UNIT 3: Agent and Institution (Corporate Governance
Failures, Codes, and Principles)
Introduction
Corporate governance (CG) refers to the framework of rules, relationships, systems, and
processes within and by which authority is exercised and controlled in corporations. It is the
system by which companies are directed and managed, aiming to carry out business as per the
stakeholders' desires. The underlying reason for the CG system is the stakeholders’ pursuit for
preserving their respective share of profit earned by business enterprises. Corporate
governance has become a highly discussed topic, partly because good governance has
sometimes been lacking at various levels. Scandals and failures across the globe have
highlighted the critical need for robust CG practices. These failures demonstrate weaknesses in
CG mechanisms and underscore the importance of effective oversight, transparency,
accountability, and ethical conduct. Studying these cases and the resulting reforms helps in
understanding the vital role of CG in maintaining stable capital markets, protecting investors,
and ensuring the long-term sustainability of corporations.
This section will analyze major global corporate failures, identify the corporate governance
weaknesses they revealed, examine the reforms needed to improve standards, introduce key
international codes and principles, and discuss how these principles can be applied in the
governance of companies.
Major Global Corporate Failures
Corporate failures serve as significant lessons, prompting reflection on governance practices.
They are major reasons for changes in company law and often expose instances where auditors
or management have fallen below expected standards.
1. Bank of Credit and Commerce International (BCCI) Scandal (UK)
○ Background: Established in 1972, BCCI was founded by Agha Hassan Abedi
and incorporated in Luxembourg, with headquarters in London. Its focus was on
the third world, and Abu Dhabi became a major shareholder.
○ Failure Details: BCCI secretly financed its main borrower (the Gulf shipping
group), which was close to bankruptcy in the late 1970s. The bank falsified its
books for 15 years, creating fictional transactions to cover up non-performing
loans and using customer deposits to falsely portray financial health. The Bank of
England (BoE) granted BCCI a licence in 1980, which was later regarded as a
mistake. A 1982 BoE memo described BCCI as 'on its way to becoming the
financial equivalent of The Titanic'. The bank was investigated for money
laundering, links to figures like Manual Noriega, Colombian drug barons, and the
Abu Nidal terrorist organization. The CIA even admitted using BCCI 'as a way to
move money'. An undercover US federal agent uncovered how BCCI
manipulated international finance systems for money laundering. This led to
charges against over 80 people, and BCCI pleaded guilty to money laundering,
paying a fine.
○ Exposure and Aftermath: Auditors (Price Waterhouse) alleged transactions
were 'false or deceitful' in 1990. The BoE ordered an investigation which found
'evidence of massive and widespread fraud', leading to the bank's closure in July
1991. The collapse caused thousands of depositors to lose money. The BoE
Governor stated the fraud involved management and the culture was 'criminal'.
Investigations found that the BoE failed to spot the fraud, being responsible for
mistakes, though not deliberate negligence or conspiracy. US reports were highly
critical of BCCI, BoE, CIA, Justice Department, and US regulators for having
information but failing to use it, allowing BCCI to secretly acquire US banks. The
reports claimed BCCI bribed political figures, discredited truth-tellers, engaged in
massive anonymous trading and money laundering, and failed to protect
depositors, all while auditors allegedly knew about the poor practices for years.
Litigation followed against the BoE.
○ Weaknesses Exposed: Widespread fraud and falsification of accounts, lack of
transparency, failure of internal controls, regulatory oversight failures, potential
complicity or negligence of auditors, manager misconduct, use of the bank for
illicit activities (money laundering, supporting criminal/terrorist groups).
2. Vivendi Collapse (France)
○ Background: Originally a water company (Compagnie Generale edes Eaux -
CGE), it was renamed Vivendi and diversified into media and
telecommunications.
○ Failure Details: Through massive acquisitions in the 1980s and 1990s, Vivendi
became the world's second-largest media company. This aggressive strategy
involved costly acquisitions led by Jean-Marie Messier.
○ Exposure and Aftermath: In July 2002, Vivendi reported a liquidity crisis and
disclosed a significant loss of Euro 23.3 billion. The group collapsed due to flaws
in governance, primarily stemming from overexpansion through costly
acquisitions.
○ Weaknesses Exposed: Poor strategic decision-making, aggressive and
potentially reckless growth strategy (overexpansion), inadequate management
oversight of acquisitions and resulting financial health.
3. WorldCom Scandal (US)
○ Background: WorldCom was one of the biggest telecommunications companies
in the US. Bernie Ebbers was its CEO.
○ Failure Details: WorldCom engaged in accounting irregularities, including
scheduling journal entries that erroneously increased revenue. This was fictitious
revenue, violating US GAAP. They also recognized revenue from long-term
contracts before providing the service, another US GAAP violation. Additionally,
they capitalised excess capacity expenses (line costs) instead of expensing
them, violating accounting standards like FRS 16. These actions artificially
reduced expenses, increased assets, boosted profits, and presented a stronger
balance sheet. They also manipulated reserves, creating 'hefty slush funds' to
manage and inflate earnings.
○ Auditing Issues: Management suppressed the internal audit function, keeping it
understaffed and withholding information to prevent discovery of fraud. The
internal audit VP, Cynthia Cooper, uncovered the truth by gathering information
secretly. External auditors (Arthur Andersen) initially refused to address concerns
raised by internal audit and later claimed they had approved the methods.
WorldCom switched auditors to KPMG after the Enron scandal. Arthur Andersen
failed to detect accounting irregularities, leading to a loss of public trust and
implication in both the Enron and WorldCom frauds.
○ Corporate Governance and Accountability Issues: The system of valuing
companies solely on share value contributed to management behaving
improperly under pressure to meet targets. The CEO, Bernie Ebbers, who lacked
industry knowledge, pursued an aggressive acquisition strategy without
consolidating the companies, leaving only acquisitions as a way to boost stock
value. His remuneration package was myopic, focusing on quick profits tied to
share price, incentivizing short-term gains over long-term success. There was a
culture problem driven by top management. A significant issue was the absence
of accountability from top management; Ebbers, despite claiming limited
involvement, had authority and forced others to comply. He was able to gamble
with company funds with little personal repercussion, potentially increasing his
wealth through shares or receiving a severance. The board and audit committee
failed to oppose the CEO/CFO and even provided large loans to Ebbers and
others, creating conflicts of interest and distracting the CEO.
○ Weaknesses Exposed: Fictitious accounting practices and manipulation of
financial statements, weak internal controls, suppression of internal audit, failure
of external audit (Arthur Andersen), lack of auditor independence, executive
misconduct and fraud, lack of top management accountability, weak board
oversight and failure to challenge management, conflicts of interest, inappropriate
executive compensation structures, culture of misconduct, focus on short-term
gain/share price over long-term sustainability.
4. Enron Conundrum (US)
○ Background: Enron, a Texas-based energy trading company, became a byword
for company fraud. It had significant revenue and employees before its 2001
collapse.
○ Failure Details: Enron used a complex accounts structure to hide huge debts
behind fraudulent off-balance sheet partnerships. Top executives were found
guilty of insider trading and lying to investors.
○ Auditing Issues: The scandal significantly shook the auditing profession and led
to a crisis of confidence in auditors and financial reporting reliability. Questions
arose about audit quality and auditor independence, as their auditors (Arthur
Andersen) also received large fees for non-audit services. Investors were misled
by Andersen's financial projections, which understated losses and liabilities. The
lack of auditor independence played a significant role, partly due to personal
relations and large non-audit fees.
○ Aftermath: The Enron case demonstrated that the mere presence of accounting
and auditing standards is insufficient if auditors are not completely independent
of the company they evaluate. It became symbolic of shareholders' failure to
protect their interests due to asymmetrical information and conflict of interest
within the board. The ties between executive managers and shareholders were
destroyed due to manager greed prioritizing self-interest.
○ Weaknesses Exposed: Massive accounting fraud and manipulation (using
off-balance sheet entities to hide debt), insider trading, misleading investors, lack
of auditor independence, conflict of interest (auditors providing non-audit
services), failure of external audit, asymmetrical information disadvantaging
shareholders, conflict of interest on the board, manager greed and self-interest at
the expense of shareholders, lack of board oversight and supervision, failure of
ethical business decision making, lack of a speak-up culture, failures of
compliance functions, lack of 'Conscious Commitment' to honesty, integrity, and
transparency by senior leadership.
5. Lehman Brothers Failure (US)
○ Context: The bankruptcy case of WorldCom was considered unprecedented until
the breakdown of Lehman Brothers in 2008. Poor corporate governance,
including weak risk management standards at many financial institutions,
contributed to the devastation wrought by the 2008 financial crisis, aptly named
the “Great Recession”. Warnings from senior executives at institutions like AIG
and Merrill Lynch about excessive exposure were reportedly ignored.
○ Weaknesses Exposed (in the context of the 2008 crisis it was part of): The
sources attribute the financial crisis, of which Lehman's failure was a major part,
to poor corporate governance, including weak risk management standards.
However, the provided sources do not contain specific details regarding the
particular actions or governance failures within Lehman Brothers itself that led to
its collapse, beyond its context within the broader crisis caused by poor CG and
risk management in the financial sector.
(Note: While the sources list Maxwell Communications as a major failure in the outline for
Chapter 13, detailed information about this specific case is not present in the provided excerpts.
Therefore, it cannot be detailed here based solely on the given sources.)
Corporate Governance Weaknesses and Inadequacies Exposed
The global corporate failures discussed highlight systemic weaknesses and inadequacies in
corporate governance frameworks and practices:
● Lack of Board Effectiveness: Boards often suffered from limitations in skills and
competence or the inability of non-executive directors (NEDs) to effectively monitor and
control senior executives. In some cases, boards were dormant, part of management, or
simply acted as rubber stamps.
● Poor Oversight and Supervision: Failures in board oversight and supervision were
critical factors. Directors failed to challenge or oppose senior management decisions,
even when questionable.
● Weak Ethical Leadership and Culture: A lack of 'Conscious Commitment' to core
values like honesty, integrity, and transparency by senior leadership was a common
thread. Culture problems driven from the top enabled misconduct.
● Failures of Compliance Functions: Critical compliance functions, including legal and
audit, failed. Internal control systems were inadequate or compromised.
● Lack of Accountability: There was often an absence of accountability for top
management, allowing them to act with impunity for personal gain. Penalties were not
always commensurate with wrongful acts.
● Insufficient Auditor Independence and Quality: Auditors' independence was
compromised, often by providing lucrative non-audit services. They failed to detect
significant accounting irregularities and relied on management-provided information
instead of conducting independent investigations.
● Asymmetrical Information and Lack of Transparency: Information was withheld or
manipulated, creating asymmetry between management and shareholders. Financial
reporting was misleading. Disclosure was inadequate.
● Conflicts of Interest: Conflicts of interest arose from auditors providing non-audit
services, boards providing loans to executives, and executives pursuing personal
interests over the company's best interest.
● Poor Risk Management: Weak standards and practices in risk management
contributed to crises. Warnings about excessive risk exposure were sometimes ignored.
There was often board risk blindness.
● Inappropriate Incentives: Executive compensation structures incentivized short-term
gains or share price increases rather than long-term sustainability or ethical conduct.
● Stakeholder Disregard: Focus was often solely on shareholder value or short-term
profit maximization, neglecting the interests of other stakeholders like employees,
creditors, and society.
● Dominant Shareholder Issues: In some cases, controlling shareholders pursued their
interests at the expense of minority shareholders.
Major International Codes and Principles of Corporate Governance
In response to corporate failures and the identified weaknesses, various codes and principles of
corporate governance have been developed globally to guide best practices and promote
reform.
1. Cadbury Committee, 1992 (UK)
○ Purpose: Set up by the London Stock Exchange and the Bank of England to
address the financial aspects of corporate governance following concerns about
financial reporting and accountability.
○ Focus: Focused on the control and reporting functions of the Board of Directors.
○ Key Contribution: Developed the Code of Corporate Governance, also known
as the 'Code of Best Practice'.
○ Recommendations: Included recommendations related to the Board of
Directors, Non-executive Directors, Executive Directors, and Reporting and
Control. For instance, it recommended specific practices for the Board of
Directors and the composition and role of the audit committee, including having a
majority of independent non-executive directors and at least one member with
financial knowledge. Infosys, for example, benchmarked its corporate
governance against the Cadbury committee recommendations.
○ Significance: It was one of the foundational documents defining principles of
corporate governance.
2. OECD Principles of Corporate Governance
○ Purpose: Provide specific guidance for policymakers, regulators, and market
participants to improve the legal, institutional, and regulatory framework
underpinning corporate governance, focusing on publicly traded companies.
○ Development: Originally issued in 1999, they were revised in 2003 and agreed
upon by OECD governments in 2004, becoming the international benchmark for
corporate governance. The revision process involved extensive consultations and
drew on experiences from Regional Corporate Governance Roundtables.
○ Key Areas: The Principles cover six key areas:
■ Ensuring the basis for an effective corporate governance framework.
■ The rights of shareholders.
■ The equitable treatment of shareholders.
■ The role of stakeholders in corporate governance.
■ Disclosure and transparency.
■ The responsibilities of the board.
○ Approach: They are principles-based and non-prescriptive, allowing
relevance in various legal, economic, and social contexts. They emphasize the
need for enforceable laws, effective enforcement agencies, and establishing
checks and balances between boards and management.
○ Relevance: The Principles are highly relevant to corporate failures, addressing
issues like dormant boards, rubber-stamp boards, passive shareholders,
controlling shareholders prioritizing self-interest, and conflicts of interest.
Attention to stakeholders is highlighted as a unique feature.
○ Significance: They form the basis for many reform initiatives globally and serve
as a framework for policy dialogue in regional reforms.
3. Sarbanes-Oxley (SOX) Act, 2002 (USA)
○ Purpose: A US federal law enacted in response to major corporate scandals like
Enron and WorldCom.
○ Applicability: Applies to public companies registered with the Securities and
Exchange Commission (SEC).
○ Key Provisions: Legislates several principles recommended in the Cadbury and
OECD reports. It includes eleven sections specifying duties regarding corporate
governance, compliance, and disclosure.
■ Audit Committees: Requires independent board audit committees.
■ Financial Reporting Certification: Mandates CEOs and CFOs to
directly and individually certify the accuracy of financial reports.
■ Auditor Independence: Includes requirements for public accounting
firms, rules for the separation of duties (detailing non-audit services
auditors cannot perform), and auditor rotation (partners every 5 years,
firms every 7 years). These measures are designed to guard against
fraudulent practices and conflicts of interest.
■ Public Company Accounting Oversight Board (PCAOB): Created the
PCAOB to set standards and rules for audit reports and to investigate and
enforce compliance at registered accounting firms.
■ Penalties: Introduced criminal penalties for misleading financial reports.
○ Significance: SOX introduced stringent requirements, particularly concerning
financial reporting, internal controls, and auditor independence. Many
recommendations in India, like those from the N.R. Narayana Murthy Committee,
are considered a culmination of SOX provisions.
Reforms Needed and Application of Corporate Governance Principles
Corporate failures necessitate significant reforms to improve governance standards and protect
stakeholders. The international codes and principles provide the foundation for these necessary
changes and guide their application.
1. Strengthening Board Effectiveness and Accountability:
○ Boards must be comprised of individuals with appropriate skills, experience,
knowledge, wisdom, and dynamism.
○ The institution of independent directors is essential to bring objectivity to the
board and enhance its effectiveness.
○ Board responsibilities should be clearly defined, focusing on strategic guidance
and oversight of internal controls, not day-to-day management.
○ Boards must actively monitor and challenge management, not merely act as
rubber stamps.
○ Mechanisms for ensuring board responsibility and accountability need to be
re-designed and strengthened.
○ Boards should conduct regular self-evaluations of their effectiveness.
2. Enhancing Transparency and Disclosure:
○ CG requires transparency and disclosure for all stakeholders.
○ Financial reporting must be sound, transparent, credible, and present a true and
fair view of affairs.
○ Disclosure should focus on the quality of data.
○ Relevant information, including risks, compliance, and related party transactions,
must be disclosed to stakeholders and the board.
3. Ensuring Auditor Independence and Quality:
○ Auditor independence is paramount and must be strictly protected.
○ Restrictions on auditors providing non-audit services that could compromise
independence are necessary.
○ Auditor rotation can help enhance independence.
○ Auditors must adhere to strict protocols, technical standards, and conduct
independent investigations.
○ Independent oversight bodies (like the PCAOB in the US and NFRA in India) are
needed to set standards, investigate, and enforce compliance by auditors and
firms.
○ Auditors play a role in promoting accountability within the organization.
4. Implementing Robust Internal Controls and Risk Management:
○ Companies must have proper systems for internal control.
○ Management should control risks through a properly defined framework.
○ Procedures for risk assessment and minimization should be in place, with the
board being informed and reviewing them periodically.
5. Promoting Ethical Conduct and Value-Based Culture:
○ A strong, value-based corporate culture with clear ethics and principles is
fundamental.
○ Boards should define and enforce codes of conduct for board members and
senior management, with compliance affirmation required annually.
○ Leadership must demonstrate personal and professional integrity.
6. Protecting Stakeholder Interests:
○ CG must balance the interests of all stakeholders, including shareholders,
employees, suppliers, customers, and the community.
○ Shareholders' rights, including electing the board and receiving equitable
treatment, must be protected.
○ Attention to stakeholders is a key principle.
○ Corporate Social Responsibility (CSR) should be managed seriously by the
board, recognizing the company's impact on economic, social, and environmental
landscapes.
7. Ensuring Regulatory Compliance and Enforcement:
○ Companies must comply with all relevant laws and regulations.
○ Regulatory frameworks must be enforceable and supported by effective
agencies.
○ Regulators (like SEBI in India or SEC in the US) play a crucial role in monitoring
and enforcing CG standards.
○ Laws should impose personal penalties on individuals responsible for misconduct
and unjust enrichment.
8. Learning from Failures:
○ Corporate bodies need to learn from their failures to move towards success.
Analyzing past scandals helps identify common problems and inform necessary
reforms.
Forming an Opinion on the Application of Important Principles
Based on the analysis of corporate failures and the principles outlined in codes like Cadbury,
OECD, and SOX, it is evident that applying important CG principles is critical for the effective
governance of companies. These principles move beyond mere compliance with the law; they
embody a commitment to ethical conduct, transparency, accountability, and the balanced
consideration of all stakeholder interests.
Applying principles such as board independence, robust audit functions, comprehensive
disclosure, effective risk management, and a strong ethical culture helps to:
● Mitigate the risk of fraud and misconduct: As seen in Enron, WorldCom, and BCCI,
where these elements were weak, fraud thrived.
● Protect investors and stakeholders: CG ensures accountability to shareholders,
employees, and others affected by the company's actions. Failures like WorldCom and
BCCI directly harmed investors and depositors.
● Improve decision-making quality: Independent boards and effective committees are
better equipped to make decisions in the best interest of the company and its
stakeholders, rather than being swayed by dominant personalities or short-term
pressures.
● Enhance corporate reputation and access to capital: Good governance increases
goodwill, market reputation, and trust, making it easier to attract domestic and foreign
investment.
● Ensure long-term sustainability: A focus on stakeholder interests and ethical
practices, beyond just short-term profit, contributes to the company's longevity.
While laws and regulations (like SOX) provide a mandatory baseline, the principles (like those
from Cadbury and OECD) often provide the deeper rationale and broader scope, encouraging
companies to strive for governance excellence rather than just minimum compliance.
Implementing these principles effectively requires a conscious commitment from the
senior leadership and embedding them into the very fabric of the organization.
In conclusion, the application of key corporate governance principles is not just a regulatory
requirement in certain areas but is fundamental to building trust, ensuring stability, and
achieving sustainable success in the global business environment. The lessons from past
failures serve as stark reminders of the consequences when these principles are neglected.
