Section 6
Governance and Ethics
SECTION OVERVIEW
Janette Rutterford
In this, the last section of Financial Strategy, we attempt to take a step back from the issues of adding value or measuring performance, and ask some more general questions, including: Is shareholder value maximisation the right goal? How can shareholder value be reconciled with the problems of using managers as agents for shareholders? And, what about other stakeholders such as employees and pensioners? Have they been forgotten at the expense of manager and shareholder greed? What role should ethics play in corporate governance? And, what is the best system of corporate governance? We also try to link a number of the themes discussed in earlier sections of the book.
These issues have become all the more urgent with the large number of company collapses from the last stock market boom. Commentators have begun to ask whether managers simply forgot to be ethical in their pursuit of gain for themselves or for their shareholders. And yet, the shareholder emphasis had already been brought into question by Will Hutton in his book, The State We're In, published as early as 1995. The stock market boom of the late 1990s had appeared to prove him wrong.
The US has perhaps suffered the greatest shock, with the apparent sophistication of accounting rules, of regulation and of investment analysts not being sufficiently on the ball to spot creative accounting or, indeed, fraud. The first article in this section, “It's Time to Rebalance the Scorecard”, by James Higgins and David Currie, discusses possible reasons for the failure of corporate ethics in the US in the context of performance measurement. The authors look at a sample of firms using the balanced scorecard approach and find that about 90 per cent of these do not use social responsibility measures of any kind. They argue that social responsibility and stakeholder considerations should be explicitly made part of the measurement of managerial performance.
The second article in this section is “Stakeholder Capitalism”, an extract from Will Hutton's book, The State We're In. This book had a major impact on corporate governance thinking when it appeared, challenging the domination of the shareholder maximisation approach and arguing that the continental European version, which considered stakeholders such as employees, pensioners, the local community, lenders, government as well as shareholders, had much to offer. And yet, by the end of the twentieth century, the continental European model had apparently lost the battle to rampant capitalism. German companies such as Siemens introduced management incentive schemes linked to shareholder value, DaimlerChrysler threatened to close factories down unless workers worked longer hours for the same pay, and other companies such as Vivendi Universal in France made acquisition after acquisition in a bid to enhance shareholder wealth – as well as enrich the CEO, Jean Marie Messier.
Case Study 13 is an article published in 2005 in The Economist, which argues that, despite the stock market boom and bust in the years between the publication of Will Hutton's book and the publication of this article, stakeholder capitalism was essentially dead and buried and that, despite its flaws, the Anglo-American model of corporate governance was far superior. See if you agree.
“Controversy Incorporated”, by David Cogman and Jeremy Oppenheim, looks at the role of ethics in corporate governance. It essentially argues, rather after the event, that ethics is in the end good for the firm and good for shareholders. In a sense, it is a reversion to the dividend policy and signaling literature. Firms can signal via their ethical stance that they are better than their competitors; this will give them access to cheaper cost finance and, in the end, achieve the desired goal of enhancing shareholder wealth.
Case Study 14 is a revealing interview with the CFO of Microsoft by Bertil Chappuis and Tim Koller. The discussion ranges over a number of topics, from the pitfalls of executive compensation using share options, to the role of dividends as a signaling mechanism, to the role of corporate ethics and the ever more complex role of the CFO and the finance division.
Case Study 15 is a detailed case study of Parmalat, an Italian dairy products company which entered bankruptcy protection in 2003 after acknowledging that $3.95 billion supposedly on deposit with a bank did not exist. It was subsequently discovered that Parmalat had debts totalling $14 billion, eight times higher than previously thought. In 2005, Calistro Tanzi, the firm's founder, with 15 others, went on trial in Italy charged with false accounting, market rigging and misleading Italy's financial markets regulator. Parmalat, a world leader in its field, had apparently complied with the Preda Code, the Italian code of corporate governance, and yet managed to hide accounting fraud for more than a decade. Creative accounting, and downright fraud, were hidden from stakeholders, and the governance bodies, until it was too late. An interesting cross-cultural case study.
The final case study, Case Study 16, touches on another issue which throws up cultural differences and conflicting objectives. Corporate pension funds in the Anglo-American-Dutch world have tended to be funded, with employees on retirement being paid pensions linked to salary. Investment risk has been borne by the firm and hence by the shareholders. In the boom years of the 1990s, with pension funds benefiting from high equity values, firms were able to reduce their pension contributions, enhancing earnings figures and hence shareholder value. In the bear market of the 2000s, the opposite is true, with the added problem of new accounting rules requiring greater disclosure of pension liabilities and actuaries requiring market values rather than historic cost values to be used. These combined changes have led companies to incur on-or off-balance sheet net pension liabilities, sometimes out of all proportion to the size of their business assets and liabilities. The interesting question here is who should bear the investment risk? Many companies are switching to defined contribution schemes, where employees take the investment risk, at the same time taking the opportunity to reduce their share of pension contributions. The pie is being divided differently between existing pensioners, who are doing well, future pensioners, likely to do worse, and companies which will suffer for years to come with the already accumulated liabilities. The case study, an article from the Financial Times by Lucy Warwick-Ching, raises a few of these unresolved issues.