Understanding Corporate Governance

By Stanley Epstein

Not so long ago a successful company was simply one that was profitable. How that company was managed, the ethics of its owners and management were simply of no interest or consequence to the public at large.

Things have changed in the last couple of decades. It is no longer enough for a company to merely be profitable; it also needs to show good corporate citizenship through a whole host of practices and policies like environmental awareness, ethical behavior and sound corporate governance practices.

Interest in the corporate governance practices of modern corporations, particularly in relation to accountability, increased dramatically following the high-profile collapses of a number of large corporations during the early 2000s, most of which involved accounting fraud; and then again after the recent financial crisis in 2008.

Continuing corporate scandals in various forms have sustained both public and political interest in the regulation of corporate governance.

In the U.S., the major scandals include Enron and MCI Inc. (formerly WorldCom). Their demise was the driver for the U.S. federal government passing the Sarbanes-Oxley Act (SOX) in 2002. This piece of legislation was intended to restore the public’s confidence in corporate governance.

Similar corporate governance failures in other countries such as Parmalat in Italy and Siemens in Germany stimulated increased regulatory and legal interest.

This article is a brief introduction to Corporate Governance. In it we are going to look at its definition, its foundations and its core principles.

Corporate governance in a broad sense is the mechanisms, processes and relations through which corporations, businesses, organizations, company’s or firms are controlled and directed. To make life simpler I will refer to all of these different organizations as ‘corporations’.

Corporate governance can be defined simply as “a system of rules, practices and processes by which a corporation is directed and controlled”.

In essence corporate governance involves balancing the interests of the many stakeholders in a corporation. These stakeholders include its shareholders, management, customers, suppliers, financiers, government and the wider community.

We can take this definition and expand it, taking it to the next level to provide greater granularity. Doing this our original definition of corporate governance can be expanded as follows;

“A system of rules, practices and processes by which a corporation is directed and controlled,

• with the focus on internal and external corporate structures with the intention of, 
• monitoring the actions of management and directors and thereby,
• managing agency risks which may arise from the misdeeds of corporate officers”.

To undertake the corporate governance process an organization needs to have the right governance structures, processes and mechanisms.

Governance structures identify the distribution of rights and responsibilities among different participants in the corporation.

Who are these participants? Generally (but not exclusively), these include the board of directors, managers, shareholders, creditors, auditors, regulators, and other ‘interested’ parties (who are referred to as ‘stakeholders’). This also includes the rules and procedures for making decisions in corporate affairs.

Corporate governance processes through which corporations' objectives are set and pursued are in the context of the social, regulatory and the market environments.

Governance mechanisms include monitoring the actions, policies and decisions of corporations and their agents.

The agency risk mentioned in the expanded definition is the risk that the management of a corporation will use its authority to benefit itself rather than shareholders. An example is that of directors or managers who may elect to pay themselves higher salaries, which increases overhead, rather than to pay out extra profits as dividends. In a more sinister example, these directors or managers may actually steal the business' money.

Corporate governance practices are affected by attempts to match up the interests of all stakeholders.

Current deliberations on corporate governance tend to refer to various principles that have been set out in a number of documents that have been published since 1990. There are three core ‘source’ documents for Corporate Governance Principals.

These documents are;

1. The United Kingdom’s Cadbury Report of 1992,
2. The OECD Principles of Corporate Governance (1998 and 2004), and
3. The United States Sarbanes-Oxley Act of 2002.

The Cadbury and OECD reports present general principles around which businesses are expected to operate to assure proper governance.

The Sarbanes-Oxley Act, is an attempt by the United States federal government to transpose several of the principles recommended in the Cadbury and OECD reports into Federal law.

There are five core principals in the area of corporate governance. We will briefly examine each of these five principles in greater detail.

Rights and equitable treatment of shareholders

Corporations should respect the rights of shareholders and assist shareholders to exercise those rights. Shareholders can be helped to exercise their rights by open and effective communicating of information and by encouraging them to participate in general meetings of the corporation.

Interests of other stakeholders

Corporations should recognize that they have legal, contractual, social, and market driven obligations to non-shareholder stakeholders. Included in this category are employees, investors, creditors, suppliers, local communities, customers, and policy makers.

Role and responsibilities of the board of directors

The board needs sufficient relevant skills and understanding to review and challenge management performance. The board also needs to be of adequate size and have the appropriate levels of independence and commitment.

Integrity and ethical behavior

Integrity should be a fundamental requirement in choosing corporate officers and board members – there should be no exceptions to this rule. Corporations should develop, publish and explain a code of conduct for their directors and executives that promotes ethical and responsible decision making.

Disclosure and transparency

Corporations should clarify and make publicly known the roles and responsibilities of board of directors and management to provide stakeholders with a level of accountability. They should also implement procedures to independently verify and safeguard the integrity of the company's financial reporting. Disclosure of material matters concerning the corporations should be timely and balanced to ensure that all investors have access to clear, factual information.

In this article I have provided a brief introduction into Corporate Governance, what it is and the tools that are used to facilitate its execution as well as the five core corporate governance principles.

Broken Benchmarks

From Bloomberg

“The Libor Scandal Sets Off a Wave of Probes. Imagine a “benchmark” as a notch on a carpenter’s bench used to measure. Simple enough. But what if the carpenter cheated, moving his marks to be able to charge a little more for a piece of lumber? In their role in modern financial markets, benchmarks set by traders help establish costs for mortgages, gasoline and money itself. They’re hard to understand and easy to manipulate. At the heart of the problem lies an inherent conflict: The figures are determined by the very firms that have the most to gain from where they’re set. Regulators agree that the main financial benchmarks are broken.”

read more>>

Former Julius Baer executive hands over offshore bank details to WikiLeaks

A former executive at Swiss bank Julius Baer has handed over the offshore account details of around 2,000 corporations and high net worth people - including politicians - to WikiLeaks.

Rudolf Elmer presented CDs containing the information, which he claims reveals potential tax evasion, to WikiLeaks at the Frontline Club in London, two days before he goes on trial in Switzerland.

The former Julius Baer COO in the Cayman Islands earlier told the “Observer” newspaper that he is handing over the data on multinationals, hedge funds, artists and around 40 politicians, which comes from three financial institutions, "in order to educate society".

WikiLeaks founder Julian Assange, currently on bail, was at the press conference to receive the data, which he said would be vetted before publication and that some of it may also be handed over the Serious Fraud Office.

Assange also says that in 2008 Julius Baer went to court in the US in a failed bid to have WikiLeaks.org shut down over previous revelations.

Elmer left Julius Baer in 2004 and has since become a self-styled whistleblower seeking to expose the use of offshore accounts for tax evasion, describing himself on his Website, swisswhistleblower.com, as an activist, reformer and banker.

Later this week the ex-banker faces trial in Switzerland over allegations that he breached bank secrecy and threatened Julius Baer officials.

You can watch the full press conference below.

Fraud - Ernst & Young's 11th Global Fraud Survey

Ernst & Young's 11th Global Fraud Survey sheds light on how businesses have coped with increasing fraud and corruption risk during the financial crisis, and examines the growing pressures on the CFO, internal audit, legal and compliance functions. It reviews the risks and challenges that businesses will face as they navigate clear of the financial crisis and begin to focus on growth.

This reflects the views of over 1,400 senior decision-makers in major companies in 36 countries across the world.

Fraud continues to rise as compliance struggles for recognition. The survey indicates continued need for anti-fraud measures, even against a tough financial background. However, this could be a result of the way fraud has come under the spotlight in recent years.

David Stulb, global leader of Ernst & Young's fraud investigation and dispute services practices says: "Regulators in western Europe have become much more aggressive and have been using US-style investigative techniques and settlement practices. In some jurisdictions, such as the UK, significant outreach efforts to encourage whistleblowers have been undertaken. These efforts are believed to have already yielded results."

Stulb explains that legislative developments have also been a factor. "While there was lively debate over the UK Bribery Act in the weeks before its passage, the final version of the Act is very robust, including penalties against corporations for failing to prevent bribery."

At the same time, there has been a drop in resources available to those that must prevent and react to instances of fraud. Ernst & Young states that one in five of the survey respondents from legal departments have seen their budgets fall in the last year.

Stulb says: "The UK lawyers and compliance officers I regularly meet are eager to hear about new and emerging risks for their organizations and what steps they can take to mitigate them. However, I suspect many of them face significant internal challenges to secure the investment required to take these steps."

The survey also shows the growing, and uncertain, nature of compliance as a specialty. More than half of those in the field have been in a compliance role for less than five years. This reflects the substantial growth in recruitment in this area, but also suggests some challenges ahead. Outside of specialist fields, there can be a lack of appreciation for the role that compliance can play in an organization. Some 70% of chief compliance officers interviewed said demonstrating the value of compliance to the wider organization was a significant challenge.

According to Stulb, though, this can be related to the industry that officers work in, particularly those under the scrutiny of external regulators.

"Many companies operating in heavily regulated industries, such as financial services and life sciences, have developed sophisticated compliance and internal audit systems. They are keenly aware of the value brought by investing time and effort to protect their brand, and, as a result, compliance is already high on their corporate agenda."

The report also looks at growth in the next year, in particular mergers and acquisitions. Fifty-three percent of global respondents said they are targeting growth for their companies in the next year, with 42% in Japan targeting aggressive growth.

This is likely to throw up particular issues as groups expand into new markets with different cultural practices, emphasizing the importance of thorough due diligence pre-acquisition.

Key findings specific to the UK include:

• Increased enforcement against fraud, bribery and corruption is a priority in many major markets. The passage of the UK’s Bribery Act is the latest example of a more robust approach to punishing the unethical conduct of individuals and corporates. Individual executives and directors will not be immune from prosecution. 76% of our UK respondents say their directors are concerned about personal liability for actions carried out by their company.
• Despite this concern, organizations are not behaving in a way that would increase their own protection. Alarmingly, 18% of UK companies have not performed a fraud risk assessment over the last 12 months, and 1 in 10 (8%) have never completed one. Performing such an assessment will help prioritise actions to deal with the most significant fraud risks and is therefore fundamental when budgets and resources are scarce.
• Having coped through the downturn, many companies are now looking for new growth opportunities, which may come through entering new markets or making acquisitions. These efforts can expose companies to numerous new risks, potentially including corruption issues. To minimize such risks, businesses should undertake thorough, focused pre-acquisition due diligence. However, 34% of UK respondents rarely or never perform fraud or corruption related pre-acquisition due diligence, while 47% rarely or never perform a similarly focused post-acquisition review. These steps are vital to reducing the risk of successor liability and subsequent regulatory enforcement actions.

When growth returns, we expect more challenges, more potential for fraud, more exposure to corruption and more interest from regulators. In the coming months, if they haven't done so already, companies will need to review or improve their procedures to achieve long-term sustainable and ethical growth.

Download Ernst & Young’s 11th Global Fraud Survey at:

http://www.ey.com/Publication/vwLUAssets/Driving_ethical_growth_-_new_markets,_new_challenges:_11th_Global_Fraud_Survey/$FILE/EY_11th_Global_Fraud_Survey.pdf

Doing the right thing – A question of Ethics

I recently blogged on Finextra about Ethics and regulation in the financial world under the title “It is more about ethics than policing” (http://www.finextra.com/community/fullblog.aspx?id=3918 )

In this blog I wrote;

"So the FSA is going to beef up on its staff in the oversight of the banks. As I see it, this approached is doomed before it even starts. The regulator, whether it is the FSA or any other, cannot match both the expertise and the innovativeness of the staff in the banks. The reason for this is simple. The regulator cannot compete with the banks in terms of direct payments, like salaries, or other incentives like bonuses.


This gets the whole issue back to what got the financial industry into this mess in the first place.


Putting more overseers in to monitor what is going on is also of doubtful value. It is an approach that will only lead to lulling everybody back into a false sense of security (again). This will last only until the next crisis emerges.


The real solution lies with bank managements accepting, in all sincerity, that they do have a real obligation to abide by certain ethical standards (and bankers in their position of trust within the community should know all about this) and that profits are not the only game in town.


If they can't get this right then no amount of new rules or new inspectors are going to make any difference.”

Bryan Foss responded to my comments with the following;

“Absolutely agree - this issue is about ethics and no amount of expensive (funded by the consumer it aims to protect) regulation will be enough to counter the effects of boards with objectives that are misaligned from their stakeholders (whether customers, investors, employees, suppliers, partners or regulators).


As an NED I have a responsibility to represent all these stakeholders at different times and the ethical challenge makes sense on the board and in leading and being a member of the key assurance committees (Audit, Risk, Nominations and Remuneration for example).


There is some excellent work being done in this area, but so far with insufficient impact on the big banks, or even on the government or FSA as regulator. Too many 'same olds' are moved around or called back in so that things don't really change at all - just look at the FSA and UKFI, if you can find the key names or how the appointment process is supposedly 'transparent'.


One person who is starting to influence these boards and to shake things up with the various regulators (wider than the FSA) is Prof. Roger Steare, Corporate Philosopher with CASS (City University Business School).


There is much more to be done, but we may now be at, or very close to, the tipping point where ethics really count - and there are more than a few people ready to give a final push .......”

Roger Steare is the Corporate Philosopher (http://www.rogersteare.com/). He works with people in businesses all over the world who want to do the right thing. He helps them build trust and sustainability. This short video is like a breath of fresh air.