current developments in corporate governance tarp, bailouts, and bonus payments— how should...

Current Developments in Corporate Governance

TARP, Bailouts, and Bonus Payments—How Should Internal Audit Groups Address Current Issues?

James K. Carter CIA CPA

Current Topics in Corporate Governance James K. Carter CIA CPA


• Correction to Bio– Currently:

Accounting InstructorEast Central CollegeUnion, Missouri


Today’s Agenda• Back to the basics: What is Corporate

Governance?• Current Issues in Corporate Governance• Internal Audit’s Role in Corporate

Governance• Strategies for Implementing Internal

Audit Corporate Governance Reviews


Quick Poll

• Number of people from a publicly traded company? Private? NFP?

• Number of people from an entity which received any type of government bailout fund?


Back To The Basics…Corporate Governance Definition:• Corporate governance is the set of processes, customs,

policies, laws, and institutions affecting the way a corporation (or company) is directed, administered or controlled. (Wikipedia)– Corporate governance also includes the relationships

among the many stakeholders involved and the goals for which the corporation is governed.

• Also: The relationship between all the stakeholders in a company. This includes the shareholders, directors, and management of a company, as defined by the corporate charter, bylaws, formal policy and rule of law. (Investopedia)


‘Stakeholders’ Includes:• The Regulatory

Body– Chief Executive

Officer– Board of Directors– Management– Shareholders– Auditors

• Other Stakeholders– Suppliers– Employees– Creditors– Customers– The Community At

Large


What’s New?!?

This definition has not changed. What HAS changed is the corporate environment--especially over the past few

years…


Current Issues• Sarbanes Oxley Act of 2002• Emergency Economic Stabilization Act of

2008• Troubled Asset Relief Program of 2008

(TARP)• Bailouts and Buyouts of troubled companies

and industries

(we’ll come back to these in a few minutes)

Media…

Scott Adams is so great at pointing out the extremes of our issues…


Corp Gov DefinitionIn A Board Culture of Corporate Governance, (by Gabrielle O'Donovan) corporate governance is described as 'an internal system encompassing policies, processes and people, which serves the needs of shareholders and other stakeholders, by directing and controlling management activities with good business savvy, objectivity, accountability and integrity. Sound corporate governance is reliant on external marketplace commitment and legislation, plus a healthy board culture which safeguards policies and processes‘ (emphasis added)


Corp Gov Themes• An important theme of corporate governance is to ensure

the accountability of certain individuals in an organization through mechanisms that try to reduce or eliminate the principal-agent problem

• A related but separate thread of discussions focuses on the impact of a corporate governance system in economic efficiency, with a strong emphasis on shareholders' welfare

• There are yet other aspects to the corporate governance subject, such as the stakeholder view and distinct corporate governance models in other parts of the world


Corp Gov Themes (continued)• O'Donovan goes on to say

– ‘The perceived quality of a company's corporate governance can influence its share price as well as the cost of raising capital.

– Quality is determined by the financial markets, legislation and other external market forces plus how policies and processes are implemented and how people are led.

– External forces are, to a large extent, outside the circle of control of any board.

– The internal environment is quite a different matter, and offers companies the opportunity to differentiate from competitors through their board culture.

– To date, too much of corporate governance debate has centered on legislative policy, to deter fraudulent activities and transparency policy which misleads executives to treat the symptoms and not the cause.'


Corp Gov Themes (continued)

Therefore, Corporate Governance is also a system of structuring, operating and controlling a company with a view to achieve long term strategic goals to satisfy shareholders, creditors, employees, customers and suppliers, and complying with the legal and regulatory requirements, apart from meeting environmental and local community needs.


Corp Gov International Themes• In India, a SEBI committee on Corporate Governance

defines corporate governance as:

– the acceptance by management of the inalienable rights of shareholders as the true owners of the corporation and of their own role as trustees on behalf of the shareholders. It is about commitment to values, about ethical business conduct and about making a distinction between personal & corporate funds in the management of a company.”

– The definition is drawn from the Gandhian principle of trusteeship and the Directive Principles of the Indian Constitution. Corporate Governance is viewed as ethics and a moral duty.


Delegation of Authority in Corp Gov• In corporations, the shareholder delegates decision rights

to the manager to act in the principal's best interests.

• This separation of ownership from control implies a loss of effective control by shareholders over managerial decisions.

• Partly as a result of this separation between the two parties, a system of corporate governance controls is implemented to assist in aligning the incentives of managers with those of shareholders.

• With the significant increase in equity holdings of investors, there has been an opportunity for a reversal of the separation of ownership and control problems because ownership is not so diffuse.


Delegation of Authority (Cont’d)

The Board of Directors often plays the key role in corporate governance. It is their responsibility to endorse the organization's strategy, develop directional policy, appoint, supervise and remunerate senior executives and to ensure accountability of the organization to its owners and authorities.


Board of Director FunctionsBoard functions that generally are retained by the board and

are central to their focus include:

• Selecting, monitoring, evaluating, motivating and compensating, and when necessary replacing the CEO and other key members of senior management;

• Monitoring corporate performance and assessing whether the corporation is being appropriately managed by the senior management team;

• Providing strategic guidance to the senior management team and reviewing and approving financial objectives and major corporate plans and actions;

• Developing corporate policy;• Reviewing and approving major changes in auditing and

accounting principles and practices;


Board Functions (continued)

• Overseeing audit, internal controls, risk management and ethics and compliance;

• In a public company, overseeing financial reporting and related disclosures;

• Declaring dividends and approving share repurchase programs;• Making decisions on major transactions and other material

events• concerning the corporation for submission to the shareholders

for approval; and• Performing any other functions prescribed by law, regulation or

listing rule, or the corporation’s certificate of incorporation or bylaws.

(from Report of the Task Force of the ABA Section of Business Law Corporate Governance Committee On Delineation of Governance Roles & Responsibilities)


Shareholder InfluenceA number of factors have given rise to the greater influence of

shareholders:

• The growth of pension funds with inherent long-term obligations and investment horizons, which led them to focus on the governance of companies in their portfolios;

• Changes in SEC regulation in 1992, coupled with technological innovation (internet) that respectively, removed legal barriers and eased the ability of institutional investors to communicate with one another and coordinate efforts;

• Clarification by regulators that pension fund and mutual fund fiduciaries• have a fiduciary duty with respect to the voting rights associated with

the portfolio;• Regulations that require mutual funds and investment advisors to

disclose voting policies;• Increasing reliance by mutual and pension funds on proxy advisors

(who have business incentives to support increased areas for shareholder consideration and voting);


Shareholder Influence (continued)• Revision of the SEC’s position on executive pay issues related to ordinary

business and the resulting focus of shareholder proposals on compensation issues and expanded executive compensation reporting requirements, which require greater pay disclosure and explanation;

• Moves by an increasing number of companies (especially large cap companies) to replace plurality voting with majority voting for uncontested director elections, putting teeth into shareholder campaigns (often recommended by proxy advisors) to withhold votes from or vote against re-electing directors (and with the recent abolition of broker discretionary voting in uncontested elections, these shareholder campaigns may achieve greater success);

• Increased sophistication and organization of shareholders in voicing their concerns, positioning for negotiation and engaging media attention through focus lists, against and withhold vote campaigns for directors, shareholder proposals, and proxy contests;

• Increased media and public attention to governance issues due to a number of high profile governance failures and scandals, and increased legislative and regulatory receptivity to the imposition of reforms;

• The trend in removing classified boards and other anti-takeover devices (as evidenced, for example, by the reduced rate of poison pill adoption and renewal); and

• Lowered participation of individual shareholders in proxy voting due to e-proxies, which enhances the influence of institutional shareholders.


Shareholder PerceptionsAn area of considerable difference among shareholders relates to

variations in the time horizons of their investments:

• Insurance companies and public, private and union pension funds tend to maintain a relatively long-term focus in their investment activities.

• Mutual funds tend to invest on a much shorter-term basis, with an average holding period of significantly less than 2 years.

• Hedge funds also tend toward short-term strategies, with “a time horizon potentially measured in minutes.”


Current Themes• Report of the Task Force of the ABA Section

of Business Law Corporate Governance Committee On Delineation of Governance Roles & Responsibilities– Issued August 1, 2009– Examines whether, in the large U.S. public

corporation, the decision rights and responsibilities of shareholders and boards of directors are shifting, and, if so, the implications of any such shift.


Task Force Observations 1Significant governance reforms are currently under consideration by

Congress and the SEC, spurred by events leading to the financial crisis. Renewed concern that our society is deeply dependent on the continued health and viability of corporations for economic growth has heightened the scrutiny of current corporate governance practices.

The Task Force believes that the following observations are relevant to current and potential reform discussions:

• The traditional delineation of distinct roles and responsibilities of shareholders and boards of directors in the modern public corporation, as developed primarily through state corporate law, has helped position the U.S. public corporation as a powerful economic engine for the creation of wealth over the long term.

• Shareholders and boards of U.S. public companies have become increasingly active and engaged in their roles. Generally, this increased engagement has been a positive development, and is consistent with the traditional distinction in roles and responsibilities.


Task Force Observations 2• While tensions between the roles and, in particular,

the decision rights of shareholders and boards are apparent, to date the roles and responsibilities have not shifted to any significant degree.

• Effective corporate governance requires responsible conduct and informed judgments from shareholders and boards.

• Effective corporate governance also requires respect for the distinct roles of shareholders and boards in corporate decision making.


Task Force RecommendationsThe report summed its recommendations up as:

“Shareholders, boards and the executives to whom they delegate management authority and those involved in legislative and regulatory reform initiatives should give special consideration to the long-term nature of corporate wealth-generating activity and strive to avoid undue short-term focus and pressures that may impede the capacity of the corporation for long-term investments and decisions necessary for sustainable wealth creation.”


Task Force RecommendationsSpecifically, Shareholders should:• Act on an informed basis with respect to their

governance-related rights in the corporation, and form company-specific judgments regarding such matters while taking into account their own investment goals.

• Apply company-specific judgment when considering the use of voting rights and contested elections to change board composition.

• Consider the long-term strategy of the corporation as communicated by the board in determining whether to initiate or support shareholder proposals


Task Force RecommendationsBoards should:

• Embrace their role as the body elected by the shareholders to manage and direct the corporation by:

(a) affirmatively engaging with shareholders to seek their views;(b) considering shareholder concerns as an important data point in the development

and pursuit of long-term corporate strategy; and(c) facilitating transparency by ensuring that shareholders are informed of the

company’s efforts toward achieving its identified long-term goals and objectives.

• Acknowledge that, at times, the company’s long-term goals and objectives may not conform to the desires of some shareholders, and be prepared to explain board decisions nevertheless to pursue such goals and objectives to shareholders and the market.

• Disclose with greater clarity how incentive packages are designed to encourage long-term outlook and to reward steps toward achieving long-term strategies while discouraging unduly risky behavior.


Task Force RecommendationsPolicy Makers and Regulators:

• In the context of reform initiatives, understand the rationale for the current ordering of roles and responsibilities in the corporation and assess the impact of proposed reforms on such ordering.

• Carefully consider how best to encourage the responsible exercise of power by key participants in the governance of corporations so as to promote long-term value creation.

• Ensure that there is equal transparency of long and short, and direct and synthetic, equity positions of shareholders.


Another Current Study…“Political Connections, SEC Enforcement and Accounting

Quality”• Issued by The Rock Center for Corporate

Governance at Stanford University• Authored by Maria M. Correia• Issued on August 21, 2009


Political Connections Study ResultsAbstract

The study examines whether firms and executives that have built political connections through political contributions and lobbying face lower enforcement costs by the SEC. The study found that firms with low accounting quality have greater political expenses on average. They appear to increase these expenditures during the period of the misreporting and are more likely to target them to the Congressional Committees with stronger ties to the SEC during this period. This evidence suggests that these firms may be using political contributions to lower enforcement costs. In order to test the effectiveness of these payments, three different stages of the enforcement process were examined: the review of filings by the Division of Corporation Finance and the subsequent issuance of comment letters, the decision to begin an enforcement action against the firm or its executives and the monetary and non-monetary regulatory penalties faced by respondents in the enforcement action. Some evidence was found that politically connected firms are less likely to have a restatement initiated by a comment letter from the SEC, are less likely to be involved in an SEC enforcement action and face lower penalties on average.


Political Connections Study ResultsA key portion of the Conclusion states:

“I find strong evidence that firms may be using be using political expenditures to avoid investigation and prosecution by the SEC. In particular, I document an association between misreporting and political expenditures. Not only do misreporting firms contribute more on average but they are also more likely to target their political contributions to politicians serving on Committees with a strong relationship to the SEC. In addition, these firms exhibit a pattern of contributions over time that suggests that they are likely contributing on a transactional basis. In particular, they boost their political expenditures during the misreporting period.”


Back to Current News Headlines• Companies receiving bailout funds:

– continued sales incentive meetings to high-profile destinations

– continued taking customers to high profile events and destinations

– continued using corporate jets for executive travel to meetings and events

• Press and politician comments have effected business in travel locations


More Current Headlines

• Other issues include:– Executive salaries– Executive bonuses– Industry pay practices (Wall Street)– Opting out of bailout programs by

companies to avoid scrutiny

More Media…


Internal Audit’s Response?

• What is Internal Audit supposed to do?!?– What are your IA groups doing to

reduce the risk of reputational harm to your companies?


Internal Audit’s Response• Policy Reviews• Meeting, Travel and Other Reviews• Training on Reputational Risk in the

Current Regulatory and Political Environment

• Audits of Contributions (Political & Charitable)

• Audits of Executive Travel• Audits of Sales Incentive Programs• Other Audits and Reviews Specific to

Your Company and/or Industry


Coordination With Other Imperatives

• How does reducing reputational risk tie in with an organization’s Sarbanes-Oxley Act or other internal controls compliance?


• What are the key components that you believe should exist in an audit program to reduce the risk of violating good Corporate Governance principles?

Coordination With Other Imperatives


• How do you, as an internal auditor, approach senior management concerning implementing or expanding this type of audit program?

How To Implement


Questions?


[email protected]@EastCentral.edu

mailto:[email protected]

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