Corporate Governance has been the mantra for good business practice. Discuss the legal issues in the recent financial crisis of the major rollback of corporate governance. Does ‘best practice’ corporate governance deliver ‘best practice’?
What Is Corporate Governance?
Corporate governance is defined to be “the system by which business corporations are directed and controlled” and derives its origins from the Latin word gubernare: ‘to steer’. This means that the governance of a company is put into the hands of the captain on board which in a company are the directors who direct the company from within. There have been many prominent and well-publicised global business failures such as Lehman Brothers, HIH Insurance and closer to home: the Transmile Bhd scandal. This has lead to corporate governance issues becoming more and more important to safeguard investors’ interest as well as to increase the public’s confidences in the financial sector. Good corporate governance also makes the business environment a transparent one and ensures that companies can be held accountable for their actions, as well as contributing to the growth and financial stability of a company.
Elements for good corporate governance vary between individual companies but do not differ very much as the main essence of corporate governance is to monitor those parties within a company which possess control over the resources which are owned by investors and shareholders. In Australia, the Australian Securities Exchange (ASX) published the Corporate Governance Principles and Recommendations which articulated eight core principles that underlie good corporate governance:
- Lay solid foundations for management and oversight.
- Structure the board to add value.
- Promote ethical and responsible decision making.
- Safeguard integrity in financial reporting.
- Make timely and balanced disclosures.
- Respect the rights of shareholders.
- Recognise and manage risk.
- Remunerate fairly and responsibly.
The CIPE believes that no matter what nature the business may be, only good corporate governance can lead to superior and consistent business performance. To ensure transparency and accountability of corporations, external regulations have been developed in almost every country.
Malaysia has its own code of Corporate Governance: the Malaysian Code of Corporate Governance which was developed by the Malaysian Institute of Corporate Governance (MICG). The MICG was established in 1998 and their main objective was to make the country practice and be more aware of good corporate governance. To do this, the MICG collaborated with Bursa Malaysia to lay down ground rules for a company’s listing. In Chapter 15 of the Revamped Listing Requirements, one of the requirements specifies that a listed company must make sure that its board of directors makes statements showing their compliance with the code of Corporate Governance. In other countries, corporate governance is advocated in the form of the Cadbury Report of the UK, the Sarbanes-Oxley Act of the USA, and the Principles of Good Corporate Governance and Best Practice Recommendations of Australia to name a few. On a global level, the Organization for Economic Co-operation and Development (OECD) is developing internationally recognized and accepted standards for good corporate governance.
The Directors’ Fiduciary Duties
There are many areas of organization within a company which are greatly affected by the quality of corporate governance. Shareholders may own a company but when it comes to decision-making that duty is passed on to the directors of the company who at senior management level, are responsible for deciding the business operations of the company and the path that the company goes. Thus, a director is a person with a fiduciary duty: a person (director) who is entrusted with power or property with the understanding that the aforementioned person is working for the benefit of the individual (the shareholders) who gave them that trust. The fiduciary duties of directors in the UK have been laid down in the Companies Act 2006 as being the following:
- a duty to act within powers;
- a duty to promote the success of the company;
- a duty to exercise reasonable judgment;
- a duty to exercise reasonable care, skill and diligence;
- a duty to avoid conflicts of interest;
- a duty not to accept benefits from third parties;
- a duty to declare an interest in proposed transactions or arrangements.
According to the Companies Act 1965 of Malaysia, any director that breaches the fiduciary duty is personally liable for any secret profits made by the director (if any); or for any damage suffered by the company as a result of the breach; as well as imprisonment for up to five years or thirty thousand ringgit fine.
As people holding positions of power, greed may sometimes overcome them and the directors exploit and breach this fiduciary duty for various reasons; to make private profits for themselves or to create an illusion of performing well in their position to make sure they are able to extend their term of serving on the board of directors. Good corporate governance should involve the board of directors meeting regularly to discharge duties in an efficient manner as well as make a list of responsibilities for the board and the decisions that the board should take. Weak corporate governance is usually the reason for a company’s financial difficulties and the temptation of senior officials to misuse their power and commit fraud: “governance failures may start within companies, but ultimately reflect weaknesses at the top”. A court case in Australia involving breach of director’s duties was the case of ASIC v Macdonald where all the non-executive directors and the CEO breached Section 180(1) of the Corporations Act 2001 by approving an ASX announcement at the board meeting where the directors knew full well that the announcement contained numerous false and or misleading statements. The courts charged all 10 executives involved for breach of duties under the Act and sought for a maximum fine of $200,000 as well as disqualification from ever managing a company against each director. Such is the severity of breach of fiduciary duties.
Consequences Of Poor Corporate Governance: Large-Scale Corporate Scandals
One of the scandals that shook Malaysian corporate circles was the scandal of Transmile Bhd where the external auditors discovered that the company had fabricated revenue and profit figures (overstating up to RM530 million) through creative accounting. The two directors involved in the scandal were charged for “knowingly authorizing the furnishing of a misleading statement” and the Securities Commission told the court that the ‘misleading statement’ made by Transmile could have induced investors to purchase more of Transmile’s shares. Another case was the Megan Media Bhd case where the company announced a massive unaudited loss of RM1.27billion in 2007. This was due to deliberate misrepresentation of the financial statements by the company’s accountants. Further investigations exposed internally fraudulent activities which appeared to involve falsified invoices, payments and trade creditors as well as embezzlement by internal executives of the company.
China Aviation Oil (CAO) of Singapore is another example of “poor governance at the highest levels”. In late February 2006, the company’s former finance chief was jailed for two years and fined S$150,000 for making false and misleading statements about losses made in risky trading in oil derivatives in 2004. In March 2006, three directors from the head company in China were fined $150,000 each for intentionally failing to notify the Singapore Exchange (SGX) about the trading losses. One director, Jia Changbin was fined an additional S$250,000 for insider trading. Another director – the former CEO – was sentenced to jail for conspiring to cheat, failing to notify the SGX of the company’s losses as well as making false and misleading statements, breaching his director’s duties by engaging in insider trading. After the drama, the minister for State-Owned Assets Supervision and Administration Commission said that “had we had a sound internal auditing and risk management system, the incident of CAO could have been avoided.”
In Australia, one of the largest corporate failure was of HIH Insurance where senior executives were discovered to be involved in manipulating the true financial status of the company and publishing financial statements that showed non-existent profits as well has attempting to enter the US and UK markets without proper financial provision. Furthermore, the directors were guilty of “reckless corporate behavior … misleading shareholders … and spending vast amounts of money on [themselves].” The failure of HIH Insurance was seen in one of the Australian court cases of R v Lo where the offender charged was the company secretary of the HIH Group. The company secretary pleaded guilty to recklessly making false and misleading statements with the intent to obtain a financial advantage for CIC Insurance Ltd and FAI Insurance Ltd (both subsidiaries of the Group) and also failing to exercise his powers and discharge his duties for a proper purpose by signing a misleading statement. The court held that the offender’s conduct was a noteworthy departure from the standards of honesty and diligence in corporate governance in which the “market economy is reliant.”
The most recent corporate scandal to hit the USA was the massive collapse of Lehman Brothers in 2008 which mirrored the 2001 scandal of Enron and Arthur Andersen. Lehman Brothers filed for bankruptcy protection after failed discussions to find a solution to save the company; and this lead to panicked clients removing their investments from the bank as well as extreme drop in stock prices and the devaluation of its assets by various credit rating agencies. The courts appointed an examiner to look into the sudden liquidation to make better sense of the actual reasons that lead to the bankruptcy. The court-appointed examiner recently published his report and discovered that Lehman Brothers had actually made use of an accounting procedure known as ‘repo 105′. What Lehman did was it entered into repurchase agreements with certain banks and the deal between them was that Lehman would sell “toxic” assets to the other bank with the understanding that Lehman would buy them back in the near future. Other banks use repo 105 in their accounting treatments as well, but they recorded it in the books as loans while Lehman recorded them as sales. By doing this, Lehman succeeded in “transferring” toxic assets to cash and made their financial status a lot healthier; misleading credit-rating agencies and shareholders. Litigation is ongoing but the court-appointed examiner has already concluded that there will be reason to hold claims against Lehman’s CEO and CFO as well as their auditors, Ernst & Young who failed to make the investment bank’s shady operations known.
How The Financial Crisis Was Caused By Poor Corporate Governance.
The 1997 Asian crisis stays in the minds of many investors as one of the biggest financial crisis to hit the region with many countries taking more than a decade to recover from it. The then Asian crisis was mainly caused by poor corporate governance of numerous leading financial institutions in a range of different Asian countries. The International Chamber of Commerce noted that mismanagement, inappropriately structured boards and lack of supervision over related party transactions led to domestic and foreign investors losing confidence. This lead to increase in capital outflows and fall in capital inflows by investors which caused a massive decrease in stock prices which lead to the market breakdown. Within the year of 2008 to 2009, a total of around 8898 companies have either been placed in administration, liquidation, or receivership. This damage was not solely restricted to small operations or SMEs but also involved a number of big brands that have failed including names such as ABC Learning, Kleins, Strathfield and Midas.
The OECD published a report in 2009 explaining the lessons learnt from the recent 2008 global financial crisis and the article concluded that the financial crisis could actually be attributed to failures and weaknesses in corporate governance. When these regulations were tested, the OECD found that these regulations did not actually serve their purpose to maintain a healthy level of risk undertaken by finance companies. The Shareholder Bill of Rights Act of 2009 wrote that one of the main reasons for the financial and economic crisis faced by the United States (and possibly the rest of the world) was due to a widespread failure of corporate governance.
Poorly governed companies are not restricted only to issues of ethics (what directors should or should not do) but also issues of risk. One very interesting example was lately given by Alistair Darling, UK’s Chancellor of Exchequer: “Last summer, just as the crisis began to bite, a senior banker told me that ‘from now on we will only lend when we understand the risks involved.’ I did wonder what they had been doing up until then.” This strange quote illustrates well that before the financial crisis, many companies were poorly governed and not paying attention to what they were doing. Issues of risk are of high importance within a company; especially financial institutions as taking on excessively high levels of risk may lead to the collapse and bankruptcy of the institution. In the case of Lehman Brothers, the bank’s risk committee only met twice and in the case of Bear Stearns’ (another highly publicized corporate failure in the USA) the risk committee was formed just before the company collapsed. Another example is subprime lending: one of the main causes for the 2008 financial crisis – where banks provided credit to borrowers who had poor credit history such as a history of default and bankruptcy. If banks were well governed, had strong ground rules and had been sufficient communication between top executives and lower-level management, they then would not have participated in superfluous subprime lending, taking on more risk than they could afford.
Does ‘Best Practice’ Deliver ‘Best Practice’?
So does best practice corporate governance actually deliver best practice? Not all companies go down the path of Lehman Brothers, HIH Insurance and Transmile Bhd. Most appreciate that good corporate governance and corporate social responsibility increases the public’s confidence, attracts investors and increases overall efficiency and productivity of the company. A recent study by the Australian Treasury examined the relationship between a company’s implementation of the ASX’s Principles of Good Corporate Governance and Best Practice Recommendations and its financial performance and found that “companies with better corporate governance outperformed those companies that were less compliant.” Evidence of whether well-governed companies are able to weather the financial crisis is apparent; all the companies that are currently thriving and expanding are proof of good corporate governance such as General Electric, Royal Dutch Shell and Toyota Motor, who were listed on Forbes Top 25 companies in the world ranking at number one, two and three respectively. Furthermore, companies such as Apple, McDonald’s, Google and Honda Motor made the list of global high performers despite the world economy being plunged in deep recession. Forbes.com predicted these companies were “likely to survive today, thrive tomorrow” because of how fast growing and well-managed they are. Successful global companies such as these are very large in size but the key is good corporate governance which ensures that a company can survive during chaotic times and continue to expand and thrive and be profitable. Also according to Forbes.com, the company currently topping the list of 100 Best Corporate Citizens is Hewlett-Packard which beats all other companies in terms of corporate governance, philanthropy and environmental impact. Joshua Skolnick writes that in economically turbulent times, often the most financially secure and well-managed companies survive whilst any company that has been concealing its shaky foundations are likely to be uncovered in the tumultuous environment.
Many countries and companies are scrambling to build a strong foundation in good corporate governance especially after the financial crisis. Good corporate governance is a combination of fairness, transparency, independence, honesty, responsibility, accountability, reputation, judgment and integrity; and good corporate governance improves the public’s perception and support for the profession and the actions of said individuals within that profession. For a corporation or institution to survive the winds and rains of the volatile economy, it is vital that there is a strong perception for corporate governance in the company. Poor corporate governance does not only affect the profitability of companies as a whole, but also the millions of jobs that have been created by these large companies and institutions. Once these institutions collapse, thousands of workers lose their jobs and find it difficult to find another place of employment. For example, when General Motors in the USA collapsed, the company slashed 47,000 jobs worldwide and closed 14 plants in North American and Europe over the next three years. Hence, corporate governance is an issue of ethics not only to shareholders. The appropriate word should be stakeholders, everyone who is affected however directly or indirectly by the company or institution.
It has been evident that during the financial crisis, those corporations and institutions that hid behind shaky foundations were exposed and either did not survive the financial crisis or needed government assistance (e.g. AIG, General Motors, Lehman Brothers). Other companies such as those previously listed by Forbes.com continued to do well despite the financial crisis that plunged the world into uncertainty. As Mats Isaksson of OECD says, “the most obvious lesson [from the recent financial crisis] is that corporate governance matters. Company executives, policymakers, regulators and shareholders need to pay more attention to corporate governance.” Jane Diplock of the New Zealand Securities Commission also adds that people have discovered the hard way through numerous bankruptcies and collapses, that steadfast ethical practice is an absolute necessity for global markets to have a strong foundation.
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