The UK and USA Corporate Governance Frameworks - Essay Example

?Introduction The UK and US firms have evolved in differing ways in terms of corporate governance, and continue to evolve in slightly different ways.Corporate governance refers to “the system by which corporations are run” and the word system includes “formal and informal structures and relationships” (Cadbury, 1991). While there has always been a spirit of free markets in both countries, this changed after the scandals of the late 1990s-early 2000s, such as Enron and WorldCom. Prior to this, in the United States, auditing companies were self-regulating; now they have oversight. Disclosure and transparency about executive pay also ensued after the Enron debacle. In the UK, new disclosure principles were put into place which are designed to give the board more transparency. Prior to the scandals, boards of directors in the UK were not monitored, and this led to firm failures for a variety of reasons. Now the boards are monitored and regulated, and the board must abide by principles that state how they are to function. The following details how the two countries differ and what they have in common in the area of corporate governance. I. Enron and WorldCom In order to understand why corporate governance in the UK and the United States evolved, one must under the precipitating factors in their evolutions, and that was the Enron and WorldCom scandals in the late 1990s-early 2000s. The reasons why the Enron and WorldCom scandals occurred in the United States were many-fold. First, the structure of corporate governance changed in the late 1980s, as hostile takeovers changed the way that corporations did business. (Holmstrom & Kaplan, 2001, p. 133). Because of the cost of leveraging a buyout, managers became sensitive to their firm’s market price, which led them to take greater risks in inflating the stock prices. This tendency was aided by the fact that there was a general sense of deregulation fever that had taken hold, and the fact equity-based compensation for CEOs had soared from 5% in 1990 to 60% in 1999 (Cornelius &Kogut, 2003, p. 31). What this means was that, since the CEO pay was tied to the performance of the company, there was further reason for the CEO to inflate numbers, because it would also inflate his or her salary. Because of this tie from the performance of the company to the CEO pay, the CEO was given further reason to obsess over the day to day price of the firm. Moreover, there was a failure of accounting in catching the Enron and WorldCom debacles (Cornelius &Kogut, 2003, p. 33). Arthur Andersen, the accounting firm behind the Enron scandal, went from being one of the most well-respected professional firms in the world to a shamed company that was not only responsible for the Enron scandal, but securities frauds in Waste Management, Sunbeam, HBOCMcKesson, The Baptist Foundation and Global Crossing as well (Cornelius &Kogut, 2003, p. 35). II. The Evolution of UK Corporate Governance in Response to Corporate Scandals Compared to the U.S., UK has a different market structure, in that the UK had more firms, each of whom are smaller than typical U.S. companies (Gugler, 2001, p. 184). This is shown by the fact that, as of 2005, the largest corporate voting block was under 10% of votes, and this was contrasted by the average size of block in Austria was 26%, in Germany, 27%, and 20% in Italy; moreover, family ownership was sparse, at only 5% (Morck, 2005, p. 582). And, whereas the United States has become a country where there is a relatively strong amount of power concentrated in the hands of shareholders because of the events of the late 1980s, the UK corporation, by and large, does not have any shareholders, at least they did not as of the early 2000s – in 1995, 84 percent of UK firms did not have shareholders (Gugler, 2001, p. 184). However, this changed after the Enron scandal, and the emphasis has evolved towards transparency. Further, the UK traditionally has emphasized internal controls and financial reporting, and less on external monitoring devices (Hamill, McGregor & Rasaratnam, 2002, p. 3). This is because the traditional view that markets should be free, and that self-monitoring. However, this changed in the wake of the scandals, both in the U.S. and the U.K. While the U.S. had the Enron and WorldCom scandals, the U.K. dealt with scandals of her own. One was the collapse of Baring Bank, which was primarily due to one rogue trader, named Nick Leeson, who was making fraudulent transactions (Brown, 2005, p. 13). Leeson occupied a great deal of power in Barings Limited, as he was both the Chief Trader and Head of Settlements, which means that he could make any trades he wanted without any oversight – the fox was in charge of the chicken coop, so to speak. This was brought to the attention of the auditors, which stated that this set-up provided great risk, but Barings did nothing to rectify it. In the end, it was this lack of governance that proved to be the undoing of the firm, as Barings single-handedly brought the bank down (Drennan, 2004, p. 261). Another scandal was the collapse of the Maxwell group, which was due to the ethics of Robert Maxwell. (Drennan, 2004, p. 259). Maxwell took control of Mirror Group Newspapers from Reed International in 1984. Maxwell then took complete control of MGN’s finances. Maxwell did the same for other companies that he owned, completely controlling the cash flow within and between these companies, while borrowing money from the pension funds, which eventually led to the collapse of the company and the loss of pensions to thousands (Drennan, 2004, p. 260). Therefore, after the above scandals, the U.K. implemented different oversight regulations that were principle-based, in that these regulations stated broad principles that were to form the backbone of any corporate governance, but did not implement rules. Therefore, each individual corporation was free to implement the principles as they saw fit, but they had to implement some kind of governance that fit with the principles, and there was increased transparency to make sure that this occurred. One of the changes that occurred was in the regulatory framework, which was already robust before the scandals, but needed to be reworked to placate the public (Fearnley& Beattie, 2004, p. 118). Since the Enron debacle was partially the fault of lax auditing procedures, the U.K. set up the Coordinating Group on Auditing and Accounting Issues, which focused on financial reporting, auditing, corporate governance and the structure of auditing and accounting oversight (CGAA). This review of the regulatory system led to regulations regarding auditor independence (Fearnley& Beattie, 2004, p. 127). Another major change dealt with the Board of Directors and their functions. The Board of Directors in the U.K., and the U.S., are elected to represent the interests of individual shareholders (Gillespie & Zweig, 2010, p. 4; Roles and Responsibilities of Directors and Boards). They hold meetings about the direction of the corporation, and give reports to shareholders, and are responsible for directing the company while acting in the best interest of not only the shareholders but the corporation, and they deal not only with the business and financial issues of the company, but also issues such as corporate governance, corporate ethics and corporate social responsibility. They set the strategy for the corporations, along with the corporate structure, and establish the mission and values of the corporation (Roles and Responsibilities of Directors and Boards). Therefore, presumably, if the Board of Directors are doing their jobs, scandals such as Enron, WorldCom, Barings Bank and Maxwell would not occur, because the Board oversight would catch these incidents before they could become scandals. Unfortunately, Gillespie & Zweig (2010) argue that Boards are often negligent, because they have a responsibility to the corporation and the shareholders to guide the company, but they do not do this, but become meek cheerleaders because they are beholden to the CEO who brought them aboard (Gillespie & Zweig, 2010, p. 5). Therefore, the U.K. set up principles by which the corporations’ Board of Directors must abide. The regulatory framework on corporations’ Boards is set out through the U.K. Corporate Governance Code, which implemented a set of principles by which Boards must follow, and the biggest principle is that Boards are to be robust and take their jobs seriously. Also, the CEO and the chairman of the board must be two different people. Boards must be balanced, in that the individuals on the board must represent a wide range of skills, experience, and knowledge. All board members must come up for re-election, procedures must be transparent, and must maintain sound risk management. The board must also maintain a dialogue with shareholders. The board must meet regularly, and each board member must continually update their skills. They must state in their annual report how the performance evaluation of the board has been conducted, and how they conducted their responsibility in preparing annual reports and accounts (UK Corporate Governance Code). These are just some of the principles that have been established to make the boards accountable to their shareholders, and force them to take their positions seriously, as opposed to being the happy gladhanders with no responsibility that they used to be. Further, the U.K. implemented procedures that increased transparency. These disclosures are related to corporate governance. It states that an issuer must have a body that is carrying out the functions mandated by disclosure and transparency rules, and at least one member of the body must be independent, and one must have expertise in auditing. The relevant body must monitor financial reporting, monitor the effectiveness of the internal control, internal audits and risk management; monitor the statutory audit; review and monitor the independence of the statutory auditor; and issue a corporate governance statement . The statement must reference the Corporate Governance Code and explain how the firm diverts from the Code, if this is the case. The corporate governance statement must also disclose the company’s internal controls and risk management system, in relation to the financial reporting process and must contain “a description of the composition and operation of the issuer’s administrative, management and supervisory bodies and their committees” (UK Corporate Governance Code). The annual report must also disclose such information as how the board operates,; how the board of directors was elected; how many meetings the board has had in the year; if a CEO is chairman of the board, why this is so; how performance evaluations of the board is conducted; if there is no internal audit function, why this is; and the steps that are taken to ensure that the board understands the views of the major shareholders of the company (UK Corporate Governance Code). The OECD has further instituted principles in response to the scandals. The principles are that shareholders should have more power to hold management accountable; that unfunded executive share options should be abolished; and that proper checks and balances should be put into place so that the corporate sector is strengthened, including the principle that accounting firms cannot also act as consultants (Schifferes, 2004). Although these are principles, not rules, they form the basis for the countries participating in the OECD to formulate their own rules that are based upon these principles. III. The Evolution of the United States Corporate Governance in Response to the Scandals As with the U.K., the U.S. has also traditionally believed in the power of the free market Hamill, McGregor & Rasaratnam, 2002, p. 3). However, in the wake of the scandals, the U.S. implemented a series of rules, as codified in the Code of Federal Regulations, by which corporations must abide. Some of these rules involve transparency in the disclosure of executive compensation (Colley et al., p. 112). According to the SEC, all corporations must disclose any remuneration made to the CEO, CFO and the three most highly paid officers (Right2Info). The rules apply to the following disclosures: “(1) tabular disclosures regarding executive remuneration and director remuneration;(2) narrative description of other types of remuneration and any information material to an understanding of the tabular information, and (3) a Compensation Discussion and Analysis (“CD&A”)” (17 C.F.R. § 229.402(b) (2008)) . The way that all companies must disclose this information is through their annual proxy statement, which the SEC's website makes available on-line (17 C.F.R. § 229.402(b) (2008)). Additionally, there are other regulations that are designed to increase transparency about executive and director compensation. For instance, there are regulations that require disclosure regarding “(i) beneficial ownership of public company securities by persons owning 5% or more of any class of the company’s voting securities and executives and directors;(ii) transactions between the company and related persons (generally defined to include officers, directors, 5% beneficial holders, and close family members of these individuals);and (iii) disclosure regarding a company’s processes and procedures for the consideration and determination of executive and director remuneration.” (17 C.F.R. § 229.407 (2008). Additionally, the United States instituted the Sarbanes-Oxley Act (SOX Act), which created a quasi-governmental agency, which created oversight over accounting firms, thus ending the reign of self-regulating principles (McMullin, 2009). The Sarbanes Oxley Act was enacted after Enron, and the main point of the Act was to end self-regulation for auditors. It appointed five member of the Public Company Accounting Oversight Board, and two of these members must be certified public accountants, and they are to “register public accounting firms; (2) establish or adopt auditing, quality control, ethics, independence, and other standards relating to the preparation of audit reports for issuers; (3) conduct inspections of accounting firms; (4) conduct investigations and disciplinary proceedings, and impose appropriate sanctions; (5) perform such other duties or function as necessary or appropriate; (6) enforce compliance with the Act, the rules of the Board, professional standards, and the securities laws relating to the preparation and issuance of audit reports and the obligations and liabilities of accountants with respect thereto; and (7) set the budget and manage the operations of the Board and the staff of the Board” (Smith & Walter, 2006, p. 188). Also, like the U.K., the United States has encouraged the board of directors and the CEO to be two different people, although this is not a requirement. What is a requirement is that firms must disclose if their board of directors and CEO are the same person, and each firm must give a rationale for their decision in this regard. Moreover, the SEC has approved heightened disclosure rules, explained below (Key Issues: The CEO and Board Chair). Conclusion The U.K. and the U.S. has evolved because of the scandals that were created during the late 1990s to early 2000s. The U.S. had WorldCom, Enron and many others; the U.K. had Barings Bank and Maxwell, among others. Because these scandals were due to the lack of oversight and transparency, the two countries instituted regulations to correct this. However, the U.K. instituted a series of broad principles by which individual corporations must fashion their individual rules. Regardless, these individual corporations must show that they are abiding by the principles set forth, and this is how the U.K. has instituted transparency principles. In contrast, the U.S. instituted a series of rules that are codified by the Code of Federal Regulations which also deal with transparency, as well as instituting the Sarbanes Oxley Act that put forth rules regarding auditing independence. Nonetheless, the two countries did evolve after these scandals, as, prior to the scandals, their market structures emphasized free markets. After the scandals, the markets are regulated in these two countries in these two different ways. Of course, judging by the recent failure of the banking industry, perhaps these regulations did not go far enough. Table of Contents Introduction........................................................................................................................................................1 Enron and WorldCom.......................................................................................1 The Evolution of UK Corporate Governance in Response to Corporate Scandals..................2 The Evolution of the United States Corporate Governance in Response to the Scandals........5 Conclusion.......................................................................................................................................6 Bibliography Benston, G. & Kaufman, G. (1996). “The appropriate role of bank regulation,” The Economic Journal, vol. 106, no. 436, pp. 688-697. Cadbury, A. 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