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Corporate Governance Financial Responsibility, Controls and Ethics Corporate Governance Financial Responsibility, Controls and Ethics Erik Banks CORPORATE GOVERNANCE This page intentionally left blank Corporate Governance Financial Responsibility, Controls and Ethics ERIK BANKS © Erik Banks 2004 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2004 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y.10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 1–4039–1668–3 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress. Editing and origination by Curran Publishing Services, Norwich 10987654321 13 12 11 10 09 08 07 06 05 04 Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne Contents List of figures xi List of tables xiii Acknowledgments xv The author xvi PART I: THE FUNCTION OF CORPORATE GOVERNANCE 1 1 Governance defined 3 The re-emergence of governance 3 Basic corporate structure 11 Limited liability, equity investors, and debt holders 11 Value maximization and the search for enterprise value 14 Diffusion, control, and the agency problem 17 Forms of ownership and control 20 Accountability and the need for corporate governance 22 Internal governance 24 External governance 24 The benefits of governance 30 2 Internal governance mechanisms: corporate accountability 32 The board of directors 34 Executive management 42 Internal control groups 44 Code of conduct 47 Implementation of internal governance measures 48 Best practice codes 50 v vi CONTENTS 3 External governance mechanisms: systemic accountability 54 Regulatory oversight 54 Legal/bankruptcy regimes 56 Capital markets access 59 Corporate control activity 61 Mergers, acquisitions, and spin-offs 65 LBOs and MBOs 67 Antitakeover defenses 68 Block holder monitoring 70 Activist institutional investor monitoring 74 External audits 77 Credit rating agency review 79 4 Protecting internal and external stakeholders 83 Direct and indirect stakeholders 85 Shareholders 86 Labor/employees 88 Creditors 90 Customers and suppliers 94 Professional service providers 96 Communities 97 Indirect stakeholders 98 Protecting stakeholders 99 PART II: CORPORATE GOVERNANCE PROBLEMS 101 5 Common failures in the governance process 103 Flaws in governance 103 Detecting governance flaws 105 Failure of board directors and executive management 106 Ineffective boards 107 Breach of duties of care and loyalty 115 Entrenched management 115 Failure of corporate policies 116 Failure of internal controls 131 Lack of technically qualified, independent controls 132 Liberal accounting policies 133 Excessive risk-taking 134 Inadequate internal audits 135 Failure of external controls 136 Inadequate regulatory mechanisms 136 Insufficient legal/bankruptcy regimes 140 CONTENTS vii Lack of block holder/activist investor monitoring 140 Weak/underdeveloped capital markets 141 Misguided/insufficient corporate control activity 143 Unacceptable external audit practices 144 6 The impact of governance problems on corporate operations 147 First stage impact: reputational damage 150 Second stage impact: early financial problems 151 Third stage impact: growing financial distress 154 Fourth stage impact: bankruptcy 157 The impact of bankruptcy on stakeholders 159 7 Studies in flawed governance I: companies 166 Company studies 170 Case study 1: Enron, USA 170 Case study 2: Arthur Andersen, USA 175 Case study 3: WorldCom, USA 179 Case study 4: Tyco International, USA/Bermuda 185 Case study 5: Adelphia Communications, USA 189 Case study 6: Allfirst/Allied Irish Bank, USA/Ireland 192 Case study 7: Waste Management, USA 196 Case study 8: SAirGroup (Swissair), Switzerland 200 Case study 9: Vivendi, France 204 Case study 10: Daewoo Group, Korea 208 Case study 11: Asea Brown Boveri, Sweden/ Switzerland 211 Case study 12: Kirch Media, Germany 214 Case study 13: Ahold, the Netherlands 217 Case study 14: Lernout and Hauspie, Belgium 220 Case study 15: Global Crossing, USA/Bermuda 223 Case study 16: HealthSouth, USA 226 8 Studies in flawed governance II: sectors and industries 231 Case study 1: global external auditors 232 Case study 2: US energy trading companies 239 Case study 3: Japanese sokaiya scandals 244 Case study 4: US investment banking and research 247 Case study 5: Indonesian business and banking groups 250 viii CONTENTS PART III: CORPORATE GOVERNANCE REFORMS 257 9 Strengthening the governance process I: micro reforms 259 Strengthening the board of directors and executive management 261 Establishing active, independent, and responsive boards 262 Reducing board size 264 Creating technically expert, independent board committees 264 Separating the roles of chairperson and CEO 271 Aligning board director interests 274 Limiting D&O insurance coverage 274 Piercing the corporate veil for directors and executives 275 Reducing information asymmetries 276 Refocusing corporate policies 276 Developing rational compensation standards 277 Creating effective disclosure 279 Supporting shareholder rights 281 Returning excess capital 283 Defining and publicizing strategy 283 Developing and demonstrating a long-term perspective 284 Engaging institutional investors 285 Enhancing internal controls 286 Developing proper accounting policies 286 Enhancing internal audit 287 Reinforcing a culture of risk management 287 Implementing crisis management programs 288 Conducting effective post-mortems 289 10 Strengthening the governance process II: macro reforms 291 Promoting changes in regulatory oversight 292 Regulating potential conflicts of interest 293 Promoting uniform and meaningful accounting rules 294 Developing proper regulatory disclosure 295 Encouraging long-term investment 297 Protecting assets, investments, and pensions 297 Enhancing general governance mechanisms 298 Strengthening legal frameworks and bankruptcy processes 299 Deepening capital markets and promoting corporate control activity 301 Enhancing external audit practices 303 Encouraging investor activism 304 The legislative angle: the example of Sarbanes–Oxley 307 CONTENTS ix Creating a Public Company Accounting Oversight Board 308 Ensuring auditor independence and establishing an audit committee 309 Assigning corporate responsibility 311 Enhancing financial disclosures 312 Resolving analyst conflicts of interest 313 Assigning accountability for corporate and criminal fraud 314 Expanding white collar crime penalties 314 The international view of S–O 315 11 Improving corporate ethics 318 Corporate ethics versus corporate responsibility 319 Creating and reinforcing a proper ethical culture 320 Ethical norms 323 Ethical behavior and internal governance mechanisms 325 12 Summary: towards substantive governance 327 Simple rules of substantive governance 328 Can governance changes work? 332 Appendix: implementing global best practice 335 Supranational 338 OECD 338 BIS 340 European Union 342 Australia 344 Belgium 345 Brazil 348 Canada 349 France 352 Germany 354 Italy 356 Japan 359 Korea 361 Malaysia 364 The Netherlands 366 Singapore 368 South Africa 371 Spain 374 Sweden 376 Switzerland 377 United Kingdom 380 United States 384 x CONTENTS Notes 390 The language of governance 463 Selected bibliography 483 Index 490 List of figures 1.1 Assets, debt and equity and the conveyance of rent/control rights 13 1.2 Insider and outsider ownership systems 23 1.3 Summary of internal and external governance mechanisms 25 2.1 Internal governance mechanisms 33 2.2 The internal governance process 33 2.3 Aspects of internal governance 49 3.1 Elements of external governance 55 3.2 Monitoring by block holders and activist institutional investors 77 3.3 Sample of global and national credit rating agencies 81 4.1 Corporate stakeholders 86 4.2 Capital class, seniority, and expected return 92 5.1 Micro governance failures 107 5.2 Board and executive management governance failures 107 5.3 Internal control failures 132 5.4 External control failures 137 6.1 Stages arising from governance problems 149 7.1 Enron weekly stock price, January 2000–April 2003, US$, NYSE/OTC 174 7.2 WorldCom weekly stock price, June 2000–April 2003, US$, NYSE/OTC 183 xi xii LIST OF FIGURES 7.3 Tyco weekly stock price, January 2000–April 2003, US$, NYSE 188 7.4 Adelphia Communications weekly stock price, January 2000–April 2003, US$, NYSE/OTC 191 7.5 AIB weekly stock price, January 2000–April 2003, £, LSE 195 7.6 Waste Management
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