Corporate Governance and Accountability

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Corporate Governance and Accountability
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Corporate governance

1. Protects the rights of shareholders to trade
   shares, to obtain timely and regular information
   about corporate well being, participate and vote
   in general shareholder meetings, elect and remove
   members of the board, and share in corporate
   profits.
2. Recognises and protect the rights of
   stakeholders.

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Ethical principles supported by law

• Honesty and Transparency
• Responsibility and Accountability
• Fairness and Justice
• Avoidance of conflicts of interest and related
  party dealings
• Application of the principles of good corporate
  governance

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Corporate governance underpins corporate survival

• Not just formal accountability but vital for
  investor confidence - affects capitalisation,
  regulation, reputation
• Now measured by GovernanceMetrics International
  cf. Corporate Governance Authority, Transparency
  International.
• http//www.gmiratings.com/(svoakc45be23zh450xr2pw4
  5)/Default.aspx
• World Bank sponsored Global Corporate Governance
  Forum lthttp//www.gcgf.org/gt

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Why is good corporate governance important?
It can lower the cost of capital. It promotes
investor confidence. It is important to respond
to global best practice.
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How is good corporate governance achieved?
There are various models of good corporate
governance. Most recently, the OECD has set
guidelines. The Cadbury Committee in the UK,
benchmarked CG and then the General Motors
Guidelines on Significant Corporate Governance
Issues. The Canadians and the ASX Corporate
Governance Council have espoused similar
principles.
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OECD recommendations 2004

• Disclosure of
• The financial and operating results of the
  company.
• Company objectives.
• Major share ownership and voting rights.
• Remuneration policy for members of the board and
  key executives, and information about board
  members, including whether they are independent.
  
• Related party transactions.
• Foreseeable risk factors.
• Issues regarding employees and other
  stakeholders.
• Governance structures and policies

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Good corporate governance and development

• 1991 - following collapse of firms declared
  healthy in audited returns, the Financial
  Reporting Council, the London Stock Exchange and
  the UK accountancy profession established the
  Cadbury Committee to inquire into financial
  aspects of corporate governance.

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What is corporate governance?
Corporate governance is the system by which
companies are directed and managed. Good
corporate governance structures add value to
corporations and provide accountability and
control systems.
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Good corporate governance and development

• 1991 - following collapse of firms declared
  healthy in audited returns, the Financial
  Reporting Council, the London Stock Exchange and
  the UK accountancy profession established the
  Cadbury Committee to inquire into financial
  aspects of corporate governance.

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Cadbury Report Recommended

• Conformity with its Code of Best Practice. This
  was voluntary.
• More clear and detailed financial reporting in
  order to
• Inspire public confidence in corporations
• Enable directors to advance the best interests of
  the company and to avoid concentrations of power.
• The clear separation of the responsibilities of
  CEO and chair of the board.

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Non-executive directors should

• Have a stronger role on boards
• Should be selected according to formal processes
• Be clearly independent from the management of the
  company
• Not have business interests which could conflict
  with those of the company

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Cadbury also recommended

• The establishment of an Audit Committee with at
  least 3 non-executive directors and access to
  independent audit advice

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Implementation

• Since 1993, the London Stock Exchange has,
  required listed companies to include in annual
  reports statements of compliance with the Code of
  Best Practice or, give reasons for not doing so.
• In December 1994, Guidance to the interpretation
  of the Cadbury Code was issued. This was
  perceived as a watering down of the Code.

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Implementation 2

• The Code had called upon the directors to report
  on the effectiveness of the companys system of
  internal control, the Guidance requires only that
  directors state
• that directors are responsible for the companys
  system of internal financial control
• that such a system is only relatively secure, not
  absolutely so
• the most important procedures for internal
  financial control
• that directors have reviewed the system of
  control
• Ernst and Young, The Cadbury Codes Requirements
  on Internal Control at http/www.ernsty.co.uk/acct
  ing/ifc/ifc2.htm.

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ASX principles

• Derived substantially from the lead of Cadbury,
  but good practice in any setting.

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Principle 1 Lay solid foundations for
management and oversight

Formalise and disclose the functions reserved to
the board and those delegated to
management.Adopt a formal board charter that
details the functions and responsibilities of the
board or a formal statement of delegated
authority to management.
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Principle 2 Structure the board to add value
A majority of the board should be independent
directors. An independent director is independent
of management and free of any business or other
relationship that could materially interfere with
or could reasonably be perceived to interfere
materially with the exercise of their
unfettered and independent judgment.
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Principle 3 Promote ethical and responsible
decision-making

• Clarify the standards of ethical behaviour
  required of company directors and key executives
• Establish a code of conduct
• Promote integrity

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Principle 4 Safeguard integrity in financial
reporting
Require written statements from the CEO and the
CFO to the board that the companys financial
reports present a true and fair view of its
financial condition in accordance with relevant
accounting standards. Establish an audit
committee of at least 3 non-executive directors,
not chaired by chair of board.
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Principle 5 Make timely and balanced disclosure
Develop continuous disclosure policies and
procedures.
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Principle 6 Respect the rights of shareholders
Design and disclose a communications strategy to
promote effective communication with shareholders
and encourage effective participation at general
meetings.
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Principle 7 Recognise and manage risk
Establish a system to identify, assess, monitor
and manage risk inform investors of material
changes to the companys risk profile. The CEO
and CFO should certify to the board that the
companys risk management and compliance systems
are operating effectively.
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Principle 8 Encourage enhanced performance
Disclosure of performance evaluation of the
board. Induction program for new directors. All
board members to have direct access to company
secretary. Board members to have access to
independent advice at company expense.
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Principle 9 Remunerate fairly and responsibly
Disclose companys remuneration
policies including cash, fees and other
benefits. The board should establish a
remuneration committee
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Why were not such measures already in place?

• Why did it take the collapse of Enron, WorldCom,
  HIH Insurance and many other firms to move the
  industry, investors and governments to act?
• Was it because of the accepted dogma that high
  risk is good for business because it produces
  high returns?

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Such rules are a floor, not a ceiling

• The GM Corporate Governance Guidelines by
  contrast, place a stronger emphasis on Directors
  skills and suitability for the Board, eg. Item 4,
  Director Orientation and Continuing Education
• The Board and Management will conduct a
  comprehensive orientation process for new
  Directors to become familiar with the
  Corporation's vision, strategic direction, core
  values including ethics, financial matters,
  corporate governance practices and other key
  policies and practices .... The Board also
  recognizes the importance of continuing education
  for its directors and is committed to provide
  such education in order to improve both Board and
  Committee performance.

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Classic Symptoms Preceding Collapse
Overstatement of the value of assets,
and understatement of liabilities in financial
reports. Use of related party transactions to
disguise the reality, e.g. to create a false
impression about earnings. Delays in financial
reporting.
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Continuing financial losses and cash flow
deficiencies Weak management Inadequate
management succession planning Looming debt
payments concealment of bad debts Inadequate
capital expenditure programs Lack of adequate
information systems Shareholder disputes

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The case of Enron

• Kenneth Lay, former chairman and CEO of Enron,
  claims that he and the board were misled by CFO,
  Andrew Fastow (who has pleaded guilty to fraud
  and is to be sent to jail).
• A clutch of Enron officers have pleaded guilty to
  crimes, so what does that say about the CEO and
  boards governance?

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Fastow

• Fastow joined Enron in 1990 and promoted to CFO
  in 1998 after designing innovative financial
  structures that reduced Enrons debt allowing it
  to diversify its activities.
• He began building off-the-books partnerships in
  1997 to increase its capital and hide debt.
• Fastows take from his deals was 30 million.

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Not just rotten apples

• Enrons culture, which included strategies such
  as the war for talent, licenced officers to act
  on their own initiative but to act without regard
  for probity. This made it possible for Enron to
  manipulate the Californian energy market.
• It adopted a veritable thicket of questionable
  accounting practices, such as booking its energy
  trades at full value rather than at the value of
  its margin, thus inflating profits.

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The culture at Enron

• It was clear that Enron routinely engaged in
  sharp practice, that it sought to disguise this
  from investors and the financial world by a
  complex and all but unintelligible structure of
  accounts and partnerships.
• It is clear that Enron encouraged maverick
  behaviour by sacking the lowest performing 10 of
  staff and promoting the best 10. Results were
  all that counted.

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Deliberate deception

• Enrons auditor was Arthur Andersen. It signed
  off the accounts each year as a true and fair
  representation of the corporations financial
  condition for which it received over 20 million.
  It received over 20 million also in consulting
  fees.
• The SEC received Enrons reports year after year,
  but no one there was alert to the danger.
• Hence the resort to legislative reform of the
  formal accountability mechanisms.

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Sherron Watkins, Enron heroine, interviewed in
June, 2004

• Do you think that post-Enron America is a more
  ethical place?
• Not really. We are building more Enrons, but we
  don't want to admit it. I fall into Warren
  Buffett's camp when he says that C.E.O. pay is
  the acid test. When C.E.O. pay has been reduced,
  then I'll believe that our business leaders have
  adopted a spirit of corporate reform.
• If the government were to demand a pay ceiling
  for C.E.O.'s in this country, what should it be?
• J.P. Morgan said that C.E.O.'s should not make
  more than 20 times the average hourly worker.
  We're above 500 times right now! The average
  worker gets, let's say, 20 an hour. So the
  highest C.E.O. salary should be -- 1 million a
  year.
• Interviewed by Deborah Solomon, NYT.

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Sarbanes - Oxley Act

• Sarbanes-Oxley (2002) passed in wake of Enron and
  other collapses to strengthen corporate
  governance and restore investor confidence and
  public trust in accounting and reporting
  practices.
• Establishes enhanced governance and management
  standards for all US publicly listed companies
  and public accounting firms.
• Establishes the Public Company Accounting
  Oversight Board under the SEC to oversee public
  accounting firms and issue accounting standards.

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SOA 2

• CEOs and CFOs now have to sign off on all company
  financial statements, the audit committee of the
  board must be made up of independent outside
  directors, and companies have to have thier audit
  of internal financial controls audited
  externally.

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Functions of the Public Company Accounting
Oversight Board

• register public accounting firms
• establish "auditing, quality control, ethics,
  independence, and other standards relating to the
  preparation of audit reports for issuers"
• conduct inspections of accounting firms
• conduct investigations and disciplinary
  proceedings, and impose appropriate sanctions
• enforce compliance with the Act, securities laws
  and rules,and professional standards

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The Board requires public accounting firms

• Among other measures to
• Maintain audit working papers for 7 years
• Adopt 2nd partner review and approval of audit
  reports .
• Accounting firms to adopt quality control
  standards.
• Conduct annual quality reviews for accounting
  firms with ? 100 reports others every 3 years.

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Section 106 Foreign Public Accounting Firms.

• Foreign accounting firms who audit a U.S. company
  are subject to registrations with the Board.

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Section 201 Services Outside The Scope Of
Practice Of Auditors Prohibited Activities.

• Unless specifically approved by the Board, it is
  unlawful for a public accounting firm to provide
  any non-audit service to a client undergoing
  audit, including
• services related to its financial statements
• financial information systems design and
  implementation
• internal audit outsourcing services
• management functions or human resources
• investment adviser, or investment banking services

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Section 203 Audit Partner Rotation.

• The lead audit and the reviewing partners must be
  rotated every 5 years.

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Section 206 Conflicts of Interest.

• The CEO, CFO, Chief Accounting Officer or
  equivalent cannot have been employed by the
  company's audit firm during the 1-year period
  preceding the audit.

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Section 301 Public Company Audit Committees.

• Audit committee members are members of the
  corporations board of directors, and shall be
  independent, i.e. not in receipt of any
  consulting, advisory, or other compensatory fee
  apart from a directors fee.
• The SEC may make exceptions to this rule.
• The AC is directly responsible for the
  appointment, remuneration, and oversight of the
  corporations accounting firm.
• Audit committee have the authority to engage
  independent advice, in order to carry out its
  duties. The corporation shall provide appropriate
  funding to the audit committee.

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Section 302 Corporate Responsibility For
Financial Reports.

• The CEO and CFO shall attest to the
  "appropriateness of the financial statements and
  disclosures contained in the periodic report, and
  that those financial statements and disclosures
  fairly present, in all material respects, the
  operations and financial condition of the issuer."

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Section 303 Improper Influence on Conduct of
Audits

• It is unlawful to influence auditors in any way.

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Section 401 (c) Study and Report on Special
Purpose Entities.

• The SEC shall examine off-balance sheet
  disclosures to determine a) their extent
  (including assets, liabilities, leases, losses
  and the use of special purpose entities) and b)
  whether generally accepted accounting rules
  result in transparent financial statements
• and make a report containing recommendations to
  the Congress.

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Section 402(a) Prohibition on Personal Loans to
Executives.

• Generally, it is unlawful for to extend credit to
  any director or executive officer. Consumer
  credit companies may issue credit and credit
  cards to its directors and executive officers on
  the same terms and conditions made to the general
  public.

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Section 404 Management Assessment Of Internal
Controls.

• Requires annual reports to contain an audited
  internal control report
• Nature and effectiveness of the internal control
  structure for integrity in financial reporting.

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Title VIII Corporate and Criminal Fraud
Accountability Act of 2002.

• It is a felony "knowingly" to destroy documents
  or to "impede, obstruct or influence" any
  existing or contemplated federal investigation.
• Employees of corporations and accounting firms
  are extended "whistleblower protection.

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Title IX White Collar Crime Penalty Enhancements

• Creates a crime for tampering with a record or
  otherwise impeding any official proceeding.
• SEC given authority to seek court freeze of
  extraordinary payments to directors, offices,
  partners, controlling persons, agents of
  employees.
• US Sentencing Commission to review sentencing
  guidelines for securities and accounting fraud.

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The effect ?

• Accounting firms and lawyers are booming on the
  back of Sarbanes-Oxley.
• In May 2004, RateFinancials found
• That most financial statements did not reflect
  public companies' true financial states.
• In November it found that
• That related party transactions were still common.

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By years end

• The Big Four audit firms were moving back into
  consulting having sole their consulting arms
  after the Andersens debacle.
• Since 2002, all have been wary of using the term
  consulting in their literature.
• Regulators' sanctions have not been as punitive
  as initially feared. While auditors are not
  allowed to offer non-audit related services to
  audit clients but can do so for all other
  companies. Philip Aldrick Telegraph, 29/12/2004.

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Misconduct encouraged

• By lack of a system of laws that clearly state
  obligations and prohibitions
• By a diminished sense of personal responsibility
• By lack of enforcable laws and regulations
• By a small risk of being detected
• By insufficient penalties
• By a climate of sharp practice
• By a lack of ethical recognition

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But law and enforcement

• Will not replace ethics and a personal sense of
  responsibility
• Will not prevent corruption by themselves
• Still rely upon a level of trust fear will make
  people risk averse and stifle business.
• Are expensive means of securing compliance

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Principle 10 Recognise the legitimate interests
of stakeholders
The board should set standards of public
accountability for the company and oversee
adherence to these. Establish a code of conduct
to guide compliance with legal and other
obligations.