Corporate governancecrisisandreform


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Corporate governancecrisisandreform

  1. 1. The Crisis of Corporate Governance and Its Reform TELECOMMUNICATION INDUSTRY Charlie Chen | October 20, 2013
  2. 2. Introduction This research report analyzes the failure of corporate governance in telecommunication industry and its recent reform through literature review, root cause analysis and recent strategic development in the reform of cooperate governance. This report pays particular attention to corporate governance in the telecommunications industry, and, highlights areas of corporate governance reform in this sector and broad industry as well. The report examines the evolution of corporate governance in this sector and investigates the failure of cooperate governance and its negative impacts on the business (using some of the landmark cases as examples). It also outlines/examines the reform approaches and recommends good policies and practices which should contribute to sustainable and valued creation of the business. Literature Review of Corporate Governance DEFINITIONS OF CORPORATE GOVERNANCE Corporate governance is, “the framework of rules, relationships, systems and processes within a corporation, and by which authority is exercised and controlled in the corporation.” It encompasses the mechanisms by which companies, and those in control, are held to account. Corporate governance influences how the objectives of the company are set and achieved, how risk is monitored and assessed, and how performance is optimized(ASX Corporate Governance Council, 2010, p. 3). COMPETITIVE MARKET SELECT FIRM WITH GOOD COOPERATE GOVERNANCE Some of the literature on corporate governance adopted a Darwinian view of organizations (Kole & Lehn 1997). Those researchers suggested the firm success in competitive market should have a good corporate governance. The firm which failed in the competitive market supposedly did not have good corporate governance. The competitive market acts as a natural selector for firms having good or bad corporate governances. AGENCY THEORY Internal and external governance mechanisms help to bring the interests of managers in line with those of shareholders including: An effectively structured board; Compensation contracts that encourage shareholders orientation; Concentrated ownership holdings that lead to active monitoring of executives. 2|P A G E
  3. 3. Agency theory claims shareholders have the right to residual claims since they are the residual risk bearers…They have a direct interest in the allocation of corporate resources to make the largest residual possible. Agency Theory are guided by the assumption of utility-maximizing, self-interested human behavior (Clarke, 2007, P.24). BOARD OF DIRECTORS AND EXECUTIVE COMPENSATION Based on Hermalin and Weisbach’s research, (1) high proportions of outside directors are associated with better decisions-making; (2) Board size is negatively related to both general organization performance and the quality of decision-making; (3) Poor company performance, CEO turnover, and changes in ownership are often associated with changes in the board (Hermalin, et al. 2001). The US survey, performed by Murphy and Core, supports several board compensation conclusions. First, the sensitivity of pay to performance has increased. Second the majorities of this pay are executive stock options. However, the interrelationship between executive compensation and other corporate governance mechanisms remains a fruitful area (Denis, et al., 2001). OWNERSHIP AND CONTROL Himmelberg, Hubbard, and Palia (1999) used panel data and concluded that a large fraction of the cross-sectional variation in managerial ownership is endogenous (Denis, et al., 200, p.14). Ownership by insiders and by foreign investors is most often associated with better performance of the company (Denis, et al., 2001, p.21). LEGAL PROTECTION Shleifer and Vishny (1997) believed that good corporate governance systems are a combination of legal protection of investors and some form of concentrated ownership(Denis, et al., 2001, p.28). The Crisis of Corporate Governance THE TELECOM CRASH IN USA Company Bankruptcy Date Liabilities WorldCom Inc. 7/21/2002 45.9BN Adelphia Communications Corp. 6/25/2002 17.3BN Global Crossing Ltd. 1/28/2002 14.6BN 3|P A G E
  4. 4. NTL Inc. 5/8/2002 14.1BN Williams Communications Group Inc. 4/22/2002 7.1BN XO Communications Group Inc. 6/17/2002 5.8 BN (Harmantzis, 2004, p.5) THE CRISIS OF WORLDCOM CORPORATE GOVERNANCE The Rising Star From 1995 until 2000, WorldCom purchased over sixty other telecom firms. In 1997 it bought MCI for $37 billion. It was the largest corporate merger of US history. In the mid 90’s WorldCom moved from long distance discount voice carrier into Internet and data communications carrier market. It was handling 50 percent of all United States Internet traffic and 50 percent of all e- mails worldwide. By 2001, WorldCom owned one-third of all data cables in the United States. • Its Market Value 125 Billion and stock price @$63.50(WorldCom, Capital Edge, Kshitiji 2012). The Falling Star Beginning modestly during mid-year 1999 and continuing at an accelerated pace through May 2002, the company (directed by Bernie Ebbers (CEO), Scott Sullivan (CFO), David Myers (Controller) and Buford Yates (Director of General Accounting)) used fraudulent accounting methods to disguise its decreasing earnings to maintain the price of WorldCom’s stock. The Catastrophes of its Failure On July 21, 2002, WorldCom Filed for Chapter 11 bankruptcy protection which was the largest such filing in the United States History at the time ($4.58 bn in liabilities). The company defaulted within two months of the decline to “junk” status. The largest corporate accounting scandal in the United States, estimated at $11BN as of March 2004 Almost 20,000 employees lost their jobs. Investors lost more than 180bn (Harmantzis, 2004) THE RESPONSE OF US PRESIDENT AND US CONGRESS President Bush called for tough new legislation to restore faith in American business. Mr Bush said those guilty of corporate fraud should be sent to jail for the sake of US capitalism. He argued that people guilty of such abuses should be prevented from holding high-level business positions again. 4|P A G E
  5. 5. TH ROOT CAUSE OF WORLDCOM CORPORATE GOVERNANCE FAILURE Lacking Corporate Governance The Root Cause of WorldCom’s Failure was lacking corporate governance. The WorldCom case has become a kind of poster child and a genuine case study in the failure of corporate governance, in this new century. (Thornburgh, 2004) Incompetence of the Board of WorldCom The company’s board of directors was not paying attention to how the company was running. Along the way, WorldCom amassed billions of dollars in debt, weighing down its sagging cash flow with massive debt-service obligations. The Board of directors had a “habit of rubber stamping senior management decisions without scrutinizing” (Capital Edge, 2012) Toxic Culture of Senior Management Team The senior management team of WorldCom believed that their actions were not “really” illegal. They set unrealistic financial targets and inability to meet them. The account department recorded of a/c entries without any evidence. Company was capitalizing its line costs. (Line costs were operating expenses but WorldCom classified as capital expenditure). Corrupted Senior Management Team Chief Financial Officer Scott Sullivan and Controller David Myers were arrested. Myer’s pleaded guilty for three accounts of conspiracy. Buford Yates Jr. pleaded guilty for two accounts of securities fraud and conspiracy. At his peak in early 1999, Ebbers was worth an estimated $1.4 billion and listed at number 174 on the Forbes 400. Time Magazine named him the tenth most corrupt CEO of all time. The Recent Reform Efforts from Regulators SARBANES-OXLEY ACT The response of the US Congress to the push of major reform in corporate governance appeared at that time was to rush pass the Sarbanes-Oxley Act. This legislation attempted to place a new regime of internal controls in US corporations, but reverberated in business regulation around the world. (Clarke, 2007, p.17) OECD CORPORATE GOVERANANCE PRINCIPLES The corporate governance framework should: 5|P A G E
  6. 6.      Promote transparent and efficient markets, be consistent with the rule of law and clearly articulate the division of responsibilities among different supervisory, regulatory and enforcement authorities. Ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights. Recognize the rights of stakeholders established by law or through mutual agreements and encourage active cooperation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises. Ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company. Ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders (OECD, 2004). THE MAJOR CORPORATE GOVERNANCE CHANGES POST-SOX corporate governance changes can be grouped into three categories: AuditRelated Changes, Board-Related Changes and Accounting Rule Changes (Clark, 2006). Audit-Related Changes Most important post-SOX governance changes are relating to the processes of auditing and presenting financial data. Under the new regime, public company must have an internal control and it must be tested and evaluated by external auditors. Board-related Changes Require public companies to have majority of independent directors on their board. Key committees can have only independent directors. This mandated change should encourage the board of directors act as judgmental monitors with due diligence of the management of the company and reduce the conflict of interests. The new standard also requires independent directors of the board to hold regularly scheduled executive sessions without present of company’s management and other insiders. Accounting Rule Changes SOX 302 requires executive officers and principal financial officers to provide personal certified financial statement, quarterly and annual reports. Public companies must now identify and discuss their “critical accounting policies” in their annual report. The Critical Accounting Policy is one that is heavily dependent on managerial judgments and estimates, and also economically significant to the company in question. 6|P A G E
  7. 7. THE PROPOSED NEW CORPORATE GOVERNANCE PRINCIPLES The Business Roundtable (association of chief executive officers of leading U.S. companies with more than $6 trillion in annual revenues) of Corporate Governance Committee recommended following corporate governance guiding principles: 1. The duty of the board of directors of a public corporation is to select a chief executive officer and to oversee the CEO and senior management in the competent and ethical operation of corporations. 2. It is the responsibility of management to operate the corporation in an effective and ethical manner to produce long-term value for shareholders. The board of directors, the CEO and senior management should set a “tone at the top” that establishes a culture of legal compliance and integrity. Directors and management should never put personal interests ahead of or in conflict with the interests of the corporation. 3. It is the responsibility of management, under the oversight of the board, to develop and implement the corporation’s strategic plans, and to identify, evaluate and manage the risks inherent in the corporation’s strategy. The board of directors should understand the corporation’s strategic plans, the associated risks, and the steps that management is taking to monitor and manage those risks. 4. It is the responsibility of management, under the oversight of the audit committee and the board, to produce financial statements that fairly present the financial condition and results of operations of the corporation and to make the timely disclosures investors need to assess the financial and business soundness and risks of the corporation. 5. It is the responsibility of the board, through its audit committee, to engage an independent accounting firm to audit the financial statements prepared by management and issue an opinion that those statements are fairly stated in accordance with Generally Accepted Accounting Principles. 6. It is the responsibility of the board, through its corporate governance committee, to play a leadership role in shaping the corporate governance of the corporation and the composition and leadership of the board. 7. It is the responsibility of the board, through its compensation committee, to adopt and oversee the implementation of compensation policies, establish goals for performance-based compensation, and determine the compensation of the CEO and senior management. Compensation policies and goals should be aligned with the corporation’s long-term strategy, and they should create incentives to innovate and produce long-term value for shareholders without excessive risk. These policies and the resulting compensation should be communicated clearly to shareholders. 8. It is the responsibility of the corporation to engage with long term shareholders in a meaningful way on issues and concerns that are of widespread interest to long- 7|P A G E
  8. 8. term shareholders, with appropriate involvement from the board of directors and management. 9. It is the responsibility of the corporation to deal with its employees, customers, suppliers and other constituencies in a fair and equitable manner and to exemplify the highest standards of corporate citizenship. These responsibilities and others are critical to the functioning of the modern public corporation and the integrity of the public markets. No law or regulation can be a substitute for the voluntary adherence to these principles by corporate directors and management in a manner that fits the needs of their individual corporations (Principles of Corporate Governance 2012) RECOMMENDED EXECUTIVE COMPENSATION REFORM In their new paper, "Paying for Long-Term Performance" (Bebchuk et al. 2010), Professors Lucian Bebchuk and Jesse Fried offer some concrete suggestions for ways to tie executive compensation to a company's long term performance. Bebchuk and Fried argue that equity incentives can be designed to prevent the gaming of equity grants both at the front end, when they are granted, and at the back end, when they are exercised. By requiring executives to hold the equity for a longer period of time, boards will not need to replenish that executive's holding as frequently. This will also reduce the incentives to focus on the short-term profits, since the payoff from his or her equity will depend on stock prices in the long run. COOPERATE GOVERNANCE FRAMEWORK The failure and closure of prominent organizations around the world has raised serious questions regarding the effective and efficient ways in which companies are being managed and controlled. This has led to the publication of various Corporate Governance related guidelines and legislations, e.g. the King III Report on Corporate Governance in South Africa. How to deal with Corporate Governance is an issue that can no longer be ignored by both public and private sector organizations. 8|P A G E
  9. 9. All Board of Directors, individual directors and executive managers have a duty and responsibility to ensure that good Corporate Governance principles are being observed in their organizations. Executive Management are required to demonstrate that they have the necessary integrity, experience and competence needed to direct and control the organizations they are responsible for ( Conclusion Telecommunication industry deregulation in 90’s has provided a natural experiment of what kind of crisis can lack of corporate governance bring to us. Many contemporary corporate governance failure cases in US and Australia represented wake up calls for us to pay attention to corporate governance. Based on my observation, without or lack of good corporate governance, in many cases, equivalent to issue CEO a license to failure. As Thomas Clarke (2007) pointed out, it is the interests of firms, investors and economies wherever they are based in the world, whatever industry they are in and whatever system they have adopted, to commit to strive for the highest standards of governance. Good corporate governance is the mechanism to ensure the sustainability of the company (balance shot term gain and long term prospect). The author believes, business need to focus on the reform in the following key areas of corporate governance: 9|P A G E
  10. 10.  Vision transparency,  Performance monitoring,  Effectiveness,  Accountability for business activities as well as organization’s social values. References Andrew Campbell and Stuart Sinclair, 2009, Using the crisis to create better boards, THE McKINSEY QUARTERLY 2009 ASX Corporate Governance Council, Corporate Governance Principles and Recommendations with 2010 Amendments, 2nd Edition 2010, p. 3 Bebchuk, Lucian. A. & Fried, Jeese. M. 2010, PAYING FOR LONG-TERM PERFORMANCE, University of Pennsylvania Law Review, v. 158 No. 7B Benjamin E. Hermalin, Nancy E. Wallace, “Firm performance and executive compensation in the savings and loan industry” Journal of Financial Economics, 61 (2001) 139–170 Business Roundtable 2012, Principles of Corporate Governance 2012, Washington, DC USA Chen, Charlie. 2013, The Corporate Governance Failure of WorldCom Clark, Robert. 2006, Understanding and Resolving Crisis-generated Corporate Governance Reform, Corporate Governance Law Review, Vol. 1, No. 4 Clarke, Thomas. 2007, International Corporate Governance, Routledge, London and New York Clarke, Thomas. 2010, RECURRING CRISES IN ANGLO-AMERICAN CORPORATE GOVERNANCE, University of Technology, Sydney Denis, Diane and K;McConnell, 2003, International corporate governance, John J Journal of Financial and Quantitative Analysis, Mar 2003 Eichenwald, K. 2002, For WorldCom, Acquisitions Were Behind Its Rise and Fall, Gaa, J. C. 2010, Corporate Governance and the Responsibility of the Board of Directors for Strategic Financial Reporting, Journal of Business Ethics (2009) 90:179–197 10 | P A G E
  11. 11. Grant, Gerry H 2003, The evolution of corporate governance and its impact on modern corporate America, Management Decision; 2003, 41, 9 Hermalin, Benjamin. E. and Wallace, Nancy. E. 2001, Firm performance and executive compensation in the savings and loan industry, Journal of Financial Economics 61 (2001) Hermalin, Benjamin. E. and Weisbach, Michael. S. 2012, Information Disclosure and Corporate Governance, THE JOURNAL OF FINANCE, VOL. LXVII, NO. 1, FEBRUARY 2012 Harmantzis, F.C. 2004. Inside the Telecom Crash: Bankruptcies, Fallacies and Scandals – A Closer look at the WorldCom case, Kakabadse, N.K. 2009, Corporate Governance: Global Issues for the Future, Northampton Business School, University College Northampton Khanna, Vikramaditya S. 2003. Should the top behaviour of top management matter?,Georgetown Law Journal. 91. Kole, Stacey; Lehn, Kenneth, 1997, Deregulation, the evolution of corporate governance structure, and survival The American Economic Review; May 1997 Kshitiji 2012,WorldCom, Capital Edge Noked N. 2012, Principles of Corporate Governance2012, The Harvard Las School Forum on Corporate Governance and Financial Regulation, OECD 2004, OECD Principles of Corporate Governance, OECD PUBLICATIONS, PARIS,FRANCE Paul Coombes and Mark Watson 2004,Three surveys on corporate governance, THE McKINSEY QUARTERLY 2004 NUMBER 4 Sidak, J. Gregory. 2003,The failure of good intentions: The WorldCom fraud and the collapse of the American telecommunications after deregulation’, Yale Journal on Regulation. 20 Thornburgh, D. 2004, A Crisis in Corporate Governance? The WorldCom Experience, California Institute of Technology, California, USA Wilhelm, Paul G 1993, Application of distributive justice theory to the CEO pay problem: Recommendations for reform, Journal of Business Ethics; Jun 1993; 12, 6 11 | P A G E