Corporate Governance rasa Introduction to Corporate Governance 1 Learning Objectives {At the end of the chapter, the students will be able to: ‘a, articulate the need for corporate governance; b. understand the reasons on the occurrence of corporate scandals; c. define corporate governance; d. explain the goals of corporate governance; e. _ explain the concept of “agency problem’; and {differentiate between the roles of “those charged with governance” and the management team. Introduction ‘The 2000s did not sit well in the business and financial community. This turbulent decade will forever be remembered in the vortex of history of modern business as a time of accounting shenanigans and corporate failures. Corporate giants such as Enron, ‘WorldCom, and Tyco among others collapsed and eventually filed for bankruptcy. When the dust has cleared, many employees lost their jobs and billion dollars of investments evaporated in thin air. These financial scandals sent shock waves across global stock markets affecting the investing community. When financial scandals of these magnitude happen, investors often ask the question, “Where were the auditors?” But to others, the question should have been, “Where was the corporate governance?”Case Analysis: “The Fall of Enron” a Figure 1. Enron’s office in Houston, Texas, USA In 2001, Enron Corporation was a colossal energy company, with an annual revenue ‘of more than 100 million. At that time, it ranked 7th in terms of revenue. Enron was formed in 1985 through the merger of Houston Natural Gas and InterNorth of Nebraska, During its early years, Enron had a simple business model, operating as a natural gas pipeline company centered on the delivery of specific amounts of natural gas to utilities ‘and other customers. However, after the deregulation of the electricity market in the early 1990s, Enron's business evolved from hard assets to more complex and speculative energy derivatives. It also began to trade natural gas commodities. These, among others, increased the risk in Enron’s operations. Meanwhile, to finance projects and its ambitious aggressive business strategies, Enron's debts and its debt ratio increased. These movements in Enron’s financial leverage could affect the company’s stock price and, consequently, the stock options of corporate executives. Because of these, corporate executives began to window dress Enron's accounting records to make it appear that the company’s financial condition is sound, Enron officials at that time were Chief Executive Officer (CEO) Jeffrey Skilling, Chief Financial Officer (CFO) Andrew Fastow, and Board Chair Kenneth Lay. One of the questionable accounting practices applied to Enron’s corporate financials was perpetrated through the use of improper transactions involving “special-purpose entities” (SPEs). SPEs are legal entities set up to accomplish specific and very narrow Corporate objectives, However, in the case of Enron, many special purpose entities (SPES) were simply created to conduct improper off-balance sheet accounting intended to hide ‘massive losses and debts from the eyes of the investing public. GOVERNANCE, BUSINESS ETHICS, RISK MANAGEMENT, AND INTERNAL CONTROLThe audit committee members who were supposed to ensure proper accounting treatment merely performed a cursory review of these SPE transactions. It was found Out later that those members of the audit committee such as John Mendelsohn and John Wakeham (Enron's independent directors) were receiving sizable “perks” from Enron. Mendelsohn, for instance, was the president of MD Andersen Cancer Center which receives cash donations from Enron, On the accounting side, these SPE transactions involved Enron receiving borrowed funds that were made to look like revenues, without recording the liabilities on the company’s statement of financial position. This effectively resulted to high revenues which bolstered the company’s profit ratio while, at the same time, showed a manageable leverage or debt level. As such, investors and stock analysts were made to believe that Enron was doing well, at least financially. The SPE loans were guaranteed with Enron stock which, at that time, was trading at ‘over $100 per share in the New York Stock Exchange (NYSE}. The start of the collapse was ‘when Enron's stock price declined. Creditors of Enron started to recall the loans due to the decline in the company’s valuation. The company found it too difficult to maintain its financial position. In August 2001, Jeffrey Skilling resigned as CEO. This created a firestorm of controversies over the ability of the company to continue business operations and led to loss of Enron's reputation. The day after Skilling resigned, Enron’s Vice President for Corporate Development, Sherron Watkins, sent an anonymous letter to Kenneth Lay. In her letter, Watkins expressed her fears that Enron “might implode in a wave of accounting. scandals.” Enron eventually reported a third quarter 2001 loss of $618 million and a one-time adjustment decreasing shareholders’ equity by a staggering $1.2 billion. The adjustment was related to transactions with partnerships run by CFO Fastow. Fastow had created those off-balance sheet partnerships for Enron and for himself. He personally earned $30 million dollars in management fees from deals with those partnerships. Fastow’s conflict of interest was allowed because Enron's Code of Ethics was not strictly implemented. Hopes of financial rescue from corporate “white knights,” Dynergy and ChevronTexacoCorp., almost bailed out Enron from bankruptcy when they announced a tentative agreement to buy the company for $8 billion. However, Enron's credit rating was downgraded to “junk” status in November. Eventually, Dynergy and ChevronTexacoCorp. ‘withdrew their purchase agreement. After the purchase withdrawal, any hope of financially resuscitating of Enron collapsed. Enron's stock price plummet to only $0.40 per share and the company for bankruptcy. ‘After the Enron bankruptcy, the Sarbanes-Oxley Act was passed with the objective of protecting corporate investors through strengthening of corporate governance, strict, regulation of the audit profession and internal controls over financial reporting. ‘CHAPTERQuestions: 1. When did the risk in Enron’s operatis manage? jons and business model become difficult to 2. Is Enron a well-governed company? Provide substantial reasons. 3. How were investors affected by the bankruptcy of Enron? How about Enron’s employees? 44, Iswindow dressing of the corporate financials proper? How doesit affect the analysis of investors regarding the financial health of the company? 5. Were the independent directors of Enron really “independent”? 6. Are the management fees being received by CFO Andrew Fastow proper? 7. How can we prevent another scenario similar to the Enron issue? Definition of Terms ‘Accounting shenanigans — accounting schemes that distort amounts and disclosures in the financial statements in order to hide financial problems and/or to paint a brighter picture of economic performance. Itis synonymous with the term “window dressing.” ‘Agency problem ~ a situation that exists when the “agents” of the corporation use their authority for their own benefit and not for the benefit of the “principal” or owners. ‘The term “agents” pertains to corporate managers while “principal” pertains to the shareholders of the company. Audit committee — committee composed of directors tasked to perform oversight of the financial reporting process, selection of the external auditor, and receipt of audit findings from both internal and external auditors. Board of directors - the governing body elected by the stockholders that exercises the corporate powers of a corporation, conducts all its business and controls its properties. Corporate governance - system of stewardship and control to guide organizations in fulfilling their long-term economic, moral, legal, and social obligations toward their stakeholders. Corporate Issuer — a corporation that issues securities such as stocks and bonds to the public. Debt ratio~a measure of financial soundness computed as total liabilities divided by total assets. Energy derivatives — are complex financial instruments whose underlying asset is based ‘on energy products such as oil, natural gas, or electricity. Energy derivatives are traded on a formal exchange such as the Chicago Mercantile Exchange. 4 GOVERNANCE, BUSINESS ETHICS, RISK MANAGEMENT, AND INTERNAL CONTROL,Enterprise risk management - a process, effected by an entity’s board of directors, management, and other personnel, applied in strategy setting and across the enterprise that is designed to identify potential events that may affect the entity, ‘to manage risks to be within its risk appetite, and to provide reasonable assurance regarding the achievement of entity objectives. Executive director — a director who has executive responsibility of day-to-day operations ofa part or the whole of the organization External auditor — independent accounting firm that renders a report or opinion on the financial statements of client-companies Independent director’ a person who is independent of management and the controlling shareholder, and is free from any business or other relationship which could reasonably be perceived to materially interfere with his/her exercise of independent judgment in carrying out his/her responsibilities as a director. Internal contro? ~ a process effected by an entity's board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting, and compliance. ‘Management ~ a group of officers given authority by the board of directors to implement the policies it has laid down in the conduct of the business of the corporation, Nonexecutive director? ~ a director who does not perform any work related to the operations of the corporation. Off-balance sheet accounting — the practice of not reflecting an asset and/or a liability on the financial statements. Organisation for Economic Co-operation and Development (OECD) — inter-governmental entity founded in 1961 intended to stimulate economic growth through the formulation of policies for “better lives.” Publicly-listed company —a company whose shares of stock are traded in the stock market such as the Philippine Stock Exchange. Sarbanes-Oxley Act ~ a corporate governance regulation passed in the United States requiring the strengthening of corporate governance structures among corporate issuers, stricter regulation of the auditing profession, and assessment of internal controls over financial reporting among others. purpose entity ~ an entity created for a narrow and specific business objective; for instance, an SPE is created simply for the purpose of obtaining finance. Spec Stakeholders — any individual, organization, or society at large who can either affect and/or be affected by the company's strategies, policies, business decisions, and operations in general. This includes, among others, customers, creditors, employees, suppliers, investors, as well as the government and community in which it operates. CHAPTER Introduction to Corporate GovernanceStakeholder theory — states that the corporation exists not only for the benefit of the ‘stockholders but also for the benefit and protection of the other stakeholders such ‘as employees, creditors, suppliers, government, and the society in general. Stockholder theory - theory stating that the corporation exists for the benefit of the shareholders or stockholders. Short-termism —a term that connotes actions of corporate managers intended to increase short-term profits only. White knight - a “friendly” investor that purchases a target company at a fair price and with the support of existing management and directors. The Need for Corporate Governance: Sarbanes-Oxley Act The opening vignette highlights the need for corporate governance. It is a must. Corporate governance, in a nutshell, is the effective way of “directing and controlling companies.” The way in which companies are directed and controlled is of interest to investors, directors, managers, regulators, auditors, and practically, to everyone. In line with the above statement, corporate officers such as CEOs, CFOs, directors, and others, must act for the long-term best interests of shareholders and other stakeholders. Without corporate governance, Figure 2. Sarbanes-Oxley Act or SOX Acta shown in the Enron scandal, it will be game over. The term “corporate governance” became a household name ever since the Enron and WorldCom fiascos struck the business world. As presented in the opening vignette, the Sarbanes-Oxley Act (SOX Act) was passed in the United States right after those financial scandals. The SOX Act is primarily a corporate governance regulation, SOX seeks to strengthen the functioning of the board of directors in the oversight ‘of managerial performance as well as enhancing board independence. Enhancing board Independence essentially requires the appointment of more independent directors on corporate boards. These independent directors, aside from being detached from operational duties, must not have any business dealings with the company which could affect the exercise of objective and independent judgment. SOX regulations also require evaluation of internal controls to ensure reliable and transparent financial reporting to investors. Investors need financial information to aid in their investment decisions. SoX also instituted improvements in the oversight of the conduct of audits of corporate financial statements, whistle-blower policies, and transparent disclosures of financial and nonfinancial information among others. 6 ‘GOVERNANCE, BUSINESS ETHICS, RISK MANAGEMENT, AND INTERNAL CONTROL,The following key points summarizes the important provisions of Sox: Strengthening of external auditor's independence: The external auditor of a corporate issuer is prohibited from performing eight non-audit services, namely: bookkeeping, information systems design and implementation, appraisal or valuation services, actuarial services, internal audit, management functions or human resources, investment adviser, and legal services unrelated to the audit. Corporate officers and directors are prohibited from fraudulently misleading or coercing their external auditors in the performance of their examination of the financial statements, Members of the audit team must wait for a one-year period before accepting employment as CEO, CFO, or its equivalent in an audit client. Audit engagement partners must be rotated every five years. Proactive and more independent audit committees: All covered companies must have audit committees wherein majority are to be “independent.” ‘ Audit committee members may not accept any consulting, advisory, or other compensatory fees from the issuing company. Audit committees are directly responsible for the appointment, compensation, and oversight of the auditor’s work. Disclosure as to the existence of a “financial expert” on the audit committee. Assessment of internal controls over financial reporting: Managementis required to make an assessment of the effectiveness of the company’s internal controls over the financial reporting process. The CEO and CFO must certify the assessment of internal controls over the financial reporting process. Auditors are to perform an attestation of the management's assessment of internal controls aver the financial reporting process. Fraud prevention Provides criminal penalties for obstruction of justice or destruction of accounting and other documents Provides protection to “whistleblowers” who report fraud and other irregularities of corporate officials, CHAPTER + Introduction to Corporate Governance 7On the surface, the financial scandals of the 2000s seem to be merely accounting and financial reporting issues, However, a closer scrutiny of the facts would show that they ‘are more of corporate governance issues. The absence or lack of corporate mechanisms provided opportunity to accounting abuse and fraud, resulting to bankruptcies and affecting peoples’ lives and investments. Indeed, a sound corporate governance structure is a must. The SOX Law will be extensively discussed in the next chapter. Source: Public Company Accounting Oversight Board, 2002. Sarbanes-Oxley Act. Accessed August 20, 2020, hetps://pcacbus.ore/About/History/Documents/PDFs/Sarbanes_Oxley_Act_of_2002.paf Definition of Corporate Governance The new definition of corporate governance can be found in the Principles of Corporate Governance crafted by the Organisation for Economic Co-operation and Development (OECD). The OECD is an inter-governmental entity founded in 1961 intended to stimulate economic growth through the formulation of policies for “better lives.” It defined corporate governance as: Corporate governance is the system of stewardship and control to guide organizations in fulfilling their long-term economic, moral, legal, and social obligations toward their Figure 3. Logo of the Organisation for Economic stakehdlders. Co-operation and Development Reference to OCECD website: Public Company Accounting Oversight Board. 2002. Sarbanes-Oxley Act. Accessed August 20, 2020. https://www.oecd.org/dat/ca/Corporate-Governance-Principles-ENG.pdf ‘The definition of corporate governance can be broken into three parts: ae a system of stewardship and control of corporate entities; 2. It is intended to fulfill long-term obligations (economic, moral, legal, so company; and 3, It benefits the stakeholders. Concept of “Stewardship” and “Control” Corporate governance is distinct from operating and managing the business. ‘Management runs the business and is involved in the day-to-day operations of the company. However, the idea of doing business is not simply to operate a business. There must be an oversight or monitoring of corporate performance and operating results. This is the essence of stewardship and control. This role is being performed by the board of directors. Simply stated, management deals with “running the business” whereas corporate governance deals with “making sure that the business is being run properly.” 8B —_ GOVERNANCE, BUSINESS ETHICS, RISK MANAGEMENT, AND INTERNAL CONTROLDuring pandemic times or during periods of economic difficulty, corporate governance plays a critical role. During the 1997 Asian financial crisis, companies that implemented effective governance survived. These companies had functioning Corporate boards which were able to monitor liquidity, Implement business continuity plans, and advice management on action plans to be undertaken, This is also a sign of a well- governed company. Figuratively, corporate governance works a “captain of the ship who must navigate the ship to safer waters in the midst of a bad weather.” Figure 4. The captain serves as the steward of the ship and controls its movement. Fulfillment of Long-term Obligations Corporate governance is not simply a deterrence to fraud nor an end in itself. Corporate governance is the process through which the company can fulfill its long-term economic, moral, legal, and social obligations to stakeholders. In this sense, stakeholders include not only the investors but also creditors, suppliers, employees, government regulators, and even the society as a whole. Fulfillment of economic obligations would include providing sufficient returns to shareholders such as dividends. However, dividends can only be declared legally if and when there are sufficient earnings. To ensure the sufficiency of revenues, profit, and dividends, the board of directors must periodically conduct an oversight of the financial performance of the company. If the company is performing adversely, the board of directors can question the management team for its unsatisfactory performance. It may also give advice to management on how to improve its operating results. Figure 5. Fulfillment of Long-term Economic Goals to Stakeholders (Cash flows, Profit, an Dividends) Payment of appropriate compensation to employees is one of the moral obligations of the company to its employees. Legal obligations would include being able to comply with legal requirements and contractual obligations. Fulfillment of corporate social responsibility is also within the objectives of corporate governance. Introduction fo Gotparate GovernaStockholder Theory and Stakeholder Theory Stockholder theory suggests that the corporation exists for the benefit of the shareholders or stockholders. Therefore, corporate managers (e.8,, CEO, CFO) have a duty to maximize returns to the benefit of stockholders. On the other hand, stakeholder theory states that the corporation exists not only fo, the benefit of the stockholders. It also exists for the benefit of the other stakeholders, The other stakeholders include employees, creditors, suppliers, government, and the society in general. While corporate managers have a duty to maximize shareholders’ returns, they also have a duty to the society as a whole. This would include paying taxes to the government, repayment of debts to creditors, and protecting the environment among others. It is noteworthy to mention that the OECD definition emphasizes the stakeholder theory. Peres Crees Figure 6. The internal and external stakeholders, Long-term Sustainability Goal of Governance According to the OECD, “Corporate governance is a system of direction, feedback, and tontrol using regulations, performance standards, and ethical guidelines to hold the board and senior management accountable for ensuring ethical behavior—reconciling long ‘term customer satisfaction with shareholder value—to the benefit of all stakeholders and society.” Topay TOMORROW Figure 7. The OECD definition gives focus on Jong-term and sustainable growth rather than just short-term profits. 10 GOVERNANCE. BUSINESS ETHICS, RISK MANAGEMENT, AND INTERNAL CONTROL,The OECD further states that the purpose of corporate governance is to maximize ‘the organization's long-term success, creating sustainable value for its shareholders and stakeholders. Corporate governance must not only ensure that short-term profit goals are achieved. Its goal is to ensure achievement of long-term profitability and cash flows. This is to prevent the so-called “short-termism.” “Short-termism” is a term that connotes actions of corporate managers intended to increase short-term profits only. It is relatively easy to increase the profit for next year in order to meet profit targets. Managers, for instance, could reduce the company’s advertising expenses as well as its research and development (R and D) costs for next year. At the same level of revenue, and all other things held constant, profit for next year will certainly increase. Managers will then be rewarded in terms of performance bonuses for achieving a certain profit target. However, due to the reduced budget for advertising and R and D, there will be limited Product exposure to customers and lack of product improvements. Because of these, revenue will decrease for the long-term period following next year. Thus, such a financial strategy is not sustainable over the long-term although it enables managers to achieve the profit target in the short-term. The Agency Problem The “agency problem’ is a situation that exists when the “agents” of the corporation Use their authority for their own benefit and not for the benefit of the “principal” or ‘owners. The term “agents” pertains to corporate managers while “principal” pertains to the shareholders of the company. Acompany owned by a thousand or more shareholders will not be run by the owners themselves for that would result to disorder and chaos, Besides, not all shareholders Possess managerial ability to manage their own businesses. In this case, the owners will hire managers. As hired individuals, these managers (the agents) must act for the best interests of the owners (the principal). However, this does not always hold true in real life such as in the case of Enron, ‘As mentioned previously, managers tend to focus on just short-term profit in order to achieve the profit target and thereby obtain bonuses to the detriment of the owners. Itis also possible on the part of managers to engage in self-dealing transactions that will not benefit the owners of the company. Take the case of a purchase manager in an ABC Company who sets up his own trading business. ABC Company, through the purchase ‘manager, buys materials from the trading business at excessive prices. This transaction benefits the personal business of the purchase manager but it is disadvantageous on the art of ABC Company. CHAPTER’ Introduction Wo Corporate Governance "To ensure that corporate managers act in the best interests of the owners, the following are being implemented: 1. External and internal audits; ce by the board of directors; performance and/or stock price, 2. Oversight of managerial performan 3. Management compensation is linked to corporate 4, Code of ethical conduct; 5. Internal controls; and 6. Government regulation (e.g, Sarbanes-Oxley, SEC regulations). Difference Between Governance and Management Governance and management are ‘two distinct functions. Management takes charge of the day-to-day operations of the business. Simply stated, management deals with “running the business.” Healy ere Governance, on the other hand, eee “ensuring that the business is being run properly.” Furthermore, this oversight and governance role is being performed by the board of directors together with various. Figure 8. The Roles of the Board of Directors and board committees such as the audit Management committee and risk oversight committee. Management When it comes to setting the future direction of the company, the board of directors approves the company’s strategic plans and long-term capital investment proposals. It is the management who will implement these plans. Managers will carry out projects intended to provide the company with steady revenue and cash flow streams. The board of directors, though detached from operating these projects, must conduct an oversight of actual performance. Board Independence For an appropriate oversight and assessment of managerial performance, the board of directors must be both objective and competent. Otherwise, the result of nV performance assessment will not be truthful and will not meet its intended objectives. Inthe case of small and family-owned businesses, the managers are also the members of the board. This is acceptable since the business has no public accountability due toi size and nature. In case of poor managerial performance or fraudulent activities, only the 12 GOVERNANCE, BUSINESS ETHICS, RISK MANAGEMENT, AND INTERNAL CONTROLfamily members suffer the consequences. However, it will be a different case when it comes to a bank or a publicly-listed company. When a bank is ordered “close” by the Bangko Sentral ng Pilipinas (BSP) or goes bankrupt, many depositors are affected. When a listed company closes, the shares of ‘many investors evaporate into nothing, That is why there is strict regulation regarding the composition of the board of directors of a bank and a publicly-listed company. Government regulators require a minimum number of independent directors in the corporate boards of these entities. ‘An independent director is a person who is independent of management and the controlling shareholder, and is free from any business or other relationship which could reasonably be perceived to materially interfere with his/her exercise of independent judgment in carrying out his/her responsibilities as a director. An independent director is generally expected to perform an honest assessment of managerial performance that a director who is part of management. On the other hand, nonexecutive directors (NEDs) are those who are not involved in operations and are not corporate officers. Independent directors are automatically NEDs but not all NEDs are independent directors. Board Setups There are two types of corporate board setups, namely: 1, alkexecutive board; and 2. board with nonexecutive directors. An all-executive setup is a board comprised solely of executive or corporate managers. As discussed previously, this is often the case for small or family-owned corporations. The second type is often the case for publicly-listed companies and other regulated entities such as banks and insurance companies. Governance Structures Majority — Executive Board All Executive Board = I} semana irs i Figure 9. An All-Executive Board Figure 10. A Combination of Executives and Nonexecutives in the Board CHAPTER + Introduction to Corporate Governance 13