Regulation, Compliance, and Governance Issues - Essay Example

Regulation, Compliance and Governance Failure in Corporate Governance Corporate governance can be defined as a set of processes, rules and practices that is followed by companies for controlling or directing their operations. It aims at balancing interests of the management and shareholders of a company by separating the ownership and control function. Effective corporate governance is seen to greatly enhance the outcome of a business. On neglecting this aspect, companies have faced even bankruptcy. There are several examples of corporate governance failure. The two major examples in this case are that of Enron Corporation and Northern Rock Bank. The essay highlights on similarities and dissimilarities between the failures of Enron and Northern bank. Regulations that are introduced for addressing such corporate failures are also discussed. Failure of Enron Enron Corporation was an esteemed energy provider company, which had its headquarters in Houston, Texas. Prior to the period of December 2001, Enron had enjoyed a prosperous position in the United States (US) and achieved the seventh position for being the most innovative firm operating worldwide. The main problem for Enron had surfaced from wrong and questionable practices followed therein. The company desired to expand its territory and operations through diversification of the products as well as introduction of online trading. Nevertheless, following its success, Enron breached the usual practices that are prevalent in the industry. Instead of acting as a broker between the sellers and buyers, the company traded in products and gas. This fact indicated that purchasers bought the products and gas from Enron directly, whereas the latter bought the same directly from suppliers (The Economist Newspaper Limited, 2014). Hence, it can be stated that continuity of business operations was solely dependent on proper credit rating. Eventually, when the credit rating of Enron dropped drastically, the sellers and buyers stopped the trade. The board of Enron had devised a very risky strategy, which could not be undertaken by the security of the company, given that there was a drastic slump in credit rating and consequently, in the trade (The Economist Newspaper Limited, 2014). Enron had devised another strategy by appointing Special Purpose Entities (SPEs), which were basically a third party who collected investment funds from companies and people. Even though these entities were not directly related to Enron, yet the latter was the guarantor of payment for the borrowed funds. This process was executed by offering shares to the investors. It was observed that the company collected huge amount of fund through these practices, which adversely affected its credit rating as borrowing fund from external sources was regarded as symptoms of organisational issues (McLean and Elkind, 2003). Additionally, economic downturns added to the challenges encountered by Enron. Hence, more amount of debt was added to the company’s liability and it was hard to manage the situation. Owing to such challenges, Enron declared bankruptcy in December 2001. The company’s share price fell from $80 to less than a dollar. Such a downfall had occurred mainly due to failure in corporate governance, which not only shammed reputation of the company, but also entailed bankruptcy (Todea and Stanciu, 2009). Failure of Northern Rock Northern Rock was an established mortgage provider in the United Kingdom, which owned a respectable position in London Stock Exchange. Nevertheless, in August 2007, there was bank run in all the branches as the customers perceived that they could lose their money. This prediction was justified as they became aware of the fact that Northern Rock had taken a huge loan from Bank of England. It would be worth mentioning that the situations leading to this issue had originated from the financial crisis, which had severely affected the world economy (BBC Business, 2007). Apart from the financial crisis, it was the failure in corporate governance that had further damaged the business. This failure resulted in bad relationship with Bank of England and regulatory authorities of the United Kingdom and the situation worsened subsequently (Summon, 2011.). The decline in corporate governance was initiated when the Board of the bank had approved of the risky money making system. The normal procedure for every bank in the UK is to obtain money from the customers or depositors, which are payable in long-term on higher interest rates. These funds are loan to the banks (Broadbent and Laughlin, 2013). Hence, the distinction between payment of interest to the depositors and the interest obtained from loans formed profit for the banks. Nevertheless, Northern Rock did not follow the usual practices and undertook a different strategy. Northern Rock collected credit from the depositors that were payable in short run and provided loan to others from the same fund, which was payable in long run. When the borrowed fund matured, the amount was distributed after obtaining the long run interest received from the loans. This process continued until the middle of 2007, when the Monetary Policy Committee of the UK raised the rate of interest in order to combat inflation. This act initiated a crisis in the mortgage market that resulted in banks unwilling to extend loans. It had also affected Northern Rock, who no longer could pay the short-term borrowings. This poor practice pertaining to corporate governance did not comply with the regulations. The bank should have supervised its internal control system so as to protect assets of the stakeholders. The financial crunch of the bank became public and the customers as well as the investors enquired about their deposits and investments made (Llewellyn, 2008). Besides the above mentioned reason, the high pay that was given to the top executives even during the financial crunch greatly added to the business failure. Moreover, extension of the tenure of non-executive directors of the board was also revealed, which indicated infringement of combined code, thereby restricting authority of the board to act independently. Similarities between two failures From the above discussion, the similarities between the two events can be observed very clearly. Both Enron and Northern Rock had applied and approved of wrong practices in order to earn greater amounts of profit for their own benefit. The two firms had devised incorrect strategies to extract money from the depositors and earn interest out of the same, thereby violating the regulation of corporate governance. The most important similarity between the two cases is that both the firms had violated the corporate governance rule and consequently encountered collapse. In both the cases, the shareholders stopped purchasing or transacting securities after becoming aware of financial status of the firm. Such situations resulted in the decline of share price related to both the firms (Davies and Green, 2008). Another major similarity between the two failures was that, in both Enron and Northern Rock, the directors did not have the right to act independently, which was majorly due to lack of proper structure and roles of the directors as well as separate remunerations. Enron had 14 members in its board, who are basically external members. These members dominated the business operations, which was why the worsening situation could not be controlled, thereby affecting the shareholders’ interest. These external directors owned significant amount of shares in the company and also received consultation fees. Additionally, the compensation system of Enron added to the worries as the earnings of these directors were manipulated in their favour (Davies, 2006). Apart from the above mentioned similarities, there is another similar issue. It relates to misrepresentation of the financial statements that were audited by the external auditors (Dell’Ariccia, Igan and Laeven, 2009). The external auditors related to both the firms failed to effectively carry out their responsibility by way of helping the latter to conceal their irrelevant expenses and highlight on the fictitious assets. The role of the auditors was to critically examine presentation of the financial statements and assess every minute detail for detecting flaws. However, no such duty was performed by the external auditors in both the companies. On the contrary, they assisted Enron and Northern Rock to disguise failure with successful financials. Dissimilarities between two failures The chief dissimilarity between the failures of both the firms is that Enron collapsed completely due to bankruptcy; whereas, Northern Rock was taken over by Virgin Money. Another vital difference involves the dissimilar approaches adopted pertaining to corporate governance. It is observed that the Code of Corporate Governance of the UK and the US does not adhere to the same rules. Failure to comply with the UK Code is not regarded as an offence. Then again, in the US, the same is considered as a crime as it does not conform to the 2002 Act (Hoflich, 2011). Success or failure of the regulation introduced to address such corporate failings Many regulations have been developed for addressing such kinds of corporate failures. Even so, these events of corporate failure could not be avoided as the firms had entirely ignored the rules. The following reports could not make any difference to the global economy as corporate failures continued to occur like, that of Enron and Northern Rock. Cadbury Report In December 1992, Cadbury Report was published. It had addressed the wrong use of power and the need for an individual’s integrity, openness and accountability in respect of decision making process of a company. Its main aim was to provide right information to the shareholders and reinforcement of self-regulation. The report also enhanced the scope of auditors’ independence (ICAEW, 2014a). Greenburry Report In 1995, Greenburry Report was declared by Sir Richard Greenbury. The report highlighted on the main issues pertaining to director’s pay. This particular issue was initially indicated by the public. The public claimed that the directors were overpaid even when a company failed to perform well. The main goal of the report was to provide answers to the general public regarding pay of directors and accountability. The report comprised the following Code of Best Practice: 1) Remuneration policy 2) Remuneration Committee 3) Service compensation and contract 4) Disclosure The report advised that companies operating in the UK should execute these codes of practice and comply with the annual compliance statement. The remuneration committee constituted non-executive directors, who were responsible for reviewing the pay of executive directors. The report also mentioned that the director’s pay should be fully disclosed, including pensions. The remuneration policy should be described in the annual reports (ICAEW, 2014a). Hampel Report (1997) In 1997, the Committee of Corporate Governance declared the Hampel Report. This report elaborated on certain recommendations and was formulated with cooperation from London Stock Exchange. The result was Combined Code: Principles of Good Governance and Code of Best Practice. The report stated that the auditors were liable to describe the status of internal control to the directors privately. Henceforth, directors should preserve and critically review the information obtained from the auditors. Companies should re-evaluate the business needs by way of scrutinizing the internal audit function at a regular basis. The combined Codes of previous reviews were recorded in a single report. The internal control was regarded as the main issue pertaining to both operational and financial position of the company (ICAEW, 2014b). The board of directors had the duty to monitor work of the senior executives. However, the responsibility of the non-executive directors was extended in order to support decision making for the long run. The directors were paid in shares and the shareholders were encouraged to give their votes. The small investors could also give their recommendations during company meetings (Cambridge Judge Business School, 2014). Turnbull Report In 1999, Turnbull Report was published by the Institute of Chartered Accountants, England and Wales. The report highlighted on assistance provided to the companies for realizing their requirements through Combined Codes. The codes were related to a company’s internal control. When the companies do not opt for monthly internal audit function, they are seen to execute the same annually. The board demanded that the vital procedures should be declared so that companies can manage their financial and operational risk (Mian and Sufi, 2008). The main recommendation of Turnbull report was to shift the organisational focus on management of the risk. Channels for the internal audit were also prepared. A flexible system was developed for improving the situations and periodical review was made compulsory (Mian and Sufi, 2008). Conclusion It can be concluded that the increasing number of failure in corporate governance in UK and US has led to financial crisis and bankruptcies. The similarities between the corporate failures of Enron and Northern Rock indicated that the companies around the world had undertaken almost the same poor practices which could bring disaster in the economy. It is observed in the above research, that the financial crisis in US and UK had given rise to a number reports that were directed towards the companies. However, it can be stated that the reports failed to bring any change in further occurrence of corporate failures. Reference List BBC Business, 2007. Northern Rock Ups Sub-Prime Rate. [online] Available at: [Accessed 1 August 2014]. Broadbent, L. and Laughlin, R., 2013. Accounting control and controlling accounting: interdisciplinary and critical perspectives. Bingley: Emerald Group Publishing Limited. Cambridge Judge Business School, 2014. The Cadbury Report. [online] Available at: [Accessed 1 August 2014]. Davies, A., 2006. Best practice in corporate governance: building reputation and sustainable success. London: Gower Publishing Limited. Davies, H. and Green, D., 2008. Global financial regulation. Cambridge: Polity Press. Dell’Ariccia, G., Igan, D. and Laeven, L., 2009. Credit Booms and Lending Standards: Evidence from the Subprime Mortgage Market. [pdf] International Monetary Fund. Available at: [Accessed 1 August 2014]. Hoflich, P., 2011. Banks at risk: Global best practices in an age of turbulence. New York: John Wiley & Sons Ltd. ICAEW, 2014a. The Greenbury Report. [online] Available at: [Accessed 1 August 2014]. ICAEW, 2014b. Internal Control: Guidance for directors on the Combined Code. [online] Available at: < http://www.icaew.com/en/library/subject-gateways/corporate-governance/codes-and-reports/turnbull-report > [Accessed 1 August 2014]. Llewellyn, D.T., 2008. The Northern Rock crisis: A multi-dimensional problem waiting to happen. Journal of Financial Regulation and Compliance, 16(1), pp. 35-58. McLean, B. and Elkind, P., 2003. The smartest guys in the room: The amazing rise and scandalous fall of Enron. New York: Penguin Books. Mian, A. and Sufi, A., 2008. The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis. [pdf] International Monetary Fund. Available at: [Accessed 1 August 2014]. Summon, 2011. Accounting Standards and Financials Reporting, Guilty For The Actual Crisis. [online] Available at: [Accessed 1 August 2014]. The Economist Newspaper Limited, 2014. Accounting For Change. [online] Available at: [Accessed 1 August 2014]. Todea, N. and Stanciu, I., 2009. Auditor Liability In Period Of Financial Crisis. [pdf] Annales Universitatis Apulensis Series Oeconomica. Available at: [Accessed 1 August 2014]. Read More