The increasing capability for serious
economic disasters means that companies that lie are equivalent
of Bin Laden’s terrorists thriving in our midst, says Dr
Madhav Mehra President World Council for Corporate Governance.
Seismic waves of corporate collapses continue to rip through
the boardrooms across the world. The foremost question in
everybody’s mind today is how to avert the corporate scandals
the likes of which have been witnessed with Enron, Worldcom,
Tyco, Global Crossing and the lot. What we must remember
is that there is nothing new in the accounting frauds that
have paralysed the US markets. According to A. Larry Elliot
and Richards J Schroth author of the book How companies
lie, Enron and others are just the tip of a deeply submerged
iceberg. The tricks used by Enron have been used by companies
before with impunity. In an indictment before a US court
Thomas Newkirck of SEC’s Enforcement Division stated:
Our complaint describes one of the most egregious accounting
frauds we have seen. For years, these defendants cooked
the books, enriched themselves, preserved their jobs and
duped unsuspecting shareholders.
This is not an indictment of ENRON or Worldcom. This is
a charge against the founder of WASTE, a Chicago based recycling
firm which was the darling of investors in 1980s. In 1998,
the company restated its accounts for the prior six years
which discovered a fraud of $3.5 billion.
"Companies since the South Sea Bubble have used accounting
methods not to state earnings but to inflate them and hide
losses. Even General Electric, world’s most admired company
has long been suspected of mastering the art of financial
engineering rather than real business performance. As Warren
Buffet reminds us, while Enron has become a symbol of the
shareholders abuse, there is n o shortage of egregious conduct
elsewhere in corporate America or shall we say rest of the
world. We know the classic story of the accountant who was
asked by his potential employer, how much does 2 + 2 add
up to? He replied, depends on what you have in mind, sir."
It is curious that each time we are confronted with market
collapse our immediate response is to seek new rules and
revise old codes. Little do we realise that corporate discipline
is not something that can be achieved simply by revising
codes or adding new ones. Human greed is so insatiable and
human ingenuity so profound that we will find a way to beat
any system. The very people who today are crying for company
law reform and severe penalties were part of the procession
of cheerleaders of Keneth Lay of Enron and Bernie Ebbers
of Worldcom. They are the ones who stoked the fires of impossible
expectations from their new found heroes and lured them
to make commitments they knew could not be sustained. The
culprits include the investors who were so inebriated with
irrational exuberance of 1990s that they almost willed the
companies to tell lies.
The public outcry following the accounting frauds in US
has led to the passing of the Sarbanes-Oxley Act which creates
accounting oversight board, strengthens auditor independence,
requires CEOs to certify accounts, enlarges rules governing
conflicts of interest and increases criminal penalties.
President Bush signed the Act into law on 30 July 2002 and
called the legislation the most far reaching reforms of
American business practices since the time of Franklin Delano
Roosevelt. In the UK, the Department of Trade and Industry
has appointed Derek Higgs, Chairman Partnerships UK Plc,
to review the issues of conflict of interest. He has already
been criticised as he is also the non executive director
of Allied Irish Bank which was in the news recently for
detection of a massive fraud. The key issues on which Derek
Higgs is inviting views are:
- What role should
non-executive directors perform and how does this compare
to the present position?
- What knowledge,
skills and attributes are needed and what can be done to
attract, recruit and appoint the best people to non-executive
roles?
- Do existing structures
and procedures facilitate effective performance by non-executive
directors?
- Do existing relationships
with shareholders or others need to be strengthened?
- How can non-executive
directors best be supported to perform their role?
India too has appointed a Committee under Naresh Chandra,
its former Cabinet Secretary and an illustrious Indian Ambassador
to US to examine the entire gamut of issues pertaining to
the Auditor- Company relationship, professional regulatory
bodies and role of independent directors.
As Enron debacle indicates, good corporate governance code
is no guarantee of good corporate governance. There needs
to be stricter monitoring and enforcement of laws on punishment
for corporate scams to ensure that those violate the public
trust do not go scot-free. Along with a requirement of disclosures
and accountability, laws should be amended to mete out swift
and deterrent punishment to the offenders.
The cornerstone of an effective board is the institution
of independent directors. Our first question should be to
find out why it is not working. Indeed why a person like
Lord Young, the then President of UK’s Institute of Directors
called for its abolition? The key to all this is the manner
of their selection. In a survey conducted in the UK it was
found that as much as 75% of non-executive directors are
recruited as a result of an informal networking by an existing
director. A classic example is of a system called Golden
Triangle whereby a director of company A sits on the board
of company B while the director of company B seats on the
Board of company C and the director of company C seats on
the board of company A. The triangle is called Golden because
non-executive director appointed by this arrangement invariably
end up on remuneration committee as well. It is no wonder,
therefore, that Lord Young has lambasted the institution
of independent directors. He argued that relying on part
time outsiders who barely spend 15 hours a year to police
boardrooms was naïve and dangerous nonsense. Non-executive
directors appointed this way become a greater liability
and more harmful than executive directors who at least know
the business.
In fact, non-executive director is a misnomer and an oxymoron.
Non executive directors are outside directors who have no
previous connection with the board nor have any management
ties. It is the non-executives and not the CEOs who are
the eyes and ears of the shareholders. Theirs is the job
to bring objectivity and impartiality to the board’s decision
making. They also widen the horizon of the board in formulating
strategy, applying both a wider general experience and any
relevant special skill and knowledge that the board may
otherwise lack. Cronyism in the appointment of non-executives
and the cosiness in the supervision of board room pay can
spell disaster to independence and make a joke of non-executives.
Non-executive directors are crucial to maximising effectiveness
of the board and it is time that the process of recruiting
independent directors is given as much importance as appointment
of a CEO. Ideally, appointment of both auditors and non-executive
directors needs to be made by a group or a vehicle, which
is independent of the board. The process needs to be made
as transparent as possible which is possible only if each
appointment is made through an appointment committee. This
committee should develop criteria for the appointment and
engage an independent search firm for recruitment.
Auditor independence is another area of concern. Their
judgement becomes questionable when auditors perform a significant
consultancy role. It has often been noticed that the audit
contract is a loss leader linked to a lucrative consultancy
contract. As Mike Rake, International Chairman of KPMG says
that auditors accepting consulting services in the same
company simply is unacceptable. Having a $3m audit fee and
$100m non-audit services [fee] just does not meet the perception
test. Forbidding auditors from offering other services to
clients must become an article of faith for ensuring good
corporate governance. Worldcom paid Arthur Andersen $12.4
million last year for such services compared to $4.4 million
for audit fees. Sarbanes-Oxley Act’s requirement of rotation
of auditors to prevent cosy relationships undermining the
integrity of the audit is also worth emulation. Andersen
had been Worldcom’s auditor since 1989. Periodic change
of the auditor might have led to more probing and indepth
examination of accounts.
The most important task before us is to establish common
international accounting standards. For far too long the
accounting standard have been emphasising form over substance.
We need to move away from the prescriptive rule making to
the ground realities of business. This poses one of the
biggest challenges for the International Accounting Standards
Board. We also need to settle once for all the controversy
over accounting for share options which according to John
McFall, chairman of the Treasury select committee, whose
report on the financial regulation of public limited companies,
post-Enron, has been recently published, allows rich executives
to retire to a life time of luxury. It is strange why stock
options have not been treated as an expense so far and why
it was left for Warren Buffet of Coca-Cola to take the lead
in this respect.
There is also a need to rein in excessive executive compensation.
Prudential shareholders had set a good example in scrapping
a new pay scheme that could have netted its Chief Executive
Jonathan Bloomer a £4.6 million bonus on top of his
basic salary of £660,000 if certain targets were met.
It has now been generally admitted that corporate governance
principles in US have been used to advance corporate greed
of CEOs. In 1990s while CEO salaries increased by 30% a
year the employee wages remained static. In his recent address
commemorating 9/11, Bill McDonough, President New York Federal
Reserve, denounced the excessive increase awarded by CEOs
to themselves during the past decade. Reminding the congregation
of the commandment to love thy neighbour as thyself, he
said the policy of vastly increasing executive compensation
was .terrible bad social policy and perhaps even bad morals.
He pointed out that studies now indicated the average chief
executive made 400 times more than the average production
worker, compared with the ratio of 42:1 two decades ago.
Mr McDonough urged chief executives and directors to adjust
pay levels to more reasonable and justifiable levels.
In fact, independent auditors, non-executive directors
and audit committee are also not enough. What is needed
is greater overall accountability from everyone in the company
from a clerk to a CEO. They need to be educated to detect
a fraud at an early stage and realise that it is their job
to report any suspicious transactions and activities. If
they do not they could face prison sentences and financial
ruin. What we need is a culture change within companies
to fight the financial fraud, which in the UK alone, according
to City fraud litigation specialist Philippsohn Crawfords
Berwald, has registered an alarming increase of 200% during
the last 6 months. Lot of this fraud is also a byproduct
of new technology. Organisations must use every opportunity
for exposing staff to training in new technologies. Remember,
highly motivated, continuously developed and trained staff
are the best insurance against fraud.
Sarbanes-Oxley Act has done a commendable job in introducing
an Oversight Board which will have five members appointed
by SEC to oversee accounting firms that conduct audit of
public companies. This board will set standards to uphold
the integrity of public audit and will have the authority
to investigate abuse and discipline offenders. There are
in the UK 23 regulatory bodies which make the task of supervision
of auditing standards extremely difficult. There is an urgent
need for a single independent body to oversee all accounting
aspects on the lines of US’s Oversight Board.
The requirement of personal certification of accounts by
CEOs with deterrent penalties for wrong doers is another
step in the right direction. It is necessary for each CEO
to get their financial directors to check whether the financial
reports give you and your shareholders a truthful account
of the state of the company or uses accounting discipline
to hide behind the figures. Remember the phrase profit is
an opinion whereas cash is a fact. CEOs must ask themselves
do the financial reports reveal the information you would
need if you were an outside investor? Are your reports comprehensible
to a lay man? Annual report should contain a section written
by the audit committee summing up issues and explaining
them in simple language keeping special regard to any items
of creative accounting such as accelerated revenue recognition
of balance sheet vehicles and other complex transactions
to hide company losses.
IT can have an important role in improving the effectiveness
of the board. Businesses are becoming increasingly complex
and problems such as Enron are natural to occur when business
has become global. Failures of Enron in fact are not of
accounting but management. Accounting was used to hide those
management failures. Important thing, therefore, is to prevent
such management failures through better governance structures
and creating real time systems like digital dash-boards
that help you access constantly fresh data about different
streams of operation to keep things under control.
Legislators can wave their magic wands and pass any number
of rules. These will be of no avail until we realise that
the market realities themselves have changed vastly during
the last few years. According to Elliot and Schroth the
forces driving the slide include:
- Complexity.
In business, particularly in global business, complexity
becoming deeper and wider and is providing the hiding places
for new forms of business deception.
- Technology.
Advancements are proving speed for business maneuvers, both
the good and the legal and the bad and illegal.
- Inability to
Grasp Reality. Corporations are losing touch with the
performance reality states of their business operations,
finance and accounting, deal making consequences, and the
value of their intellectual capital.
- The Need for
Precision. Managerial task require more rigor, more
precision, and complete accountability in the boardroom
and from the leadership teams.
Unless corporations understand the new requirements for
business performance and the importance of innovation, budgetary
controls and closer monitoring, legislations will be like
firing grenades to stop a tornado. Corporate directors need
to be more radical and revolutionaries constantly spurring
their companies towards creating new competitive spaces
through a spiral staircase of innovation.
The corner stone of the absolute minimum standards for
the constantly gyrating new economy for corporate managers
will be a new form of scientific management based on performance
reality and accuracy in reporting on corporate capabilities.
There needs to be a National Quality Programme for accuracy
in corporate information and all forms of company disclosures.
We should make quality assurance as part of the corporate
reform movement. This will be the foundation for real performance
quality programme based on precision of information and
reporting of corporate data. Quality Awards need to be restructured
and applied to corporate information problems. Currently
Six Sigma is applied for developing and delivering near
perfect product and services. This can be used to improve
the management capability for advancing the best companies
and checking the fraudulent.
Good corporate governance is required not only to prevent
frauds but to maximise value for all stakeholders. The role
of non-executives in the Boards is not only of watch dog
but also, and more so, of creating wealth. Shareholders
are at far greater risk from a mismanaged and under performing
business than an errant individual. Companies have to bear
in mind the potential trade-off between polishing corporate
reputation and delivering growth, says a survey report by
the Economist Intelligence Unit. Tight governance can protect
firms and investors from fraud, error and undue risk, but
it can also threaten agility and innovation.
Executives at the top ten firms by market capitalisation
in the US, the UK, France, Japan and Germany have expressed
concern that tougher corporate governance rules would negatively
affect merger and acquisition deals because of lengthening
due diligence procedures. A majority of company bosses also
believe that the ability of their firm to make effective
decisions would be compromised by closer scrutiny and tighter
legislation. And while corporate governance is seen as a
leading issue by the vast majority of those polled in this
survey, it ranked relatively low on the list of dangers,
executives saw threatening their firms’ share price. Adverse
markets, a shortage of top quality management, reputational
risk and a lack of innovation all beat out concerns over
poor financial reporting and lack of transparency. The report
also calls into question the ability of the regulators to
set more than a broad framework for good corporate governance.
Ultimately rules are no substitute for ethics or how trust
operates in business, says the report’s author, Victor Smart.
There is no one set of regulations which is going to stop
Enron.
It should be remembered that, while laws and their enforcement
are necessary to drill good governance practices, they will
never be enough to eliminate them. Human ingenuity is so
phenomenal that people find ways to overcome these. There
is a strong need for voluntary action. This comes from personal
commitment to ethics, social values, equity, fairness, transparency,
rule of law, legitimacy, respect for individual and recognition
of diversity and gender balance as value enhancer. What
we need is an inner value system, garnished by a strong
belief that translucence and deceit will not pay. We must
know that knowledge economy has changed the world. Earlier
companies made money by not informing people. Today you
make money by informing people. The problem comes of informing
people when you have failed. In an innovative economy of
today when you have to constantly design new models you
cannot have a winner all the time. When you are hitting
at a constantly moving target you are bound to miss some
shots. The answer is to have courage to own your failures
and share them with shareholders. Courage is the obverse
of transparency. Transparency cannot be achieved without
courage.
The real problem is our education system which does not
prepare us to handle failures and traps us in self-conceit
of success at any cost. Also at fault is our system of overemphasising
short term gains and the corporate culture of living from
quarter to quarter. CEOs are more interested in managing
the stock than creating strategic value for business. We
must change our horizons and focus on long term goals. We
must realise we have to lose some battles to win a war.
We must start from our schools and teach our children the
power behind failures, the power unleashed by the three
words I am sorry. Failures are pathways to success. Owning
failure is what gives you strength. As the ignominious fall
of America’s iconic enterprises proves disowning failure
is a recipe for disaster.
