Journal of Governance and Regulation / Volume 1, Issue 1, 2012 CORPORATE GOVERNANCE IMPLICATIONS FROM THE 2008 FINANCIAL CRISIS Hugh Grove*, Lisa Victoravich** Abstract The importance of structural corporate governance factors identified by the New York Stock Exchange’s 2010 Commission on Corporate Governance was reaffirmed here with various empirical and forensic studies. The key, recurring structural factors were all-powerful CEO (the duality factor and related Board independence issues), weak system of management control, focus on short term performance goals (and related executive compensation packages), weak code of ethics, and opaque disclosures. Such weak corporate governance factors were key contributors to both fraudulent financial reporting and excessive risk-taking which facilitated the U.S. financial crisis in 2008. Corporate governance listing requirements by major stock exchanges around the world will help mitigate such problems from recurring in the future. Keywords: Corporate Governance, Financial Crisis, Banks, Risk-Taking * University of Denver, School of Accountancy, Denver, CO 80208-2685, United States Tel: 303-871-2026 (Phone) Fax: 303-871-2016 (Fax) E-mail: [email protected] ** University of Denver - Daniels College of Business, 2101 S. University Blvd., Denver, CO 80208, United States E-mail: [email protected] Introduction aided by a giant “shadow banking system” in which banks relied heavily on short-term debt. The At the end of January, 2011, the U.S. Financial Crisis Commission concluded: “when the housing and Inquiry Commission (Commission 2011) wrote in the mortgage markets cratered, the lack of transparency, report’s conclusions: “the greatest tragedy would be the extraordinary debt loads, the short-term loans and to accept the refrain that no one could have seen this the risky assets all came home to roost” (Chan 2011). coming and thus find nothing could have been done. In the aftermath of the U.S. financial crisis of If we accept this notion, it will happen again.” The 2008, the New York Stock Exchange (NYSE) Commission also concluded that the 2008 financial sponsored a Commission on Corporate Governance crisis was an “avoidable” disaster caused by which issued the following key corporate governance widespread failures in government regulation, principles (2010): corporate mismanagement and heedless risk-taking • The Board of Directors’ fundamental objective by Wall Street. It found that the Securities and should be to build long-term sustainable growth Exchange Commission (SEC) failed to require big in shareholder value. Thus, policies that promote banks to hold more capital to cushion potential losses excessive risk-taking for short-term stock price and to halt risky practices and that the Federal increases, and compensation policies that do not Reserve Bank “neglected its mission by failing to encourage long-term value creation, are stem the tide of toxic mortgages.” inconsistent with good corporate practices. Citing dramatic breakdowns in corporate • Management has the primary responsibility for governance including taking on too much risk, the creating a culture of performance with integrity. Commission portrayed incompetence with the Management’s role in corporate governance following examples. Citigroup executive conceded includes establishing risk management processes that they paid little attention to mortgage-related and proper internal controls, insisting on high risks. Executives at American International Group ethical standards, ensuring open internal were blind to its $79 billion exposure to credit-default communications about potential problems, and swaps. Merrill Lynch managers were surprised when providing accurate information both to the Board seemingly secure mortgage investments suddenly and to shareholders. suffered huge losses. The banks hid their excessive • Good corporate governance should be integrated leverage with derivatives, off-balance-sheet entities as a core element of a company’s business and other accounting tricks. Their speculations were strategy and not be simply viewed as a 68 Journal of Governance and Regulation / Volume 1, Issue 1, 2012 compliance obligation with a “check the box” direct result of the compensation practices at these mentality for mandates and best practices. Wall Street firms” (Lohr 2008). • Transparency in disclosures is an essential Concerning the lack of disclosure transparency element of corporate governance. by these banks in not using fair value reporting for • Independence and objectivity are necessary their assets, Arthur Levitt and Lynn Turner, former attributes of a Board of Directors. However, SEC chairman and former SEC chief accountant, subject to the NYSE’s requirement for a majority respectively, observed (Levitt and Turner 2008): of independent directors, there should be a “There is a direct line from the implosion of sufficient number of non-independent directors Enron to the fall of Lehman Brothers—and that’s an so that there is an appropriate range and mix of inability for investors to get sound financial expertise, diversity and knowledge on the Board. information necessary for making sound investment • Shareholders have the right, a responsibility and decisions. The only way we can bring sanity back to a long-term economic interest to vote their shares the credit and stock markets is by restoring public in a thoughtful manner. Institutional investors trust. And to do that, we must improve the quality, should disclose their corporate governance accuracy, and relevance of our financial reporting. guidelines and general voting policies (and any This means resisting any calls to repeal the current potential conflicts of interests, such as managing mark-to-market standards. And it also means a company’s retirement plans). expanding the requirement to disclose the securities positions and loan commitments of all financial Structural Corporate Governance Issues institutions. Fair value reporting, when properly complied with and enforced, will simplify the Various empirical studies have investigated the information investors need to make informed impacts of these structural problems of corporate decisions, and bring much needed transparency to the governance upon banks’ risk taking (stock market market. By reporting assets at what they are worth, based measures) and financial performance (return on not what someone wishes they were worth, investors assets, non-performing assets, etc.). The following and regulators can tell how management is corporate governance variables have been found to performing. This knowledge in turn is fundamental to have a significant, negative impact on risk taking and determining whether or not an institution has financial performance (Allemand et. al. 2011, Grove sufficient capital and liquidity to justify receiving et. al. 2011, Victoravich et. al. 2011): loans and capital. We should be pointing fingers at • CEO duality (the CEO is also the Chairman of those at Lehman Brothers, AIG, Fannie Mae, Freddie the Board of Directors) Mac, and other institutions which made poor • CEO and Board of Directors entrenchment and investment and strategic decisions and took on independence (only staggered re-elections of dangerous risks.” long-serving Board members versus all Board Furthermore, at a recent Town Hall discussion, members re-elected every year) entitled Does Wall Street Really Run the World?, • Senior Directors (over 70 years of age) Lynn Turner (2011) made the following comments. • Short-term compensation mix (cash bonuses and “There was greater attention to risk management shorter-term stock options (1 to 4 years) versus when Wall Street firms were partnerships with longer-term stock options, awards, and restricted individual partner liability twenty years ago versus stock) today as corporations (similar to the evolution of the • Non-independent and affiliated Directors (larger Big Four accounting firms). Wall Street firms percentages of such directors versus independent changed from raising money for corporations and directors) serving as investment brokerage firms to a new • Ineffective risk management committees (few or emphasis on trading for its own sake and for their no meetings or no such risk committees) own shareholders. There was eleven trillion dollar Also, high leverage (debt to equity) levels were market cap destruction from the economic crisis of associated with high levels of banks’ risk taking and 2008. These firms were not really creating value but poor financial performance in these studies. When were selling toxic investments such that a Rolling implementing the $700 billion bailout of major U.S. Stone reporter nicknamed Goldman Sachs the banks, the U.S. Treasury did not replace any existing Vampire Squid. Paul Volcker has commented that the bank Board members but added new Directors to last real innovation of Wall Street banks was the represent taxpayer interests. Many of these original ATM thirty years ago, actually by a Nebraska bank.” Directors oversaw the big banks and brokerage firms when they were taking huge risks during the real Structural Corporate Governance: estate boom. A corporate governance specialist Bear Stearns and Lehman Brothers concluded: “these boards had no idea about the risks Examples these firms were taking on and relied on management to tell them” (Barr 2008). A senior corporate Corporate governance for risk management and governance analyst said: “this financial crisis is a company oversight was very weak at both Lehman 69 Journal of Governance