.What role does corporate culture play in risk-taking and accountability?

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Chapter Objectives

To define corporate • governance

To describe the history • and practice of corporate governance

To examine key issues • to consider in designing corporate governance systems

To describe the application • of corporate governance principles around the world

To provide information on the • future of corporate governance

Chapter Outline

Corporate Governance Defined

History of Corporate Governance

Corporate Governance and Social Responsibility

Issues in Corporate Governance Systems

Corporate Governance Around the World

Future of Corporate Governance

Corporate Governance C H A P T E R 3

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Fannie Mae and Freddie Mac: Poor Decisions Contributed to Crisis

O P E N I N G C A S E

Fannie Mae and Freddie Mac will go down in history as major players in the mortgage crisis. Fannie Mae is a stockholder-owned corporation created to purchase and securitize mortgages so funds are available to institutions that lend money to homebuyers. Freddie Mac buys and sells mortgages and resells them as mortgage-backed securities. This increases the money available for mortgage lending and home purchases. Both companies were encouraged by President Clinton and Congress to buy loans from banks that made higher-interest mortgage loans to low-income families (known as subprime loans). Yet with a lack of proper oversight, the companies mismanaged the situation and the government had to intervene during the 2008 mortgage crisis.

Before 2008, Fannie Mae and Freddie Mac guaranteed about half of the $12 trillion in the mortgage market. Yet with the economy in decline homeowners increasingly could not afford the mortgage payments on their houses. The shares of Fannie and Freddie plummeted as more houses were foreclosed on and fewer people were in the market to buy.

As early as 1999, the New York Times predicted that giving out subprime loans could cause trouble during an economic downturn, requiring government intervention. Yet the companies appeared to ignore these warnings. They donated large amounts to lawmakers sitting on committees that regulated their industry; and as late as 2007, the government passed new rules saying that Fannie Mae and Freddie Mac could buy $200 billion more in subprime loans. The prophetic warnings of critics came true during the next economic downturn, forcing the companies to regret their poor decisions.

However, Fannie Mae’s situation went beyond bad decision making. The company was also under investigation for accounting errors. Civil charges had already been filed against Fannie Mae’s CEO, CFO, and the former controller, who

allegedly manipulated earnings to increase their bonuses.

Similarly, in 2003 Freddie Mac announced that it had underreported earnings by over $5 billion, which was the largest corporate restatement in financial history. Three years later, it was forced to pay $3.8 million after it was revealed the company had been making illegal campaign contributions between 2000 and 2003.

In 2008, James Lockhart of the Federal Housing Finance Agency (FHFA) announced that Fannie Mae and Freddie Mac would be put into a conservatorship of the FHFA, using funds from the U.S. Treasury, as part of the government efforts to stem the hemorrhaging in the mortgage industry. CEOs Daniel Mudd and Ryan Syron were investigated for allegedly lying to investors about earnings, portraying Fannie Mae and Freddie Mac as being more stable than they were. Bad decisions and managerial misconduct clearly contributed to these companies’ downfall and to the financial crisis of 2008–2009.1

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9781133891710, Business and Society: A Strategic Approach to Social Responsibility and Ethics, Debbie M. Thorne – © Cengage Learning. All rights reserved. No distribution allowed without express authorization

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84 CHAPTER 3

B usiness decisions today are increasingly placed under a microscope by stake- holders and the media, especially those made by high-level personnel in publicly held corporations. Stakeholders are demanding greater transpar-

ency in business, meaning that company motives and actions must be clear, open for discussion, and subject to scrutiny. Although some organizations have oper- ated fairly independently in the past, recent scandals and the associated focus on the role of business in society have highlighted a need for systems that take into account the goals and expectations of various stakeholders. To respond to these pressures, businesses must effectively implement policies that provide strategic guidance on appropriate courses of action. This focus is part of corporate gov- ernance, the system of checks and balances that ensures that organizations are fulfi lling the goals of social responsibility.

Governance procedures and policies are typically discussed in the context of publicly traded firms, especially as they relate to corporations’ responsibili- ties to investors.2 However, the trend is toward discussing governance within many industry sectors, including nonprofits, small businesses, and family-owned enterprises. We believe governance deserves broader consideration because there is evidence of a link between good governance and strong social responsibility. Corporate governance and accountability are key drivers of change for business in the twenty-first century. It is abundantly clear, to experts and nonexperts alike, that corporate governance is in need of immediate attention by a wide range of firms and stakeholders. The corporate scandals at firms such as AIG, Countrywide Financial, and Lehman Brothers represented a fundamental break- down in basic principles of the capitalist system. Investors and other stakeholders must be able to trust management while boards of directors oversee managerial decisions.

Late 2008 and 2009 marked the beginning of a crisis of confidence in global business, particularly in the financial industry. Some of the nation’s oldest and most respected financial institutions teetered on the brink of failure and were either bailed out or acquired by other firms. The 2008–2009 global recession was caused in part by a failure of the financial industry to take appropriate responsibility for its decision to utilize risky and complex finan- cial instruments. Loopholes in regulation and the failures of regulators were exploited. Corporate cultures were built on rewards for taking risks rather than rewards for creating value for stakeholders. The governance systems at many of these companies did not take into account the risks or how to provide adequate oversight to prevent misconduct. In some cases, managers looked for loopholes in the laws or in unregulated areas such as derivatives. Ethical decisions were based more on what is legal rather than what was the right thing to do.

Unfortunately, most stakeholders, including the public, regulators, and the mass media, do not always understand the nature of the financial risks taken on by banks and other institutions to generate profits. The intangible nature of financial products makes it difficult to understand complex financial trans- actions. Problems in the subprime mortgage market, which deals with giving higher-rate mortgages to people who do not qualify for regular credit, sounded the alarm in the most recent economic downturn.

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CORPORATE GOVERNANCE 85

In this chapter, we define corporate governance and integrate the concept with the other elements of social responsibility. Then, we examine the corpo- rate governance framework used in this book. Next, we trace the evolution of corporate governance and provide information on the status of corporate governance systems in several countries. We look at the history of corporate governance and the relationship of corporate governance to social responsibility. We also examine primary issues that should be considered in the development and improvement of corporate governance systems, including the roles of boards of directors, shareholders and investors, internal control and risk management, and executive compensation. Finally, we consider the future of corporate gover- nance and indicate how strong governance is tied to corporate performance and economic growth. Our approach in this chapter is to demonstrate that corporate governance is a fundamental aspect of social responsibility.

CORPORATE GOVERNANCE DEFINED In a general sense, the term governance relates to the exercise of oversight, con- trol, and authority. For example, most institutions, governments, and businesses are organized so that oversight, control, and authority are clearly delineated. These organizations usually have an owner, president, chief executive officer (CEO), or board of directors that serves as the ultimate authority on decisions and actions. Nonprofit organizations, such as homeowners associations, have a president and board of directors to make decisions in the interest of a community of homeowners. A clear delineation of power and accountability helps stakehold- ers understand why and how the organization chooses and achieves its goals. This delineation also demonstrates who bears the ultimate risk for organizational decisions. Sarbanes-Oxley and the Federal Sentencing Guidelines put responsibil- ity on top officers and the board of directors.

Although many companies have adopted decentralized decision making, empowerment, team projects, and less hierarchical structures, governance remains a required mechanism for ensuring continued growth, change, and accountability to regulatory authorities. Even if a company has adopted a consensus approach for its operations, there has to be authority for delegating tasks, making tough and controversial decisions, and balancing power throughout the organization. Governance also provides oversight to uncover and address mistakes, risks, and misconduct. Consider the failure of boards at Enron, AIG, and Tyco to address risks and provide internal controls to prevent misconduct.

We define corporate governance as the formal system of oversight, account- ability, and control for organizational decisions and resources. Oversight relates to a system of checks and balances that limit employees’ and managers’ oppor- tunities to deviate from policies and codes of conduct. Accountability relates to how well the content of workplace decisions is aligned with a firm’s stated strategic direction. Control involves the process of auditing and improving orga- nizational decisions and actions. The philosophy that is embraced by a board or firm regarding oversight, accountability, and control directly affects how corpo- rate governance works.

corporate governance the formal system of oversight, accountability, and control for organizational decisions and resources

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86 CHAPTER 3

Corporate Governance Framework The majority of businesses and many courses taught in colleges of business operate under the belief that the purpose of business is to maximize profits for shareholders. In 1919, the Michigan Supreme Court in the case of Dodge v. Ford Motor Co.3 ruled that a busi- ness exists for the profit of shareholders, and the board of directors should focus on that objective. On the other hand, the stake- holder model places the board of directors in the central position to balance the interests and conflicts of the various constituencies. External control of the corporation includes government regulation, but also includes key stakeholders such as employees, consumers, and communities, who exert pressures for responsible conduct. Many of the obliga- tions to balance stakeholder interest have been institutionalized in legislation that pro- vides incentives for responsible conduct. The

Federal Sentencing Guidelines for Organizations (FSGO) provides incentives for developing an ethical culture and efforts to prevent misconduct. At the heart of the FSGO is the carrot-and-stick approach: By taking preventive action against misconduct, a company may avoid onerous penalties should a violation occur. Sarbanes-Oxley legislation holds top officers and the board of directors legally responsible for accurate financial reporting.

Today, the failure to balance stakeholder interests can result in a failure to maximize shareholders’ wealth. General Motors and Chrysler failed to understand customer needs, employee reactions to downsizing, and government regulatory issues. This resulted in both companies failing to achieve shareholder goals. Most firms are moving more toward a balanced stakeholder model, as they see that this approach will sustain the relationships necessary for long-run success.

Both directors and officers of corporations are fiduciaries for the shareholders. Fiduciaries are persons placed in positions of trust who use due care and loyalty in acting on behalf of the best interests of the organization. There is a duty of care, also called a duty of diligence, to make informed and prudent decisions.4 Directors have an obligation to avoid ethical misconduct in their role and to provide leader- ship in decisions to prevent ethical misconduct in the organization. Directors are not held responsible for negative outcomes if they are informed and diligent in their decision making. Ford’s directors can be held responsible for the accuracy of financial reporting, however. Manufacturing cars that lose market share is a serious concern, although it is not a legal issue. This means directors have an obligation to request information and research, use accountants and attorneys, and obtain the services of consultants in matters where they need assistance or advice.

“The philosophy that is embraced

by a board or firm regarding

oversight, accountability,

and control directly affects how corporate

governance works.”

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CORPORATE GOVERNANCE 87