Principle and practice of corporate governance
“Using The Example Of A Particular Company, Discuss How And Why Weak Corporate Governance May Be Responsible For Corporate Failure.”
Corporate governance has become a prominent topic in the past two decades because of the following reasons: i) worldwide privatization; ii) the integration and deregulation of capital market; iii) take over wave; iv) the growth of private saving and pension fund reform; v) East Asia crisis in 1998, that raised concern about corporate governance in emerging market; vi) series of recent corporate scandals and corporate failures in USA. The content in the essay is structured as follows. First part will deal with the basic understanding of corporate governance and its different mechanisms. It will be followed by the argument that weak corporate governance leads to corporate failure, WorldCom case and reaction of the world related to failure.
What is corporate governance? Corporate governance is the system of check and balance which ensure that companies discharge their accountability to their stakeholder and act in a socially responsible way. Corporate governance assures suppliers of finance of getting return on their investment. Corporate governance is important for corporate success as well as for social welfare.
There are different theoretical frameworks that explain and analyse corporate governance e.g, agency theory, stakeholder theory, transaction cost theory, organization theory and stewardship theory. There can be a narrow view of corporate governance in which agency relations exists between mangers and shareholders or a broader view where relationship exists between mangers and stakeholders. However, both have a objective of promoting accountability of executive director.
What are the different mechanisms of corporate governance? From the perspective of shareholder theory, different corporate governance mechanisms which can alleviate the agency problem between shareholders and mangers are as follows: i) through the use of debt; ii) labour market for manger; iii) market for corporate control; iv) companies own large shareholder; v) board of directors; vi) Gate-Keepers”.
Corporate failure takes place when above mentioned corporate mechanisms fail to perform appropriately. (eg: Worldcom).
Worldcom formally known as LDDS began its operation in 1985, offering its services to commercial customers and local retail. In 1989, LDDS became public after the merger with Advantage Companies. In May 1995, it became known as Worldcom after the merger with Witel. In 1998, Worldcom paid $42 billion to acquire MCI this was the largest takeover in US history at that time. This acquisition made Worldcom nation's second largest long distance company after AT&T. However, Worldcom wanted to be at the top and in 1999, Worldcom tried to acquire Sprint, but this acquisition was not allowed by the U.S Justice Department. This rejection made Worldcom executive realize that large scale acquisition was no longer a feasible means for expanding the business and from year 2000, company began drifting. In June 2002, Worldcom's fraud was disclosed when it restated its financial results for all four quarters of 2001 and first quarter of 2002. In July 2002, Worldcom filed for bankruptcy protection after the discovery of its several accounting irregularities.
Worldcom was one of the largest public company accounting frauds in the history and this fraud was commited from 1999 until 2002. Ebbers the CEO of the company played a major role in the fraud. He had many non- worldcom business interest for which he had taken massive amounts of margin loan from commercial banks by securing his Worldcom shares. During 2000, telecom industry was experiencing a down run and at the same time Worldcom stock prices also started to fall down. In order, to avoid margin call he needed company stock to perform well. Instead of managing the internal affair of his company which was not integrated properly because large acquisitions in a span of shot time, he gave more importance on numbers and promoted the use of unethical means to keep the company's stock price up. So the fraud was directed by knowing misconduct of few senior executive officers at its Clinton, Mississipi Headquarters and it was implemented by its accounting and financial department personnel at various locations, but none of the employees raised concern on the entries they were making. This fraud was implemented and directed by CFO of Worldcom, Scott Sullivan and he was assisted by Worldcom's controller, David Myers. Accounting fraud was detected by Worldcom's head of internal audit department Cynthia Cooper 2002.
Worldcom's accounting fraud was committed in two major ways i) reduction of line cost, one of the major expenses of the company and ii) exaggeration of reported revenues. Line cost adjustment was made by improper realise of accruals and by capitalization of operating line cost. Worldcom's personnel employed the process of “Close the gap” for exaggeration of their reported revenues and most of these questionable revenues were booked to “Corporate Unallocated” revenue accounts.
Line costs were the costs paid to carry voice call or data transmission from its starting point to its end. This was the major expense of Worldcom business and its performance was measured to ratio of line cost expense to revenue. Worldcom by capitalizing the line cost increased its revenue in the accounting book and this helped Worldcom to project better growth and reach its projected numbers.
There was a major corporate governance failure in Worldcom because of its ineffective board, lack of transparency, lack of internal control and failure on the part of the auditor
Role of board in Worldcom's failure : The general functions of the board of directors are advisory function and monitoring function. Boards responsibility include formulating policy and showing foresight, strategic thinking, supervise the management and exercise accountability towards shareholders and stakeholders. The directors of Worldcom only attended the board meetings and had little or no involvement in company's business. There was lack of transparency between the senior management and the board of directors. Worldcom's board relied on insufficient information they received from the management without creating an environment which could have created an opportunities of learning of issues which required their attention.
Generally the board is presided by a chairman and he performs an important monitoring on the board. However, in Worldcom in spite of Chairman, Ebbers presided over the board meetings, determined board's agenda and its decisions, making it just an honorary title held by Roberts. Board of Worldcom was deceived because management had complete control over the board agenda. Company should have effective board so that it is governed properply. Worldcom's board of directors and its committee were just a rubberstamp for the ambitions of CEO and CFO. Board can be perform effectively if it as a combination of both executive directors as well as non-executive directors (unitary board system). Non-executive directors help to reduce the conflict of interest between the management and shareholders, as they perform a monitoring function by introducing an independent voice to the boardroom. Worldcom board had more than 50% non-executive of directors. However, none of the directors made any attempt to curb, stop or challenge the conduct of Ebbers or Sullivan which they thought as questionable or not right. Most of the directors were officers of company acquired by Worldcom and they trusted the management blindly. It was the responsibility of board to prevent and detect fraud because of its fiduciary duty.
Worldcom's board structure included three committees i) Audit committee; ii) compensation committee ; iii) nominating committee. Audit committee is supposed to oversee the financial statement and make effective use of its internal financial department, but Worldcom audit committee failed to do so. Worldcom expanded quickly, through a series of large acquisition, each of these raised concern on accounting and internal control. These acquisitions were not integrated posing problem to the company and audit committee, audit committee members should have recognised it. In spite of all these problems Audit committee meet only for three to five hours a year, this was insufficient to understand company's accounting practices and function effectively. Andersen was the company's auditor and it employed “non-traditional” approach for auditing of worldcom. However, Audit committee did not understand this “ non-traditional” approach and it failed to discuss this with Andersen. Audit committee did not establish a strong reporting mechanism between itself and Internal audit department. As a result, internal audit department was under the control of management and spend too much time in operational and not audit related function.
Ebbers had substantial outside business interest for which he had taken margin loans from commercial banks by securing his Worldcom shares. These interests of Ebbers were consuming too much of his time and energy, board should have questioned this but it failed to do so. To the contrary, compensation committee was generous enough to give loans and guaranty for Ebbers, without initially informing the board and without taking appropriate step to protect the company. There was some ambiguity whether the compensation committee had the authority to give Ebbers such a huge loan of $400 billion so that he can protect his private financial empire. However, in spite of this vagueness Compensation committee was generous enough without thinking whether this would be a right way to use the shareholders money.
“Gate keeper” of Worldcom also failed to function adequately. From the perspective of agency theory, the audit function is another important governance mechanism which helps shareholders monitor and control the management. Directors are required to provide the annual report and financial statement of their company to the shareholders, as apart of their fudicary duty. The audit of these financial statement presented by the directors provide an objective and external check. Therefore, an auditor must be effective and independent while conducting any audit. Andersen was the outside auditor of Worldcom and it had identified Worldcom as a “maximum risk” client, but they failed consistently to perform necessary test on the numbers presented to them. Andersen was notified at least on two occasions in 2000 by Brabbs, a senior executive of Worldcom UK office, that Worldcom management was making fraudulent entries in the financial records, by reversing $33.6 million in their line cost accruals, as a result, they consider themself under accrued. Andersen employees had no supporting documents for this reversal. Despite of this Andersen did not inquire about this accounting issue with the management. Furthermore, Andersen failed to follow proper accounting standard and make proper use of the tools available with them. They relied on the information provided by the management without corroborating it.
Worldcom's control department was also weak. Its legal and inter audit department were not effective to control management wrongdoing because of their weak structure. Senior management provided lack of support to the legal department by not involving them in its inner workings. In addition to this the legal department were in broken groups and had no consist reporting structure or hierarchy. Internal Audit department of Worldcom had the responsibility of monitoring the internal control and operational system of the company. Internal control has been defined by Rutteman working group as “the whole system of controls, financial and otherwise, established in order to provide reasonable assurance of: effective and efficient operations; internal financial control and compliance with laws and regulations.” However, Internal audit department were under the control of management and were involved only in operational rather financial audit. Furthermore, internal audit department activities were limited and were under staffed to perform its function.Worldcom had no ethical code of conduct as part of its compensation process. Worldcom's culture was to follow the orders of the superior without questioning their authority. This prevented most of the employee having knowledge of the fraud to raise an alarm.
Worldcom fraud also had effect in the product market which caused its competitor to make wrong decisions and bad investments.
As expected, Worldcom and other corporate debacle have produced a flood of legislative and regulatory response around the world. US came up with Sarbanes and Oxley Act, 2002. UK responded through Higgs and Smith report. It also redrafted its Combined Code. OECD principles of corporate governance 2004, emphasised on effective framework for governance. Even UN reacted strongly to these scandals. Sarbanes and oxley Act 2002, requires the CEO and CFO to certify that financial statement filed with the SEC is accurate and it also requires that listed company follow the corporate governance guidelines. The Act prohibits the corporation from giving credit to its directors or officers. Furthermore, the act requires members of the committees to be independent. Similarly OECD principle of corporate governance 2004 laid as follows, Corporate governance framework should protect shareholder right, it should ensure timely and accurate disclosure of information, it required the board to act in a fully informed way and follow the duty of care. Similarly in Higgs and smith report, emphasis was placed on role of board of director, independence of most the directors in the board committee and requirement of greater transparency.
However, even after these rules and principles corporate scandal does occur most recent is the Satyam scandal, where there was failure on the part of the auditor Pricewatercooper and the CEO was using companies money wrongly.
A good corporate governance practice could have prevented the fall of Worldcom. In Worldcom “The check did not balance and the balance did not check!” Corporate governance is just a means and not an end. Corporate governance principles can prevent a fraud from happening but not stop. However, if these principles are followed effectively then it will not only assure greater performance of firm but also assure greater economic growth. We can relate this much better with the recent financial crisis which the world is facing. If the business and financial community wants to prosper and keep the confidence of investing public then they must do the right thing.
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