Corporate Governance
and Accountability
Corporate governance
1.
2.
Protects the rights of shareholders to trade
shares, to obtain timely and regular
information about corporate well being,
participate and vote in general shareholder
meetings, elect and remove members of
the board, and share in corporate profits.
Recognises and protect the rights of
stakeholders.
Ethical principles supported by
law

Honesty and Transparency
 Responsibility and Accountability
 Fairness and Justice
 Avoidance of conflicts of interest and related party
dealings
 Application of the principles of good corporate
governance
Corporate governance underpins
corporate survival
Not just formal accountability but vital for investor
confidence - affects capitalisation, regulation,
reputation
 Now measured by GovernanceMetrics International cf.
Corporate Governance Authority, Transparency
International.
 http://www.gmiratings.com/(svoakc45be23zh450xr2pw4
5)/Default.aspx
 World Bank sponsored Global Corporate Governance
Forum <http://www.gcgf.org/>
Why is good corporate
governance important?
It can lower the cost of capital.
It promotes investor confidence.
It is important to respond to
global best practice.
How is good corporate governance
achieved?
There are various models of good corporate
governance. Most recently, the OECD has set
guidelines. The Cadbury Committee in the
UK, benchmarked CG and then the General
Motors Guidelines on Significant Corporate
Governance Issues. The Canadians and the
ASX Corporate Governance Council have
espoused similar principles.
OECD recommendations 2004
Disclosure of
1.
2.
3.
4.
5.
6.
7.
8.
The financial and operating results of the company.
Company objectives.
Major share ownership and voting rights.
Remuneration policy for members of the board and key executives,
and information about board members, including whether they are
independent.
Related party transactions.
Foreseeable risk factors.
Issues regarding employees and other stakeholders.
Governance structures and policies
Good corporate governance and
development
1991 - following collapse of firms declared
healthy in audited returns, the Financial
Reporting Council, the London Stock
Exchange and the UK accountancy
profession established the Cadbury
Committee to inquire into financial aspects
of corporate governance.
What is corporate governance?
Corporate governance is the system by which
companies are directed and managed.
Good corporate governance structures add
value to corporations and provide
accountability and control systems.
Good corporate governance and
development
1991 - following collapse of firms declared
healthy in audited returns, the Financial
Reporting Council, the London Stock
Exchange and the UK accountancy
profession established the Cadbury
Committee to inquire into financial aspects
of corporate governance.
Cadbury Report Recommended
Conformity with its Code of Best Practice. This
was voluntary.
More clear and detailed financial reporting in
order to:
 Inspire
public confidence in corporations
 Enable directors to advance the best interests of the
company and to avoid concentrations of power.
The clear separation of the responsibilities of
CEO and chair of the board.
Non-executive directors should
Have a stronger role on boards
Should be selected according to formal
processes
Be clearly independent from the management
of the company
Not have business interests which could
conflict with those of the company
Cadbury also recommended
The establishment of an Audit Committee with
at least 3 non-executive directors and
access to independent audit advice
Implementation
Since 1993, the London Stock Exchange has,
required listed companies to include in
annual reports statements of compliance
with the Code of Best Practice or, give
reasons for not doing so.
In December 1994, Guidance to the
interpretation of the Cadbury Code was
issued. This was perceived as a watering
down of the Code.
Implementation 2
The Code had called upon the directors to report on the
effectiveness of the company’s system of internal
control, the Guidance requires only that directors state :
 that directors are responsible for the company’s system
of internal financial control
 that such a system is only relatively secure, not
absolutely so
 the most important procedures for internal financial
control
 that directors have reviewed the system of control
Ernst and Young, The Cadbury Codes Requirements on Internal
Control at http:/www.ernsty.co.uk/accting/ifc/ifc2.htm.
The essential corporate governance principles
A compan y should: Page
1. Lay solid foundations for management and oversight 15
Recogn ise and pub lis h the respective roles and respons ibilit ies
of board and manag ement.
2. Structure the board to add value 19
Have a board of an effective co mposit ion , size and commitm ent
to adequa tely d is cha rge its respons ibili tie s and du ties.
3. Promote ethical and responsible decision-making 25
Actively promote ethical and respons ible decision-making.
4. Safeguard integrity in financial reporting 29
Have a structure to ind ependen tly ve rif y and safegu ard the integrit y
of the company ’s finan cial r eporting.
5. Make timely and b alanced d isclosure 35
Promote tim ely and balanc ed disclosure of all material matters
conc erning the co mpany .
6. Respect the rights of shareholders 39
Respect the rights of shareho lders and facil itate the effective exe rcis e
of those rights.
7. Recognise and ma nage risk 43
Establi sh a sound system of risk over sight and manage ment and
internal control.
8. En courage enhanced performance 47
Fair ly review and actively encou rage enhanc ed board and
manage me nt effectivenes s.
9. Remunerate fairly and responsibly 51
Ensu re that the level and compositi on o f remuneration is sufficient
and reasonab le and that it s relationsh ip to corporate and individu al
performanc e is defined.
10. Recognise the legitimate interests of stakeholders 59
Recogn ise lega l and other obli gations to all legitim ate stakeho lders.
Principle 1: Lay solid foundations
for management and oversight
Formalise and disclose the functions reserved to the
board and those delegated to management.
Adopt a formal board charter that details the functions and
responsibilities of the board or a formal statement of
delegated authority to management.
Principle 2: Structure the board to add
value
A majority of the board should be
independent directors. An independent
director is independent of management and
free of any business or other relationship that
could materially interfere with – or could
reasonably be perceived to interfere materially
with – the exercise of their unfettered and
independent judgment.
Principle 3: Promote ethical and
responsible decision-making
Clarify the standards of ethical behaviour
required of company directors and key
executives
Establish a code of conduct
Promote integrity
Principle 4: Safeguard integrity in
financial reporting
Require written statements from the CEO and
the CFO to the board that the company’s
financial reports present a true and fair view
of its financial condition in accordance with
relevant accounting standards.
Establish an audit committee of at least 3 nonexecutive directors, not chaired by chair of
board.
Principle 5: Make timely and balanced
disclosure
Develop continuous disclosure policies and
procedures.
Principle 6: Respect the rights of
shareholders
Design and disclose a communications
strategy to promote effective communication
with shareholders and encourage effective
participation at general meetings.
Principle 7: Recognise and
manage risk
Establish a system to
identify, assess, monitor and manage risk
inform investors of material changes to the
company’s risk profile.
The CEO and CFO should certify to the board
that the company’s risk management and
compliance systems are operating effectively.
Principle 8: Encourage enhanced
performance
Disclosure of performance evaluation of the
board.
Induction program for new directors.
All board members to have direct access to
company secretary.
Board members to have access to independent
advice at company expense.
Principle 9: Remunerate fairly
and responsibly
Disclose company’s remuneration policies
including cash, fees and other benefits.
The board should establish a remuneration
committee
Why were not such measures
already in place?
Why did it take the collapse of Enron,
WorldCom, HIH Insurance and many other
firms to move the industry, investors and
governments to act?
Was it because of the accepted dogma that
high risk is good for business because it
produces high returns?
Such rules are a floor, not a
ceiling
The GM Corporate Governance Guidelines by contrast,
place a stronger emphasis on Directors’ skills and
suitability for the Board, eg. Item 4, Director
Orientation and Continuing Education
The Board and Management will conduct a
comprehensive orientation process for new Directors to
become familiar with the Corporation's vision, strategic
direction, core values including ethics, financial
matters, corporate governance practices and other key
policies and practices .... The Board also recognizes the
importance of continuing education for its directors and
is committed to provide such education in order to
improve both Board and Committee performance.
Classic Symptoms Preceding
Collapse
Overstatement of the value of assets, and
understatement of liabilities in financial
reports.
Use of related party transactions to disguise
the reality, e.g. to create a false impression
about earnings.
Delays in financial reporting.
Continuing financial losses and cash flow
deficiencies
Weak management
Inadequate management succession planning
Looming debt payments & concealment of
bad debts
Inadequate capital expenditure programs
Lack of adequate information systems
Shareholder disputes
The case of Enron
Kenneth Lay, former chairman and CEO of
Enron, claims that he and the board were
misled by CFO, Andrew Fastow (who has
pleaded guilty to fraud and is to be sent to
jail).
A clutch of Enron officers have pleaded guilty
to crimes, so what does that say about the
CEO and board’s governance?
Fastow
Fastow joined Enron in 1990 and promoted to
CFO in 1998 after designing innovative
financial structures that reduced Enron’s
debt allowing it to diversify its activities.
He began building off-the-books partnerships
in 1997 to increase its capital and hide debt.
Fastow’s take from his deals was $30 million.
Not just rotten apples
Enron’s culture, which included strategies such as
the ‘war for talent’, licenced officers to act on their
own initiative but to act without regard for probity.
This made it possible for Enron to manipulate the
Californian energy market.
It adopted a veritable thicket of questionable
accounting practices, such as booking its energy
trades at full value rather than at the value of its
margin, thus inflating profits.
The culture at Enron
It was clear that Enron routinely engaged in sharp
practice, that it sought to disguise this from
investors and the financial world by a complex and
all but unintelligible structure of accounts and
partnerships.
It is clear that Enron encouraged maverick behaviour
by sacking the lowest performing 10% of staff and
promoting the best 10%. Results were all that
counted.
Deliberate deception
Enron’s auditor was Arthur Andersen. It signed off
the accounts each year as a true and fair
representation of the corporation’s financial
condition for which it received over $20 million. It
received over $20 million also in consulting fees.
The SEC received Enron’s reports year after year,
but no one there was alert to the danger.
Hence the resort to legislative reform of the formal
accountability mechanisms.
Andersen accused of knowing that
¥ Reduction of shareholder equity was a result of
improper
classification of hundreds of millions of dollars
as increases, rather
than decreases in equity value
¥ Enron lied about charges against income as
non-recurring, although Andersen believed
Enron did not have a basis for this, and took no
steps to correct the record
¥ Andersen was alerted to possible fraud at Enron
¥ Andersen audit team directly contravened
approved
accounting standards
Andersen management decided that
documentation that could assist Enron in
responding to the SEC should be collated
¥ It then began destroying Enron documents at its
Houston offices
¥ Similar procedures were enacted by staff
working on Enron audit matters in Oregon,
Illinois and London
¥ When the SEC served Andersen with a
subpoena relating to its work for Enron.
audit teams were instructed that there could be
no more shreddingΣ because the firm had been
officially servedΣ for documents
Andersen was charged with knowingly,
intentionally and corruptly persuading and
attempting to persuade Andersen employees, to
(a) withhold records, documents relevant to
criminal proceedings and (b) alter, destroy,
mutilate and conceal objects with
intent to impair the objectsΥintegrity and
availability for use in such official proceedings.
The Verdict
¥ After a 6-week trial and 10 days of deliberation, a jury found Arthur Andersen
guilt y of obstructing justice when it destroyed Enron Corp. documents while on
notice of a federal inves tigation by the SEC.
¥ The jury rejected Ande rsenΥs defense that the documents were destroyed as part
of its hous ekeeping du ties and no t as a ruse to keep Enron documents away from
the regulators
¥ Andersen received the maximum sentence of 5 years probation and a $500,000
fine
¥ 35,000 people lost their jobs worldwide
Sherron Watkins, Enron heroine,
interviewed in June, 2004
Do you think that post-Enron America is a more ethical place?
“Not really. We are building more Enrons, but we don't want to
admit it. I fall into Warren Buffett's camp when he says that
C.E.O. pay is the acid test. When C.E.O. pay has been
reduced, then I'll believe that our business leaders have
adopted a spirit of corporate reform.”
If the government were to demand a pay ceiling for C.E.O.'s in
this country, what should it be?
J.P. Morgan said that C.E.O.'s should not make more than 20
times the average hourly worker. We're above 500 times right
now! The average worker gets, let's say, $20 an hour. So the
highest C.E.O. salary should be -- $1 million a year.
Interviewed by Deborah Solomon, NYT.
Sarbanes - Oxley Act
Sarbanes-Oxley (2002) passed in wake of Enron and other
collapses to strengthen corporate governance and
restore investor confidence and public trust in
accounting and reporting practices.
Establishes enhanced governance and management
standards for all US publicly listed companies and
public accounting firms.
Establishes the Public Company Accounting Oversight
Board under the SEC to oversee public accounting
firms and issue accounting standards.
SOA 2
CEOs and CFOs now have to sign off on
all company financial statements, the
audit committee of the board must be
made up of independent outside
directors, and companies have to have
thier audit of internal financial controls
audited externally.
Functions of the Public Company
Accounting Oversight Board
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register public accounting firms;
establish "auditing, quality control, ethics,
independence, and other standards relating to the
preparation of audit reports for issuers;"
conduct inspections of accounting firms;
conduct investigations and disciplinary
proceedings, and impose appropriate sanctions;
enforce compliance with the Act, securities laws
and rules,and professional standards
The Board requires public
accounting firms
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Among other measures to:
Maintain audit working papers for 7 years
Adopt 2nd partner review and approval of audit reports
.
Accounting firms to adopt quality control standards.
Conduct annual quality reviews for accounting firms
with  100 reports & others every 3 years.
Section 106: Foreign Public
Accounting Firms.
Foreign accounting firms who audit a U.S.
company are subject to registrations with
the Board.
Section 201: Services Outside The Scope Of
Practice Of Auditors; Prohibited Activities.
Unless specifically approved by the Board, it is
unlawful for a public accounting firm to provide any
non-audit service to a client undergoing audit,
including:
 services related to its financial statements
 financial information systems design and
implementation
 internal audit outsourcing services
 management functions or human resources
 investment adviser, or investment banking services
Section 203: Audit Partner Rotation.
The lead audit and the reviewing partners
must be rotated every 5 years.
Section 206: Conflicts of Interest.
The CEO, CFO, Chief Accounting Officer or
equivalent cannot have been employed by the
company's audit firm during the 1-year period
preceding the audit.
Section 301: Public Company Audit
Committees.
Audit committee members are members of the corporation’s board
of directors, and shall be independent, i.e. not in receipt of any
consulting, advisory, or other compensatory fee apart from a
director’s fee.
The SEC may make exceptions to this rule.
The AC is directly responsible for the appointment, remuneration,
and oversight of the corporation’s accounting firm.
Audit committee have the authority to engage independent advice,
in order to carry out its duties. The corporation shall provide
appropriate funding to the audit committee.
Section 302: Corporate Responsibility
For Financial Reports.
The CEO and CFO shall attest to the
"appropriateness of the financial statements and
disclosures contained in the periodic report, and
that those financial statements and disclosures
fairly present, in all material respects, the
operations and financial condition of the issuer."
Section 303: Improper Influence on
Conduct of Audits
It is unlawful to influence auditors in any way.
Section 401 (c): Study and Report on
Special Purpose Entities.
The SEC shall examine off-balance sheet
disclosures to determine a) their extent
(including assets, liabilities, leases, losses and
the use of special purpose entities); and b)
whether generally accepted accounting rules
result in transparent financial statements
and make a report containing recommendations to
the Congress.
Section 402(a): Prohibition on Personal
Loans to Executives.
Generally, it is unlawful for to extend credit to any
director or executive officer. Consumer credit
companies may issue credit and credit cards to
its directors and executive officers on the same
terms and conditions made to the general public.
Section 404: Management Assessment
Of Internal Controls.
Requires annual reports to contain an audited
internal control report
Nature and effectiveness of the internal control
structure for integrity in financial reporting.
Title VIII: Corporate and Criminal Fraud
Accountability Act of 2002.
 It
is a felony "knowingly" to destroy documents
or to "impede, obstruct or influence" any
existing or contemplated federal investigation.
 Employees of corporations and accounting firms
are extended "whistleblower protection”.
Title IX: White Collar Crime Penalty
Enhancements

Creates a crime for tampering with a record or
otherwise impeding any official proceeding.
 SEC given authority to seek court freeze of
extraordinary payments to directors, offices, partners,
controlling persons, agents of employees.
 US Sentencing Commission to review sentencing
guidelines for securities and accounting fraud.
The effect …?
Accounting firms and lawyers are booming on the back of
Sarbanes-Oxley.
In May 2004, RateFinancials found:
That most financial statements did not reflect public
companies' true financial states.
In November it found that:
That related party transactions were still common.
By year’s end
The Big Four audit firms were moving back into
consulting having sole their consulting arms after the
Andersens debacle.
Since 2002, all have been wary of using the term
‘consulting’ in their literature.
Regulators' sanctions have not been as punitive as initially
feared. While auditors are not allowed to offer nonaudit related services to audit clients but can do so for
all other companies. Philip Aldrick Telegraph, 29/12/2004.
Misconduct encouraged
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By lack of a system of laws that clearly state obligations
and prohibitions
By a diminished sense of personal responsibility
By lack of enforcable laws and regulations
By a small risk of being detected
By insufficient penalties
By a climate of sharp practice
By a lack of ethical recognition
But law and enforcement
 Will
not replace ethics and a personal sense
of responsibility
 Will not prevent corruption by themselves
 Still rely upon a level of trust: fear will make
people risk averse and stifle business.
 Are expensive means of securing
compliance
Principle 10: Recognise the legitimate
interests of stakeholders
The board should set standards of public
accountability for the company and oversee
adherence to these.
Establish a code of conduct to guide
compliance with legal and other obligations.