History of Corporate Governance

A Brief History Of
Corporate Governance
1

Corporate Wrongs Over the
Recent Past
Over the past two decades, the investment world
has seen a large number of scandals relating to
companies which are attributed to failure of
governance.
These have been caused by a combination of
number of factors, principally the three
corporate sins, leading to such things as:
2

• Company mangers (principally the executive directors) lost
sense of business or corporate ethics.
• Earnings become the prime measure of a company’s success.
Directors were not prepared to show low profits or losses.
This led to the use of unethical practices (like creative
accounting, falsification of books etc. ) to increase or show
higher earnings.
• Boards were generally ineffective and played into the hands of
executive directors, approving improper financial statements
and condoning unfair corporate decisions.
• Mangers awarded themselves huge bonuses and stock
options, often at the expense of other shareholders. 3

• Company concentrated on short term gains and showing
higher current profits, often sacrificing the long term
objectives.
• Auditors colluded or failed to stop the executive directors
from using improper accounting policies. In the process they
lost their independence which they surrendered for getting
higher audit fees.
• The disparity in remunerations between higher and lower
level employees grew to uncomfortable levels. A culture of
greed developed among senior managers.
• Most small investors lost interest in long term investments
and concentrated on short term gains through share price
movements.
4

Some Major Corporate Tragedies Arising
out Of Poor Governance in USA
• WorldCom
This Phone and Communications company used age-old
technique of using improper accounting policies to misallocate
$3.8 billion in expense and treated them as assets, thereby
inflating profits and awarding huge bonuses to executive
directors. Its Chairman borrowed over $408 million from the
company to cover personal debts.
• Enron
This energy company created outside partnerships that helped it
to hide its poor financial conditions. It regularly misstated its
earning and assets. Executive paid themselves huge bonuses
and also earned billion of dollars selling company’s share,
given to them as part of their remuneration package. The
company eventually went bankrupt.
5

• Waste Management
This waste management company misstated its earnings
by $17 billion over six years period (1992-97). Its
directors were ultimately sued for accounting fraud.
Tyco
The Chief executive of this company, Dennis Kozlowiski
was charged with deliberately dodging sales tax on
purchase of artwork for his personal residence, routing it
through company books.
6

• Peregrine Systems
This Southern California software company overstated revenue
by $100 million over a three year period.
• Rite Aid
Three executives of this drugstore chain were indicted for
charges relating to securities and accounting fraud in the
1990s.
7

Some Major Corporate Tragedies Arising
out Of Poor Governance in UK
• Barings Bank
The management of this bank failed completely in its internal
controls, letting a single employee cause a loss of $1.4 billion
in stock trading. When Nick Leeson, its head of settlements
department was made of trading, he was not asked to
relinquish the former charge. This was a fatal internal control
failure that allowed his activities go completely unchecked.
The bank never questioned the legitimacy of huge payments
authorized by Leeson to Singapore Money Exchange (SIMAX)
and Osaka Stock Exchange (OSE). The bank with 233 years
history and considered one of Britain’s best merchant banks
eventually had to close its operations in Singapore.
8

• Mirror Group of Newspapers
Robert Maxwell, born in Czechoslovakia, became a naturalized
British. He rose from extreme poverty to being a very
influential businessman. His many investments included
Mirror Group of Newspaper. He is presumed to have fallen
overboard from his luxury yacht and his body was
subsequently found floating in the Atlantic Ocean. It was in
October 1991 when the exposure of his frauds became
inevitable. It was subsequently found that he had
misappropriated hundreds of millions of pounds from his
various companies, even from the pension fund of Mirror
Group. The Group was declared bankrupt as were his sons.
9

• Polly Peck International
• This company went from being a small firm with a market
capitalization of just £300,000 to being a constituent of FTSE
100 index in less than 10 years with a market value of over
£1.7 billion. Its principal owner, Asil Nader, set up or bought
over 200 subsidiary companies in various parts of the world
including interests in Japanese Company Sansui, but mostly in
Turkey and Northern Cyprus. A large number of irregular
payments to Cyprus companies were detected, totaling over
£58 million. Asil Nader was formally charged with 70 counts of
fraud when the company collapsed in 1991.
10

Evolution of Corporate
Governance
• The world reaction to these corporate wrongs was massive
and led to the development of laws and codes for better
corporate governance.
• Some of the international initiatives on governance are:
11

Cadbury Report 1992 (UK)
• Following serious financial scandals and collapses (e.g. BCCI
and Mirror Group), and a perceived general lack of confidence
in the financial reporting of many UK companies, the Financial
Reporting Council, the London Stock Exchange and the
Accountancy Profession established the Committee on the
Financial Aspects of Corporate Governance, in May 1991. It
was chaired by Sir Adrian Cadbury and came out with its
landmark report in Dec. 1992, recommending a Code of Best
Practice with which the boards of all listed companies should
comply.
12

Greenbury Report 1995 (UK)
• The Greenbury Committee was formed to look into the
directors’ remuneration packages and disclosure about it in
the annual reports.
13

The Combined Code 1998
(UK)
• This report combined the recommendations of Cadbury
report, Greenbury report and Hampel report into one code. It
has two sets of recommendations: one for the company and
other for the institutional investors. It promotes the principle
of comply or explain for the directors. It laid emphasis on
maintenance of good internal controls, covering all aspects of
company's’ operations, reviewing the controls systems atleast
annually and informing shareholders about its efficacy.
14

Turnbull Report 1999 (UK)
• Chaired by Nigel Turnbull, this committee was set up by the
Institute of Chartered Accountants in England and Wales to
provide guidance to its members who prepare or audit
financial statements for companies, on the implementation of
the internal control requirements of the Combined Code.
15

OECD Principles of Corporate
Governance, 1999
• The organization of Economic Cooperation and Development
(OECD) published its principles of Corporate Governance in
1999. Prior to its issuance, the document was discussed with
the governments of members countries, private sector and
relevant international organizations like the World Bank. The
main principles ordained by the document are:
• 1. The rights of shareholders must be protected.
• 2. All shareholders should be equitably treated.
• 3. All stakeholders should be allowed to play their role as
provided in the law.
• 4. Importance of timely and accurate disclosures to promote
transparency.
• 5. Accountability and responsibility of the board of directors.
16

Basle Committee Guidelines
(1999)
• This committee issued its guidelines in 1999 related to
enhancing corporate governance in the banking companies.
These have been influential in the development of corporate
governance practices in the banks across the world. It covers
many things, including:
• 1. Compensation issues of directors.
• 2. There should be appropriate oversight by and on senior
management.
• 3. The importance of the work by both internal and external
auditors, and internal checks.
17

Smith Report 2003 (UK)
• This report covered the role and importance of audit
committees. It stated that while all directors have a duty to
act in the interest of the company, the audit committee has a
particular role, acting independently from executive directors,
to ensure that the interests of shareholders are properly
protected in relation to the financial reporting and internal
controls.
18

Code of Corporate
Governance issued by SECP,
2002• Pakistan’s regulatory body SEC issued a code of corporate
governance in 2002 which was subsequently revised in 2005.
All stock exchanges were required to add the code clauses to
their listing requirements. There are six main areas addressed
by this code, i.e. the board of directors, CFO and company
secretary, corporate and financial reporting framework,
corporate ownership structure, audit committee and
compliance with the code of corporate governance.
19

Sarbanes-Oxley Act 2002,
(USA)
• The scandals like Enron and WorldCom strengthened the
perception that the close relationship between the directors
and external auditors is largely the cause of corporate illsgoing
unnoticed to the extent that it becomes too late to save the
company. These scandals led to the US Congress passing the
Sarbanes-Oxley Act in 2002 which introduced reforms in the
various areas of corporate management as well as listing
requirements for NYSE. Many countries have incorporated
segments of this law into their own relevant regulations or
codes.
• This Act provided for the following, inter-alia:
20

• 1. It placed considerable responsibility on CEO and CFO in
relation to accuracy and completeness of the company’s
annual report.
• 2. It strengthened the independence of external auditor.
• 3. The audit committees were required to have at least one
financial expert, who should be clearly named as such.
• 4. It set up a new regulatory body, called Public Company
Accounting Oversight Board, for auditors of US listed firms.
21

Emergence of Corporate
Governance Models
• Corporate Governance refers to the way companies are
financed and structured in an economy in terms of
entrepreneurial and functional decision-making. Over the past
forty years or so, three main models of corporate governance
have been emerged in the world. Most of countries in the
world have one or other of these models. These are:
• 1. Anglo-American Model (AAM)
• 2. Japanese Model (JM)
• 3. German Model (GM)
22

Salient Features of Anglo-
American Model
• This model is based on free-economy theory and operates
essentially on the premise that the free inter-play of market
forces sets the price for capital as well as decides who gets to
run a company. Companies in this model operate to maximize
the wealth of its shareholders who decide who to assign the
responsibility of running the company. The prime measure of
the efficiency of the BoD is the rate of return earned on the
investors. The AAM works on a triangular (Principle-
Watchdogs-agent) relationship comprising of shareholders,
BoD and the managers.
23

• Under AAM, the bulk capital is provided by the institutional
investors.
• Only 25% of total equity is owned by managers.
• Company relies on a combination of debt and equity.
• The shareholders do not bother the board for as long as their
interest is served.
• This lead towards non-interference in election of Directors.
• Thereby, the executive directors elect their own nominees to
serve as non-executive directors, who fail to exercise due
control over the conduct of their appointer executive
directors.
• This has been the prime cause of most governance problems
faced in USA and UK.
24

Salient Features of Japanese
Model
• The Japanese companies most follow the keiretsu system,
which by definition means a group of associated or related
companies having inter-locking directorates and shareholding.
Typically, a group has a number of companies, some operating
in the same industry, other in the different industries.
• The capital for these companies is provided by banks through
equity and debt. Quite often banks are also part of the group
performing the task of gathering funds for the group through
their deposits. Some of the better known keiretsu groups in
Japan are Mitsubishi, Mitsui, Sumitomo, Toyota and IBJ.
25

• The bank providing debt and equity also paly a dominant role
on selecting the BoDs for their group companies. Their hold
on the board is quite firm and therefore can influence the
decision-making processes of the group companies according
to the group interest.
• For quality governance, the groups seek and appoint good
professionals as non-executive directors of the group
companies. The high level of interaction between the funding
bank and investee companies keep the boards on their toes.
26

Salient Feature of German
Model
• Quite like Japanese model, institutional investors, including
both public and private sector banks, play a very important
role in the German companies and their corporate governance
model. The boards of German companies have a significant
number of nominees from financial institutions who look into
the interests of all stakeholders.
• The most apparent difference in the German model lies in
composition of board of directors, comprising of two tiers by
law. The lower tier called Management Board comprises
entirely of executive directors.
• The upper tier is non-executive supervisory board having
compulsory representation from institutional investors. No
one can serve at both tiers of the board.
27

• The supervisory board can summon members of lower tiers
for clarifications at its meetings.
• However, the strict role of institutional investors allows the
companies to have a much higher debt to equity levels.
• The individual ownership of shares in German companies is
relatively lower than in USA or UK companies.
28

History of Corporate Governance

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