Speeches

WINDS OF CHANGE - EMERGING ISSUES
Keynote addess at Abu-Dhabi conference
organised by the Institute of Chartered Accountants

Dr Madhav Mehra
President, World Council for Corporate Governance

Despite all round gloom in European economies, economic performance of UAE is on the upswing. The success story of UAE stems from the diversity of its workforce. Diversity is the greatest value-enhancer in the knowledge economy. UAE has a unique mix of Arabs, Indians, Philippines, Egyptians, embracing diverse religions in its workforce. That indeed is its strength". This was stated by Dr Madhav Mehra, President, World Council for Corporate Governance in his keynote address to 300 Chartered Accountants in Abu Dhabi last week who had assembled to celebrate their annual day and had invited Dr Mehra to address them on, "Winds of Change - the Emerging Issue". Dr Mehra added "While we all recognise the profound ways in which our lives are being altered hour by hour by then accelerating pace of technology, few of us understand how to respond to these changes. What we term as digital economy or knowledge economy or the new economy is fundamentally different from the industrial economy. In industrial economy when we shared things, the value of the things remained the same. Exchange of capital does not increase the overall value of the transaction. But knowledge is fluid. Firstly it can be transferred at little cost. Secondly its value increases when it is shared and unlike capital it can never be used up. The more you share the greater it becomes. Now comes the most crucial message of the knowledge economy. The increase in value depends on the degree of diversity of parties sharing knowledge - diversity in terms of experience, qualifications, age, gender, ethnicity, environmental influence, history, region, race and religion". Dr Mehra asserted, in an economy driven by innovation value will be created only by the clash of ideas and conflict of opposing views. Unlike the previous economy value does not come from deference but difference, not from conformity but dissent. Constitution of diverse boards therefore, is a prerequisite to creating long term corporate values.

The second lesson is that the value will not created by perfection but difference. Customers no longer need products which are perfect. They want products which are different, profoundly different. Wealth will be created not by optimization but innovation, not by perfection but by seizing the unknown, however imperfectly".

Third lesson is "do not waste your time defending the past" or justify our failures. The world is changing so fast that even you repeated the previous success, you will be left behind. The best is to use the seven golden words of English language-"I am sorry, we made a mistake" and move on because there is a whole world of new opportunities ahead of you which you lose by sticking to the past or defending it. Look at Richard Grasso, how long he took to defend the archaic system of New York Stock Exchange. Once he ordered the investigations against LABranche, its largest specialist trading firm, NYSE it fell like a pack of cards taking Grasso alongwith it. The strobe-like glare of public scrutiny is so strong today that any malfeasance if not admitted instantly can wreck havoc.

The seismic waves of corporate collapses that continue to rip through the boardrooms are not so much because of accounting frauds but a poor model of corporate governance adopted by the west and now being apishly copied by our own corporates. In this modle CEOs have not been focusing on generating wealth but manipulating earnings to justify large bonuses to enhance their pay packages. The worst sufferers are the very companies which were held as models of corporate governance. Throughout the last 2 decades CEOs have been grabbing power that belonged to shareholders in the name of corporate governance and misusing it for personal gains. During the period while worker's wages in US rose only by 60% CEO salaries have risen by 4300%. The differential between an ordinary worker and a chief executive has moved from 1:20 to 1:400 during these 2 decades. The unfortunate thing is that India too is now following this race closely. A study conducted by Centre for Corporate Governance indicates the differential has gone upto 1:300. There is an urgent need to rein in excessive compensation. Mr. Narayan Murthy of Infosys has suggested that the differential between the CEO and the shop floor workers should not exceed 1:20.

Fundamental changes taking place in the market landscape require that boards should become competitive. For this they have to spur company wide innovation. Innovation is not something you can order like breakfast in Taj Palace. It has to come from the heart. If workers think that management is using corporate governance for corporate greed and using every opportunity to enhance their remuneration regardless of whether the company is making profit or not, they will never put their heart and risk themselves in experimenting to find radical ways to improve things. The real reasons for poor market performance, are lethargy in innovation to counter the gravitational pull of obsolescence, short termism and excessive focus on quarterly profits.

The migration from industrial to knowledge economy has brought several other fundamental changes that require 180% shift in our strategies. While all through history we have been talking about the power of sharing we have actually been practicing the power of plutocracy. We never believed in our hearts that we can enhance value by sharing with others. In the industrial economy goods are limited and giving more to one means having less for oneself. Knowledge economy has changed all this. In the case of knowledge when you share it both sides gain. But here is the most crucial message of the knowledge economy. The gain depends on the degree of diversity of the group that shares knowledge. Greater the diversity in age, experience, gender, qualification, ethnicity, environment and religion, greater the value.

This is particularly relevant in the context of corporate governance. So far corporate governance has been viewed purely from the point of view of shareholders. Computer simulations have indicated that stakeholders collaborations can enhance the corporation's value by a factor of 10. Employee knowledge alone contributes as much as 70% of corporate assets. This shows how our focus purely on maximizing wealth for shareholders alone is self-defeating.

The malaise in the governance of corporations is far deeper than what appears on the surface. 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. Unbridled greed pose the biggest threat to capitalism. Corporates still use moral language but they do not believe it has any objective foundation.

If there is one lesson to be learned from the high profile corporate failures of Enron, WorldCom, Marconi et al, it is that we must move away from the western model of a box ticking approach to corporate governance. Enron had ticked every box. The chairman of its audit committee was a person of irreproachable reputation and no less than the Dean of Standard Business School. Law, rules and regulations are never an answer for the issues of head and heart. The heroic act of New York Stock Exchange's Attorney General, Eliot Spitzer, in imposing fine and restitution of $1.4 billion on 3 big banks i.e. Citibank, Merril Lynch & CSFB is a classic case of the futility of external enforcements. These fines were expected to end the multimillion dollar pay packets some analysts enjoyed in the bill market, which were justified by the amount of investment banking business they brought in. But such is the bizarre world of corporate finance that soon after CSFB had offered an equity analyst at JP Morgan Chase a package that could earn him upto $4 million in the first year. Where will this money come from if not the unholy alliance between the analysts and underwriters.

To think that Enron, Marconi and Vivendi are simply isolated cases where corporations have cheated the innocent public is to show evidence of extreme naiveté. Lynn Turner, Chief Accountant of the SEC from 1998-2001 who was earlier a partner of Cooper & Lybrand admitted in a TV interview "All the Big Five accounting firms helped Wall Street investment banking firms to engineer hypothetical transactions to make companies look better than they actually were.

Instead of bashing Enron, we should be grateful to it for throwing open the murky world of corporates and providing us an opportunity of getting real with the huge problem of cleansing it. Arthur Levitt, the former chairman of Securities and Exchange Commission tried for 4 years to curtail the power of Accounting profession. He could not succeed even in having a meeting of the Big Five in his office. Finally, he had to hold it in the office of one of them. Paul Sarbanes and Mike Oxley have gone a long way since then in establishing an Accounting Oversight Board with majority of non financial members and banning non audit work. Yet, Naresh Chandra Committee has not drawn lesson from it to clip the power of India's accounting profession and has failed to recommend establishment of the oversight board in India.

Enron has also debunked the myth of role models. Enron itself was declared the "most innovative company" by Fortune for five successive years. McKinsey, the super consulting firm, was consultant to Enron and collected fees of $10 million a year. A McKinsey director attended board meetings and the CEO himself was a former McKinsey partner. Super star CEO Jack Welsh is suspected of not generating but managing earnings of General Electric. Corporate preacher George Soros himself has been fined for insider trading. Corporate hero Messier of Vivendi has the police raiding his premises.

In these turbulent times public values have undergone a sea change. There is a call for return of power from corporates to people. Social good has become one of the most paramount competitive differentiator. People want participation, accountability and transparency. In the nineties the corporates could live through by following the Nixon doctrine - "thou shalt not be found out". This option is no longer available in the new economy. Companies which are not transparent will pay a heavy price. New York Attorney General Eliot Spitzer's success in bringing US's top financial institutions and corporate giants like Sandy Weil to their knees was due to the power of internet. It was the clinching evidence of their inhouse e-mails that helped him build cast iron cases against Solomon Smith Barney and Merrill Lynch. There is only one certainty in the uncertain world of today, that if you try to hide behind stealth and translucence, you are certain to be found out.

India's Joint Parliamentary Committee had missed a terrific opportunity of cleansing its political system in the way President Bush had done soon after the Enron scandal in the US. It is a cardinal mistake not to capitalise the post Enron righteous reaction and indict those responsible for UTI scam which has inflicted so much suffering to India's common man and has been largest single factor responsible for shattering public confidence in the stock markets.

Another major reason for corporate collapses is the "mortal fear in which the today's CEO lives of the stock market which forces him to inflate quarterly earnings. We have to educate investors to ignore quarterly reports and take a long view of the company's performance". Few companies are looking at the sustainability issues to build corporations that last.

The heart of corporate governance is the independence of directors. Directors will never be independent unless they are recruited and paid by an outside agency. World Council for Corporate Governance is helping establish such an agency for recruitment and placement of Non Executive Independent Directors. But non executive directors will be ineffective unless we can restrict the number of directorships an individual can hold and take up with non performing directors.

Pay for CEOs has continued to escalate last year despite falling share prices, depressed corporates profits and increasing shareholder angst according to a new research. Income Data Services say that total earnings, including benefits, bonuses, payments on long-terms incentive plans and notional gains on options exercised during the year was up 23% in the UK. The continued lack lustre performance of the companies and relentless demands of pay increases by executives have put shareholders up in arms against their directors. The problem was emphasised by Bill McDonough President of New York Fed on the first celebration of the terrorist attack on Twin Towers of 11 September in 2002. He pointed out that the differential between the CEO and workers pay which 42:1 has risen to 400:1 during the last 2 decades.

Studies in US & UK both countries show no link between the remuneration of chief executives and corporate performance except the size of company. So all through the last 2 decades CEOs have been finding ways to upsize the companies through ill conceived mergers and acquisition. . Over 60% of the mergers and acquisitions destroy shareholder value which increasing CEO remuneration. Most value-destroying companies are serial acquirers. Our challenge therefore is how to develop proper criteria to measure CEO success.

In a recent article Prof Jensen, with Joseph Fuller of the Monitor Group, argued: "As the historic bankruptcy case of Enron suggests, when companies encourage excessive expectations or scramble too hard to meet unrealistic forecasts by analysts, they often take risky value-destroying bets. In addition, smoothing financial results to satisfy analysts' demands for quarter-to-quarter predictability frequently requires sacrificing the long-term future of the company. Quarterly reports therefore are the biggest bane of the corporations. It is the fear of the quarterly results that drives CEOs to inflate earnings.

The glorification of greed continues with the rape of corporations for the personal enrichment of the senior executives and the creation of ventures whose business plan do not extend beyond the initial public offering. Greed is the biggest threat of the market economy and may well become the death knell of the capitalism. So, the biggest challenge before us is how to handle this greed. How can human behaviour be rewarded other than through the money. One, therefore, has to look for fundamental purpose of the corporation. It is relevant to draw attention to Enron again in this context.

In their book on Enron's demise What Went Wrong At Enron Peter Fusaro and Ross Miller record that when at Harward Business School Mr Skilling was asked what he would do if his company was producing that might cause harm - or even death - to people who used it, he is said to have replied: "I'd keep making and selling the product. My job is a businessman is to be a profit centre and to maximise return to the shareholders. It's the government's job to step in if a product is dangerous". The traditional belief that the corporations are to maximise shareholder value cannot hold ground in the interdependent world of today. The value of the corporations is created by cooperation of various stakeholders viz employees, customers, suppliers and public policy and community at large. Such cooperation cannot sustain unless each of the stakeholders can answer the question: "what's in it for me?" Corporations role, therefore, has to change to maximize the value for all stakeholders.

The problems in corporate governance are the problems of execution. There is too much rhetoric. The real question is how do we handle greed before it destroys capitalism. For this we need to change our model and move it away from a box ticking approach. There is still an argument as to whether more money is destroyed by frauds or strategy. There are many among business still not convinced about the moral angle of business. Corporate governance is not just a legal formality. It is an instrument of business and social transformation. Our biggest challenge lies in replacing greed for running the corporation to a zest for making a difference to the community. Corporate governance, therefore, is an issue of the heart and not simply statutory compliance. To have the institution managed in the interest of real owners has been a challenge at all times. The question will we be able to meet is effectively even in the 21 st Century?

The simplistic view that prevailed in 1990s that business leaders need to focus exclusively on shareholder value as determined by the share price and that financial analysts are the best judge of business strategy simply cannot hold ground today. The ultimate purpose of the corporations has to be to make a difference to the community. Companies have to find innovative ways to contribute to broader needs of society and at the same time improve the revenue and cut operating costs. The corporations need to find new models of constructive engagement involving all stakeholders to bring about change in the society. The business must look for innovative formats that stimulate systemic thinking and dialogue rather than posturing. The question is no longer whether the business has a role in social change but how it should play this role and corporate governance has to be a catalytic for that change. Corporate governance has to be based on equity and fairness. Company's goal should not be the prosperity of a few but many. Inequality can be the greatest threat for the security of corporation. People can live in poverty but not injustice. Indeed, social good has become the greatest competitive differentiator.

The good news is that the role of business today is far more encompassing than ever before. Its constituency is global. So, its mindset should not be stuck into parochial grooves as in the case with national governments. It must recognise that its success will come from involving everyone and that it is only the clash of ideas that will sparkle innovations that will sustain the corporations in the future. For this the corporations must recognise the impotence of diversity and dissent. The value today is created not by conformity but diversity deference but difference.

Today it is the economy that drives politics. It is the business that drives governments. In fact, the political system has failed to address the human problems of inequity, poverty and terror. Business run on principles of transparency, equity, accountability, integrity and responsibility can make a difference that could give pride to execution and the true incentive for driving the corporations.

Inequality can be the greatest threat to corporations. In today's connected world people can live in poverty but not injustice. Equality and fairness have to be the cornerstone of corporations. Company's goal should not be the prosperity of few but many. Indeed social good has become a corporations differentiator and helps market capitalisation. There are some of the thoughts that need to be developed to provide a framework of governance that will help emerging economies achieve both economic and social transformation.

Adam Smith also wrote "The Theory of Moral Sentiments". While emphasising the importance of self interest he expected it to be enlightened and moral. Corporate Governance is to highlight the reputational risk posed to companies and shareholders by public disclosure of frauds. Their concern about good behaviour is not because it is right but because its absence affect the value of their stock.

For making corporate governance work we have to go through a profound metamorphosis from inside out. We have to change our metaphors of success from "winner takes all" and "success at all costs" and develop an inner value system which prides on ethics, morality, equity, legitimacy, transparency, diversity and most of all courage to own failures. Surveys indicate that investors will pay upto 28% more from companies with good governance practices. 60% also said they will punish companies that are not socially responsible. The conclusion is obvious. No corporation can survive in these turbulent times without embedding principles of corporate governance and corporate social responsibility.

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