Can Corporate Governance Prevent Future Financial Crises?

By | June 14, 2019

Courtesy of Dina El Mahdy

 Over a decade ago, the US market and global economy experienced a financial crisis that erased $8 trillion in stock market wealth and led to unprecedent government intervention in financial markets. This crisis was preceded, less than ten years prior, by the dot-com bubble, which saw several companies fail due to outright fraud. These high-profile failures led to a fundamental transformation in U.S. corporate governance law. Unfortunately, these changes were insufficient to prevent the global financial crisis.

Corporate governance has been variously defined as a set of procedures that are either imposed by internal policies and procedures; through the board of directors; or by external systems such as policymakers, regulations, stock exchange rules, and market forces. Corporate governance has been a mainstream topic in the law, finance, accounting, and business worlds since the collapse of major firms such as Enron and WorldCom due to corruption and fraud. Anecdotal evidence suggests that current governance mechanisms have failed to restore investors’ trust in managements’ ability to protect shareholders’ wealth, thereby leading to increasing calls for proposals to instigate another set of standards, revamp the existing ones, or perhaps eliminate them altogether.

This blog post highlights key changes to U.S. corporate governance in the wake of the dot-com bubble and identifies their inherent weakness in preventing future financial crises. The 2008 financial crisis revealed a need to rethink what corporate governance is capable of. I believe a corporate governance regime that is more focused on proactive measures for preventing fraud can go a long way toward preventing the high-profile scandals that accompany every financial crisis.

Concurrent Corporate Governance Codes

In response to widespread fraud and corruption during the dot-com boom, legislators in the US introduced the Public Accounting Reform and Investor Protection Act, which is widely known today as the Sarbanes-Oxley (SOX, hereafter) Act of 2002. It is, by far, the most significant corporate governance legislation in the twenty-first century. Indeed, it had such a profound effect worldwide that some countries (e.g., Canada, France, Germany, and South Africa) adopted their own form of SOX in response to invasive corporate fraud. Most, if not all, of SOX sections are reactive in nature and attempt to “restore” investors’ trust in corporations.

SOX focused on enhancing the reliability and relevance of financial reporting through a set of regulations that held management accountable for financial reporting. For example, Section 302 requires management to provide an assessment on the effectiveness of the firm’s internal controls and procedures. The internal controls of a firm is equivalent to the written manual of a new piece of equipment, as you need to have clear guidelines, and follow them, in order to effectively and efficiently operate the equipment. Likewise, the internal controls must be clearly written, understandable, and, most importantly, adopted and accepted by the firm at all levels. Effective internal controls should achieve four objectives: (1) Enhance the effectiveness and efficiency of operations, (2) Ensure the reliability of financial reporting in accordance with the Generally Accepted Accounting Principles, (3) Ensure compliance with internal and external rules and regulations, and (4) Safeguard assets.

Section 404 of SOX was issued in 2003 to replace Section 302 and required auditors to provide attestation to the management assessment of internal controls. Underlying Section 404, the auditor’s responsibility expanded to providing an additional report on the effectiveness of internal controls. SOX created the Public Company Accounting Oversight Board (PCAOB), which provides oversight over the auditing industry and aids in setting auditing standards.

Section 302 of SOX mandates that the CEO and CFO of a (public) company certify that financial statements are free from errors or fraud. Failure to certify financial statements is a criminal act under SOX. SOX also requires the forfeiture of executives’ compensations if financial statement misconduct occurred within a year (as evidenced by accounting restatements), a provision known as Clawback under Section 304. Section 407 requires disclosing the financial expert on the audit committee and expands the definition of financial expertise to encompass other non-accounting areas of expertise.

Can Corporate Governance Prevent Future Financial Crises?

Opponents of SOX  claim that it led to an outflow of capital from the U.S., pointing, as evidence, to the fact that the highest number of Initial Public Offerings (IPOs) take place in Hong Kong and other international markets. They also argue that public companies are now more likely to go private to avoid regulatory oversight and save the hefty cost of SOX compliance. Proponents, on the other hand, suggest that SOX strengthened corporate governance mechanisms in the form of more board meetings, timely discovery of accounting restatements, and disclosure of internal control weaknesses; they also note that it helped bring talented members to audit committees and enhanced the reliability of financial statements. But, a more interesting question remains unanswered: can current governance mechanisms curb future financial crises? The answer is probably not. This is because current corporate governance mechanisms are reactive in nature, attempt to take actions after the fact, and do not target the main source of fraud and corruption, which is firm culture.

So, what can be done to prevent another crisis? The answer is straightforward and involves taking a step back and working on promoting proactive corporate governance mechanisms. I do believe that SOX was instrumental in improving corporate governance overall. It held executives accountable for the reliability of financial reporting for the first time in history, opened the eyes of directors and auditors to the importance of having internal control systems in place, and promoted audit quality through creation of the PCAOB. The current regulations, however, need to be revisited at least once every four years or so to make sure that governance codes are accomplishing their intended objectives.

Fraud has many colors, and the adaptability of law has become critical in dealing with the ever-changing business environment. Additionally, the costs and benefits of such codes are not the same for all firms. The scalability of these codes is important due to the fact that one size does not fit all. The quest for one form of “correct” corporate governance seems inconsequential and no longer serves the needs of global capital markets.

Research in accounting, law, finance and economics can play a role in the development of proactive corporate governance regulations. For example, the traditional focus on agency theory needs a second look. Not all managers are untrustworthy. Likewise, not all female executives are ethical. Looking into the components of corporate culture that directly impact earnings, manipulation is not black and white, and is far more complex than it appears. Contingency Theory, an alternative to Agency Theory, suggests that the association between corporate governance codes and firm value is moderated by either internal or external factors. Stewardship Theory suggests that managers are inherently trustworthy. Stakeholders’ Theory claims that there exists a conflict of interest between not only managers and shareholders, but also various stakeholders with direct claims to the firm, such as creditors, policymakers, and labor unions, to name a few.

Another issue to consider is ownership concentration. To date, current governance mechanisms are not scaled to fit companies with and without a controlling shareholder. While completely banning dual-class shareholders (because of the transformation brought by controlling shareholders at the early stages of firms, especially in the technology industry) could be bad for the economy, it is reasonable to assume that such a unique corporate structure requires special governance codes. At a minimum, these firms need a sunset clause for the dual-class system and an opportunity for Class B voting shareholders to have equal voting rights at some point in the life of the company. Academicians can play a significant role in studying whether, when, and how this sunset clause can benefit shareholders of equal voting rights. Similarly, internal control regulations need to focus on how to prevent internal control weaknesses instead of focusing on disclosing such weaknesses. It would be more cost-efficient to prevent fraud than to deal with its pervasive and lingering consequences.

Similarly, current clawback provisions focus on forfeiting executives’ compensation only when the firm restates financial statements, which is reactive by definition. It would be more efficient to design mandatory strong clawback provisions that focus on long-term bonuses and equity-based compensations to prevent fraud and material misstatements before it becomes too late, such as the case with Wells Fargo. In 2016, Wells Fargo lost $20 billion in market capitalization when the public learned about the fraud related to fake accounts. The $60 million clawback from its top executives represented a forfeiture of unvested compensation. The magnitude of the fraud ($5 million) to the consequences of the fraud ($20 billion) highlights the importance of preventing fraud, since the consequences of fraud are above and beyond the cost of fraud itself. The SEC is still working on Rule 10D-1 that would make clawback provisions mandatory for all firms, an effort that would proactively protect shareholders and promote ethics.

The SEC and stock exchanges are working tirelessly to protect shareholder interest by enhancing the reliability and transparency of financial statements.  While there are numerous disclosure requirements, there are still more to consider. For example, board interlocking – the practice of board directors serving on multiple corporate boards – is an important phenomenon that strengthens social ties and can lead to an increase in the flow of information across firms. Although board interlocking appears beneficial to board members in terms of accumulated knowledge and expertise, it poses a risk to US corporations. It is hard to believe that one man can serve two masters. The dissemination of competitive information, know-how, secrets and corporate policies across firms is simply not protected when board members are interlocked.

Corporate governance codes are not the only codes that are directly or indirectly linked to firm value. ESG (Environment, Social and Corporate Governance) is a growing concept that emphasizes the role of corporate social responsibility in long-term firm value. The limited focus on financial information is also unwarranted, as non-financial information can serve an important role in key decisions that have a direct impact on the quality of financial reporting. Recall that corporate culture should be the focal point of fraud prevention. It is unlikely for a socially responsible firm to deliberately mislead investors. Incentivizing socially and environmentally responsible firms could have positive ramifications on corporate ethics, culture and value.

Aside from the hype behind cryptocurrency and today’s market price of bitcoin, blockchain technology itself could be a useful tool for the US government. In fact, blockchain technology could serve as an innovative attempt to prevent fraud and oligopolistic concentration of the financial markets and enhance the transparency of disseminating information. Blockchain is a Distributed Ledger Technology (DLT) in the form of a chain, or blocks. Think of each block as a record of data; in bitcoin’s case, the data is transactions.  For each transaction to be executed, all participants on the block must agree on the validity of this transaction. Once network participants reach a consensus, each transaction will be sealed by immutable cryptography. Blockchain can offer many advantages to financial reporting and financial statement preparation: (1) It prevents the backdating of information, meaning that managers cannot undo transactions in order to either overstate earnings or understate expenses, (2) It reduces market frictions such as delayed processing and huge transactions fees through smart contracts, (3) It enhances the transparency and speed of disseminating information, and (4) It enables real-time auditing and oversight by various governance bodies inside and outside the firm. Embracing disruptive technologies like blockchain can significantly reshape the future of corporate governance.

Conclusion

No corporate governance regime will ever be able to prevent all instances of fraud and corruptions However, this should not stop policymakers from periodically revisiting current corporate governance standards to better understand their impact on businesses, consumers, and the economy. Current corporate governance mechanisms are insufficient to prevent future financial crises because they are reactive in nature. By switching to a proactive corporate governance regime, as recommended above, the likelihood of fraud and corruption, and hence future financial crises, will significantly decline.

 

.

 

 

So, the answer to the question on whether concurrent corporate governance can prevent future financial crises is possibly not. Nevertheless, revamping these codes and focusing on proactive ones can definitely lessen the likelihood of fraud and corruption and hence future financial crises.

 

This blog post is based on the published article:

El Mahdy, Dina. (2019). Corporate Governance and the Financial Crisis: What Have We Missed? Journal of Accounting and Finance, 19 (2), 42 –55. Full text is available at:

https://ssrn.com/abstract=3365354

 

Leave a Reply

Your email address will not be published. Required fields are marked *