Would Corporate Governance Restrain the Delinquent Activities of Company Directors?

Would Corporate Governance Restrain the Delinquent Activities of Company Directors?

 

Introduction

            Companies or business organizations encounter and address a variety of issues everyday. These issues range from addressing business and marketing plans, customer service, employee management, internal and external conflicts, profit generation, and control and regulation. To address these issues, companies need different strategies and plans to ensure the sustenance and maintenance of their operation and production.

            However, the operation of any business organization is not as simple as it looks. Theoretically, companies must operate effectively to gain profit and to provide products or render service to consumers. Hence, business organizations are being comprised of teams that perform different functions to somehow make its operation simpler and better. In line with this, though, not all business organizations or companies achieve a smooth-sailing operation, for with the presence of different cultures, personalities and motives in the company, decision-making and governance is largely affected and altered. For this reason, good leadership strategies will be most useful, in encouraging teamwork and compliance from employees or colleagues.

With the presence of differences, many conflicts are being generated, which could entirely disrupt the company’s operation. One major conflict that could happen in the company is when a leader or group of leaders fails to meet the expectations of their subordinates or commit abusive acts that violate the rights of every individual in the business organization. For this matter, this paper discusses the application of corporate governance and regulation in targeting and restraining the delinquent activities of company directors. The concept of corporate law and corporate governance will be discussed, in relation to the duties of directors in the company and some rules or laws governing business organizations. In addition, a specific case will be related in reference to the concepts and issues.

 

Corporate Governance Mechanism

            To understand the importance and the significance of corporate governance and regulation, it is best to define and examine first the systems that it is applied to, which pertains to corporations or business organizations.

               (2007) reports that in a general sense, a corporation is a business entity that is may be made up of a single person or a group of people, known as sole corporations or aggregate corporations, and given many of the same legal rights as an actual person. They exist as virtual or fictitious persons, granting a limited protection to the actual people involved in the business of the corporation, with the limitation of liability as one of its many advantages (2007). Limitation of, or limited liability means that the shareholders of a corporation generally do not have any legal responsibility beyond the capital they have contributed to the corporation in return for their shares, and is the attribute most laypeople associate with the corporate form (2004). With the composition of corporations, it is evident that to be able to govern this organization efficiently and effectively, it would be necessary to implement regulations and laws that would grant each individual in the organization their rights and privileges. Granting them their rights and privileges would allow them to grow and develop individually and increase their contribution for the improvement of the corporation. To be able to do this, corporations and business organizations must be able to understand the essence of corporate law.

            Corporate law or corporations law is the field of law concerning the creation and regulation of corporations and other business organizations, which includes the law governing the relationships among various constituents of a corporation, such as shareholders, directors and management. It also includes securities laws that govern the conditions under which corporations can issue shares and is aimed at preventing fraudulent offering schemes (2006). From this definition, it is evident that the range and scope of corporate law is wide, that it encompasses laws that govern the interrelationship of the important players in the field of business. The existence of corporate law would be beneficial, for it enables key players to subsist harmoniously with one another, in reference to a variety of regulations and to their common goal or objective. The corporate law has several functions, and according the(2004), the central issue for corporate law is how to meditate three kinds of agency conflicts, namely, conflicts between managers and shareholders, conflicts between majority and minority shareholders, and conflicts between the firm and third parties. Because corporate law governs the relationship of the key players of corporations, it is essential that each key player should be strictly complying with the regulation to ensure a harmonious relationship. Managing conflicts between managers and shareholders would ensure effective and sustainable interrelationship, for the continuous growth and development of the company. Managing conflicts between minor and major shareholders would help maintain and sustain the resources needed by the corporation and its employees, while managing conflicts between the organization and third parties would enable the corporation to adapt with competition through proper business planning and management. With these functions and importance in mind, corporations will be able to efficiently sustain its operation and resources.

            In line with corporate law is the concept of corporate governance, which is a set of processes, customs, policies, laws and institutions affecting the way of corporation is directed, administered or controlled, and includes the relationships among the stakeholders and the goals for which the corporation is governed. Its principal players are the shareholders, management and the board of directors, where stakeholders include employees, suppliers, customers, banks and other lenders, regulators, the environment, and the entire community (2006). In addition, it deals with issues of accountability and fiduciary duty, essentially advocating the implementation of guidelines and mechanisms to ensure good behavior and protect shareholders. It focuses on the economic efficiency view, which aims to optimize economic results, with a strong emphasis on shareholders welfare. It is also used to monitor whether outcomes are in accordance with plans, to motivate the organization to be more fully informed to sustain or change organizational activity, and to support their actual behaviors with the overall participants ( 2006). In addition,  and (1995) reports that the term corporate governance was coined to answer the issues regarding corporate fraud and corporate collapse, and to address the greediness of bosses or managers. The salaries of senior managers have risen far faster than earnings generally, and their pay has been enhanced by share option packages, which allow them to buy shares in the company at a future date for a figure around the current price. Consequently, it made many salaried managers to become very rich and have generous payoffs, while security of employment for most workers has been reduced.

            The problems mentioned enable each corporation and business organizations to put in mind and to examine the fiduciary duties and responsibilities of directors or managers. (2003) emphasizes that courts have established a framework for interpreting fiduciary duties with respect to corporate decisions and established standards by which to judge when directors have fulfilled or failed to fulfill these duties. The framework is discussed as follows:

• Meaning of Fiduciary Duties – Directors of corporations owe duties of care and loyalty to the corporation and its shareholders, which requires the board of directors to act in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and in upholding the best interest of the corporation and its shareholders (2003).
• Duty of Care – The duty of care is subjective as it recognizes that the duty varies based on the director’s qualifications and the nature of the company. It is also objective, for it requires of the director, values of honesty, diligence, common sense, informed judgments and reasonable actions (2003).
• Duty of Loyalty – This requires directors to exercise their powers in relation to the corporation’s interests and not in their own interests or of any other person in the corporation (2003).
• Courts’ Standard for Judging Potential Violations – In the event that directors are accused of violating their fiduciary duties, courts review their actions in accordance with the Business Judgment Rule or BJR, which requires courts to give respect to decisions by directors who have carefully exercised their business judgment (2003).
• Standard for Determining Whether the BJR will Apply – The standard rests on whether or not directors follow appropriate procedures in analyzing a corporate decision and give substantive attention to the key features of the decision (2003).

With these fiduciary duties in mind, corporations and even directors themselves will be able to attain appropriate outcomes, such as the financial security of the organization, and the expression of a moral and social responsibility to the members and the community at large ( 2002). However, despite this, some directors still commit violations in the company, which affects the entire corporation or organization. Due to the existence of these violations, one specific case has become the basis for laws regarding the violations of the fiduciary duties of directors and corporate law. This specific case is the Foss v. Harbottle case, where two minority shareholders initiated legal proceedings against their company directors, and claimed that the directors had misapplied the company’s assets. Although the court dismissed their claim and held that when its directors wrong a company, only the company itself has the standing to sue, the court established two rules: 1) the proper plaintiff in an action in respect of a wrong alleged done to a company is prima facie the company itself, and 2) where the alleged wrong is a transaction, which might be made binding on the company on all its members by a simple majority of the members, no individual member of the company is allowed to maintain an action in respect to that matter for the simple reason that if a mere majority of the members of the company is in favor of what has been done then cadit quaestio, the matter admits of no further argument (2006). However, although these rules were developed and implemented, the abuse of authority of directors in some corporations was not halted, and this largely affects the operations of companies as a whole. This is because the rules developed from the case is said to have some loopholes. It has been reported that if the first rule was not made, every member of an organization would be able to sue any director, officer or shareholder alleged to have enriched themselves at the company’s expense, and there might be as many bills in equity as there are shareholders multiplied into the number of defendants (2006). In essence, the company has the discretion of suing the director who has committed violations, based on the decision of the majority of its Board. If ever everybody in the corporation has the power to sue directors easily, then the higher authorities in the organization will not be able to exercise their power in relation to decision-making. Although each employee has his or her own free will, each is still bound by the rules and regulations of their company.

Moreover, in relation to the second rule developed under the Foss v Harbottle case is the majority rule principle, which requires making decisions that are made by voting with a majority determining the position of the entire group, resulting to prompt and clear decisions ( 1998). Despite the advantages of using this process, in some instances, this could also be seen as disadvantageous for if ever the majority of the Board of Directors decides on not pursuing a case on one of its members, then the whole corporation will suffer. This process depends on the motives and opinions of the members of the organization, and if for instance, every member has selfish motives in the company along with the violator, then restrictions and sanctions will not apply.

Because of these incidences, it is important to note the importance of restraining the delinquent activities of company directors. Primarily, delinquent activities refer to actions that are opposite the norms or practices of the organization. Having a negative connotation, delinquent activities are often referred to in relation to morality and social practices. This is why, in the corporate setting, delinquent activities must be curbed and restrained. Primarily, delinquent acts and practices must be controlled to be able to uphold the common aim or goal of the company. In doing delinquent acts, the mission and vision of the organization is being neglected. Second, lessening delinquent acts enable directors to serve as models for all employees of the organization. In doing so, the rest of the employees in the corporation will also be able to do what is right for themselves and for the company. Third, restraining such acts lessens the existence of pragmatism in the company, for pragmatism contributes to the diversity in the organization. In addition, reducing pragmatism lessens the difficulty of employees in accomplishing the company’s goals and objectives. Fourth, restraining delinquent acts helps sustain and maintain the organization’s effective and efficient operation. Fifth, it provides employees with adequate resources, for their needs will be provided efficiently by the company, without the hassle of setting aside for the greedy intentions of the directors. In relation to this is the allocation of resources for compensation, incentives, and rewards, which contributes and encourages the motivation of employees in an organization (1997). In addition, providing these compensations would increase the productivity of employees, thus, increasing the productivity and sales of the whole company. Seventh, reducing the incidence of delinquent cases enable the corporation to put more effort and time to other more important problems or crises being faced by the company. Eighth, the reduction of delinquent acts of directors would promote “care” of the employees, which would allow them to grow and develop individually. This would ensure the growth and improvement of the corporation as well, for the employees will also give back the care they have received from their director and the management. Ninth, restraining delinquent acts shows the loyalty of the director to the company, which entitles him or her for a higher position and more compensation. This would also entitle the director privileges, as rewards for his or her loyalty, which is more favorable on the director’s part. Tenth, restraining the delinquent activities of the director would ensure better rendering of service to the consumers of the corporation, and lastly, it enhances the effective and efficient communication and teamwork of the employees in the corporation, as each perceives the director to be a credible and reliable individual in dissipating information and knowledge within the corporation. From the given reasons and benefits of curbing the delinquent activities of directors in a corporation, an effective enforcement must be adopted.

An effective enforcement would be the implementation of the provisions of the Companies Act 2006, which replaces and codifies the principal common law and equitable duties of directors, with an emphasis on their corporate social responsibility (‘Companies Act 2006’ 2006). Seven codified duties are being emphasized:

• Act within the directors’ powers – abiding by the terms of the corporation’s memorandum and articles of association and decisions made by the shareholders
• Promoting the success of the company – directors must promote actions that benefits the shareholders as a whole, in terms of long-term consequences of decisions, interests of employees, fostering the company’s business relationships with suppliers, customers and others, making an impact on the community and the environment, maintaining a reputation for high standards of business conduct, and acting fairly among members
• Exercising independent judgment – directors must not restrict action in relation to pursuing agreement entered by the company
• Exercising reasonable care, skill and diligence
• Avoiding conflicts of interest
• Not accepting benefits from third parties
• Declaring an interest in a proposed transaction with the company

The effective enforcement of this new Act enables the directors of corporations and business organizations to efficiently evaluate their duties and responsibilities, which would contribute to their effective performance. Upholding these guidelines would make somehow lessen the delinquent activities of directors, thus, resulting to a more productive and efficient corporation.

 

Classical Difference between Both Legal Systems

            From the definitions and discussions above regarding the concepts underlying corporate governance mechanisms, it would be essential to take note of the differences of both legal systems, namely corporate law and corporate governance. According to “contractarians”, corporate law has no function other than as an approximation of the bargain the parties would have struck themselves had transaction costs not prevented negotiation and memorialization of the deal, and is nothing more than a series of default rules, an off-the-rack vehicle, whose features are binding on no one (1995). It was said to address the conflicts between the important players of the corporation, in accordance to attaining the corporation’s common goals and objectives. On the other hand, corporate governance refers to set of process, practices and laws in directing a corporation, and this encompasses corporate law as a whole. While corporate law addresses the management of conflicts among the important players of the corporation, corporate governance does the same, but has a larger scope, including the entire community.

            From this, it can be seen that both legal systems tackle the management of conflicts and the operation of the corporation as a whole. However, the use of corporate law is more specific than corporate governance. In addition, due to this difference, corporate law can be regarded as limited in scope and range, compared to corporate governance, which encompasses a variety of functions. In addition, corporate law is selective, as it only includes conflict management, compared to corporate governance. Moreover, the implementation of the new Companies Act 2006 underlying corporate governance is an additional development that would enhance the duties and responsibilities of directors toward the corporation or business organization. In this light, it would be more beneficial if both legal systems would be used simultaneously, in sustaining the governance and the control of the whole corporation. Furthermore, the use of each legal system must be evaluated and based on the situation, as corporate law is more case specific than corporate governance.

            However, despite their differences, both legal systems also have their general trend of convergence. It has been reported that policy-makers and practitioners increasingly distinguish the role of company law as a means to enhance the functioning of the business sector, and increased attention is given to the design of company law from different perspectives ( 2006). These different perspectives include improving corporate competitiveness, ensuring access to human and financial capital, promoting entrepreneurial incentives, and improving capital or resource allocation (2006), and these perspectives are also being tackled by the corporate governance. In connection, corporate governance standards promote fairness, transparency, and accountability, which are essential to the sustainable development of the corporation. By regulating the relationship between management and shareholder, good governance acts as a source of competitive advantage advancing the growth of the whole corporation and the individuals or other business organizations involved with the corporation (2006). Similarly, these objectives are also the aims of the implementation of the corporate law, and with the convergence of the two legal systems, the management of the corporation will be improved and efficient. For this reason, corporations must be able to employ the use of both legal systems to their management, for with the combination of these systems, the whole corporation will have the advantage of addressing more problems more efficiently, and attaining their short-term and long-term objectives or goals effectively. Furthermore, the use of both legal systems would be beneficial, for they have a central role to play in the development of equity markets, which are essential in securing the property rights of shareholders. Strong legal protections safeguard shareholders, especially minority shareholders, from having their investments seized by insiders, such as directors, officers, entrepreneurs, and controlling shareholders ( 2004). As an answer to this, several laws and rules must be adopted and implemented by a corporation to uphold the rights of every individual in the organization.

 

Enron’s Collapse

            Enron Corporation was an American energy company based in Houston, Texas, and was one of the world’s leading electricity, natural gas, pulp and paper, and communications companies. It achieved infamy at the end of 2001, when it was revealed that its reported financial condition was sustained mostly by institutionalized, systematic, and creatively planned accounting fraud, which resulted to its notorious image and symbol of willful corporate fraud and corruption (2007). The decline of the sales and operation of the company was said to be caused by its use of complex partnerships to keep some $500 million in debt off its books and mask its financial problems so that it could continue to obtain cash and credit to manage its trading business (2002). In addition, the corporation lied about its profits and stands accused of a range of shady dealings, including concealing debts so they did not show up in the company’s accounts (2002). Due to this, the lawsuit against Enron’s directors, following the scandal, was notable in that the directors settled the suit by paying very significant amounts of money personally, and even caused the dissolution of the Arthur Andersen accounting firm, resulting to larger effects on the wider business world (2007), and the largest bankruptcy in American history (2002).

            Because of this issue, a variety of responses and opinions came to being. Primarily, Kenneth Lay, the chairman and chief executive of Enron who had been credited with the corporation’s success and was now widely blamed for its failure (2002), which is maybe due to his inefficiency and delinquent activities within the corporation. Secondly, the failure of the corporation was attributed to the decline of stock price as Internet-related and telecommunications companies fell out of favor with investors, and unknown to most observers, the falling stock price put increasing financial pressure on the company, which had used its stock to guarantee loans and other liabilities and to sweeten deals for outside lenders and investors ( 2002). Third, in relation to the recorded debt of the corporation, how much of the executives of the Arthur Andersen accounting firm knew of Enron’s activities is still unclear, but lower-level employees of the accounting firm complained to their superiors about improper accounting methods and Andersen himself shredded thousands of pages of documents relating to the case of Enron, which shows that the corporation paid almost no income taxes over five years by shuffling profits to different offshore locations ( 2002). In addition, Enron provided millions of dollars to finance Mr. Bush’s 2000 election campaign (2002). Moreover, another cause of the downfall is the cancellation of the corporation’s video-on-demand deal, which added to the risky deals Enron has made in underperforming investments of various kinds, began to unravel, causing it to suffer a huge cash shortfall ( 2002). The diversity in the opinion of analysts leads the public to conclude that all of these reasons contribute to the downfall and bankruptcy of the corporation. In addition, this diversity in opinion is also beneficial, as it enables many individuals to perceive the situation at different angles and scenarios that would make the investigation easier and faster. The variation and the many possibilities of the downfall of Enron should be identified and examined effectively, so that other corporations must learn from it. In this way, directors of different corporations would be warned of the possibility of bankruptcy, without the proper guidance and compliance from the various laws and rules of corporate law and governance.  

            However, despite the differences and diversity in opinions are the commonalities of the response. It has been reported that the description of the modern corporation provides valuable insight into the tendency toward financial fragility and the role of regulation, for the company’s most important asset is its expected future earning capacity, which is an intangible and volatile asset, whose price is determined by social expectations about the future (2005). In addition, the nature of this asset benefits the consolidation of market power, and through the mechanism of equity finance and stock market, the corporation is able to convert expectations of future profitability into contemporary purchasing power, which can be used to realize those expectations or to divert income ( 2005). This opinion can be applied to the management and operation of Enron, however, the corporation has undermined the regulatory processes needed to limit fraudulent corporate practice. Changes in the accounting industry from auditing toward consulting, allowed the growing involvement between the interests of management and the guardians of fair reporting, and changes the way managers are paid, such that the growth of stock options provide new incentive to engage in deceptive accounting practice and manipulate stock price ( 2005). From this, the downfall of Enron all boils down to criticizing the strategies of directors and other employees in earning large sums of money from their corporations, such that it involves delinquency activities that result to such unpleasant consequences. Although the bankruptcy of Enron is caused by a variety of reasons and events, the primary reason for the corporation’s downfall is the delinquent acts of certain individuals, such as Arthur Andersen himself, Kenneth Lay, and other authorities in the corporation. The case of Enron Corporation is one good example for other business organizations to effectively evaluate and implement rules and laws regarding corporate governance. From what happened to Enron, the directors of other corporations and business organizations will be able to do away with delinquent activities, which could lessen the threat of bankruptcy and other problems in the company.

            In line with this is the rule-based regulatory approach of the United States, which addresses fraud and other cases of improper behavior in the corporate world, and as a response to this, many individuals demand a law, more severe penalties, and more direct government regulation of financial service providers (2004). Applying more laws and rules on the corporate world would be beneficial, as these laws would restrict the delinquent activities of many directors and employees that would contribute to the downfall and decrease in the efficiency of the whole organization. Laws and regulations would also be advantageous, for they serve as guides on the behavior of the workers in the corporation. However, the danger with excessive regulation of directors is that business organizations will become dominated by a rules-reliant culture, to the extent that business activity will diminish significantly. If corporations and business organizations will spend their time generating and implementing rules, employees and workers will be limited in their actions, which would not allow them to grow and develop individually. In addition, without excessive rules, workers have more flexibility in making changes (2006) in several aspects of production and operation. This further improves and develops the ability of each worker to cope with changes and come up with creative ideas in providing solutions to problems. With excessive rules, each would rely too much on its provisions, limiting the potential of each to think for the growth of the company.

            In relation to this, is the Sarbanes-Oxley Act, which mandates substantive corporate governance consisting of the provisions that require independent audit committees, restrict corporations’ purchases of non-auditing services from their auditors, prohibit corporate loans to officers, and require executive certification of financial statements (2005). In the event that France and Germany will be adopting this act, it would be somehow applicable to their systems, as this act would lessen the tendency of directors to do illegal acts and obtain money from the corporation. Using these corporate governance provisions, corporations in countries like France and Germany will have the chance to lessen the number of corporate fraud and insolvency cases. However, this would also restrict the exercise of power and authority of directors in the company. In addition, the implementation of excessive rules would create an over-complex and prescriptive system that would be difficult to enforce, such that because of laws, each individual in the corporation will become stiffened by compliance to rules and regulations, limiting their potential to think critically regarding certain situations. With strict compliance to corporate rules and regulations, changes would be difficult to address, for workers perceive these rules as superior, and alterations would be incorrect or inferior. However, changes are important in any business organization, for these contribute to the growth and development of the company. Moreover, implementing excessive rules and laws would deeply undermine the traditional board autonomy, for this means the strict compliance to the rules being implemented, and involves coercion and compulsion from every employee in the corporation. It poses damaging effects on the rewards system, erodes employee pride, limits flexibility, and undermines motivation of employees who want to see how their job fits into a grand shared mission (2000).

            From the above arguments and evidences, it can be understood that the implementation of corporate laws and concepts in corporate governance involves high risks, which would somehow enable a corporation to come up with ways on how to cope with changes and the problems presented by the interaction of various factors in the business world. High-risk taking involves sacrificing some important values, principles, and objectives in the company, which are crucial and essential for the development and growth of the corporation. However, in line with high risks are high rewards for that certain risk. In relation to the above discussion, the high risk pointed out is the implementation of new corporate laws for the improvement of a corporation’s governance, and its high rewards include the attainment of short and long-term goals, the continuous development and improvement, and the sustenance of the whole corporation.

 

Conclusion

            From the discussion above, it can be deduced that although corporations and business organizations employ the use and observance of corporate laws and corporate governance, these two legal systems are said to be similar and at the same different, in relation to its scope and limitation. Because of this, both legal systems must be incorporated in the management of a corporation, to control, direct and assist in its aim to sustain and maintain its production and operation. Furthermore, with the cases and laws presented, it is evident that these laws are necessary to be adopted in a business organization to enable directors and employees work efficiently and effectively together and enhance communication and interrelations. However, these laws and rules must be evaluated and assessed carefully so that corporations will not be limited in its actions and decisions that would hamper its development and improvement.