An Effective Governance Framework and Rights of Shareholders - Essay Example

?US and United Kingdom in Rules versus Principles In Corporate Governance Frameworks and the period 1990-2002 I. Introduction Corporate governance “refers to the system of laws, regulations, and institutions that is intended to oversee the conduct of managers and their companies on behalf of investors, including both equity holders and lenders” (Larsch 2006, p. 2). The system of corporate governance includes the board of directors, the professional service firms for audit and legal advice, and the government regulators (Larsch 2006, p. 2). A country’s system of corporate governance “comprises the formal and informal rules, accepted practices, and enforcement mechanisms, private and public, which together govern the relationships between people who effectively control corporations” (Oman and Blume 2005, p. 1). For Hurst (2004, p. 7) corporate governance refers to “the broad range of policies and practices that stockholders, executive managers, and board of directors use to (1) manage themselves and (2) fulfill their responsibilities to investors and other stakeholders”. Corporate governance includes hose that may be applicable to nonprofit institutions (Hall 2003, p. 3). After the financial crisis of 1997-1999, the global community upgraded concerns to improve corporate governance given” crony capitalism” and other threats to the stability of the world economy (Oman and Blume 2005, p 1). II. Rules versus Principles in Corporate Governance One major way to categorize the approaches to corporate governance is to dichotomize corporate governance in terms of “rules versus principles”. The rules-based approach to governance follows the regulations established by authorities (Harryrram 2009, p. 1). In contrast, the principles-based approach moves away from rigidity and allow flexibility (Harryrram 2009, p. 1). One such rules or regulations are those embodied in the United States’ Sarbanes-Oxley Act of 2002 (Harryrram 2009, p. 1). The Sarbarnes-Oxley Act is also known as the Public Company Accounting Reform and Investor Protection Act (Harryrram 2009, p. 1). The Act was a response to corporate and accounting scandals of Enron and WorldCom (Harryram 2009, p. 1). The Enron scandal broke out in 2001 while the WorldCom scandal broke out in 2002 (Corporate Narc, 2011; Schmidt 2005). Through the Sarbarnes-Oxley Act, “accounting self-regulation was largely dismantled and a radically new framework was implemented for regulating auditors, analysts, financial disclosure, and internal controls” (Waitzer 2006, p. 9). Further, the U.S. Securities and Exchange Commission (SEC) obtained broader powers and state attorneys generals acquired greater control over corporations (Waitzer 2006, p. 9). As of 2006, the U.S. Securities and Exchange Commission (SEC) had estimated that compliance with the Sabarnes-Oxley Act cost a company around US$91,000 or a total of US$ 1.24 billion for all companies of the United States (Waitzer 2006, p. 13). Corporate governance in the US has been identified with following rules. In particular, from the onset of the Sabarnes-Oxley Act of 2002, corporate governance in the US has been associated with following the rules of the Sabarnes-Oxley. In contrast, corporate governance in the UK has been associated with the principles-based approach. The appeal of principles-based approach to corporate governance is based on at least the following points (Harryram 2009, p. 1): 1. Principles are easier to enumerate compared to a detailed set of rules; 2. Principles are easier to understand by employees and clients; 3. Principles allow flexibility given the variability of firm characteristics like size, risks, and other variables; and 4. Principles-based governance allows firms to respond more variably to variable market conditions in the interest of enhancing competitiveness and promoting innovation. Nevertheless, according to the claim of Harryrram (2009, p. 1), both the US and Britain have become more rules-based given the spate of corporate scandals over the years. Harryrram’s view (2009) appears supported by an OECD document authored by Oman and Blume (2005) that pointed out that “in many of today’s OECD countries the transformation from relationship to predominantly rules-based systems” constitute an important task for improving corporate governance (p. 1-2).1 III. US and Application of Rules-Based Corporate Governance, 1990-2002 McLuhan (2006, p. 1) emphasized that corporate governance in the United States follow a strict set of rules with steep penalties for violators targeting top managers, board members, and the accounting and auditing professions. Edwards (2003, p. 2) explained that this arose because of the pervasiveness of corporate misconduct revealed by the stock market bubble of 2000. Edwards (2003, p. 2) that there was a massive failure of U.S. corporate governance to prevent misconduct before 2002. Thus, the need for more rules that the Sabarnes-Oxley addressed. According to Edwards (2003, p. 2), some of the corporate misconduct that increased sharply before 2002 have been those related to excessive compensations to CEOs and reporting failures. Edwards asserted (2003, p. 2), that reporting failures are clearly manifested in the excessive increases in earning restatements since 2000. For Edwards (2003, p. 4), the first and second lines of defense in US corporate governance consisted largely of state-based corporate and federal securities laws until the Sarbarnes-Oxley was introduced. This statement from Edwards (2003) clearly pointed out that the rules approach to corporate governance dominated in the United States even before Sabarney-Oxley. Federal securities laws “empowered shareholders” by requiring corporate disclosure, rights to sue fraudulent managers, and proxy-voting (Edwards 2003, p. 4). Corporate laws required managers and directors to uphold obligations to shareholders and penalize them if they fail to meet obligations (Edwards 2003, p. 5). According to Edwards (2003, p. 5), the third governance mechanism or line of defense has been the right granted to shareholders and their elected directors to employ incentive compensation structure for both managers and directors that aligns the interest of the latter with those of shareholders. Executive compensation “has been increasingly tied to company stock performance” and this was implemented through stock options or restricted stock rewards (Edwards 2003, p. 5). As of 2002, the more frequent corporate scandals involved over-statement of revenues and understatements of costs and diversion of company funds for the private use of managers (Edwards 2003, p. 8). According to Edwards (2003, p. 8), prominent examples include WorldCom’s intentional misclassification of $11 billion in expenses as “capital investments”; Enron’s creation of off-balance sheet partnerships “to hide the company’s deteriorating financial position and enrich Enron executives”; and the HealthSouth’s overbilling of Medicare and fraudulent accounting practices. Meanwhile, according to Edwards (2003, p. 8), the cases of Adelphia and Tyco were examples of corporate looting. Earlier, in 1992, the US Securities and Exchange Commission had required public companies to disclose top executive compensation in relation to stock performance (Holmstrom and Kaplan 2001, p. 135). The move represented a substantial shift from the pre-1980s when companies focused on earnings per share, growth, and other measures believed to affect stock performance (Holmstrom and Kaplan 2001, p. 135-136). U.S. business scandals that occurred during the 1980s---particularly those related to government contracts---gave rise to emphasis on rules in corporate governance (Hurst 2004, p. 6). The emphasis on US corporate governance that emerged from the scandals of the 1980s revolved compliance with national land local laws and regulations (Hurst 2004, p. 6). IV. Principles-Based Corporate Governance in the UK and 1990-2002 Armour (2008, p. 39) pointed out that the structure of English Corporate Law gives considerable power to shareholders in general meetings to control many aspects of the managerial agency problem without need for litigation. In the United Kingdom, a Combined Code on Corporate Governance “sets out a number of substantive corporate governance requirements that apply to listed companies incorporated in the UK” (Armour 2008, p. 40). The Combined Code is a framework of overarching principles that have been “fleshed out by a series of ore specific provisions” (Armour 2008, p. 40). Further, “it is also well-known that the Code is not formally ‘binding’ on listed companies” (Armour 2008, p. 40). The Code gives firms the option to “comply or explain” (Armour 2008, p. 40). This means that if the companies do not comply with the code, “they must give reasons for noncompliance” (Armour 2008, p. 40). Further, while it is consider to be a breach of the Code for failing to report if a company has complied with the Code or explain why they have not complied with the Code, Armour (2008, p. 40) reported that there is no reported instance of the government taking action against companies for non-compliance with these requirements. Some of the key provisions of the Code include a minimum number of independent non-executive directors, separation of the CEO and Chairman of the board, and establishment of separate nomination, remuneration, and audit committees, which must be composed by independent directors (Armour 2008, p. 40). The Combined Code of Corporate Governance “prescribes corporate governance practices without any associated enforcement mechanism” (Armour 2008, p. 40). In the UK, even if the prescription of corporate governance practices under the Combined Code has no formal enforcement mechanism, there is an enforcement of a set of standards for good management (Armour 2008, p. 40). Armour (2008, p. 40) reported that, a high proportion of firms complies with the Code or explains why they do not (Armour 2008, p. 40). Studies indicate that the mean compliance moved from 85.9% in 1998 to 90.5% in 2003-2004 (Armour 2008, p. 41). Further, 83% of non-compliance was explained consistent with the approach of principles-based corporate governance (Armour 2008, p. 41). According to Armour, principle-based governance has been feasible in the United Kingdom because “English company law gives shareholders considerable power in relation to corporate managers” (2008, p. 48). In the United Kingdom, shareholder power serves as the powerful means by which manager compliance with shareholder interests is secured (Armour 2008, p. 48). Related to this, institutional investors have been the significant actors in the UK listed companies since the 1950s (Armour 2008, p. 48). Institutional investors own roughly about 45% of listed company shares in the UK as of 2006, from about 20% in 1957 and around 55% in 1981 to 1994 (Armour 2008, p.49-50). For much of the period between 1957 to 2006, “institutional investors have been a catalyst for development in UK corporate governance, their preferences lay behind many of the informal mechanisms of enforcement” (Armour 2008, p. 49). Armour (2008, p. 49) emphasized that principles-based governance has been working well in the United Kingdom because “institutions holding a significant proportion of shares in the UK market have a collective interest in the good governance” of firms. Armour explained (2008, p. 56) that the UK approach to corporate governance has its origins in history (Armour 2008, p. 56). Since the earliest days, the boundaries between public and private enforcement mechanisms have been blurred (Armour 2008, p. 56). Institutional investors traditionally favored informal private enforcement. This community, with prompting from the Bank of England, facilitated self-regulatory bodies that become public agencies but their approach to enforcement focused on reputation that characterizes self-regulation (Armour 2008, p. 61). It is appears that this condition explains the stress on principles rather than rules in corporate governance in the United Kingdom. In effect, Armour explained that despite the Maxwell scandal, Barings Bank collapse, Polly Peck Case, and many other corporate cases in the UK in 1990-2002, the emphasis on principles rather than rules has worked well in the UK because stockholders have greater rights in the UK and institutional investor fulfilled an important role in ensuring best practices in corporate governance. Most likely, the Cadbury Report as well as the Greenbury Committee Report of the early 1990s played important roles in shaping 1990-2002. V. Comparative Analysis Several materials have argued that although the US and UK framework for governance have been different, there is a movement towards a greater similarity between the UK and the US approach to corporate governance. This is a point emphasized by materials like Harryrram (2009) and the OECD (2004). For example, Stanwick (2008, p. 58) pointed out that CEO compensation has been an ongoing controversial subject in the two nations. Stanwick (2008, p. 58) pointed out that in the United States, the responsibility to raise objections on the level of compensation given to CEOs and other members of top management lies with institutional investors. In contrast, shareholders in the United Kingdom routinely vote on executive compensation packages and they can reduce the payments given to executive (Stanwick 2008, p. 58). Perhaps the appropriate way of interpreting the view that while the US and the UK are heading towards the same direction in corporate governance, the US has continued to emphasize on rules while the UK has continued to emphasize on principles even if the overarching framework between the two are similar. There are traditions in the US and the UK that continues to persist: while the UK has continued to stress on shareholder rights, there is a large space under the US corporate governance rules for managers to invoke rules that can insulate them from shareholder’ assertion of prerogatives, perhaps invoking managerial prerogatives. It must be noted that as early as 2002, Maassen reported that there is a global pressure for the harmonization of corporation laws (p. 189). Indeed, this is the likely explanation why there is a movement for both the US and to the UK to move into the same direction with regard to corporate governance. VI. Conclusion Based on a review undertaken by this work, we have a good basis to say that while the US and the UK implement contradictory approaches to corporate governance, there is a movement towards a similarity of emphasis even as there is a tendency for the old ways to persist: the US emphasizing on rules while the UK emphasizing on principles to follow. In 2004, both the UK and the US have subscribed to a set of principles for corporate governance. The set of principles included those pertaining to an effective governance framework, rights of shareholders, equitable treatment of shareholders, role of stakeholders in corporate governance, disclosure and transparency, and board responsibilities (OECD 2004, p. 7). The OECD corporate governance framework called for the promotion of transparent and efficient markets, rule of law, articulation of division of responsibilities among supervisory, regulatory and enforcement authorities (OECD 2004, p. 17). Hurst (2004, p. 2) even pointed out that UK and US business practices are not as different as many assume in the era of globalization. Meanwhile, Stanwick (2008, p. 57) reported that there are acually three governance frameworks worldwide: the United States’ Sabarnes-Oxley Act, the European Commission’s Action Plan, and the Organization for Economic Cooperation and Development (OECD) Corporate Governance Framework. However, as we have pointed out based on OECD (2004, p. 7), the UK and the US both subscribe to the OECD framework for corporate governance. In 2006, the United Nations Conference on Trade and Development recommended that “where there is a local code on local governance, enterprises should follow a ‘comply or explain’ rule whereby they disclose the extent to which they followed the local code’s recommendations and explain any deviations” (p. 31). 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Washington: Woodraw Wilson International Center for Scholars. Available in: [Accessed 15 March 2011]. Read More