The Problems Surrounding Corporate Governance - Essay Example

Contents 2 1Introduction 3 2 Discussion 7 2.1A brief overview of the national systems of corporate governance 7 2.2 Corporate governance in the modern era of crisis 10 2.3Stakeholder theory model and corporate governance 13 3Conclusion 21 Bibliography 21 Abstract Corporate governance scandals seem to appear at close intervals in US (between the years 2000-2001 corporate governance scandals erupted in leading US firms, like General Electric, Qwest, WorldCom, Arthur Andersen, Halliburton, Tyco, Adelphia, AOL Time-Warner, Health South, Global Crossing, Merrill Lynch, and Enron); while Europe has also witnessed its fair share of corporate governance failures, as evinced in the cases of Parmalat, Ahold, and Vivendi. These implosions primarily originated from the failure of the public policies that included the governmental implementation of flawed corporate governance, and an improper regulation, a lack of accountability that aided in various malpractices adopted by the fund managers. In a majority of the cases related to corporate governance scandals, it was seen that the maximum damage was done within legal limits. At present, we find that the existing regulatory processes have lost their meaning owing to the constant modifications made to the structure of a modern corporate house. Besides these, the ‘do-nothing’ policy adopted by the various governments and the regulatory bodies, the lack of accountability, faulty auditing systems, and an overall flawed corporate governance, have aggravated the already existing problems. However, the recent economic crises and scandals have forced much expert attention on the system of corporate governance, its regulations, leading to the public disclosure of many of the financial figures associated with the processes. Here, attention has been specifically focussed on the shortcomings, related to the primacy of shareholder values that dominate the entire system. The recent incidents of the corporate scandals in US and elsewhere have highlighted the problems that exist between company managers and the shareholders. This article will examine the nature of the corporate governances that are in existence, and the stakeholder theories that play an important within it. The article will study various aspects of corporate governance to conclude that the problems perceived in today’s corporate governance may not be entirely rooted in the peculiar nature of corporate shareholding. The problems surrounding corporate governance are rooted in the peculiar nature of corporate shareholding 1 Introduction “We fear to grant power and are unwilling to recognize it when it exists” - Oliver Wendell Holmes 1 The sudden bankruptcy of Enron in December 2001, a role model in the field of good corporate governance, wiped out, almost overnight, the securities of a job, health care benefits, and retirement savings, of more than 6000 US workers. Along with it also crumbled the mighty auditing and business services firm of Arthur Andersen. In this entire fiasco, Kenneth Lay, the CEO of Enron received $53 million (his salary in 2000), along with another $123 million in the form of exercised stock options, and additionally, a further sum of $361 million in unexercised stock options, for his role play.2 Proving that this was just not an isolated case, where the blame could be laid at the door of few ‘rotten apples,’ major scandals had erupted all over US and Europe within the next few months, forcing all attention on the aspects of corporate governance and the role of the shareholders, that have an important position within financial investment firms. According to the “stakeholder theory” or SHT of a corporation, shareholders form a single component, amongst a large group of important stakeholders. Like the employees, the customers, the firm’s suppliers, and associated local communities, the shareholders also have an investment in the firm, and thus, also influenced by the corporation’s losses or profits that it incurs within the market economy. As per a very clichéd call which opines that “in the same way that a business owes special and particular duties to its investors…it also has different duties to the various stakeholder groups.”3 Under modern corporate rules, the firm and its managers are under an obligation to give the shareholders just dividends on their investment made, but the company is also duty to its other stakeholders, and these obligations transcend the border of all corporate laws. In case of contending issues, the claims and interests of the various shareholders have to be alleviated or even forgone, in order to accomplish the basic obligations towards the stakeholders. Thus, one can come to the conclusion that this idea of shareholders as being just a component of the stakeholder group does hold much water, under the scope of the existing corporate laws, in a majority of the present market economies. Under the jurisdictions of corporate laws, shareholders enjoy the elevated status of being the firm owners, where they have the right to elect all, or a majority, of the Board of Directors of the firm. This Board of Directors as per the corporate rules has the right to appoint and also expel any senior executive employee, approve or disapprove of any major policies, and choose the management strategies of the corporation. Thus, overall, theoretically at least, we find that the shareholders possess the right to effectively treat the firm in a manner where they can optimize the returns on their financial investments, made on the firm. The primary objectives of the Board of Directors are to assure that the firm operates in a manner, where it respects the various legal processes and obligations made under various contracts with other stakeholder groups. However, if they wish, they can also instruct their managers to keep in view the only objective of maximization the company’s profits and subsequently increasing the shareholder values; and doing this would not entail any violation of laws or rights.4 This is because, as is universally accepted, that “a company is unable, over the long-term, to earn a return on its capital that covers the cost of its capital, then ultimately, it will fail due to the inability to attract the capital needed to replace its assets,” 5 thus implying the simple fact that in order to survive and sustain, a business firm must be made highly profitable within the market economy. The Board of Directors (presumably under guidance from the shareholders that select them) may use this theory to ask the managers to work towards making profits for the firm, thus making the firm work for the benefit of its shareholders. Owing to the exceptional amount of power and control, and an elevated status that are seemingly bestowed upon the shareholders under the existent corporate law, there are not many theorists that have taken up the cause in favour of stakeholder rights. It has always been assumed that under the existing corporate governance laws, shareholders already possess enough power which ensures that they take care of their interests; and being under certain legal obligations, the firm and its managers take special care of the stakeholders’ interests. Stakeholder theorists, after taking into account the groundwork for shareholders’ rights, have always maintained that the curtailing and delineating of these rights is necessary, in order to uphold the rights and claims of the other stakeholder groups within the corporation. However, an in-depth look into the matter of “Enron” shows us a very different picture. “Enron” is used as an example in this case as it had been one of the most famous corporate scandals to have hit the US market economy during the early part the 21st century, and was a part of a series of corporate scandals that the American business world had witnessed during 2000 and 2001. In the investigations that followed the Enron bankruptcy charges, revealed that the shareholders within the firm did not have the adequate power to inveigle the senior management into following their personal financial interests. 6While there are no clear explanations of what led to these scandals, nevertheless the source of all of these scandals were traced to the break-down of the governance of the organisations, as regards the relationship between the Board of Directors, the shareholders, and the senior executives.7 After the scandal broke out, the concerned authorities rapidly tried to distinguish the problems in governance, and soon a patchwork was worked out, in the form of various modified laws and voluntary codes, in order to prevent any such future scandals.8 Nearly all the reforms that have been brought in after the Enron episode, are aimed at strengthening the accountability of the senior corporate management to their Board of Directors and their shareholders. Thus, these later developments pointed to the fact that the problems surrounding corporate governance, after all, may not be rooted in the peculiar nature of corporate shareholding. 2 Discussion 2.1 A brief overview of the national systems of corporate governance Investors within the various business firms need some sort of assurance that their investments made in the form of financial capital, social capital and human capital, would be invested in a manner that would generate a good return. Corporate governance is the process through which the different firms make these form of investments possible, and it comprises of a Board of Directors functioning within certain legal frameworks and financial market economy, to a comprehension of the broader cultural nuances regarding the position of the corporation within the society. Thus, one can summarily say that corporate governance comprise of “the whole set of legal, cultural, and institutional arrangements that determine what publicly traded corporations can do, who controls them, how that control is exercised, and how the risks and returns from the activities they under- take are allocated.”9 When we find that in the modern context, public firms are amongst the major dominant global players, it becomes imperative that we examine the form, structure, and functioning of corporate governance, in order to have a better comprehension of the various global power structures. Corporate governance, in a more generic form, can be said to describe “the institutional matrix that channels financial flows. In a world where foreign exchange trading tops $1.5 trillion per day, it is an essential component of the contemporary world economy.” 10 Within the precincts of corporate governance, there are different processes through one can create a framework that would aid to regulate the processes necessary to provide the responsibility of corporate governance to its stakeholders. These different processes, and historically, the varying measures opted by the nations owing to their inherent tradition and culture, explain why the legal entities of the business firms vary worldwide, and also reflect the mode in which a firm is provided with the permit/license, to operate within the periphery of its domestic markets. The permit licence is administered by the regulatory frameworks made enforceable by the various legal entities, collective trade contracts, and the norms pertaining to the functioning of the internal and external stakeholders. Corporate governance is generally distinguished into two major types, the Anglo-American system, and the Rhineland (also known as the Japanese) system, as has been represented in Fig 1.11 The classification is primarily based on certain basic features of corporate governance, like market profiling, legal aspects, labour management, etc. The Rhineland system “is characterised by a relatively high and concentrated ownership of large companies, with banks, families and insurance companies being the dominant providers of corporate capital. This is accompanied by a stronger tradition of social dialogue between management and trade unions. The Anglo-American systems are characterised by liquid and lightly regulated markets for both capital and labour.” 12 The picture is slightly different in cases of the developing nations, though in a majority of the cases, it has been seen that the outlines of the nature of corporate governance often echo those of their previous colonial rulers. It has been observed that generally developing countries have their own perspectives, based on which they tend to depend more on informal measures and corporate governance institutions. The chief difference between the corporate governance of a developed nation and a developing country is based on the problem of the ‘principle agent,’ and as Oman confirms, “the key potential conflict of interest tends not to be between managers and shareholders per se but between dominant owner-managers on one hand and minority shareholder and other investors on the other.”13 Fig 1: “Historical overview of the national systems of corporate governance as has been observed through the various ages.” 14 2.2 Corporate governance in the modern era of crisis A closer look at the modern form of corporate governances of the large business firms, especially the publicly listed ones, whose equity is in the stock market trading, have been seen to command large amount of power and influence over various decisions, that tend to affect the lives of many common men in offices, within communities, and in the economic and political circles that are responsible for making decisions at the local, national, and international levels. In the recent times, we find that the various activities and equities of the firms have acquired a globalised form, which has transformed their governing systems and systems of internal production chains, thus, giving them the scope to avoid being accountable to the national government and to play with the various systems for their own profits. The globalisation of these firms, which has been actively supported by national governments eager to let in the flow of foreign direct investments from various foreign investors in order to boost their own national economic growth and development, has also given rise to a sort of “regulatory competition” between the various national and regional level trade jurisdictions. The situation now is thus, the corporations can ‘choose’ the jurisdictions that are less regulatory, and thus more suitable for their operational purposes. It has been seen that often while the larger firms through various legal processes and the globalised nature of their supplied products, manage to evade their direct responsibilities by choosing suitable zones of operations, the actual decisions are however taken by a few, from the higher echelons. At present, the world economy is more or less, controlled by only around 200 companies; and going by their asset values, of these 200 firms, around 51 organisations can be considered as large multinational corporations.15 With large number of global mergers and acquisitions, that are transnational in nature and account for than 80% of global FDI cash flows, 16 it is not surprising that all national trade policies are now created in a manner where they favour the inward bound investors, which is achieved by means of internal trade deregulation, creating policies that favour the opening of the domestic markets, bilateral and multilateral trade relations and investment agreements. Such large scale globalisation has led to rapid ‘offshoring,’ where there are products transfer, through FDI or by means of sub-contracting, of goods production and other services to a different country, with the intention importing them back to their home countries, which has resulted in a sense of insecurity amongst the home workers. The OECD has noticed another problem, where it reported that the competition amongst the nations and the different regional groups to attract more FDI, there is a constitutional risk of eroding corporate responsibilities to the main stakeholders within the firm. A company can establish its operational division in a place, where the regulatory jurisdictions, pertaining to credit enforcement, functional transparency, shareholder and stakeholder rights, taxpaying, and enforcement of environmental and social rules, are considerably lax. This allows for a wide scope, where the corporate decision makers can avoid their accountability towards society, by evading paying taxes, which would have otherwise used for the various public services. Another problem noticed in the area of corporate governance, owing to rise in globalisation, is an increasing disconnection along lines of shared corporate responsibilities, which include broken links between workers, Board of Directors, shareholders, and other stakeholders. Firms are now finding it easier to avoid their social responsibilities using various complex and sophisticated legal contracts. In fact, often in the modern context, to effectively control a company’s management does not necessitate that one must become the owner, thus making the traditional theory, where it was claimed that all firms worked together as a single legal entity, quite irrelevant. Modern firms are more of “moving targets,” with the outline of shared corporate responsibilities quite hazy and not clearly shown to the general public, sometimes even, completely hidden away from public scrutiny.17 In this context, we will now examine the relationships between the corporate governance and the stakeholder theory or model. 2.3 Stakeholder theory model and corporate governance “If the principal economic function of the corporate form [is] to amass the funds of investors, qua investors, we should not anticipate their demanding or wanting a direct role in the management of the company” - Henry G. Manne.18 From the overview of the historical development of national system of corporate governance (fig 1), we can view the diversities that have developed over the years in the arena of corporate governance. In the time period between 1980 and 1990, there came into eminence of one model which soon dominated the various existing theories of corporate governance. This was known as the “shareholder value” model,19 and within the scope of this model, the corporation was seen as a nexus of contracts (also known as the ‘contractarian theory’), forged between the firm and its management team on one hand, and the different claimants of the company on the other. Thus, according to this model, the corporation can be delineated as a series of contractual agreements that exist between the personal interests of the shareholders. Here the value model postulates that, in reality there is no existence of the corporation as an autonomous body, with its own self rationalising interests. Within this model, the shareholders are assumed to possess a unique kind of a relationship with the corporation. This is because the profits on their invested money, in the form of dividends, or the value of the share, are not by ‘contractual,’ as they cannot be established in advance. Thus, the shareholder value is the only component member within the corporation, whose investment is completely firm oriented. This is in opposition to the nature of the “generic” investment made in a contractual bond, thus giving the shareholders an enduring claim on the firm, with special control rights. Other stakeholders have their interests protected under the various contractual terms, like creditor contract, or contract for labour, etc. Thus, they are not represented within the corporation frame beyond the terms of their contract negotiations. Thus, one can conclusively state that optimising the profits of shareholders is equivalent to optimising the interests of the business firms and the stakeholders, and the Board of Directors along with the senior management have their duties confined towards achieving the optimum shareholder value, which on breaking down is assuredly corrected by the equity market (under the realms of corporate control market). The entire corporate structure, comprising of international, national, and regional corporate laws and the market economy, all have been developed aimed at elevating the shareholder value, as per this model. Along with this, “a number of reputational intermediaries serve to enforce shareholder value. Public corporations must have their books certified by an outside auditor, and accounting firms have incentives to maintain their reputation for doing rigorous, high-quality audits because the value of their certification is only as good as their auditing quality”20 while investment banks continue to do their business with same corporations for years on end, thus they justifiably underwrite only the collateral of the corporations that has been carefully examined and audited. Similarly, the financial experts placed at the various brokerage organisations, work towards finding in details the necessary financial data of the firms they examine and audit, in order to make careful and prudent recommendations to their clients. Thus, all members of the governance, that is, the financial analyst, the investment bankers, the accountants must necessarily work towards bringing in the maximum profits (dividends) and also maintain a good reputation for their work, in order to ensure that there are no dearth of investors. A closer look at this model shows us that superficially, the theory may appear simple, but in practical use, it has many unwanted results, like putting priority on shareholder values often lead to short-term investments that may not be safe in nature; and also underinvestment, since the financial resources are shifted away from the firm’s long term interest.21 A business firm cannot be operated as a “contractual spot market”; this way they would ultimately turn into a firm of lawyers that are in a state of conducting unending negotiations. Further, this model completely does away with the other corporate components, like the workers, from the functioning of a corporate governance model. The rise of the shareholder value model had mainly taken place during the 1980s, by various investors within business firms, who later turned into well known players, in the global capital market. One of type of these investors in the form of Pension funds, saw their relative credit resources GDP (within the OECD) jump from a mere 38% in the early 1980s, to a whopping 144% in 1999, that portrayed a mixed portfolio with a shift towards acquiring global equities, and functioning in even newly emerging risky market arenas, away from the safer corporate and state bonds. 22 As a sum total, it was found that in aggregate, nearly $11 trillion securities were under the corporate governance management played by the various investors using the shareholder value model, that represented the workers retirement income benefits and lifetime savings (as was lost in the case of Enron, after their bankruptcy), which were being invested and again reinvested within the realms of the global equity market shares. 23 Outside the OECD, it was seen that share in all pension fund assets in relative to the country’s GDP, had increased from 41% to 56% in Malaysia, and 26% to 52.5% in Chile, during the years 1993 to 2001.24 Here, a situation soon arose where we find that the financial investors had commissioned the management of their investments to various asset managers, whose interests were ascertained by the nature of their fees, and they worked towards achieving profits that were short term in nature, without keeping in mind the long-term interests of their subjects. Thus, we find that without any appropriate regulation by the government and the firms, and a lack of market incentives, the requirements of the actual owners of these group investment schemes, that is the workers and their families, were relegated to a position of secondary importance, within the portals of the economic investment market. The ones that came into eminence were the various asset managers, who ran for competitions, in order to acquire contracts for managing different company funds. Thus, we find that it were not the members of the governing bodies or the shareholders, in the various institutional investor firms, that decided as to where and how to invest the capital amount. These asset managers are then appraised on their achievement ratings as regards other funds, at the time of the contract renewal. The market incentives are then distorted to represent financial performances that are invariably short term in nature, and are relative to the nature of the competing funds. Thus, we find that the institutional investors’ profits lie not in the long term sustainable nature of the investments, but in financial returns that are short term in nature, and which can be sold off, as when things don’t work as they are supposed to (referring to times when the entire investment goes wrong in the hands of the asset managers). Thus, this proves beyond doubt that in cases of crises it is these asset managers and the financial investor experts that create a situation where a failure in their nature of the investments made with the financial capital may arise; since these players often operate in dangerous waters, without much say from the shareholders or even the Board of Directors. Here in this context, it is worth mentioning the fact that there are number of observable dimensions to the relationships between the shareholders and the corporations that had been observed over time and jurisdictions, within the realms of corporate theory. These varied dimensions summarily lie on 2 distinct planes, where first, there is an appropriate level of participation from the side of the shareholders in matters of corporate governance; and next, in the nature of the shareholder interests. There are a large number of varying roles for investors as have been observed within this plan, where we find that the shareholder may be represented as the principal or the main factor, or the owner; a trust beneficiary; a gatekeeper; investor; observer; member of a political entity; or even a partner in managerial works25. The extent of the participation rights of the shareholders, and the standing of their interests, differs greatly, and along with it changes the power of the shareholder within the realms of corporate governance. As for example as per the ‘nexus of contracts theory’ the shareholder is seen as an investor that has limited rights and power to participate but with dominant interests in the invested capital.26 In collectivist theories, like the Team Production theory, we find the very nature of the shareholders is challenged along with their theory of the dominant interests in the invested capital over interests of the other stakeholders.27 After the Enron episode and the burst of the dotcom bubble, there were re-evaluations on the actual nature and role of the shareholders which resulted in great ambivalence, regarding the actual role of the shareholders in such cases of sudden crashes. According to one line of thinking, it is the Board of directors and gatekeepers that should have shouldered the responsibilities during such crises, 28 with the shareholders being the victims or mere bystanders, without any prior knowledge of the inner play. According to another line of thinking, shareholders cannot be said to be blameless, and as Justice Brandeis had once commented, “there is no such thing….as an innocent stockholder. He may be innocent in fact, but socially he cannot be held innocent.”29 This interpretation of the shareholder’s guilt30 focused on the some of their investments on short-term interests, like the hedge funds,31 that see them as more of potential threats to the firm, rather than being victims.32 However, as more firms were busted and the crises deepened, there were a growing perception that the major corporations in the line of financial investing have played the role of being incompetent regulators, and were deficient in their monitoring role33 and failed to take note, as to where the money was being invested and how. They also failed to take note of the excessive high packages that were being paid to their CEOs, even during the time of the economic crash down.34 The ambivalence on the role of the shareholder in the entire crises is seen in the shift of the recent corporate law scholarships from dispensing traditional discourse about according protecting to the investors, to starting a discourse on how to protect the business from the hands of the investors,35 though debate still exists as to the extent of their actual role in creating problems within corporate governance. 3 Conclusion From the above discourse, thus, it stands out that the shareholders in most of the cases did not have a major role in creating the major financial crises of the 2000-2001 that had resulted in the economic breakdown of many of the large financial corporations. Despite some line of thinking that did not put the shareholders entirely above the line of guilt, it is more or less certain, that in majority of the cases the shareholders are mere bystanders, and do not have the power or the status to handle or interfere in the corporate governance, though it is certain that their investments are considered as playing a dominant role. Thus, it is evident that in this peculiar nature of the corporate shareholding system, where the shareholders have no rights on the nature of the investments made, yet their financial capital interests are given primary importance, do not have much of role in the problems faced in the line of the modern corporate governance. The problems within the corporate governance emerge more from the lack of effective regulatory and monitoring systems, that should focus more on the activities of the assets managers and investors, and the nature of the investments that are being made. Bibliography Anabtawi, I., (2006). 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