The recent financial crisis has put the issue of corporate governance under more scrutiny. Businesses have expressed their intention to realign their activities and functions in order to survive financial crises while governments have come together to seek regulations that would prevent against future financial crises. It has been said that the major cause of the recent 2007-2009 global financial crisis were unsound corporate governance issues.
Grinstein et al (2008) notes “The credit bubble was not just a simple market failure, but a failure of business leadership, corporate governance and risk management, exacerbated by flawed incentive structures with banks.” G7 and G20 countries have been setting up meetings in a bid to identify governance failures and weaknesses, and subsequently recommend harmonized regulations that would be applicable for all publicly traded companies, with possible regulations being more biased towards financial institutions. It is often felt that stringent corporate governance practices may have averted the widespread financial crisis
A thorough analysis of the global financial meltdown may point out towards macro-economic instabilities such as the real estate bubble, and corporate governance failures. From a corporate governance perspective, banks could be viewed as having irresponsible behavior due to their aggressive risk taking strategies. Poor governance has led to the collapse of a number of companies, notably Enron, Lehman Brothers, Merrill lynch, a financial management and advisory company, and Fannie Mae (Gordon 2009).
Although corporate governance failures and weaknesses are partly to blame for the financial crisis, there lacks detailed analyses that clearly try to establish a relationship between corporate governance weaknesses and the financial crisis. This research will therefore try to explore how corporate governance models could lead to a financial crisis. The research will also seek to assess the connection between the nature of the corporate governance model and the development of the financial crisis. In conclusion, the research may recommend effective changes to the corporate governance model that could be applicable to most companies in order to prevent the re-occurrence of future financial crises (Jensen and Murphy 2004).
The research question in this case is to what extent that corporate governance can prevent a financial crisis. It may be found that effective corporate governance practices may help prevent against the occurrence of a financial crisis. In this case, the findings will help justify the purpose of the study, which could point out to further research on the topic. Further research may offer more efficient recommendations that may be used by companies in determining appropriate corporate governance practices that will maximize their value, while governments and other regulatory bodies such as stock exchanges authorities may establish comprehensive legislation that encourages accountability and effectiveness, thereby preventing against the occurrence of future financial crises.
A corporation is a mechanism created to “enable the different stakeholders to contribute capital, expertise, and labour for their mutual benefit” (Frydman and Saks 2008). The shareholders participate in the profits of the enterprise without taking responsibility for the operations, while management runs the company without being responsible for the personally providing the funds. As representatives of the shareholders, directors both have the authority and responsibility of establishing basic corporate policies and ensure that such policies are followed (Kirkpatrick, G. (2008; Anderson, Mansi and Reeb 2004; Barth and Landsman 2010).
The board of directors has, therefore, an obligation to approve all decisions that might affect the long-term performance of the corporation. This means that the corporation is essentially managed by a board of directors who oversee the top managers, with the direction of the various stakeholders. The term corporate governance refers to the relationship among these three groups in determining the direction and performance of the corporation.
Over the past decade, shareholders and various interest groups have seriously questioned the role of the board of directors in a corporation. They are often concerned that outside board members often lack sufficient knowledge, involvement, and enthusiasm to do an adequate job of providing guidance to top management. Some boards are usually concerned with keeping the chief executives of the company happy, rather than in safeguarding the interests of the shareholders (Adams and Mehran 2003).
Laws and standards defining the responsibilities of the board of directors vary from country to country. For example, board members in Ontario, Canada, face more than 100 provincial and federal laws governing director liability. The United States, however, has no clear national or federal laws. Specific requirements of the directors vary, depending on the state in which the corporation charter was issued. There is nevertheless a developing worldwide consensus concerning the major responsibilities of the board (Georgen et al 2008).
In a legal sense, the board is required to direct the affairs of the corporation but not to manage them. It is charged by law to act with due care, or due diligence. If a director or the board as a whole fails to act with due care and, as a result, the corporation is in some way harmed by the actions of the top management, the careless director or directors can be help personally liable for the damage done (Becht, M. (2009; Cheffins and Black 2006).
Some of today’s trends in corporate governance that are likely to continue indicate that boards are getting more involved not only in reviewing and evaluating company strategy, but also in implementing it. Institutional investors such as pension funds, mutual funds and insurance companies are becoming more active in boards and are putting increasing pressure on top management to improve corporate performance. For example, the California Public Employees’ Retirement System (CalPERS), one of the largest pension systems in the US, annually publishes a list of poorly performing companies in its portfolio, hoping to embarrass management into remedial action (Boone et al 2007).
The financial crisis could be traced back to unethical behavior on the part of financial institutions. There is no worldwide standard of conduct for business people, which could explain why some managers may act in unethical behaviors.
Cultural norms and values vary between countries and even between different geographic regions within a country (Choi and Fisch 2008). For example, what is considered as a bribe in one country to speed up service is sometimes considered in another country as a normal business practice. Another possible reason for what is often perceived to be unethical behavior lies in the difference in values between business people and key stakeholders. Some managers may believe that profit maximization is the key goal of the firm, whereas some shareholders may believe that the goal of the company is to grow its market share by delivering value to customers (Davis 2007).
The corporate governance is one of the widely discussed issues in the corporate world, academia as well as the media. The issue has gained even more attention after the scandals surrounding the collapse of Enron that shattered the public trust in both the corporate governance and the corporate entities overall (Shorter and Labonte 2007). Several other reputable companies have collapsed on what some analysts explain is due to poor governance (Ryan and Wiggins 2004).
In the collapse of Enron, accounting fraud was to blame on the part of the top executives, which could not have happened if an effective corporate governance system was in place to detect and prevent fraudulent activities. Lehman Brothers Holdings Inc., a global financial services firm, failed due to misleading information about its financial position while Merrill Lynch & Co.’s directors were said to have breached their duty of care by agreeing to sell the company unduly in a rushed sale to bank of America as well as providing false and misleading statements regarding the sale of Merrill Lynch’s preferred stock and bonds. Fannie Mae gave false and misleading statements regarding the company’s business and financial results (Brancato et al 2007).
Top management responsibilities, especially those of the CEO, involve getting things accomplished through and with others in order to meet the corporate objectives. The top management’s job is therefore multidimensional and is oriented toward the welfare of the total organization (Acharya and Franks 2009). The CEO, with the support of the rest of the top management team, must successfully handle two primary responsibilities crucial to the effective strategic management of the corporation: (1) provide executive leadership and strategic vision, and (2) manage the strategic planning process (Finegold et al 2007).
In the open capital market with widely dispersed shareholders, compensation packages have been used as a tool for attracting the best top management team. Bonuses have been used to rewards performing managers that work towards the ultimate goal of the creation of shareholder value through profit maximization (Harford et al 2007). Such performance related remuneration packages, among others, have been deemed as the solution to corporate governance issues, whereby the board is satisfied that the managers will be motivated to increase shareholder value.
However, such incentive programs have significant side effects in that they often cause management to engage in overly risky activities in the name of profit maximization, which endanger the funds of the shareholders. The management may also decide to engage in profits that offer high initial short term profits, rather than in projects that will lead to the maximize the value of the shareholders on a long term basis (RiskMetrics 2008).
Performance based compensation systems have been in a number of cases not been closely tied to the strategy and risk taking policy of the company, and may allow managers to stray from the long term interests of the shareholders. Such incentive systems are also seen as encouraging and rewarding high levels of risk taking, which may not enable a company to cope with a crisis. Most companies were over exposed to the subprime mortgage risk; hence the subprime mortgage crisis led to their collapse, for example the case of Lehman Brothers (Andrews et al 2008).
This section outlines the research design and instruments used to collect data. It also defines the methods used to analyze the data collected. This research study is exploratory, relying on primarily secondary data. Through secondary research, extensive library and internet research was carried out to build on more knowledge on the developments in the research topic, using historical information on the demise of several companies and the financial meltdown to determine whether poor corporate governance led to the 2007-2009 global financial crisis (Bebchuk and Fried 2004). Newspapers, journals, publications as well as the internet were perused for the latest information in the field under study. Data obtained was subjected to qualitative analysis, based on descriptive statistics using non statistical techniques on subjective statements and explanations.
According to the “Shareholder Bill of Rights Act of 2009”, among the grounds of the financial and crises that the US, and the world in general, face presently have been an extensive collapse of corporate governance in the companies and financial institutions. The recent financial crises have led to many shareholders raising stern questions over the liability and sensitivity of some organizations and boards of directors to the demands of shareholders, and have led in a decline of investor’s confidence. In many occasions, shareholders push corporations, financial intermediaries, to increase their short term returns by leveraging.
Thus, the boards of directors, managements, investors with individual interests, and regulators, all, to an extent, have allow short term organizational concerns, hence devastating the desired long run goals of the company. For instance, following the recent financial crisis many companies took too many risks in ambitions to achieve the shareholder’s expectations in the short run, however this led to much bigger troubles to the corporations that they has expected.
Thus, shareholders, boards and managers and those engaged in lawmaking and regulatory reform processes should give more consideration to the long term nature of business wealth-creating activities and put efforts to keep away from gratuitous short term focus and pressure that may obstruct the competence of the corporation for long term opportunities and decisions essential for sustainable wealth optimization. The various stakeholders and intermediaries should be encouraged to take up a long-run outlook which will in due course support and empower boards of directors to take up long term approaches for expansion and sustainability, and to rely more on long term, forward-expecting metrics in determining commensuration and productivity incentives.
The board of directors should be more involved in the company. The most effective boards accomplish much of their work through committees. Although they do not usually have legal duties, most committees are granted full power to act with the authority of the board during board meetings. This committee acts as an extension of the board and, consequently, my have almost unrestricted authority in certain areas.
The audit, compensation, and nominating committees are usually composed of outside directors. Highly involved boards tend to be very active. They have their tasks of monitoring, evaluating and influencing management performance, and initiating and determining the strategic options to management. Due to the loopholes in the regulation of the financial market players and the monitoring mismatch, more strict regulation is necessary in order to prevent a future financial crisis.
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