Comparative Corporate Governance - Essay Example

Comparative Corporate Governance Introduction: The Enron scandal which erupted in 2000 was one of the major causes for the media frenzy and investor displeasure that erupted in the marketplace. Enron officials were discovered to have bribed tax officials and paid no taxes at all between the years 1996 and 1999, despite being the seventh largest corporate entity in the United States.(BBC Report, 2003). Financial statements had been manipulated to reflect profits at a time the Company was approaching bankruptcy and the net outcome of the scandal was that hundreds of employees and stakeholders ended up losing their savings. There are several causes that have been cited for the crisis, including the conflicts of interests of Board members and auditors. (Deakin and Konzelmann, 2003:583). But the most relevant one that has been offered is the inherent defects in the shareholder model that the Company had adopted. This model focuses on maximization of shareholder value to the exclusion of other strategic corporate interests. The other major corporate governance model – Rhineland Model, on the other hand, is known as the stakeholder model because it is less susceptible to the kind of financial crisis that afflicted Enron due to the financial manipulation that was taking place. This essay will examine the proposition that the Enron financial scandal might not have occurred if the Company had implemented the Rhineland model rather than the Anglo Saxon model. Analysis: The Anglo Saxon system of corporate governance places its emphasis upon “free market operation”, where the ultimate objective of organizational function is the achievement of shareholder value.(Berghe and deRidder, 1999:40). The German system which is based on the Rhineland Model, is much more concerned with a “socially corrected market economy.”(Berghe and deRidder, 1999:40). This Model attributes a much wider role to the corporation than the maximization of shareholder value. Attention is also directed to other stakeholders in the corporation in terms of objectives, criteria for performance as well as the corporate governance structure and processes. The basic assumption of the Rhineland model is that both labor and capital are necessary and cooperation between the two is important. As a result, it is not only the interests of the shareholders that will be of paramount importance, but also those of employees, customers and suppliers (Vitols:337). When there is a conflict of interest, the interests of the enterprise will take precedence over the interests of shareholders. Hence, the major difference between these two forms of corporate governance is that the Anglo-Saxon model allows the market to predominate and play the significant role in regulating interactions between various players such as owners and managers, employees and firms or among top managers as well as inter-firm relationships. Shareholders in the Rhineland model are more stable partners as compared to Anglo Saxon shareholders; they also hold to a longer term focus. The Anglo Saxon model promotes shareholder value as the exclusive focus of corporations; a policy which originated during the Reagan-Thatcher era of the 80s.(Lazonick and O’Sullivan, 2000:14). The Anglo Saxon model has prevailed due to the large numbers of institutional investors in international capital markets. The belief is that because international capital markets are dominated by institutional investors, corporations need to adopt the shareholder model or risk being deprived of the capital finds that they need for purposes of investment and survival (Vitols, 2001:338). The Anglo-Saxon model emerged as a means for centralized but growing American corporations to tackle the competition from countries such as Japan and because the size of companies was getting larger. In order to accommodate the belief that the market is superior in terms of allocation of resources, the agency theory posited that shareholders were the principals in corporations while managers were their agents. The Anglo-Saxon model thus emerged as a means to prevent managers from using their positions of corporate power to line their own pockets, hence it was the market that could serve to provide the levels of corporate control required to punish managers who performed poorly. This led to the emphasis shifting to the maximization of shareholder value, because a good return on the stock effectively meant superior performance (Lazonick and O’Sullivan, 2000:16). With the rise in the number of institutional investors, shareholders also acquired collective power to take over organizations and to replace existing managers with others who would focus on improving profitability of the organization. The problem with the Anglo-Saxon model however, is that in the last few decades, it has produced a shift in corporate resource allocation by managers away from the retain and reinvest policy towards downsize and distribute, with an emphasis on decreasing the size of the labor force and increase the return on equity.(Lazonick and O’Sullivan, 2000:18). The stakeholder model has been subject to criticism because it encourages corporations to focus their efforts on short term gains rather than investing from a long term perspective.(Vitols, 2001:337). In the case of Enron, the root cause of the crisis was its focus on short term stock price appreciation, because senior management also owned stocks and were keen to artificially inflate stock prices.(Deakin and Konzelmann, 2003:584). During a state of reduced profits the corporation was going through, large loan amounts were sanctioned against questionable transactions. The financial statements were manipulated such that these transactions were accounted for as energy trades, thereby showing what was actually a loan to be a profit (BBC News Report, 2002). This allowed for a boosting in its share prices, while hiding its actual status, which was a rapid move in the direction of bankruptcy rather than a healthy, profitable concern as the statement deceptively showed. This demonstrates that because the shareholder model was in place, the overriding concern was with showing profits in the short term and boosting the share prices. The objective of artificially inflating the value of the Company’s stock led Enron to the use of ‘special purpose entities’ to conceal debts, but this ‘asset lite’ strategy neglected to make provision for long term growth. (Deakin and Konzelmann, 2003:584). This lack of provision for long term growth also meant that when the business cycle went down, Enron became vulnerable to implosion. Deakin and Konzelmann (2003) pointed out that in the wake of the Enron scandal, if the regulatory framework is not adjusted such that the focus is shifted from organizational operations directed only towards the attainment of shareholder value, then similar meltdowns are also possible in the future. Corporate governance must require corporations not to neglect long term growth while achieving short term objectives. If Enron had adopted a stakeholder model, the outcome may have been different. For instance the ownership patterns would have been different; rather than small shareholdings by private investors, the Company would have had large shareholdings by strategic investors. (Vitols, 2001:337). This would have mitigated or limited the scope for financial manipulation by top executives of the firm, either in siphoning away profits for their own use due to the motivation of greed and then artificially inflating profits. Since the objective of the Rhineland model is not only profitability, it would not have been so easy for a few top executives to manipulate financial statements. The Rhineland model does not have a single Board; rather it has a dual Board with multiple power centers. Hence power is distributed among multiple sources. Important decisions of the Company are not taken by a CEO or by a few individuals, rather a consensus must first be reached through negotiation between top managers with different functional responsibilities, as well as between top managers and employee representatives.(Vitols, 2001:340). The Rhineland model which is in place in Germany has multiple primary goals, as opposed to merely maximizing shareholder value and ensuring profitability. Some of these goals are ensuring profitability and retaining market share, but employment security is also one of the goals. (Vitols, 2001:337). As a result, the kinds of performance incentives and employment contracts generated at corporations with the two models are different and there is a higher level of concern and arrangement for employee and stakeholder interests within the Rhineland model. The investigation into the Enron Company also revealed that as a result of the financial manipulation had taken place, the retirement savings of thousands of individuals, employees and investors were completely destroyed and the negative impact even extended across the global arena, hurting Enron investors across the world (BBC Report, 2003). The shareholder model is characterized by the fact that the relationships of companies with their stakeholders and employees is temporary in nature, hence the interests of the employees and stakeholders at Enron was not rated to be as important as the need to maintain shareholder value by ensuring that the value of the Enron share did not drop in the market (Berghe and deRidder, 1999:40). This caused huge losses to Enron employees and stakeholders who found their savings disappearing in an instant, as the fraud was revealed. If Enron had adopted a stakeholder model, the Company would not have faced such an outcome. Under this model, the management seeks lasting institutional relationships with all its stakeholders, including employees and all these interests are monitored in a balanced way.(Berghe and deRidder, 1999:41). As mentioned above, employees and stakeholders play a significant role under the negotiated stakeholder value generation method utilized in corporations using the Rhineland model. All decisions made by the Company are arrived at by consensus, in which employees, stakeholders and/or their representatives also play a part. The interests of the employees and stakeholders are taken into consideration; hence any strategy that caused the Company to dip into the savings and pension funds of its employees for example, would have been unacceptable and could not have occurred. Since the stakeholder model is not focused purely on short term outcomes, but is also concerned about long term objectives in order to ensure that the interests of its stakeholders are not compromised, the dissolution of the long term savings of the corporation, or disregarding their long term interests would not have been an acceptable part of company strategy. The Anglo Saxon model discourages a policy of long term investment in the Company. According to the logic of this theory, if corporate managers are not able to allocate the resources of the Company in such a manner as to maintain the value of shareholder assets, then the free cash flow should be distributed to the shareholders in order to enable them to direct it to alternative uses as they see fit. .(Lazonick and O’Sullivan, 2000:28). Since the focus of this model is upon ensuring the profitability of the corporation in order to ensure that the share values are sustained at a high level, this also produces a policy of downsizing and distributing in order to create shareholder value. Restructuring is believed to be necessary and desirable, in order to enhance the efficiency of functioning of the corporation. The arguments offered in support of the move towards downsizing and distribution is that it creates efficiency and improves shareholder value because it allows for reallocation of resources. Through distribution of resources, it becomes possible for labor and capital markets to allocate the resources to start-up companies that work fast, are flexible and can generate the kind of innovation that is believed to be necessary as a prime driver of the economy (Lazonick and O’Sullivan, 2000:28). But the speed at which companies are downsized also has unpleasant side effects in that it does not make effective provision for employees. It also produces a corporate culture where employee and other stakeholder interests remain unprotected. This may well be the reason why the interests of Enron’s employees were sacrificed at the altar of profitability in order to maintain a falsely inflated share market value. The Rhineland model includes greater accountability, largely because of the systems of checks and balances that exist within it and the focus on long term growth. While the Anglo-Saxon model may ignore long term corporate development in favor of higher short term profits to enhance share values, the Rhineland model seeks to achieve profitability but not at the expense of its stakeholders. Since innovation is the driving factor governing a corporation’s competitiveness in the global market today, the Anglo Saxon model seeks to achieve it through diversion of resources into start up enterprises that can produce innovative solutions quickly, but it is the German and Japanese companies that have been able to sustain innovation and compete effectively in the global marketplace. One of the salient reasons for this may lie in their stakeholder models of corporate governance, where the corporate functions as an integrated entity where decisions are made through consensus. This also changes the way the corporations deal with their employees, and the strategy of these corporations is directed towards implementing long term measures to ensure continued and sustained profitability without sacrificing the interests of any of its stakeholders. As a result, it naturally incorporates corporate social responsibility, while the Anglo Saxon model has demonstrated the need to inculcate CSR. This may also be noted in the Sarbanes Oxley Act, passed in 2002 by the United States Congress with the objective of ensuring that publicly traded corporations were made accountable for their financial activities by requiring them to institute internal financial controls and social responsibility. It is considered to be one of the most important pieces of legislation that has brought about sweeping changes in corporate governance and (Valenti, 2008). Conclusions: On the basis of the above, it may thus be noted that the Rhineland Model is one that incorporates higher levels of social responsibility and takes into account the interests of its stakeholders. It may be noted that if Enron had incorporated the Rhinehold Model in its operations, it would have naturally included social responsibility and a corporate culture that cares for the interests of its stakeholders. This would not have allowed scope for the kind of financial irregularities which occurred. Power is distributed among multiple centers in the Rhineland model, such as functional, managers and employees apart from directors, hence decisions are reached by consensus and there is greater accountability within the organization. The future of the business model that Enron represented – the Anglo Saxon model – is therefore an important aspect to consider. The lack inherent within it is evident from the Enron scandal, namely, (a) focus only on short term profitability to the exclusion of long term objectives and (b) a failure to take into account the interests of the stakeholders and employees of the corporation. As a result, unless the regulatory framework is adjusted in such a way that it becomes unattractive for companies to adopt this model, then it is likely that scandals like Enron which erupted earlier, will only happen again, as other corporate entities obsessed with short term profitability once again neglect the interests of other stakeholders in the corporation. …………………………………2458 words References: * BBC News Report, 2002. “Enron fraud charge for British bankers”, http://news.bbc.co.uk/2/hi/business/2071106.stm; * BBC Report, 2003. “Enron bribed tax officials”, February 14, 2003, http://news.bbc.co.uk/2/hi/business/2756345.stm, * Berghe, Lutgart and deRidder, Liesbeth, 1999. “International Standardisation of good corporate governance: Best practices for the Board of Directors”, Springer. * Deakin, Simon and Konzelmann, Suzanne J, 2003. “After Enron: An Age of enlightenment?” Organization, 10(3):583-587 * Lazonick, William and O’Sullivan, Mary, 2000. “Maximizing Shareholder value: a new ideology for corporate governance”, Economy and Society, 29(1):13-36 * Valenti, Alix, 2008. “The Sarbannes Oxley Act of 2002: has it brought about changes in the boards of large U.S. corporations?”, Journal of Business Ethics, 81: 401-412. * Vitols, S, 2001. “Varieties of Corporate Governance: Comparing Germany and the UK” (pp. 338-360), IN Hall, P. A. and Soskice, D. (eds), “Varieties of Capitalism: the Institutional Foundations of Competitive Advantage”, Oxford: Oxford University Press. Read More