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

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

2. Contents of Topic 6 • Ownership and control • Agency theory • Agency costs • Definition of Corporate Governance (CG) • Objectives of CG • Issues of CG

3. Topic 6 Learning Objectives 3 • Describe the characteristics of listed companies • Explain the concept of separation of ownership and control • Explain the meaning of conflict of interest in the context of the relationship between shareholders and professional managers • Explain the origin of corporate governance problems in a public listed company • Explain the objectives of CG • Describe the issues of CG

4. Private versus public listed companies (PLCs) Shareholders Board ofDirectors Management 0 4 Private Structure Listed Structure Owners Managers

5. Characteristics of public listed 5 • 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. Separation of Ownership from Control Ownership belongs to shareholders Control surrendered to board of directors Shareholders have voting power only Board of directors makes strategic decisions Limited power relative to board and management team Management team makes daily operational decisions Conflict of interest when management team does not act in the best interest of shareholders Both are powerful relative to shareholders

7. Conflict of interest 7 Corporate governance problems Conflict of interest Managers and shareholders have conflicting objectives Shareholders want maximization of profit and wealth Managers have personal interest

8. 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

9. 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

10. Defining Corporate Governance (1) 10 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. Corporate refers mainly to large listed companies

11. 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.”

12. Elements of CG definition 12 • 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

13. Corporate governance mechanisms 13 • 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

14. 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.

15. Key issues of corporate governance 15 • Excessive business risk taking and lack of risk control; • Bad communication of information • The ethical issues Directors’ remuneration made at their own discretion; Financial Reporting irregularities and auditing; Lopsided decision making powers;

16. 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

19. Bad communication of information 19 • Poor communication - jeopardize shareholders position – make wrong decision • Need clear communication policy with shareholders – media, website, dialogue, press-conferences and general meetings • Need constant communication between directors and shareholders • Shareholders need to know performance and activities in a timely and accurate manner

20. Financial reporting irregularities and auditing 20 • 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 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

21. 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

22. Excessive business risk taking and lack of risk control 22 • Risk – leads to losses or lost of property • Need internal control and risk management system • to protect assets and investment • to manage risk exposure • Risks versus returns • Unnecessarily taking excessive risk • No system to manage risks

23. 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

24. 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

25. 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 26

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 27

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 28

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 29

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 30