Corporate Governance of the Becksville Limited and the Worldspice Limited - Essay Example

CASE ANALYSIS ON CORPORATE GOVERNANCE OF THE BECKSVILLE LIMITED AND THE WORLDSPICE LIMITED The OECD (1999) refers to corporate governance as “the system by which business corporations are directed and controlled. The OECD (1999) further emphasizes that “corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs”. By doing this, OECD (1999) explains that corporate governance likewise “provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance”. This notion of corporate governance is similar with the explanation provided by Cadbury (1992). Fine corporate governance is linked with a lesser cost of capital, elevated returns on equity, better efficiency, consideration of the roles and responsibilities of the Board of Directors, integrity and ethical behaviour, disclosure and transparency and more constructive handling and equitable treatment of each and everyone of the shareholders in a firm such as respect for the rights of shareholders and recognition that the company has legal and other obligations to all legitimate stakeholders (Claessens, 2006), unlike in this case study. David and Victoria are the directors of the Becksville Limited and own between them sixty five per cent of the shares. There are two other shareholders who take little or no part in the running of the company. Both David and Victoria are also the directors of Worldspice Limited which is a company, like Becksville Limited, that deals with sporting and entertainment activities. Worldspice Limited went into a creditors voluntary winding up and there is a substantial deficit such that the creditors expect no more than 10 pence in the pound. Worldspice Limited had become insolvent mainly as a result of many speculative investments in attempting to develop the company’s activities. This speculative attitude was also adopted by David and Victoria in the running of Becksville Limited and this company has suffered losses resulting in the company being unable to pay a dividend for the past three years. David and Victoria have taken £25,000 per year each by way of Directors remuneration during this period. David and Victoria have also in 2004 and 2005 made considerable donations amounting to £100,000 to various charities. The minority shareholders of Becksville Limited have now discovered that David and Victoria in June 2005 rejected the opportunity to purchase the rights to the music of a very popular group, The Ants. This rejection was based on the Becksville Limited s strained finances. David and Victoria subsequently used their personal funds to purchase these rights. One of the members of this group has now died and David and Victoria have sold the rights to an American company at a substantial profit. Advise for the Liquidator of the Worldspice Limited and the Minority Shareholders of Becksville Limited In view of the above situation, a number of advises can be provided for the liquidator of the Worldspice Limited and the minority shareholders of Becksville Limited. According to Galai, et al. (2005), “the shareholders of firms have the right to force reorganization or liquidation if the value of the said companies falls below a certain threshold, however, default does not necessarily lead to immediate change of control or to liquidation of the firm’s assets by its debtholders”. That is, Galai (2005) expounds, “liquidation is driven by a state variable that accumulates with time and severity of distress”. Likewise, “Chapter-11 of the US bankruptcy codes enables prolonged operation of firms in financial distress” (e.g., Weiss and Wruck (1998). Assessment of the status of a firm is done by determining the overall firm value as well as the values of equity and debt (Galai, et al., 2005). The viability of a firm is determined in each distress event according to the accumulated information about the firms records. This record is captured by a new state variable that accumulates the weighted distress events, which are defined as any period spent by the value of the firm’s assets below a predetermined distress threshold. Liquidation is executed once this state variable exceeds a certain value. There are features of bankruptcy procedures, as discussed by Galai et al. (2005), such as (1) Recent distress events may have a greater effect on the decision to liquidate a firm’s assets than old distress events. A distress event that occurred a long time ago may have a light effect on the liquidation decision, since the nature of the firm might have been completely changed during that time (management replacement, nature of activity etc.). In such a case, the willingness of court and debtholders to avoid immediate liquidation would be stronger than in a case where the distress event occurred recently; (2) Severe distress events may have greater effect on the decision to liquidate a firm than mild distress events. A mild financial distress does not necessarily lead to immediate liquidation of the firm assets. The performance of the Becksville Limited and the Worldspice limited can be assessed by determining, based on records the different types of corporate securities, breadth and depth of their capital markets, security issues, corporate ownership structures, dividend policies, efficiency of investment allocation, analyze complex capital structure scenarios, assess how well investors, both shareholders and creditors, are protected by law from expropriation by the managers and controlling shareholders of firms and assess potential strategies of corporate governance reform. The legal approach is a more fruitful way to understand corporate governance and its reform than the conventional distinction between bank-centred and market-centred financial systems (La Porta et al., 2000). Investor protection turns out to be crucial because expropriation of minority shareholders and creditors by the controlling shareholders is pervasive (La Porta et al., 2000). When outside investors finance firms, they face a risk, and sometimes near certainty, that the returns on their investments will never materialize because the controlling shareholders or managers simply keep them. In this case in point, David and Victoria are overpaying executives such that they have taken £25,000 per year each by way of Directors remuneration during this period under study. In general, expropriation is related to the agency problem described by Jensen and Meckling (1976), who focus on the consumption of “perquisites” by managers from the firm’s profits. It means that the insiders use the profits of the firm to benefit themselves rather than return the money to the outside investors. The legal approach to corporate governance holds that the key mechanism is the protection of outside investors—whether shareholders or creditors—through the legal system, meaning both laws and their enforcement. Research by Grossman, Hart, and Moore, summarized in Hart (1995), makes a further key advance by focusing squarely on investor power relative to the insiders, and distinguishing between the contractual and the residual control rights that investors have. Economists have used this idea to model financial instruments not in terms of their cash flows, but in terms of the rights they allocate to their holders. In this framework, investors get cash only because they have power. This may be the power to change directors, to force dividend payments, to stop a project or a scheme that benefits the insiders at the expense of outside investors, to sue directors and get compensation, or to liquidate the firm and receive the proceeds. La Porta, Lopez-de-Silanes, Shleifer, and Vishny (2000) argue that the legal rules and the effectiveness of their enforcement shape these rights. When the rules, such as the voting rights of the shareholders and the reorganization and liquidation rights of the creditors, are extensive and well enforced by regulators or courts, investors are willing to finance firms. When the rules and their enforcement do not protect investors, corporate governance and external finance do not work well. One way to think about this is that legal protection of outside investors makes the expropriation technology less efficient. At the extreme of no investor protection, the insiders can steal a firm’s profits perfectly efficiently. Without a strong reputation, no outsider would finance such a firm. As investor protection improves, the insiders must engage in more distorted and wasteful diversion practices, such as setting up intermediary companies into which they channel profits. Yet these mechanisms are still efficient enough for them to want to divert a lot. When investor protection is very good, the most the insiders can do is overpay themselves, put relatives in management, and undertake some wasteful projects. After a point, it may be better just to pay dividends. As the diversion technology becomes less efficient, the insiders expropriate less, and their private benefits of control diminish. Firms then obtain outside finance on better terms. By shaping the expropriation technology, the law also shapes the opportunities for external finance. All non-controlling investors—large or small, shareholders or creditors—need their rights protected. Minority shareholders require the right to be treated in the same way as the more influential shareholders in dividend policies and in access to new security issues by the firm. The significant but non-controlling shareholders need the right to have their votes counted and respected. Even the large creditors—investors typically viewed as so powerful that they need relatively few formal rights—must be able to seize and liquidate collateral, or to reorganize the firm. Without an ability to enforce their rights, investors are likely to end up with nothing even if they hold claims to a significant fraction of the firm’s capital. Outside investors’ rights are generally protected through the enforcement of regulations and laws. Some of the crucial regulations are disclosure and accounting rules, which provide investors with the information they need to exercise other rights. Protected shareholder rights include those to receive dividends on pro-rata terms, to vote for directors, to participate in shareholders’ meetings, to subscribe to new issues of securities on the same terms as the insiders, to sue directors for suspected expropriation, to call extraordinary shareholders’ meetings, and so on. Laws protecting creditors largely deal with bankruptcy procedures, and include measures that enable creditors to repossess collateral, to protect their seniority, and to make it harder for firms to seek court protection in reorganization. In different jurisdictions, rules protecting investors come from different sources, including company, security, bankruptcy, takeover, and competition laws, but also stock exchange regulations and accounting standards. Enforcement of laws is as crucial as their content. In most countries, laws and regulations are enforced in part by market regulators, in part by courts, and in part by market participants themselves. The Origins of the United States Public Company Accounting Reform and the Investor Protection Act of 2002 in the Context of the Regulatory Spectrum Based on the study by Claessens (2006), there are major events that are responsible for the heightened interest in corporate governance. During the wave of financial crises in 1998 in the Russian Federation, Asia, and Brazil, the behaviour of the corporate sector affected all the economies, and deficiencies in corporate governance endangered the stability of the global financial system. Just three years later, confidence in the corporate sector was sapped by corporate governance scandals in the United States and Europe that triggered some of the largest insolvencies in history. In the aftermath, not only has the phrase corporate governance become nearly a household term, but economists, the corporate world, and policymakers everywhere have begun to recognize the potential macroeconomic consequences of weak corporate governance systems. The scandals and crises, however, are just manifestations of a number of structural reasons why corporate governance has become more important for economic development and well-being (Becht, Bolton, and Roell 2003). The Major Elements of the Act There are main provisions of the United States Public Company Accounting Reform and Investor Protection Act of 2002. The Act requires that the audit committee of the board be composed solely of independent directors, and that it (rather than the full board or management) be responsible for the appointment, compensation, and supervision of the companys independent auditors. The audit committee must be given authority to engage its own counsel and consultants, and must contain at least one financial specialist. The Act prohibits auditors from performing, for audit clients, certain listed services, such as bookkeeping, design and maintenance of financial information systems, and internal audit services, and prohibits the partner in charge of the audit from serving in that capacity for more than five years. The Act requires auditors to report to the audit committee "all alternative treatments of financial information within generally accepted accounting principles that have been discussed with management officials of the issuer [i.e., company], ramifications of the use of such alternative disclosures and treatments, and the treatment preferred by the registered public accounting firm." The partner in charge of the audit may not serve as such for more than five years. The Act establishes a Public Company Accounting Oversight Board, which is structured as a private non-governmental body with five full-time members and funded by assessments on all public companies. The act places no limit on what the board can tax and spend, and since it can levy taxes on virtually the entire economy it appears to be an unprecedented delegation of authority and of doubtful constitutionality. The oversight board is to make rules for how audits are to be conducted, and in some respects how accounting firms will be run. Oddly, even though the oversight board will have a profound effect on the accounting industry, no more than two of the five members may have an accounting background. The Act requires chief executive officers and chief financial officers of public companies personally to certify that the companys reports to the Securities and Exchange Commission comply with SEC regulations and fairly present, in all material respects, the financial condition and results of operations of the company. A knowing misstatement can result in a personal fine of $1 million and ten years in prison. This provision applies to all 16,000 public companies; the similar SEC rule, which required certifications by August 14, 2002, applied only to the CEOs and CFOs of the 947 largest companies. Comparison and Contrast of the US Public Company Accounting Reform and the Investor Protection Act of 2002 with the British Legislation and Governance Developments Over the Period 1985-2000 The Combined Code, according to Selected Issues in Cooperate Governance (2003), presents a synthesis of the principles and recommendations of the Cadbury, Hampel and Greenbury reports. Francies (2000) mentions that it likewise “makes several important advances on the preceding body of United Kingdom corporate governance codes. The Combined Code consists of a preamble, a set of principles of good corporate governance (Code principles) and a code of best practice (Code provisions). Both the Code principles and the Code provisions are divided into two sections, one pertaining to companies and one pertaining to institutional shareholders (Francies, 2000). Like the Cadbury Code before it, the Combined Code has been linked to the listing requirements of the London Stock Exchange (LSE). The Combined Code has been appended (though not added) to the listing rules, and the listing rules themselves were amended to require every listed company to disclose in its animal report how it has applied the Combined Codes principles and whether it has complied with its specific code provisions (Francies, 2000). The majority of British company law is contained in the Companies Act of 1985. In March 1998, the United Kingdom Department of Trade and Industry launched an important initiative aimed at identifying and addressing problems with the existing state of British company law. In March 2000, the steering group of the Company Law Review published a consultative paper which analyzed and made proposals on key areas of the governance of United Kingdom companies. The main themes and proposals contained in the paper represent the possible future of British company law. This article discusses both the existing state of United Kingdom company law and potential new developments which might be anticipated by the Company Law Review. There is clearly a role for codes of practice, in particular in the corporate governance field, as well as for requirements operated through stock exchange listing rules and elsewhere"(Company Law Review steering group consultation document, 2000, page 62). The Cadbury Report asserts that the "board should retain full and effective control over the company and monitor the executive management". This proposition is echoed by the Combined Code, which states that every company "should be headed by an effective board which should control and lead the company" (Current Trends in Corporate Governance). The Code provisions specify various necessities for an effective board, including regular meetings, a formal schedule of matters for decision, a company secretary at the disposal of board members and adequate training of new directors. The Code provisions also state that "all directors should bring an independent judgment to bear on issues of strategy, performance, resources, including key appointment, and standards of conduct" (Francies, 2000). According to Francies, 2002, United Kingdom case law lays down general obligations that directors should comply with the companys constitution and by-laws, run the enterprise for the benefit of the company and not for any other purpose, maintain independence of judgment, avoid profiting personally from their position and to avoid conflicts of interest and apply reasonable care and skill in exercising all their functions. In its Company Law Review the steering group considered the creation of a statutory provision defining directors duties, and noted that such a provision would need to include a duty of fidelity or loyalty. However, the steering group has wrestled with the question of to whom this duty is owed. The traditional United Kingdom model of corporate governance obligates directors to operate the company for the economic benefit of its shareholders. This obligation is reflected in the powers of shareholders to hold directors to account (Corporate Governance News, March 2003). The steering group has considered whether this basis of company operation should continue or, alternatively, whether it should be possible, or even obligatory, for directors to override the interests of shareholders where the economic interests of those with direct relationships with the company (such as employees or suppliers) or broader ethical or social considerations demand it. (Company Law Review, page 9). The steering group has expressed concern that these interests are not adequately protected in the current company law (Francies, 2000). The Cadbury Report states that there should be a clearly accepted division of responsibilities at the head of the company to ensure a balance of power and authority such that "no one individual has unfettered powers of decision". The Combined Code provisions require that a company which combines the posts of chairman and chief executive offices in one person offer a public justification for this decision. Furthermore, the Code provisions state that, regardless of whether the posts are held by the same or different persons, there should be a strong and independent non-executive clement on the board, including an officially-identified senior independent directors other than the chairman. The Code provisions require that the chairman, CEO and senior independent director all be identified in the companys annual report (Francies, 2000). In its Company Law Review the steering group has echoed the need for separation of these top two corporate responsibilities, and it has stated that it may recommend requiring the chairman to be an independent director, thereby precluding the chief executive from assuming this position. The Cadbury Code states that the board "should include non-executive directors of sufficient calibre and number for their views to carry significant weight in the boards decisions". The Combined Code specifies that the board should include a balance of executive and non-executive directors, with non-executives comprising not less that one third of the board, and that the majority of non-executive directors should be "independent of management and free from any business or other relationship which could materially interfere with the exercise of their independent judgincnt". The Code provisions. in a requirement which goes beyond the recommendations of the Cadbury, Grecnbury and Hampel reports, also recommend that a companys independent non-executive directors be identified in the companys amlual report, presumably to allow investors to evaluate the independence of the board (Francies, 2000). There is proof that United Kingdom institutional investors are taking their role in corporate governance seriously. Most recently, in June 2000 the National Association of Pension Funds (NAPF) published an extensive set of corporate governance standards. The NAPF standards serve as a proxy voting guide to be followed by member funds. This set of standards is likely to be extremely influential, as f&ids represented by the NAIF make up approximately -W% of all United Kingdom equity. The NAPFs standards follow the Combined Code, but create stronger requirements in some areas. Most notably, the NAPF standards prohibit the practice of combining the posts of chairman of the board and CEO into one person, contain a ten-part test to determine board member independence, prohibit re-pricing share options due to underperformance and recommend an annual shareholder vote on the report of each companys remuneration committee (Francies, 2000). British institutional investors have already played an important role in strengthening United Kingdom and international corporate governance. This has been the case for two main reasons. First, many institutional investors have come to the conclusion that well-governed companies perform better than their poorly-governed counterparts. Second, due to the increasing level of shareholder activism now being exercised by both individual investors and important sources of institutional money such as pension funds, fund managers who hope to attract such investors must, in turn, become more activist in their own investing activities (Francies, 2000). The results of this focus on corporate governance by British institutional investors have been impressive, both in the United Kingdom and elsewhere. For instance, Londons Hermes Investment Management, one of the leading activist institutional investors in the United Kingdom, has used its influence as an important shareholder to effect corporate governance reform in companies from the United Kingdom to Latin America and Asia. Hermes focus on corporate governance has been shared by many other United Kingdom institutional investors, with 41% of British fund managers stating in May 1999 (in a survey conducted by Russell Reynolds executive search firm) that they had avoided investing in a company or sold stakes "because of a companys failure to practice good corporate governance" (Francies, 2000). The Act Attempts to Resolve the Principal-Agent Issue in the American Context The campaign has gained traction with Treasury Secretary Henry Paulson questioning whether regulations are hurting the competitiveness of U.S. financial markets by driving some companies away from them. With the string of scandals that began with Enron Corp.s collapse nearly five years ago fading further from memory, an array of companies and business leaders have been making the case that the laws and rules enacted amid the crisis are overly onerous and costly. Two groups - one formed by the U.S. Chamber of Commerce, the other a committee of business, legal and academic figures - have been drafting proposals touching on corporate governance rules, class-action lawsuits against companies and executives, criminal prosecution of companies by the government and other areas. The Committee on Capital Markets Regulation, which describes itself as an independent group of business, legal, investor advocate and academic figures, is releasing a report Thursday billed as "a major study of how to improve the competitiveness of the U.S. public capital markets," with recommendations to policymakers and Congress for changes in laws and regulations. Among them: easing of the rules for corporate financial controls that are a key part of the 2002 Sarbanes-Oxley anti-fraud law. In the last few years, companies - especially smaller ones - have been complaining vocally and publicly about the costs of complying with the requirements for companies to file reports on the strength of their internal financial controls and to fix any problems. The private-sector committee is headed by Glenn Hubbard, the dean of Columbia Universitys business school and a former economic adviser in the Bush administration, and John L. Thornton, chairman of the Brookings Institution think tank and a former Wall Street executive. Its mission won praise from Paulson, who said in a speech last week that "the right regulatory balance should marry high standards of integrity and accountability with a strong foundation for innovation, growth and competitiveness." But New York Governor-elect Eliot Spitzer, who pursued major Wall Street investment firms and mutual fund companies as the states attorney general, called the groups positions "tired old criticisms from people who have never come to grips with the fact that there were serious ethical lapses that needed to be remedied." "Contrary to their claims, fighting fraud is good for business because it levels the playing field for honest corporations," Spitzer told The Associated Press Thursday. The influential private-sector panel also is recommending tightening the legal standard the government must meet to charge companies with crimes, reducing the liability of auditors in shareholder lawsuits over accounting fraud and a shift to a financial regulatory system based on principles rather than rules. Companies should be prosecuted for wrongdoing "but just do it in extreme circumstances where top-to-bottom youve got a bunch of crooks or incompetent people," Hal S. Scott, a professor at Harvard Law School and director of the Committee on Capital Markets Regulation, said in a telephone interview. At the same time, it makes sense for the government to go after miscreant company executives, he said. Overall, Scott said, shareholder rights need to be enhanced while "the burdens of wasteful regulation and legislation need to be decreased." The Securities and Exchange Commission is planning to make some changes next month to the Sarbanes-Oxley internal-control rules that will reduce compliance costs for companies. But Senator Christopher Dodd, D-Conn., who will become chairman of the Senate Banking Committee in the new Congress, said recently he believed the rules effect on competitiveness was exaggerated by the critics. "Im not quite as convinced as others are that theres as big a problem associated with Sarbanes-Oxley as some have suggested," Dodd said. And some observers, including Lynn Turner, a former SEC chief accountant, have warned against a major easing by the SEC of the rules - saying that would erode the investor protections in the 2002 law. References: BECHT, MARCO, BOLTON, PATRICK and ROELL, ALISA. (2003). Corporate Governance and Control. In George Constantinides, Milton Harris, and René Stulz, eds, Handbook of the Economics of Finance. Amsterdam: North-Holland. CLAESSENS, STIJN. Corporate Governance and Development. The World Bank Research Observer Advance Access, February 23, 2006. Published by Oxford University Press on behalf of the International Bank for Reconstruction and Development / The World Bank. CADBURY, SIR ADRIAN. (1992). The Code of Best Practice. Report of the Committee on the Financial Aspects of Corporate Governance, Gee and Co Ltd. CHEFFINS, BRIAN R. Current Trends in Corporate Governance. 10 Duke J. of Comp. & Intl L. 5. 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France: OECD Publications Service. Selected Issues in Cooperate Governance. Regional and Country Experiences. United Nation Conference on Trade and Development, New York and Geneva, 2003. WEISS, L. A. and Wruck, K.H. (1998). Information Problems, Conflicts of Interest, and Asset Stripping: Chapter 11’s Failure in the Case of Eastern Airlines. Journal of Financial Economics, 48, 55-97. Read More