Publications

CORPORATE COLLAPSES
Stemming the rot

Companies since the South Sea Bubble have used accounting methods not to state earnings but to inflate them and hide losses. Even General Electric, world’s most “admired company” has long been suspected of mastering the art of financial engineering rather than real business performance. As Warren Buffet reminds us, while Enron has become a symbol of the shareholders abuse, there is n o shortage of egregious conduct elsewhere in corporate America or shall we say rest of the world. We know the classic story of the accountant who was asked by his potential employer, “how much does 2 + 2 add up to”? He replied, “depends on what you have in mind, sir”.

It is curious that each time we are confronted with market collapse our immediate response is to seek new rules and revise old codes. Little do we realise that corporate discipline is not something that can be achieved simply by revising codes or adding new ones. Human greed is so insatiable and human ingenuity so profound that we will find a way to beat any system. The very people who today are crying for company law reform and severe penalties were part of the procession of cheerleaders of Keneth Lay of Enron and Bernie Ebbers of Worldcom. They are the ones who stoked the fires of impossible expectations from their new found heroes and lured them to make commitments they knew could not be sustained. The culprits include the investors who were so inebriated with “irrational exuberance” of 1990s that they almost willed the companies to tell lies.

The public outcry following the accounting frauds in US has led to the passing of the Sarbanes-Oxley Act which creates accounting oversight board, strengthens auditor independence, requires CEOs to certify accounts, enlarges rules governing conflicts of interest and increases criminal penalties. President Bush signed the Act into law on 30 July 2002 and called the legislation “the most far reaching reforms of American business practices since the time of Franklin Delano Roosevelt”. In the UK, the Department of Trade and Industry has appointed Derek Higgs, Chairman Partnerships UK Plc, to review the issues of conflict of interest. He has already been criticised as he is also the non executive director of Allied Irish Bank which was in the news recently for detection of a massive fraud. The key issues on which Derek Higgs is inviting views are:
· What role should non-executive directors perform and how does this compare to the present position?
· What knowledge, skills and attributes are needed and what can be done to attract, recruit and appoint the best people to non-executive roles?
· Do existing structures and procedures facilitate effective performance by non-executive directors?
· Do existing relationships with shareholders or others need to be strengthened?
· How can non-executive directors best be supported to perform their role?

India too has appointed a Committee under Naresh Chandra, its former Cabinet Secretary and an illustrious Indian Ambassador to US to examine the entire gamut of issues pertaining to the Auditor- Company relationship, professional regulatory bodies and role of independent directors.

As Enron debacle indicates, good corporate governance code is no guarantee of good corporate governance. There needs to be stricter monitoring and enforcement of laws on punishment for corporate scams to ensure that those violate the public trust do not go scot-free. Along with a requirement of disclosures and accountability, laws should be amended to mete out swift and deterrent punishment to the offenders.

The cornerstone of an effective board is the institution of independent directors. Our first question should be to find out why it is not working. Indeed why a person like Lord Young, the then President of UK’s Institute of Directors called for its abolition? The key to all this is the manner of their selection. In a survey conducted in the UK it was found that as much as 75% of non-executive directors are recruited as a result of an informal networking by an existing director. A classic example is of a system called Golden Triangle whereby a director of company A sits on the board of company B while the director of company B seats on the Board of company C and the director of company C seats on the board of company A. The triangle is called Golden because non-executive director appointed by this arrangement invariably end up on remuneration committee as well. It is no wonder, therefore, that Lord Young has lambasted the institution of independent directors. He argued that relying on part time outsiders who barely spend 15 hours a year to police boardrooms was naïve and “dangerous nonsense”. Non-executive directors appointed this way become a greater liability and more harmful than executive directors who at least know the business.

In fact, non-executive director is a misnomer and an oxymoron. Non executive directors are outside directors who have no previous connection with the board nor have any management ties. It is the non-executives and not the CEOs who are the eyes and ears of the shareholders. Theirs is the job to bring objectivity and impartiality to the board’s decision making. They also widen the horizon of the board in formulating strategy, applying both a wider general experience and any relevant special skill and knowledge that the board may otherwise lack. Cronyism in the appointment of non-executives and the cosiness in the supervision of board room pay can spell disaster to independence and make a joke of non-executives. Non-executive directors are crucial to maximising effectiveness of the board and it is time that the process of recruiting independent directors is given as much importance as appointment of a CEO. Ideally, appointment of both auditors and non-executive directors needs to be made by a group or a vehicle, which is independent of the board. The process needs to be made as transparent as possible which is possible only if each appointment is made through an appointment committee. This committee should develop criteria for the appointment and engage an independent search firm for recruitment.

Auditor independence is another area of concern. Their judgement becomes questionable when auditors perform a significant consultancy role. It has often been noticed that the audit contract is a loss leader linked to a lucrative consultancy contract. As Mike Rake, International Chairman of KPMG says that auditors accepting consulting services in the same company simply is unacceptable. “Having a $3m audit fee and $100m non-audit services [fee] just does not meet the perception test.” Forbidding auditors from offering other services to clients must become an article of faith for ensuring good corporate governance. Worldcom paid Arthur Andersen $12.4 million last year for such services compared to $4.4 million for audit fees. Sarbanes-Oxley Act’s requirement of rotation of auditors to prevent cosy relationships undermining the integrity of the audit is also worth emulation. Andersen had been Worldcom’s auditor since 1989. Periodic change of the auditor might have led to more probing and indepth examination of accounts.

The most important task before us is to establish common international accounting standards. For far too long the accounting standard have been emphasising form over substance. We need to move away from the prescriptive rule making to the ground realities of business. This poses one of the biggest challenges for the International Accounting Standards Board. We also need to settle once for all the controversy over accounting for share options which according to John McFall, chairman of the Treasury select committee, whose report on the financial regulation of public limited companies, post-Enron, has been recently published, allows rich executives to retire to a life time of luxury. It is strange why stock options have not been treated as an expense so far and why it was left for Warren Buffet of Coca-Cola to take the lead in this respect.

There is also a need to rein in excessive executive compensation. Prudential shareholders had set a good example in scrapping a new pay scheme that could have netted its Chief Executive Jonathan Bloomer a £4.6 million bonus on top of his basic salary of £660,000 if certain targets were met. It has now been generally admitted that corporate governance principles in US have been used to advance corporate greed of CEOs. In 1990s while CEO salaries increased by 30% a year the employee wages remained static. In his recent address commemorating 9/11, Bill McDonough, President New York Federal Reserve, denounced the excessive increase awarded by CEOs to themselves during the past decade. Reminding the congregation of the commandment to love thy neighbour as thyself, he said “the policy of vastly increasing executive compensation was ….terrible bad social policy and perhaps even bad morals”. He pointed out that studies now indicated the average chief executive made 400 times more than the average production worker, compared with the ratio of 42:1 two decades ago. Mr McDonough urged chief executives and directors to adjust pay levels “to more reasonable and justifiable levels.

In fact, independent auditors, non-executive directors and audit committee are also not enough. What is needed is greater overall accountability from everyone in the company from a clerk to a CEO. They need to be educated to detect a fraud at an early stage and realise that it is their job to report any suspicious transactions and activities. If they do not they could face prison sentences and financial ruin. What we need is a culture change within companies to fight the financial fraud, which in the UK alone, according to City fraud litigation specialist Philippsohn Crawfords Berwald, has registered an alarming increase of 200% during the last 6 months. Lot of this fraud is also a byproduct of new technology. Organisations must use every opportunity for exposing staff to training in new technologies. Remember, highly motivated, continuously developed and trained staff are the best insurance against fraud.

Sarbanes-Oxley Act has done a commendable job in introducing an Oversight Board which will have five members appointed by SEC to oversee accounting firms that conduct audit of public companies. This board will set standards to uphold the integrity of public audit and will have the authority to investigate abuse and discipline offenders. There are in the UK 23 regulatory bodies which make the task of supervision of auditing standards extremely difficult. There is an urgent need for a single independent body to oversee all accounting aspects on the lines of US’s Oversight Board.

The requirement of personal certification of accounts by CEOs with deterrent penalties for “wrong doers” is another step in the right direction. It is necessary for each CEO to get their financial directors to check whether the financial reports give you and your shareholders a truthful account of the state of the company or uses accounting discipline to hide behind the figures. Remember the phrase “profit is an opinion whereas cash is a fact”. CEOs must ask themselves do the financial reports reveal the information you would need if you were an outside investor? Are your reports comprehensible to a lay man? Annual report should contain a section written by the audit committee summing up issues and explaining them in simple language keeping special regard to any items of creative accounting such as accelerated revenue recognition of balance sheet vehicles and other complex transactions to hide company losses.

IT can have an important role in improving the effectiveness of the board. Businesses are becoming increasingly complex and problems such as Enron are natural to occur when business has become global. Failures of Enron in fact are not of accounting but management. Accounting was used to hide those management failures. Important thing, therefore, is to prevent such management failures through better governance structures and creating real time systems like digital dash-boards that help you access constantly fresh data about different streams of operation to keep things under control.

Legislators can wave their magic wands and pass any number of rules. These will be of no avail until we realise that the market realities themselves have changed vastly during the last few years. According to Elliot and Schroth the forces driving the slide include:

§ Complexity. In business, particularly in global business, complexity becoming deeper and wider and is providing the hiding places for new forms of business deception.
§ Technology. Advancements are proving speed for business maneuvers, both the good and the legal and the bad and illegal.
§ Inability to Grasp Reality. Corporations are losing touch with the performance reality states of their business operations, finance and accounting, deal making consequences, and the value of their intellectual capital.
§ The Need for Precision. Managerial task require more rigor, more precision, and complete accountability in the boardroom and from the leadership teams.

Unless corporations understand the new requirements for business performance and the importance of innovation, budgetary controls and closer monitoring, legislations will be like firing grenades to stop a tornado. Corporate directors need to be more radical and revolutionaries constantly spurring their companies towards creating new competitive spaces through a spiral staircase of innovation.

The corner stone of the absolute minimum standards for the constantly gyrating new economy for corporate managers will be a new form of scientific management based on performance reality and accuracy in reporting on corporate capabilities. There needs to be a National Quality Programme for “accuracy” in corporate information and all forms of company disclosures. We should make quality assurance as part of the corporate reform movement. This will be the foundation for real performance quality programme based on precision of information and reporting of corporate data. Quality Awards need to be restructured and applied to corporate information problems. Currently Six Sigma is applied for developing and delivering “near perfect product and services”. This can be used to improve the management capability for advancing the best companies and checking the fraudulent.

Good corporate governance is required not only to prevent frauds but to maximise value for all stakeholders. The role of non-executives in the Boards is not only of watch dog but also, and more so, of creating wealth. Shareholders are at far greater risk from a mismanaged and under performing business than an errant individual. Companies have to bear in mind the potential trade-off between polishing corporate reputation and delivering growth, says a survey report by the Economist Intelligence Unit. “Tight governance can protect firms and investors from fraud, error and undue risk, but it can also threaten agility and innovation.”

Executives at the top ten firms by market capitalisation in the US, the UK, France, Japan and Germany have expressed concern that tougher corporate governance rules would negatively affect merger and acquisition deals because of lengthening due diligence procedures. A majority of company bosses also believe that the ability of their firm to make effective decisions would be compromised by closer scrutiny and tighter legislation. And while corporate governance is seen as a leading issue by the vast majority of those polled in this survey, it ranked relatively low on the list of dangers, executives saw threatening their firms’ share price. Adverse markets, a shortage of top quality management, reputational risk and a lack of innovation all beat out concerns over poor financial reporting and lack of transparency. The report also calls into question the ability of the regulators to set more than a broad framework for good corporate governance. “Ultimately rules are no substitute for ethics or how trust operates in business,” says the report’s author, Victor Smart. “There is no one set of regulations which is going to stop Enron.”

It should be remembered that, while laws and their enforcement are necessary to drill good governance practices, they will never be enough to eliminate them. Human ingenuity is so phenomenal that people find ways to overcome these. There is a strong need for voluntary action. This comes from personal commitment to ethics, social values, equity, fairness, transparency, rule of law, legitimacy, respect for individual and recognition of diversity and gender balance as value enhancer. What we need is an inner value system, garnished by a strong belief that translucence and deceit will not pay. We must know that knowledge economy has changed the world. Earlier companies made money by not informing people. Today you make money by informing people. The problem comes of informing people when you have failed. In an innovative economy of today when you have to constantly design new models you cannot have a winner all the time. When you are hitting at a constantly moving target you are bound to miss some shots. The answer is to have courage to own your failures and share them with shareholders. Courage is the obverse of transparency. Transparency cannot be achieved without courage.

Corporate scandals and the consequent collapses have a lethal effect on the poor and the old. Not only these destroy their life saving and reduces them to penury and desperation they take away their confidence in the markets self. They have no hope to make good their loss. It is a great national loss. We have to something, therefore, to prevent them happening again. But revising codes of corporate governance is certainly not the answer. We have a great capacity to beat the codes. Andersen have asserted all along that whatever they did at ENRON or WORLDCOM was within the law and thousands of firms do the same. Again nothing that President Bush has said in the aftermath of so many accounting scandals is new. Plastering over the capitalism’s cracks simply won’t work. It needs a systemic change which will come only by looking inside and not from outside. It is we who have to change our paradigm from individualism to integration, from tangibles to intangibles, from capital to knowledge, from objects to relationship, from parts to the whole, from domination to partnership, from structures to process, from short termism to long termism, from growth to sustainability, from confrontation to collaboration and from covering up failures to owning them up.

It is unfortunate that our economic structures are built on an inaccurate view of the human psyche. Scientists have recently discovered that the small, brave act of cooperating with one another, of choosing trust over cynicism, generosity over meanness, altruism over selfishness makes the brain light up with quite joy. Experiments conducted on young women engaged in cooperative effort showed the longer they engaged in cooperative strategies, stronger were the blood flows to the pathways of pleasure. Obviously our effort should be to increase opportunities of cooperation and down play unbridled competition.

As we move into 21st century there is a growing recognition that the ultimate goal of economic effort ought to be to improve the quality of life. Money is not a measure of all things that make us happy and markets are not the best mechanism to enhance human happiness. Indeed, if completely unfettered, they can do the opposite by encouraging selfish behaviour. Our focus should not be only on financial capital but also the human capital, intellectual capital and environmental capital. Good Corporate Governance must aim on maximising the value of all capital.

We need to think of business designs that go beyond the externalities of quarterly profits and provide intrinsic sustainable value to all shareholders. With its belief in equity, fairness, transparency, legitimacy, integrity and responsibility corporate governance is the best vehicle to improve quality of life for all and enhance the value of financial, human, social and environmental capital of this planet. Alas, it may take many more scandals to move to such a radical solution but since the alternative is so grave it might be worthwhile to steer the debate in this direction.

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