Internal and External Aspects of Corporate Governance Ahmed NaciriInternal and External Aspects of Corporate Governance Ahmed Naciri é Routledge Taylor & Francis Group NewYork LondonFirst published 2010 by Routledge 270 Madison Ave, New York, NY 10016 Simultaneously published in the UK by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN ©2010 Ahmed Naciri Typeset in Sabon by IBT Global All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers ‘Trademark Notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. Library of Congress Cataloging in Publication Data Naciri, Ahmed. Internal and external aspects of corporate governance / Ahmed Naciri. p. cm. —(Routledge studies in corporate governance ; 5) Includes bibliographical references and index. ISBN 978-0-415-77641-7 (hardback : alk. paper)—ISBN 978-0-203-86529-3 (ebook) 1. Corporate governance, I. Title. HD2741,N33 2010 658.4’2 —dc22 2009021335 ISBN10: 0-415-77641-4 (hbk) ISBN10: 0-203-86529-4 (ebk) ISBN13: 978-0-415-77641-7 (hbk) ISBN13: 978-0-203-86529-3 (ebk)Contents List of Comprehensive Cases List of Appendices List of Tables List of Figures Abbreviations Acknowledgments Preface 1 Corporate Governance and Corporate Strategy 2 Corporate Governance: The Voluntary and the Legal Erameworks 3__The Board of Directors and Corporate Governance 4 The Standing Committees of the Board of Directors. and Corporate Governance 5 Internal Control and Corporate Governance 6& Risk Management in Corporate Governance 7 International Financial Reporting and Corporate Governance 8 Financial Auditing and Corporate Governance 9 Credit-Rating Activities and Corporate Governance 10 Financial Markets and Corporate Governance Bahan dengan hak cipia11 Corporate Governance in Less Developed Economies 12 Corporate Governance Requirement of Trust 13 Corporate Governance: the Road Ahea' Notes References Index Bahan dengan hak cipiaComprehensive Cases 11 Adam Smith. The Wealth of Nations 21 The Sarbanes-Oxley Act Bal New York Stock Exchange Statement of Corporate Governance Practices 4. Microsoft Corporation Audit Committee Del Internal Control Guidance for Directors on the Combined Code 61 Harvard University Risk Management System wl. JERS Financial Statements 8.1 Royal Bank of Canada, Report of Independent Registered Chartered Accountants pt. Credit-Rating Agencies Around the World 10.1 The Madoff Ponzi Scheme il.1 The Global Corporate Governance Forum 12.1 The Theory of Moral Sentiments Bahan dengan hak ciptaAppendices ZA Consolidated Balance Sheet at 31 December 200X 7B Consolidated Income Statement for the Year Ended 31 December 200X 7G Consolidated Cash-Flow Statement for the Year Ended 31 December 200XTables 3.1 The Most Significant Responsibilities of the Chairman of the Board 3.2 Measures to Be Taken by the Board for Ensuring an Appropriate Corporate Governance System 3.3 Strategic Planning Process 3.4 Risk Identification and Management 83. Internal Control 3.6 Oversight of Communications and Public Disclosure Airframe KLM, Board of Directors Committees Audit Committee Financial Information Review Audit Committee Duties With Regard to External Audit Audit Committee Actions With Regard to Monitoring Internal Control : Nomination Committee Duties Remuneration Committee Duties Potential Standing Committees Common Categories of Control Activities The Process of Information Identification, Capture, and Distribution 6.1 Table 6.2 Examples of Risk Measurement ZA Recognition Criteria for the Elements of Financial Statements 7.2. ist of Adopted IFRS Bahan dengan hak cipiaLS International Accounting Standards (IAS) ZA International Financial Reporting Interpretations (IFRIC) 2S International Auditing Standards Adopted by the AASB 26 The Use of IFRS by. Jurisdictions 8.1 Report of Independent Registered Public Accounting Firm 8.2 Big Four Accounting Firms’ Global Revenues for the Year 2007 9.4 Examples of Credit Ratings by the Three Largest Credit-Ratings Agencies: 9.2 Ratings Criteria, Agencies Versus Banks 10.1 New York Stock Exchange Regulations: Statement of Corporate Governance Practices Bahan dengan hak cipiaFigures Pl The financial hurricane. Four failure stories of fraud. 13 Classification of corporate governance defense mechanisms. 14 Corporate governance defense mechanisms’ assumed objective. LS Internal control objectives. 16 The financial decision-making triangle, IEM model. Dak Agency causes. 2a Agency consequences. 23 International initiative in corporate governance. 24 World Bank governance framework for development, gb OECD 2004 corporate governance principles. 2.6 Requirements for ensuring the basis for an effective corporate governance framework. Shareholders’ rights respect and key ownership functions Shareholders’ equitable treatment. Stakeholders’ role enhancement mechanisms. Disclosure and transparency. 2s Global corporate governance forum’s approach to improving governance. 2:12. Sarbanes-Oxley main provisions The board and directors’ common legal responsibilities. 1 3.2 Criteria for selecting appropriate officers. Bahan dengan hak cipiaFunctions of the board and directors. Directors” ‘ific functions. Requirements for an efficient board of directors. Criteria for maintaining board of directors’ efficiency. Legal and fraudulent corporate authority hierarchies. Corporate governance managers. Executive committee main roles in the organization. Nomination committee main duties. Compensation committee main duties. Internal control main objectives. Roles and responsibilities in internal control within the organization. Components of internal control. Specific control factors for an appropriate environment. Internal control monitoring process. Risk management process. The board of director’s responsibilities in risk management. The organization’s risk profile. Risk management strategies. Risk management monitoring model. rated program of risk management. TASB structure for adopting IFRS. The IASB’s standards-sctting process. International assurance and auditing standard board structure for adopting ISA. he IAASI The conceptual framework. The elements of financial statements. Financial statement fraud schemes. The market fraud trap. The audit process. Corporate-ratings principle. Credit-rating process. ’s standards-setting process. Bahan dengan hak cipia$3 Credit-ratings main users. 9.4 Income statement and types of risk. 10.1 Dow Jones Industrial Average, February 25-March 2, 2009. 10.2 Takeover premiums. 12.1 Joint board and management gains from trust. 12:2 The mistrust zone. isa. Trustiness zone. 124 Optimal BM 13.1 The risk return trade 13.2 The market for safe passe 13.3 The actors of the financial chaos. 13.4 The power shift in corporate governance. Bahan dengan hak cipiaAbbreviations AASB AICPA APB AR AICD BCBS BIS BMTR CASC CPAB CEO CFO CG CGRR CICA CPAAOB CSA CLO COsO CRA CR DR Australian Accounting Standards Board American Institute of Chartered Public Accountants Accounting Principles Board Audit Risk Australian Institute Company Directors Basel Committee on Banking Supervision Bank of International Statement Board Management Trust Relationship Canadian Accounting Standards Committee Canadian Public Accountability Board Chief Executive Officer Chief Financial Officer Corporate Governance Corporate Governance Regional Roundtables Canadian Institute of Chartered Accountants CPA and Auditing Oversight Board Canadian Securities Administrators Chief Legal Officer Committee of Sponsoring Organizations of the Treadway Commission Credit Ratings Agencies Control Risk Detection RiskEBT EBIT EC ED FASB FSAP FSF GAAP GAAS GCGF IAASB TAPS IAS IASB IDA IFAC TFRIC IFRS IOSCO JSLC MR MD&A MENA NASDAQ NED NSG NYSE OECD PCAOB PIOB ROSC SAC SEC Earnings Before Taxes Earnings Before Interest and Taxes European Community Executive Director Financial Accounting Standards Board Financial Sector Assessment Program Financial Stability Forum Generally Accepted Accounting Principles Generally Accepted Auditing Standards Global Corporate Governance Forum International Auditing and Assurance Standards Board International Auditing Practice Statement International Accounting Standards International Accounting Standards Board Investment Dealers Association International Federation of Accountants International Financial Reporting Interpretations Committee International Financial Reporting Standards International Organization of Securities Commissions Joint-Stock Limited Company Misstatement Risk Management Discussion and Analysis Middle East and North Africa Region National Association of Security Dealers Automated Quotation Non-Executive Director National System of Governance New York Stock Exchange Organisation for Economic Co-operation and Development Public Companies Accounting Oversight Board Public Interest Oversight Board Reports on the Observance of Standards and Codes Standards Advisory Council US Securities and Exchange CommissionSOE State-Owned Enterprises SOX Sarbanes-Oxley Act SRO Self-Regulatory Organizations TSX Toronto Stock Exchange UQAM University of Quebec in MontrealAcknowledgments This book would never come to being without the encouragement and the assistance of many people. I would like to express my thanks to my family and to Miguel Rojas, Guilene Fontaine, Terry Clargue, Abdelillah Bakiri, Lorn Switzer, Michel Nadeau, and many others. I am also indebted to many organizations whose materials help conceive this book: the Organization for Economic Co-operation and Development (OECD), the World Bank (WB), the Corporate Governance Forum (CGGF), the United States General Accounting Office (US-GAO), the American Institute of Chartered Public Accountants (AICPA), the Committee of Sponsoring Organizations of the Treadway Commission (COSO), the International Organization of Securities Commissions (IOSCO), the Financial Accounting Standards Board (FASB), the International Accounting Standard Board (IASB), the International Federation of Accountants (IFAC), the European Commission (EU), the Royal Bank of Canada (RBC), Abrema Corporation, the Riotinto Corporation, Harvard University (HU), University of California (UC), the New York Stock Exchange (NYSE), Public Companies Accounting Oversight Board (PCAOB), Reports on the Observance of Standards and Codes (ROSC), Public Interest Oversight Board (PIOB), and many others.Preface Unfortunately, current events tend to confirm Galbraith’s assertion “that the world of finance let itself to be understood only if we admit that maximum admiration go to those who open the way to big catastrophes.” Indeed, the current financial crisis is nothing else than a direct consequence of doubtful executive behaviors encouraged by environment and dominated by frauds, accounting number falsifications, huge embezzlements ($40 billions in the Madoff case), and excessive executive pay (that skimmed an average of $100 a working minute for the year 2007). Such misdemeanors have ended up weighting heavily on business relations, market conditions, and economic growth. Further, by becoming the normal standard of modern corporation scenery, such business deviations have created a devastating turmoil that is still spreading and intensifying, and consequently investors have lost any confidence in corporate disclosure and market mechanisms and tend to see the current crisis as something really quite new and different from any crisis that was experienced before. Managers were indeed to blame, but they were used as scapegoats to bigger and more dangerous offenders; as it happens, the major market players like large investors, auditors, rating agencies, financial institutions, and even monitoring agencies and, for sure, they all bear direct responsibility for today’s chaos. Indeed, none of them seems to have done its job appropriately, and each did not resist the temptation of turning its activities from instruments of production of goods and services to relentless short-term profit- generating machines. The thirst for easy gain and the propensity for fraud have progressively changed their activities into a market for safe passes, where complaisant certifications and proofs of compliance with rules can be acquired for generous fees. Obviously, as for managers, many of these market major players have crossed the mistrust line and they ought to be sued and punished instead of beingcompensated, as it seems the case with some of these so-called rescue programs. After all, should a liar be believed when he promises not to lie anymore? Would it be because of the strong ties that link the capital to politics, that architects of the current economic disaster not only seem to be compensated but also often maintained in commands, despite voices that are calling for their immediate replacement? Instead of going after real delinquents, some people are blaming for the financial chaos we are currently enduring, the free-market system that is by far the most ingenious human creation. Major market players are to blame instead; they have seriously interfered with its normal functioning, and it ought to be protected from them and “provocative as it may sound in today’s febrile and dangerous climate, freer and more flexible markets will still do more for the world economy than the heavy hand of government” (The Economist, 2008b). Adepts of Friedman theory still believe that corporations have only one responsibility: maximizing their shareholders’ wealth, and should not, therefore, try to do good actions with others’ money. They still challenge the idea that businesses can do well and do good at the same time. Such poisonous beliefs can, however, be misleading: first, corporations are there because society enables them to exist and second, the appropriate question that should be asked is: can businesses be conducted honestly? In face of the crisis we are currently in, the answer can only be yes and, at least, it should. Corporate governance is the path to be followed by businesses and other organizations to ensure their alignment toward such objective and should indeed be looked at as systemic process, having some of its mechanisms rooted in organizations themselves; but others, much impacting, are originating from outside. For a corporate governance initiative to succeed, it is primordial that all classes of mechanisms of governance work efficiently, but it is also required that a clear and precise social orientation toward honesty and trust is taken. As we know, dishonesty and mistrust are not new in human relations, but that is also the case for trust and honesty. Of course, some rebalancing of regulations is needed, particularly where innovation outpaced gappy supervisory regimes. Although laws and regulations may prove to be useful in signaling the direction society would like to see its businesses take, they always prove insufficient in establishing trust and honesty, especially when promulgated out of urgency. In all cases, laws and regulations should deal with principles not rules. Besides, the legislature is divided between its desires of saving individual self-interest, supposed to keep business activities running, and making sure that such self-interest is pursued within ethics and trust boundaries. Self-interest does not, however, limit itself to money: it may include reputation and othersocial value. Only a change of attitude can present any hope; even if attitudes are over time learned opinions and don’t change unless a major event occurs, change can be initiated from the current crisis and this opportunity should not be missed; it should rather be seized to bring more attention to ethics and honesty in doing business Anyway, the recent euphoria for easy gains has prompted swindles to the advanced scene of corporate management; after misappropriating corporate and small-investor wealth, they are requiring that cost of their misconduct to be externalized on those who are not responsible for them. Some of the victims have lost their life saving in such adventures and others all their retirement benefits. Malfeasants ought to be stopped, sued, punished, and replaced by more honest managers. Indeed, it was forgotten that trust in business is first about excellence and high achievement rather than malfeasance. The fraudulent corporate hierarchy of authority that seems to be instituted, which has marginalized honest managers and excluded them from corporate strategic decision making, should be reverted. And this may constitute a real test to the current crisis resolution. Indeed, the degree of the hegemony of a system can be measured by its tendency to persist in error. It is the time to react and ask whether modern managers were, at all, taught trust and honesty and whether we adopted a culture that tolerates and even justifies business abuse of trust. Our educational programs are also to blame; they should reflect such business ethical orientation. Till very recently our business schools seem to prompt students to wealth maximization regardless of the means used. The current financial chaos, which has taken years to build up, may also take years to cure. The objective is not to completely eradicate mistrust, because this may prove to be impossible, but rather to make a critical mass of managers to cross back the line to the trust zone as represented in Figure P.1. Indeed, “we will often ashamed by the best of our actions, if people know all motivations that produce them.” (La Rochefoucauld, 1834) Corporate governance internal and external mechanisms covered in this book should be looked up as powerful operating instrument that can help improve corporate behavior and introduce more ethics to business transactions and relations. This book also calls for everybody’s participation to this noble task in these crucial times, because after all our financial system cannot be other than the reflection of our current collective values and beliefs. It reminds those among us requiring honesty today from the financial system that we should also ask ourselves, Are we honest enough to save the system or does “the unfair hurts us, only when it does not benefit us?” (Vauvenargues).STUISia \Tus' Figure P.1 Trust-mistrust zones.1 Corporate Governance and Corporate Strategy Wealth creation always precedes wealth distribution and requires autonomy, freedom to prosper but more importantly good governance (accountability) to sustain and develop. Autonomy and freedom to undertake may prove worthless in isolation and only an accountable and transparent autonomy, as suggested by corporate governance, would seem to be the panacea. Corporate governance is seen in this book as all the principles, mechanisms, and processes that are used to govern organizations ethically. Today and in the aftermath of serious embezzlements in major corporations throughout the world due to failures of diligence, ethics and accountability, that is, corporate governance, are becoming da powerful means: of value creation (Gompers, Ishii, & Metrick, 2001). Indeed, “corporate governance has a role of vital importance to play one that is often not fully understood” (Oman, Fries, & Buiter, 2003). Most corporate governance works have, however, concentrated on immediate governance mechanisms like board structure and committees. On the other hand, most of the literature on the subject had originally taken a narrow view that aimed at ensuring that firms are mainly operated in the interests of shareholders. As commonly underlined, however, the theoretical justification for such a view is based on the existence of a perfect and complete market and in this is something that cannot be encountered in most countries. Consequently, these assumptions are far from being reasonable (Allen, 2005). In such case, a broader view of corporate governance, one that focuses on ensuring that society’s resources are used efficiently, may prove to be more appropriate. This chapter emphasizes the necessity of dealing with corporate governance in a systemic way, underscoring interactions between its diverse components and emphasizing its multiple impacts on corporate strategy and free-market value. CORPORATE GOVERNANCE MECHANISMS’image not availableimage not availableimage not availableCorporate privileges would have no value if an appropriate market was not tailored and created specifically for them. For this reason, corporate advances and sophistications were accompanied, hand in hand, with the financial market development and sophistication and these changes have had profound implications for corporate governance (Bradley, Schipani, Sundaram et al., 1999). The result was a new financial order, mainly characterized by a vast volume of financial transactions, but also doubtful opportunities of frauds, a kind of financial hurricane that is impossible to master, at least till now, as represented in Figure 1.1. Indeed, corporate specific characteristics have contributed to exchange development and to exchange transactions explosion. By creating new financial instruments such as options, derivatives, and exchange indexes, the exchange fuels the financial hurricane even more by adding fuel to the fire process. Market exchange operators became voracious and can hardly wait for an event to occur; they tend to anticipate them along with their eventual return in a foolish race for profit, creating more often false expectation that result in many unnecessary deceptions. Major fraudulent transactions, although involving corporations, are now of a macro nature and are taking place at the market level. A recent round of financial frauds is seen as the natural and inevitable consequence of a trend which was building up for so long now. Inevitably the market becomes the master governance system (Clarke, 2005, p. 1410). “Ironically, the blunt truth is that recent accounting scandals and broader phenomenon have made corporate managers more accountable to the market” (Coffee, 2002) and less to shareholders or citizens. Consequently, the corporation has become the privileged field for fraud and misappropriation that are both difficult to detect and to predict, due mainly to market sophistication. Corporations’ gain of power and their lobbying activities for regulations dilution has rendered them difficult to monitor, and engaged them in an interdependent complex system of conflicts of interest.image not availableimage not availableimage not availableCORPORATE GOVERNANCE Corporate governance deals with the way managers govern themselves, but most importantly it is a matter of personal conviction and values. To fully understand the concept of governance, a brief history will be helpful. The word itself comes from the old French gouvernance, meaning government. It quickly crossed the English Channel, losing, however, its letter u and becoming “governance.” While keeping the same meaning, the term has been shelved for many centuries. The way it is used today appears like a three-note melody. It all started at the end of the eighties, when international organizations, faced with repeated failures of their structural adjustment programs, were searching for ways out; that have decided for its use again. Seriously disillusioned, World Bank officials incriminated political frameworks in developing countries and called for upstream action directed on the mode of government. Status of international agencies expressly prohibits them from interfering in the political system of their clients, while such systems have a determinant impact on the success of structural programs. The term governance was called to the rescue. Denominated in technical terms, it allows circumventing political issues. The World Bank, for instance, defines governance as “the way in which power is exercised in the management of social and economic resources of a country for development.” Such a definition is made instrumental by imposing a set of four requirements, easier to define than to implement: (i) Establishing a state of law that guarantees the security of citizens and law enforcement; (ii) Setting a good public administration that requires proper management and equitable public spending; (iii) Underscoring responsibility and accountability, which require that managers are accountable for their actions before the citizens; and (iv) Requiring a transparency that allows each citizen to access and use pertinent information. The restructuring orientation of the World Bank model will inspire most corporate governance legislative initiatives that follow, especially the Sarbanes-Oxley Act of the United States (Sarbanes- Oxley, 2002). By the end of the 1990s, many Asian countries were facing a severe financial crisis and again, international experts saw a governance crisis caused by a lack of business ethics and effective transparency. The Asian financial crisis of 1997 has actually placed governance on the agenda of the Organisation for Economic Co- operation and Development (OECD), which published its governance principles in 1998, dealing with:image not availableimage not availableimage not availableFigure 1.3 Classification of corporate governance defense mechanisms By themselves, however, none of these mechanisms of corporate governance defense has been completely effective. Institutional mechanisms alone are not strong enough to ensure honesty and efficiency within the organization. Laws and legislation imposing specific governance models on their own have not been successful either. The corporate governance system will be given a better chance to work if each class of corporate governance mechanisms is meant to be supportive of the others and when actors adopt an ethical attitude toward business. Together they may form a whole, a kind of “diversified” package, whose purpose is to ensure efficiency and ethics within the organization and ultimately maximize the market value of shares. The relative weight of any component in the package may vary, however, with the nature of relationships among people and environments, and as their balance changes, their impact on corporate governance efficiency may change as well. HOW CORPORATE GOVERNANCE ENHANCES ORGANIZATION VALUE Finance views of corporate governance emanates from the strong belief that shareholders’ interests are best served by actions that maximize share prices in the short run, mainly because this view firmly assumes that today’s price of shares fully reflects the market’s best estimate of the value of all future profits and growth that will accrue to the company whose share is involved (Blair, 1995). Other views of corporate governance exist. The market myopia view, for instance, questions the ability of today’s stock prices to be a reliable enough guide for future value and return from the company’s investment, to the exclusive focus of managerial consideration. The social responsible company view believes that corporations do not exist solely to provide returns to shareholders. Instead, corporations must serve a large social purpose. The idea that corporations should have some social purpose, beyond maximizing shareholder wealth, is making its way. It is currently more commonly believed that corporations should exist to create wealth for the whole society. Accordingly, the aim of corporate governance mechanisms and the responsibility of corporate directors are undergoing a certain shift in their purposes, and companies are more and more expected to work for a broader goal that may include shareholders’ wealth maximization, indeed (Blair, 1995). As underlined in Figure 1.3, all corporate governance defense mechanisms, whether institutional, operational, informational, orimage not availableimage not availableimage not availableevery dollar of risk taken, while the organization is ensuring investment in its businesses to secure its future growth objectives. Practically, such an aim is reached through the thorough analysis of the various risk elements to which the corporation is exposed and the assessment of the impact and the likelihood of each one of them. By acting this way, the corporation is obviously hoping to certainly meet market expectation of return stability and growth. Risk management and internal control systems appear to be but two faces of the same coin. While risk is the possibility that the corporate return can be adversely affected by an unexpected event or action, internal control is the process by which the organization makes sure risks are kept at their lowest level possible. Management needs, therefore, to effectively balance risks and controls. Control procedures should be tailored in a way that risks can be brought back to levels with which management is comfortable and accept exposure. Internal controls and risk management policies are more efficient when proactive, value- added releaser, and cost-effective. Performing efficiently and managing risk intelligently may not be enough if it is not brought to the attention of investors in the marketplace. In order to be able to inform and convince investors, individually and collectively as a market, about the effectiveness of its internal control (risk management and revenue-cost management), organizations need to have in place an efficient and transparent reporting system. As we know, investors express their appreciation of the organization through their required rate of return, translating into market price in exchanges. Such required rate of return usually incorporates an informational risk component, associated information asymmetry (Barry & Brown, 1986), which can be reduced by the adoption of a reporting strategy, based on transparency (Botosan, 1997; Dye, 2001). Doubt with regard to financial reporting quality will surely impact the overall risk of the organization and consequently will increase investors’ required rate of return. Corporate governance informational quality depends, however, on the state of other internal mechanisms (Healey & Palepu, 2001). Figure 1.6 allows the full understanding of the importance of corporate transparency. In the IEM model exposed in Figure 1.6, “I” goes for investor, “E” for the organization (enterprise), and “M” for the market. The EM axis describes information flows, the IM axis describes the assessment or valuation process, and the IE axis describes the decision-making process. Figure 1.6 shows that, like a beam of light emitted by a pocket flashlight, the information emanating from the firm (EM) will be taken into consideration by the investor, and therefore reflected on the value of shares (MI), only if the mirror, represented by the market, does not warp this reality, that is, only if information is transparent.image not availableimage not availableimage not availablecorporate governance mechanisms, whether institutional, operational, reporting, or external, which is value maximization of the organization through ethics and efficiency. Such objective will constitutes the main theme throughout the book. Chapter 2, “Corporate Governance: The Voluntary and the Legal Frameworks,” shows that two conventional approaches of corporate governance have been proposed, the voluntary contractual approach and the legal approach (the imposed approach). It emphasizes their limits and underscores the supervisory role played by the international organizations. Chapter 3, “The Board of Directors and Corporate Governance,” stresses the fact that most recent corporate governance legislations, guidelines, and reforms focus on reorganizing and formalizing the board of directors’ structure and introduce new standards of accountability in order to provide the board with the necessary conditions for the success of its role. Chapter 4: The standing committees of the board of directors are given a wide range of responsibilities and functions. The high emphasis placed on the committees’ system for resolving board issues can probably be explained by its practical benefits, although it may also present some problems. Chapter 5: Internal control indicates that the shortest way for an organization to achieve its objective is by having in place an efficient internal control system that can help in achieving performance and profitability targets, preventing loss of resources, ensuring reliable financial reporting and compliance with the law. Chapter 6: Risk management underscores the fact that risk taking activity is unavoidable for organizations and that those that do not take risks may actually be failing their responsibilities. It is therefore an obligation for organizations to manage effectively their risks. Chapter 7: “International Financial Reporting and Corporate Governance,” expresses clearly the need for _ international comparability and advocates international convergence. It explains how international financial reporting standards (IFRS) may impact corporate governance quality. Chapter 8: Audit systems make it clear that the responsibility of publicly disclosed financial statements, quality, and completeness lie in the board of directors’ hands. The board usually entrusts such a task to one of its special committees (called the audit committee), which in turn can use an external auditing service to help execute the job. Chapter 9: Credit rating, financial institutions, and corporate governance explain how credit ratings are used by investors, issuers, investment banks, broker-dealers, and governments, It also discusses the economic role of credit ratings in corporate governance. Chapter 10: Financial market and corporate governance suggest thatimage not availableimage not availableimage not availablethinking for decades, with regard to the nature of the relationships between stakeholders and the management; and this is what is termed as agency relation, also defined as a contract under which one party (the principal) engages another party (the agent) to perform some service on his/her behalf. It is easy to understand that within the provisions of such contractual relationship, the principal will likely be delegating some of his decision-making rights to his agent. This, of course, is in line with the belief that the structure of authority within the organization is actually a succession of authority delegations: (i) shareholders delegating to the board, (ii) the board delegating to the CEO, and (iii) the CEO delegating to other high-ranking officers of the organization. Given the heavily delegating character of the organization, one can then understand that agency problems will arise mainly from of the impossibility of perfectly contracting for every possible action of any delegated agent. His decisions, by the way, will finally affect not only his welfare but also the welfare of the principal who delegates him the necessary authority to do the job. The main agency challenge in a corporate governance framework and at least the most impacting emerges from the difficulty of finding ways of inducing managers to act in the best interests of their shareholders. The seriousness of such challenge is hopefully supposedly reduced, as specific managerial incentives are discovered and used to induce managers to respect the shareholders’ wealth-maximizing rule in their decision making (Jensen & Meckling, 1976). As with any cost, agency costs will inevitably be captured by financial markets, and will ultimately be reflected in companies’ share prices. Agency costs can then be seen as the market value loss to shareholders, arising from divergences of their interests from those of corporate managers. Agency problems have multiple origins and lead to diverse consequences. Management can, for instance, “use pre-commitment to dividend payments to mitigate the agency conflict due to poor governance” (Kose & Knyazeva, 2007). AGENCY ORIGINS Agency theory focuses on aligning the potentially conflicting interests of owners and managers. From an agency perspective, managers cannot be trusted and this may prove to be an extreme hypothesis; consequently, boards have to actively participate in corporate strategic choice and ensure management monitoring if shareholders’ interests are to be protected against management’s self-interests (Kiel & Nicholson, 2003). As underscored previously, agency problems would always occur whenever contractual relations involve conflicts of interest between partners, and this seems to be always the case, but also because contractual agreements have their own inherent limitations, because it will always be impossible to contract for all possible scenarios entitledimage not availableimage not availableimage not availablethe mandate and its spirit. Monitoring costs usually cover the cost of writing contractual agreements and the cost of auditing. Although such costs are initially carried by the principal, it is agreed that they will ultimately be assumed by the agent because his compensation is supposed to be adjusted to cover such costs. This is at least what is commonly suggested (Fama & Jensen, 1983). Most recent corporate governance national systems have dealt with certain aspects of agency monitoring, because they believed that monitoring activities may act as a powerful deterrent to managerial malfeasance. The US Securities Exchange Commission requires, for instance, that listed companies provide statements of compliance with the Sarbanes Oxley Act provisions with regard to organization’s internal and external auditing activities. European corporate governance directives require the same, although with less conviction. Residual Loss — [ Boning Costs | Figure 2.2. Agency consequences Bonding costs are the direct consequence of the agent awareness of being the ultimate bearer of the monitoring costs. Consequently, he is likely to set up appropriate structures to avoid paying too much and he will try, for instance, to discipline himself and have in place an appropriate system allowing him to show the shareholders that he is acting in their best interests. The voluntary establishment and adherence to such systems have their own costs, however, and the agent is believed to accept to bear them, at least up to a certain level. These costs have come to be known as bonding costs. As part of bonding costs, we can mention the cost of the additional information to be disclosed to shareholders, but bonding costs are not all financial. Agent acceptance of bearing bonding cost is far from being irrational, and the agent will cease incurring them as soon as the marginal reduction inimage not availableimage not availableimage not availablecitizens and convinced of the benefits of an efficient management and rational and equitable public spending policies. In order for the previous requirement to materialize, it is assumed that not only responsibility and accountability within public administration must exist, but also that civil servants are accountable for their actions before their citizens. The last requirement underlines the fundamental role of transparency which should allow each citizen easy access and the use of pertinent information. Figure 2.4 World Bank governance framework for development. As most international organizations did, the World Bank has also adopted the OECD principles (discussed later) as its benchmark instrument and part of its member countries’ surveillance procedures, mainly the Reports on Standards and Codes (ROSC). The World Bank initiative can legitimately be considered as the ancestor of all initiatives that follow in the field, and also seems to have inspired them deeply. Regardless of the fact that some may have seen in the World Bank governance framework a kind of a nostalgic Friedman-Reagan neoliberal mode! and an instrument of market globalization, it seems to have succeeded, in some way at least, in empowering an increasing the number of developing countries taking care of their own economic destiny. THE ORGANISATION FOR ECONOMIC CO- OPERATION AND DEVELOPMENT CORPRATE GOVERNANCE PRINCIPLESimage not availableimage not availableimage not availablemain objective of corporate governance framework should unmistakably be the protection of the shareholders and the facilitation of the exercise of their rights. Steps to be taken in order to achieve shareholders’ rights protection are summarized in Figure 2.7. It is the view of the OECD that the protection of shareholder rights should be intended to allow shareholders the full exercise of their rights. In this regard the OECD 2004 principles underline specifically the fact that shareholder rights should encompass basic rights such as securing efficient methods of registration of ownership; transferring or conveying shares; obtaining on a timely and regular basis relevant and material information on the corporation; participating and voting in general shareholder meetings; electing and removing board members; and having a share in the profits of the corporation. Shareholders should further be placed in a position where they can easily exercise their ownership rights, that is, they should, for instance, have the right to be sufficiently informed and particularly to participate effectively in fundamental corporate change decisions such as: “amending the statutes, articles of incorporation or similar governing documents of the company; authorizing additional shares issue; and authorizing extraordinary transactions, including the transfer of a substantial part or all assets that in effect result in the sale of the company” (OECD, 2004a). It is worth mentioning that the OECD 2004 principles requirements go beyond the corporation to include institutional investors acting in a fiduciary capacity. These institutional investors are also required, first, to disclose their overall corporate governance and voting policies with respect to their investments, and this includes the procedures that they have in place for deciding on the use of their voting rights; and second, to disclose how they manage material conflicts of interest that may affect the exercise of key ownership rights regarding their investments; Shareholder participation Shareholder righ Market for corporate controlimage not availableimage not availableimage not availableAccess to relevant information assured Figure 2.9 Stakeholders’ role enhancement mechanisms. Disclosure and Transparency Disclosure and transparency is the favored governance issue of most legislation and guidelines. OECD 2004 principles are no exception. They state that “the corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company.” Components of an effective corporate disclosure and transparency system, as imagined by the OECD 2004 principles, are summarized in Figure 2.10. Auditing Quality Figure 2.10 Disclosure and transparency.image not availableimage not availableimage not availableglobal, regional, and local initiatives that aim to improve the institutional framework and practices of corporate governance, a number of governments gave voluntary contributions to create a joint World Bank-OECD Global Corporate Governance. Housed in the joint IFC/World Bank Corporate Governance and Capital Markets Department, it has undertaken work in developing countries and helped to finance the OECD roundtables, based on OECD principles. The GCGF is a multidonor trust fund cofounded by the World Bank Group and the OECD aimed at the promotion of sustainable economic growth and poverty reduction within the framework of agreed-upon international development targets. The forum contributes to the efforts of the international community to promote the private sector as an engine of growth, reduce the vulnerability of developing and transition economies to financial crises, and provide incentives for corporations to invest and perform efficiently in a socially responsible manner. It fosters cooperation with various corporate governance programs and plays a coordinating role among donors, founders, and other relevant institutions (GCGF, 2008). The forum seeks to address the corporate governance weaknesses of middle- income and low-income countries in the context of broader national or regional economic reform programs. The forum has an extensive program to support corporate governance reform in developing countries. Strengthening corporate governance is an essential part of creating the necessary climate for investment and economic development. Sound corporate governance practices can inspire investor and lender confidence and spur both domestic and foreign investment. The forum focuses on practical, targeted corporate governance initiatives at the local, regional, and global level. The GCGF’s approach is summarized in Figure 2.11.