness of its multiple players and intermediates that create the problem. Indeed, stories of fi nancial frauds, scandals, and questionable ethical behavior in the business and professional world constitute the free market’s daily share of misfortune. The nonrespect of the basic honesty rules by major market players and intermediaries is increasingly becoming a major management problem and seriously threatens not only companies’ ability to persevere as going concerns (Enron, 2002; Madoff, 2008) but also the fi nancial system as a whole (banking crisis, exchange crisis). Quite naturally, distrust and dishonesty abound in situations that have progressively and insidiously created the need for mandated performance and have addicted modern organizations to complex laws and regulations that are designed to bring about the standards of fairness that ethical principles would dictate and that were actually cleverly transformed into limits to zones where fraud is permitted. Law and regulations will never be enough, and recent events tend to show how fragile the modern fi nancial system is and how it cannot be fi xed by law and regulations only. They also demonstrate that one of the most striking features of corporate governance practices in recent years is that greed appears to be widespread and can be quite pernicious. Many elements have significantly contributed to the deterioration of the situation, and what once was thought to be a financial fraud limited to the corporate sector has established itself as a whole system disaster. It is, may be, for this reason that the suggested solutions to date fall short of solving the problem, due mainly to their inability to tackle the issue as a whole.

286

Internal and External Aspects of Corporate Governance

As the fi nancial crisis takes hold across the globe, companies face tough choices and are submitted to hard circumstances. While it may not come naturally to mind, improving corporate governance will be vital in making the most beneficial use of the situation (Salazar, 2008). Indeed, effective decision-making processes, transparency, robust risk management, optimum internal controls, and reliable regular reporting are needed to attract and sustain the confidence of shareholders. All these may not, however, be enough and here are some more complex issues around the governance crisis that may not just revolve around classical governance issues: are investors, for instance, really acting like owners? Are corporations ready to take the challenge of adopting more human values? And are the fi nancial market players really committed to better corporate governance or is it really just a money game? “For as long as the world economy was growing fast, fi nancial markets commanded grudging allegiance” (The Economist, 2009a), and it is obvious that most, if not all, market players have accommodated themselves with the systemic weak governance that prevailed and have contributed significantly to the flourishing of the system under attack today, and it is fair to be concerned about the entire fi nancial system’s weak governance. Take, for example, shareholders over several past decades: they were increasingly requiring companies to create much more value for their shares than the economic fundamental will allow. Led by aggressive institutional shareholders, they were demanding that managers be given more incentive to focus on such abnormal objectives. They were virtually considering hiring unscrupulous mercenary managers to do the job, while ousting or marginalizing at best, honest managers. Such requirements have resulted in the exploding blend of fraud and greed we are facing today. There are, of course, executives who create enough wealth for their organizations and for which they deserve to receive outstanding compensation, but most managers were, however, faced with the impossibility of constantly creating value, as required by market players, and have succumbed to the temptation of using some orthodox means of cooking the numbers for the sake of betraying the market. Actually, it is like requiring A grades from a C student. What would one expect? As expected in the face of the current fi nancial disaster, society seems ready to impose some social values back on the corporations, but they were apparently resisted at every turn, mainly because they were wrongly perceived as wealth- and power-decreasing measures. The business community is vigorously opposing any rule which may curb its freedom and it is making it clear that the only way for the public to protect its interests is still through the enhancement of market mechanisms. Markets require, however, honesty and faithfulness; “they require trust and faith in the integrity of data and information and in the reliability of promises. Even more, they depend on the existence of principles, standards, and well-understood rules that defi ne how the system operates” (Clark, 2003). In front of what might

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be seen as a failure, the business-consulting community is transforming corporate governance principles into management tools that exist by themselves and creating thus a new and very lucrative market. Accounting fi rms’ revenues, for instance, have never been so high, as after the recent corporate governance reforms, despite the fact that their responsibility in most failures need not be proven. The corporation, once the engine of economic development, has been indeed transformed into an implacable means of virtual or real wealth accumulation, power concentration, and political influence. Its managers have reinvented the cult of personality, and are worshiped and generously given gifts for performance they have never achieved. Consequently, the corporate concept that was intended to be a strong means of wealth creation, supposedly to be equitably distributed among citizens, is instead deviated to be a wealth discriminating mechanism, where very few take advantage of the mass of small shareholders. Corporate functioning gains distribution should indeed be rethought, but more seriously a perfidious cycle of greed has been introduced throughout the whole financial system with the blessing of corporations’ boards of directors which allowed it to happen and go unchecked (Lorch et al., 1989). Historically, boards of directors often have insufficient access to corporate information and are usually put in a position where they cannot satisfy their responsibilities efficiently. Further, some boards don’t even invest the required time for ensuring an effective management activities’ oversight. In behaving in such a way, boards are actually discharging their ultimate duty, ensuring proper leadership for an organization (Lorch et al., 1989), and this has another side effect, translating in boards’ committees not doing their jobs responsibly either. It is actually unreasonable to expect more from boards. “Their members, after all, are part-timers, and while they’re expected to be independent, they have to rely heavily on managers and auditors for information” (Lorch et al., 1989). Boards’ inefficiency is always comforted by managers’ complacency, leading to situations where everything seems usually to be going well, even when it is not. On the other hand, management separation from corporate ownership creates an impacting situation hardly discussed in the literature: the division of managers in two groups, the true and the fakes. True managers are out there to manage corporations and the fakers are out there waiting for personal opportunities to occur at the corporate and shareholding expense and at the same time making it hard for true managers to do their job or even last in organizations. Their endeavor is rendered easy by the natural abdication to responsibility of honest managers in this kind of circumstance. Fake managers prove to be even more dangerous whenever board rooms become accessible to them; they tend to take their tricks and pranks as management competencies and the result is often disastrous in the long run. Fake managers have flourished with the enforcement of oligarchic corporate structures, where CEOs, with help with major shareholders, easily institute a fraud authority hierarchy within corporations and proceed to

288

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the usurpation of shareholders’ authority and set the corporate agenda. They consequently decide the whole corporate run-up and the salary to be paid, that is, hundreds of times the wages of their average employee. Each CEOs of an S&P 500 has made, in the crisis year 2007, a salary of $46,666 a day or $100 a minute. This result translates indeed into an insane situation where sometimes a single individual is granted a compensation which is higher than the total remuneration of all his corporate employees. Some corporate managers seemed to have certainly forgotten that their remuneration was originally designed and awarded on the assumption of honor in execution and competency. Should these super managers be reminded today that the actual crisis is no more than the expression of incompetence in risk management, supposedly of their responsibility? Would you trust a ship captain who does not prepare for facing a storm while crossing the ocean? Able captains can indeed be identified on stormy days only. Are not we in position of requiring reimbursement of huge compensations from fraudulent and/or incompetent managers? Have not they been paid for the things they have never done? Despite such management failure, these new kinds of supermen and, to a lesser extent, superwomen are yearly voted huge divine compensations, even when corporate performance is on the negative side. The phenomenon is not, of course, limited to corporate managers and can be encountered in sport, show business industry, and the like, but this fact does not dismiss corporate revenue sharing among stakeholders from its unfairness and not only at the individual level, but also at the national and the international levels. Corporations, which have become the predominant means for concentrating and distributing wealth in free markets, are operated with the narrow goal of enhancing the wealth of their managers fi rst and shareholders second. “The result throughout the world has been to increase the wealth of the already wealthy and to externalize the costs of wealth maximization on those who are not” (Mitchell, 2009). Executive compensation plans are phenomena that frustrate most investors and may have contributed significantly to the erosion of market confidence. Investors and citizens are still wondering why executives are in such a high salary bracket and calls for reform have proliferated, asking for the independent board compensation committees to develop, review, approve, and monitor executive compensation arrangements. Lately and as a result of the many corporate scandals that have involved executive pay legislators, courts and regulatory agencies have focused their attention on how governing boards may or may not have effectively reviewed executive compensation arrangements (Peregrine et al., 2006). It seems that in most cases where big excesses were identified, they had to do with compensation committees not holding the line. “They granted packages that ensured their executives would receive above-average pay even though all executives can’t be above average” (Hall, 2003). It seems, however, that fi rms with large institutional block holders are to benefit from more freedom and

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perhaps more accuracy in fi xing their compensation plans and may suggest that block holders may play a monitoring role in this area. Further, there are few business activities that have received as much media attention and provoked as much anger as excessive executive compensation, yet “there was little evidence that companies have changed their compensation practices in response to harsh criticism” (Core et al., 2008). Signs are indicating that the regulatory structure did not keep pace with the changes that have affected the fi nancial and the corporate governance systems during the few recent past decades. Public intervention in market economy is, however, often decried on the basis of the interconnection of economic freedom with political freedom (Friedman & Friedman, 1980). It is actually feared that government intervention may end up hampering information disclosure and thus diminishing market efficiency. Supporters of government interventions believe that government has the legitimacy, even the obligation, to intervene in defi ning and enforcing basic market principles; they usually, however, fail to indicate how strong such intervention should be. The controversy surrounding government intervention in the free market economy may explain government hesitation in many countries, with regard to the solution to be opposed to the current fi nancial crisis: they are torn between their strong obedience to the Reaganism-Thatcherism philosophy stemming from Friedman’s model, and the ferociousness of the actual fi nancial crisis. The Reaganism article of faith resides in fi nancial deregulation and was backed by most liberals around the world. Its main argument is that regulations stifle innovation and undermine competitiveness. Deregulation has led to intense competitive pressures “to which fi rms responded by deploying more capital and seeking higher returns” (Clayton, 2008). Deregulation is also blamed for the lack of transparency and the lack of understanding about the values of many assets. It had also encouraged innovation in all sectors, including the financial sectors, where its damage is today at the core of the current crisis. Indeed, innovative new fi nancial products have contributed significantly to the loss of control of the market by the monitoring agencies. Although “previous fi nancial crises did not cause us to seriously question our informational architecture like this one has” (Yellen, 2008). This crisis, while weakening monitoring activities, has increased market inefficiencies and wiped out or discredited major sources of fi nancial-market information that are crucial for fi nancial markets to function. Although confronting crisis by regulations may present their own potential unintended consequences and some companies, sources of the current governance crisis, are among the most regulated entities, there are, nevertheless, numerous studies suggesting very impacting inefficiencies in the stock markets by detecting high abnormal return behaviors that even the most convinced free market defenders recognize and they are usually the work of the major market players. There are several sources of market inefficiencies, information asymmetry, regulatory arbitrage, and market impeders.

290 Internal and External Aspects of Corporate Governance Information asymmetry describes the situation where managers are more or better informed than investors, and this often creates an imbalance of power in transactions and leads to inefficiencies in the market. Examples of such problems are a moral hazard, describing the situation where managers insulated from risk may behave differently from the way they would behave if they were fully exposed to the risk. Regulatory arbitrage consists of manipulating legal rules for fi nancial advantage. This is the work of big market players, individuals, corporations, even larger economic bodies, such as states, acting either irrationally or egotistically (too rationally). Some of the inefficiencies are actually the direct outcomes of these “non bona fide” market participants’ activities (Vaknim, 2003). By acting in such a way, these large market players become “value substructures” rather than being “value adders.” Because they contribute to the reduction of the level of trust in the marketplace, they, therefore, create a negative value added and tend to feed off market inefficiencies and imperfections and, by their very actions, enhance them (Vaknim, 2003), under the helpless eye of monitoring agencies. Market impeders, fi nally, are actions that keep that market from functioning smoothly. The most known is the trade restricting arrangements: monopolies, cartels, trusts, and other illegal organizations. The short and the long of it is that competition enhances and increases efficiency and that, therefore, anything that restricts competition weakens and lessens efficiency. The deregulation wave that has swept the whole fi nancial and business spectrum during the last few decades has had a direct effect of weakening the corporate and market monitoring activities. After ensuring the weakening of the monitoring activities and by advancing the free market philosophy, corporations made sure that the auditing activities were obedient, mainly through generous consulting contracts. The external auditors and the rating agencies are obvious examples of confl icts of interest in the fi nancial structure; the market is another. External auditors and rating agencies are assumed to solve an asymmetric information problem between corporations and investors by giving those doing the investment a reliable assessment of the riskiness of fi nancial investments and they seem to fail frequently (Yellen, 2008). “In some cases they collect a large fee and provide little more than a clean bill of health to an unhealthy client” (Richard, 2008). On this basis, Fannie Mae later sues KPMG for failing to report lapses in accounting until a government report found many weaknesses, and “Ernst & Young was also singled out for the clean bill of health it gave Lehman Brothers, just two months before it collapsed” (Reddit, 2008). XL Leisure Group is yet another example. This, Britain’s third-largest tour operator, fi led for bankruptcy in September 2008, leaving thousands of holidaymakers stranded. It issued a set of accounts, signed off by its auditors, that gave no hint it was about to go under (The Economist, 2008c), and cases similar to XL Leisure Group can be multiplied by thousands. Auditors were sometimes working in connivance with clients. We relate

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here the case of auditors hired by investment banks to identify the bad apples in the barrel and pull them out, that is, borrowers with payments they couldn’t afford, houses with inflated appraisals, people lying about their income. After, however, much talking, the supposed bad apples were put back in the barrel. The investment banks had a strong fi nancial incentive to do that. “They put the bad apples back in the barrel because they knew that they could sell the bad apples along with the good apples and, at least in the short term, nobody would know the difference” (Arnold, 2008). They may actually make more money behaving that way and this is known in the fi nancial jargon as “passing the trash.” Another area where external auditors have clearly expressed their inefficiency and proved their significant contribution to the market decline is the so-called backdating transaction, involving setting the strike price of an option retroactively to a day when the stock traded less expensively. An option with a lower strike price is more valuable because it costs less to exercise and has a higher return. The deluge is growing daily, with a fresh batch of companies announcing stock option accounting problems undetected by auditors, and it is pretty clear by now that the stock option backdating scandal is much more widespread than initially believed. The accounting profession is also attracting attention on the possible impact of nonaudit fees on auditors’ independence because “providing substantial amounts of non-audit services to clients may make it more likely that auditors concede to the wishes of the client management” (Basioudis et al., 2007). This is especially the case when diffi cult judgments are made. Overall, external auditors’ reputation is seriously tarnished and they are subject to more and more criticism, and the question “So where are all those expensive auditors who are paid a great deal of shareholder money to catch such problems?” is more often asked. But just as in past accounting scandals, auditors are trying to run away, or at the very least, blame the accounting rules (MacDonald, 2008) or advocating rating agencies. “No doubt the auditors were relying on the credit ratings agencies, which had so many of these things rated AAA” (Reddit, 2008). The damage is, however, so widespread that the auditors may not get away with it this time. Indeed, recent governance reforms were supposed to ensure that auditors were doing their job correctly and no matter how you look at these issues, most would agree that the system needs outstanding fi xing. The other serious threat to the fi nancial architecture comes from the credit-rating agencies that miss the mark (Moss, 2008). They are recently very often suspected of confl ict of interest. There have been concerns that these agencies were paid fees by the issuers of the debt instruments they rate, driven by confl icts of interest. It seems that they did not hesitate to boost mortgage investments that have lately collapsed and “just as Juvenal wondered who guards the guards, the international fi nancial community is wondering who rates whom?” (Mainelli, 2003). Although the concern was

292 Internal and External Aspects of Corporate Governance more frequently expressed towards the international auditing and accounting profession, credit-rating agencies surely share the same blame. “In some ways, governance of credit rating agencies is a thornier problem than the governance of auditors” (Mainelli, 2003). Credit-rating agencies would like to be seen as operating in a competitive market and adding value for their customers, yet the fi nancial community perceives their activities as “controlled by a duopoly—Moody’s and Standard & Poor’s—or at best a triumvirate—if Fitch is rated in the top group.” There is a feeling that too much power is left in too few hands and pressing voices are inviting for monitoring such power and market dominance (Fight, 2001). The frustration of the fi nancial community has gone as far as to question the usefulness, the quality, and integrity of the ratings themselves” (Mainelli, 2003). Indeed, a recent SEC report found serious weaknesses in the practices at Standard & Poor’s and Moody’s, as well as Fitch’s ratings. A lack of disclosure of conflicts of interest and a lack of oversight of such confl icts were mentioned.1 Frustration with rating agencies is so strong that some critics even claim “that rating agencies can be compared, in certain cases, to protection rackets. They cite the practice of unsolicited ratings whereby the credit rating agencies rate an organization ‘in the public interest’ and then appear to improve the rating subsequent to being paid by the organization” (Mainelli, 2003). Academicians themselves, except for a very few, are blamed for not being able to denounce frauds, despite the huge amount devoted to academic research. Financial analysts have their own share in the current fi nancial misfortune adventure. They are generally classified in one of three broad categories, depending on the nature of their employment: sell-side, buy-side, and independent. Unlike sell-side analysts, buy-side and independent analysts typically are not associated with companies that underwrite the securities they cover and generally have few, if any, other confl icts that could impair the objectivity of their research. Investment analysts are assumed to serve to reinforce market efficiency by structuring information and offering insights and analysis on listed companies. They may also present a real risk of conflicts of interest, especially for those on buy side. Their failure or success is the function of their performance. “Thus, their interests generally are perceived to be more aligned with those of the money managers they work for and those of their clients” (IOSCO, 2003). It becomes obvious that the sellside analyst’s work in an environment overran numerous undetected confl icts of interest and invisible pressures. Sell-side analysts are usually faced with the dilemma of seeing their client success and at the same time being submitted to factors that can create tremendous pressure for performance and impair their objectivity. These performance requirements may create reason for issuing recommendations that confl ict with investors’ interests and economic fundamentals. A number of potential confl icts of interest faced by sell-side analysts generally arise as a result of (IOSCO, 2003):

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• The various commercial activities pursued by full-service investment fi rms; • Analyst compensation arrangements; • Financial interests in covered companies held by analysts and their fi rms; • The reporting of relationships within full-service investment fi rms. Actually, fi nancial analysts make huge bonuses when their business unit is making big returns. So the faster they could fi nalize a deal—good, bad, or ugly ones—and sell them to investors, the more money that they made (Arnold, 2008). Other parties involved in corporate governance observance deserve their share of blame. Many governance advisory fi rms that compile indexes that are supposed to evaluate the effectiveness of a publicly held company’s governance practices fail to do their job appropriately (Stanford School of Business, 2008). And what about those educational institutions that did not see the crisis coming despite the huge amount of money devoted to research? They could have at least decried the disastrous trend that developed over a long period of time. The contributions of corporations to education and research may have something to do with this situation. The mission of any educational institution is to educate future executives who will make a difference in the world of business, and who will make the world a better place to live. The primary responsibility of educational institutions is to shape and influence the generations of leaders joining our economy and our systems, and to help them understand what creates an outstanding organization: what makes markets work, and the importance of trust and integrity in such process. Facts in the area of education force us to conclude that there is currently a lack of ability of our educational institutions in training honest and competent executives. How can we explain the inability of many executive to see the crisis coming? They basically fail to use an efficient risk management policy they should have learned in their university classes. It seems that virtually every aspect of the fi nancial governance system in the economy has significantly deteriorated during the last few decades; standards have eroded, principles are no longer respected, and individual malfeasances have flourished. “In situations like this—when conflicts of interests arise, and when the institutions no longer provide clear guidance and a framework for action” (Clark, 2003), individuals become easy prey to many facets of temptation and the potential for wrongdoing becomes stronger. Faced with all theses facts, it is therefore not surprising to see confidence in markets vanishing and to question the role of regulating agencies in preventing the current crisis. “In other words, if the market has a fault, it is not that it is irrationally spooked today, but that it was irrationally complacent in the past, . . .” (Zingales, 2008).

294

Internal and External Aspects of Corporate Governance

THE MARKET FOR SAFE PASSES Financial activities in capitalist economies are heavily organized around intermediation, whether fi nancial, regulatory, or informational. Intermediary institutions are consequently central for the fi nancial system monitoring and economic growth. Financial intermediaries are part only of the whole intermediation system; they are fi rms that borrow from consumer/savers and lend to companies that need resources for investment. Other intermediaries of nonfi nancial nature play a very impacting role in economic activities. We can mention, for instance, intermediation in credit rating, in auditing, or even in compliance with rules and regulations. Information in intermediation activities lacks transparency and is subject to much criticism, especially with regard to confl ict of interest, as discussed earlier. Given the number of failures when performing their jobs appropriately, intermediation activities appear today like a market for safe passes, allowing buyers to cross the gate of standards and regulation or to ensure access to the fi nancial market. Figure 13.2 summarizes the situation; intermediaries appear like bargaining ethics principles for fees. They tend to allow clients to respect the form of laws and other requirements, with disregard to the principle. KPMG, PricewaterhouseCoopers, BDO Seidman, and McGladrey & Pullen all gave a clean bill of health to the numerous funds invested with Bernard Madoff and his asset-management fi rm (Gandel, 2008).

Figure 13.2

The market for safe passes.

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The process appears to be simple: standards setters and regulators, often dominated by intermediaries’ representatives, set up the rules, and intermediaries, given their common oligopoly positions, gain exclusivity. Intermediation mechanisms seem these days to be used regardless of their usefulness. There is indeed a serious risk that intermediation may be used not for its intrinsic value but rather as safe pass for regulatory constraint or market access barriers. Further, whenever market discipline is removed, intermediation increases risk for users. Indeed, whenever intermediary agencies are in oligopoly position, users usually have the tendency to shop for the less demanding and the more compromising agencies, because all agencies are able to ensure meeting regulatory requirements or gain access to the capital markets, even if it is for the wrong reasons. In view of such a race for mediocrity, agencies will inevitably lower their professional requirements. Confl ict of interest is usually backed up by the existence of powerful vested interest groups, from which most economies of the world seem to be currently suffering. These are groups deeply rooted in local and national political structures and which dominate economic activities. They generally contribute to the undermining of healthy market functioning as well as democratic political institutions. Powerfully vested interest groups continue, indeed, to benefit from generous government support and enjoy protected oligopoly position. Aware of their undue privileges, vested interest groups have always taken the valuable precaution of being represented in government spheres, either directly or by standing alliances. Such unfair public protection usually acts as a deterrent for anyone who might react against their insensitivity and arrogance. Conflicts of interest in the intermediation market is even facilitated by what we call the “accounting accordion syndrome,” which sheds even more doubt about the ability of the current accounting system to give fair financial positions of companies. The current accounting system is actually becoming no more than a collection of disparate items having different origins and submitted to different models of evaluation. It was, in our view, a big mistake to depart from the historical cost model. Although the search for the fair value can be no more legitimate, such endeavors should have been made outside of the classical historical model. Originally, accounting was intended to play a notary role and it was progressively introduced to play an evaluation role, for which it was not prepared or conceived. The draft proofing continues. On December 2008, for instance, the FASB and the IASB released a joint discussion paper suggesting a new model for the recognition of revenue, thereby changing the landscape for both US GAAP and IFRS. Revenue is a significant item for all reporting companies and any changes in the revenue recognition model can have a fundamental impact on a company’s results. Furthermore, “Earnings management is most likely to occur where there exists vagueness and subjectivity within Accounting Standards. Upon application of these Standards, management is permitted to exercise a certain level of judgment or discretion in the determination of the reported accounting numbers” (Wells, 1997).

296

Internal and External Aspects of Corporate Governance

THE SEARCH FOR A CURE Corporate governance crisis “becomes global crisis and requires a global response, preferably by an institution that is inclusive and that has political legitimacy” (Stigliz, 2008). Nothing can affect economy more than investors’ loss of confidence. Indeed, when people don’t have a fi rm belief in future success, they will inevitably refrain from investing their time, energy, and capital in ways that will discourage the economy’s growth. Investors’ confidence has been undermined in many ways over the last two decades. Overall, pervasive confl icts of interest and outrageous impunity have caused the current backslash of confidence in the fi nancial system and institutions and the current turmoil that costs the world a large amount of wealth (several dozens of trillions of dollars without any offset in gains) “and this is not simply a liquidity crisis or simply a problem of a messed-up fi nancial system” (Merton, 2008). Modern economy becomes what can be called by now a confl ict-of-interest economy, where each involved party thinks only of itself and is ready to reach its objective by any means. “These conflicts of interest include the well-publicized confl icts between chief executives and their shareholders; banks and customers’ investments; and auditors and boards of directors and their shareholders” (Merton, 2008). With regard to confl icts of interest arising from some activities like investment banking, the view that confl icts had a systematic adverse impact on customers was not confi rmed empirically (Mehran et al., 2006), and fortunately not all corporations put themselves in situations of confl icts of interest. Nevertheless, corporate excesses, institutions’ inadequacy, and market distortions have rendered the laissez-faire ideology nondefendable. They demonstrate that corporations cannot generally be self-ethical and that markets cannot be self-regulating enough. The situation has weakened the free market system regarding its capacity of distinguishing true investors from speculators, and unfortunately it became dominated by speculators, interested only in the short-term appreciation in asset values. Finally, “an alternative paradigm was adopted whereby ‘bubbles lead to booms’ instead of financial and economic stability ensured by sound long-term macroeconomic policies” (Prabaht, 2008). There is a real need to reexamine the role of fi nancial markets in the economy. They should not be considered an end in themselves. “They should be evaluated on how they serve citizens and how they constitute a means to economic growth and prosperity for all” (Stigliz, 2008). “To work, markets require managers who understand the importance of integrity in the creation of trust, and who inspire that trust in their people, their organizations, and in the communities and the larger society of which they are part” (Clark, 2003). The modern fi nancial system, like an old car that has defied time and that seems inexhaustible, despite the absence of any maintenance or repair, once in the hands of a mechanic, each of its parts calls for replacement. Due to the lack of resources, in the short run, a choice has to be made for the

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more urgent repair. In this period of turbulence and uncertainties, change of attitudes seems to represent the priority of priorities. Simultaneously, executives with strong values are needed, managers who place a high value on excellence, on building organizations where people thrive, on creating the long-term value for customers and for investors. These are managers who understand the larger purpose of the corporation and the principles and standards that drive its success. These are executives whose behavior matches and reinforces those values. In a word, these are executives with integrity. Integrity, however, extends honesty and goes beyond it to involve the “match between what executives say and what they do.” Executives with integrity also act on the basis of strong values, principles, and standards, whether in public or private. Such executives are trustworthy and inspire confidence within their organizations. Besides being crucial to organizations, executives’ behaviors can also have an influence far beyond the working environment. On aggregate basis, trustworthy executives affect trust and confidence in the whole economic system. Trustworthy executives are crucial for restoring faith and confidence in the fi nancial system, institutions, and organizations. Given the global character of the current crisis, the common belief is that no government can resolve the actual governance crisis alone and there must be, therefore, more cooperation in setting policies. There are also numerous calls for a reform in the governance of the international economic institutions and standard-setting bodies. The international community must commit itself to developing the institutions and instruments for increasing the stability and the fairness of the global fi nancial system. It is not enough to rearrange the system; the system must be transformed, and unless, however, far more fundamental reforms are taking place, it will not be possible for these institutions to play the role they should—decision making must reside with international institutions with broad political legitimacy, and with adequate representation of both middle-income countries and the least developed countries. Very few people still doubt this is still a good system and many are convinced that this is a good way to handle it. “To hand it over to trial lawyers. But that is apparently what we are going to do” (Mills in Lagace, 2003).

THE REINFORCEMENT OF THE DUTY OF TRUST Trust is the basis of every human relationship and it is necessary for the success of any human organization. The duty of trust requires from the parties involved in a human relationship not to act in a way that is likely to destroy or seriously damage the relationship of trust between them and it is implied by the law into every contract. For this reason, any breach of trust constitutes also a fundamental breach of contract. The range of conduct that may breach the duty of trust is broad; it covers any failure to act

298

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positively in the interest of the relationship. Breaches of trust have common features. They all violate the terms of the agreement between the parties involved and the person who breaks the trust has been entrusted with something like administering funds or investing someone else’s money, and so on. The current fi nancial system seems to be running out of trust “of both the people and the information, and the processes that have proven so successful in driving the economy” (Clark, 2003). For this reason, laws and regulations will always prove to be insufficient in imposing trust and honesty in business relations. Trust should be reintroduced and enhanced and law should actually be used only for the assuring of its respect. It will always be impossible to regulate every possible business malfeasance. Financial markets were recently emptied of trust and are faced with several problems (Clark, 2009): (i) They have become more pervasive, and fi rms have used them badly; (ii) We have seen managers substitute market-based incentives for judgment and for standards where they shouldn’t; and (iii) we have seen governance institutions compromising principle in the pursuit of market opportunity. Markets should continue to be powerful and effective, but the problems of mistrust that have invaded them should be addressed (Clark, 2009). It seems that “provocative as it may sound in today’s febrile and dangerous climate, freer and more flexible markets will still do more for the world economy than the heavy hand of government” (The Economist, 2008d). The second action that may give the market new credibility resides in the abolition of the strongly enforced impunity system that has built as trust deserted markets. Managers long ago discovered that if there is one area where they can lie with relative impunity, it is about their duty of trust. Corporations are assumed to be run into areas of risks, and mangers know it and they also know that the risks will catch up at some point in time either normally or through speculative channels. A relatively large number of managers simply took the short-term upward curve of reward, ignoring bad times to come, because of their intent to leave their corporation before troubles draw closer. They surely have to be held responsible for their wrongdoings and held responsible for the corporate frauds they initiate. Some mangers are the main architects of the current fi nancial crisis, which is presented as some kind of unavoidable global financial malaise. Facts would indicate that it was actually the massive explosion of the artificially fabricated bubble by managers who did not do their job appropriately and under the benediction and scrutiny of the whole fi nancial system. One might have a good thought, for “those poor executives at Tyco, Parmelat, Enron, and NatWest must have been provoked by the whole situation. After all, they are paying the price in prison for their comparatively minor misuses of shareholder funds” (Calxeurope, 2008). Actually, what is the point of an executive trying to make long-term honest returns for shareholders and get “compensated” for it when he could get higher rewards in less time and even be offered a better position?

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Each one of us would agree that there must be some price for this lack of morality in business affairs. “In this era of spectacular boom there has been a vast disconnect between senior executive sense of responsibility and their accountability” (Calxeurope, 2008). The situation was encouraged by the insane links weaved between business communities and political spheres. As a fi rst step, politicians should not be allowed to raise money “from these same people who have done so well by defrauding investors” (Lagace, 2003); and second, “that he who reaps the gains also bears the losses,” because “shielding investors from their deserved losses only makes them complacent and sows the seeds of the next crisis” (Zingales, 2008). Fraudsters should therefore restitute whatever amount was defrauded. “The evidence is clear that too many people crossed too many lines” and the problem may not be solved in regulatory agencies alone. Awareness has to prevail and boardrooms, executive offices, hallways, and conference rooms should be put to work. The solution will need to come also from classrooms and research and every educational institution has the duty to be involved (Clark, 2003). Future generations of executives need to be educated differently, by emphasizing ethics’ values in business relations, how to reduce conflicts of interest, and how to build stronger institutions of governance.

AN OPPORTUNITY FOR CHANGE The current chaos can actually represent a real opportunity for change. Indeed, the current crisis and the corporate governance reforms it initiates seem to have brought more attention to ethics in business relationships and “more managers are waking up to the ways in which positive values contribute to a company’s effective day-to-day functioning, as well as its reputation and long-term sustainability” (Paine, 2002). It is sometimes argued that the managers who convert to corporate governance may have done it for risk management considerations, that is, to avoid loss of reputation and the risk of being caught following a fraud. There seems, however to exist an expanding acknowledgment for the crucial role played by corporate governance, and “the ideas and procedures that were once the preserve of very large ‘Western’ corporations are now being adopted globally (Al-Moataz et al., 2007), although little attention was paid to the appropriateness of such a transfer process. On the other hand, there is nothing as persistent and difficult to change as attitudes, which can change only under major pressure and extraordinary events, and this seems to be the case with the current fi nancial chaos. Such chaos should be looked at as an opportunity that should be seized for reforming the current system. In order to do so, however, corporate governance should be considered in a systematic way. It is not enough to focus on managers and their wrongdoing; other players have had far more impacting negative effects on corporate governance failure and yet escape unscathed. Figure 13.3 summarizes the major contributors to the current fi nancial chaos.

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Internal and External Aspects of Corporate Governance

Figure 13.3

The actors of the financial chaos.

Although economic growth and wealth creations are legitimate concerns, there is no reason why they should be the only one for a society. Further, policymakers, who traditionally should worry about issues of ethics in business, are losing control of businesses to major market players. Recently, however, and in an unprecedented effort to mute criticisms over the lack of public oversight of corporations, major governments passed, since 2003, sweeping corporate governance regulatory reform bills, anticipating that they would calm the fears of investors and bring confidence back to corporate fi nancial reporting (Heier et al., 2004). Apparently they did not, and markets (increasingly dominated by multinational institutional investors) directly control managers by setting for them return and risk benchmarks and are becoming the true masters of corporations and their managers and corporate boards are becoming legal fictions. Weakening board authority was yet another consequence which has gone almost unnoticed. Indeed, faced with a board’s inefficiency, large investors in the capital market tend to exercise their formal governing power over management directly, escaping the board that might be dominated by top managers (Hendry et al., 2004). Such a shift is represented in Figure 13.4. In a fraudulent authority hierarchy, boards are used by the management for three reasons: fi rst, to satisfy the requirements of company law (Stiles & Taylor, 1996); second, to serve as another valuable tool for management. Board members are handpicked so that management retains control of decisions made by the board (Pfeffer, 1972); third, to play a “rubber stamp” role to legitimize strategic decisions made by management, under major shareholders pressure (Hendry et al., 2004). Major shareholders are one of the major architects of the current fi nancial crisis, for by their unreasonable requirement of constant higher return and lower risk, they push managers toward fraud. There are actually no natural phenomena that can stand such requirements, and economic activities are mainly characterized by ups and downs. By tailoring their return requirements out of such boundaries, it can be seen as an invitation for fraud on the part of investors and their analysts.

Corporate Governance

Market

Board

Management

Board

Figure 13.4

301

Management

Market

The power shift in corporate governance.

On the other hand, markets were, for so long, considered efficient, that is, capable of departing from the basics for evaluating companies. Recent corporate crises have shown this is not the case. Any crisis solution has to take this reality into account. It is a great deal easier to combine ethical commitment and economic development in developed environments, where investors are appropriately educated, “information is free-flowing and people have real choices about where to work, invest, and consume” (Paine, 2002). Ethical commitment and economic success combinations are, however, subjected to a number of conditions: (i) a well-understood corporate governance framework and an effective legal system, (ii) a free press that does not distort information, and (iii) well-educated citizens. However, sound judgment and rational decisions have more chances to be made by educated investors and citizens having a permanent access to transparent information. It seems almost impossible to think about corporate governance without “paying attention to the broader social and institutional context in which a company is operating” (Paine, 2002). The current fi nancial crisis is like setting fi re in a construction site to hide irregularities and cash insurances claims. The free market system must be complemented by principle-based legislation backed by serious enforcement, putting emphasis on individual responsibility. Whenever people are held personally responsible for their actions rather than as a corporate representative, they tend to weigh their choices more cautiously (Montgomery, 2003). On the other hand, “the illegal and the illegitimate should be stamped out, cruelly. Freedom to all . . . only when the righteous freely prosper and the less righteous excessively suffer—only then will we have

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entered the efficient kingdom of the free market” (Vaknim, 2003). Corporations and the fi nancial market role in modern society are overdue for a serious rethink (Mitchell, 2009).

CONCLUSION Although dishonesty and mistrust are as old as mankind itself, the situation raises the question of whether modern managers are, at all, taught the social values of trust and honesty and whether we, as a society, adopt a culture that tolerates and even justifies business abuse of trust. The negative consequences are socially, culturally, and economically devastating. The modern fi nancial system has missed a fi rst historical rendezvous to correct itself with the collapse of the communism system in the late sixties. It has instead faced the event with much arrogance and lack of humility and we are today paying the price. Consequently, the last two decades of euphoria for easy gain “has given rise to swindles and frauds and the bad apples that commit them. We need to fi nd out who they are and take appropriate action. But our problems run much deeper. . . . But the evidence is clear that too many people crossed too many lines” (Clark, 2003), and even some good people were forced to do the wrong things, or else lose their jobs, but we are fortunate to have a great number of people in our economy who did not succumb to those incentives (Clark, 2003). The current fi nancial disaster takes years to build up and it may be years before the cure starts to have any effect. Consequently, everybody should afford to be a bit more public-spirited in these peculiar times. Our fi nancial system is the reflection of our collective values and beliefs, and those among us requiring honesty today from the fi nancial system should also ask themselves if they are they honest enough.

Notes

NOTES TO THE PREFACE 1. Free translation.

NOTES TO CHAPTER 1 1. The Oxford English Dictionary. 2. This restrictive view of transparency is merely a consequence of the conventional view of corporate responsibility, which is limited to enriching the shareholder.

NOTES TO CHAPTER 2 1. The World Bank, at: http://www.worldbank.org.

NOTES TO CHAPTER 3 1. At : http://www.rbc.com.

NOTES TO CHAPTER 10 1. Stock market rallies, like the one on October 28 that carried the Dow Jones Industrial Average almost 900 points higher. 2. http://www.londonstockexchange.com/en-gb/products/training/corporategovernance.htm. 3. https://www.rbfcu.org/NB/html/Investments/Dictionary_T.htm.

NOTES TO CHAPTER 12 4. The case of a negative α can also be considered. This is the case of fraud. We can indeed consider the case where the management team not only keeps the allocation received without performing consequently, but also bill the nomination committee an extra amount which can go as high as the market value of the company.

304

Notes

NOTES TO CHAPTER 13 1 http://www.newsinferno.com/archives/4315, as accessed Friday, December 5th, 2008.

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Index

A Abarbanel, S., 184, 305 Abrema. See Australian Educational Research Pty. Ltd, 306 Accountability, 8–10, 45 Accounting Standards Board, 16–17 Admati, A., 53, 305 Agency agent, 22 bonding costs, 25 consequences, 26 earnings retention, 24 monitoring costs, 25 moral hazard 23, 290 origins, 22 principle, 22 Residual losses, 25 theory, 21 time horizon, 25 Agoglia, C. P., 97, 319 Agrawal, A., 12, 305 Ahlawat, S., 129, 305 AICD. See Australian Institute Company Directors Air France-KLM board committees, 87 Aizenman, J., 243, 305 Allen, F., 1, 305 Al-Moataz, E., 299, 305 Alter, C., 265, 305 Altman, E. I., 218 American Institute of Certified Public Accountants, 115, 116, 120, 199, 305 AICPA, see American Institute of Certified Public Accountants APB, see accounting Standards board Arnold, C. 291, 293, 305. Ashbaugh, S. H.

Ashraf, N., 280, 305 Assets Atieh, S. H., 305 Atkins P. S., 171, 306 Audi, R., 262, 306 audit, 91 feared disadvantages, 104 finance, 101 governance, 87 microsoft audit committee, 107 nomination, 97 strategic, 88 compensation, 100 consulting services, executive, 89 external auditor, 99, 128, 197, 210, 219 Australian Educational Research Pty. Ltd, 306 Australian Institute Company Directors, 107, 306 Axelrod, R., 263, 306

B Bachrach, M., 263, 306 Balkan, J., 10, 306 Baratz, S. M. Barry, C. B., 15, 306 Bartlett, R. P., 24, 306 Barton, J., 184, 306 Bartram, S. M., 133, 306 Basioudis, L. G., 203, 306 Baygan-Robinett, G. H., 253, 306 Beetham, D., 54, 306 Beretta, S. E., 315 Berg, J., 271, 273, 306 Bergen, J. V., 227, 228 Berle, A.A., 55, 234, 306 Bews, N. F., 262, 306

326

Index

Biekpe, N., 314 Bishop, R., 28, 306 Bitner, L. N., 12, 306 Bittlingmayer, G., 234, 306 Black, B. S., 8, 21, 243, 306 Blair, M. M., 12, 306 Blanchet, J., 172, 307 Blaskovich, J., 194 Bloom, W., 45, 307 Board of directors, 55–56 chairman, 67 composition, 45, 55 corporate governance responsibility, 54 directors, 63 directors’ nomination criteria, 69 duty of concern, 59–60 duty of supervision, 59–60 duty of trust, 59–60 duty to quit, 59–60 fiduciary responsibility, 59–60 functions, 60–62 independence, 56 integrity, 58 non-executive directors, 64 resolutions, 73 conflicts of interest, 72 structure, 57–58 syndrome of broken ladder, 79 trust relationship, 269 Boeing, C., 316 Boritz, J. E., 321 Botosan, C., 15, 307 Bozzolan, S., 315 Bradley, M., 4, 307 Brancato, C., 130, 307 Brick, I. E., 107, 307 Britain. See United Kingdom Brown, D., 184, 307 Brown, S. G., 15, 306 Brundin, E., 57, 307 Brunner, A., 215, 307 Buiter, W., 1, 316 Bukspan, E., 264, 279, 307 Burgstahler, D., 183, 184, 307 Byrne, J., 64, 100, 307

C Cally, J. E., 244, 307 Calxeurope, 299, 307 Camerer, C., 305 Canada, IFRS, 170 Canadian Institute of Chartered Accountants, 170, 307

Capital accumulation Capital adequacy Capital market capital structure Caprio, G., 246, 307 Carey, P., 192, 307 Carter, D. A., 80, 307 Cattrysse, J., 109, 127, 307 CBC News, 80, 307 CEO. See Chief Executive Officer CFO. See Chief Financial Officer CICA. See Canadian Institute of Chartered Accountants Chalayer, S., 181, 308 Chaur, S., 66, 308 Chenggang, X., 254,317 Chhaochharia, V., 56, 308 Chidambaran, N. K., 307 Chief executive officer, 22, 38, 45–49, 62–69, 71–77, 100–106, 113, 134, 138–139, 184–185, 267, 279 Chief Financial Officer, 45–49, 91, 221 China, 42, 170–171 CICA, 70, 76, 170,183 Claessens, S., 20, 243, 245, 308 Claire, R., 262, 308 Clark, K. B., 69, 286, 293–296, 298–299, 302, 308 Clarke, T., 10, 308 Clayton, R., 289 Clifford, S. W., Jr. Cohen, L., 66, 308 Collins, D., 217, 305 Comiskey, E. E., 308 Committee of Sponsoring Organizations of the Treadway Commission, 109, 152, 308 Committees of the board structure, 84 Core, R., 186, 289, 308 Corporate control forms, 232 COSO. See Committee of Sponsoring Organizations of the Treadway Commission Cox, C. H., 97, 316 Credit rating agencies, 209 banks’ rating, 215 concerns regarding, 218 definition, 206 philosophy, 207 principles, 207 process, 211

Index role, 208 symbols, 212 users, 213 Crocker, J., 68, 308

D D’Souza, F. P., 307 DaDalt, P. J., 195, 321 Daily, C., 12, 71, 141, 252, 256, 308 Dalton, D., 308 Dann, L. D. Davidson, W. N. ,195, 321 Deakin S., 20, 255, 309 Dechow, P., 24, 309 DeFond, M. L., 92, 309 Degeorge, F., 184, 309 Dejong, R. E., 316 Deloitte Derivatives Desender, K. A., 134, 309 De-Silanes, L. F., 314 Dey Report Dey, D., 55, 309 Dickhaut, J., 306 Dolan, R. C., 12, 306 Doupnik, T. S., 97, 319 Dow Jones index, Doyle, J. T., 108, 111,309s Due Process Handbook Due process approach 154–160 Dugan, T. M., 311 Duisenberg, W. F., 240, 309 Dulewicz, V., 68, 309 Durnev, A., 243, 209 Dussauge, P., 269, 309 Dye, R. A., 183, 309

E Earmes, M., 307 Earnings management, 182 fictitious revenues, 182 fraudulent evaluations, 182 improper disclosure, 182 timing differences, 182 Economist, 6–7, 220–221, 224, 241, 263, 282–284, 305 Ebersole, 267, 309 Edmonds B., 237, 309 Eisinger, J., 210, 220, 309 Elbertsen, J., 57, 320 Elkhoury, 218, 310 Elliot, J. A., 315 Elsayed, K., 57, 310

327

Emerging economies, 239 Emmons, 281, 310 Enron, 6, 8, 28, 83, 310–317 Ernst & Young, 202, 290, 310 Ertimur, Y., 58, 310

F Fama, E.F., 25, 77, 226, 267, 310 Family owned companies Farber, D. B., 317 FASB. See Financial Accounting Standards Board Felix, W. L., 195, 310 Ferri, F., 58, 310 Fiechter, J. L., 307 Financial Accounting Standards Board, US 161–165, 307 Financial Accounting Standards Foundation Financial auditing audit committee, 194 auditor’s opinion, 201 earnings management techniques, 181, 184 executive compensation, 185 financial reports, 195 Flores, F., 318 frame work, 179 fraud trap, 185 frauds, 181 objectives, 179 options backdating, 185 process, 187 reasonable assurance, 200 responsibility, 192 Financial markets as a counseling mechanism, 231 as a governance defense mechanisms, 23 as a governance disciplinary mechanism, 232 as a governance enhancing mechanisms, 229 as a remuneration mechanisms, 229 corporate control, 234 efficiency, 226 non-listed companies, 239 See also capital markets IFRS Financial statements, 175–178 Fitch, 210–213 Fitzgerald, J., 316 Fleiderer, P., 53, 305 Fogel, E., 66, 310 Forbes, 28, 310

328

Index

Frankel, 6–7, 310 Friedman, xxi, 30, 284–285, 289, 310 Fries, S., 1, 316 Frost, 218, 310 Fukuyama, F., 28, 266, 310

G Galbrait, xxi Gambetta, D., 264, 310 GAO. See General Accounting Office of the United States Garette, B., 309 Gaspar, J. M., 232, 310 Gay, K., 68, 309 Geiger, M. A., 306 General Accounting Office of the United States, 115, 119–123, 310 Generally acceptable accounting principles, 38, 47, 151–152, 169–170 Godfrey, J., 12, 311 Goldman Sachs, 7 Goldwasser, D. L., 150, 311 Gompers, A. P., 1, 243, 311 Gore, A. K., 97, 103, 311 Greenspan, A., 260, 311 Greenwood, 311 Grinstein, Y., 56, 311

H Hage, J., 305 Hall, T.W., 254, 255, 288, 311 Hammersley, J. S., 127, 311 Han Kim, E., 309 Hann, R. N., 309 Hansmann, H., 243, 311 Harvard University, ix, xxv, 150, 311 Healey, P. M., 15, 311 Heier, J. R., 108, 311 Hexter, H., 307 Higgs, 203, 311 Higgs, D. 65, 311 Higgs report, 311 Higson, A., 305 Hoarau, C., 312 Holm, C., 198, 200, 312 Hsieh, P. G., 308 Hu, X., 309

I IAASB. See International Auditing and Assurance Standards Board IASCF. See International Accounting Standards Committee Foundation

IAS. See International Accounting Standards IASB. See International Accounting Standards Board IAS PLUS, 312 IFAC. See International Federation of Accountants IFRS. See International Financial Reporting Standards Indexes market, 4, 293 Institute of Chartered Accountants in England and Wales, 312 ICAEW. See Institute of Chartered Accountants in England and Wales Internal Accounting standards Board, 151–156 Internal control common activities, 120 communication, 122 control activities, 119 definition, 109 effectiveness, 126 environment, 115 integrity and ethical values, 117 monitoring, 124 ongoing control activities, 126 process, 114 structure, 112 International Accounting Standards, 151–154, 161–164 overview, 165–166 International Accounting Standards Board, 151, 153–157, 160 International Accounting Standards Committee Foundation, 152, 154, 157, 312 International Auditing and Assurance Standards Board, 151–152, 157–160 International auditing standards of auditing, 158–159, adopted 169 International Federation of Accountants, 151–152, 157–158 International Financial Reporting Standards 17, 19, 151–153 process 154–156 International financial reporting convergence, 170 framework, 160 process, 154 structure, 151

Index International Organization of Security Commission, 152, 219, 313 IOSCO. See International Organization of Security Commission ISA, 169, 240–269 Ishii, J. L., 1, 311

J Jain, T., 208, 313 Jaiswall, M., 315 Jang, H., 243, 215 Jennings, M., 265–267, 313 Jensen, M. C., 23–25, 111, 227, 235, 240, 266, 272, 310 Johnstone, K. M., 324 Jordan, C. E., 259, 324

K Kerwer, D., 210, 313 Keynes, J. M., 239, 313 Kiel, G. A., 22, 313 Kim, W., 306 Knapp, M., 313 Knoeber, C., 12, 305 Knyazeva, A., 22, 313 Konzelmann, S. J., 20, 305 Koresh, G., 218, 305 Kose, J., 22, 305 Kothari, S. P., 313 KPMG, 7, 129, 132, 202, 290, 294, 314 Krahnen, J. P., 215, 307, 314 Kreps, D. M., 271, 273, 314 Kulmala, H. I., 314 Kunitzky, S., 314 Kyereboah-Coleman, A., 217, 314

L La Porta, R., 214 La Rochefoucault, xxiii Laaksonen, T., 262, 314 LaFond, R., 217, 305 Lagace, M., 299, 314 Laux, V., 204, 315 Lehavy, R., 305 Leibenstein, H., 314 board of directors, 251 corporate governance weaknesses in, 247 definition, 242 family businesses, 250 non-listed companies, 245 state owned enterprises, 252 Light, J. O., 281, 314 Limited liability

329

principle, 2–3 Litan, R. E., 314 Lopez, T. J., 108,314 Lorch, J., 287, 314 Lori, J., 321 Loutskina, E., 313 Lumsden, A. J., 83, 314

M MacAvoy, P. W., 64, 315 MacDonald, E., 186, 203, 291, 314 Mace, M. L., 251–252, 314 MacIver, E., 314 Madoff, B., xxi, 6, 51, 263–264, 283, 285, 294, 319 Ponzi Scheme, 241 Mainelli, M., 291–292 Manne, H., 234, 314 Masulis, R. W., 65–66, 314 Mather, P., 311 Matsumuto, D., 314 McCabe, K., 306 McClure, B., 236, 313 McColgan, P., 314 McInerney, C., 308 McVay, S. E., 309 Meckling, W. H., 21–23, 266, 313 Mehran, H., 296, 313 Mens, G. C., 306 Mergers and acquisitions (M&A), 103, 232 Merton, R., 296, 315 Mezgar, I., 262, 315 Michelon, G., 315 Mike, L., 307 Miller, G., 317 Mills, D. Q., 263, 315 Millstein, I. M., 64, 315 Minority shareholders Minow, N., 55, 315 Mitchell, L. E., 288, 302, 315 Mobbs, H. S., 65, 314 Moment, M., 2634, 315 Monks, A. G., 55, 315 Moody’s, 208, 210, 213, 215 Morelle, E., 130, 315 Moss, D., 281, 315 Mulford, C. W., 130, 315 Myers, R., 222, 315

N Naciri, A., 45–46, 307 Narasimhan, M. S., 100, 315 Nelson, B., 59, 315

330

Index

Nelson, M. W., 315 New York Stock Exchange, 83, 231 Newman, K. R., 307 NYSE. See New York Stock Exchange Nicholson, G., 22, 313 Nikolaev, V., 313 Niskanen, W. Nordqvist, M., 307

O O’Hara, M., 80–81, 316 OECD. See Organization of economic cooperation and development OECD 2004 principles, 32–38, 40, 42, 57, 60, 63, 209 Oman, C., 1, 242–245, 248, 316 Organization of economic cooperation and development authority usurpation, 81 corporate governance board responsibility, 38 corporate governance disclosure and transparency, 37 corporate governance principles, 31 effective framework for corporate governance ,32 stakeholders’ role shareholders’ treatment, 36 shareholders’ rights, 35 Ortmann, A., 271, 316

P PCAOB. See Public Companies Accounting Oversight Board Paine, L. S., 20, 299, 301, 316 Palmiter, A. R., 316 Palmrose, Z., 184, 316 Papakonstantinou, E., 306 Peasnell, K. V., 182, 184, 316 Peregrine, M. W., 288, 316 Perpetuity principle, 3 Pfeffer, J., 300, 316 Pinto, A. R., 207, 208, 317 Pistor, K., 242, 254, 317 Pomerleano, M., 307 Ponzi schemes Madoff, 6, 241 Pope, P. F., 307 Pornsit J., 181, 317 Powell, W., 265, 317 Prabaht, P., 181, 317 Pricewaterhouse Coopers, 7, 57, 195–196, 276, 317 Public Companies Accounting Oversight Board, 46–47, 187 317

Q Qiang, C., 106, 317

R Rasmus, R., 317 Reddit, D., 290–292, 317 Rejie, P., 319 Revsine, L. R., 186, 317 Rezaul, K., 319 Richard, P., 290, 317 Richardson P., 290, 317 Risk management average controllable risks, 138 concept, 130 control, 145 reporting, 146 controllable, 139 measurement, 140 integrated program, 147 least controllable risks, 138 objectives, 133 profile, 136 responsibility, 134 Risk-return trade-off, 12–14 Roe, M. J., 27, 317 Ronen, J., 183, 317 Rose, C., 317 Rosen, R. E., 131, 317 Rossouw, G. J., 306 Royal bank of Canada, 67–68, 205, 317 Ruback, R. S., 225, 232, 234, 238, 240, 318 Rupley, H., 314

S Sadan, S., 183, 217 Sako, M., 269, 318 Salazar, L., 286, 318 Salomon Brothers, 6, 284 Sanwal, S., 318, 319 Sarbanes-oxley analyst conflicts of interest, 52 audit committee, 48–49 auditor independence, 45 auditor’s allowed and forbidden services, 47 corporate and criminal fraud accountability, 49 corporate responsibility, 45 enhancing financial disclosure, 47 financial statement certification and quality, 48–49 provisions, 44

Index public company accounting oversight board, 46–47 Securities Exchange Act (1934), 48 Security Exchange Commission (SEC) Sengupta, P., 244, 318 Seward, J. K., 64, 318 Shamsher, M., 203, 321 Sharfman, B. S., 66, 318 Sharma, R., Shleifer, A., 23, 234, 244, 246, 314 Simkins, B. J., 307 Simko, P., 306 Simmel, G., 261, 269, 318 Simnett, R., 192, 307 Simpson, W. G., 307 Singh, A., 309 Sloan, R. 24, 309, 318, 320 Smith, A., 3, 318, The Wealth of Nations, 20 trust, 266 Theory of Moral Sentiments, 280 Solomon, R. C., 262, 318 Stakeholders xv, 3, 9, 21, 25, 30, 32, 36, 37, 44, 50, 62, 64, 67, 78, 92, 113, 118, 122, 131, 139, 143, 147, 173, 174, 194, 203, 245, 263, 266, 269, 288 Standard & Poor’s, 210 credit rating symbols, 212–213 history, 210 Stanford School of Business, 283 Stanley, J., 194, 318 Stigliz, R., 296, 318 Stiles, P., 267, 300, 318 Stout, L. A., 64, 229, 264, 318 Strier, F., 217, 318 Stubben, S., 58, 310 Sudeep, S., 61, 83, 319 Sudhakar, V. B., 185, 319 Sundaram, A. K., 4, 307 Sytse, D., 250, 319

T Tanewski, G., 192, 307 Tang, A. P., 112, 319 Tarpley, R. L., 315 Taylor, B., 60, 309, 318 Thomas, M., 281, 319 Titman, S., 319 Toll, S. J., 318 Tonello, M. H., 307 Toronto Stock Exchange Tracy, P., 235, 319 Treasury Board of Canada, 71, 131, 319 Trompeter, G. 319

331

Trueman, B., 183, 319 Trust in business relations, 261 in corporate governance, 266 trustfulness, 270 trustworthiness, 271 Tsai, L. C., 308 Tsakumis, G. T., 97, 319 TSX guidelines, 53, 319 Turnbull, S., 97, 110, 319, 320 Tweedie, D., 320 Tzioumis, K., 20, 308

U Upadhyay, A., 320

V Vaknim, S., 290, 302, 320 Vaknin, S., 240, 320 Van Den Berghe , L., 83, 320 van Veen, K., 57, 320 Vandervelde, S. D., 314 Vatnick, S., 259, 320 Vaughn, M., 242, 320 Vauvenargues, xxiii Vera-Munoz, S. C., 92, 320 Verrecchia, R., 308 Verstegen, R., 320

W Walpole, R., 320 Walsh, J. P., 64, 318 Walt Disney, 320 WB. See World Bank Weber Shandwick, 278, 279, 320 Weber, M., 215, 307, 311, 314 Weisbach, M., 24, 77, 320 Wells, J., 181, 187, 295, 318, 320 Westerman, G. F., 133, 320 Westphal, J. D., 320, 80, 87, 267 Wikipedia, 2, 20, 202, 280, 310, 320, 321 Williamson, O. E., 321 Witherell, B., 321 World Bank, 8, 28–29, 39–42, 321 governance framework Wu, Y. J., 314

X Xie, B. 184, 195, 321 Xu, L., 319

Y Yellen, J., 289, 290, 321 Yeung, E., 311 Young, C. S., 308

332

Index

Younkins, E. W., 263, 321

Z Zabihollah, R., 321

Zajac, E. J., 320 Zhang, P., 111, 114, 186, 194, 321 Zingales, 293, 299, 321 Zulkarnain, M. S., 203, 321