The UK and USA Corporate Governance - Research Paper Example

Table of Contents 1. Introduction 2 2. Corporate Governance 3 3. Agency and Stakeholder Theory 5 4. Discussion: Stakeholder versus Agency Theory 5 5. Corporate Governance Codes 6 6. UK Model 6 7. UK Scandals and Authorities’ Responses 7 8. UK combined codes 9 9. US Model: Rules-based approach 10 10. US Scandals 10 11. Enron 10 12. WorldCom 11 13. Sarbanes-Oxley Act (2002) 11 14. Conclusion 11 Topic:  The UK and USA Corporate Governance frameworks are predicated on fundamentally different approaches to principal/stakeholder protection, one being rules-based, the other principles-based. Introduction A company cannot only be accountable to its shareholders. Various other stakeholders and their direct and indirect interests are involved in the business affairs of the company. Gone are those days when the companies were only accountable to the shareholders and no one else! Enron debacle, WorldCom collapse and certain other giant companies did not only sink their boats but many related stakeholders did lose their considerable amount of investment within a period of a few days. But, the corporate scenario before these financial debacles was same in the United Kingdom in the early 1990s when the Bank of Credit and Commerce International (BCCI) shocked the financial world with its financial losses. Given to the severity of the BCCI, Bank of England intervened to financially support the BCCI. On 5th July 1991, BoE closed down the UK branches of the BCCI and dismissed the staff. On the same day, the regulators in the United States of America, France, Switzerland, and certain other countries acted in the same way. When asked to the BoE to clarify its actions over the issue of BCCI, the BoE responded that instead of creating a panic in the financial world, BoE considered it better to slowly and gradually shut down the branches of the BCCI without experiencing further financial problems over BCCI. These two events raised many serious questions over the governance and management of the companies. The investor community and other stakeholders did not much rely on the companies and on their Boards. The investors had lost their trust over the entire corporate structure since the debacles occurred in the mega companies in the corporate world. These financial debacles separately impacted in the US and in UK; and as a result, the respective regulatory authorities faced different financial situations which caused them to devise their financial and regulatory policies in response to the financial debacles respectively faced by them. Corporate Governance Corporate governance has become a part of the corporate world. The importance of corporate governance is that it deals with the conflicts of interests occurring between or among different stakeholders. In today’s corporate world, there would be many occasions where the events of conflicts of interest do occur. Every stakeholder tries to serve his or her interests; sometimes attaining these interests require compromises on the other’s stakes. In order to reduce the chances of conflicts of interest among different stakeholders, the theory of corporate governance has been put in place. Although there is no consensus based definition for corporate governance, yet many scholars give a considerable weight to the definition provided by the Organisation for Economic Cooperation and Development (OECD) (1999) describing corporate governance as “a set of relationship between a company’s board, its shareholders and other stakeholders. It also provides the structure through which the objectives of the company are set and the means of attaining those objectives, and monitoring performance, are determined.” This definition seems to be comprehensive; it takes into account both the internal and external aspects of a company. Internally, corporate governance requires the company to implement internal controls; externally, it requires the company to understand the relationships between other related stakeholders who are directly or indirectly find their interests in the company’s business affairs. Additionally, corporate governance works like a corporate mechanism helping the company to determine and achieve its corporate objectives at the same time evaluating performance of the company; these aspects are the fundamental aspects for the company to attain and sustain its corporate objectives. In addition, corporate governance has developed principles which are: CEO and Chairman should not be the same person Shareholders have right to receive accurate relevant information The responsibilities and roles of the Board should be in the public domain Responsible and ethical decision-making should be promoted by organisations Stakeholders and shareholders should be treated equitably and rightly Furthermore, a list of stakeholders is not limited to the creditors and suppliers; rather shareholders, bondholders, customers, staff, management, pensioners, tax and regulatory authorities, board of directors including non-executive directors, and all those members of social community who are directly or indirectly affected by the business; and they can be job seekers, borrowers, house owners and so on. Despite so much knowledge is available on the concept of corporate governance, yet we have been experiencing giant debacles in the shape of Enron, WorldCom, BCCI, Barings and so on. This is the most common frame work that guides many companies to determine their course of actions with their shareholders and other related stakeholders. Before going to critically analyse the US rules based corporate governance and UK principles based corporate governance frameworks, it is utterly important to understand the agency and stakeholder theory. Agency and Stakeholder Theory Both are considerably opposite theories. Jensen and Meckling (1976) define an agency relationship as a contract in which one or more persons (the principal (s)) engage with another person (the agent) to perform some service on their behalf. As a result, this relationship delegates a decision-making authority from the principal to the agent. Under the terms of this contract, the agent is authorised to take and implement contracted related decision on behalf of the principal. Stakeholder theory is defined as a theory in which stakeholder is taken as a party that has a ‘stake or interest’ in the company. Most importantly, this is referred as those individuals or organisations or groups external to the company. They can be employees, customers, bankers, government and so on. Letza et al (2004) contend that physical human resources, information and knowledge are more important than physical assets. In that direction, Solomon and Solomon (2004) is of the opinion that a well managed company likely to continue high levels of dialogue interaction with other relevant stakeholders. Discussion: Stakeholder versus Agency Theory Both theories oppose each other. In agency theory, profit maximisation is the primary objectives and shareholders always expect that from management of a company. On the other hand, the supporters of the agency theory argue that profit maximisation is too narrow an objective. But, that does not satisfy the supporters of agency theory, who further argues that earned profits is reinvested into the company this ultimately benefit all stakeholders. In addition, Jensen (2001) contends that the aim of social welfare is served when market value is maximised. Additionally, Sternberg (1997) argues that for the company to satisfy the needs of all stakeholders would not be an easy job besides the list of stakeholders is not small as well. Furthermore, companies are primarily formed to serve the objectives of their shareholders; there is no rule that require companies to work for the social services for and other non-monetary purposes. Corporate Governance Codes The corporate governance codes are devised to serve a variety of objectives. These objectives cannot be exactly the same. It is this reason that has introduced different corporate governance codes in the US and UK. However, there are certain objectives which are directly or indirectly being served with the implementation of these objectives-accountability, transparency, structure and composition of board, independent directors, performance related executives pay and the rights of the shareholders. UK Model The UK model is based on the “comply or explain” principle. This principle requires a company either to comply with the given Codes or explain the cause of non-compliance. The UK model provides an opportunity to companies decide their corporate behaviour towards the codes of corporate governance by setting up principles that normally should be followed in the corporate practices. The UK model is mostly driven by the market forces. There is less governmental or regulatory involvement in the business affairs. Since the entire UK model is based on the tenets of principles rather than rules, it would not be easy for the relevant authorities to enforce the required principles. The authorities may not enjoy the required level of enforcement leverage which is enjoyed by the authorities in the US. Additionally, some business concerns may find it appropriate not to comply with the principles, and they may have an understandable point to do so, but that non-compliance may be done at the cost of investors and other stakeholders since the chances of fraud cannot be wished away, but they can only be minimised. UK Scandals and Authorities’ Responses Three major scandals shocked the corporate world between the periods of 1990 to 2000. In which Bank of Credit and Commerce International (BCCI), Polly Peck and Barings came to the limelight. In respond to these major corporate collapses, UK Code was devised and introduced to the corporate world. BCCI, founded by Agha Hasan Abedi in 1972, was a large bank having branches in 70 countries. BCCI was registered as BCCI parent company in Luxembourg and a major subsidiary in Cayman Islands. The major problem of BCCI began when one of its major customers, Gulf Group-a shipping company, could not repay its loan in 1970s. Additionally, Agha Hasan Abedi and Swaleh Naqvi, one of Abedi’s associates, tried to hide the losses of the bank and falsified the accounts. Since the Gulf Group was unable to repay the loans, BCCI had no way but to deceive the auditors and regulators into believing that Gulf Group could meet its principal and interests payments. The Bank of England (BoE) intervened and shut down the UK branches of BCCI in orderly manner; this step of BoE received a heavy criticism over its strategy towards BCCI. Another bank followed the tracks of BCCI. Barings Bank collapsed in 1995. In the early 1970s and 1980s, Barings had set up Barings Securities and in April 1992, Nick Leeson was appointed general manager of Barings Futures (Singapore). He was made in charge of ‘front office-dealing in futures and options’ and ‘back office-broking activities. Subsequently, Leeson was given trading licence allowing him to work as a trader onto the trading floor at Singapore International Monetary Exchange (SIMEX). Owing to his unauthorized trading activities losses reached 6 million pounds in 1993. This entire financial storm was developing in Singapore; however, Barings’ staff in London did not give much heed to the warning signals coming from Leeson’s operations, which reached 742 million pounds by February 1995, which was more than twice the reported capital of the Barings Group. ultimately, Barings eventual losses totalled 830 million pounds and it took over by ING (a Dutch Bank). Polly Peck, was a small clothing company, stock lost 75% of its value within one month period. Asil Nadir was a Chairman and CEO of Polly Peck International. After a successful history in the period of 1980s, Nadir’s multi-national conglomerate business was put under the administration in 1990. After purchasing and investing many small and large companies in many counties of the world, his final 1989 transaction did not see such corporate investments in the coming days; rather the privatisation plan of Nadir raised the eyebrows of many. His success business stories had nothing to do with the realistic business situation. In order to hide the true business situation Nadir tried to privatise the company. On September 23 1990, Sunday Times claimed of insider dealing through complex European office network but before that on September 20 share price collapsed. UK combined codes Various reports and codes are published to introduce corporate governance in the corporate world. In respond to the above collapses, these codes are developed. On the leadership, effectiveness, accountability, remuneration, relations with shareholders, principles based guidelines are provided to. Cadbury Report (1992) Green bury Report (1995), Hampel Report (1998). Higgs Review (2003): they were subsequently published in response to the above mentioned collapses. US Model: Rules-based approach On 30 July 2002, the Act was signed into law without receiving any suggestions from the business community. The shock of Enron collapse did not leave any point for the US authorities not to do so. The scale of financial devastation was so huge that the US regulatory authorities even did not consider it to appropriate to consult on this issue with the business community. Compliance is mandatory: whether a corporation prefers it or not, the corporation has to comply with the rules provided in the US Act. As a result, no company can ever try to circumvent unpleasant rules; this leads to avoid considerable risks. In addition, investors know the structure of corporate governance of their corporations as there is only way to do business in US that is to comply with the regulatory requirements. Considerably, the US model ensures the practices of good corporate governance. However, the lack of flexibility may be disadvantageous for those corporations who may have appropriate reasons not to follow the rules of the US model. As a result, this would create additional problems for such corporations in the US for doing business activity. In addition, due to this rule, some companies may avoid investing in the US as there are inflexible corporate rules. Additionally, those corporations who find it difficult to go with such rigid corporate rules may plan to disinvest and take away their investment. These can negatively impact on the American economy, which is already under a severe financial distress left by the recent way of the financial crisis; drastically increasing the graph of unemployment and cost of living. US Scandals Enron was on the world’s largest energy group operating in the US in 2001. Later in the same year, Enron filed for Chapter 11 bankruptcy. Kenneth Lay became CEO of Internet North in 1985; soon he renamed it ‘Enron’. Jeff Skilling, after introducing the ‘business light’ strategy and risk management model; was handed over the responsibility of CEO in February 2001. Sherron Watkins discovering that entities were hiding losses worth millions of dollars informed to Ken Lay, who upon receiving the information appointed an investigation committee led by Enron’s lawyers. In August 2001, Skilling’s resignation made Kenneth Lay Chairman and CEO of Enron. All these facts led to the Chapter 11 bankruptcy. WorldCom The boat of WorldCom was drowned by Bernie Ebbers (former CEO). In 2002, WorldCom filed for bankruptcy under Chapter 11. WorldCom admitted to misclassifying capital expenditures in previous periods. As a result, Bernie Ebbers was charged with fraud, making false statements and conspiracy. Long Distance Discount Services (LDDS) was renamed as WorldCom in the early 1980s after the deregulation of telephone market in US. In 1985, Ebbers became CEO of LDDS and converted into a profitable business. This success prompted Ebbers to adopt a risky behaviour by pursuing the strategy of mergers and acquisitions. In 1999, US Justice Department blocked the merger between WorldCom and Spring; a large telecoms provider in the Us. Additionally, Ebbers personal expenses substantially grew and he had obtained loans of $341 million with lower interest rates. All these facts led brought the bankruptcy of WorldCom. Sarbanes-Oxley Act (20020 Enron and WorldCom collapses considerably influenced this piece of legislation. This piece of legislation was promoted by Paul Sarbanes and Michael Oxley. Section 906- statement by CEO and CFO certifying that all issued periodic reports fully comply with the Securities Exchange Act and fairly represent the financial condition and results of operations; non-compliance would bring up to $1m and /or up to 10 years in prison. Conclusion The UK model is based on principles and the US model is based on the rules. The UK model defines’ comply or explain’ approach for the companies if they do not wish to comply with the requirements of UK ;and other hand, there is no such provision present in the US model. All corporations are required to follow the corporate governance rules provided in the relevant sections of the US model. References 1. Jensen, M.C. and Meckling, W.H. (1976) ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’, Journal of Financial Economics, Vol. 3: 305-60 2. Sternberg, E. (1997) ‘The Defects of Stakeholder Theory’, Corporate Governance: An International Review, Vol. 5, No. 1: 3-10. 3. Letza, S., Smallman, C., Sun, X. (2004), "Reframing privatisation: deconstructing the myth of efficiency", Policy Sciences, Vol. 37 pp.159-83. 4. Solomon, J and Solomon, A. 2004. Corporate Governance and Accountability. John Wiley & Sons. 5. Jensen, MC 2001, ‘Value Maximization, Stakeholder Theory, and the Corporate Objective Function. Journal of Applied Corporate Finance 14: 8-21. Read More