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Tell Me Now Review, Issue 2, 2002

Corporate Collapses & Corporate Governance

Welcome to the second issue of Review from Tell Me Now, the leading online research and business information firm specialising in answering research questions you can't - or simply don't have time to - find answers for yourself.

In this issue of the Review, we look at the subject of corporate governance and set out to answer some commonly asked questions about this very topical issue. We also provide a rich digest of links to recent articles about corporate governance and other resources for further reading.

This information on corporate collapses and corporate governance has come from a variety of sources including interviews with industry experts, proprietary news services, government information, market research databases and the Internet.

Happy reading!

Cindy Tschernitz
Director
Tell Me Now

Corporate Collapses and Corporate Governance

Governance and accounting practices have come into sharp focus since the collapse of Enron and WorldCom in the US and HIH, Ansett, OneTel and Harris Scarfe in Australia and Swissair and the German media empire, Kirch in Europe. The inability of the boards and management of many companies to foresee problems in their businesses and reporting of inflated earnings has seriously undermined investor confidence and has given rise to questions of the competence of independent auditors. In Australia, Andersen's alleged involvement in verifying false accounts is a subject of the current HIH Royal Commission and Ernst & Young and PWC are being sued for $200m relating to the collapse of retailer Harris Scarfe. Alan Greenspan, chairman of the US Federal Reserve has called for a business environment which "significantly penalises malfeasance." The "irrational exuberance" of the 1990s has had its time.

Questions:

1. What Led to the Corporate Collapses in the USA?
2. What are the Implications for Corporate Governance in Australia?
   • Comments from Colin Carter
   • Regulation & Reform in Australia
3. Reform in the USA
   • Stock Options and Executive Compensation
4. Why be a Board Member?
   

Answers:

Corporate greed and short-terminism could be blamed for many of the problems in which these large corporates find themselves. In the USA, the auditors had become an effective lobby force on Capitol Hill. The accounting profession was joining forces with corporate America and the number of audit failures afflicting corporate America was increasing. In the 6 years preceding Enron's crash, the SEC estimates that investors lost a hundred billion dollars (USD) owing to faulty, misleading or fraudulent audits. Corporations such as Xerox, Lucent and Sunbeam were affected.

Investors weren't given a true picture of a company's liabilities since an accounting convention meant that stock options were not treated like ordinary expenses. Shareholder lawsuits against the accounting firms proliferated. In response, the Big Five and their trade associations united as a political force. From 1989-2001, accounting firms spent nearly $US39 million on bipartisan political contributions. This resulted in legislation being passed which made it harder for shareholders to sue businesses and their auditors when the businesses failed. The industry now had more power than the regulators. (The Private Securities Litigation Reform Act was passed in 1995).

In 1998, a report on Pricewaterhouse found 9 executives had made 80 investments in companies they were supposed to be auditing - a violation of the most basic independence standards.. The SEC fined Pricewaterhouse $US2.5 million after finding 8,000 further violations and called for an investigation into compliance with independence rules at the rest of the Big Five firms.

In May 2000 the accounting industry stopped the investigation by an independent group, the Public Oversight Board (created after the Penn Central collapse.) The POB was supposed to act as the profession's conscious. The SEC uncovered a huge case of accounting fraud at Waste Management, Inc. Arthur Andersen had approved numbers it knew were misleading. Practically every CFO and CAO in the firm's history had come from Andersen.

In 2001 Andersen paid a $US7 million penalty to the SEC without admitting or denying guilt, after it was charged with fraud.

In 2000, the SEC tried to restrict accountants' ability to consult for the same companies they audited. Arthur Andersen argued this would cut its market potential by 40% and took the fight to Capitol Hill. In the end, the SEC agreed to let the firms continue to consult for the companies they audited. The firms agreed to disclose details to investors.

In 1997, Arthur Andersen knew Enron was inflating its income. In 2001, Enron was forced to reveal its profits had been off by about 20% over 3 years. On the 2 Dec 2001 Enron filed for bankruptcy and Arthur Andersen was indicted on charges of obstruction of justice for destroying documents related to its Enron work. Investors lost an estimated $US93 billion. Andersen had collected one million a week from Enron in the year before Enron's collapse. Over 50% of that was non-auditing work. (1)

"Excessive CEO pay is the mad-cow disease of American boardrooms," says J. Richard Finlay, chairman of Canada's Center for Corporate & Public Governance. "It moves from company to company, rendering directors incapable of applying common sense." A study by Finlay shows that many boards devote far more time and energy to compensation than to assuring the integrity of the company's financial reporting systems.

Enron's implosion is the most visible manifestation of a system in crisis. A report filed by William C. Powers Jr., an Enron board member clearly documents a total breakdown in corporate governance. He and his colleagues found an almost total collapse in board oversight. (2)

Professor Robert Brenner of UCLA in his book about the US market called "The Boom and the Bubble" says that companies are being forced to use accounting tricks to create the illusion of rising profits because the market is over-valued. The stock market became the motor for the economy. How did this happen? When a company's share price is way up, it finds it very easy to raise money. The banks find it quite promising to lend to them because they seem wealthy. Or they can sell their shares at these high prices and get money very easily and this is what American corporations did. They were investing in the face of falling profitability but that investment was driving the boom. The government did not want to regulate or look too carefully at what the corporations were doing because it saw the need for the continuation of these high share prices so that the economy would keep going forward.

2 What are the implications for Australia?

2a. Interview with Colin Carter Senior Adviser, The Boston Consulting Group

Colin has conducted Board Reviews for many of Australia's top twenty companies in the past two years and has strong views on how Boards can be more effective and contribute to improved company performance. He is writing a book on the subject with Jay W. Lorsch, to be published by Harvard Business School Press in 2003.

Q. What is your view on Board performance in Australia?
Boards and auditors are in the spotlight. But in the long run, changing the rules may not make any difference. Hidden costs are likely with no real gain. To set the Board up as the policeman isn't satisfactory and telling a Board it has to be tougher isn't much help. There is a challengeable assumption that Boards can always do more. The reality is that Boards are very part-time. Australian directors are more active, spending twice as much time on Board work as the average director in America or Europe. But they have the same job description eg. they agree on strategy, monitor performance, appoint the CEO, and sign-off on accounts. This suggests that there may be a greater degree of delegation from the Board to management in the USA and Europe.

Q. Is there a connection between Board management and the corporate collapses?

A. There is no provable correlation between Board management and performance. Obviously, being well governed helps performance but how can we tell what is well governed? All that can be measured is what can be seen from the outside and this misses the most important factors such as whether the directors are smart and hard working, and whether there is a high level of transparency in the relationship between management and board. Companies that have crashed such as Enron conformed to many of the supposed best practices that can be seen from the outside such as having a majority of independent directors .

Q. Has the practice of treating stock options as off balance sheet been a factor?
A. Stock options have contributed to the downfall of some of these companies. Two ideas have dominated thinking on what constitutes good corporate governance:

• Being independent of management
• Being aligned with shareholders - the way to enforce this was with stock options. This was a perfect idea in theory, but it was not well executed. The core problem was compounded by companies wanting to reprice the options and not include them as an expense.

2b. Regulation & Reform in Australia

Corporate law reform has been ongoing in Australia since 1996 through CLERP (Corporate Law Economic Reform Program). There is also a Joint Committee of Public Accounts and Audit which has been inquiring into the independence of auditors. The question has been raised of compliance with accounting standards and also being able to certify that the accounts are 'true and fair.' David Knott, Chairman of Australia's main corporate regulator, Australian Securities & Investments Commission (ASIC), believes the corporate collapses will lead to more stringent controls on business. ASIC supports an improved framework of international accounting standards as well as more rigorous audit practices. Mr Knott has condemned the increased use of lucrative options packages for Australian executives. Other business leaders and organizations such as the Institute of Chartered Accountants have supported the view that companies should start expensing options.

Westpac believes that improved transparency from financial institutions would lead to greater shareholder confidence and a desire to invest. Westpac issued a Social Impact Report in July on the company's performance and governance practices across social, environmental and economic dimensions. This is an audited, triple bottom line report conforming to new global standards under the United Nations sponsored Global Reporting Initiative. (3)

3 Reform in the USA

What changes should occur to ensure that corporate boards fulfill the oversight role that shareholders expect of them?

Federal regulators, and the stock exchanges have all proposed reforms, but some believe they're not going far enough. A better corporate governance system requires accountability of all directors. At a minimum, the exchanges should limit every board to no more than two insiders, require every board to appoint a lead director who can convene the board without the CEO, assign only independent outsiders to the audit, compensation, and nominating committees, and restrict directors from serving on more than three boards.

A ban on stock sales by directors for the duration of their terms would encourage them to blow the whistle on management when necessary without fear of the short-term price declines that may follow. Mandatory term limits--requiring directors to resign after 10 years or at age 70, whichever comes first--would prevent board members from becoming entrenched.

Even more important, the exchanges should require every board to conduct an extensive annual self-evaluation, involving both a review of board policies and an anonymous appraisal of individual directors. (4)

President Bush has signed a corporate fraud bill. If put into practice, it should address many areas of corporate governance and accounting such as restricting the services which accounting firms can provide to their clients when they are also acting as auditors.

3a. Stock Options and Executive Compensation

Alan Greenspan, US Federal Reserve Board chairman, has argued strongly for reform of the accounting treatment of options. Options were estimated in 2001 to constitute 58 per cent of the remuneration of chief executives of large American companies. Research has shown that reported earnings for many companies would be overstated by 20 per cent or more. (5)

President Bush made several speeches during July to corporate America on the need for improved practices and intolerance of fraud. Coca-Cola has decided to change its accounting practice to report stock options as an expense. Warren Buffet, chairman of Berkshire Hathaway and a Coca-Cola director believes that other companies will also do this. Reported profits will be very different - if Coca-Cola had included options as an expense last year, its profits would have shrunk by $US202 million. Companies such as JH Heinz, Delta Airlines and Washington Post Co are thinking about it. But earnings for companies such as General Electric, Exxon and Wal-Mart would be down a more modest 1 or 2 per cent. (6)

Companies have shielded top executives from losses in a falling market. Some awarded huge option grants despite poor performance, while others made performance goals easier to reach. Nearly 200 companies swapped or repriced options--all to enrich members of a corporate elite who already were among the world's wealthiest people.

When CEOs can clear $1 billion during their tenures, executive pay is clearly too high. Worse still, the system is not providing an incentive for outstanding performance. It should be a basic tenet of corporate governance never to reprice or swap a stock option that is under water. (7)

4 Why be a Board member?

Some directors may think the risks inherent in being a board member are not worthwhile. The rewards can be substantial. Directors are endowed with prestige and are part of an enviable network. According to executive-search firm Spencer Stuart, in the USA, some 5,500 people serve on the boards of companies in the S&P 500. They get paid on average $37,000 a year and make an additional $1,200 per meeting. Big companies like Citigroup and Coca-Cola pay $125,000 a year. (8)

The upside of the current environment, where companies are under more scrutiny than ever, is that directors will have more confidence in putting pressure on their management and CEOs for accurate information and assurances that they won't be the next Enron.

Sources

Footnotes

(1) The Accountant's War by Jane Mayer The New Yorker Apr 22 & 29, 2002, p64-72. Interview with Arthur Levitt, Jr, Chairman of the SEC under President Bill Clinton.

(2) How to Fix Corporate Governance The Crisis in Corporate Governance - Special Report, Business Week 6 May 2002.

(3)Westpac's Social Impact Report

(4) The Board Special Report -- The Crisis In Corporate Governance Business Week 6 May, 2002.

(5) Coming clean on options is still a long way off, Leon Gettler, The Age 19 July 2002 and Change would put many in red, Leon Gettler & Caroline Overington, The Age 18 July 2002.

(6) Coca-Cola to report options as expenses, New York Times - published in The Age 16 July 2002.

(7) Executive Pay Special Report -- The Crisis In Corporate Governance Business Week 6 May 2002.

(8) Trouble in the Boardroom Fortune 13 May 2002, p113The problems faced by U.S. corporate boards of directors as a result of government investigations and shareholder lawsuits from accounting scandals.

Articles and reports

Principles of Corporate Governance – The Business Roundtable White Paper May 2002 (a 37 page pdf document).

Sets out the roles of the Board of Directors and Management.

A Premium for Good Governance Robert Newell and Gregory Wilson McKinsey Quarterly No 3 2002

Findings of a survey of companies in emerging markets which show that institutional investors the world over are looking for high standards of good governance and will pay a premium for shares in companies that meet them.

Fixing Broken Boards : Interviewing Ira Millstein, by Alex Taylor III Fortune 22 July 2002

Millstein, a senior partner in a New York law firm has spent two decades urging boards to more actively oversee their companies.

Reform : The Only Option (For Stock Options, that is) by Justin Fox Fortune 12 August 2002

The Amazing Stock Option Sleight of Hand by Justin Fox Fortune 25 June 2002

The Enron Down Under - The ripples from a big insurer's collapse continue to spread Economist 25 May 2002 p74

Interview: Jillian Segal - ASIC Business Sunday 16 June 2002

The Powers Report http://commerce.senate.gov/hearings/021202powers.pdf

Testimony of William C Powers, Chairman of the Special Investigative Committee of the Board of Directors, Enron Corporation Before the committee on Commerce, Science and Transportation, United States Senate 12 February 2002.

A Cure for Enron Style Audit Failures Jay Lorsch HBS Working Knowledge 13 May 2002 (excerpted from "The Cure for Creative Accounting," Financial Times 10 April, 2002.)

Corporate Governance 2nd ed Robert A G Monks & Nell Minow (eds), Blackwell Publishing 2001

An update to Monks and Minow's original textbook on corporate governance. Includes new case studies on Daimler-Benz, Dow Jones, Saatchi & Saatchi, Furr's/Luby's, Mirror Group, General Motors and Sears.

Robert Brenner The Boom and the Bubble : the US in the world economy, Verso Books, 2001.

Robert Shiller Irrational Exuberance Princeton University Press, 2001

Shiller examines the rise of the US stock market and explains why he believes it is overvalued.

The Book Minders Alan Deans The Bulletin 30 April 2002

Investigates the role of the auditors in the wake of some costly corporate collapses.

WorldCom – the Next Enron? The Business Report, Radio National with Rachel Mealey 29 June 2002

The Crisis in Corporate Governance – Special Report, Business Week 6 May 2002

Restoring Trust in Corporate America Business Week 24 June 2002

Business must lead the way to real reform

Panel discussion with Hugh Morgan, CEO WMC and Paul Anderson, former CEO BHP. The Business Show SBS TV 7 July 2002

Discussion on the alignment of executive compensation with shareholders and whether stock options should be treated as a salary cost, and why the system is open to abuse.

Bon Voyage to Paul Anderson Business Sunday 30 June 2002

The outgoing CEO of BHP’s views on corporate health in Australia, including the questions of corporate governance and CEO compensation.

Who Should Regulate the Stock Market? Business Sunday 28 July 2002

Interview with Senator Stephen Conroy, Federal Opposition Finance Spokesman. Can Australian investors trust Australian business and can the Australian Stock Exchange be a listed for profit company and an effective regulator?