The Crisis And Its Effects On Corporate Governance
September 24, 2009

 

 

Author: Jose Antonio Quesada. Member’s of IMEF’s National Technical Committee on Corporate Governance and Legislation

 

The effects of the crisis are obvious.  One of the primary reasons for this setback has been the lack of rigor shown by company administrators.   Additionally - the powers that be - assumed that many problems would fix themselves based on the free-market theory, and that self-regulation would produce the necessary changes, assuming that setbacks would be caused by "market inefficiencies", and would disappear naturally from the system.   

 

Appealing to the people's ethics, or a change in corporate culture, sounds right, but, unfortunately, it is not enough. It is necessary to define and implement more thoughtful models that are less vulnerable to the effects of actions intended to obtain immediate profits and engage in speculative transactions. Previously, stakeholders looked for self-control, balance, value and guarantees. Now, their priorities are stability, solvency, effectiveness and transparency. 

 

HIGH-ALERT ISSUES

There are various high-alert issues related to corporate governance as a result of this crisis. Firstly, there is the definition of the purpose of the publicly-traded company as the creation of value for stakeholders, in the understanding that this refers to the immediate increase in the stock price.   How can a corporation’s mission be linked to stock market volatility? A company’s purpose is neither to satisfy the stakeholders’ interests nor the algebraic sum of the interests of all the stakeholders at a given time.  Rather, its purpose is the continuity of a medium and long-term strategic project with self identity.   

 

Secondly, there is the belief that the internal balance of powers in the company is almost infallibly achieved, through the implementation of a mechanical structure based on managerial cost models that embody good governance techniques: board members’ quotas (mostly external, independent among external) and a predetermined formal structure of bodies and regulations (the Board; intermediate bodies; committees for compensations, risk policies, auditing, and corporate practices, among others; the President of the Board; and internal regulations). 

 

FINDINGS

The crisis has confirmed that the managing directors must not control the Board, as previously occurred; in addition, it has revealed that external independent board members do not ensure having a healthy and efficient Board. In light of the demagogy regarding the use of corporate governance, it is obvious that having many independent members on the Board is immaterial, and that it is much more important to have members with corporate and sector experience and sufficient capacity to analyze and decide on proposals.   The Board must have qualified and capable personnel, even if these are retired directors, working executives or "other external advisors", provided that they know the risks of the business in depth. 

 

Another lesson that can be learned from this crisis is the need for the Board to efficiently separate the ownership and management in company decision-making.  For the Board of Directors, it is essential that their role as representatives of the stakeholders (ownership) be more important than their role as executives (management). 

 

For publicly-traded companies around the world with influential stakeholders, and large firms where institutional investors control most of the equity, it would be advisable for these important stakeholders to be part of the Board, or be represented by the individuals appointed by them, in the understanding that such people will be qualified and capable.  In other words, the model seeks to have a Board consisting of stakeholders, as opposed to the classical Board of self-sufficient executives (many of whom believe they own), or the useless and utopian Board of independent members. 

 

RESPONSIBILITY

The administrators' formal responsibility is enormous and increases during crises, due to the following: 

 

-          Diversification of activities beyond the corporate purpose established, without prior authorization from the stakeholders

-          Increase in the number of financial risks and contracting of excessive liabilities.

-          Declaring or not declaring even though they should, the company’s bankruptcy or the responsibility of those who ask for the refinancing of the debt, in order to conceal insolvency or the lack of cash flow or the responsibility of those who grant uncollateralized financing. 

-          Facing and deciding on issues that may cause the Company not to be considered a going concern and its subsequent filing for bankruptcy. 

 

 

CHANGES

Considerations related to the implementation process: 

-          The stakeholders need no reforms to the financial legislation (Robert Cyran; May 20, 2009). 

-          The financial crisis, in most cases, makes reform more difficult rather than favoring it. 

-          Large-scale reforms do not work in either advanced or in low-level democracies; such reforms are only useful in intermediate democracies. 

-          These reforms result in winners and losers (intended to reduce resistance to the change). 

 

 

 

However, this responsibility must be distributed correctly: it would be impossible to implement the legal dogma of joint liability for the Board members. Most of the decisions of the Board of Directors are predetermined by the management team, which is liable in the case of fraud or negligence (the Securities Law of the Mexican Banking Commission clearly differentiates between the Board of Directors and management. 

 

Liability for almost all corporate decision-making corresponds to the managing directors (management committee, general directors and assistant general directors, among others), and not to the board members whose function consists of supervising and controlling, but not of managing the company. 

 

CONFLICTS

Conflicts between corporations and majority stakeholders or control groups are a crucial issue barely addressed by the reports and the Code of Corporate Best Practices.  The government and regulatory bodies must first consider whether it is in the public interest for the economy’s strategic sectors (energy, banking and telecommunications, among others) to continue to be open to investment by international competitors as now they are. 

 

It is likely that many people may not understand how the public sector can be managed by people with ties to the current government before becoming state companies or entities controlled by the political power of foreign countries.   An example of the latter is the nationalization of the banking system and the subsequent sale of the primary Mexican banks to foreign financial entities.  The majority stakeholder, as well as the primary stakeholders, must think about the speculative strategies that have often led to investments in sectors that have nothing to do with the company’s business purpose driven by exorbitant debts, so as to, in most cases, consolidate third-party balances and conceal its own negative financial position.  These decisions may also be influenced by the vulnerability of uncollateralized financing.  

 

Today, many of the loans are hanging by a thread, since the terms for replenishment of guarantees and termination due to bankruptcy, because of radical changes in the market conditions or solvency ratios, give the financing institutions the option (and, in certain cases, the obligation), to stop cash flows at any time.  They can also advise administrators involved in speculative transactions, to reconsider their advisability, under their own responsibility. 

 

Once the majority stakeholder is part of the Board, he must be aware that his interests are subordinated to those of the company and that he cannot abusively exercise either his right to information or any other right established by the legislation.  In addition, he cannot use his position to promote related atypical transactions, nor may form part of the Board of Directors, in the event of any conflict of competence or structural interest. 

 

Also, he cannot disclose self-reserving market tips or publish relevant confusing material.  Companies are united and joined by a strategic project that is approved by the Board, ratified by the stakeholders' board, and with the prior support of the majority of the stakeholders: in the event that the referred stakeholder is a competitor, or has interests opposed to those of the company (which frequently occurs in large companies, particularly in the case of manufacturing companies), the law, as a general rule, does not allow such stakeholder to participate in the management of the company or to act as counselor, since he may not meet the trust, loyalty and confidentiality requirements, to which the administrators are subject. In the event that stakeholders want to obtain more, they must pay the control premium, through a Public Stock Offer (OPA, Spanish acronym). 

 

IN CRISIS

The existence of independent advisors is currently in crisis, and joint and several liability of administrators is under discussion.   In addition, the limitation of the stakeholders’ voting rights may be reviewed, especially when there is a conflict of interest between the stakeholder and the company.  In this case, it would be logical for the voting right for this stakeholder to be limited or, even, in the defense of all of the other stakeholders, for this stakeholder to be excluded from the vote whenever it involves an issue that explicitly shows the aforementioned conflict. 

 

These are the issues on the corporate governance agenda. There is nothing new.   

 

“The crisis has confirmed that the managing directors must not control the Board, as previously occurred". 

 

 

 

Author: Jose Antonio Quesada. Member’s of IMEF’s National Technical Committee on Corporate Governance and Legislation. This article does not represent FEI or IMEF opinion unless specifically noted above.