Regulatory Response to Corporate Scandals - Essay Example

?The regulatory response to the corporate scandals in the USA and the EU was diametrically different, reflecting their diverse corporate governance system, legal culture as well as business practices. Discuss Introduction It is true that companies around the world attempt to attract funds from investors in order to expand and develop their activities. Usually, before investors decide to invest their money in any investment company, they seek to ensure that the financial situation of the company is secure and reliable.1 Also, they need to have confidence that the company will be properly managed and controlled in order to be profitable. In order to have this assurance, investors generally rely on the published annual report and accounts of companies. However, although the annual report and accounts may provide a reasonable approximation of companies’ activities, there are issues not shown in the annual report and accounts that could affect these companies’ financial situations, as well as the reputation of international stock markets2. For instance, despite the fact that the annual report and accounts seemed healthy, the last decade faced a large number of corporate scandals and collapses. These corporate crises have affected several people, as in the case of shareholders, managers, directors, employees and consumers. Some would argue that the main cause of these corporate crises is the weakness of corporate governance regulations in the world, as well as a need to have good corporate governance codes in order to prevent further scandals and collapses.3 As a consequence, countries have been trying during the last decade to develop and update their corporate governance systems. In fact, countries’ responses to regulate their systems were diametrically different, because of the differences in their legal cultures, political contexts and business practices.4 In order to illustrate the international response of regulating corporate scandals, this essay aims to reveal and discuss the differences between both the USA and the EU responses. The reason of choosing these nations is that they have faced many corporate scandals that had international implications. In the first part of this essay, the link between the evolution of corporate governance and scandals will be analyzed. In this part, the shortcomings of the USA and the EU regulations that appeared after scandals will be mentioned. Subsequent to that, the difference of the USA response will be explained. In this part, the Sarbanes-Oxley Act and its new provisions, Sections 302 and 404, will be discussed. Finally, the differences of the EU response will be discussed in light of the national and the pan-European level. 1. Corporate Governance Evolution and Scandals It is widely believed that the development of corporate governance codes has often been driven by financial scandals, corporate collapses and similar crises. For instance, at the beginning of the 1990s various financial scandals and corporate collapses happened in the UK, as in the case of Coloroll, Polly Peck and Maxwell.5 These crises led the Financial Reporting Council and the London Stock Exchange to establish the Committee on the Financial Aspects of Corporate Governance in May 1991; Sir Adrian Cadbury chaired this council in order to improve the UK’s Code of corporate governance. As a consequence, in December 1991 the Committee issued the Cadbury Report that influenced many corporate governance codes across the world.6 The Report stated several recommendations that focused on corporate governance issues, in particular, the operation of the main board, the role of non-executive directors and the reporting and control mechanism of firm.7 Additionally, the development of corporate governance codes, supported by many non-governmental organizations, issued principles and practices that should govern corporates globally.8 For example, the Organization for Economic Co-operation and Development (OECD) published its Principles of Corporate Governance in 1991; this was revised in 2004.9 Furthermore, the World Bank issued its Report on Corporate Governance Activities, which is quite similar to the OECD Principles.10 Also, the International Corporate Governance Network (ICGN) that was founded in 1995 issued its Statement on Global Corporate Governance Principles in 1999, which was revised in 2005.11 Obviously, all these international codes and principles cover the main factors of corporate governance that may be capable to prevent scandals and collapses from occurring in the future, especially transparency and disclosure, control and accountability, audit, corporate boards and structure of the share ownership.12 Even though countries’ codes and international principles of corporate governance seem to be too heavily influenced, compliance is generally on a voluntary disclosure basis.13 In counties such as the UK compliance is on a ‘comply or explain basis’ mechanism. This means that a company should comply with the code, but if it cannot comply with any particular aspect of it, then it should explain why it is unable to do so. This disclosure provides detailed information to investors about any instance of non-compliance and enables them to decide whether the company’s non-compliance is justified.14 The development wave of corporate governance crossed both the USA and the EU. Before illustrating the differences between the two nations’ responses to regulating corporate governance, it is important to analyze the effect of scandals on these nations in order to reveal the shortcomings of their regulations. 1.2 Enron As an energy trader, Enron was ranked in the USA’s Fortune top ten list of companies in 2000.15 In December 2000 Enron issued its accounts, which showed that it had made a health profit of $979 million. However, Enron took advantage of US accounting rules, which enable companies to set up corporate vehicles, so-called special purpose entities or (SPEs), to manage assets off balance sheets. The return on an asset can be maximized and risk minimized by transferring it to an SPE, which must at some point repay the debt that it has incurred to the vendor company. An outside investor comes in to supply external capital and share the risk with the vendor, in exchange for which they also gets to share in the high rate of return that the SPE can provide.16 As a result, the debts grew and in October 2001 Enron disclosed an account problem by losing more than $1 billion. The list of charges against Enron was quite long and included accounting fraud, bribery to foreign governments to win contracts abroad, and manipulating the Californian energy market and the Texas power market. In December 2001 Enron filed for bankruptcy.17 1.3 WorldCom WorldCom was one of the largest providers of telecommunications services in the US.18 Although Enron is identified as the most famous case of corporate fraud, WorldCom is recognized as the largest corporate fraud in US history.19 In June 2001 WorldCom disclosed $3.8 billion of profits in its financial annual statements, but after an internal audit by the Securities and Exchange Commission’s (SEC) accountants, they found the disclosure amount was improperly recorded.20 Therefore, in July 2002 WorldCom filed for bankruptcy and its chief financial officer (CFO) Scott Sullivan pleaded guilty to criminal charges related to the fraud.21 1.4 Parmalat Italian company Parmalat was a world leader in the dairy food business. They were controlled by Calisto Tanzi’ family.22 The major issue within Parmalat was the falsification of accounts when ?4.2 billion in assets mysteriously vanished from its balance sheet.23 It collapsed and entered bankruptcy protection in December 2003 after acknowledging massive holes in its financial statements.24 1.5 Scandals’ Outcomes discussion The three examples above of high-profile corporate collapses and scandals revealed a large number of shortcomings in the way that the companies were run and managed. Enron and WorldCom highlighted the main areas that are needed to reorganize the USA’s corporate governance system. They highlighted the requirement for external auditors to ask unfettered questions intelligently and insightfully. In addition, these scandals demonstrated the need for independent directors on boards and committees who will be able to question and monitor executive directors.25 On the other hand, Parmalat highlighted the weaknesses that may exist in family-owned firms when members of the family take a dominant role across the board structure. Parmalat’s board lacked for independent directors. There were thirteen directors and only three were independent. This was a dysfunctional composition of the board.26 It seems clear that the main reason for all these corporate scandals and collapses was the extent of companies to comply with corporate governance codes and principles, in particular, on the disclosure methods of the annual accounts. These issues affected the structure of the share ownership system, which is completely different in the USA and EU. In fact, this system is the exact cause of the diametrically different response in the two nations and it will be discussed in the following sections. 2. The USA Response After the financial scandals of Enron and WorldCom, the American Congress agreed on reforms that have had a significant impact in the USA and globally. These reforms are embodied in the Public Company Accounting Reform and Investor Protection Act (2002); widely identified as the Sarbanes-Oxley Act or the SoX.27 Before analyzing the Sarbanes-Oxley Act, it is important to know why the USA’s response was diametrically different from the EU’s response. 2.1 Difference Elements of the USA Response The issue of revealing and discussing the reasons of making the USA response completely different from the EU response relies on different aspects related to corporate governance system legal culture. First of all, the USA is characterized by dispersed ownership systems that seek to separate ownership and corporate control, which are dominated by managers.28 This system is distinguished by many values, such as strong securities markets, rigorous disclosure standards, high share turnover, high market transparency and financial statement restatements.29 In effect, financial statement restatements aim to reveal annually for shareholders and investors the financial situation of businesses. According to the United States General Accounting Office (GAO), there has been a rapid acceleration in financial statement restatements in the USA -- which are rare in Europe -- since the 1990s. For instance, the GAO published a study, which illustrated that the number of earnings restatements by publicly held US corporations averaged roughly 49 per year from 1990 to 1997, increased to 91 in 1998, and then soared to 150 and 156 in 1999 and 2000, respectively.30 However, although there was a significant increase in companies’ financial statement restatements, the GAO was not able to account and monitor them. Indeed, this issue affected on managers’ behaviour in the USA, as they became more optimistic about earnings growth, even if irregularly or illegally, due to the fact that they have the dominance on the dispersed ownership system.31 This obviously appeared in the median compensation of chief executive officers (CEO) because some of them were involved in financial fraud, as in the case of the mangers of Enron and WorldCom. For example, in 1990 the median compensation of a CEO in the USA was $1.25 million with 92% of this amount paid in cash and 8% in equity, but in 2001 the median compensation of CEO was over $6 million of which 66% was in equity.32 In contrast, the scale of compensation and its composition is certainly different in the EU. For instance, in 2004 CEO compensation as a multiple of average employee compensation was estimated to be 531 to 1 in the USA, otherwise only 16 to 1 in France, 11 to 1 in Germany and 25 to 1 in the UK.33 Therefore, the nature of the dispersed ownership system played a major role in the response of the USA owing to mangers’ dominance. This clearly appeared on their behavior since they were involved in financial fraud in order to increase their compensations. Second, the nature of the dispersed ownership system in the USA needs greater enforcement owing to the fact that shareholders do not dominate and control companies.34 Obviously, once ordinary citizens enter the equity securities markets and invest their money in stocks, they demand political protection and legal retribution against fraud and fiduciary abuse.35 This clearly appeared after the financial scandals and corporate collapses of Enron and WorldCom, because the economic losses in the USA were by individual investors and not institutional investors as in the EU. Hence, this reveals the enforcement gap between common law, such as the USA and civil law countries, since the size of securities markets in the USA are very wide and contain individual investors who always demand political protection after scandals.36 2.2 The Sarbanes-Oxley Act: New Provisions The issues of both Enron and WorldCom’s fraudulent and unreliable financial reporting led the USA Government to reform its corporate governance system by adopting the Sarbanes-Oxley Act which was signed into law on July 30, 2002.37 This Act contains new provisions designed to improve the quality of financial reporting and auditing. Besides this, it created the Public Company Accounting Oversight Board (PCAOB), which seeks to protect the interests of investors and the public interest by providing reliable information and maintaining the independence of audit reports.38 One of these new provisions is Section 302 of the Sarbanes-Oxley Act, which concerns corporate responsibility for financial reports. It stipulates that the CEOs and CFOs shall “certify in each annual or quarterly report” because they “are responsible for establishing and maintaining internal controls” and “have designed such internal controls to ensure that material in formation relating to the issuer and its consolidated subsidiaries is made known to such officers by others within those entities, particularly during the period in which the periodic reports are being prepared”. This means that executives claim the reports filed to the SEC are reliable and do not contain any material misstatements or omissions. Moreover, they claim the company has implemented effective disclosure controls and procedures to ensure transparency.39 Second, Section 404, which concerns management assessment of internal controls, provides that company’s reports must “state the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting” and “contain an assessment, as of the end of the most recent fiscal year of the issuer of the effectiveness of the internal control structure and procedures of the issuer for financial reporting”. In other words, this section seeks to strengthen the role of independent external auditors who must report on the reliability of management’s assessment of internal control structures and the procedures of the issuer for financial reports. 40 2.3 The Sarbanes-Oxley Act: Criticism and discussion The implication of the Sarbanes-Oxley Act on the companies, which were listed at the American’s stock exchanges, has been widely debated since the last decade. Many commentators discussed the impact of Section 404 on both American and non-American companies.41 Opponents of the Sarbanes-Oxley Act argue that it has resulted in a number of unforeseen consequences for both America’s stock markets and their firms, whether they are American or non-American. First of all, they believe that the compliance cost of the Sarbanes-Oxley Act’s provisions, in particular Section 404, is extremely high for small public firms on account of the fact that the cost includes the additional internal controls required to achieve compliance with the new regulation as well as the extra audit fees paid to the outside auditors attesting to the management’s assessment.42 In addition, small firms pay disproportionately high costs because of the fixed cost nature of compliance on the Act.43 Second, opponents think that the Sarbanes-Oxley Act also affects American’s stock markets; instead of restoring the confidence of investors and public companies, it leds some companies to delist their activities from the New York Stock Exchange (NYSE) and the Nasdaq Stock Market (NASDAQ), and migrate to less intensively regulated securities markets, such as those in London and Hong Kong.44 Third, the Sarbanes-Oxley Act also affects non-US companies because they are not exempted from the Act’s provisions, despite the fact that the SEC used to provide exemptions for them.45 In fact, this has discouraged from foreign companies determination to enter the American’s stock exchanges. Fourth, critics of the SoX believe that it was born in an environment of emergency and a panic period stemming from Enron and WorldCom collapses. This did not give the creators of the SoX enough time to identify all the shortcomings of America’s corporate system and provide the reasonable solutions.46 On the other hand, it is generally agreed that the Sarbanes-Oxley Act leads to several advantages on America’s stock markets and firms. First, supporters of the SoX’s reforms believe that increasing the price of compliance for the new procedures leads to improving companies’ internal control structure and financial reporting.47 Also, companies’ earnings after SoX better reflect the actual economic profits of the firms, since executives are very cautious when it comes to reporting performance. As a consequence, when the purpose of the Sarbanes-Oxley Act is achieved, the cost of compliance will be significantly decreased.48 Second, in order to ease the pressure of compliance on small and foreign companies, the SEC suggested that companies, which spend 5.4 million staff hours each year, have to comply with the Sarbanes-Oxley Act.49 Third, proponents of SoX argue that it has a profound effect on restoring the confidence of investors and firms because the reaction of SoX was strong and immediate after the Enron and WorldCom collapses.50 Therefore, it seems clear that weighing the benefits of the Sarbanes-Oxley Act against the drawbacks, especially in Section 404, is perhaps still too early. Otherwise, according to the current circumstances, it is logical to conclude that SoX’s reforms are undoubtedly decisive and strong against financial fraud and corporate scandals. It provides crucial solutions to ensure that such corporate collapses and scandals should never happen again. 3. The EU Response The evolutionary wave of corporate governance financial scandals and corporate collapses has crossed the Atlantic to Europe. The European Union’s response to reorganize corporate governance has faced different barriers to issuing uniform regulation for all its members, as in the case of the Sarbanes-Oxley Act in the USA. Some of these restrictions relate to the different system that each member follows and others belong to members’ legal culture. In this part, it will be revealed why the EU’s response was so different from the USA’s. Specifically these concerns are considered in the light of the national level and the pan-European level. 3.1 The Differences of the EU Response After the financial scandals and corporate collapses in the USA, there was a view that these crises were American phenomenon with no direct relevance for Europe. Supporters of this view believed that the US suffered from greedy executives, conflicted auditors, reliance on accounting rules not principles and an obsession with quarterly earnings.51 Nonetheless, this claim was overconfident and never justified because Europe has affected many corporate collapses since the 1990s such as Barings Bank, Royal Ahold and Parmalat. The issue of making the EU response different relies on diverse standards. First of all, the European Union is not a federal state, as in the case of the USA. It consists of 27 member states, which have different systems of corporate governance that reflect their different cultures and views about the roles of corporations.52 For instance, more than forty corporate governance codes relevant to the EU have been adopted at national or international levels since the 1990s.53 Hence, reaching a consensus in order to obtain a European corporate governance code needs more time and it appears to be too difficult because all members have to ratify the code. In the USA, scandals and collapses have a huge impact globally because stock exchanges, for example, NYSE and NASDAQ contain firms from different countries. Yet, in the EU, there is no stock exchange playing any role similar to that of the NYSE or NASDAQ.54 Although the London Stock Exchange is one of the biggest marks in the world, its firms are only English. It should also be observed that the board structure in the EU has an enormous impact on making the EU response different. It is divided into two different models, unitary board or one-tier model and dual board or two-tier model.55 For example, in the UK and the majority of EU Member States the unitary board is predominant; it is characterized by one board comprising both executive and non-executive directors responsible for all aspects of the company’s activities.56 On the other hand, in Austria, Germany, the Netherlands and Denmark the dual board is predominant. It consists of a supervisory board that oversees the direction of the firm and an executive board of management that is responsible for the running of the business.57 The main cause making the EU response different is the ownership and control system. The majority of the European countries, especially with the dual board, follow the concentrated ownership system. This system is characterized by controlling blockholders, weaker securities markets, high private benefits of control and lower disclosure and market transparency standards.58 Two points related to the concentrated ownership system need to be understood in order to know why the EU response to reorganize corporate governance is different. First, a controlling shareholder does not need to rely on indirect ways of control, just as equity compensation or stock options in order to incentivize management as it in the USA. Rather, it can rely on a command and control system because it can directly monitor and replace management. Then, corporate managers have less discretion to engage in opportunistic earnings management and less motivation to create an earnings spike.59 Second, the controlling shareholder has much less interest in the day-to-day stock price of its company since the controlling shareholder seldom sells its control block into the public market.60 As a consequence, these two points, less use of equity compensation and less interest in the short-term stock price, illustrate why there are fewer accounting irregularities in the EU than in the USA. This plays a major role in slowing the wheel of reorganizing corporate governance in the EU. 3.2 The EU Response According to the above reasons and because each member of the EU has its code on corporate governance, it is better to analyse the EU response in the light of the national and pan-European level. 3.2.1 National Level Because of the increase of corporate collapses in the EU, all Member States agreed to improve their corporate governance codes in order to provide a healthy environment for all companies.61 In effect, their attempt was based on harmonising their national legislation in corporate governance in order to accord their history, legal, culture and business practices. As a consequence, most of the European countries adopted the UK code because it had well developed corporate regulations and effectively illustrated the most fundamental issues related to corporate governance.62 However, some forces have affected the European countries’ harmonisation of their national corporate codes. For instance, these include the increase of globalization and integration on countries’ economy practices, the opening of financial markets, the increase of foreign institutional investors’ roles and the recommendations on corporate governance practices of international organizations.63 It is logical to conclude that all the EU Member States have introduced their corporate codes by adopting principles rather than rules. Additionally, their codes are flexible and updated and the compliance system is based on the comply or explain rule.64 3.2.2 Pan-European Level At the end of 2001 the European Commission established the EU High Level Group of Company Law Experts, which comprised of seven legal experts to provide independent advice for modernizing company law in Europe. The group was headed by Jaap Winter and was independent from the governments of the EU Member States.65 In April 2002 the Group published its report ‘the Winter Report’ (2002) that contained several recommendations about financial disclosure, audit, management and directors’ remuneration and board structure. Moreover, it highlighted all the issues that need to be observed by the European Commission and recommended the Commission establish an EU Company Law Action Plan in order to implement these recommendations.66 On May 21, 2003 the European Commission published the Modernizing Company Law and Enhancing Corporate Governance in the European Union - A Plan to Move Forward, which is also known as the Action Plan of 2003.67 The objectives of the Action Plan were to strengthen shareholders’ rights and improve protection for employees, creditors, and other parties with which companies deal. This was meant mainly to create and maintain confidence in companies within the European Union.68 Furthermore, the Commission intended to foster the efficiency and competitiveness of business, with special attention to some specific cross-border issues.69 The Action Plan contained twenty-four proposed measures to be taken. They were prioritized and divided into three steps: short term (2003-2005), medium term (2006-2008) and long term (2009-onwards).70 In general, the momentum of the Action Plan as well as of its forerunner, the High Level Group report, was conspicuous. In fact, the reaction has been positive, though there have also been criticisms. The criticism resulted from fundamental opposition under the subsidiarity principle, the economic concept of regulatory competition, to more specific critiques of the single actions proposed.71 The Commission was not impressed by the fundamental critique, however, and was proceeding with various instruments concerning the different actions. I shall come to some of these later on. Therefore, it appears to be that the High Level Group report and the Action Plan were compatible the Member States differences’ in their legal cultures and business practices. Conclusion It seems clear that countries’ codes of corporate governance are more or less regularly updated and improved whether before or after the bubble of financial scandals and corporate collapses. The problem of reorganizing corporate governance codes appears under different circumstances. Some of them are based on the variety of the ownership system, others on the differences between countries legal cultures and business practices. In fact, creating a strict code such as the Sarbanes-Oxley Act, or harmonizing corporate governance codes, as in the case of Europe, are not enough. What are needed are more explanations of the problem in order to avoid scandals and collapses in the future. There should be more studies revealing future potential problems that also cover any forthcoming threats. Read More