In Place of Strife

The surge in "in-house" frauds (ten types of fraud are listed here) is hardly surprising, given the ongoing recession and near collapse of the global banking system,  people and companies are becoming desperate. The world’s stock markets have been tumbling and investor confidence is at a low point.

 

Scandals, frauds and mismanagement are occurring in organisations ranging in size from the small to the multi national.

 

The economic and ethical meltdown arose for a number of reasons, I highlight the following as my personal top ten “chart busting” favourites:

1 The Gordon Gekko mentality of “greed is good”, all credit to that most insightful film “Wall Street”; which has beguiled senior executives, investors and external auditors.

 

Whilst the Western economies were growing and shares in both the US and London were enjoying an unparalleled bull market investors and others, such as non executive directors (who should have known better), did not question too publicly, if at all:

- the remuneration packages of senior executives

- the growth and investment strategies, most notably within the banking and hedge funds, that led to a world-wide "Ponzi" scheme of breathtaking proportions; as the banks bundled poisonous assets with good assets and sold them to one another in a Russian Roulette version of "pass the parcel".

- the corporate governance arrangements (such as the composition and “independent pro activity” of the audit committee) of the companies they were involved with.

 

To me this Gekko beguilement is best summed up by a quote from Bernie Ebbers (ex CEO of WorldCom) when asked about low investor returns on capital. He replied “investors do not care if a company’s return is 6 or 60 percent. They only care if the share price goes up”.

His comment insightfully highlights the short term vision of investors, and unwittingly highlights many a senior executive’s contempt for them.

2 Much like the emperor who was sold the invisible suit, once the magic spell is shown to be a sham the illusion cannot be recreated.

 

Specifically, the emperor needs some real clothes!

 

These will take time and genuine effort, measured by hard work not “sophisticated financial solutions” (such as sub prime debt and complex off balance sheet arrangements whereby, for example, assets are held in the Cayman Islands and liabilities in Bermuda), to weave.

3 Companies and banks need to re-evaluate their method of remunerating senior executives.

 

The practice of offering large levels of share options and bonuses is all very well, in theory. However, it places a significant pressure on the executive to always talk the stock up, and in the case of the less honest to arrange for transactions and off balance sheet schemes that give a misleading picture as to the earnings and gearing of the company.

4 Even the very act of awarding share options and bonuses is suspect; as the remuneration committee, whose job it is to review the level of senior executive remuneration and determine if it is fair and reasonable, are not in a position of complete impartiality. After all, they are hired by the same executives (even if the appointments of the non executives, who make up the remuneration committees, are asked to be approved or rather “nodded through” by the shareholders) for whom they are reviewing the pay awards.

Sometimes investors start to “rattle the cage” and complain about the level of remuneration. However, even if they are successful in delaying or preventing a change, such as in the case of Marconi (in early 2001), by then it may be too late.

5 The external auditors do not escape unscathed from the stench of cronyism and greed that contaminates many board rooms. Following the mega mergers of the eighties, there are effectively four main players in the market. These firms audit the majority of the quoted companies in the US and UK. The freedom of choice is therefore limited, even if companies wished to shop around.

That is in itself wishful thinking on my part, many of the audit firms have held the same client for years, some for fifty years or more. The “comfort blanket” of familiarity, complacency and dislike of change has in effect lead to a stagnant audit market. The only area seen as offering growth potential by the big four is in the area of consultancy and “added value services”; sold by the big four with an almost evangelical fervour.

I spent a few weeks in the late "lamented" Andersens’ spiritual home, in St Charles (near Chicago) at the beginning of 2000, observing one of their audit courses.

 

I even have a certificate to prove it!

 

This was indeed an eye opening experience. The key objective of a client review, it would seem, was not to do a good audit but to sell in extra services. Andersens’ has long since consigned itself to the dustbin of history. 

In my view, a stagnant audit market is not good for the companies, investors or auditors.

6 The relationship between the external auditor and client could, in my opinion, even be termed incestuous; many quoted companies hire staff and senior executives that were trained by their audit firms.

 

This, to my view, creates the following risks:

- The arms length relationship between auditor and client is tarnished.

- Both auditor and client develop a blinkered approach to the operation of the business, and their attitude to the audit process itself.

 

The auditor takes the point of view “this is the way the audit was done by the previous auditor who is now CFO, and so this is the way we do it now”.

 

Whilst the business, having hired past auditors, have in effect taken in a pool of people who have not necessarily the optimum range of experience gained by working in other industries or companies required to stimulate new ideas.

- The “old boys’ club” exerts a powerful influence over both client and auditor not to rock the boat. The client will be reluctant to change auditor, and the auditor may be reluctant to address concerns with respect to the business that he comes across during its review.

7 Companies, in addition to using the services of external audit, more often than not have an internal audit department (even if this is just to pay lip service to corporate governance requirements).

 

The mission of which should be to provide the Board with independent assurance as to the quality of the business controls, and the adequacy of the risk management process. To enable the internal audit department to function independently its reporting line should be to an audit committee which should comprise a majority of non executive directors.

 

Herein lies two problems:

- Internal audit departments often do not report only to the audit committee, but have a dual line to a senior executive (usually the CFO). This severely limits the independence of the department. It is indeed interesting to note that Cynthia Cooper (Head of Internal Audit at WorldCom) had to bypass her boss (the CFO) and go directly to the audit committee to report the discovery of the capital expenditure fraud.

- How independent, and competent, are the non executive directors? The shareholders in Royal Bank of Scotland (RBS) or Northern Rock may be forgiven for thinking that there were no non executives working during the period of value destruction.

The effectiveness, and indeed raison d’être, of the internal audit department is effectively nullified by a dual reporting line and a non independent audit committee which does not proactively question the status quo and actions of the senior executives.

8 A non executive, in my view, cannot exercise his or her fiduciary duty adequately if he or she has a string of executive positions (many hold half a dozen or more). How can an individual devote sufficient time to each company with such a spread of responsibilities?

9 Even more disturbing, in my opinion, are those cases where non executives hold positions on the boards of companies for which they worked for many years in an operational capacity. Companies offer these positions as a sinecure for years of loyal service. The thin veil of independence is exposed to be a sham. Whilst the non executive may well understand the companies operations, he or she is in no position to think or act independently.

10 At an even more basic level there are those non executives who, because of their age, are simply not up to the job; they have become inflexible, they do not understand the changing environment. I have personally witnessed the elderly chairman of an audit committee dozing off during the meeting.

The solution to these ills, in my opinion, is as follows (note that none of these points is earth shattering, they are simple common sense):
 

 Companies should have an independent, pro active internal audit department (see Attributes of a World Class Internal Audit Department)

 

 Open up the auditing profession to more competition, by enforced rotation of external auditors every five years or so.

 Place an enforced period of suspension, of at least one year, between a senior manager or partner in an audit firm relinquishing a particular client and joining that self same client.

 Companies should limit share option and bonus schemes to only account for a maximum percentage (say ten percent) of an individual’s total remuneration.

 

This proposal invariably receives the curt riposte from companies (or rather their senior executives) that in order to attract the best you must pay “top dollar”. Well my riposte to this goes as follows:

- It has been my experience to observe the careers of quite a number of senior executives at close quarters. Their careers tend to follow similar paths. They arrive at the organisation and in keeping with their egos, and position, they identify a number of areas that need to be improved; otherwise the organisation may well as they put it “cease to exist”.

 

With much fanfare of corporate videos and “managed” change programmes the new mantra is disseminated to the employees. These change programmes/projects tend to be given a five year time span. However, one small problem; the executive tends only to stay in that position for two years (their ego and supercharged need to move on “to face new challenges” prevents them seeing the project through to completion).

 

This scenario I call “two year managers for five year projects”. The long suffering employees and organisation then endure the whole process over again with another executive who decides to change the change programme. The result, an organisation constantly changing but going nowhere.

- The concept that if you pay “top dollar”, you will get the best always amuses me. To my view all that a super charged salary and benefit package does is attract those with the largest egos and greediest personalities. They move on after a short period of time to the next role which offers even more money; having no thought, or loyalty, for the people or organisation they leave behind.

- Regarding the quality of management attracted by these packages; ask the shareholders of eg RBS, Northern Rock or Enron if they feel they were well served by the senior executives they were told were the best money could buy!

In short, if a senior executive starts to complain about his level of remuneration; then show him the door and help him on with his coat.
 

 

 The cost of the share option schemes should be taken immediately to the profit and loss account. “An expense is an expense, is an expense!”, no prevarication. This way it is clear to all the world exactly how expensive the senior executives are.

 

 Non executive directors should only be recruited from outside of the organisation.

 

 The remuneration of non executive directors should be increased, and the number of posts which they hold reduced (maximum three); to allow them to devote a more appropriate amount of their time to the company.

 

 Internal audit should report directly to the audit committee. The committee should consist of a majority of non executive directors who should be appointed in terms of the above. There should be no dotted line to other directors. Dual reporting lines, in my experience, weaken the independence and effectiveness of the internal audit function.

 

 The chairman of the audit committee should, like the senior partner from the external auditors, attend the AGM and be prepared to answer questions from the investors. 

 

 The chairman of the audit committee should be given the formal right to address the AGM without hindrance from the Board.

 

 The annual report should contain a statement from the audit committee signed by the chairman of the audit committee.

 

 External auditors should not provide add on consultancy services to their audit clients.

 

 Companies should adopt a code of conduct outlining their attitude to ethical principles, covering core values such as:

 

- Honesty
- Trust
- Respect
- Fairness

The code should state the company’s commitment to:

- Society (eg environmental issues, quality of service and products etc.)

- Shareholders (eg providing a decent return on equity)

- Employees (eg covering issues such as harassment, discrimination and quality of work)

The code should give clear guidelines as to the company’s attitude to, eg:

- Integrity of records.

- Bribes and commission payments.

- Interests outside the company leading to potential conflicts of interest.

- Respecting national and international law (eg obeying tax laws; viz complex off balance sheet schemes to evade tax should be disassembled immediately).

The code should be distributed to all employees, shareholders and be freely available to other interested parties. Compliance with the code should be audited annually, and a report to this effect placed within the annual report (what gets measured gets done!).

Why not stop delaying and just let’s get on and implement these changes now!

This author consults with leading institutions through GLG