Corporate Governance

Principles and Issues

Donald Nordberg

• Publisher: SAGE Publications Ltd
• Year: 2010
• ISBN:
  9781473903371
• Edition: 1
• Topic: Business
• Subtopic: Financial Accounting
• Index: Business

Offering a fresh look at the commonly accepted view of what constitutes good governance, Donald Nordberg explores the contexts of board decisions and draws upon his academic research and years of business and financial journalism in Europe, North America and Asia to provide a distinctive and pertinent contribution to the literature on corporate governance. The book:

- Features 21 detailed case studies, drawn from international examples, to prompt discussion and analysis

- Provides topical, up-to-date examples and evidence

- Gives attention to the important question "What next for Corporate Governance?"

Supporting features include: Case Study questions; "Agenda Point" boxes to provide further analysis and consideration on topical issues; Further readings; Companion Website, featuring online resources.

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ONE

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Introducing corporate governance

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Case: Lehman Brothers and the subprime crisis

In November 2008, Richard Fuld was called to testify before a US Congressional committee investigating the sudden collapse of Lehman Brothers, the investment bank he had headed for many years. Its deep involvement in the markets for asset-backed securities – bonds developed from what were called ‘subprime’ mortgages and derivatives contracts associated with them – had brought the bank to a crisis two months before. When the US government refused to bail it out, credit markets around the world seized up, accelerating the growing slump of the world economy. The next day, perhaps realizing the mistake of allowing Lehman Brothers to fail, the US Treasury pumped money into the American Insurance Group (AIG), a company that had become the biggest player in a gigantic global market for credit default swaps – tradable securities that initially served as insurance against corporate borrowers, individual mortgage-holders and the banks who lent to them being unable to meet their commitments. As credit dried up around the world, almost any credit default swap might have to pay out. There was insufficient money to pay them all at once. The US Treasury saved AIG, but it proved too little and too late to prevent a string of calamities of varying degrees of severity in Italy, France, Japan, Thailand, Germany, the UK and even Switzerland.

By the end of November, several major commercial banks in a variety of countries had, in effect, been nationalized. Citigroup, the world’s largest bank, had been propped up with new equity supplied by US taxpayers, and the entire banking system of a whole country – Iceland – was on its knees. Investments made by Icelandic banks – especially in the retail sector across Europe – were threatened as other banks refused to lend the retailers money to pay their suppliers for merchandise in the run-up to the busy Christmas sales.

The problems in the system were not entirely of Lehman Brothers’ making, of course. It had been only one of many intermediaries in the complex web of transactions that collapsed in on itself that month. In the preceding months, Britain had been forced to nationalize a mortgage lender, Northern Rock, after other banks had lost confidence in its ability to repay loans it had taken from other banks to fund its activities. America’s biggest stockbroker, the venerable Merrill Lynch, had been impelled into a takeover by Bank of America, the country’s second largest commercial bank. Wachovia, the fourth largest, was salvaged by Wells Fargo. On Wall Street, the model of investment banking that had dominated capital markets – from mergers and acquisitions advice, to stock and bond trading, commodities futures and lending to the burgeoning hedge fund industry – had come to an end. After Lehman filed for bankruptcy, its rivals Goldman Sachs and Morgan Stanley, the last two large investment banks, turned themselves into commercial banks, subjecting themselves to a myriad of new regulations in exchange for the right to borrow the money they needed to stay afloat directly from the Federal Reserve, America’s central banking system (for background, see Economist, 2008a, 2008b, 2008c).

The legislators wanted to hear from Fuld just what he had done to earn the $500 million he had taken home from Lehman Brothers over the last nine years. (It was not that much, he protested, something closer to $250 million.) But they also wanted to know: How did the board of directors – the people charged with watching over the policies and practices of the company known as Lehman Brothers Holdings Inc. – how had they so completely failed in their duties to the shareholders, that is, the owners of the business they had pledged to serve? How had they failed to see that the business had gone bad, that the assets of the bank had become so ‘toxic’ – the word that had become an emblem of the banking crisis – that it had afflicted with global financial system, spreading the discomfort throughout the world economy? Were they simply asleep on the job? And what of the directors of all the other banks, brokers and businesses now threatening the wealth of their shareholders, the jobs of their employees, the pensions of their retired workers and of all those whose savings were locked up in other pension funds that invested in stock, debt and property markets now threatened with one of the greatest collapses of value in the modern history of finance? How could these smart people get things so catastrophically wrong?

This was not, to be sure, the first time that directors of public companies had presided over massive destruction of value, despite widespread use of mechanisms of corporate governance – ranging from auditors to credit rating agencies, voluntary codes of conduct to stringent laws on liability and listing requirements of stock exchange – to prevent just that. In the first few years of the twenty-first century, the Italian dairy company Parmalat failed under allegations of fraud and misdealing, and Ahold, a Dutch supermarket group, reeled under a scandal of false accounting. In America, the names of Enron and WorldCom, once among the largest and most respected companies in the country, became synonymous with corporate greed, arrogance, fraud and deception. Aided and abetted by their auditors, the venerable firm of Arthur Andersen, these two colossuses proved to be only two of a string of companies that had exploited every loophole in the US regulatory system to pump up their financial statements well beyond a true reflection of the state of the business. The first wave of internet-related euphoria in financial markets – the dot-com bubble – burst at about the same time, wiping trillions of dollars off the nominal value of stock markets in America, Germany, France, Italy, the UK and just about every developed economy in the world.

A decade earlier in the UK, major three companies failed in spectacular fashion, the Bank of Credit and Commerce International, better known as BCCI, Polly Peck International, a trader in fruit and textiles, and Maxwell Communication, a newspaper publisher run by a larger-than-life proprietor and one-time member of parliament whose apparent suicide led to the unravelling of his business empire in the US and UK alike.

These were massive failures in the practice we know of as corporate governance. But the lessons we learn from corporate governance extend into almost all areas of life in organizations. How do family-owned companies cope when the founder of the business retires? How do small, private companies deal with the interests of people who provided capital – the initial funding – to get the business started in the first place? When a business floats shares on public markets, how do its directors look after the interests of those outside shareholders, those not directly involved in the business, too numerous and perhaps too widely spread around the country and the world to consult individually for their views and whose interests will not, anyway, all be the same? How do other organizations – charities, government agencies, clubs and trade associations – look after the interests of their donors, taxpayers, members and beneficiaries? What structures and processes will help the people entrusted with running them remain accountable to their interests? While this book will focus on the affairs of quoted companies drawn mainly from the major western economies, it will do so knowing that readers will be seeking lessons as well about the affairs of other organizations in other parts of the world whose aim is to create value for those whose interests they represent.

Questions arising

Let’s remember, for the moment, that the subprime mortgage market benefited many people in society, before the system crashed. Poorer people got a chance at home ownership, by virtue of the way this market – initially, at least – held the promise to distribute risk more widely than ever before. And remember that Lehman Brothers was only one of many banks and corporations that become entangled in the crisis.

1	What approaches might the Lehman board or the US government have used to prevent a disaster?
	a)	Which are external to the company?
	b)	Which are internal to the company?
	c)	Which external to the profession/industry?
	d)	Which internal to the profession/industry?
	e)	Which have force of law?
	f)	Which have force of custom and practice?
	g)	Which have ethical force?
	h)	Which draw their force from politics and power?
2	What power did Richard Fuld have to prevent a disaster?
3	What power did the board of Lehman Brothers have?
4	To whom were they responsible?
5	To whom were they not responsible? What were the limits of their responsibility?

What is corporate governance?

Seeking a tidy definition of any subject presents difficulties, but few are less tidy than corporate governance. Corporations create employment for many if not most people in the advanced economies around the world. Their profits fuel wealth creation, through the payment of dividends they pay to their shareholders or the money they invest in research and development to create new products or to reduce the costs of creating the goods and services that people around the world want to buy. Much of the improvement we have seen in living standards in the last 200 years can be attributed to corporate activity, since the industrial revolution made mass production possible and with it made products available to the masses. Governing such entities involves overseeing strategy, human resources, financial accounting, marketing, external communications, factories and organizational structures and deciding how they all fit together.

Corporations – the large businesses operating on a scale that one individual person could easily control and only a few could ever dream of owning – also operate in ways unlike other entities, other ‘economic actors’. Unlike individual people, corporations are difficult to hold to account. You cannot imprison a corporation. Their owners claim property rights over them, but in a very peculiar way. Owners’ rights over the corporation scarcely justify using the term ‘ownership’ at all.

Corporations occupy an odd place in the political systems in which they reside. Even the word ‘reside’ is odd: to create the structures we know of as corporations, nineteenth-century political and legal theorists decided to treat them as though they were people. Companies – groups of people working as an economic unit – were allowed to incorporate and in so doing become ‘legal persons’, entitled in law to enter into contracts with people and other corporations, and given the protection of law as though they were people. But unlike people – or, until the past few decades, partnerships between people – corporations, received in law the recognition that their members, that is, their shareholders or ‘owners’, were not personally liable for their debts or if something went wrong. This protection in law allowed corporations to amass the large amounts of capital needed to build large enterprises using large machinery and employing large numbers of people. Through that protection, they grew throughout the twentieth century into the enterprises we know today (for background, see McCraw, 1997).

Many large corporations, the ones we sometimes call multinational enterprises or ‘transnational’ companies, have more income and produce more wealth than many countries. Their employees may well be citizens of a country – or of more than one – but their expatriate managers may have a greater sense of allegiance to the corporation than to any single nation-state. Their actions – if nothing else through threatening to move their legal seat from one political jurisdiction to another – can prompt governments to change policy. A few have conspired to overthrow governments, so great is the potential of their power (for the case of ITT and Chile, see Sampson, 1973).

Most corporations, of course, do not enjoy such power let alone use it. But neither are they easy to subsume under law in any one jurisdiction. Particularly in the liberal democracies that fostered the growth of corporations and the economic welfare they allowed, governments claim legitimacy through their right to govern the people who live under their jurisdiction. Corporations cannot claim such legitimacy, yet they can govern, in many ways, the lives and activities of the workforces and the companies and individuals who supply them or buy the products and services they create. The scope of this power sits ultimately but uncomfortably under the jurisdiction of law and society. But the power they possess puts them and the managers who lead them in a position to do much damage as well as much good.

How, then, do we govern these corporate entities? In the narrow sense, corporate governance looks at the mechanisms put in place inside companies to guide their actions and monitor their performance. Most writing and thinking about corporate governance focuses on the role of the board of directors, the group of people who sit at the top of the enterprise, deciding what direction it should take, what strategies it should adopt, hiring a team of managers and then holding them to account for the performance they deliver. Another aspect of corporate governance looks at how those boards of directors relate to their owners, the investors who bought shares in the corporation and claim, through the legitimacy of their property rights, to have some sort of say over the affairs of the corporation. These two areas – ...