The best-intentioned legislation can have unintended consequences. Corporations have had a tall order ahead of them as they attempt to navigate the balance between profit, risk and sustainability during times that are fast and continually changing. Governments have had to take a stronger role with regulation relative to the dual charge to protect shareholders and to improve the economy. Corporate scandals always point to board of director oversight.
Chain of Events Led to Financial Decline
Over time, there has been much debate over whether regulation is too tight or too loose to help corporations find the balance that keeps the economy growing and still protects shareholders. It has been a decade-long process to understand the chain of events that caused the decline of the economy. Here’s a short summary of the timeline that led to the financial crisis of 2008.
The deregulation of the banking industry in 1999 opened up lending practices, which led to a housing boom with extremely low mortgage interest rates. This led to the vast reselling of mortgage loans and the growth of subprime mortgages. The Federal government mandated an increase on subprime loans under the promise by large banks, Freddie Mac and Fannie Mae, that they’d heavily scrutinize the loans. The Federal government raised the rates on subprime borrowers to offset the financial losses of smaller banks. As rates went up, many homeowners couldn’t afford their mortgage payments, and large numbers of homes went into foreclosure. High rates of foreclosures created the banking crisis of 2007, which spread to Wall Street in 2008.
Unfortunately, the finance industry is still trying to develop regulation in such a way as to kick-start the economy while continuing to protect shareholders. It’s a work in progress and will continue to be for the foreseeable future.
In short, many financial experts point to two issues that got our nation into this predicament—a focus on trading rather than on raising capital and poor corporate governance.
Impact of the Financial Crisis: Long-lasting and Far-reaching
The real estate and financial markets have been hardest hit by the financial crisis, which has had a trickle-down effect to the everyday consumer. More importantly, the United States has long held a reputation for having strong global financial power. That power continues to diminish the longer the financial instability continues.
Governing bodies took swift action after 2008 to increase regulations, which are forcing corporations to be more accountable and transparent. Boards of directors take the heat when things go awry, so long-standing traditions in the way that they function are changing. When corporate mistakes and bad practices come to light, or when there is any other type of scandal, fingers point to the board of directors and their governance practices.
To better understand the role of boards and governance, let’s take a look at a couple of concrete examples of poor governance and the problems they created.
In light of financial concerns, shareholders sometimes hire proxy advisors to perform certain duties for them. Some of these duties include helping to translate agendas, provide vote management software, develop voting policies, perform research and execute their votes by proxy.
Glass Lewis & Co., the proxy firm for Toshiba shareholders, has held an eagle eye over the Toshiba board for repeated instances of accounting irregularities at the company and its subsidiaries. The proxy firm recently revealed a 25-page report that expressed concerns over the board’s lack of oversight over internal controls, internal financial reporting procedures and auditing systems.
In 2015, Toshiba admitted to overstating profits for seven years, causing them to pay a penalty of a record fine in Japan. This year, Toshiba needs to take a more-than-$6 billion write-down in its nuclear business. These oversight issues could lead to a de-listing from the Tokyo Stock Exchange if the trend continues. Currently, Toshiba is working to sell off assets in its memory chip business to offset losses in the Westinghouse nuclear business.
Glass Lewis is concerned enough about board performance that they are recommending that shareholders vote against all directors at the next company shareholder meeting. The proxy firm called out six of the board directors who participated on the board’s audit committee or took top management roles during the scandals. The Glass Lewis report also singles out CEO Satoshi Tsunakawa, who took the helm after board turnover the previous year.
The Volkswagen (VW) company has also had its share of bad press surrounding poor governance practices. VW found itself in a Catch-22 in trying to walk the line between fuel efficiency and emissions control.
Industry leaders relied on research that showed that diesel-operated vehicles fared better on CO2 emissions than gasoline, but they had higher concentrations of nitrogen oxides (NOX), which pollute the air. Europe set more relaxed standards on emissions than the U.S. At the end of the day, European governments had to make a choice between allowing the harmful emissions or saving their automotive industry.
Somewhere within the company, VW came up with a solution called a defeat device. The device detects when the auto is being tested for emissions and limits oxide emissions for the duration of the test, fooling testers into thinking that the car operates at safer levels than it does.
The controversy surrounded VW Chief Executive Martin Winterkorn, and whether he was aware that the device was being used. Investors are concerned that Winterkorn was in on the deception and allowed it to take place. They are even more concerned by the prospect that he lacked oversight and may not have been aware of the deception at all. Either way, the onus for the scandal falls on VW’s board for its lack of oversight and its failure to confront management about the use of a known deceptive device.
Bank of America
Early on in the recent financial crisis, poor governance also came to light at Bank of America. Ken Lewis was the CEO at the time, and he was able to win over the board to approve the $50 billion acquisition of the failing Merrill Lynch & Co. business. Board members displayed hesitance to oppose Lewis, and the transaction went through. Bank of America also acquired the failing Countrywide Financial Group in 2008 for $4.4 billion. Lewis agreed to incur all of Countrywide’s bad mortgage practices. University of North Carolina’s banking professor Tony Plath noted that the deal cost the bank $40 billion by 2012, calling it “the worst deal in the history of American finance.”
Clearly, the board of directors failed in their duties of corporate best practices in the area of managerial oversight.
The Wrap-up: Good Corporate Governance Regulations
The finance industry has much to learn from real-time examples of good and poor corporate governance. There’s no question that well-rounded, diverse boards who are not afraid to challenge management decisions are an important component that works in tandem with corporate governance regulations to improve the economy and keep corporations honest and transparent. All eyes are on the financial industry, corporate boards and governments to see how they will work together toward profitability and a growing economy for the future.