CBEB3101 Business Ethics Lecture 7 Semester 1, 2011/2012 Prepared by Zulkufly Ramly

1

CBEB3101 Business Ethics Lecture 7

Semester 1, 2011/2012Prepared by Zulkufly Ramly

Contents of Topic 62

1. Ownership and control

2. Agency theory

3. Agency costs

4. Definition of Corporate Governance (CG)

5. Objectives of CG

6. Issues of CG

Topic 6 Learning Objectives3

1. Describe the characteristics of listed companies

2. Explain the concept of separation of ownership and control

3. Explain the meaning of conflict of interest in the context of the relationship between shareholders and professional managers

4. Explain the origin of corporate governance problems in a public listed company

5. Explain the objectives of CG

6. Describe the issues of CG

4

Private versus public listed companies (PLCs)

Private Structure Listed Structure

Owners

Managers

Owners

Managers

Characteristics of public listed5

Based on Anglo-American (Saxon) model

Issued shares and trade able in share market

Listed in share market

Requires substantial fund

Large number of shareholders

Shareholders do not manage the company

They delegate control to professional managers

6

Ownership belongs to shareholders

Separation of Ownership from Control

Control surrendered to board of directors

Shareholders have voting power only

Board of directors makes strategic

decisionsLimited power

relative to board and management team

Both are powerful relative to

shareholders

Management team makes daily

operational decisionsConflict of interest when management team does not act in the best interest of

shareholders

Conflict of interest 7

Managers and shareholders have conflicting objectives

Shareholders want maximization of profit and wealth

Managers have personal interest

Conflict of interest

Corporate governance problems

The meaning of accountability

8

directors are answerable

to shareholders

act in shareholders’ best

interest and expectations

provide good and reliable

information

address shareholders’

concerns

run the company with the

required legal framework

Consequences of lack of accountability

9

Management acting in

self interest and behaving

unethically

Shareholders do not know

much about activities and

performance of company

Shareholders may remove

directors

Defining Corporate Governance (1)10

Corporate refers mainly to large listed companies

Governance refers to the way in which an

entity or body of people is governed; and

the functions of governing

Hence, CG is principally concerned with the

way PLCs is governed.

Defining Corporate Governance (2)11

Malaysian Code on CG (2000) “... as the process and structure used to

direct and manage business and affairs of the company towards enhancing business prosperity and corporate accountability with the ultimate objective of realising long term shareholder value, whilst taking into account the interests of other stakeholders.”

Elements of CG definition12

To monitor top management team - use their power for the benefits of shareholders

To ensure adherence to laws and regulations

To contribute to firm performance so as to create long-term shareholder value and to attract new investment

To give confidence to investors to invest in the country’s capital market

Corporate governance mechanisms13

Legal and regulatory framework e.g. Bursa, Securities Commission, Companies Commission of Malaysia etc

Independent board of directors

Independent non-executive directors

Audit, nomination, remuneration and risk management committees

External and internal auditors

Internal control and risk management systems

Shareholders – institutional, family, large, government

Stakeholders

Some brief principles of corporate governance

14

The board and its directors are to be properly structured with sufficiently experienced, skilled and knowledgeable members;

The composition of the board should be balanced by executive, non-executive and independent directors;

Committees of the board should be established to carry out review and recommend important matters concerning auditing, remuneration and nomination, among others;

The should be reasonable systems to evaluate and access risks and internal control, so as to form risk management;

Sufficient care should be devoted in financial reporting and disclosure;

Constructive communication and dialogue with shareholders and individual directors should be encouraged.

Key issues of corporate governance15

Directors’ remuneration made at their own discretion;

Financial Reporting irregularities and auditing;

Lopsided decision making powers;

Excessive business risk taking and lack of risk control;

Bad communication of information

The ethical issues

Directors’ remuneration made at their own discretion

16

In Malaysia there is no legal requirement for board to seek shareholders’ approval for remunerating directors (exception - share option scheme)

Directors decide their own remuneration

The basis for remunerating sometimes are not based on their individual, company and peer companies performance

Shareholders do not object high remuneration UNLESS it is not supported by good performance

Shareholders object ‘fat cat directors’

There should be procedures to determine remuneration packages

17

Inflated executive compensation: Justified?

Yes to high pay

Rewarded for outstanding performance

Provide an incentive for innovation and risk-taking

Scarce talents to run large and complex organizations

18

Inflated executive compensation: Justified?

No to high pay

Hurts firms’ ability to compete with foreign rivals

Cause resentment, weaken the commitment of hardworking lower and midlevel employees

Failed executives are rewarded with inflated pay

Bad communication of information19

Need constant

communication between

directors and shareholders

Shareholders need to know

performance and activities

in a timely and accurate

manner

Poor communication -

jeopardize shareholders

position – make wrong

decision

Need clear communication

policy with shareholders –

media, website, dialogue,

press-conferences and

general meetings

Financial reporting irregularities and auditing20

Directors are accountable to report the financial health and status of the company to shareholders

They control financial information, hence may manipulate or ‘window dressed’ - misleading

Financial reports should show balanced assessment of company’s position and adhere to financial reporting standards

Financial reports should be subject to an independent audit Is the auditor independent

from the management influence?

Scandals of Enron, WorldCom, Adelphi and Tyco International highlighted that external auditors had failed in their duty to safeguard the interest of shareholders

Lopsided decision making powers 21

The board is the highest decision making body

Lopsided power - Shareholders are owners but directors make most decisions

Directors do not always make decisions that benefit company

Need sufficient independent element in the board Appoint independent directors

Separate posts of CEO and chairman Avoid one person dominating the decision Balance the lopsided decision making power

Excessive business risk taking and lack of risk control

22

Risks versus returns Unnecessarily taking

excessive risk No system to manage risks

Risk – leads to losses or lost

of property

Need internal control and risk management system to protect assets and

investment to manage risk exposure

The ethical issues (1) 23

Ethics and CG are interrelated Business ethics – concerned

with good and bad or right and wrong behaviour and practices that take place in business

Corporate governance – concerned with the way the directors and managers of firms control and manage their resources on behalf of shareholders

CG provides guidelines, systems and procedures for corporate dealings

The ethical issues (2) 24

BUT the extent of CG effectiveness largely depends on behavior of directors and managers

Directors and managers must be ethical in managing firms’ resources

Managers can still engage in unethical behavior despite the

existence of CG guidelines

The ethical issues (3) 25

‘Greed’ and unethical practices of managers - root cause of corporate scandals

The extent to which managers and firm engage in in ethical practices determines its reputation in the market

However, ethical issues are difficult to regulate because law and regulations alone can never guarantee fair practice

26

Enron scandal 2001 In August 2002, Michael Kopper, an assistant to Andy

Fastow (the former finance director) pleaded guilt to charges of wire fraud and money laundering.

Andy Fastow was found guilty of money laundering, fraud, conspired to inflate profits and enriched himself.

Enron top executives sold over $1b of Enron shares to other investors fully knowing that the co. was in trouble financially – shareholders were told the opposite.

In short, this is a clear e.g. of agency problems

Case Example 1

27

Time Warner Twice a year, Chairman and CEO boards one of his

company’s four jets to visit his own small vineyard in Italy that produces RM300 wine per bottle. Cost = USD$60k –USD$170k per trip.

General Electric Former vice-chairman flies to his vacation homes in

Florida and Boston using company’s jet.

Who pays? SHAREHOLDERS

Issue – pursue own benefit at the expense of shareholders wealth.

Case Example 2

28

Lone Star Industries (a US Company) CEO James Stewart allegedly billed the company

USD1m for ‘purely personal expenses’ including taking his personal music teacher on Lone Star trips to three continents.

The BOD did not scrutinise the CEO’s expenses and admitted that they ‘did not know what he was doing.’

In 1990, Lone Star filed for bankruptcy.

An illustration of opportunistic behaviour and managerial agenda at the expense of shareholders.

Case Example 3

29

RJR Nabisco (a US Company) CEO Wilson spent USD68m developing

smokeless cigarettes without informing the BOD.

Issue: He exceeded spending limits without BOD’s approval.

Wilson’s successor arranged for his directors to rub shoulders with celebrities, use corporate planes and apartments.

He handpicked the directors hoping they will support him

Case Example 4

30

The HIH Insurance Group (Australian co.)

Was one of the largest underwriter in Australia; collapsed in 2001.

Investigation by the government revealed that money was wasted by extravagance, paying too much for business acquired (empire building?), largesse and questionable transactions.

Also revealed, an unwise acquisition of FAI Insurance, which performed poorly in the UK and USA.

It was concluded that HIH’s collapsed was due to the lack of accountability for performance, and a lack of integrity in the company’s internal processes and systems.

Combined, all these features led to a series of biz decisions that were poorly conceived and poorly executed.

Case Example 5