Law on Corporate Governance - Coursework Example

Law on Corporate Governance Total Number of Words: 5,089 Table of Contents I. Introduction ………………………………………………………………. 3 II. Basic Concept and Role of Board of Directors in Terms of the Mechanism behind the Corporate Governance ……………………… 4 a. Role of Executive Directors in Corporate Governance …. 9 b. Role of Non-executive Directors in Corporate Governance ………………………………………... 10 III. WorldCom’s Board of Directors ………………………………………... 12 IV. Enron’s Board of Directors ……………………………………………… 12 V. Effective Strategy for the Creation of a Good Board ………………… 13 VI. Most Appropriate and Effective Method of Remunerating Executives and Directors ……………………………… 15 VII. Discussion …………………………………………………………………. 17 VIII. Conclusion …………………………………………………………………. 21 References ……………………………………………………………………… 23 - 27 Introduction Since corporations are a significant part of our society, there is a need for law makers to fully understand the theory and concepts that makes a corporation a social phenomenon. In reality, not only does a corporate theory serve as a framework in enabling us to examine the ethics and values of a company but also constitute a lot in the development of modern corporation law.1 The large amount of money involved in big companies increases corruption within the business practices. In many cases, the board of directors and executives of a corporation are among the individuals who are behind the practice and development of a corrupt culture. Since shareholders have the power to either appoint and/or dismiss the members of the board of directors, the European corporate law behind the UK model of companies are focused on investigating shareholders and board of directors. 2 Corporate theories are used to help us understand the origin of a corporation and how a corporation operates. These legal documents discuss about the significant individuals behind the formation of a company such as the owners and/or shareholders among others. To enable the readers to have a better understanding of the subject matter, the student will first discuss the theory behind the role of board of directors in terms of the mechanism behind the corporate governance will be tackled. In the process of discussing the role of directors, the elements behind the creation of a good board will be identified followed by discussing the most appropriate and effective method of remunerating directors and executives. In line with discussing the remunerating approaches, the student will discuss the type of remunerating method used at WorldCom and Enron. Basic Concept and Role of Board of Directors in Terms of the Mechanism behind the Corporate Governance Shareholders are responsible in selecting and electing their preferred members of the board to be their representatives in managing the business affairs whereas the board of directors appoint, hire, and delegate specific role and responsibility to selected CEO. Since the CEO handles the actual management of the business operations, the CEO becomes accountable to the business owners and board of directors. In other words, collusion between the shareholders, board of directors, and the CEO allows the business owner(s) to manipulate the financial records of the company at the expense of the stakeholders and external shareholders. This makes corporate governance one of the most controversial topics related to business and finance.3 Under the concept of corporate governance, the board of directors has an important role in terms of balancing the monetary interests of the business owners with the profit-sharing of its employees and other stakeholders by voting for major financial decisions.4 As a result of maintaining a mutual relationship among the business owners, external shareholders and other stakeholders, the company could strengthen the company’s long-term survival. Corporate governance is actually referring to a system of authoritative direction or government which includes the specific role and responsibilities of the owners or the shareholders, the board of directors, and the Chief Executive Officer (CEO).5 Aside from discussing the universally accepted roles and responsibilities of shareholders, board of directors, and the CEO; corporate governance is often used as a policy for business organization in relation with the actual structure of the board, the activism of the shareholders, and overall business performance.6 Corporate governance is based on a neutral, objective, and publicly acceptable corporate values.7 These are some of the reasons that made a lot of businessmen consider good corporate governance as an acceptable business ethics and a moral duty on the part of a corporation’s board of directors and executives. For this reason, the creation and implementation of good governance is believed to have a positive effect over the success of a company’s business performance. Corruption such as bribery, the practice of illegal and marginally legal offshore financing and/or manipulating the corporate financial documents8 is an act of abuse of power on the part of private or public officials.9 It can occur either privately within an institution10 or involves public officials practice corruption in exchange for their own personal gains11. To prevent employees and board of directors from engaging in corrupt business practices, the CEO and/or the chairman should implement initiatives on corporate governance to balance the interests of the shareholders and the management’s interests.12 As a result, the CEO could minimize the possibility that the company would encounter problems on the way the business is being handled by the stakeholders. The board of directors behind a corporation also plays a crucial role in the success of corporate governance aside from the increase in the company’s profitability and overall business performance by continuously hiring and firing the company’s top management.13 As a golden rule, executive and non-executive directors should always make important objective business decisions for the best interests of the company.14 Since the only way for executive and non-executive directors to perform their duty effectively is to have an access to all the company’s business information15, the board of directors are required to meet regularly in order to discuss the latest strategic plans and issues that could significantly affect the success of the business.16 In general, the board of directors are responsible in three major areas which contribute a lot to the success of the business. These includes: (1) control; (2) resource acquisition; and (3) service 17 aside from determining the corporate goals, development of strategic plans to meet the corporate goal, and implementing organizational policies to meet the business objectives.18 Since not all of the directors are directly and/or actively engaged in the daily operations of the business, there is a need for us to become aware of the major differences between the role and responsibilities of the executive and non-executive board of directors with regards to corporate governance. The differences between the role and responsibilities of an executive and non-executive board of directors can be easily noted such that executive directors are the ones who are directly involved in the daily business transactions that occurs within and outside the company whereas the non-executive or outside board of directors are not. Despite the differences in the responsibilities of executive and non-executive directors, the Commission has publicly announced under the modernized company law and the enhanced corporate governance though out the European Union states wherein directors should at all times ensure their collective responsibility when it comes to monitoring the financial and non-financial information behind the corporation.19 Role of Executive Directors in Corporate Governance Unlike the non-executive directors, the executive board of directors have the access on valuable information related to the business’ activities. By examining the financial statement of the company, executive directors will have an access over the company’s record on daily sales and expenses and other major business transactions like public shares, loans, and investments. Since business’ shareholders are also the owners of the company, these individuals are likely to have the authoritative power to manipulate any forms of legal or illegal transactions that will occur in the business.20 To create a good board, executive directors are encouraged to take advantage of their rights to look through the company’s official documents. In the process of going through the company’s financial statement, executive shareholders should take note of any signs of unusual business records that could adversely affect the long-term business operations by consulting the issue with the group of non-executive directors to avoid unnecessary bias judgement. Considering that the shareholders or owners of a corporation are the ones who directly appoint the members of the board, it becomes an unwritten rule that directors would normally protect the interest of the shareholders more than the other stakeholders which includes the employees, suppliers, government, public investors, and money lenders like the bank.21 For this reason, most of the real-life business cases such as in the case of Enron and Worldcom are contradictory to what corporate governance informs us with regards to the actual role of the executive and non-executive directors within a business organization. Role of Non-executive Directors in Corporate Governance Similar to the role of executive directors in corporate governance, the role of non-executive board of directors in corporate governance includes the responsibility in terms of reducing conflicting interests between the actual shareholders, executive board of directors, and the management team who works behind the company.22 Even though non-executive directors are not active in the daily operations of the business, these individuals are expected to strictly and regularly monitor the progress of the overall business, legal and ethical performance, strategic choices and implementation techniques used by the top management, including the appointing or removing members of the senior management aside from giving the rest of the board members some advice with regards to the strategies used in enabling the company reach the corporate goals and business objectives.23 By strictly monitoring the performance of the company directors, the non-executive directors could somehow improve the accountability of executive directors with the company’s shareholders and external investors.24 Therefore, it will be less likely on the part of the executive board of directors to abuse their authoritative power on manipulating the profitability of the company. Several studies reveal that there is a synergistic link between the role of non-executive directors and the role of institutional investors in the sense that the non-executive directors’ effort in ensuring that the business is free from any forms of corruption protects the welfare of the external investors.25 To make a good board, the non-executive board of directors are strongly encouraged to actively participate in the board meetings with the rest of the directors and shareholders to protect the interests of the public investors.26 WorldCom’s Board of Directors WorldCom’s board of directors is composed of CFO Scott Sullivan, compensation committee chairman Stiles A. Kellett, and the rest of the senior executive and non-executive board of directors.27 Aside from having the position as CFO and compensation committee chairman, Sullivan and Kellett are also a part of the executive board of directors at WorldCom. Considering the fact that CEO Bernard John Ebbers was able to manipulate Sullivan and Kellett, the rest of the WorldCom’s board of directors did not fulfil their duty to strictly monitor the WorldCom’s management activities28. As a result, they failed to protect the interests of its stakeholders. Enron’s Board of Directors Enron’s board of directors is generally composed of CEO Kenneth Lee Lay and Rebecca Mark-Jusbasche as the Chariman and CEO of Enron International and the Vice Chairman and CEO of Azurix including its 18 directors known as: John Wakeham, John Urquhart, Charles Walker, Herbert Winokur, Charles LeMaistre, John Mendelsohn, Frank Savage – also a member of Finance Committee, Wendy and Phil Gramm, Robert Belfer, Norman Blake, Ronnie Chan, John Duncan, Paulo Ferraz-Pereira, Joe Foy, Robert Jaedicke, Jerome Meyer, Ken Harrison – also the CEO of Portland General Electric, CFO Andrew Fastow, ex-CEO Jeff Skilling, Chief Accounting Officer Richard Causey, and Chief Risk Officer Rick Buy among others voluntarily participated in the CEO Kenneth Lee Lay’s decision to manipulate the company’s financial records29. Unlike the WorldCom’s Case wherein only a few significant directors were found guilty of criminal acts, Enron’s case had several directors who have actively participated behind the global scam. As a result a planned conspiracy behind the cashing in of as much as $1.1 billion worth of Enron’s shares while stock price was still high, small-scale public investors30, employees who agreed to invest their 401(k) retirement plan into Enron’s shares, and money lenders like banks were severely affected by the fraudulent business activity. Effective Strategy for the Creation of a Good Board To create a good board, companies should implement the two-tier board structure instead of the typical unitary board structure. A two-tier or dual board structure is normally composed of the management board and the supervisory board.31 The management board is composed of executives who run the business operations. With a chief executive who is responsible in monitoring the performance of the business executives, there is a higher possibility that the company will maintain the efficiency of its business operations. On the other hand, the supervisory board is responsible in developing business strategy on behalf of the company. Given that supervisory board is composed of highly competitive non-executive directors32, corruption within the business organization is less likely to occur. Contrary to two-tier board structure, a unitary board structure is composed of executive and non-executive board of directors who are directly involved in making important strategic decisions that contributes to the improvement of the company’s operational efficiency and success in growth strategies.33 Therefore, there is a higher possibility that the shareholders will develop a corrupt business culture by encouraging or bribing the executive directors to participate with the illegal activities. This is possible because non-executive directors can be inactive in monitoring the decision-making of the executive directors and the shareholders. Also, collusion between the shareholders, executive directors, and the CEO makes it difficult for non-executive directors to trace any signs of anomalies since the CEO had already manipulated the information presented in the financial statement. Between the unitary and two-tier board structure, the unitary board structure is normally used by most large-scale companies like Enron and Worldcom in the United States.34 Because of the imperfectness in the framework of the unitary board structure, serious accounting fraud happened in the case of both companies. Most Appropriate and Effective Method of Remunerating Executive Directors There is really no specific approach that could effectively remunerate the executive directors. During the past few years, there were quite a lot of methods used to remunerate executive directors. Aiming to retain and motivate executive directors to improve transparency and provide the best quality job performance with regards to monitoring daily business activities that occur within a corporation, shareholders normally use attractive pay packages, pension rights, annual bonuses, long-term incentive schemes, share options, as well as additional compensation and benefits.35 Based on the empirical test that was conducted by Cyert, Kang & Kumar (2002), there is a higher risk of corporate bankruptcy in case the equity ownership of external shareholders is greater than the actual shares of the board of directors and the CEO’s equity compensation.36 It means that there is a tendency on the part of the executive and non-executive directors to becomes less motivated in performing their role and responsibility on monitoring the daily business activities of the company. On the contrary, the case of Enron proves that increasing the shares of directors is not an effective way of motivating directors to perform their duty in safeguarding the interests of the minority stakeholders. Considering that executive directors are able to have an access over the company’s financial statement, each directors may closely guard their own personal interests and decide to cash out their shares as soon as they see signs that the company’s profitability is following a declining trend. Remunerating strategies used by WorldCom and Enron is a combination of the typical remunerating methods. Aside from extremely high remunerating packages offered by WorldCom, director Kellett was given the privilege to lease WorldCom’s corporate jet for $1 each month37. In other words, the close ties the CEO Ebbers developed with director Kellett and Sullivan enabled him to manipulate the company’s financial statement. With the active participation of Sullivan, WorldCom was able to improperly state as much as $3.9 billion worth of operational expenses and create as much as $133 million in revenue as Ebbers received payments of more than $77 million, other benefits like $1.5 million cash payment for life each year.38 On the other hand, Kellett approved the $408.2 million Ebbers’ personal loan from WorldCom in exchange of his WorldCom stocks39. The case of Enron is different. Its board of directors received an annual salary of more than $350,000 each aside from the stocks and stock options they received to act as Enron’s board members40. Despite the large sum of money each director received annually, these individuals chose to conspire with Lay instead of performing their duty. Discussion Failure of WorldCom started when the company decided to concentrate in acquiring other companies in exchange of WorldCom stocks as a growth strategy41. The tight market competition combined with its inability to adopt with new technology made the business experienced a significant reduction in its revenues and profitability. Since the company was understaffed, the company’s internal audit department became less focused on monitoring the company’s financial performance. Eventually, WorldCom’s desire to encourage public investors to invest in the company combined with the personal benefits they receive from the business owner made some of its directors tempted to manipulate its annual financial reports. On the contrary, Enron started to build fraudulent global networks through partnership strategies as a way of removing debts away from its financial statement and selling high prices of Enron’s shares42. Enron’s case was solely for the benefit of its executive members and their families since the corporate directors were able to cash out their stocks even before the company declared bankruptcy. The study of Hung & Mondejar (2005) concluded that there is no significant impact between the level of entrepreneurial innovation and the presence of either executive and/or non-executive directors.43 This findings is true regardless of whether the company decided to increase the number of independent non-executive directors to at least half of the total number of directors as suggested in Higgs Report44 in the sense that the CEO has the power to build a close relationship with its directors and lure them with material wealth such as in the case of WorldCom and Enron. In relation with the worldwide controversy behind the bankruptcy of Enron and Worldcom, several studies suggest that the size of the company significantly affect the effectiveness of corporate governance such that a smaller group of boards is more efficient than larger groups.45 This is true since Enron was composed of 18 members. However, it does not always apply in the real world since WorldCom with lesser number of boards size also became globally known for its fraudulent acts. Upon analyzing the case of Enron and WorldCom, it is the board structure that causes these two companies to have negative corporate governance. Despite the complexity in the organizational structure of WorldCom and Enron, the application of a unitary board structure made it easy for CEOs to tempt its board members into corrupt business practices. With the use of two-tier board structure, WorldCom and Enron could have had prevented the development of a corrupt culture since the framework of a two-tier is designed to minimize possible collusion within the business organization. As a result, the executive and non-executive directors will be able to perform their main responsibility in terms of effectively balancing the monetary interests and welfare of its shareholders. The collapse of Enron and Worldcom has enormously affected the public confidence especially on the stock market. Aiming to preserve the public confidence on the stock market in UK, the European Commission issued an Action Plan on Modernizing the Company Law and Enhancing the Corporate Governance throughout the European Union back in May 2003.46 As part of improving the corporate governance in UK, the action plan includes issues related with the need to increase transparency in financial statements and non-financial information, capital maintenance, recapitalization and international corporate restructuring among others. The falsification of the actual values in the financial statement of a company is one of the most common offenses done by corporate accountants. To avoid similar business scandals in UK, the government should continuously strengthen the corporate law and corporate governance by legally make the board members who will be proven guilty of misconduct to be held liable for criminal charges.47 Conclusion Even though the corporate governance in UK is already stable, there is still a need to regularly improve the policy as well as the UK company law because of the continuously changing market environment. By making the UK corporate governance and company law free from possible loop-holes, the country could avoid going through business scandals which could negatively harm the reputation of the local businesses throughout the United Kingdom. Some people may consider that a larger size of board could result to less efficiency in terms of effectively performing their role and responsibilities within the business organization. The case of WorldCom and Enron shows that the size of the board members is not really a factor that causes conspiracy within the working environment since it would be more costly on the part of the CEO to encourage a larger group of directors to be involved in fraudulent business activities. Between the use of unitary and two-tier board structure, it is best to use the two-tier board structure since this framework allows lesser opportunity for directors to collude with the CEO. Even though there is not much study conducted to prove the efficiency of using the two-tier structure, the negative result of using the unitary board structure as seen in the case of WorldCom and Enron is sufficient for corporate governance to consider the promise associated with the use of a two-tier board structure. Personally, I do not consider unitary board structure to be the main cause of Enron and Worldcom scandals. Even if most businesses in UK would try to convert its board structure from the traditional unitary into two-tier structure, there will always be a way for shareholders and executive directors to plan on another fraudulent case. Under the law of business ethics, corruption is unethical because it causes serious financial and economic harm not only on the part of the stakeholders48 but also with the general public. On a legal point-of-view, corruption is considered a serious corporate crime which should be punishable under the European law.49 To protect our society and the global markets from unethical business practices, it is necessary to eradicate the incidence of corruption by strengthening the existing framework on UK corporate governance. 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