Trust in the economy, protection of corporate good will

The year 2001 will be remembered as the year of corporate scandals. The most dramatic of these occurred in the United States—in companies such as Enron, WorldCom, Tyco, and others. Even before these events fully unfolded, a rising number of complaints about executive pay, concerns about the displacement of private-sector jobs to other countries through offshoring, and issues of corporate social responsibility had begun to fuel emotional and political reactions to corporate news in the United States and abroad. Most of these scandals involved deliberately inflating financial results, either by overstating revenues or understating costs, or diverting company funds to the private pockets of managers.

The Enron scandal came to symbolize the excesses of corporations during the long economic boom of the 1990s (Lindstrom, 2008). Hailed by Fortune magazine as “America’s Most Innovative Company” for six straight years from 1996 to 2001, Enron became one of the largest bankruptcies in U.S. history. Its collapse in December 2001 followed the disclosure that it had reported false profits, using accounting methods that failed to follow generally accepted procedures. Both internal and external controls failed to detect the financial losses disguised as profits for a number of years. At first, Enron’s senior executives, whose activities brought the company to the brink of ruin, escaped with millions of dollars as they retired or sold their company stock before its price plummeted. Enron employees were not so lucky. Many lost their jobs, and a hefty portion of their retirement savings invested in Enron stock. Because the company was able to hide its losses for nearly five years, the Enron scandal shook the confidence of investors in American governance around the world.

Outside agencies, such as accounting firms, credit rating businesses, and stock market analysts, had failed to warn the public about Enron’s business losses until they were obvious to all. Internal controls had not functioned, either. And Enron’s board of directors, especially its audit committee, apparently did not understand the full extent of the financial activities undertaken by the firm and, consequently, had failed in providing adequate oversight. Some experts believed that the federal government also bore some responsibility. Politicians in both the legislative and executive branches received millions of dollars in campaign donations from Enron during the period when the federal government decided to deregulate the energy industry, removing virtually all government controls. Deregulation was the critical act that made Enron’s rise as a $100 billion company possible.

In June 2002, shortly after the Enron debacle, WorldCom admitted that it had falsely reported $3.85 billion in expenses over 5 quarterly periods to make the company appear profitable when it had actually lost $1.2 billion during that period (“MCI, Inc.,” 2008). Experts said it was one of the biggest accounting frauds ever. In its aftermath, the company was forced to lay off about 17,000 workers, more than 20% of its workforce. Its stock price plummeted from a high of $64.50 in 1999 to 9 cents in late July 2002 when it filed for bankruptcy protection. In March 2004, in a formal filing with the SEC, the company detailed the full extent of its fraudulent accounting. The new statement showed the actual fraud amounted to $11 billion and was accomplished mainly by artificially reducing expenses to make earnings appear larger.

What motivated executives to engage in fraud and earnings mismanagement? Why did boards either condone or fail to recognize and stop managerial misconduct and allow managers to deceive shareholders and investors? Why did external gatekeepers, for example, auditors, credit rating agencies, and securities analysts, fail to uncover the financial fraud and earnings manipulation and alert investors to potential discrepancies and problems? Why were shareholders themselves not more vigilant in protecting their interests, especially large institutional investors? What does this say about the motivations and incentives of money managers (Edwards, 2003)? Because of the significance of these questions and their influence on the welfare of the U.S. economy, the government, regulatory authorities, stock exchanges, investors, ordinary citizens, and the press all started to scrutinize the behavior of corporate boards much more carefully than they had before. The result was a wave of structural and procedural reforms aimed at making boards more responsive, more proactive, and more accountable, and at restoring public confidence in our business institutions. The major stock exchanges adopted new standards to strengthen corporate governance requirements for listed companies; then Congress passed the Sarbanes-Oxley Act of 2002, which imposes significant new disclosure and corporate governance requirements for public companies, and also provides for substantially increased liability under the federal securities laws for public companies and their executives and directors; and the SEC adopted a number of significant reforms.

Contemporary Corporate Governance

Corporate governance plays an essential role in contemporary business. It should improve decision-making, transparency, and accountability. Firms with strong governance can also manage risk and compliance more effectively and ensure they can meet their social and environmental responsibilities. Effective governance systems in the post-Sarbanes-Oxley era revolve around key elements:

• Effective Board oversight of business executives.
• Well-functioning Board of Directors’ committees to manage the systems of checks and balances.
• Disclosure of ineffective internal controls, lack of transparency, fraud, and misleading financial reporting.
• Protection of stakeholder rights.

Since the 1970s, governance has focused on governance for institutional investors and shareholder activists. Shareholder primacy is the corporate governance theory featured heavily in Chapter 5 that positions shareholders as the priority for firms. This prioritization of shareholders has significantly impacted corporate governance because it disproportionately focuses on business strategies that support increased stock valuation. However, governance was refocused after the corporate scandals of the likes of Enron and WorldCom and the 2008 financial crisis.

Poor oversight enabled financial misconduct, which inflated profits and hid losses. Governance failure also resulted in excessive compensation that, while having the appearance of being tied to corporate success, did not guarantee improved firm performance.

References

Edwards, F. R. (2003). U.S. corporate governance: What went wrong and can it be fixed? Paper prepared for the B.I.S. and Federal Reserve Bank of Chicago conference, “Market Discipline: The Evidence across Countries and Industries,” Chicago.

Lindstrom, D. (2008). Enron scandal. Microsoft® Encarta® Online Encyclopedia.

“MCI, Inc.” (2008). Microsoft® Encarta® Online Encyclopedia.