Corporate Governance in the Aftermath of the Global Financial Crisis, Volume I

Zabihollah Rezaee

• Publisher: Business Expert Press
• Year: 2018
• Print ISBN: 9781606493588
• eBook ISBN: 9781631571534
• Topic: Business
• Subtopic: Business General
• Index: Business

Corporate governance has evolved as a central issue for public companies in the aftermath of the 2007–2009 global financial crisis. Corporate governance is a process (journey) of managing corporate affairs to create shareholder value and protect interests of other stakeholders. This book presents a road map for various functions and measures of corporate governance. The participants in the corporate governance process are the board of directors, executives, stakeholders, internal and external auditors, financial analysts, legal counsel, and regulators. This book is organized into four separate volumes; each volume can be utilized separately or in an integrated form. The first volume consists of five chapters that address the relevance and importance of corporate governance as well as the framework and structure of corporate governance. The second volume consists of four chapters that present the three prevailing corporate governance functions of oversight, management, and monitoring. The third volume consists of four chapters that address corporate governance functions performed by corporate gatekeepers, including policy makers, regulators, standard-setters, internal auditors, external auditors, legal counsel, and financial advisors. The fourth volume consists of five chapters that address the emerging issues in corporate governance, including governance for private companies and nonprofit organizations and convergence in global corporate governance.

CHAPTER 1

Financial Markets, Investor Confidence, and Corporate Governance

Introduction

This chapter presents the importance and dynamics of relationships between capital markets and businesses as perceived by the investors and transformed through corporate governance. A wave of financial scandals at the turn of the twenty-first century and the 2007–2009 global financial crises eroded public trust and investor confidence in corporate America and its financial reports. Several initiatives and reforms, including the Sarbanes-Oxley Act of 2002 (SOX) of 2002, the Dodd-Frank Act (DOF) of 2010, and the Securities and Exchange Commission (SEC)-related implementation rules and regulations, as well as listing standards of national stock exchanges, and corporate governance best practices were established to restore investor confidence in public financial information and the financial markets. These reforms are a continuous process, creating new measures and practices for public companies and their directors, officers, accountants, auditors, legal counsel, financial analysts, investing banks, and others to effectively discharge their duties and improve their accountability. Effective corporate governance can improve corporate culture, corporate strategic decisions, sustainable performance, reliable financial reports, prospects, and growth. This chapter also examines the role of corporations in our society and financial markets and how corporate governance theories, principles, and mechanisms can advance this role.

Corporate governance can be defined broadly from: (1) the agency theory perspective as the process of aligning management interests with those of shareholders; (2) the regulatory and compliance perspective as a process of ensuring compliance with all applicable laws, rules, regulations, and standards; and (3) the stakeholder theory as a process of creating shareholder value while protecting interests of other stakeholders such as creditors, employees, customers, suppliers, government, environment, and society. The primary role of all corporate governance participants as defined in this book centers around the fundamental theme of protecting investors, enhancing long-term shareholder value, creating shared value for all stakeholders, restoring investor confidence, and supporting strong and efficient capital markets. Corporate governance measures (e.g., independent directors, competent and ethical executives, effective internal controls, credible external audits) can play an important role in minimizing the agency problem and ensuring that management’s interests are aligned with those of stakeholders in creating shared value for all stakeholders. The pervasiveness of financial scandals and the related loss of billions of dollars of shareholder value have received extensive media coverage and attention from regulators and standard-setters on all aspects of corporate governance and financial reporting, from excessive executive pay to manipulation of financial earnings. This chapter provides an introduction and background as a plan and foundation for corporate governance presented throughout the volume.¹

Importance of Financial Markets

A vital financial system and a reliable financial information are essential for economic growth and development worldwide. The function of the financial markets in the United States is to serve the needs of a widespread and global ownership structure whereby about half of Americans, directly or indirectly, through retirement plans and mutual funds, are engaged in the capital markets, and many global investors invest in the financial markets. Investor confidence in the global capital markets is the key driver of global economic growth, prosperity, and financial stability. Corporate governance can strengthen the safety, efficiency, depth, and liquidity of capital markets around the world. Effective corporate governance ensures strong investor protection, which gives rise to high-quality financial reports, and the interaction of these two variables may result in economic growth and prosperity for the nation. Competition among global capital markets can be healthy in producing an adequate level of protection for investors through the right balance of corporate governance and regulatory reforms.² Global investors are typically willing to pay a premium for shares listed in capital markets governed by tougher corporate governance reforms.

The existence and persistence of financial scandals and the consequences of the 2007–2009 global financial crises have eroded public trust and investor confidence in public financial information and capital markets. However, the Center for Audit Quality’s (CAQ) annual Main Street Investor Survey shows that domestic investor confidence in the U.S. capital markets have recovered largely in recent years. In the 2015 CAQ survey,³ 73 percent of investors indicated they have some confidence in U.S. capital markets, which shows a considerable increment from the 61 percent recorded in 2011. However, the confidence measure remains 11 percentage points below when compared with the confidence measure of 84 percent before the 2007 financial crisis. While investor confidence has wavered during the past decade, the past few years have shown that investor confidence has improved with an ascendant trend. The financial markets and thus investor confidence in the markets play an important role in society by providing investors the opportunity and means of investing in public companies, enabling public companies to raise capital through public investment, and efficiently encourage the allocation of scarce capital resources.

The free enterprise system in the United States is developed and promoted with a keen focus on creating jobs and wealth, enabling growth, fostering innovation, rewarding initiatives and risks, and effectively using resources. This widespread and global investment by individual and institutional investors has been accomplished and will continue to prosper as long as investors receive reliable and useful financial information in making sound investment decisions. The liquidity, integrity, safety, efficiency, transparency, and dynamics of capital markets are vital to the nation’s economic welfare, since the markets act as signaling mechanisms for capital allocation. The capital markets have been vibrant because investors have confidence in them and are able to obtain, analyze, and price securities based on the information provided about public companies and the economy. Information is the lifeblood of the capital markets. Without information, stocks would be mispriced, capital markets would be inefficient, scarce resources (capital) would be inefficiently used and allocated, and economic growth would not be possible. Capital markets provide public companies the opportunities to raise capital to establish or expand their businesses as well as finance their investments and other public projects while enabling investors to put their capital to work.⁴ Their efficiency, liquidity, and integrity depend on their “ability to obtain, digest, and price securities derived from information about companies and the economy.”⁵ Thus, the safety and soundness of our financial market can be influenced by proactive, smart, scalable, and cost-effective regulations, and its prosperity and vibrancy depend on investor confidence.

Global Financial Markets, Investor Confidence, and Corporate Governance

There has been a widespread attention to global financial markets and the free flow of capital across international borders as well as global financial systems and regulatory reforms. No country can benefit from isolation from the rest of the world as its economy and its business are affected by the international economy and trades. Public companies worldwide form the basis for the global economy. The 2007–2009 global financial crises and the resulting global economic meltdown was caused by a variety of factors, including ineffective corporate governance and troubled financial institutions, as explained in detail in the next section. The responding global bailouts in the United States, the United Kingdom, and other countries have cost trillions of taxpayer dollars without energizing and stimulating capital markets and economy. The general perception is that subsidizing troubled companies and their executives does not serve the economy well, whereas better accountability and corporate governance improve the global economy. Bailing out these companies without effective accountability and corporate governance provides their executives with powerful economic incentives (outrageous compensation) to make decisions that destroy shareholder value.

Global capital markets are classified into those with either an inside/internal system or an outside/external system.⁶ In an inside system, in such countries as France, Germany, and Italy, there is a high level of ownership concentration, illiquid capital markets, and liberal regulation of capital markets. Conversely, in an outside system, in such countries as the United Kingdom and the United States, there is a widely dispersed ownership, liquid capital markets, an active market for corporate control, and a strict regulation of capital markets. Companies have traditionally listed on their domestic stock exchanges to ensure investor protection, and only about 10 percent of companies have chosen to list abroad.⁷ There are more than 50 stock exchanges worldwide that assist companies in conducting their initial public offerings (IPOs). Stock exchanges in China, France, India, Italy, and South Korea have recently attracted many domestic IPOs. Many state-owned enterprises in China and France have done their fund-raising domestically and have listed their IPOs on their home exchanges.

The U.S. capital markets have traditionally been regarded as the deepest, safest, and most liquid in the world and for many decades have required stringent corporate governance and regulatory measures to protect investors, which has also raised the profile and status of their listed companies. The U.S. financial markets are an important sector of the nation’s economy, as: (1) the U.S. financial services industry’s GDP in 2014 represented $1.223 trillion, accounting for 7.0 percent of the U.S. GDP; (2) the financial services sector employed about 6.08 million workers in the United States in 2015, with an expected increase of 12 percent by 2018.⁸ However, the recent competitiveness of capital markets abroad has provided global companies with a variety of choices of where to list and possibly be subjected to less vigorous regulatory measures. As these markets abroad become better regulated, liquid, and deeper, they provide companies worldwide with a preference to raise their capital needs under a different jurisdiction. Globalization and technological advances have promoted tight competition among the world’s leading capital markets (e.g., New York Stock Exchange [NYSE], London Stock Exchange, Hong Kong, Shanghai, and Dubai), and thus regulations governing these markets can have a considerable impact on the balance of capital worldwide.

Stock exchanges in the United Kingdom and the United States are the most liquid in the world. In the United Kingdom, the London Stock Exchange (LSE) is primarily for established companies, while the Alternative Investment Market (AIM) exists primarily for smaller companies. In the United States, the NYSE comprises the large-cap company market, while the NASDAQ is typically the home for high-tech and growing companies. The other active stock exchanges worldwide are the Tokyo Stock Exchange, Euronext, and Deutsche Börse. Although listing standards in the United States and the United Kingdom are similar in terms of share ownership, market requirements, information disclosures, and board models, there are some differences with respect to shareholders’ and directors’ roles and responsibilities. Technological advances and globalization, including cross-border share ownership, necessitate that many global companies observe a variety of corporate governance reforms and guidelines—at least the listing standards of the country in which they are incorporated and the country in which they are listed. These listing standards and corporate governance measures are often in conflict, reflecting differences in regulatory, legal, and cultural traditions.

Stock exchanges in both the United States and the United Kingdom have attracted numerous international companies. Foreign companies choose these two main exchanges for raising their capital needs, and investors invest in these companies because of the higher level of protection provided by these exchanges through more effective corporate governance and more vigorous regulatory measures and requirements. Some companies are listed on more than one stock exchange and are often faced with difficult, duplicitous, and confusing listing standards and corporate governance guidelines that increase the compliance costs. The pervasiveness of global financial scandals and financial crises has encouraged policy members and regulators worldwide to respond by adopting laws, regulations, and corporate measures to mitigate problems. The costs and benefits of these laws, regulations, and corporate measures are often not assessed in considering their appropriateness on regulatory measures and the international impact of such measures.

U.S. capital markets may provide the following benefits for global companies’ listings: (1) U.S. capital markets are the most liquid in the world; (2) cross-listing securities in the United States promotes visibility for foreign listings; (3) listing on U.S. exchanges subjects companies to increased disclosure requirements that can transcend to more investor confidence and thus lower risk premiums; (4) foreign investors are allowed to benefit from the high level of investor protection experienced by U.S. investors. Advantages of listing on the LSE are less restrictive listing requirements, more timing and global environment, lower compliance costs. These advantages have resulted in a majority of IPOs being listed on the London AIM in the post-SOX period (870 IPOs listed on the AIM compared with 526 IPOs being listed on NASDAQ).

Initiatives taken by G-20 and policy makers and regulators in the United States, Europe, and Asia aimed at promoting global financial markets, which enables investors to freely invest in international financial markets that are continuously monitored and enforced by a set of globally accepted regulatory reforms. The 2010 summit of the 20 largest advanced and emerging countries, better known as the G-20, was held in Toronto in June 2010 to ensure international economic cooperation by addressing the global economic crisis, reforming and strengthening global financial systems, and promoting a full return to growth with quality jobs.⁹ The most important declaration of the 2010 G-20 summit is the development of financial sector reform that encourages a systematic risk assessment, supports strong and stable global economic growth, requires prudential oversight, promotes transparency, and reinforces international cooperation. The G-20 financial sector reform consists of four pillars. The first pillar is a strong financial regulatory framework built on the progress of the Basel Committee on Banking Supervision. This regulatory framework would establish a new regime for bank capital and liquidity that will eventually raise levels of resilience for the global banking systems and enable banks to withstand the pressure of recent financial crisis.

The second pillar is effective oversight and supervision. The Financial Stability Board (FSB) of the G-20, in consultation with the International Monetary Fund (IMF), made recommendations to finance min...

Table of contents

• Cover
• Half Title Page
• Title Page
• Copyright Page
• Contents
• Preface
• Acknowledgments
• Introduction
• Chapter 1 Financial Markets, Investor Confidence, and Corporate Governance
• Chapter 2 An Introduction to Corporate Governance
• Chapter 3 Fundamentals of Corporate Governance
• Chapter 4 Corporate Governance Drivers and Sources
• Chapter 5 Corporate Governance Theories, Education and Research
• Index