Reconfiguring the Audit and Management Functions in Light of New Emerging Financial Legislation...

Reconfiguring the Audit and Management Functions in

Light of New Emerging Financial Legislation

Timur Gök

Caribbean Association of Audit Committee Members Inc.

4th Annual Meeting and Conference

St. Kitts & Nevis, Sep. 30 – October 2, 2010

2

Outline

• The Dodd-Frank Act

• Corporate Governance: Background

• Broad Provisions of the Act

• Provisions Targeting Financial Services

• Conclusion

• Appendix

The Dodd-Frank Act

The Dodd-Frank Act

4

5

The Dodd-Frank Act

• On July 21, 2010, President Obama signed The Dodd-Frank Wall Street Reform and Consumer Protection Act– Reshapes regulation of financial markets– Has corporate governance and executive

compensation implications for all public companies

– The greatest impact is on companies in the financial services industry

6

Shift in the Balance of Power

• Shareholders of US publicly-traded companies get a significantly greater voice in corporate affairs– Low-cost contests for board seats– Greater shareholder influence on executive

compensation

H.J. Gregory, “A shift in power,” Practical Law The Journal (Sep. 2010).

7

Governance Provisions

Weil, Gotshal, Financial Regulatory Reform, (July 2010).

• Governance provisions of the legislation affect all public companies and their boardroom practices

8

Governance Provisions


• The Act enhances corporate accountability to shareholders and investor protection overall, and

• May create the potential for a significant shift in governing power from boardrooms to shareholders

9

Much Remains to be Done

• Numerous implementing regulations– 500 rules to be written– 60 studies to be performed– 90 reports to be issued– To be implemented from 180 days to two

years after enactment

• SOX of 2002 called for16 rules and six studies

PWC, Boardroom Direct, (Summer 2010).

Corporate Governance

Background

True or False?

• “Management is governed by the overall goals and rules established by the board.”

11

12

Management Shareholders

Board of Directors

13

Boards of Directors

• Oversee and evaluate the business;

• Select, compensate, and, where necessary, replace senior executives;

• Review the firm’s financial objectives and its accounting.

American Law Institute

Principles of Corporate Governance

J. Macey, “Corporate Governance,” Princeton University Press (2009).

14

Fundamental Problem

• “The directors of [joint-stock] companies, however, being the managers rather of other people's money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own.”

Adam Smith, The Wealth of Nations

15

Ownership vs. Control

• A century-and-a-half after Adam Smith, Berle and Means observed that with the separation of ownership and control, corporate shareholders had “surrendered a set of definite rights for a set of indefinite expectations" concerning the economic surplus that the firm generates.

16

Legal Framework

• A director has two duties:– Duty of loyalty– Duty of care

• Judging directors’ conduct– “The ‘business judgment rule’ in U.S.

corporate law creates a strong presumption that ordinary business decisions are made in good faith, on an informed basis, and in the best interest of the corporation.”


17

Director Responsibilities

• “Directors are responsible for the overall picture, not the daily business decisions.”– The forest, not the trees

• A director’s position should be NIFO– “Nose in, fingers out!”

• In practice, often a dual role for boards– Manage and monitor

Quoted in R.A.G. Monks and N. Minnow, Corporate Governance, 3/e, (2004).

18

Conflicting Roles

• “No man should be allowed to be a judge in his own cause, because his interest would certainly bias his judgment, and, not improbably, corrupt his integrity. With equal, nay with greater reason, a body of men is unfit to be both judges and parties at the same time.”

James Madison in Federalist 10 as quoted by J. Macey (2008, p. 54).

19

Good Governance

• According to Federalist 62, good governance requires:– Fidelity to the objectives of the corporation;

and– Knowledge by which these things can best be

attained.

• Shareholders have the first of these qualities, managers and directors, the second. Neither has the other quality.

Macey, (2008).

What Is Expected of BODs?

Aspirational “best practices,” not just legal rules

• Choose and monitor the CEO

• CEO succession• Plan for and deal with

crises• Executive compensation• Nominate directors• Evaluate board’s

performance

• Business and strategic advice

• Determine risk appetite• Set standards and

monitor risk management• Compliance• M&A• Social responsibility.• Governance guidelines

20Martin Lipton, “The future of BODs,” (2010).

Election of the Board

• Theory– Directors are elected by shareholders

21

Election of the Board

• Practice:– Management picks the slate of candidates;– In most cases, these candidates run

unopposed;– Unless there is an opposing candidate (e.g., a

proxy contest), no chance of the nominees not being elected because shareholders cannot vote “no” to unopposed directors – they can only abstain by withholding their support

22R.A.G. Monks and N. Minnow, Corporate Governance, 3/e, (2004).

Problem

• Board capture– “Reliance by U.S. policymakers on boards is

wholly misplaced. Public choice, social psychology, and historical observation all suggest that boards can be counted on to be only as honest and effective as the managers they are supposed to supervise.”

23J. Macey, “Corporate Governance,” Princeton University Press (2009).

Board Capture

• At times, a self-sustaining process– Staggered boards– Confidential voting– Poison pills– Groupthink– …

• Failure of corporate governance

24

Potential Remedies

• Director “independence”

• Shareholder voting

• Controls and transparency on management compensation

25

Broad Provisions of the Act



• Proxy access authority

• Broker discretionary voting

• Say-on-pay

27Weil, Gotshal, Financial Regulatory Reform, (July 2010).


• Compensation committee and adviser independence

• Disclosure of board leadership

• Additional executive comp. disclosures

• Clawback of incentive compensation



• Hedging by employees and directors

• Compensation structures of financial institutions


30

Also of Note

• Congressional mandate for the SEC to establish the Office of Minority and Women Inclusion

• The SEC and all other financial regulators should be undertaking efforts to recruit and promote employees from all backgrounds

Provisions Targeting Financial Services

Targets

• Systemic Risk

• Banking Industry

• Hedge Funds and Private Equity

• Securities Regulation

• Insurance Industry

• Consumer and Investor Protection

32

33

Systemic Risk

• Financial Stability Oversight Council

• Office of Financial Research

• “Covered Companies” and Other Institutions

• Orderly Liquidation Authority

• Systemic Risk Determination


Regulatory Reorganization of Banking Industry

• Address the consolidation of US financial regulators

• Restrict the activities in which certain institutions may engage


35

Financial Regulatory Architecture

PWC, “10 Minutes on US Financial Reform,” (Jul. 2010).

36

Banking Industry

Volcker Rule

• Prohibition on proprietary trading

• Ban on certain hedge fund and private equity activities

Derivatives for banks

• Prohibits federal assistance to any dealer or major participant in the swaps or securities-based swaps market


Derivatives

• Centralized clearing requirement

• End-user exemption

• Regulation of swap dealers and major swap participants


Hedge Funds and Private Equity

• Elimination of private adviser exemption

• New exemptions from registration

• Records and reports for investment advisers


39

Securities Regulation

• Securitizations– “Skin-in-the-Game” Requirement

• Supplemental Disclosure Requirements

• Credit Rating Industry


Insurance Industry

• Federal Insurance Office

• Surplus Insurance and Reinsurance Reforms


Consumer and Investor Protection

• Bureau of Consumer Financial Protection

• Mortgage Reform and Predatory Lending

• Investor Advisory Committee


Conclusion

43

Bank Problem in a Single Chart

J. Reid, Deutsche Bank (2009, 2010). Alphaville, FT.com (Jan. 25, 2010).

http://ftalphaville.ft.com/blog/2010/01/25/133331/the-bank-problem-in-a-single-chart

44

The significant problems we face cannot be solved by the same level of thinking that

created them.Albert Einstein

Timur Gök

Regional Director, PRMIA Chicago

Visiting Associate Professor

Director, Arditti Center for Risk Management

Department of Finance

DePaul University

Chicago, IL 60604

312/362-5001

[email protected]

mailto:[email protected]

Appendix

The Corporate Governance Framework

47

What Is A Corporation?

• “An ingenious device for obtaining individual profit without individual responsibility”

Ambrose Bierce

The Devil’s Dictionary


48

What Is A Corporation?

• An entity that allows different parties to contribute capital, expertise, and labor, in support of corporate objectives and in return for certain benefits

• These benefits are secured by promises.• Some promises are backed by contracts

and laws; others, are merely promises (soft law and norms)

• Example: Promises to (equity) investors

T. Gök Governance 49

Stupidity and Impertinence

• “Shareholders are stupid and impertinent–stupid because they give their money to somebody else without any effective control over what the person is doing with it, and impertinent because they ask for a dividend as a reward for their stupidity.”

German banker Carl Fürstenberg

As quoted by Hellwig (2000)

50

What Is Corporate Governance?

• The mechanism by which corporate objectives are pursued and benefits are allocated.– Legal rules, economic incentives, and social

norms “by which shareholders and other outside investors attempt to assure themselves that management will perform in a manner that is consistent with their promises.”


51

Ideal?

• Corporate objective– “Our long-term economic goal …is to

maximize Berkshire’s average annual rate of gain in intrinsic business value on a per-share basis”

• Intrinsic value– “[T]he discounted value of the cash that can

be taken out of a business during its remaining life”

Berkshire Hathaway, An Owner’s Manual, (1996).

52

Obstacles

Core • Separation of ownership and controlInstitutional• Legal system• Capital markets• Product markets• Regulatory system• Norms

53

The Board vs. Management

• Ownership versus control– Incentive problem: Structural

• Information flow– Knowledge problem: Operational

• Institutions and mechanisms of corporate governance that are the most successful are those that manage simultaneously to deal with the incentives problem and the knowledge problem.

54

Governance Mechanisms


55

Solving the Agency Problem

• Incentives– At least in the U.S., much of the burden of

solving the agency problem was placed on incentives and compensation schemes

– Ever-increasing pay to “align” managers’ and shareholders’ interests

56

Law of Unintended Consequences

Target

• “Align” managers’ and shareholders’ interests

Tool

• Incentive compensation

Outcome

• Distorted incentives

57

Attentive

• “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

Chuck Prince, Former CEO, Citigroup

Financial Times, July 9, 2007

M. Nakamoto, “Citigroup chief stays bullish on buy-outs,” Financial Times (July 7, 2007).

http://www.ft.com/cms/s/80e2987a-2e50-11dc-821c-0000779fd2ac

58

Shocked

• "Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself especially, are in a state of shocked disbelief.“

– Alan Greenspan

59

Impervious

• In 2007 and the first two quarters of 2008, Merrill had lost about a quarter of the profits it had made in its 36 years as a listed company (after-tax losses of $14b and $52b of write-downs).

Financial Times, August 28, 2008

• Merrill Lynch & Co. CEO Stanley O'Neal was paid $172 million from 2003 to 2007.

60

Idiots and Aristocrats

• “All of this behaviour supporting the aristocracy only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America.”

Andrew Lahde

61

Idiots?

• Stan O’Neal left Merrill Lynch with a package (stock options, unvested shares, deferred compensation, pension payments and other benefits) worth about $160m

• Bear Stearns Cos.'s James “Jimmy” Cayne made $161 million before the company collapsed and was sold to JPMorgan Chase & Co.

62

What Should Boards Be Doing?

Solutions seem easy…

• Insiders vs. independent directors

• Supervisory board vs. management board

• Board committees

But problems run deeper…

• Board capture

• Groupthink , conformity, cognitive bias,…

J. Stein, “What boards should be doing right now,” (Dec. 2009).

Beyond Boards of Directors

64

Legal System

• In countries with poor investor protection, more concentrated ownership structures are required, as well as higher levels of insider ownership

• Stronger legal protection leads to higher firm value

• Management entrenchment less likely when shareholders are protected from dilution and granted board representation

65

Legal System

• An efficient legal system safeguards investors’ rights by leading to lower debt levels when expropriation is probable

• Stronger minority shareholders’ rights lead to higher dividend payouts

• In countries with poor legal protection higher dividends are paid as a way to limit expropriation activities

67

Capital Markets

• Development of capital markets– Financial development improves capital

allocation efficiency and facilitates the investment process

– Stock market development leads to higher debt-equity ratios

– Firms are more likely to use external finance (both debt and equity) in more developed capital markets

68

Product Markets & Governance

“monopoly … is a great enemy to good management”Adam Smith

• Does product market competition improve corporate governance?

69


• Guadalupe and Perez-Gonzalez (2006) demonstrate that “conditional on a weak legal environment, product market competition is strongly correlated with lower private benefits of control”– Competition in the product market can

potentially reduce insiders’ consumption of private benefits

70


• Product market competition– External measure based on industry-level

import penetration– Internal measure based on country-level

product market regulations

Guadalupe and Perez-Gonzalez (2006)

71


• In an early theoretical paper, Hart (1983) had concluded that “average managerial slack is lower under competition than if there is a single profit-maximizing monopolistic firm”

72


• Nickell (1996) demonstrated that– “… market power, as captured by market

share, generates reduced levels of productivity”

– “… competition, measured either by increased numbers of competitors or by lower levels of rents, is associated with higher rates of total factor productivity growth”

Governance Structures

74

Questions

• What are the governance structures that enhance shareholder value?

75

Questions

• What is the appropriate mix of inside, independent, and nonindependent outside directors on the board?

• Who qualifies as an independent director?• What is the appropriate composition of board

committees?• What kinds of directors should companies seek to attract

and how should they be compensated?• What kinds of compensation policies for executives and

directors create the most value for shareholders?• What is the impact of various antitakeover provisions?

A. Shivdasani & M. Zenner, “Best Practices in Corporate Governance: What Two Decades of Research Reveals,” JACF 2004.

76

Board Composition

• “Outside dominated” boards are better for making specific decisions– More likely to replace poorly performing CEOs– More likely to hire outside CEOs– Better acquisitions– Better bargainers when subject to takeover

• However, no direct link between board composition and shareholder value

78

Board Composition

• Benefits to one or two non-CEO executives on the board

• Among large industrial companies, those with non-CEO chairmen traded at higher price-to-book multiples

• Benefits to audit committee independence

• Benefits when CEOs not involved in nominating and selecting directors

79

Board Composition

• Among the largest 500 companies ranked by Forbes, those companies with the highest valuation multiples had boards that included eight or fewer people, while companies with a board membership of more than 14 displayed the lowest multiples.

80

Board Composition

• There are benefits and costs to having directors with multiple seats

81

Executive Compensation

• Executive equity ownership increases shareholder value and promotes better decision-making but can also have potential drawbacks

• Also, directors who receive incentive pay oversee management more actively

83

Entrenchment and Pay

• CEOs get paid more in firms where large boards make it tougher to organize opposition to the CEO; where the CEO appoints more of the outside directors; where serving on three or more boards distracts outside directors; and where the CEO and chairman of the board responsibilities reside in one person.

84

Anti-takeover Provisions

• The impact of poison pills depends on board composition– independent boards use poison pills to

bargain for higher takeover premiums

• Anti-takeover provisions may help entrench management, but can also benefit shareholders by giving independent boards increased bargaining power.

Conclusion

Governance and Value

• Corporate governance and the creation or destruction of corporate value are outcomes of a complex system of interactions among numerous factors

87

Complex System

• These factors include a country’s legal system, regulatory environment, capital markets, product markets and labor markets

• Interactions among these factors manifest themselves in different ownership and capital structures as well as governance mechanisms, and influence how effectively firms can fulfill their purposes

88

Reconfiguring the Audit and Management Functions in Light of New Emerging Financial Legislation...

Documents

Transcript of Reconfiguring the Audit and Management Functions in Light of New Emerging Financial Legislation...