Speeches

GETTING REAL ABOUT GOVERNING CORPORATIONS

Dr Madhav Mehra
President, World Council for Corporate Governance

Wall Street seems to have pronounced the death knell of capitalism. It has fallen victim to the worst form of crony capitalism of which it used to blame the Asian economies. Never before has the downward-slide been so persistent, so long and so sharp. Every measure that the US government is taking to prop up the market or the dollar seems to be working otherwise. The slide continued unabated even when President Bush was exhorting US business in Alabama to boost the confidence in the US economy and the dollar. The disease has caught up with Europe as well and no doubt is going to afflict, the rest of the world. Dollar’s weakness is not a good sign for the exporting countries of Asia and the region’s fragile economic recovery.

The strange thing about the latest stock market collapse is that it has not nose dived because of Japanese dropping the atom bomb on Pearl Harbour or Saddam Hussain’s attack on Kuwait or the Twin Tower attacks of 9/11. Americans have simply lost faith in the ability of their iconic enterprises to return their savings. The accounting frauds committed by the likes of Enron, World.com, Global Crossing, Tyco, Adelphia, Qwest, Dynergy, Xerox and the list goes on, have brought home to average investor that the earnings these companies disclose cannot be trusted. Nearly 1000 US companies have had to restate their earnings since 1997 and many more are under investigation. It is not that the fancy accounting tricks were only confined to Andersen who has been convicted in a Texas court of obstructing justice. Some of the big names of Wall Street such as Merryll Lynch have been found guilty and fined for publishing deliberately misleading research and ignoring egregious conflicts of interest.

While India and other developing countries are fortunate in not having been infected with this problem to such an extent, may be they did not pay heed to the World Bank advice of using American model and use American audit firms, their penchant for inflating profits and earnings is no less. A recent study by India’s credit rating agency CRISIL stated that 139 companies including infotech giant WIPRO, and star companies such as TISCO, NOCIL and SPIC had resorted to creative accounting and inflated their asset base in 2000-2001.

It is not the first time that the stock market has crashed or we have seen the emergence of ugly head of corporate greed. The history of capitalism is replete with examples of similar excesses starting with the affair of the tulips in Holland and the South Sea Bubble. The general assumption is that like the previous market collapses, the current crisis will spur reforms, make corporates more ethical and help market emerge stronger than before. President Bush has already called on stock exchanges to require companies to appoint majority of independent directors and audit and remuneration committees to be all independent. There is ,of course nothing new in his proposals. All this has been an integral part of corporate governance folklore which the Washington based secretariat of the World Bank and Paris based OECD Secretariat are assiduously lecturing the emerging markets about. It is assumed that rationalization of the markets; stricter punishments for defaulters, curbing the stock options, banning of consultancy by auditors, bringing more independent directors, increasing transparency of accounts and making auditors independent will bring back sanity to the markets.

The tragedy is that all this has been said before and time and time again. It is the implementation of all this which is fraught with egregious problems. Lord Young, the president of UK’s Institute of Directors has already lambasted the institution of independent directors and called for the abolition of the non executive posts. He argued that relying on part time outsiders who barely spend 15 hours a year to police boardrooms was naïve and “dangerous non-sense”. Paul Sarbanes, the US Senator has introduced a bill to set up an independent body to supervise the accounting profession, which is likely to become law despite opposition by professionals. Again will this help? Remember, Andersen, auditor to both Enron and World.com had already separated from its consultancy, now called Accenture. The remaining Big-four still have to do it.

The malaise in the governance of corporations is far deeper than what appears on the surface. Capitalism, it has now emerged, is far more deeply flawed than our analyses suggest. By feeding on ruthless competition and promoting a culture of winner takes all, capitalism has spawned virulent individualism which has grossly discounted the value system based on ethics. Corporates still use moral language but they do not believe it has any objective foundation. Like George Bush they tell other corporates “Do as I tell you, not as I do.” Naturally nobody listens.

With growing dominance of the markets and emphasis on immediate gain people’s behavior is guided almost exclusively by prudential and not moral consideration. They obey the rules, remain within the law, follow the norms, respect values only if they calculate that these will benefit them personally. They do not accept the validity of moral discipline if it runs counter to their personal objectives. In a policy driven by competitiveness and aimed to enhance the authority of markets, individual action has little to do with ethical behavior.

The rational market participant is supposed to treat everyone and everything as a means to serve his/her ends. The imperative is simply to achieve the greatest possible satisfaction of our personal preferences. So what is wrong in the CEO paying himself astronomical salary and bonus, while he is sacking the workers in the name of cost cutting and downsizing?. Why should the independent director ask awkward questions on company accounts or CEOs pay hike? He gets only a fraction of his remuneration from the company in director fees - a lot more comes from the consultancy services provided by his / her private company. Similarly what is wrong in auditing companies flogging their other services to the clients?. The fact is that you get ahead as an independent director or an auditor by billing large fees and not by blowing the whistle. As Mike Rake, the international chairman of KPMG now admits, “having a $3 million audit fee and $ 100m non-audit services fee just does not meet the perception test”. It is not for nothing that auditing firms advertise themselves all-purpose solution providers. Here is an example from Ernst & Young’s website :

“Our 84,000 people in more then 130 countries worldwide can implement a broad array of solutions in audit, tax, corporate finance, transactions, online security, enterprise risk management, the valuation of intangibles, and other critical business-performance issues.”

Would you ever rely on a food inspector who also sells catering services to the kitchen he / she inspects?

Lester Thurow wrote, nearly 40 years ago, in The Future of Capitalism that, ‘Paradoxically, at precisely the time when capitalism finds itself with no social competitors - its former competitors, socialism or communism, having died - it will have to undergo a profound metamorphosis’. It is time we began the process to bring about this “profound metamorphosis”.

The centrality of corporate governance lies in its emphasis on transparency. It is far easy to say but most difficult to implement. You cannot obtain transparency if investors expect double digit profits in each quarter. In our rapidly changing economy variations are an integral part of business. So why are we defensive about shortfalls?. We practice the three types of truths we all know - first truth is what we tell others; the second truth is what we tell ourselves but do not tell others. The third truth is what we do not even tell ourselves. The malaise in corporate governance is so deep rooted that we do not even tell ourselves that it exists. This is why it has to make its presence felt every so often by market collapses causing pain and suffering to poor shareholders for no fault of theirs.

It is curious that each time we are confronted with market collapse our immediate response is to tighten the rules and revise the codes little realizing that corporate discipline is not something that can be achieved simply by revising codes or adding new ones. The very people who are crying for retribution were part of procession of cheerleaders of Kenneth Lays and Bernie Ebbers. They are the ones who stoked the fires of impossible expectations with, what ”The Economist” says, “an unfailing supply of hero worship, with their idiosyncratic maxim that you either get it or don’t get it.” Investors were so inebriated with “irrational exuberance” that they almost willed the companies to tell lies.

One of the problems of the modern economics is that we have no perfect business models. We often aim at fastly moving targets and are bound to have a few misses. We are oblivious to the fact that failure is also value adding, that failure is the precursor of success and that no success has ever been achieved without failure. In a relationship based on trust and transparency, failure is an investment and would need to be capitalized and not expensed. Hundreds of Silicon Valley companies have demonstrated that “failure is a badge of honour,” that people should be rewarded for “good tries”.

As humans, we recognize that we reach perfection by learning from mistakes. So why do we hesitate in owning our mistakes and sharing them with our colleagues in the board & the shareholders? We are on a journey of continuous improvement where “everyday I am doing better & better”.

Transparency calls for sharing of mistakes with your board and shareholders. Their real concern is not that you did not achieve the double digit earnings-growth, but what are you doing about it and where is your plan of action for the next quarter. Investors are looking for management with their eyes on the ball who may lose a game but can demonstrate a compelling strategy that will finally win the match.

In any event market capitalization today is not determined by quarterly profits or earnings. Study after study has indicated that buyers are thronging to companies which have societal, environmental and social messages. So why inflate earnings and risk the wrath when you are exposed?. Think how it would spoil your reputation – the very key to market capitalisation.

We must realize that knowledge economy behaves differently from capital economy. Success in the knowledge economy requires boards to change their industrial age paradigms. Far more value is added by promoting the concept of sharing than competing. Sharing adds value to both sides because knowledge unlike capital is not limited by tangible assets which can be used only for one purpose. Knowledge is a fluid tangible asset that can be transferred at little cost. But sharing cannot take place without trust and trust can come only through transparency.

The problem of the American system is that it is skewed heavily in favour of shareholders. The practice of corporate governance was aimed to give the CEO unfettered authority to hire, fire and reward in the name of creating wealth for shareholders and to mitigate “principal – agent problem”. In practice most CEOs use this authority to reward themselves with huge pay hikes and vast bonuses by inflating earnings. This was largely an American disease. But of late European CEOs are also copying their US counter parts in this respect and awarding themselves hefty rises. Prudential shareholders had a hard job in preventing their boss to award himself bonuses worth £900,000. While CEO’s salary in US quadrupled in 1990s, the employees salaries only increased by 3%. Such actions take away employees confidence in management. Governance that says shareholders should get most benefits and does not care about employees who dedicate their lives for corporation is not governance but corporate greed.

In their book, “The Stakeholder Corporation” published in 1997, Wheeler and Silanpaa have asserted that “during most of the 20th century in the UK and USA, stakeholder inclusive enterprises fared better than “shareholders - first” companies. Stakeholder inclusive corporations invariably lead to better long term business performance”.

More and more people today, individuals and groups expect a business organization to adopt a triple bottomline approach, be economically viable while becoming, environmentally and socially responsible. They also expect the business to be inclusive and ethical. Kenichi Ohmae argued in The Borderless World: Power and Strategy in the interlinked Economy that: A corporation is a social institution whose responsibilities extend far beyond the well being of its equity owners to giving security and a good life to its employees, dealers, customers, vendors and subcontractors. Their whole life hinges on the well being of the corporations.

Peter Drucker, in his now classic The Concept of the Corporation, said over 50 years ago that what is needed in a redefining of the corporation as a social “institution “is an integration of the worker as a partner in the industrial system and as a citizen in society”. Yet most corporate governance definitions even today do not include employees as the beneficiary of the corporate rewards in the same way as shareholders.

If the capitalism is to survive, if it is to create wealth, it is absolutely essential that it adopts an inclusive approach to make it sustainable in the long haul. It must incorporate the social and environmental agenda, not as add-ons to a company’s economic activities but as an essential and integral, part of business strategy and its processes, to reflect the rapidly changing post-industrial economy.

The ultimate aim of good corporate governance must be to make corporations good corporate citizens. Corporate citizenship calls for creating value for the society as a whole and goes well beyond corporate social responsibility or corporate philanthropy. The transformation is achieved by following the 11 point agenda.

Sustainability
Corporate governance must recognize that at the heart of successful business there needs to be a promise of long term prosperity for all its constituents. Corporates must move away short term approaches and link all their actions to long term horizons.

A triple bottom line
Good corporate governance recognizes that a business has social, cultural and environmental responsibilities to the community in which it seeks a license to operate, as well as economic and financial responsibilities to its shareholders. Corporate citizenship is about business redefining the way in which a company focuses on a triple bottom line approach that brings financial rewards while meeting social and environmental obligations.

Making a difference
Business’s foremost purpose is to make a difference in society. It is more than philanthropy and beyond corporate social responsibility. Corporations must refit themselves into businesses which provide services the society needs rather than create artificial demand for obsolete products or services.

Employee and stakeholder empowerment
Corporate citizenship seeks to ensure that every one associated with the corporation is empowered to be able to contribute creatively an proactively. It must recognize that people want to become involved and it is for the Corporation to innovate strategies to make it happen.

Transparency
No teamwork is possible without trust and transparency. Business must be truthful in disclosing not only its financial statements but also the way in which decisions are arrived at. It must also share its responses to environmental and social consensus with its shareholders.

Equity
Transparency means sharing not only successes but also failures. Such sharing is not possible unless financial rewards are distributed equitably. The benefits must be divided not among the few but many. Creation of wealth must aim at removing inequalities and inequities.

Accountability, probity and integrity
Corporate citizenship is about improved accountability, probity and integrity. The business must aim to bring benefit to all and demonstrate it through regular audits of the organisation’s financial, environmental, social and economic processes.

Inclusivity
Corporate citizenship is about employee and stakeholder-inclusivity. Stakeholder inclusion requires a long-term, and continuous relationship to be developed with all stakeholders both inside and outside the corporation.

Diversity
Diversity has been regarded as dysfunctional throughout our economic history. It is extremely valuable in the board. It is only through the clashing of opposite ideas that the true reality emerges and real progress takes place. A lot of our national ills can be solved only if we recognize that its is the difference and not conformity that makes harmonious society.

Engagement
Corporate citizenship is about engaging with changing and diverse cultures - corporate, government, community and individual - in order to achieve sustainable social, environmental and economic success.

Dialogue
Open dialogue is at the heart of corporate citizenship. With wrenching change taking place all around us the corporation has to develop systems of regular communication within the board & between the board, shareh

olders, management, government, employees, custom, suppliers and the civil society. It is through this dialogue that the corporation will communicate its values, vision, mission and goals and share their financial, environmental and social numbers at regular intervals. It must demonstrate corporation’s commitment to all it’s constituents viz. the board of directors, management, employees, shareholders, the government and the other stakeholders and the civil society. Corporations must clarify that they are not only creating value for the corporations but making significant impact on the society by reshaping community values, attitudes and cultures.

Corporate scandals and the consequent collapses have a lethal effect on the poor and the old. Not only these destroy their life’s savings and reduces them to penury they take away their confidence in the markets itself. They have no hope to make good their loss. It is a great national loss. We have to do 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 WORLD.COM 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.

As we move into the 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.

It is unfortunate that our economic structures are built on an inaccurate view of the human pscyche. 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 quiet joy. Experiments conducted on young women engaged in cooperative effort showed that 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.

We need to think of business designs that go beyond the externalities of quarterly profits and provide intrinsic worth and meaning to shareholders while making corporations focus on the larger picture and helping to relish the joy of making a difference. 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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