The Cost of Poor Corporate Governance

Corporate Governance

The Cost of Poor Corporate Governance

  • The Cost of Poor Corporate Governance Consider three case studies that prove poor corporate governance may be far costlier than you think.
  • Date: Jan 10, 2018
  • Category: Corporate Governance

What is the cost of poor corporate governance? Perhaps we should ask: ‘what are the rewards of good corporate governance?’ In Malaysia, fostering a culture of good corporate governance has been a focus of regulators for several years. The publication of the latest version of Malaysian Code on Corporate Governance (MCCG) in 2017 seeks to continue to drive best practice and help companies move beyond seeing corporate governance as merely a compliance issue. Furthermore, investor interest in good corporate governance has grown in recent years.

Why is this?

Research commissioned by investment houses shows a correlation between high standards of corporate governance and long-term return on capital. All other things being equal, the research shows that a well-governed company is likely over time to outperform a poorly governed one. Hermes, for instance,
in a 2016 study concluded that: “companies with strong corporate oversight have tended to outperform their poorly governed competitors by an average of over 30 basis points (0.3%) per month since the beginning of 2009.” They found that underperformance by poorly governed companies was most manifest in the Asia Pacific region excluding Japan (page 4 of the study).

What are the Components of Good Governance?

Here is the menu offered by Vanguard, one of the world’s biggest asset managers. In his 2017 Open letter to directors of companies worldwide, F. William McNabb III, Chairman and Chief Executive Officer, offered four main pillars of good governance:

1

The board: A high-functioning, well-composed, independent, diverse, and experienced board with effective ongoing evaluation practices

2

Governance structures: Provisions and structures that empower shareholders and protect their rights

3

Appropriate compensation: Pay that incentivises relative outperformance over the long term

4

Risk oversight: Effective, integrated, and ongoing oversight of relevant industry- and company-specific risks

These points address the structures, incentives and processes involved in corporate governance. Of course, they will only operate effectively where throughout the organisation an attitude of mind about doing business ethically has become firmly rooted.

We can learn much about what good governance is by looking at what happens when good governance fails. As we can see from the examples below these failures often occur at multiple levels.

BP Deepwater Horizon – Failure of Top-level Corporate Governance and Weak on-the-ground Controls that Lead to an Environmental Catastrophe and the Loss of 11 Human Lives.

We begin with one of the greatest corporate disasters of the century – BP’s 2010 Deepwater Horizon. This provides a clear example of the damage that can be caused when the corporate governance arrangements fail to deliver effective scrutiny, and therefore delivery, of basic business practices.

Deepwater Horizon was an ultra-deepwater offshore drilling rig. On 20 April 2010, an uncontrollable blowout caused an explosion that killed 11 crew members. It ignited a fireball visible 40 miles away. The rig sank on 22 April 2010 with oil still gushing out of the well. The oil spill developed into the largest ever oil spill in US-waters. The well was finally capped on 15 July 2010.

The costs were huge. Taken overall, BP estimates the pre-tax costs to be $65 billion. Certainly BP had to suspend dividend payments and target the disposal of $30 billion in assets.

The disaster was a failure of corporate governance in two ways – strategic and organisational.

At a strategic level, BP had a record of poor health and safety performance compared to other oil majors. These included the 2005 fire and explosion at the Texas City refinery, costing 15 lives, the serious environmental damage caused by the 2006 Prudhoe Bay, Alaska crude oil leak and the massive 2008 Azerbaijan gas leak. Taken together, these ought to have alerted the board to an endemic problem in BP’s mode of operation. Board action was necessary but not forthcoming.

Good governance is not only about action at the top. Throughout the organisation, employees must be working in an orderly and systemic way. The Deepwater Horizon Study Group concluded (page 7/216): “This disaster was preventable had existing progressive guidelines and practices been followed.” The study lays out the evidence on which it bases its conclusion in detail. A clear lesson from this case is that good governance should not only set robust policies and procedures, but also the board must effectively oversee implementation, supported by adequate reporting and disclosure to promote transparency and accountability.

Barings – Bank Collapse due to Poor Controls

At least BP is still trading. Barings Bank was brought down in 1995 by a failure of control. Nick Leeson, the Head of the Singapore office, had run up £827 million of losses in trades that he was not properly authorised to do. This provides a clear example of the need to have robust controls and delegation of authority. In one way the bank was brought down by a single individual. Yet surely the responsibility for having ineffective systems of monitoring and approval was more widely shared.

Overall this was a failure of governance at a detailed and tactical level.

Key duties were not segregated and were totally concentrated in a single person. Leeson was allowed to combine the roles of general manager, leader of the trading team and head of the back office. This set-up facilitated him approving unauthorised trades and fabricating spurious and misleading reports to the London Head Office. In simple terms this was a breach of the most basic of controls, that is to say where an individual is empowered to commit expenditure, this should be effectively monitored by another person who is independent.

A further failure was that an August 1994 internal audit report pointed out that he was vested with authority for too many conflicting positions. It was ignored by management. Also, no limits were in place requiring senior management approval. Traders (including Leeson) had unfettered power in conducting their daily activities.

Leeson departed from the agreed trading strategy of the bank. The Kobe earthquake of 17 January 1995 sent Asian markets, and with them Leeson’s trading positions, into a tailspin. Leeson doubled down by betting on a rapid recovery of the Nikkei, which failed to materialise. Leeson confessed his unauthorised activities to the Chairman of Barings. His £827 million losses amounted to twice the trading capital of the bank. The Bank of England attempted a bailout but on 26 February 1995 Barings was declared insolvent.

Barings provides the clearest example of the point that good governance is not just about holding the right strategic positions. It is about following through those strategic positions with detailed and effective control-systems, day-in day-out. Good governance at the top is meaningless without detailed follow-through on the ground.

Singtel – Reputation Risk through Third Parties

Good governance is not just a matter of having the right arrangements at board level and effective implementation by staff. External agents and contractors must adhere to the highest standards too, though clearly the stakes are lower where the ethical lapse is with a contractor rather than being to do with the direct actions of the company.

This case highlights how actions of Singtel’s external contractor lead to the company suffering reputational damage in March of 2015. Gushcloud, a marketing consultancy working for Singtel, commissioned young people to post spurious complaints about other service providers. In particular, they were told to share: “you have had enough of your current mobile plan not being able to meet your current needs and on how you have thoughts to sign up for a new plan.” This instruction undermined one of the ways in which modern marketing works where user reviews, recommendations and comments have significant impact on customer decisions. Gushcloud, as Singtel’s agent, was inciting the young people to make untrue statements that were damaging to Singtel’s competitors.

Once the practice was exposed, the CEO of Singtel posted an apology on-line including a direct apology to Singtel’s competitors who had, in effect, been maligned by the campaign: “The senior management and I apologise, in particular to M1 and Starhub, that our actions in this incident did not live up to our high standards and values”. The CEO of Gushcloud also apologised. The Singtel employee responsible for the activity was terminated.

Singtel escaped relatively lightly from the incident, at least in part from prompt action when the details came to light. Nonetheless the incident shows that companies are potentially vulnerable not only from the actions of their employees but also from agents acting on their behalf.

The Cost of Poor Corporate Governance

The examples above remind us of how easy it is to get corporate governance wrong – and the costs associated with doing so. At the same time, the evidence shows that good corporate governance provides a material contribution to the continuing success and profitability of a company. Businesses therefore have a dual incentive to implement effective corporate governance.

Author

Peter Truesdale, Corporate Citizenship

Peter Truesdale is a Director at Corporate Citizenship based in London. Peter has over 25 year’s experience working on corporate responsibility and sustainability matters both in-house and as a consultant. His specialisms include Corporate Governance, Codes of Conduct and investor-facing indices, such as DJSI and MSCI. Peter is a graduate of Oxford University in Modern History.

  • Tags : Governance, Reputation Risk.

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