GOOD GOVERNANCE

AND SOCIAL
RESPONSIBILITY
MODULE 3B
1.d. The Shareholders’ Contract

The role of residual risk bearer creates special contracting problems for
shareholders.

The fixed claims of other groups—employees for wages, for example, or suppliers
for payments—are relatively easy to assure in legally enforceable contracts.

By contrast, the profitability of a firm, upon which the return to shareholders

depends, cannot be mandated in a contract. In a firm without a separation of
ownership and control—that is, in a firm in which shareholders operate the business
—there is no problem protecting the shareholders’ return since they control the
operation. Profitability is in their hands.

However, once shareholders leave the task of operating a firm to professional

managers and hence separate ownership and control, a problem arises as to how
shareholders can be assured that these managers will operate the firm for
maximum profitability.
The solution to this problem is for shareholders to accept the role of residual risk
bearer only on the condition that they also have control. The roles of residual risk
bearer and holder of control rights are conceptually distinct.

In theory, different groups could hold these roles, and sometimes they do. In practice,
however, few investors would be willing to become residual risk bearers without
obtaining control.

Without control rights, investors would generally insist on significantly higher returns
to compensate for the greater risk, with the result that the cost of capital for firms
would be much higher.

Alternatively, firms can lower their capital costs by offering control rights as well as
claims on profits when they seek capital from investors.

Thus, control rights can be viewed not only as a demand by investors to secure the
return on their contribution of capital but also as an offer from firms to obtain
investors’ capital on favorable terms.
Combining risk bearing and the right to control in the shareholders’ role is not a
complete solution to the contracting problem, however.

Shareholders cannot merely order managers to operate a firm for maximum

profit, because what managers need to do to make a firm maximally profitable is
complex and uncertain.

The best shareholders can do is ask managers to exert their best effort to be
profitable.

This is commonly done not only by aligning managers’ interests with those of
shareholders by means of bonuses and stock options, but also by imposing a
fiduciary duty on managers to act in all matters in the shareholders’ interest.
The fiduciary duty of directors and officers is a major feature of the law of corporate
governance, which is designed to overcome the fact that shareholders cannot bind
persons by explicit contracts that fully specify the conduct to be performed.

That the fiduciary duty of management flows mainly to shareholders is often thought
to privilege shareholders in some way, but it should be understood that making
shareholders the sole beneficiary of managers’ fiduciary duty is a solution to the
distinctive contracting problem that equity investors have with a firm.

This solution reflects the vulnerability of shareholders and the relative invulnerability
of all other groups, which, in any event, are better protected by, and thus prefer, other
contractual means for securing their due return.
To summarize, corporate governance is the contract between shareholders and a firm
that confers control rights on the shareholders, along with the benefit of managers’
fiduciary duty, in order to protect the shareholders’ claim to residual revenues or
profits.

Unlike the contracts that other groups enter into with a firm, this contract is unusually
complex due to special contracting problems in the relationship between shareholders
and the firm.

Although the terms of this contract are, to some extent, specified by law, corporations
still have great flexibility to negotiate with investors in a market, and the law itself
largely reflects the terms that would result from market negotiations.
Thus, the tendency of corporate governance laws to recognize
the primacy of shareholders is determined by both public policy
and the market and is justified on both grounds.

That is, shareholder primacy serves to promote the welfare of

society and is the result of voluntary, efficiency-promoting
market transactions.
Corporate governance, with its doctrine of shareholder primacy
and the objective of shareholder wealth maximization, appears
to privilege shareholders and elevate their interests above
those of other groups, most notably employees, customers,
suppliers, and non-shareholder investors, as well as community
members.

These groups, along with shareholders or stockholders, are

commonly identified as stakeholders. Sample definitions of a
stakeholder are “those groups who are vital to the survival and
success of the corporation” and “any group or individual who
can affect or is affected by the achievement of the
organization’s objectives.”
The concept of a stakeholder highlights the fact that a corporation interacts
continually with its stakeholder groups and that much of the success of any
business organization depends on how well all of these stakeholder relationships
are managed.

The concept of a stakeholder is of undeniable importance: Corporations have

stakeholders, and their effective management is essential for achieving corporate
success.

More problematic is the use to be made of this concept. How should managers of
a firm think about stakeholders?

In particular, how does the important task of managing stakeholder relationships

fit with the doctrine of shareholder primacy and the objective of shareholder
wealth maximization?
No less a corporate titan than Jack Welch, the former CEO of General Electric,
who was hailed by Financial Times as the “the father of the ‘shareholder
value’ movement,” declared, “On the face of it, shareholder value is the
dumbest idea in the world. Shareholder value is a result, not a strategy. . . .

Your main constituencies are your employees, your customers and your
products.” For Welch, there is no necessary conflict between shareholder
value and stakeholder focus: The latter is essential for achieving the former.

Stakeholder Theory

The concept of stakeholders has been developed in recent thinking about

firms into a theory, called stakeholder theory. Thomas Donaldson and Lee E.
Preston distinguish three uses of stakeholder theory: descriptive,
instrumental, and normative.
First, the theory can be used as a description of the corporation
that enables us to understand the corporation better.

Thus, a researcher who believes that the stakeholder theory

accurately describes corporations can use it to answer
questions about how corporations are organized and managed.

The claim that stakeholder theory provides an accurate

description can be confirmed to the extent that the answers to
these research questions are put to a test and empirically
verified.
Second, the stakeholder thing can be used instrumentally as a
tool for managers. Even if making a profit for shareholders is the
ultimate goal of corporate activity, this point does not provide
much help in the daily conduct of business.

By contrast, telling managers to handle stakeholder relationships

well is a more practical action guide that may actually lead to
greater profit.

In addition, companies faced with social and political challenges

may find that relationships with stakeholder groups are valuable
resources.
Third, the stakeholder theory can be used as a normative
account of how corporations ought to treat their various
stakeholder groups.

Normative stakeholder theory would have managers

recognize the interests of employees, customers, and others as
worth furthering for their own sake.

As Donaldson and Preston explain, “The interests of all

stakeholders are of ‘intrinsic value.’”

The central claim of a normative stakeholder theory is that

corporations ought to be operated for the benefit of all those
who have a stake in the enterprise, including employees,
customers, suppliers, and the local community.
1.e. Protecting Stakeholders

As a normative account of corporate governance, stakeholder theory is

sometimes presented as an alternative to the standard shareholder- or
stockholder-centered model, and a contrast is made between the stockholder
and stakeholder theories of corporate governance as incompatible systems.

If this is done, the two theories agree on at least one point:

The purpose of the firm is to enable each corporate constituency or stakeholder

group to obtain the maximum benefit from its involvement in the productive
activities of a business organization.

By providing inputs or resources to a firm, each group contributes to the creation

of wealth, and this wealth is then distributed among all participants.
The answers of the stockholder theory to the two questions about protecting
stakeholders and determining their just return are straightforward:

• The best means for protecting each group’s rightful return are contracts and legal rules,
and

• the return that each group has a right to receive is the market value of its contribution.

For example, employees typically work under legally enforceable contracts that specify
their wages and other conditions of employment, and any disputes arising from a
contract can be litigated in court.

In addition, legal rules, mainly those of labor law, supplement employees’ contracts to
provide further protection.

Similarly, suppliers and consumers are protected by sales contracts, as well as the body
of commercial law, and securities law and the law of corporate governance protect the
interest of investors in the operation of a firm.
2. Corporate Accountability

The recent scandals at Enron, WorldCom, and other companies

were not the result of misconduct by a few individuals.

They revealed major weaknesses in the systems of corporate

control by which corporations are held accountable.

The collapse of Enron, as well as WorldCom, involved

fraudulent conduct by employees that evaded the controls
ordinarily imposed on corporations by financial reporting
requirements and oversight by executives and the board of
directors.
The Sarbanes-Oxley Act of 2002 (SOX), which was passed in the
wake of Enron’s collapse, reflected the belief of Congress that
there were deep flaws in the American system of corporate
accountability.

The various provisions of SOX thus address the three major

components of the American system for holding corporations
accountable:

• financial reporting,

• corporate management, and

• criminal law.
Enron’s filing for bankruptcy on December 2, 2002, followed
more than two months of revelations about the company’s
declining financial situation.

When third-quarter earnings were reported on October 16,

2001, Enron announced that it was writing down the value of
certain investments by $ 1.01 billion and that investor equity
had shrunk by $1.2 billion.
More bad news followed on November 8 when the company
revealed that its net income dating back to 1997 was $586
million less than had been previously reported, due to
improper accounting practices.

When investors realized that Enron’s reported income had

been greatly exaggerated and that large amounts of debt had
been hidden in dubious off-balance-sheet partnerships, all trust
was eroded and the company’s stock lost almost all value.

Enron’s collapse was due not merely to bad business decisions

that had been hidden from investors but also to a plundering of
the company by insiders.
What does this case illustrate about a company’s financial reports?

The first line of defense against incompetence and outright criminality by corporate
executives is a company’s financial reports.

The law requires that public companies prepare financial statements that present a
fair and accurate picture of their financial condition, and these statements must be
audited and attested to by a certified public accounting firm.

Although audited financial statements are intended primarily to aid investors in

making sound investment decisions and to increase the efficiency of financial
markets, they also serve as an important check on management by making
corporate operations more transparent.
The ability of the market to react swiftly to changes in a
company’s situation makes it an effective monitor of managers’
performance.

Because investors rely so heavily on financial reports, they are

also tempting vehicles for committing fraud.

By presenting a false picture of a company’s financial condition,

executives can cover up poor performance and continue to
receive lavish compensation.

In many of the recent scandals, fraudulent accounting also

enabled executives to dump much of their stock before bad
news became public.
2.a. Accounting and Auditing

Accounting is the recording and presentation of the financial transactions of an

organization.

Any organization, whether it is a business corporation, a not-for-profit organization, or

a government unit, must keep track of its revenues and expenditures and compile this
information in ways that provide managers with an understanding of the organization’s
financial condition.

Accountants also compile an organization’s financial information in reports that are

presented to outside parties, such as creditors from whom the organization is seeking
loans or the government, which requires that certain information be disclosed. All
public companies are required by law to issue an annual report that details all assets,
liabilities, revenues, and earnings in a consolidated balance sheet and income
statement.
Auditing is an inspection of an organization’s accounting records to
determine their accuracy, completeness, and reliability.

This inspection may be conducted inside the organization by managerial

accountants or internal auditors, who are employees of the organization,
or by outside, independent public auditors, who are certified public
accountants (CPAs).

In addition to inspecting an organization’s financial accounting records, a

CPA conducting an independent audit also examines the organization’s
financial accounting system and offers a report or opinion about both the
accounting records and the accounting system.
The independent auditor’s report or opinion may be unqualified, which means that the
organization’s financial records fairly represent its financial condition and have been prepared
according to GAAP, or qualified, which indicates either that the audit was not complete in scope
or that GAAP was not followed completely.

An independent public audit should be conducted in accord with Generally Accepted Auditing
Standards (GAAS). If corporate accounting and auditing were properly done, then fraud and
other kinds of financial wrongdoing would be difficult to commit, and detection would be easy.

Individual accountants and auditors, being human, are subject to ethical lapses; but, more
importantly, there are certain structural problems with the practices of accounting and auditing
that impair their effectiveness as a first line of defense against financial scandals.
2.b. Job Pressure

Managerial accountants and internal auditors, who are

employees of a company, and the outside CPAs, who are
engaged by the client company, are subject to intense pressure
to achieve the financial picture that top executives want to
convey.

Often the pressure comes to meet earnings expectations in

order to maintain a company’s stock price or allow executives
to make bonus or stock option targets.

Such “earnings management” is possible because accounting

rules allow great flexibility in their application. This flexibility is
permitted so that companies can choose the accounting
treatments that provide the fairest representation of their
financial condition.
Arthur Levitt, a former chairman of the SEC, addressed the
abuse of the flexibility in the accounting system with a call for
higher ethical standards:

Our accounting principles weren’t meant to be a straitjacket.

Accountants are wise enough to know they cannot anticipate
every business structure, or every new and innovative
transaction, so they develop principles that allow for flexibility
to adapt to changing circumstances. That’s why the highest
standards of objectivity, integrity and judgment can’t be the
exception. They must be the rule.
Accountants may also be pressured to approve accounting
treatments that are not in accord with GAAP, as when
WorldCom personnel were ordered to record accruals as
revenue and line charges as capital expenses.

Such cases require accountants to have the moral courage to

resist. CPAs are not employees who can be fired for failing to
please management; but CPA firms are still selected by
management, and they have a strong incentive to please the
client in order to be retained.

Enron, for example, was one of Arthur Andersen’s most valued

clients, and the company succeeded in having accountants who
objected to Enron’s accounting removed from the Enron team.
2.c. Conflict of Interest

CPA firms have many interests besides serving clients, which put them in conflict-of
interest situations.

In addition to a desire by a firm to retain clients, individual CPAs may have a financial
relationship with the company being audited by, for example, owning stock in that
company or a company doing business with it.

The CPA firm may also have other clients who have business relationships with or
who are competitors of the company being audited. Any such relationships might
impair the objectivity and independence of the CPAs engaged in an audit.

For this reason, “The Code of Professional Conduct of the American Institute of
Certified Public Accountants” requires CPAs to maintain objectivity and
independence and be free of conflicts of interest.
The AICPA code specifically prohibits having “any direct or
material indirect financial interest” in an audit client and any
loan from the company or anyone related to it.

This prohibition does not address the conflict that results

when auditors take positions with a company that he or she
formerly audited.

The prospect of an attractive job with an audit client might

influence an auditor’s judgment.

A number of top executives at Enron had previously been with

the Houston office of Arthur Andersen on the Enron account.
In 1984, the U.S. Supreme Court declared the public interest
paramount:

By certifying the public reports that collectively depict a

corporation’s financial status, the independent auditor assumes
a public responsibility transcending any employment
relationship with the client. The independent public accountant
performing this special function owes allegiance to the
corporation’s creditors and stockholders as well as to the
investing public. This “public watchdog” function demands that
the accountant maintain total independence from the client at
all times and requires complete fidelity to the public trust.
The ideal of total independence from the client and complete
fidelity to the public is very difficult to achieve in practice, in
view of the competition for clients and the high fees they
generate.

These two sources of conflict of interest have led to proposals

—so far unimplemented—that auditing and consulting services
be provided by separate firms and that audits be publicly
funded.
2.d. Confidentiality

Accountants have a strict duty of confidentiality that prevents them from disclosing
information about a client without that client’s consent, except when required to do so by
law.

One such legal requirement is that an accounting firm that withdraws from an auditing
engagement because of suspected wrongdoing by the client must file a report with the SEC
detailing the reasons for the withdrawal.

However, any other information about suspected wrongdoing should not be disclosed to
other parties, including any companies that are harmed by the wrongdoing or another
accounting firm that takes over the engagement.

An example of the difficulties that a duty of confidentiality creates is provided by the

experience of Arthur Andersen in the late 1960s.
Example:

After an Arthur Andersen team audited Fund of Funds and found no problems,
the same team began an audit of King Resources, which had business dealings
with Fund of Funds.

The auditors discovered that King Resources had sold properties to Fund of
Funds at inflated prices.

If Andersen informed Fund of Funds of the fraud, then King Resources might
sue for breach of confidentiality.

However, if Andersen said nothing, then Fund of Funds might sue Andersen for
concealing the information. Andersen chose the latter course and was
successfully sued by Fund of Funds for failing to disclose the inflated prices.
2.e. The Expectations Gap

The ability of auditors to detect fraud and other wrongdoing is limited by what
auditors are expected to do and what they can reasonably accomplish. An audit
conducted according to GAAS is not intended to be a forensic audit to uncover
fraud; rather, it is designed to provide reasonable assurances that a company’s
records are accurate representations.

Auditors examine the records prepared by the company’s own accountants,

and they test only selected transactions. If a company’s accounting system is
judged to be adequate, then less effort is expended in testing.

A “clean” or unqualified opinion attests only the accuracy of the company’s

books and not to the company’s solvency or future prospects.
2.f. Executives and Directors

The main locus of decision making in corporations is in director

boardrooms and executive suites.

Accordingly, directors and executives, especially the chief

executive officer (CEO), play a critical role in ensuring corporate
accountability.
Example:

Although the Enron board of directors included many distinguished, competent,

and diligent individuals and exemplified many good corporate governance
practices, its members twice voted to rescind the company’s conflict-of-interest
policy so that the chief financial officer (CFO), Andrew Fastow, could serve as the
managing partner of several special purpose entities.

These off-balance-sheet partnerships not only allowed Fastow to enrich himself at

the expense of Enron shareholders but also created enormous risks of which the
board was apparently unaware.

The twin failures of the board of directors to exercise its proper oversight role and
of the CFO to avoid flagrant conflicts of interest were major causes of Enron’s
collapse.
Another cause of the massive fraud at Enron lay with its other
top executives, including the CEO, Jeffery Skilling, and the chair
of the board, Kenneth Lay.

Skilling was convicted in 2006 of 19 counts of conspiracy,

insider trading, obstruction of justice, and securities fraud and
was sentenced to more than 24 years in prison, later reduced to
14.

Lay was convicted in a joint trial with Skilling of 10 criminal

charges, with a likely prison sentence of 20 or 30 years, but he
died before his scheduled sentencing.
The example of Enron illustrates that top executives may be not
only weak points in ensuring accountability in a corporation but
also important subjects of accountability systems.

Systems must be in place to ensure the accountability of both

boards and executives as well as the effectiveness of