Corporate governance in the aftermath of the global financial crisis, Volume IV : Emerging Issues in Corporate Governance [First edition.] 9781631571503, 1631571508, 9781631571527, 1631571524, 9781947843721, 1947843729, 9781947843745, 1947843745

Table of contents :
v. 1. Relevance and reforms --
v. 2. Functions and sustainability --
v. 3. Gatekeeper functions --
v. 4. Emerging issues in corporate governance.

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Emerging Issues in Corporate Governance Zabihollah Rezaee

Corporate governance has evolved as a central issue for public companies in the aftermath of the 2007–2009 global financial crisis. Corporate governance is a process (journey) of managing corporate affairs to create shareholder value and protect interests of other stakeholders. This book presents a road map for various functions and measures of corporate governance. The participants in the corporate governance process are the board of directors, executives, stakeholders, internal and external auditors, financial analysts, legal counsel, and regulators. This book is organized into four separate volumes; each volume can be utilized separately or in an integrated form. The first volume consists of five chapters that address the relevance and importance of corporate governance as well as the framework and structure of corporate governance. The second volume consists of four chapters that present the three prevailing corporate governance functions of oversight, management, and monitoring. The third volume consists of four chapters that address corporate governance functions performed by corporate gatekeepers, including policy makers, regulators, standard-setters, internal auditors, external auditors, legal counsel, and financial advisors. The fourth volume consists of five chapters that address the emerging issues in corporate governance, including governance for private companies and nonprofit organizations and convergence in global corporate governance. Zabihollah (Zabi) Rezaee is the Thompson-Hill Chair of Excellence, PhD coordinator, and professor of accountancy at the University of Memphis. He received his BS degree in Iran, his MBA from Tarleton State University in Texas, and his PhD from the University of Mississippi. Dr. Rezaee holds 10 certifications including CPA and has published over 220 articles, made more than 225 presentations, and contributed to 12 book chapters. He has published 10 books including two recent books on corporate sustainability. His most recent book on audit committee effectiveness was published in three volumes by Business Expert Press in July 2016.

Financial Accounting and Auditing Collection Mark S. Bettner and Michael P. Coyne, Editors

CORPORATE GOVERNANCE IN THE AFTERMATH OF THE GLOBAL FINANCIAL CRISIS, VOLUME IV

Curriculum-oriented, borndigital books for advanced business students, written by academic thought leaders who translate realworld business experience into course readings and reference materials for students expecting to tackle management and leadership challenges during their professional careers.

Corporate Governance in the Aftermath of the Global Financial Crisis, Volume IV

REZAEE

THE BUSINESS EXPERT PRESS DIGITAL LIBRARIES

Financial Accounting and Auditing Collection Mark S. Bettner and Michael P. Coyne, Editors

Corporate Governance in the Aftermath of the Global Financial Crisis, Volume IV Emerging Issues in Corporate Governance Zabihollah Rezaee

Corporate Governance in the Aftermath of the Global Financial Crisis, Volume IV

Corporate Governance in the Aftermath of the Global Financial Crisis, Volume IV Emerging Issues in Corporate Governance Zabihollah Rezaee

Corporate Governance in the Aftermath of the Global Financial Crisis, Volume IV: Emerging Issues in Corporate Governance Copyright © Business Expert Press, LLC, 2018. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means— electronic, mechanical, photocopy, recording, or any other except for brief quotations, not to exceed 250 words, without the prior permission of the publisher. First published in 2018 by Business Expert Press, LLC 222 East 46th Street, New York, NY 10017 www.businessexpertpress.com ISBN-13: 978-1-94784-374-5 (paperback) ISBN-13: 978-1-94784-375-2 (e-book) Business Expert Press Financial Accounting and Auditing Collection Collection ISSN: 2151-2795 (print) Collection ISSN: 2151-2817 (electronic) Cover and interior design by S4Carlisle Publishing Services Private Ltd., Chennai, India First edition: 2018 10 9 8 7 6 5 4 3 2 1 Printed in the United States of America.

Abstract Corporate governance has made impressive progress in the past two ­decades in the aftermath of financial scandals at the turn of the twenty-first century and the 2007–2009 global financial crisis. Corporate governance has moved to the center stage of corporate culture and business model in defining the roles and responsibilities of all corporate gatekeepers and holding them accountable for contributing to shared value c­ reation for all stakeholders. Today, corporate governance functions in an environment of ever-increasing regulatory reforms established to protect investors and the public from financial scandals and crisis and restore public trust and investor confidence in public financial information and financial markets. Corporate governance, in complying with the ever-increasing regulatory reforms, is striving to improve effectiveness. This volume presents emerging issues in corporate governance in the areas of board oversight function, managerial operation and performance, and gatekeepers’ r­esponsibilities and accountabilities. Recent regulatory r­eforms have created a better power-sharing balance between shareholders, the board of directors, and management in contributing to shared value creation for all stakeholders. This volume consists of five chapters addressing emerging issues in corporate governance including the global perspectives, convergence in corporate governance, and emerging issues relevant to shareholders, directors, and executives. This volume also examines the corporate g­ overnance of private and not-for-profit organizations and the future of corporate ­governance. Anyone who is involved with corporate governance, the financial reporting process, internal and external audit functions, and compliance with laws, rules and regulations should be interested in this volume. Specifically, corporations and their boards of directors and audit committees, executives, internal and external auditors, accountants, ­governing bodies, policy makers, regulators, users of financial statements (investors, creditors, pensioners), and other professionals (attorneys, ­financial analysts, bankers) and scholars conducting research in corporate governance will benefit from this volume.

vi KEYWORDS

Keywords business sustainability, corporate governance, emerging issues in corporate governance, global corporate governance, professional ethics, shared value

Contents Preface...................................................................................................ix Acknowledgments..................................................................................xiii Chapter 1 Corporate Governance, Performance, Evaluation, Accountability, and Reporting............................................1 Chapter 2 Transformation of Corporate Governance and Global Perspectives......................................................................23 Chapter 3 Corporate Governance of Private Companies and Not-For-Profit Organizations...........................................63 Chapter 4 Contemporary Issues of Corporate Governance...............87 Chapter 5 Future of Corporate Governance....................................137 Index..................................................................................................177

Preface In the aftermath of the 2007–2009 global financial crisis, corporate governance has been in the center stage of businesses, encouraged massive laws, regulations, rules, standards, and best practices that redefined the corporate governance structure, established significant corporate governance reforms, and created new responsibilities and accountability for corporate gatekeepers. Corporate gatekeepers are boards of directors, executives, regulators, auditors, legal counsel, institutional investors, among others. This book presents all applicable laws, regulations, rules, standards, guiding principles, and best practices impacting the structure and effectiveness of corporate governance in protecting the interests of all stakeholders, particularly shareholders. In today’s business environment, global businesses are under scrutiny and profound pressures from lawmakers, regulators, the investment community, and their diverse stakeholders to accept accountability and responsibility for their corporate governance effectiveness. Corporate governance is a process (journey) of managing corporate affairs to create shareholder value and protect the interests of other stakeholders. The landscape of corporate governance has significantly changed in recent years, and there is a need for a good book presenting the roles and responsibilities of corporate governance participants including directors, officers, stakeholders, and corporate gatekeepers. Effective corporate governance should develop a proper balance between the achievement of short-term targets and long-term sustainable performance. To effectively fulfill their fiduciary duties, corporate governance participants should lead from the front (and by example) and manage instability in hypercompetitive and global environments. This timely and relevant book describes the practice of good governance in the aftermath of the recent global crisis, with a keen focus on internal and external corporate governance mechanisms having the potential to address future global challenges. Corporate governance ­ measures are accelerating, converging, and reshaping organizational

x PREFACE

structure, corporate culture, ethics, trust, and transparency along with the roles, responsibilities, and accountability of all corporate functions designed to add value and contribute to sustainable performance. This book presents a road map for various functions and measures of corporate governance in addressing global finance, capital market, and economic challenges. Written in a practical and succinct style, it will focus on internal corporate governance mechanisms and the incorporated provisions of the Sarbanes-Oxley Act of 2002 (SOX), the Dodd-Frank Act of 2010 (DOF), the Jumpstart Our Business Startups (JOBS) Act of 2012, the Securities and Exchange Commission (SEC)-related implementation ­ rules, and global corporate governance best practices. This book presents the essential and fundamental concepts of corporate governance with a new holistic approach that addresses all corporate activities, performance, reporting, and assurance. Effective corporate governance has been the subject of extensive debate and discussion in various financial, professional, business, and accounting seminars. This book goes far beyond existing books on corporate governance that address only limited aspects of corporate governance. Organized into four separate volumes, each volume can be utilized separately or in an integrated form. The first volume addresses the relevance and importance of corporate governance as well as the framework and structure of corporate governance including corporate governance principles, mechanisms, and functions. It consists of five chapters that examine the importance and relevance of corporate governance, address internal and external corporate governance mechanisms, and present corporate governance functions, corporate governance theories, research, and education. The second volume consists of four chapters that present the three prevailing corporate governance functions of oversight, management, and monitoring. The third volume consists of four chapters addressing corporate governance functions performed by corporate gatekeepers, including policy makers, regulators, standard-setters, internal auditors, external auditors, legal counsel, and financial advisers. The fourth volume consists of five chapters addressing emerging issues in corporate governance ­including governance for private companies and nonprofit organizations, the global perspectives, convergence in global corporate governance, and emerging issues relevant to shareholders, directors, and executives.

PREFACE xi

The four volumes of this book present the essential and fundamental aspects, structure, and functions of corporate governance, with a keen focus on a new holistic approach that addresses all corporate activities, performance, reporting, and assurance. Anyone who is involved with corporate governance, the financial reporting process, and audit functions should be interested in this book. Specifically, corporations and their e­ xecutives, the boards of directors and audit committees, internal and external auditors, accountants, governing bodies, users of financial statements (investors, creditors, pensioners), business schools, and other professionals (attorneys, financial analysts, bankers) will benefit from this book. The four volumes should assist corporate governance participants with effectively discharging their responsibilities. This book is different from the existing corporate governance books in many ways: 1. Relevance: This book exposes readers to all functions of corporate governance (oversight, managerial, monitoring, and gatekeeping). 2. Comprehensiveness: Unlike existing books, this book presents a holistic approach to corporate governance by focusing on the role of all corporate governance participants (the board of directors, the audit committee, executives, SEC, Public Company Accounting Oversight Board [PCAOB], internal auditors, external auditors, investors, creditors, NYSE, NASDAQ, AMEX, other professional organizations, and users of financial reports). 3. Content Materials: This book incorporates provisions of the SOX, the DOF, the JOBS Act of 2012, the SEC-related implementation rules, corporate governance guiding principles of national stock ­exchanges, the Conference Board, the new auditing standards of the PCAOB, and other professional organizations into all chapters. Sincerely, Zabi Rezaee March 21, 2018

Acknowledgments I acknowledge the Securities and Exchange Commission, the ­Public Company Accounting Oversight Board, the American Institute of ­ ­Certified Public Accountants, Big Four Accounting Firms, and Corporate Governance Organizations for permission to quote and reference their professional standards and other publications. The encouragement and support of my colleagues at the University of Memphis are also acknowledged. In particular, two of my graduate ­assistants, Mr. Charles Bell and Mr. Matthew Cantin, provided i­ nvaluable assistance. I thank the members of the Business Expert Press team and S4Carlisle Publishing Services, including Scott Isenberg, Mark Bettner, Michael Coyne, and Premkumar Narayanan, for their hard work and dedication in editing the book. My sincere thanks are due to my family, my wife Soheila and my ­children Rose and Nick. Without their love, enthusiasm, and support, this book would not have come to fruition when it did.

CHAPTER 1

Corporate Governance, Performance, Evaluation, Accountability, and Reporting Introduction Corporate governance has evolved in the best decade as primarily a compliance process to its integration into the corporate culture and business environment. In the aftermath of the 2007–2009 global financial crisis, countries worldwide have taken initiatives to improve their corporate governance by establishing more robust corporate governance measures to enhance performance, promote economic stability, public trust, and investor confidence in their financial reporting. Good corporate governance also implies the need for a network of monitoring and incentives set up by a company to ensure accountability of the board and management to shareholders and other stakeholders. The strongest form of defense against governance failure comes from an organization’s culture and behaviors. An effective corporate governance demands proper communication among shareholders, the board of directors, management, and other gatekeepers. This communication is very important in ensuring democracy in the boardroom and transparency of managerial decisions and actions in achieving sustainable performance to create shareholder value. The role of corporate governance is to align management incentives with investor interests. Accountability and performance of all corporate governance participants should be properly measured and reported. This chapter presents corporate governance reporting (CGR), ratings, and index in reflecting the effectiveness of corporate governance measures and in establishing a benchmark in evaluating performance.

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Corporate Governance Performance Evaluation Corporate governance has evolved as a central issue within regulators and public companies in the wake of the 2007–2009 global financial crisis. Corporate governance is defined from a legal perspective as measures that enable and ensure compliance with all applicable laws, rules, regulations, and standards. From the agency theory perspective, corporate governance is defined as a process of aligning management interests with those of shareholders in creating shareholder value.1 Thus, corporate governance performance should reflect how effectively companies achieve their corporate governance objective of creating shared value for all stakeholders, while ensuring compliance with all applicable laws, rules, regulations, standards, and best practices. All corporate governance participants— from the board of directors to executives, regulators, internal and external auditors, legal counsel and financial advisers, and investors—play vital roles in the effectiveness of corporate governance. Good corporate governance is committed to transparency, which should lead to an increase in capital inflows from domestic and foreign investors. Corporate governance has evolved from compliance with laws and regulations to a business imperative in creating shared value for all stakeholders. The effectiveness of corporate governance in promoting sustainable performance and in enabling all corporate governance participants—from directors to executives, employees, and auditors—to add value to the success of their organizations should be communicated through CGR. Organizations can communicate the roles and responsibilities of all corporate governance participants and send a signal to shareholders about their success through CGR. The effectiveness of corporate governance depends on a vigilant board of directors, responsible and competent executives, and talented high-performance employees. The business culture of integrity, competency, and accountability can be measured in terms of corporate key performance indicators (KPIs), disclosed through CGR, verified by corporate governance assurance, and assessed by corporate governance ratings discussed in this chapter. Companies have recently undergone a series of corporate governance reforms aimed at improving the effectiveness of their governance, internal controls, and financial reports. Effective corporate governance promotes

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accountability, improves the reliability and quality of financial information, and prevents financial crisis and scandals. Poor corporate governance adversely affects the company’s potential, performance, financial reports, and accountability and can pave the way for business failure and financial crisis. While effective corporate governance may not ensure complete corporate success and may not prevent all corporate failures and fi ­ nancial ­crisis, ineffective corporate governance is a recipe for corporate failures and financial crisis. Corporate governance measures of the oversight function assumed by the board of directors, managerial function delegated to management, internal audit function conducted by internal auditors, external audit function performed by external auditors, and compliance function enforced by policy makers, regulators, and standard-setters are vital to the effectiveness of corporate governance, improvements in corporate governance performance, and the quality of financial information. To improve corporate governance performance, corporate governance participants—from the board of directors to executives, auditors, and legal counsel—must structure the process to ensure creating shared value for all stakeholders. The corporate governance structure is shaped by internal and external governance mechanisms, as well as policy interventions through regulations. Corporate governance mechanisms are viewed as a nexus of contracts that is designed to align the interests of management with those of the shareholders. The effectiveness of both internal and external corporate governance mechanisms depends on the cost– benefit trade-offs among these mechanisms and is related to their availability, the extent to which they are being used, whether their marginal benefits exceed their marginal costs, and the company’s corporate governance structure. Corporate governance performance can be significantly improved when there is an appropriate “balance of authority” exercised by boards, management, and shareholders in the corporate decision-making process and governance. Directors and executives are now accountable to a wide range of stakeholders, including shareholders, creditors, employees, customers, suppliers, government, and communities in which the corporation operates. In 2016, the Rock Center for Corporate Governance at Stanford ­University along with The Miles Group conducted a nationwide s­ urvey of 187 board directors of public and private companies.2 The study reveals

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that while boards generally rate themselves positively in terms of skills and expertise, significantly high negatives are a cause for concern for a large number of firms. The vast majority (89 percent) of respondents say that their board has the skills and experience necessary to oversee the company, whereas boards are less effective in taking proactive steps to ensure retaining a proper mix of skills. Over half (57 percent) of the directors agree that their board is effective in bringing new talent, and only one-third of directors (34 percent) rate their board very positively on planning for director turnover. Results of the survey suggest that boards can improve in the following areas3: 1. Trust levels are adequate as about two-thirds (68 percent) of directors report that they have a very high level of trust in their fellow board members. 2. Directors do not often provide each other with honest feedback as only a quarter (23 percent) of surveyed directors rate their boards very effective at offering feedback to fellow board members. 3. Boardroom dynamics are suboptimal for the majority of surveyed boards in the following areas: the active participation of all directors in decision making, the possibility of personal or past experience to dominate directors’ perspective, hesitation in expressing honest opinions in the presence of management, building consensus too quickly, not being focused on board issues, and a lack of proper ­understanding of the boundary between oversight function and managerial activities. Corporate top executives including CEOs and CFOs should be ­periodically evaluated by the board of directors for their performance. Executive compensation should be determined based on their performance. The 2016 public survey on executive compensation reveals that CEOs are generally overpaid with no relation to their performance; therefore, their compensation should be significantly reduced.4 The survey suggests the following: (1) CEOs are compensated more than they deserve as about 74 percent of Americans believe that CEOs are not paid the correct amount relative to their performance and in comparison with the average worker pay; (2) the majority of Americans (62 percent) believe that there

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is a maximum amount that CEOs should be paid relative to the average worker (e.g., 20 times compared with over currently paid 210 times), regardless of the company and its performance; (3) the majority believe that CEO pay should be capped in some manner; (4) the majority of respondents say that CEOs should receive only 0.5 percent of the annual revenues/value creation reported by the company as compensation; and (5) about half of respondents (49 percent) report that the government should do something to change current CEO pay practices based on the increased value creation.5 The 2016 survey of CEOs and directors on pay indicates the ­following: (1) public company directors give CEOs considerable credit for corporate success, believing that 40 percent of a company’s overall results, on average, are directly attributed to the CEO’s efforts; (2) about 76 percent of CEOs and directors believe that CEOs are paid correctly, based on the expected value of compensation awards at the time they are granted; (3) the high majority (95 percent) believe that CEO pay is aligned with performance; (4) more than 77 percent report that compensation arrangements contain the correct mix of short- and long-term incentives; and (5) about 75 percent report that a CEO’s compensation package should be performance based (rather than fixed or guaranteed).6

Corporate Governance Reporting Several corporate governance reforms in the United States have been established in the past two decades, including the SOX and the DOF to restore investor’s confidence in corporate America and financial markets. CGR is intended to present reliable, useful, timely, relevant, and transparent information regarding the way the organization is managed and run—from the independence and effectiveness of the board of directors to executive compensation and risk management and investor democratic election. Effective CGR should disclose all corporate governance KPIs in a systematic and standardized format. The content and format of such reporting should be tailored to the company’s organization culture, applicable regulatory measures, the corporate governance structure consisting of principles, mechanisms, and functions, and the roles and responsibilities of all corporate gatekeepers. The new corporate governance

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paradigm, drawn from scholarly research, suggests that shareholders and other non-shareholding stakeholders collaborate in achieving sustainability performance and disclosing both financial economic sustainability and non-financial environmental, social, and governance sustainability performance information (that create long-term shared value and resist short-termism.7) CGR entails assessing the quality and effectiveness of the organization’s corporate governance and reporting findings to interested stakeholders, including the board of directors, executives, auditors, regulatory agencies, and shareholders. CGR should disclose all relevant information about the effectiveness of the company’s corporate governance, focus on the company’s economic, governance, social, ethical, and environmental sustainability performance, provide transparent information about the company’s performance and its impacts on all stakeholders, and assess the company’s responsiveness to the needs of its stakeholders.8 Drivers of CGR are the following: (1) increasing attention on corporate governance in the aftermath of financial scandals at the turn of the twenty-first century and the 2007–2009 global financial crisis; (2) growing demand by investors and regulators on how public companies are run and managed; (3) market-driven interests in companies’ business models and KPIs; (4) changes in the balance of power between investors, the board of directors, and management resulting from new governance measures imposed by recent regulatory reforms; (5) more interest shown by stakeholders in understanding the roles and responsibilities of all corporate gatekeepers, including the board of directors, legal counsel, internal auditors, and external auditors; (6) the market demand for better alignment between management compensation and firm risk-taking and sustainable performance; (7) ever-increasing corporate governance regulatory reforms and best practices; and (8) the ongoing debate on how to improve the effectiveness of corporate governance either through principles-based and market-driven best practices or through rules-based and regulatory-driven reforms or perhaps through a combination of both.9 It is expected that regulatory reforms continue to advance, and best practices in corporate governance will evolve. The expected progress in corporate governance necessitates a better uniform and standardized

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CGR. Nonetheless, the establishment of globally accepted governance reporting presents many challenges regarding the format, content, structure, and frequency of reporting. Prevailing challenges are10 the following: 1. CGR is a sensitive issue addressing the roles, responsibilities, activities, and accountability of directors, which may have some business and legal repercussions. 2. There are a wide range of audiences for corporate governance with no clear reporting purposes. This growing diversity of audiences and of their information needs makes standardizing CGR difficult. 3. Corporate governance disclosures are often isolated from the story in the sense that major initiatives and developments along with major challenges are typically not mentioned in the governance report. 4. Inadequate focus on the effectiveness of corporate governance and the excessive use of the report as a compliance exercise reflecting the processes and procedures rather than performance 5. Investors’ lack of confidence in the value-relevance of corporate governance reports in providing useful information about the quality and performance of the board and management CGR entails assessing the quality of the organization’s corporate governance and presenting findings to interested stakeholders, including the board of directors, executives, auditors, regulatory agencies, and shareholders. Corporate governance reports disclose how well the company is managed, directed, and controlled. The extent and type of corporate governance disclosures reflected in the report can vary worldwide and at the minimum should include relevant information about the board composition, board committees and their functions, executive performance and compensation, and relations with and accountability to shareholders. Standards should be developed to assess, attest to, and report on the effectiveness of this process. Public companies do not usually report their corporate governance activities. However, in the post-SOX era, many companies have begun to disclose their corporate governance policies along with other information on their websites. Such reporting goes beyond the mandatory periodic financial reports or filings with regulatory bodies (the SEC). Corporate governance reports disclose the following:

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the company’s vision, strategies, and missions in creating sustainable stakeholder value; the composition, independence, and functions of its board of directors; and additional information pertaining to financial, economic, social, and environmental indicators. In November 2016, the King Committee released its King IV “Report on Corporate Governance for South Africa,” which became effective on or after April 2017. The new King Code is viewed as a positive step toward outcomes-based and principles-based reporting on corporate governance.11 As companies focus on the achievement of long-term sustainable performance, the corporate governance report should reflect long-term corporate governance KPIs. The integrated sustainability/CGR is now required or highly recommended by stock exchanges in several countries, including Hong Kong, South Africa, the European Union’s directive on environmental, social and governance (ESG), the United Kingdom’s strategic report, the Operating Financial Review in Australia, and some of the regulations of the SEC in the United States. A corporate governance report should at the minimum disclose the following: 1. How the company is managed, directed, and controlled 2. Relevant information about the board composition, board committees and their functions, executive performance and compensation, and relations with and accountability to shareholders 3. Information regarding management performance, compensation, and its link to performance 4. Disclosures regarding internal control assessment 5. Disclosures about risk management and assessment 6. Disclosures on foreign operations, assets, and liabilities 7. Disclosure of diversity including race and gender 8. Disclosure of nonfinancial performance including corporate social responsibility and environmental initiatives.

Corporate Governance Key Performance Indicators KPMG advises that effective corporate reporting should properly target its audience and provide sufficient, credible, and reliable information that

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would assist in investors in their decision making.12 It is unrealistic to expect all corporate directors and officers to provide accurate and complete financial information all the time. Indeed, the reported financial scandals and highly publicized financial restatements prove that directors and officers can be motivated to provide misleading and fraudulent financial reports when the opportunities exist. Thus, corporate governance measures are designed to create a culture of ethical conduct and compliance and to ensure that investors receive accurate, complete, and timely information to make investment and voting decisions. Corporate success and its corporate governance effectiveness should be measured and disclosed through KPIs. KPIs can be prepared for both financial and nonfinancial activities such as corporate governance to present a company’s progress toward achieving its goals. KPIs should reflect a company’s corporate governance effectiveness including strategic mission, goals, and how these goals are measured and achieved. KPIs should communicate key activities used by the board of directors and officers in managing an organization such as achieving a desired return on investment for shareholders, maximizing customer satisfaction, or attracting and retaining the best and most talented employees. Public companies should p ­ roperly disclose their corporate governance KPIs to inform all s­takeholders, including shareholders, about the effectiveness of their corporate governance in creating shared value for all stakeholders. These consolidated disclosure requirements include board meetings and committees; particular disclosures regarding audit, nominating, and compensation committees; and a narrative description of the company’s procedures for determining director and executive compensation, related-person transactions, director independence, and other corporate governance matters. The extent and types of corporate governance KPIs can vary among companies, their peers, industries, and countries, with the one overriding determinant of being relevant to the company and its operations. The following are some examples of corporate governance KPIs: • Number of board committees, percentage of board independence, full independence of board committees, board diversity in terms of ethnicity, sex, expertise, and minority, staggered board, separation of the position of the chair of the board, and CEO

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• Board accountability and liability, number of board meetings, number of members in the board, and percentage of insider directors on the board • Number of members in the audit committee, number of audit committee meetings, and number of audit committee financial experts • Value of stock options awarded to the directors, and the link ­between executive compensation and financial performance.

Electronic Corporate Governance Reports Using XBRL The Extensible Business Reporting Language (XBRL) format, a derivative language of the Extensible Markup Language, has recently gained considerable attention of 450 major companies and is becoming an integral component of corporate reporting.13 XBRL is a consortium consisting of a series of technical specifications intended to make business information more accessible and more easily communicated electronically. XBRL also facilitates the timely and accurate analysis of both internal and external business information. Companies and users of business reports can electronically search, download, and analyze information that is “tagged” electronically. XBRL also facilitates the timely and accurate analysis of both internal and external business information. Companies and users of business reports can electronically search and download financial and nonfinancial information. The primary benefits of XBRL are the ability to retrieve and analyze data and to facilitate interparty interactions without human interference, as well as the formalization of labels, definitions, and interpretations. XBRL defines and tags data using standard definitions that provide a mechanism for consistent structure and the use of the XBRL US Generally Accepted Accounting Principles (GAAP) Financial Reporting Taxonomy and/or other taxonomies including those developed by the International Financial Reporting Standards (IFRS) or extended (customized) tags based on either national or international accounting standards. The SEC has encouraged public companies to tag financial statement information on the EDGAR reporting system using XBRL since 2005, as

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approximately 9,600 public companies are filing XBRL-formatted information with the SEC.14 Since 2009, the SEC has required that public companies that use US GAAP file their financial statements in the XBRL format. The development of the XBRL taxonomy for sustainability reports represents an important milestone in implementing the concept of sustainability reporting. While the use of XBRL facilitates the standardization of sustainability reporting, there are many challenges that must be addressed as financial reporting paradigm shifts from a paper-based to an information-based model. A variety of XBRL taxonomy has been proposed to be used for sustainability reporting in order to harmonize the document structure for online communication by organizations. The mandatory use of XBRL-formatted financial reporting is an important step in applying XBRL to corporate governance performance as well as the effective and efficient analysis by all participants (board of directors, management, auditors, legal counsel, financial analysts, regulators, and investors) involved in the corporate reporting process. The tags of corporate governance taxonomies describe each of the corporate governance measures and have labels that are both human- and machine-readable and show their relation to other sustainability data elements and applying sustainability frameworks (e.g., GRI v.4). XBRL-tagged sustainability reports, when made publicly available, can be used by all stakeholders interested in corporate governance information. The global acceptance of XBRL-formatted corporate governance reports requires the proper development of taxonomies for both internal and external mechanisms of corporate governance. The corporate governance Taxonomy Architecture is intended to integrate the XBRL frameworks (i.e., architectures) of the IFRS and US GAAP taxonomies and then supplement them with ­nonfinancial taxonomies (e.g., GRI, CCI, WICI, GRC, CDP, CCRT, and IS-FESG) relevant to corporate governance measures. Once benchmarking and best practice taxonomy has been completed, corporate governance KPI metrics can be identified and integrated into the XBRL taxonomy. The existing XBRL taxonomies focus on objective/factual items as the basis for taxonomy elements. XBRL GL is a unique technology suggested for integrating CGR and XBRL.15

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Corporate Governance Assurance Given that CGR gains acceptance, be standardized, and practiced, then its reliability, objectivity, transparency, and credibility can be improved by providing assurance on corporate governance reports. Unlike audit reports on financial statements and internal control over financial ­reporting, assurance opinions on corporate governance reports are neither ­standardized nor regulated. A number of professionals, including internal auditors, external auditors, and other service providers, can offer assurance on corporate governance information. International accounting firms have developed expertise in sustainability reporting and assurance in general and CGR in particular, and they are well equipped and trained to provide assurance services on corporate governance reports. Currently, corporate governance reports are voluntary and normally not audited by external auditors. Accounting and auditing standards are long-established for financial reporting and auditing.16 Standards also exist for measuring, recognizing, reporting, and auditing of governance, ethics, social responsibility, and environmental activities and performance, but these are fairly new by comparison. The persisting challenge is to disclose concise, accurate, reliable, complete, comparable, and standardized sustainability reports that are relevant and useful to all stakeholders.17 The Global Reporting Initiative in April 2001 released its working paper entitled Overarching Principles for Providing Independent Assurance on Sustainability Reports that can also be used for corporate governance reports.18 Aspects of test procedures in a limit assurance engagement including timing, nature, and the extent are determined based on the practitioners’ understanding of the engagement’s circumstances, underlying subject matters, critical events, risk of significant misstatement of information, the materiality of information presented, the level of meaningful and relevant assurance for intended users, and professional judgment. The common understanding is that applied evidence-gathering procedures in a limited assurance engagement include an understanding of the ­client’s subject matter (social, governance, ethics, environmental performance); inquiries of management, board of directors, and personnel; and ­analytical procedures. The assessment of the effectiveness of internal

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control concerning subject matter information is recommended but not required. Additional test procedures may be performed if the practitioner becomes aware of matters that cause him or her to believe the information may be materially misstated. Evidence gathered by performing additional procedures should assist the practitioners in either concluding that the area of concern is not likely to cause the subject matter information to be materially misstated. Appropriate working papers should be presented for both reasonable assurance and limited assurance engagements. ­Working papers should document the type of engagement, considered subject matter and related information, engagement standard applied, test procedures ­performed, evidence gathered, and conclusions reached.19 The level of assurance provided by auditors on sustainability performance is determined by the type of sustainability category. The level of assurance from low to high depends on the type of assurance from social to economic, as well as the extent and nature of evidence-gathering procedures. In general, obtaining assurance requires an objective examination of subject matter and gathering of sufficient and competent evidence to provide an impartial assurance on the subject matter.20 Audits on financial statements reflecting the economic dimension of business s­ustainability has a high to reasonable level of assurance, whereas the review of social dimension of sustainability performance can offer only a low to limit level. Examination of corporate social responsibility performance requires assurance providers to offer limit assurance indication that the third-party provider is not aware of noncompliance with state social criteria.21 In the opinion-formulation stage, audit evidence includes information relating to the completeness, validity, and accuracy of the financial statements as a whole, such as information relating to the consistency of the financial statements with the auditor’s knowledge of the business. The audit report is the most common and highest level of assurance provided by an independent auditor to those interested in a company’s financial information. The company’s financial statements are the most common assertion upon which assurance is expressed. The preparation of the audit report is also the final phase of the auditing process, and to meet these responsibilities, auditors must have a thorough understanding of the auditing standards pertaining to auditors’ reports. This includes knowledge of the contents of the audit report regarding different types

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of opinions and the conditions that must be made for them to be issued. Independent auditors provide various levels of assurance about different types of assertions. Performing attestation is the most important way by which they add credibility to an assertion of the financial statements prepared by the company’s management. The credibility added is in the form of an audit report that expresses assurance about the assertion. This report is often the only formal means of communicating to interested parties a conclusion about a company’s financial statements. Corporate governance assurance should lend more credibility to corporate governance reports by providing assurance on the effectiveness of all corporate governance functions, from oversight function by the board of directors to management function by executives, compliance function by regulators, assurance function by auditors, and monitory function by investors. Corporate governance assurance reports provide assurance on the adequacy and effectiveness of both internal and external mechanisms, risk management, control processes as well as the integrity and reliability of both internal and external reports. A corporate governance assurance report may include the following: 1. Assurance on all seven corporate governance functions and their effectiveness 2. Assurance on the assessment and management of risks including reputational, strategic, operational, financial, cybersecurity, and compliance risks 3. Assurance on both financial economic sustainability performance and nonfinancial environmental, ethical, social, and governance sustainability performance.

Corporate Governance Ratings Public companies can be evaluated based on their corporate governance measures and practices. Corporate governance ratings are opinions of professional organizations and individual experts on the relative standing of a company’s corporate governance measures and practices as well as compliance with designated corporate governance codes to other companies in the same industry, country, or internationally. Corporate governance ratings are intended to serve as a benchmark in providing a credible and independent

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assessment of the quality and quantity of a c­ ompany’s ­corporate ­governance and suggestions for further ­improvements as well as proper information to stakeholders regarding the extent of a company’s c­ orporate governance effectiveness. Several professional organizations, including the Credit Analysis and Research (CARE) Ratings Professional Risk Opinion, and the International Credit Rating Agency’s (ICRA) Corporate Governance Rating, provide corporate governance ratings for public companies. These ratings reflect the roles and responsibilities of corporate governance participants—from the board of directors to executives, legal counsel, financial advisers, and internal and external a­ uditors—as well as their accountability. These ratings differentiate companies with high rating as a proxy for good/effective corporate governance from those with low rating as a proxy for bad/ineffective corporate governance. Thus, high ratings can assist corporations to raise public funds, improve reputation/image/credibility, enhance valuation, enable listing or continue listing on stock exchanges, and bring about more transparent relationships with shareholders and other nonshareholding stakeholders. Corporate governance, as defined in this book, is a process of directing, managing, and controlling corporate activities to create shareholder value. Thus, the corporate governance rating is the valuation of this process by independent organizations and rating agencies and should be of importance to investors and others in assessing corporate governance effectiveness. Potential users of corporate governance ratings are institutional investors, individual investors, regulators, accounting firms, corporate governance consulting and executive search firms, and public companies and their stakeholders. These corporate governance ratings are determined based on up to 100 corporate governance measures relevant to shareholder rights and democracy, board structure and composition, board committees and their roles, and audit practices and quality. Good corporate governance ratings can enable companies to improve their bottom-line performance, profit, and valuations, lower their cost of capital (both debt and equity), develop more favorable relations with regulators and all stakeholders, and have better access to financing. Adversarial and weak corporate governance ratings can result in poor performance, increased cost of capital, risky financing strategies, and susceptibility to financial crisis. Exhibit 1.1 provides the names and websites/URLs of several corporate governance rating agencies.

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Exhibit 1.1 Corporate Governance Rating Agencies Rating Agency

Website/URL

Description

Institutional Shareholders Service (ISS)

http://issgovernance.com/files/ ISSGovernanceQuickScore TechDoc.pdf

Provides proxy voting and corporate governance services to institutional investors ISS Corporate Governance Quotient, 2002 Government Risk Indicator (GRID), 2010 ISS QuickScore since 2013

GovernanceMetrics International (GMI)

https://www.msci.com/ esg-integration http://www3.gmiratings.com/

GMIRATINGS was formed in 2010 through the merger of three independent companies of The Corporate Library (1999), GovernanceMetrics International (2000), and Audit Integrity (2002)

Standard & Poor’s (S&P) Corporate Governance Scores and Evaluations, 2004

https://www. standardandpoors.com/en_ US/web/guest/ratings/ratingscriteria/-/articles/criteria/ corporates/filter/general

Evaluating the corporate governance effectiveness of S&P companies

Corporate Library

http://www.bloomberg. com/research/stocks/ private/snapshot. asp?privcapId=8081642 http://www.marketwired. com/press-release/ The-Corporate-Libraryand-GovernanceMetricsInternational-Agree-toMerge-1294553.htm

Established its Board Analyst rating service in December 2002

Investor Responsibility Research Center

http://irrcinstitute.org/

Its assessment tool, Benchmarker, includes more than 70 corporate governance data points, research, data-driven and objective analysis.

Moody’s Investors Service

https://www.moodys.com/

It provides corporate governance assessments as part of its corporate finance research product.

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A firm’s corporate governance rating has been its determinant of how effective its governance policies are, but how reliable they are and how useful they are in determining future performance has been debated. Daines, Gow, and Larcker22 examine ratings from RiskMetrics, Governance MetricsInternational (GMI), The Corporate Library, and Audit Integrity to determine the effectiveness of these ratings. The Corporate Governance Quotient (CGQ) score in RiskMetrics uses subcomponents to evaluate the overall quality, strengths, and deficiencies of a firm’s governance. The GMI score emphasizes quality, transparency, and compliance of governance principles. The Corporate Library gives the Board Effectiveness Rating, which is based more on the judgment of The Corporate Library staff. Audit Integrity focuses on the firm’s financials but considers governance to be a significant factor in the rating. Different corporate governance ratings have different predictive values. For example in predicting for negative outcomes such as restatements and lawsuits, the GMI and Audit Integrity corporate governance ratings are predictive of restatements, whereas the Corporate Library ratings are related to restatements. Audit Integrity’s rating is typically predictive of the negative outcome for lawsuits and can also significantly predict future operating performance. None of the ratings are able to predict firm value. Both the ­Corporate Library’s and Audit Integrity’s ratings have positive relationships with future excess returns, whereas a negative relationship was found for the CGQ score, suggesting more about a lower cost of capital than corporate governance. Overall, these ratings do not hold much predictive value of future financial performance. From the investors’ point of view, despite these ratings having little to no predictive value, they are still important for weeding out corporations that have weak governance policies, promoting more shareowner-friendly practices, and using proactive stock selection. The well-publicized rash of high-profile financial scandals caused some institutional investors to be more active in monitoring companies in which they invested, including paying more attention to corporate governance and considering its effectiveness in their investment decisions.23 The well-deserved, long-awaited investor focus on corporate governance generated a demand for the development of ratings metrics or systems that gather, analyze, rank, and compare the corporate accountability

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practices of public companies.24 National and international organizations, including Glass Lewis & Co. (Glass Lewis), Institutional Shareholder Services, GMI, The Corporate Library, Standard & Poor’s, and Moody’s Investment Service, have developed and published variations of corporate governance ratings that are often used by institutional shareholders in assessing their stock returns, and by bondholders in determining the costs of lending. Many of these ratings are correlated; the Glass Lewis pay-forperformance analysis and the Board Analysts’ CEO compensation rating found low correlation.25 Corporate governance ratings are evolving and as such some inconsistencies in ratings among these providers may exist. For this reason, caution should be exercised in using ratings from several providers.26 The Credit Agency Reform Act (CARA) was signed into law on September 29, 2006, amending the Securities Exchange Act of 1934. The CARA is intended to improve the quality of credit ratings and to protect investors by enhancing accountability, competition, and transparency in the credit rating industry.27 The CARA establishes a registration process that grants the SEC’s authority to register Nationally Recognized Statistical Rating Organizations (NRSROs).28 Some of the provisions of the CARA are as follows: (1) The SEC has exclusive authority for NRSRO registration and qualification; (2) NRSROs must meet criteria set forth in the CARA to be registered as a credit rating agency; (3) The SEC will oversee the registered NRSROs through examinations and enforcement actions; (4) The SEC is directed to issue rules concerning conflicts of interest and the misuse of nonpublic information by NRSROs; and (5) Registered NRSROs are subjected to disclosure requirements to improve the transparency and disclosure of conflicts of interest, procedures, and methodologies used in determining credit ratings.29

Conclusion The role of corporate governance is to align management incentives with investor interests. Good corporate governance is committed to transparency, which should lead to an increase in capital inflows from domestic and foreign investors. Good corporate governance also implies the need for a network of monitoring and incentives set up by a company to ensure

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accountability of the board and management to shareholders and other stakeholders. The strongest form of defense against governance failure comes from an organization’s culture and behaviors. Effectiveness depends on employee’s integrity and begins with the tone management set at the top. In addition, boards should routinely oversee their own actions against the acceptable governance principles. Organizations should ensure their boards have the qualifications and experience to approve an organization’s strategy and to evaluate how it is executed and reported on. The effectiveness of corporate governance is a function of the ­ robustness of internal and external governance mechanisms, corporate ­ ­ governance reforms, and the integrality and competency of corporate ­governance ­participants, from the board of directors to ­management, auditors, legal counsel, financial advisers, and e­ mployees. Corporate governance participants must structure the process to ensure the goals of both shareholder value creation and stakeholder value ­protection for public companies. The corporate governance structure is shaped by internal and external governance mechanisms, as well as policy interventions through regulations. The effectiveness of both internal and external corporate governance mechanisms depends on the trade-offs among these mechanisms and is related to their availability, the extent to which they are being used, whether their marginal benefits exceed their marginal costs, and the company’s corporate governance structure. These attributes of corporate governance should be communicated to all stakeholders through corporate governance reports.

Endnotes 1. Z. Rezaee. 2007. Corporate Governance Post Sarbanes-Oxley, Regulations, Requirements, and Integrated Processes (Hoboken, NJ: John Wiley & Sons, Inc). 2. D.F. Larcker, S. Miles, T. Griffin and B. Tayan. 2016. 2016 Survey: Board of Director Evaluation and Effectiveness. The Rock Center for Corporate Governance and the Miles Group. https://www.gsb.stanford.edu/sites/gsb/files/publication-pdf/cgri-survey-board-directorsevaluation-effectiveness-2016.pdf 3. Ibid.

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4. D.F. Larcker, N.E. Donatiello, and B. Tayan. February, 2016. Americans and CEO Pay: 2016 Public Perception Survey on CEO Compensation. Stanford Rock Center for Corporate Governance. https:// www.gsb.stanford.edu/sites/gsb/files/publication-pdf/cgri-survey2016-americans-ceo-pay.pdf 5. Ibid. 6. D.F. Larcker, N.E. Donatiello, J. Thompson, and B. Tayan. 2016. CEOs and Directors on Pay: 2016 Survey on CEO Compensation. https://www.gsb.stanford.edu/sites/gsb/files/publication-pdf/cgrisurvey-2016-ceo-compensation_0.pdf 7. World Economic Forum (WEF). 2016. “The New Paradigm,” International Business Council of the World Economic Forum. http://www .amgovcollege.org/uploads/7/8/4/7/78472964/international-­businesscouncil-of-the-world-economic-forum-the-new-paradigm.pdf 8. Z. Rezaee. 2015. 9. Ibid. 10. Report Leadership. March, 2012. Corporate Governance: Simple, Practical Proposals for Better Report of Corporate Governance. www .reportleadership.com 11. King IV. 2016. Report on Corporate Governance for South Africa 2016. http://c.ymcdn.com/sites/www.iodsa.co.za/resource/resmgr/ king_iv/King_IV_Report/IoDSA_King_IV_Report_-_WebVe.pdf 12. PricewaterhouseCoopers. 2012. Effective Reporting: It’s a Matter of Taking Steps in the Right Direction. http://www.pwc.com/mx/es/ servicios-governance-risk-compliance/archivo/2012-09-effectivereporting.pdf 13. FASB. 2017. About XBRL. Board. http://www.fasb.org/jsp/FASB/ Page/SectionPage&cid=1176157087972 14. Securities and Exchange Commission (SEC). 2012. Remarks to the IFRS Taxonomy Annual Convention (from April 25, 2010). http:// www.sec.gov/news/speech/2012/spch042512ms.htm 15. Climate Change Reporting Taxonomy. CCRT. 2013. Climate change reporting taxonomy (CCRT) due process. https://www .cdproject.net/en-us/news/pages/xbrl-due-process.aspx 16. Brockett and Rezaee. 2012. 17. Ibid.

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18. Global Reporting Initiative (GRI). 2002. Sustainability reporting guidelines on economic, environmental and social performance. Global Reporting Initiative, Amsterdam. 19. Ibid. 20. Brockett and Rezaee. 2012. 21. Ibid. 22. R. Daines, I. Gow, and D. Larcker. 2010. “Rating the Rating: how Good Are Commercial Governance Ratings?” Journal of Financial Economics 98, pp. 439–461. 23. A. Goodman, and B. Schwartz. 2004. Corporate Governance: Law and Practice (New York, NY: Matthew Bender & Co). 24. Ibid. 25. Ibid. 26. I.M. Millstein. 2005. “Beware the ‘box tickers.’” Spencer Stuart US Board Index 2005. http://content.spencerstuart.com/sswebsite/pdf/ lib/SSBI-2005.pdf 27. Securities and Exchange Commission (SEC). September 29, 2006. Credit Rating Agency Reform Act. https://www.sec.gov/ocr/cra-reform-act-2006.pdf 28. Ibid. 29. Ibid.

CHAPTER 2

Transformation of Corporate Governance and Global Perspectives Introduction Corporate governance has evolved from a compliance process to a ­strategic imperative intended to create shared value for all ­stakeholders. C ­ orporate governance reforms are developed to align management’s interests with those of shareholders and ensure the achievement of s­ustainability performance. Corporate governance measures vary among countries because of political and cultural infrastructure, regulatory framework, and information infrastructure. A dynamic financial system and reliable financial information are essential for ensuring global ­economic development and growth. The persistence of differences in global economic structure, financial systems, and corporate environment necessitates a move toward convergence in corporate governance ­measures and regulatory reforms. The emerging global corporate g­ overnance reforms are shaping the structure of capital markets worldwide and altering their competitiveness and the protection provided to investors. The globalization of capital markets and the demand for investor protection in response to financial scandals worldwide, such as Enron, WorldCom, Parmalat, Ahold, and Satyam, also require consistency and uniformity in regulatory reforms and corporate governance practices. This chapter presents the evolution and global perspective on corporate governance, corporate governance of multinational companies, and the possible convergence in corporate governance.

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A Historical Perspective of Corporate Governance Historically, the importance and relevance of corporate governance to public companies was introduced in the three-book series by Berle and Means during the time of the establishment of the Securities and Exchange Commission (SEC) in 1933.1 During that period, the primary corporate governance issue centered around the requirement of public companies to establish infrastructures to address the need for a separation of powers between the company’s management (agent) and its shareholders (principals).2 The creation of limited liability provisions for corporations, driven by significant growth in the number of shareholders investing in public companies in the early 1900s, caused more distance between shareholders and management in terms of location, knowledge, and access to the company’s day-to-day operations. These developments demand an oversight role of the board of directors, as representatives of shareholders, without much attention being given to corporate governance. Early references to the term corporate governance are documented in a speech by ­Clifford C. Nelson, the president of the American Assembly in 1978, who defined corporate governance as “a fancy term for the various influences that determine what a corporation does and does not do or should and should not do.”3 These influences at that time were commonly referred to as corporate infrastructures to separate power between management and shareholders. Corporate governance reforms were developed in response to the irregularities and failures of public companies in creating value for their shareholders. The legal view of corporate governance initially appeared in the 1984 report of the American Law Institute titled Principles of Corporate ­Governance.4 Jensen and Meckling, in their well-cited paper titled “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure,” address the potential for struggle and conflicts of interest between management and owners, as well as the need for maintaining equilibrium between these parties.5 The ultimate responsibility for maintaining a proper balance between management and the owners rests with the board of directors as it oversees managerial functions and ensures protection of investors’ interests. To maintain such equilibrium, it is important to ensure the independence of the board of directors from management and



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to improve the board of directors’ oversight function through effective corporate governance. Corporate governance at this stage was about creating a proper balance of power sharing between shareholders, the board of directors, and management, who was typically in the driver’s seat of corporate governance. The financial scandals of Enron, WorldCom, Global Crossing, among others at the turn of the twenty-first century underscore the ­ineffectiveness of corporate governance in overseeing and monitoring the opportunistic self-dealings of the executives of many public companies. Investors lost their confidence in the financial reports of public companies and thus in the financial markets. In the United States, Congress responded by passing the SOX to combat financial scandals and improve corporate governance effectiveness.6 Other countries in response to the global financial scandals and the 2007–2009 global financial crisis developed their corporate governance reforms to protect investors’ interests. In addition, a principles-based, stakeholder-driven approach to corporate governance was initiated to implement corporate guidelines. In Europe, in accordance with the “comply or explain why not” principle, corporate governance usually has a stronger chance of success than a heavy legislative approach. This provides boards with the freedom to apply a recommendation differently, or to apply another practice, if they consider that to be in the best interest of the organization with a proper explanation for noncompliance. To reinforce the culture and behaviors necessary for good governance, boards of directors should routinely check their own actions against the applicable governance principles. Boards should be sufficiently independent, competent, and focused on sustainable organizational performance. Useful governance disclosures will show the actual governance performance of the organization, not only the governance policies and procedures. Another newly developing perspective is one that involves board members with independent, nonexecutive ties to the organization. Ensuring the independence of board members needs to start with improving the independence of the nominations committee and the way it operates. In addition, regulators should also take action to further increase the number of independent nonexecutive directors on boards and further empower them to take an independent view. Another option is to provide

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the independent nonexecutive directors with a venue for disclosures, such as their own section of the business report, where they would have to disclose any concerns or issues on which they have disagreed with the rest of the board. Technological advances and global competition enable corporations and their investors to decide where to raise capital, where to invest, and where secondary trading is to occur. This in turn provides companies with a choice of what regulatory regime they prefer to operate under, and investors choose the type and extent of regulatory safeguards and protections they desire. Investor confidence in the global capital markets is the key driver of global economic growth, prosperity, and financial stability. Regulatory regimes and their legal requirements often explain the cross-country variation in ownership structure, legal and political systems, corporate governance, financial reporting, and investor protection. The safety, depth, and liquidity of capital markets around the world are associated with regulatory regimes and legal systems, with common law systems consistently outperforming civil law systems as strong investor protection gives rise to high-quality financial reports. An effective and strong investor protection environment influences the capital market reactions to financial disclosures as accounting information is more value-relevant in countries with strong investor protection. Specifically, common law countries characterized by a dispersed ownership structure and more enforceable investor protection exhibit effective corporate governance and produce higher-quality financial reports, as explained in this chapter. There are no globally accepted corporate governance reforms and best practices. Differences are mainly driven by a country’s statutes, corporate structures, and culture. Country statutes could pose challenges for regulators in adopting corporate governance reforms and financial reporting disclosures for both home companies and multinational corporations. Both the United States and the United Kingdom, for example, operate under common law, which tends to give more anti-director privileges to minority shareholders compared with countries operating under code law (e.g., Germany), in which the primary purpose is to ensure that majority shareholders do not benefit at the expense of minority shareholders. Additionally, corporate governance rules in the United States are typically regulator-led, being established by the SEC to protect investors.



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Yet corporate governance reforms in the United Kingdom are normally shareholder-led, indicating that investors are responsible for safeguarding their own interests. Corporate and capital structure can also influence corporate governance and financial disclosure requirements. One of the key differences in corporate structure involves ownership of the company. In the United States, ownership of shares is dispersed among the more than 110 million Americans who own company shares through direct investment and retirement plans. Comparative stock ownerships in Europe are more concentrated, and thus controlling shareholders are in a better position to influence corporate governance and business operations. For strong governance, organizations should ensure that their boards have the capability, the qualifications, the breadth, and the level of experience—to approve an organization’s strategy and to evaluate the way it is executed and reported on. Independent nonexecutive directors should be better supported by participating in a formal induction into the organization and professional development, training, and practical guidelines on topic areas, such as corporate governance, supervision over the implementation of financial reporting standards, and financial management. The standard of corporate governance can be determined at a corporate level or at a country level, and it is natural that they are interrelated. The corporate governance system of a country and its standard is determined by a number of interrelated factors, including political beliefs, culture, legal system, accounting systems, transparency, ownership structures, market environments, the level of economic development, and its ethical standard, as explained in the following sections.

Corporate Governance Reforms and Best Practices Corporate governance in a dispersed share ownership is designed to align the interests of management with those of shareholders. That is, management may have incentives to engage in earnings management and focus on short-term considerations at the expense of sustainable shareholder value creation and long-term performance. Conversely, with concentrated ownership, corporate governance creates a balance between the interests of minority and majority shareholders. The primary purpose of

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corporate governance in the United States is to enhance shareholder value creation, while protecting the interests of other stakeholders (creditors, employees, suppliers, customers, and government), whereas in Germany, the focus is more on protecting creditors, as banks play an important role in financing companies. The board of director system can also influence corporate governance. For example, with one-tier boards as in the United States, shareholders elect directors to oversee management in running the company. By contrast, in the two-tier board system as in Germany, the supervisory board advises, appoints, and oversees the management board in company operations. In Japan, however, a complex system of committees oversees and runs companies. Cultural and political differences can also influence corporate governance, as some cultures, such as Germany, are more collective and risk-averse than others such as the United States. An appropriate question is whether differences in corporate governance can be reconciled and whether convergence in corporate governance is possible. In 2004, the Organization for Economic Co-operation and Development (OECD) attempted a move toward corporate governance integration.7 The OECD has established a set of corporate governance principles designed to protect all investors, particularly shareholders, which the International Corporate Governance Network (ICGN) later adopted.

Differences in Corporate Governance Corporate governance is a process affected by legal, regulatory, contractual, and market-based mechanisms, and best practices to create shareholder value, while protecting the interests of other stakeholders.8 This definition implies that there is a dispersed ownership structure, and thus the role of corporate governance is to protect stakeholders’ interests by limiting the opportunistic behavior of management who controls their interests. In a capital structure, such as Germany, with concentrated ownership, where a small group of shareholders exercise control, corporate governance should ensure the alignment of interests of controlling shareholders with those of minority or individual shareholders. However, the degree of investor protection provided by corporate governance varies across countries because of differences in their legal origin. Corporate governance is also applicable



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to not-for-profit organizations (e.g., churches, universities, governmental entities) in managing and running the organizations in the best interests of their constituencies. There is a global move toward the adoption of a more long-term ­orientation and sustainability performance. This movement requires boards of directors to actively engage in guiding and overseeing a ­company’s strategy for long-term and sustainable value creation. H ­ ­ owever, the ­achievement of long-term and sustainable value creation can be affected by ­differences in global corporate governance measures presented in this section. D ­ ­ etermination of differences in corporate governance in the United States and other countries centers around (1) corporate ownership and control, (2) capital markets, (3) culture, and (4) the legal system.9 Corporate Ownership and Control Corporate ownership in countries other than the United States is much more highly concentrated through large banking institutions or family ownership. The concentration of corporate ownership and control and government ownership of a large portion of corporate shares can significantly influence corporate governance in those countries. Ownership structure is an important aspect of corporate governance, which determines the nature and extent of both internal (e.g., composition of the board) and external (e.g., rules and regulations) mechanisms needed to protect investors and minimize agency costs (e.g., information asymmetries and self-dealing by management). The ownership structure can be either (1) highly dispersed with substantial ownership by institutional investors (e.g., pension funds, mutual funds, and insurance companies), such as the United States and the United Kingdom, and usually open to cross-border portfolio holdings or (2) concentrated ownership primarily in the hands of families, such as in Europe and Japan, with potential agency costs arising between controlling owners and minority shareholders. Capital Markets Public companies in the United States raise both equity and debt directly from the public through the capital markets, whereas banks in Europe

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and Asia are the primary source of capital for companies. Public companies’ lending arrangements with banks and banks’ ownership of large blocks of shares empower banks to monitor and control the companies’ affairs and influence their corporate governance. Capital markets provide the means to alleviate scarce financial resources, which in turn facilitates access to global investments and also provides the forum for global exchanges to list public companies. Capital markets facilitate the investment process through more efficient allocation of capital, by scrutinizing management, and by mitigating financial constraints as well as requiring a specialized set of corporate governance measures. Thus, cross-listing in the U.S. capital markets enhances investor protection, reduces the cost of capital, improves access to capital, strengthens the firm’s information environment, and enhances stock valuation, and these benefits are greater for firms in large countries with weak investor protection. Culture Under the U.S. market-based corporate governance structure, shareholder value creation is the primary objective of public companies. In many other countries, corporations are responsible for protecting the interests of various stakeholders, including shareholders, employees, customers, suppliers, government, and the public. Thus, the need to balance the interests of all stakeholders drives such a corporate governance structure. Compared with the open social culture in the United States, the close familial culture prevalent in many countries also influences the corporate decision-making process and corporate governance measures. Legal System A country’s legal system is a key factor that influences corporate responsibility and authority as well as the composition and fiduciary duties of its directors and officers. The extant literature in accounting and finance examines the relationship between the legal protection of investors and the development of financial markets and corporate governance. This literature concludes that the legal system is an integral component of corporate governance. Thus, better legal systems contribute to market liquidity.



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Corporate governance listing standards do not normally exist outside of the United States. The legal system determines the nature and the degree of investor protection across countries because of differences in the legal regime. Two traditional legal regimes influencing corporate governance are civil law and common law.10 Civil law has its origin in Roman law and is practiced in countries such as France, Spain, Italy, Germany, Austria, Greece, Switzerland, Japan, Denmark, Sweden, Norway, and Finland. Common law of English origin is dominant in countries such as A ­ ustralia, Canada, the United Kingdom, and the United States. The effectiveness of the legal system in protecting investors depends on two factors: (1) the type of land where common law is perceived to be more efficient in protecting investors and (2) the level of enforcement. The global political uncertainty triggered by the surprise results of the November 2016 U.S. Presidential election and the summer “Brexit” votes has created more challenges for corporate governance, which may require that boards take a more proactive role in planning for potential uncertainty and the related costly risks. Effective corporate governance promotes accountability, improves the reliability and quality of financial information, strengthens the integrity and efficiency of the capital market, and thus, improves investor confidence.11 Poor corporate governance adversely affects the company’s potential, performance, financial reports, and accountability; it can result in business failure, inefficiency of capital markets, and loss of investor confidence. Corporate governance in the twenty-first century surpasses a focus solely on shareholder value creation, as corporations play a vital role in the global economy and capital markets. Corporate governance ultimately embraces leadership and accountability for ensuring efficiency and effectiveness of operations to compete in the global markets as well as disclosure of accurate, complete, and transparent information regarding corporate performance in the areas of economic and social activities. Corporate governance involves relationships and power sharing between a company’s management, board, shareholders, and other stakeholders, including the way the board oversees management and how board members are, in turn, accountable to both shareholders and to the company. Each country has its own corporate governance reforms that are shaped

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by economic, cultural, and ownership structure, and legal circumstances, as discussed earlier.

Organization for Economic Co-operation and Development OECD principles of corporate governance were first introduced in 1999 and since then have become a benchmark example of the best industry practices. Principles have been regularly reviewed since 1999 in order to address the real-world experiences that OECD and non-OECD companies face. The last revision of these principles occurred in 2015.12 These principles do not offer a single ideal model of corporate governance for publicly traded companies. Instead, the principles suggest a path that could eventually lead to the formation of good corporate governance in any particular organization and consequently help the organization to operate more efficiently, lower the costs of the capital, and stimulate growth. The ultimate goals of the principles are as follows: (1) to ensure an adequate framework for corporate governance; (2) to promote and advocate shareholders’ rights; (3) to treat all shareholders and stakeholders fairly; (4) to consider the interests of all parties involved, including minority shareholders, foreign shareholders, and stakeholders; (5) to disclose all material matters properly and in a timely fashion; and (6) to make the board accountable to the company and shareholders. In response to the global reach and extraterritorial effects of national regulations, the OECD published the OECD Principles of Corporate Governance in 1999, subsequently revised in 2004, and already adopted by the ICGN. These principles provide a framework and a platform for all countries in developing their own corporate governance structure. These principles are as follows: (1) Promoting transparent and efficient markets that are consistent with the law and articulate responsibilities; (2) ­Protecting and facilitating the exercise of shareholders’ rights; (3) Ensuring equitable treatment of all shareholders and giving everyone the opportunity to obtain effective redress if their rights have been violated; (4) Recognizing stakeholders’ rights as established by law and encouraging active cooperation between the stakeholders and corporation; (5) Ensuring that timely and accurate disclosure is made on the



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corporation’s material matters; and (6) Ensuring the company’s strategic guidance, the board’s monitoring of management, and the board’s accountability to the company and shareholders.13

Global Trends in Corporate Governance Technological advances, globalization, and the ever-growing regulatory reforms worldwide have advanced many corporate governance reforms and measures in the past several decades. These corporate governance advances have promoted a move toward convergence in corporate governance. There are numerous countries, organizations, and events that are working toward a converged global governance model, with a number of forces (political and cultural differences) acting as a barrier. Corporate governance has received considerable attention in the post financial crisis of 2007–2009 in response to the perception that more effective governance measures could have prevented some of the crisis. Each country has its own corporate governance reforms that are shaped by economic, cultural, and legal circumstances. These factors influence the effectiveness of corporate governance, which typically is measured in terms of creating shareholder value and protecting the interests of other stakeholders. The worldwide response to corporate scandals promotes convergence in corporate governance across borders. This convergence is particularly vital in the areas of investor rights and protections, board responsibilities, and financial disclosures. While total convergence in corporate governance reform may not be feasible, global corporate governance practices should be promoted to improve efficiency and liquidity in the global capital markets. Worldwide corporate scandals caused regulators to respond by implementing regulations designed to reinforce business integrity and restore market confidence. The enactment of the SOX was in response to the financial scandals of Enron, WorldCom, and others. The United Kingdom responded to several high-profile scandals such as Parmalat and Ahold by strengthening the Combined Code on Corporate Governance. The globalization of capital markets and the demand for investor protection in response to global financial scandals also require consistency and uniformity in regulatory reforms and corporate governance practices. As rightfully stated by Alexander Schaub, “Good corporate governance

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is an essential prerequisite for the integrity and the credibility of financial institutions, stock exchanges, individual companies, and indeed the whole market economy . . . . In today’s integrated markets, failure to deal with the regulatory issues associated with corporate governance can have strong repercussions on global financial markets and jeopardize financial stability.”14 Cross-border regulatory differences and global capital market competition center around three overriding questions: (1) What corporate governance measures and regulatory regime do provide a high level of investor protection? (2) What are the impacts of differences in corporate governance and regulatory regimes on global competitiveness of capital markets? and (3) Is listing choice affected by managerial and shareholder interests? Anecdotal evidence tends to support the general perception that tougher regulatory regime provides higher investor protection and may also have adversarial effects on global markets’ competitiveness.15 Countries have their own corporate governance reforms, measures, and best practices, which are reflective of the economic, political, cultural, and legal circumstances. The global regulatory responses to corporate scandals and financial crisis demand convergence in corporate governance worldwide. This convergence is particularly relevant in the areas of investor rights and protections, board structure, independence and responsibilities, and uniform and standardized financial and nonfinancial disclosures. While complete convergence in corporate governance may not be possible, global corporate governance measures and cross-border standards’ enforcements should be promoted to improve efficiency, soundness, and liquidity in the global capital markets. Corporate governance has played and will continue to play an important role in ensuring the usefulness and quality of financial reports and the efficiency of financial markets.16

Corporate Governance in the United States Corporate governance in the United States is often referred to as the Anglo-American model, which is based on a market-oriented approach. This market-oriented style of corporate governance is characterized as ­follows: (1) separation of ownership and control, requiring the establishment and implementation of effective corporate governance measures to ensure the alignment of management interests with those of shareholders;



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(2) widely dispersed ownership that demands effective market mechanisms and regulatory reforms to protect investors; (3) the mission of corporations in creating shareholder value and ensuring safety and efficiency in capital markets; and (4) accountability of gatekeepers (board, of directors, executives, legal counsel, auditors, financial analysts) in protecting investors from corporate malfeasance and misleading financial information.17 Regulatory reforms in the United States, including the SOX and the DOF, are intended to protect investors. The relevant issue to address is whether these reforms have generated positive externalities for investors in terms of positive changes in stock prices, and market liquidity; particularly, whether these reforms have had the widespread effect of protecting investors worldwide and making U.S. capital markets more competitive globally. Technological advances and global competition have enabled companies and their investors to decide where to invest their investments. Thus, companies can choose the regulatory regime they desire to operate under and investors have a choice of safeguards and protections provided under different regulatory reforms. An effective regulatory reform creates an environment under which companies worldwide can operate in achieving sustainable performance, being held accountable for their activities, and in providing protection for their investors. Corporate governance measures in the United States are driven by state and federal laws as well as regulations and best practices. The wave of financial scandals at the turn of the twenty-first century caused investors to lose their confidence in corporate governance, financial reports, and the financial markets. Congress responded by passing the SOX in July 2002. The SOX established a new set of corporate governance measures for public companies. These scandals encouraged regulators to issue rules to implement its provisions in an attempt to mitigate the recurrence of such scandals, protect investors, and restore their confidence in the financial markets. Many provisions of the SOX, particularly those pertaining to strengthening auditor independence, the assessment of internal control over financial reporting (ICFR), the creation of an independent board to oversee the accounting profession, and the strengthening of audit committee requirements, have been effectively adopted in other countries. Major provisions of the SOX have reinvigorated regulatory reforms in other countries, and

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many of its key provisions are cost-justified as they are being adopted globally. These globally adopted provisions of the SOX should promote integrity and efficiency in cross-border financial markets rather than cause competition disadvantage for U.S. financial markets and U.S. companies. Regulatory reforms, including the SOX in the United States, are aimed at protecting investors, and have also provided both U.S. and non-U.S. businesses with the lowest cost of equity capital in the world. The SOX was intended to have positive impacts on the capital markets through the improvement in investor confidence and enhancement in the integrity and efficiency of the capital markets. In summary, the debate over the possible impacts of SOX and its compliance costs on U.S. capital market global competitiveness centers around two key views. The first view is that the SOX and its implementation costs have led to the following: (1) increased compliance costs of regulation and the potential for liability, (2) contributed significantly to the loss of U.S. capital markets’ global competitiveness as the majority of initial public offerings (IPOs) have recently been listed on capital markets abroad, (3) encouraged U.S. companies to go private in order to reduce their regulatory compliance costs, and (4) reduced the corporate risk-taking that produces economic growth. The other view is that the SOX and its implementation rules have significantly improved the accountability of corporate America, the quality and reliability of its financial reporting, as well as the integrity and efficiency of its capital markets, and some of its best practices have reached global adoption. This view is supported by those who believe that the SOX rebuilt investor confidence in the U.S. capital markets, and investors are willing to pay a premium for more protection provided by tougher regulations.18 Several years after the passage of the SOX, which was intended to combat fraud and financial irregularities and scandals, the 2007–2009 financial crisis occurred, signifying ineffectiveness in corporate governance. Thus, the U.S. Congress passed DOF (Dodd-Frank) Wall Street Reform and Consumer Protection Act in 2010 in response to the 2007–2009 crisis.19 The DOF was intended to significantly reduce the likelihood of future financial crisis and systemic distress by empowering regulators to require more effective corporate governance and higher capital requirements for financial institutions. The DOF created new regulatory regimes



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for large financial institutions and required regulatory and market structures for financial derivatives demanding the systemic risk assessment and monitoring of financial markets. The DOF also established a Financial Services Oversight Council that would identify and monitor systematic risk in the financial system. The emerging Financial Reform Legislation in the United States (the DOF of 2010 and related SEC implementation rules) along with initiatives taken in other countries would prevent future financial crisis and their resulting global economic downturns. Laws, rules, and regulations should be cost-effective, efficient, and scalable in establishing a proper framework within which companies can operate in creating sustainable performance, pursue legitimate operations and ethical behavior, enhance shareholder value, and protect the interests of all stakeholders, including investors, creditors, employees, suppliers, customers, government, competitors, and society. Certain industries, such as natural resources, financial services, and health care could be more affected by recent changes in corporate governance reforms. However, institutional investors and those dealing with public pension funds will continue to advance governance issues with individual companies. These institutional investors will continue to encourage boards to demonstrate that they are taking proactive strategies and actions to board refreshment by establishing indicators that boards are adding directors with the proper skill sets, diversity, backgrounds, and perspectives to guide those strategies. There will be pressure on boards to split the CEO and the chair roles as well as an increased demand for clawbacks. It is expected that investors will demand, and regulators will require, public companies to disclose information on both financial economic sustainability performance and nonfinancial environmental, social, and governance (ESG) sustainability performance. Particularly, there will be an increased attention on climate change and related risks. It is expected that proper succession planning for the CEO and other key C-suite roles will be on the agenda of many boards. In the United States, there is increased focus on meaningful conversations with boards of directors, as well as a push to more clearly define and disclose the exact duties of each member. The main fiduciary of the board of directors has been to shareholders in creating value for them through improvement in sustainable financial performance, while the interests

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of other stakeholders such as creditors, employees, customers, suppliers, society, and the environment have not been adequately considered. This corporate governance misalignment, which has been caused by the legal system in the United States in making directors primarily responsible to shareholders and to no other stakeholder, encourages directors and executives to focus on the achievement of short-term financial performance. The sustainability and long-term survival of public companies can be assured where directors and executives hold accountable to all corporate stakeholders in improving financial performance as well as nonfinancial ESG performance. The aforementioned interest in ESG activities should be seen in the United States, especially as companies learn how to incorporate and report them as a part of their quarterly and annual reports. The SEC has yet to release its disclosure effectiveness review for these statements, and this federal body must also make a decision on the best way to regulate audit committee reports.20 Corporate Governance in the United Kingdom The UK approach to corporate governance reforms is more principles based, which requires companies to “comply or explain why not.” This flexible approach to corporate governance, coupled with the fact that UK shareholders are in a much stronger position than their U.S. counterparts to nominate directors and forward their resolutions, has recently made the UK capital market more attractive to global IPOs. Different types of corporate governance structures are exposed to different types of financial misconduct and scandals. For example, the dispersed ownership system of governance in the United States is prone to earnings management schemes (e.g., Enron, WorldCom), whereas concentrated ownership systems are more vulnerable to the appropriation of private benefits of control (e.g., Parmalat).21 The United Kingdom’s new corporate governance reform, the Green Paper, addresses several corporate governance issues pay-ratio disclosure, say-on-pay votes binding by shareholders and empowering employees to have more influence on company boards.22 Executive pay is an area of global concern and the United Kingdom is no exception to this as there is no relation between executive pay and long-term corporate performance



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as well as its comparison with the pay of ordinary employees. To address these concerns the reform (Green Paper) suggests the following23: 1. Annual shareholder binding votes of major components of executive pay. 2. Development of a senior shareholder committee to oversee executive compensation and other governance issues such as directors’ appointment and long-term corporate strategies. 3. Requirement that the compensation committee consult shareholders in advance of preparing executive pay policy and the chair of commendation committee has at least 1 year experience as a member of the committee. 4. Disclosure of executive pay ratios comparing to pay in the wider company workforce. The use of restricted stock rewards instead of the current long-term incentive plans. UK corporate governance measures, which are usually more stringent than U.S. reforms, stipulate the following: (1) nonexecutive directors should meet at least once per year to evaluate performance; (2) independent nonexecutive directors must be composed of at least 50 percent of the board, not including the chair; (3) there should be shareholders’ approval of new corporate arrangements and changes; (4) mandatory preparation of a corporate governance report along with a statement of compliance with the provisions of the Combined Code; (5) holding of the e­ xecutive ­session of the chair of the board with the company’s n ­ onexecutive ­directors, without the presence of the company’s executive directors; (6) the ­ ­separation of the positions of the CEO and the chair of the board; (7) the availability of a senior independent director to any shareholder to express concerns not addressed by the company’s officers; (8) directors’ responsibility for the preparation of financial statements and the review of ICFR; (9) ­shareholder advisory vote on executive compensation; and (10) annual ratification of the independent audit form by shareholders. Corporate Governance in Europe The emergence of corporate governance in Europe starts with the UK Cadbury Code in the 1990s. The Code approvals is housed on a “comply

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or explain” basis to promote corporate governance best practices, by giving companies the opportunity to either comply or explain the reason(s) for not complying with the Code’s requirements. This Combined Code on Corporate Governance was adopted in 2003. Thus, companies listed on the London Stock Exchange must comply with the Combined Code or explain why they choose not to do so. The European Union (EU) has also strengthened the robustness of financial reporting and corporate governance practices by modernizing corporate governance and allowing for both short-term and long-term strategies in addressing board structure, shareholder voting, company structure, and investor disclosures. The EU has focused on the following corporate governance issues: (1) establish a framework for enabling shareholders to exercise their rights, (2) strengthen rules pertaining to director compensation, (3) develop the European Corporate Governance Forum to promote the integration of national codes, (4) implement Annual Corporate Governance statements, and (5) enhance the responsibility and involvement of nonexecutive directors. European countries have responded to several high-profile scandals such as Parmalat and Ahold by improving their corporate governance measures. Different types of corporate governance structures can be employed to deal with different financial misconduct and scandals. For example, the dispersed ownership system of governance in the United States is susceptible to earnings management schemes (e.g., Enron, WorldCom) to align management interests with those of shareholders, whereas concentrated ownership systems in other countries are more vulnerable to the appropriation of private benefits of control (e.g., Parmalat) to ensure majority shareholders do not benefit at the expense of minority shareholders.24 Across many countries in Europe, several emerging c­ orporate governance issues will continue to prevail, including the advancement of directors and management diversity, executive compensation, and board oversight of corporate culture. It is expected that the EU will amend its Shareholder Rights Directive to include an EU-wide “say on pay” guideline that would give shareholders the right to regular votes on prospective and retrospective executive compensation. It is expected that many corporate governance issues, including making shareholder votes on executive compensation binding, mandatory disclosure of the CEO pay ratio, and



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boards’ obligations to adhere to ethical business practices, will be on the agenda of many corporate boards in Europe. The European model of corporate governance is typically known as network-oriented approach. This approach is characterized by the following: (1) the concentration of ownership and control by blockholders such as banks and institutional investors; (2) the use of a two-tier board structure, namely supervisory board and management board; and (3) the promotion of the voluntary best practices of corporate governance on “comply or explain why” led by investors.25 Concentration of voting power under the European model enables majority shareholders to engage directly in monitoring to managerial function. Accordingly, the European model necessitates corporate governance measures that ensure majority shareholders promote the interests of all shareholders, including minority investors. This model is designed to create a right balance between the interests of majority and minority shareholders. Under the European model of corporate governance, a two-tier board structure is dominant in some European countries (e.g., Germany, Austria, France, and Finland). While the United States, the United Kingdom, and Canada have traditionally adopted a one-tier board model, in which executive and nonexecutive directors collaborate in one layer, European countries like Germany have generally opted for a two-tier board model where an additional layer is designed to create a supervisory layer with nonexecutive directors and a management layer that is composed of executive directors.26 In this model, the roles of chairman and CEO are usually separate, and employee representatives are in the supervisory board. The Great Recession was the economic decline in the twenty-first century that caused varying financial crisis in countries worldwide. Among these countries Germany was one that managed to buffer such a crisis and enjoyed success after this period. Corporate governance, industrial relations, and monetary institutions fueled from the European Exchange Rate Mechanism and the European Monetary Union enhanced Germany’s competitiveness, which increased the country’s resilience to the Great Recession. The Commission of European Communities suggests that the EU should actively coordinate the corporate governance efforts and reforms of its member states, requiring each member state to identify its corporate laws, securities laws, listing rules, codes of conduct, and best

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practices, make progress toward designating a code of corporate governance, intended for use at the national level, with which listed companies should either comply or disclose noncompliance, coordinate its code of corporate governance with other member states, and participate in the coordination process established by the EU.27 Corporate Governance in Asia The Asian model of corporate governance, also known as the family controlled or government-owned model, is characterized by the following: (1) concentration of ownership, typically by families or states; (2) more internal corporate governance mechanisms exercised by family members or government; and (3) effective protection of the interests of majority owners (insider shareholders) and relatively less protection for minority investors. Corporate governance in Asian countries is influenced by the concentration of ownership by blockholders. Security laws in these countries are issued and enforced to protect government ownership of primary state-owned companies from management abuse. The Asian Crisis and the Japanese banking difficulties prompted regulators in Asia to improve their corporate governance reforms. For example, the Code of Corporate Governance for listed companies in China was developed by the China Security Regulatory Commission to do the following: (1) strengthen shareholder rights, (2) reduce governmental power, (3) introduce independent board members into the board structure, (4) require boards to evaluate management activities, (5) develop a foundation for executive and director remuneration, (6) mandate systems of ICFR, and (7) strengthen external auditor independence. China’s Code, like the UK Combined Code, is based on the approach of “comply and explain.” Some perceive the ability of the government to intervene along with the lack of proper measures to prevent and detect corporate corruption and fraud as continuing obstacles that China faces in its attempt to reform its corporate governance. South Africa also adopted the King Report on corporate governance in 2002, which is similar to the United Kingdom’s Combined Code and the approach of “comply or explain.” Corporate governance in several Asian countries, including China, India, Japan, and Hong Kong, are presented in the following subsections.



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Corporate Governance in China The Chinese government has recently initiated several corporate governance measures to support economic and financial market growth. It has also formed several state-run regulators to promote comprehensive and effective governance for listed companies in Mainland China and Hong Kong.28 The China Regulatory Commission issued a Code of Corporate Governance in 2002 that promotes governance principles and mechanisms for protecting shareholder rights and monitoring the directors and executives of listed companies. The China Securities Regulatory Commission (CSRC) is responsible for developing regulations, policies, and guidelines for listed companies and monitoring effective implementation and enforcement of regulations. Other corporate governance regulatory bodies, such as the National People’s Congress, the State Council, the Ministry of Finance, the People’s Bank of China, the Shanghai Stock Exchange, and the Shenzhen Stock Exchange, also participate in establishing listing standards and corporate governance guidelines. China’s rapid economic development has demanded increased attention from regulatory bodies, companies, academics, professionals, and investors. To promote effective and comprehensive corporate governance for listed companies in Mainland China, the Chinese government has developed a number of regulations to protect investors’ interests. Hong Kong experiences additional challenges with corporate governance as its companies tend to be controlled by families with a dominant presence on boards of directors. The Chinese government, as the core element of the modern enterprise system, has identified corporate governance expectations for the entire nation. Today China comprises state-owned enterprises and private sector companies. To promote effective and comprehensive governance for listed companies in Mainland China, the China Regulatory Commission released a Code of Corporate Governance for listed companies in 2002. This Code promotes basic governance principles, details methods for safeguarding shareholder rights, and sets out a basic code of conduct and professional ethics for directors, supervisors, and senior management of listed companies. The Code also applies to all listed companies in Mainland China and has become the standard measure in China with which to evaluate whether or not a listed company has established corporate governance practices.

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Until 1978, most Chinese enterprises were state-owned with ­administration-driven, unified, and collective governance. The C ­ ompany Law and the Securities Law, both introduced in 2006, provide the foundation for developing a corporate governance framework in China. China’s legal framework for corporate governance comprises four levels: basic laws, administrative regulations, regulatory provisions, and self-­disciplinary rules.29 Prevailing shareholder rights in China include securing methods of conveying or transferring shares, ownership registration, getting relevant, reliable, and timely material information on the corporation, participating and voting in general shareholders’ meetings, electing and removing members of the board, and sharing in the profits of the corporation. Information disclosures of Chinese corporate governance include company objectives, major share ownership and voting rights, companies’ financial and operating results, and remuneration policy for directors and officers. The directors’ election process consists of directors’ qualifications, the selection process, governance structures, and policies. The content of any corporate governance code or policy and the process by which it is implemented should also be communicated to shareholders. The Chinese board system requires strengthening the board’s fiduciary duties, including loyalty, due diligence and protection of the benefits of companies and shareholders, the establishment of the independent director system (at least one-third of the board), the establishment of special committees of the board, and the development of mechanisms for the board’s supervision and restraints over management. The Chinese government has a regulator for its particular industry or market. Each regulator has clearly defined roles and functions as handed down by the central government for both financial and nonfinancial sectors. The main regulator for securities and futures in Mainland China is the CSRC. The CSRC, which manages and monitors the national securities and futures markets, is directly under the State Council. The CSRC is responsible for studying and establishing guidelines and policies, overseeing development of these markets, as well as drafting, revising, and monitoring laws and regulations. In addition, the China Banking Regulatory Commission, the China Insurance Regulatory Commission, and the state-owned Assets Supervision and Administration Commission are



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responsible for drafting, revising, and monitoring regulations and rules within their respective areas of jurisdiction. Chinese stock exchanges have also established their listing standards similar to those in the United States. The Shanghai Stock Exchange is a membership institution directly governed by the CSRC. It bases its development on the principle of “legislation, supervision, self-regulation, and standardization” to create a transparent, open, safe, and efficient marketplace. It has a variety of functions: providing marketplace and facilities for the securities trading; formulating business rules; accepting and arranging listings; organizing and monitoring securities trading; regulating members and listed companies; and managing and disseminating market information. The Shenzhen Stock Exchange is a self-regulated legal entity under the supervision of the China Securities Regulatory Commission. Its main functions include providing venue and facilities for securities trading, formulating operational rules, arranging securities listings, organizing and supervising securities trading, offering membership supervision and oversight of listed companies, and managing and publicizing market information. Corporate Governance in India The effective implementation of the 2013 Companies Act in India has been a challenging issue for the boards of directors of many public companies as the act requires changes to corporate governance practices.30 Some of the implementation challenges of this act are: (1) an expected increase in directors’ fiduciary duties accountability and scope of responsibilities for the nomination and compensation/remuneration Committee; (2) boards oversight of CEO succession planning and evaluations of executives; (3) a mandatory minimum of at least one woman director for most listed companies; (4) boards oversight and proactive role in risk management; (5) the requirement of the establishment of a corporate social responsibility (CSR) committee; and (6) the requirement that the company spend 2 percent of net profits on CSR-related activities such as ESG initiatives. India has made much progress in the areas of director independence and related-party transactions, no doubt owing to the 2013 Companies Act

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and the efforts of the Securities and Exchange Board of India. However, many companies are finding it hard to accommodate these new expectations and have been prioritizing the new requirements, with director evaluation falling into the area that they feel can be “loosely followed.” In fact, the Indian government has had so many complaints about the number and depth of changes that it organized panels in 2015 to decide whether to remove requirements involving intercompany loans, related-party transactions, and consolidated financial statements. This is no doubt due in no small part to the planned changeover to International Financial Reporting Standards, which, as in the United States, has caused a plethora of complaints from businesses of all shapes and sizes.31 Corporate Governance in Hong Kong Corporate governance reforms in Hong Kong are more closely related to those of the United Kingdom. In Hong Kong, most listed companies tend to be controlled by families, and the family dominates the board of directors as well. The Stock Exchange of Hong Kong is the primary frontline regulatory organization responsible for the day-to-day supervision and regulation of listed companies, their directors, controlling shareholders, and market users in general in respect of all listing-related matters. The Securities and Futures Commission (SFC) supervises the securities futures and the financial industries. The SFC administers statutory requirements to ensure full disclosure and fair treatment of the investing public. It regularly monitors trading in the securities and futures markets to detect possible malpractices. It also conducts periodic inspection visits of registered persons and makes inquiries in response to public complaints about misconduct by intermediaries and market malpractice. The Stock Exchange of Hong Kong Ltd. published the Code on Corporate Governance Practices (the Code) and the Corporate Governance Report (CGR) in November 2004, and these were incorporated into the Appendix of the Main Board Listing Rules and the Growth Enterprise Market Listing Rules. The Code and the CGR became effective in 2005. Listed companies are required to confirm their compliance with the Code or, where they do not comply, to provide explanations for any variation in practice. The Code requires a clear division of the responsibilities of the



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management of the board and the day-to-day management of the company’s business. In this respect, the Code requires that the roles of chairman and CEO be separate and not be performed by the same individual. The Hong Kong code on corporate governance reporting (Appendix 14) of the Main Board Listing Rules came into effect in 2005. This establishes the principles of good corporate governance, and two levels of recommendations of code provisions and recommended best practices. The commencement of the new Companies Ordinance was established in Hong Kong in March 2014, which provides the legal framework pertaining to the formation and operation of companies and contains extensive provisions for safeguarding the interests of stakeholders including shareholders and creditors. The Companies Ordinance addresses many aspects of corporate governance, including the appointment of corporate directors, fiduciary duties of directors, in exercising the level of care, skills, and diligence that would be exercised by a reasonable diligent person, the preparation and disclosure of a comprehensive directors’ report, and rules to address the possible conflicts of interest by directors. Corporate Governance in Japan The amended Companies Act in Japan was enacted in June 2014 and went into effect in April 2015.32 The amendment introduces a new corporate governance structure for large public companies in Japan through an audit/supervisory committee, and new rules on outside directors. The new audit/supervisory committee governance structure is intended to facilitate appointments of outside directors and provide a corporate governance system that is more familiar to foreign investors. More than half of the statutory auditors must be from outside. Japan’s Corporate Governance Code, which was reformulated in 2015, is intended to make Japanese corporate governance measures more consistent with those of the Western corporate governance. One of the requirements is that the boards should have at least one external director. Currently there are two governance structures for listed companies in Japan, and these are the Statutory Auditor System and the Full Committee System. The Statutory Auditor System is the traditional, two-tier board system, whereas the Full Committee System is a new structure introduced in 2003 as an

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alternative. Companies can also use their own governance structures, for example voluntary-based boards such as management advisory boards. Statutory auditors are different from independent outside auditors as they are board members of the company in charge of monitoring the directors and managers of the company from both an accounting and operational standpoint. The full governance committee system in Japan consists of the audit, nomination, and remuneration committees. Each committee is composed of at least three directors, with a majority of members in each committee being outside directors. Overall, the Asian model of corporate governance is known as the family controlled or government-owned model. This model is characterized by the following: (1) the concentration of ownership by family families or states, (2) the existence and enforcement of more internal corporate governance mechanisms by family members or government, and (3) main focus on effective protection of the interests of majority owners (insider shareholders) and relatively less protection for minority investors.33 Corporate governance in Asian countries is influenced by the concentration of ownership by blockholders such as government and family-owned businesses. Corporate governance measures and reforms constitute the legal system that is intended to provide investor protection as well as security laws designed to protect government ownership of primary state-owned companies from management abuse.

Convergence in Corporate Governance The existence and persistence of global corporate failures and the revelation of global financial scandals encouraged regulators worldwide to address the global corporate governance deficiencies and work together to increase the effectiveness of global corporate governance. Several issues and differences, including the global information infrastructure, legal infrastructure, market infrastructure, and regulatory infrastructure, need to be considered for establishing convergence in corporate ­governance. Generally speaking, there is no globally accepted set of corporate ­governance principles and measures that monitor corporations, global financial institutions, or capital markets worldwide. Regulators in the United States, the SEC and the International Organization of Securities



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Commission, and the World Federation of Exchanges need to agree on a global regulatory framework or a corporate governance structure that can be adopted globally. Several issues need to be addressed to promote convergence in global corporate governance.34 The first and most important one is whether corporate governance principles and provisions should be made mandatory as a set of rules that all companies must comply with, as opposed to recommendations and disclosure practices that require companies to disclose whether and how they have complied with these recommendations and practices. This issue should be addressed in determining which approach will prevail in global corporate governance. In the United States, the emerging reforms are either regulated by Congress and regulators (the SOX and SEC-related rules) or mandated by the national stock exchanges (the listing standards of the NYSE, NASDAQ, and AMEX). Corporate governance reforms in other countries (the Cadbury Report and the Combined Code in the United Kingdom) are mostly in the context of recommendations for best practices, which encourage compliance rather than mandating compliance. The second issue is the rules-based versus principles-based approach to corporate governance convergence. The structure in the United States is viewed as a rules-based approach, whereas other countries are promoting a principles-based approach. The latter approach is very broad and comprehensive without specifying specific rules in terms of the number of independent nonexecutive directors and their term limits, but they are steps in the right direction in improving corporate governance and accountability and reinforcing investors’ rights. It appears that convergence would be more feasible and possible when countries agree on the principles-based approach rather than having to reconcile voluminous and often irreconcilable rules. The third issue is the consensus on the primary purpose of global corporate governance. The primary goal and focus in the United States is on the creation and enhancement of shareholder value; in some other countries, the protection of the interests of all stakeholders is considered the main goal of corporate governance. Convergence would be possible if all nations agree on the primary purpose as the enhancement of shareholder value, while protecting the interests of other stakeholders.

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Major differences that make convergence more difficult are (1) the fact that in many countries, such as the United Kingdom, the position of the CEO and the chair of the board must be separate, but there is no such requirement in the United States; and (2) the independence requirement for the majority or all members of various board committees. The EC encourages the coordination and convergence of national codes of corporate governance through high-level meetings of the European Corporate Governance Forum. These meetings are typically chaired by the Commission and include representatives from all member states, European regulators, investors, issuers, and academics.35 The United States is already participating in efforts toward the convergence of global accounting and auditing standards. Different types of corporate governance structure are exposed to different financial misconduct and scandals. For example, the dispersed ownership system of governance in the United States is prone to earnings management schemes (e.g., Enron, WorldCom), whereas concentrated ownership systems are more vulnerable to the appropriation of private benefits of control (e.g., Parmalat).36 The most important step in the convergence process is the statutory power to implement and enforce the globally accepted corporate governance principles, rules, or best practices. Different nations have different enforcement processes and criminal sanctions for checking the violation of corporate governance principles. To address this important global issue, the United Nations (UN) Secretary-General, in 2005, invited a group of representatives from 20 investment organizations in 12 countries to establish a set of global best practice principles for responsible investment (PRI).37 The process of developing PRI was coordinated and overseen by the UN Financial Initiative and the UN Global Compact. The PRIs are voluntary and aspirational rather than prescriptive. They provide a framework for incorporating ESG issues into investment decision-making and ownership practices.38 Compliance with the PRI is expected to lead not only to a more sustainable financial return, but also to a close alignment of the interests of investors with those of global society at large. The PRIs consist of six principles: 1. Integration of ESG issues into investment analysis and the decision-making process



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2. Incorporation of ESG issues into investment ownership policies and practices 3. Promotion of appropriate disclosure on ESG issues by the entities in which institutional investors invest 4. Promotion of acceptance and implementation of the principles within the investment industry 5. Collaboration among institutional investors to enhance the effectiveness of implementing the principles 6. Reporting on initiatives, activities, and progress toward implementing these principles.39 Globalization, technological advances, and the ever-growing regulatory reforms worldwide have promoted global convergence in corporate governance. The move toward this convergence has become substantially more prevalent in the post-2007–2009 global financial crisis. Recently, there have been influential attempts for improved corporate governance mechanisms worldwide. This prevalence, combined with globalization and increases in technology, has resulted in a trend toward a global corporate governance model. What has not been established, though, is whether or not global corporate governance convergence will actually occur anytime in the near future. While there are numerous countries, organizations, and events that are working toward a consistent global governance model, there seems to be a greater number of forces (political and cultural differences) acting as a barrier at this point in time. As the world becomes a smaller place over the upcoming decades, this topic will need to be readdressed. Convergence may not only become a valid possibility, it may prove to be a global necessity. Countries worldwide have their own corporate governance measures and best practices, which are typically reflective of the economic, political, cultural, and legal circumstances. The global regulatory responses to corporate scandals and financial crisis demand convergence in ­corporate governance across borders. This convergence is particularly important in the areas of investor rights and protections, board independence and responsibilities, and uniform financial disclosures. While complete convergence in corporate governance reforms may not be possible, uniform global corporate governance measures and cross-border standards

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enforcement should be promoted to improve efficiency and liquidity in the global capital markets. An unaddressed issue is whether cross-border differences in corporate governance can be reconciled and whether full convergence in corporate governance is feasible. A move toward convergence in corporate governance has been promoted since 1999 by the OECD. The OECD has established a set of corporate governance principles, which were later adopted by the ICGN designed to protect all global investors. The ICGN is a voluntary global membership organization of over 500 leaders in corporate governance including institutional investors who collectively represent funds under the management of around $18 trillion USD based in 50 countries.40 The ICGN’s mission is to strengthen and promote convergence in corporate governance standards worldwide. In summary, some issues, such as whether to adopt a set of principles-based corporate governance measures or to adopt a set of rules-based measures, mandatory regulatory-driven versus voluntary best ­practices of corporate governance, and so on, need to be resolved to make the convergence in corporate governance possible and feasible. It may be unrealistic to expect full global convergence in corporate governance. Some provisions of corporate governance that can be adopted globally are as follows: (1) investor protection measures; (2) director i­ndependence, when the majority of directors should function independently; (3) the formation of an effective audit committee consisting of independent members with financial expertise; (4) the establishment of financial and audit oversight functions; (5) the oversight responsibility of the audit committee to appoint, compensate, dismiss, and monitor the work of independent auditors; and (6) board committees and their oversight responsibilities (audit, compensation, and nomination); and cross-border regulatory oversight collaboration and cooperation.

Corporate Governance in the Post–Global Financial Crisis Corporate governance has received significant attention in the aftermath of the financial crisis of 2007–2009 because of the perception that more effective governance measures could have mitigated some of the adversarial effects



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of the crisis. The DOF attempted to address corporate governance in the aftermath of the financial crisis in many ways, as described in the previous sections. Corporate governance participants and corporate gatekeepers have been criticized for the occurrence and persistence of the 2007–2009 global financial crisis. Two overriding reasons for its persistence was ineffective risk management and inappropriate executive pay practices in the financial services industry. Several corporate governance reforms (e.g., the DOF) in the post–financial crisis era have changed the relationship between shareholders and their boards in the United States by creating a proper “balance of authority” exercised by boards, management, and shareholders in the corporate decision-making process and governance. Traditionally, the shareholder model of corporate governance has suggested that decision oversight should be separated from decision management by holding the board of directors responsible and accountable to effectively oversee managerial decisions made in creating shareholder value. This model worked well when there was less widely dispersed stock ownership and when investor value creation was the only objective of corporations. The International Federation of Accountants (IFAC) has conducted several surveys and interviews before and after the financial crisis to determine the challenges and to identify potential improvement opportunities related to corporate governance. The IFAC has made the following recommendations for effecting improvements in corporate governance in the post–financial crisis era41: 1. Directors’ primary duty is for performance, not for conformance: Although long-term survival of an organization is determined by improvements in performance and the effectiveness of conformance or compliance with all applicable laws, rules, regulations, and standards, performance creates sustainable stakeholder value. This necessitates that the board of directors find a proper balance between performance and conformance activities, with a keen focus on creating and enhancing sustainable performance. 2. Expand from shareholder perspective to stakeholder perspective: The primary goal of corporate governance is to protect the interests of all stakeholders, including shareholders, creditors, employees,

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customers, suppliers, government, and society. Corporate governance measures should be in place to create and enhance stakeholder value. 3. Achieve sustainable performance objectives in all areas of ESG activities: Organizations should take into consideration the dimensions of sustainability performance of economic, governance, social, ethics, and environmental activities. 4. Integrate governance and sustainability into the organization’s strategy, operations, and disclosures: Organizations should integrate sustainability and governance into their reporting process and produce an integrated report reflecting financial, social, and environmental performance. 5. Create an ethical and competent organization culture: Organizations should establish codes of conduct to ensure a value-based culture and communicate these codes throughout the organization and ensure compliance with them. 6. Improve the organization’s communications with all its stakeholders: Organizations should expand their financial reporting and communication channels to an integrated and holistic reporting on economic, governance, social, ethics, and environmental performance.

Corporate Governance of Multinational Corporations Multinational corporations (MNCs) play an important role in the world economy and in trade as they operate in several countries and thus contribute to economic growth and prosperities. As the number of MNCs increases and they continue to be more important to the world economy and trade, their corporate governance becomes essential in aligning the interests of their headquarters with those of their subsidiaries, which usually have divergent political, economic, cultural, and environmental interests. International Accounting Standard No. 27 states that a parent– subsidiary relationship arises when one enterprise (the parent) is able to control another enterprise (the subsidiary) in which control is defined as the power to govern the operating and financial policies of the subsidiary, or the ability to influence substantially the subsidiary’s decisions.42 In this context, corporate governance measures should not only protect the interests of shareholders of the parent company and MNCs, but also



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ensure that majority shareholders do not benefit at the expense of minority shareholders. In purely domestic corporations, corporate governance mechanisms are designed to align the interests of management and shareholders that arise from the separation of ownership and control. In a multinational corporation, corporate governance mechanisms are designed not only to align the interests of subsidiaries with those of the parent company, but also to align the interests of the management of the parent company with the interests of both its majority and minority shareholders. Thus, the potential conflicts of interest between the subsidiaries and the parent company, as well as the parent company and its shareholders, create agency costs and information asymmetry problems that management may withhold from shareholders concerning corporate governance. In a multinational corporation, a parent company can be both an agent and a principal: an agent in relation to its own shareholders and a principal in relation to its subsidiaries, with shareholders of the parent company being the ultimate residual risk-bearing owners (principals). Thus, the agents should be monitored, controlled, and bonded through a set of contracts, which are costly to write and enforce, to align their interests with the interests of shareholders. In the absence of interest alignment, the management of subsidiaries may make decisions to maximize their own interests, which may be detrimental to the long-term performance of the parent company. Likewise, the management of the parent company may make decisions that result in reducing shareholder value. Thus, the nexus of contracts to reduce agency costs constitutes the corporate governance structure between the parent company and its subsidiaries, and between shareholders of the parent company and its management. Both internal and external corporate governance mechanisms of the company have evolved over time to monitor, bond, and control management. These mechanisms are the capital markets, the managerial labor markets, regulations, investors (particularly institutional investors), and the board of directors, which may act independently, complementarily, and be substitutional, to align the interests of stockholders and management. The parent–subsidiary corporate governance structure is designed to align the interests of subsidiaries with those of the multinational corporation’s headquarters.

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The parent–subsidiary corporate governance structure is shaped by both the host and home countries’ legal, political, cultural, and regulatory systems; the business practices and historical patterns; the global capital, labor, and managerial markets; global institutional investors; and the boards of directors. Other influential factors are the international strategy of MNCs, and the subsidiary’s industry, size, and relative importance to the entire system of MNCs. Particularly, when the subsidiary is wholly owned by the parent company and is managed automatically (independently) by management who has little if any ownership interest in the multinational or the subsidiary, then the effectiveness of parent–subsidiary corporate governance becomes more crucial in monitoring and controlling the managerial actions of the subsidiary.43 Parent–subsidiary corporate governance is a very important emerging issue that affects the corporate governance effectiveness of both parents and subsidiaries. Effective internal and external corporate governance measures should be in place to monitor the appointment of members of the board of directors and to define the oversight roles, responsibilities, functions, and accountability of both parent and subsidiary boards. Management functions of both parents and subsidiaries are achieving operational effectiveness, ensuring the reliability of financial reports and compliance with both domestic and international laws, as well as framing properly defined rules, regulations, and standards. Any noncompliance with corporate governance measures by subsidiaries can result in unintended legal and financial liabilities for the parent company and subsidiaries as well as personal exposure for parent and subsidiary company directors and officers. Regulators, analysts, and investors need to know about subsidiaries and how the parent company oversees and entrenches effective corporate governance measures for MNCs. Sound corporate governance requires that all subsidiaries contribute and add value to the overall shareholder wealth for MNCs. MNCs typically face cultural, political, and jurisdictional issues that could affect their overall performance. Following a merger or acquisition of international companies, the issue of corporate governance is always the hardest one to deal with. Thus, the effectiveness of corporate governance of newly merged companies should be assessed. This assessment should address and consider the following corporate governance challenges and opportunities:



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1. How many subsidiaries exist that contribute to the overall performance of MNCs? 2. Are there any integrated governance principles for these subsidiaries? 3. What are the common and integrated corporate governance measures for both parents and subsidiaries? 4. How is the ineffectiveness of the corporate governance measures of subsidiaries being addressed? 5. What are the processes and procedures to dissolve unnecessary subsidiaries? 6. What are the election processes for the directors of subsidiary boards? All of the abovementioned issues should be considered by the board of directors of the parent company. It is important that the boards of directors and executives of both parents and subsidiaries understand and respect the roles and responsibilities of the board and management of the other. Directors and officers of both parents and subsidiaries should coordinate their activities in order to avoid conflict and unnecessary duplication, and contribute to the overall performance and success of MNCs. The existence of two listing and reporting requirements, two public shareholder constituencies, and often two legal systems demand an effective corporate governance in integrating and creating synergies in overall decisions, activities, and performance within MNCs.

Conclusion Corporate governance measures and regulations are designed to achieve this premise, and stringent regulations are considered to provide higher investor protection at higher compliance costs. In Anglo-Saxon countries, securities regulations are intended to promote market efficiency and investor confidence, where all market participants have equal access to information, financial information is reliable, and there is a fair level playing field. Regulations are not designed to ensure that all investors make a desired return on investment. In countries with efficient capital markets built based on reliable financial information, there is less need for stronger regulations to protect investors. Thus, the safety, strength, and efficiency of capital markets determine the severity of the securities

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regulations, and differences in regulations across countries can be linked to differences in investor protection against unfair trading. Thus, countries with more effective and perhaps stronger regulations for investor protection have more external financing measured in terms of more highly valued, stronger, broader, and deeper capital markets. Of course the country’s economic growth and macroeconomic stability play important roles in capital market confidence in addition to the severity of the financial regulations. In summary, there are no globally accepted corporate governance reforms and best practices. Differences are mainly driven by the country’s statutes, corporate structures, and culture. Country statutes could pose challenges for regulators in adopting corporate governance reforms and financial reporting disclosures for home companies as well as multinational corporations. The United States and the United Kingdom, for example, operate under common law, which tends to give more antidirector privileges to minority shareholders compared with countries under code law (e.g., Germany) in the sense that regulators allow too many/ too few rights to minority shareholders. Another example is that regulations in the United States are typically regulator-led, being established by the SEC to protect investors, whereas reforms in the United Kingdom are normally shareholder-led, indicating that investors are responsible for safeguarding their interests. Both a vital financial system and reliable financial information are essential for economic development worldwide. The persistence of differences in global financial systems necessitates a move toward convergence in corporate governance rules and guidelines. The emerging global corporate governance rules are shaping capital market structure worldwide as well as informing competitiveness and the level of protection provided to investors. The globalization of capital markets and the demand for investor protection in response to financial scandals such as Enron, WorldCom, Parmalat, Ahold, and Satyam also require consistency and uniformity in corporate governance rules and guidelines. Cost-effective and efficient corporate governance rules and guidelines presented in this chapter can align the interests of directors, management, and shareholders in achieving sustainable performance, which in turn promotes market efficiency and economic prosperity. The recent financial crisis and the resulting global economic meltdown were caused by various



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factors, including ineffective corporate governance rules and guidelines. The global bailouts in the United States, the United Kingdom, and other countries have cost trillions of taxpayer dollars and have yet to energize or stimulate capital markets and the economy. The general perception is that subsidizing troubled companies and their executives does not serve the economy well, whereas better accountability and corporate governance should improve the global economy.

Endnotes 1. Much of the discussion in this chapter comes from Z. Rezaee. 2008. Corporate Governance and Business Ethics (John Wiley & Sons, Inc). 2. A.A. Berle Jr., and G.C. Means. 1967. The Modern Corporation and Private Property (New York, NY: MacMillan), 1932; Revised Edition, Harcourt, Brace and World. 3. W. Ocasio, and J. Joseph. 2005. “Cultural Adaptation and Institutional Change: The Evolution of Vocabularies of Corporate Governance, 1972–2003,” Poetics 33, pp. 163–178. linkinghub.elsevier .com/retrieve/pii/S0304422X05000458 4. R.I. Tricker. 2000. Corporate Governance. History of Management Thought Series (Aldershot, U.K: Ashcroft Publishing). 5. M. Jensen, and W. Meckling. 1976. “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics 3, pp. 305–311. 6. Sarbanes-Oxley Act (SOX). July 30, 2002. https://www.sec.gov/ about/laws/soa2002.pdf 7. Organization for Economic Co-operation and D ­evelopment (OECD). 2015. Principles of Corporate Governance. Retrieved August 22, ­ 2017, https://www.oecd.org/daf/ca/Corporate-­ Governance-Principles-ENG.pdf 8. Z. Rezaee, 2007. 9. American Bar Association (ABA). August, 2002. “Special Study on Market Structure Listing Standards and Corporate Governance. A Special Study Group of the Committee on Federal Regulation of Securities. American Bar Association, Section of Business Law.” Business Law 57, p. 1487.

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10. Z. Rezaee, 2007. 11. P.A. Gompers, J.L. Ishii, and A. Metrick. 2003. “Corporate Governance and Equity Prices,” Quarterly Journal of Economics 118, no. 1, pp. 107–155. 12. Ibid. 13. Organisation for Economic Co-operation and Development (OECD). 2004. http://www.oecd.org/daf/ca/corporategovernanceprinciples/31557724.pdf 14. A. Schaub. September 27, 2005. Keynote address by Alexander Schaub, Director-General of DG Internal Markets and Services, European Commission, at a Transatlantic Corporate Governance Dialogue event organized by the European Corporate Governance Institute and the American Law Institute. http://www.tcgd.org/2005/13_schaub_keynote.php 15. Committee on Capital Markets Regulation, 2006. 16. A. Brockett, and Z. Rezaee. 2012. Sustainability Reporting’s Role in Managing Climate Change Risks and Opportunities (New York, NY: Palgrave Macmillan). 17. Z. Rezaee, R. Zhang, S. Saadulah, and D. Zeigenfuss. March, 2011. “Corporate Governance: An Analysis of Existing Syllabi,” IUP Journal of Governance and Public Policy 6, no.1, pp. 1–30. 18. P.K. Jain, and Z. Rezaee. 2006. “The Sarbanes-Oxley Act of 2002 and Security Market Behavior: Early Evidence,” Contemporary Accounting Research 23, no. 3. 19. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. 2010. Pub. L. pp. 111–203. 20. Ibid. (p. 5). 21. J.C. Coffee. March, 2005. A Theory of Corporate Scandals: Why the U.S. and Europe Differ. The Columbia Law School. Working Paper Series. www.law.columbia.edu/center_program/ law_economics 22. United Kingdom Department for Business, Energy & Industrial ­Strategy. November, 2016. Corporate Governance Reform: Green Paper. https://www.gov.uk/government/uploads/system/uploads/­attachment_ data/file/573438/beis-16-56-corporate-governance-­reform-greenpaper-final.pdf



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23. Ibid. 24. Z. Rezaee. 2007. Corporate Governance Post—Sarbanes-Oxley: Regulations, Requirements, and Integrated Processes (Hoboken, NJ: John Wiley & Sons). 25. Z. Rezaee, R. Zhang, S. Saadulah, and D. Zeigenfuss. March, 2011. “Corporate Governance: An Analysis of Existing Syllabi,” The IUP Journal of Governance and Public Policy 6, no.1, pp. 1–30. 26. G.F. Maassen. 1999. An International Comparison of Corporate Governance. https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web& cd=1&cad=rja&uact=8&ved=0CB4QFjAA&url=http%3A%2F%2F repub.eur.nl%2Fpub%2F8028%2FMaassen_9789090125916.pdf&ei=V SFtVKviK8uayASbpYGIDg&usg=AFQjCNHYN3dvKIowbuL5urPtu ukm_G5yPw 27. European Commission. 2003. Audit of company accounts: Commission sets out ten priorities to improve quality and protect investors. http://europa.eu/rapid/press-release_IP-03-715_en.htm?locale=en 28. Brockett and Rezaee, 2012. 29. Z. Rezaee, D. Lo, A. Suen and J. Cheung. 2013. “Regulatory Reforms in the Aftermath of the 2007-2009 Global Financial Crisis and their Implication in Hong Kong,” US-China Education Review 3, no.5, pp. 345–354. 30. India, 2013. “The Companies Act of 2013,” Ministry of Law and Justice. http://indiacode.nic.in/acts-in-pdf/182013.pdf 31. A. Goodman, and J. O’Kelley. 2015 (p. 9). 32. Clifford Chance. 2014. Companies Act Reform: Supervisory Function of the Board of Directors. https://www.cliffordchance.com/briefings/ 2014/07/companies_act_reformsupervisoryfunctiono.html 33. Z. Rezaee, R. Zhang, S. Saadulah, and D. Zeigenfuss. March, 2011. “Corporate Governance: An Analysis of Existing Syllabi,” IUP Journal of Governance and Public Policy 6, no.1, pp. 1–30. 34. Ibid. 35. Ibid. 36. J.C. Coffee. March, 2005. A Theory of Corporate Scandals: Why the U.S. and Europe Differ. The Columbia Law School. Working Paper Series. www.law.columbia.edu/center_program/law_economics

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37. United Nations Environment Programme Finance Initiative and the UN Global Compact. April 27, 2006. Principles for responsible investment. https://www.unpri.org/download_report/3847 = 38. Ibid. 39. Ibid. 40. International Corporate Governance Network (ICGN). 2016. ICGN Global Governance Principles. http://icgn.flpbks.com/icgn_global_ governance_principles/#p=1nationalate Governance Network 41. International Federation of Accountants (IFAC). 2010. Corporate Governance in the Wake of the Financial Crisis. www.ifac.org 42. International Accounting Standards Board. 2005. International Accounting Standard No. 27. Consolidated and Separate Financial Statements. www.iasb.org/NR/rdonlyres/51A969A8-CC91-4C2C97D7-BF6ACD8466DA/0/IAS27.pdf 43. Z. Rezaee. 2008. Corporate Governance and Business Ethics (­Hoboken, NJ: John Wiley & Sons, Inc).

CHAPTER 3

Corporate Governance of Private Companies and Not-For-Profit Organizations Introduction The effective governance of private and not-for-profit organizations (NPOs) is of great importance to the owners and stakeholders of such organizations. The primary role of governance in private and NPOs is to ensure that the organization is run and managed effectively, and its resources are safeguarded and used efficiently to benefit its stakeholders. There are more similarities than differences between corporate governance measures and practices of for-profit organizations and private and NPOs. The board of directors of private companies and the board of trustees of NPOs set an appropriate tone at the top in promoting competency and integrity within the organization. In the context of corporate governance and accountability, private companies and NPOs have the same stewardship responsibilities as those of business corporations. This chapter presents corporate governance principles, structure, functions, measures, and practices of private and NPOs including state and local government entities, health care, colleges and universities, and other nonprofits.

Corporate Governance of Private Companies The emerging corporate governance reforms discussed in the previous chapters are normally aimed at improving corporate governance of for-profit organizations, particularly public companies. NPOs or nonprofits are usually established to achieve philanthropic purposes ­

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rather than maximizing the wealth of their stakeholders. However, private companies and nonprofits, such as government entities, health care organizations, colleges and universities, and charitable organizations, have been under scrutiny for their governance. For example, the scandal in the R ­ oslyn (New York) schools shows that an outside accountant hired to perform bookkeeping in a school district assisted in covering up the alleged theft by school administrators of $11.2 million in public money.1 Corporate governance of private companies is more alike that of public companies than it is different. The governing board of private companies is ultimately legally and structurally responsible and accountable for conducting the affairs and activities of the company. Recent corporate governance reforms, including the SOX, SEC rules, listing standards, and best practices, are applicable to public companies. They are intended to improve corporate governance, financial reporting, and accountability of public companies. Congress’ intent in passing the SOX was to significantly improve corporate governance practices, financial reporting, and the audit activities of public companies. However, many of its provisions are also relevant and feasible for private companies and nonprofits. It was expected that these provisions would eventually be adopted by all organizations (private, public, and not-for-profit) as part of “best practices.” The trend toward the adoption of the best practices of corporate governance by all businesses will continue as they have the flexibility to choose the most relevant and cost-effective aspects of corporate governance reforms.2 Many of these reforms, particularly some provisions of the SOX, can be very beneficial to private companies that have no intention of ever going public. Furthermore, the SOX has become so pervasive that many stakeholders of private companies, including customers, suppliers, investment banks, and auditors, demand that they voluntarily conform to some of its key provisions. There are several reasons why private companies may choose to adopt some of the emerging corporate governance reforms including the SOX. Some of these reasons are as follows: (1) Owners of closely held companies may, in the long term, desire to go public or sell the company; (2) Private companies and their directors may believe that compliance with corporate governance reforms can promote sustainable benefits by making their business more effective and efficient; (3) Owners of private



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companies may believe that effective internal controls can improve efficiency; (4) Suppliers, customers, and even the government may require compliance with a set of corporate governance reforms; Initial Public Offering (IPO) prices can be influenced by the effectiveness of corporate governance; and (5) Lenders may require private companies to comply with emerging corporate governance reforms. Some of the prevailing provisions of the SOX relevant to nonpublic companies are as follows: 1. Improving their corporate governance by creating an appropriate balance of power-sharing between owners, management, and the board of directors, by prohibiting loans to their officers, and by strengthening their code of ethics and business conduct 2. Improving the quality of their financial reports and enhancing their communications with their shareholders and other constituencies by holding conference calls or meeting with them and/or distributing periodic quarterly and annual financial statements 3. Increasing the effectiveness of the board oversight function by ­establishing independent audit and governance committees to oversee fi ­ nancial reporting, internal controls, audit activities, and governance matters 4. Improving their internal control over financial reporting (ICFR) by implementing some of the key provisions of the SOX including internal control reports by management and audit reports by the independent auditor Private companies, like public companies, are subject to the requirements of state law and the following eight corporate governance best practices: 1. Establishing an appropriate “tone at the top” by promoting ethical, legal, and professional conduct throughout the company 2. Establishing an effective audit committee to oversee financial reporting, risk assessment and management, and internal controls 3. Developing and maintaining adequate and effective internal c­ ontrols in general and ICFR to ensure operational effectiveness and efficiency,

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reliability of financial reports, and compliance with a­ pplicable laws, rules, and standards 4. Establishing antifraud programs to prevent, detect, and deter misappropriation of assets and misstatements of financial reports 5. Using the best practices and SOX provisions to improve governance, transparency, and accountability 6. Establishing whistle-blower programs 7. Creating and maintaining a sound and reliable financial reporting process 8. Creating a system of accountability throughout the company. Effect of SOX on Private Companies Private companies are not currently required to comply with corporate governance, financial reporting, internal control, audit activities, and other SOX provisions. Nevertheless, a survey conducted by PwC reveals that CEOs from 30 percent of the surveyed fast-growing private companies reported that the SOX has already had an effect on their business.3 Financial reports of private companies are important and relevant to financial decisions made by these companies’ owners and management. The Financial Auditing Standards Board (FASB) has taken the initiative to improve the quality of the financial reporting of private companies. The Private Company Decision-Making Framework was established on December 23, 2013, to improve the accuracy of financial reporting. The framework specifically covers the areas of measurement, recognition, disclosure, display, transitions, and effective date.4 The FASB and the American Institute of Certified Public Accountants (AICPA) have traditionally studied whether financial accounting and reporting standards should be different for private companies. The general consensus has been that the accounting policies and practices of measuring, recognizing, and reporting business transactions and economic events should be the same and that companies of all sizes and types (small versus large, private versus public) benefit from uniform accounting and reporting standards. The AICPA has issued an invitation to comment on its proposal entitled Enhancing the Financial Accounting and Reporting Standard-Setting Process for Private Companies. There are several events that occurred after



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asking for comment. First, in January 2007, the AICPA and the FASB created the Private Company Financial Reporting Committee. Second, in December 2009, the AICPA, Financial Accounting Foundation (FAF), and National Association of State Boards of Accountancy (NASBA) declared that the Blue Ribbon Panel was in the process of formation. Last, in ­October 2010 and January 2011, the Blue Ribbon Panel worked on a resolution for Private Company Financial reporting and published a report.5 The FASB is considering this proposal in assessing the differences in accounting standards for private companies within the framework of generally accepted accounting principles (GAAP). The FASB and the AICPA are committed to finding ways to improve the quality, value, transparency, and costeffectiveness of financial reporting for private companies. To achieve this goal, they are jointly proposing the following: (1) improving the FASB’s current processes of assessing whether differences are needed in the current and future accounting standards for private companies and (2) sponsoring a committee designed to increase input and insights from private company constituents in the standard-setting process.6 Corporate Governance and the Initial Public Offering The initial public offering (IPO) is viewed as the beginning of the ­formation of corporate governance in a newly established public company while the initial owners attempt to maximize their wealth generated from the sale of the company’s ownership (blockholders). Traditionally, the composition of the board of directors of newly established public companies has been dominated by outside directors.7 The structure of corporate governance of these companies in terms of the percentage of ownership of blockholders and outside directors on the board can change once the company is past the IPO stage. The process of going public begins with the preparation to file a registration statement with the SEC. This statement contains the owner’s letter of intent for the offering, the estimated range of the offer price, the number of shares being offered, the ownership concentration, the governance structure, a description of the financial condition, and the use of proceeds. The information contained in the statement along with the underwriters’ identities is reported in the preliminary IPO prospectus.

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The issuing company then chooses the lead and co-managing underwriters to assist the company to register with the SEC and provide credible certification of their financial condition. During the preregistration period right before the issuing company registers with the SEC, regulations prohibit the company from conducting promotions that may boost its stock price. The underwriter reviews the prospectus to ensure that no information is omitted or incorrectly reported. The underwriter should exercise due diligence review and analysis to reduce any risk of potential legal liabilities. This preliminary prospectus is prepared and submitted to the SEC for review. The lead underwriter then begins to establish a syndicate of underwriters who are willing to participate in underwriting the IPO. During this quiet period, the issuing company and underwriters are not permitted to make any solicitations to potential outside investors. After the submission of the prospectus to the SEC and before the SEC decision to accept or reject the IPO prospectus (the waiting period), the underwriter and the issuing company communicate with institutional investors and solicit indications of interest. This process of book building should help the issuing company to estimate the demand for its newly issued stock. During this period, no written communication with potential investors is permitted, with the exception of the preliminary prospectus, and no binding sales of shares or commitments to buy shares are allowed. Shortly before the SEC declares the right to issue shares, and when there is an indication that the SEC will approve the IPO prospectus, the issuing company and the underwriter sign the underwriting agreement that finalizes the offer and the number of shares to be offered. This agreement binds the underwriter to buy the amount issued at the established price. On the effective day (the day the SEC declares the right to issue the shares), the underwriter sells the shares to investors. Upon completion of the IPO, insiders, including management, the founders of the company, and the directors who own shares of the company, are bound by Rule 144, which requires the company to report insider ownership changes that exceed 1 percent of the total outstanding shares.8 Insiders usually have a binding contract with the underwriter (known as a lockup agreement) to not sell their shares before the lockup period expires, which is typically 180 days after the IPO. After this period expires,



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Rule 144 allows insiders to sell up to 1 percent of the total outstanding shares per quarter without reporting to the SEC or participating in the primary seasoned equity offerings to raise more funds. Compliance with applicable IPO rules and regulations requires the formation and effective functioning of corporate governance mechanisms. The SEC in its securities offering reform has decided to end the so-called quiet period during which company executives and other personnel were prohibited from making public statements prior to an IPO of stock.9 This securities offering reform is intended to increase the amount of information (public presentations, written materials in addition to the prospectus) about shares that are being offered to the public in order to promote the sale of stocks and bonds to investors and improve the efficiency of the capital markets without mandating delays in the offering process. The SOX is being criticized for not addressing issues related to IPOs, which contributed to the REFCO debacle. Recent corporate governance reforms (SOX, SEC rules, listing standards, and best practices) relevant to public companies have made going public a challenging endeavor for private companies. Private companies going public and raising capital through IPOs must now comply with corporate governance reforms imposed on public companies.

Corporate Governance of Emerging Growth Companies The Jumpstart Our Business Startups Act (the JOBS Act) was enacted in April 2012 to enable emerging growth companies (EGCs) to go public without being subject to the full vigorous range of regulations applicable to publicly traded companies, as explained in detail in the next section.10 The JOBS Act, by relaxing disclosure requirements, may loosen investor protections in favor of creating more jobs. Some provisions of the act such as the increase in the shareholder limit from 500 to 2,000 to be exempt from registration requirements under the ’ 34 Act went into effect immediately and thus do not require the SEC for further rulemaking. However, EGCs require the same level of scrutiny from the SEC staff and their registration statement on risk disclosures as for all companies required to file an IPO registration statement with the SEC. The JOBS Act enables substantial loosening of restrictions around the traditional IPO process and post-IPO reporting requirements. It loosened

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investor protections with the goal of creating more jobs by reducing disclosure requirements for so-called EGCs that decide to go public and have up to $1 billion in annual revenue. The JOBS Act presents several implications for private company mergers and acquisitions and may promote and affect the Risk Management (RM) process. The JOBS Act also enables EGCs to file their registration statements confidentially so long as the confidential filings are ultimately released at least 21 days before the IPO. It is expected that EGCs will take advantage of keeping early filings confidential in order to pull their deal without the stigma associated with withdrawing a publicly filed registration statement and keep the IPO process outside the public eye and invisible to prospective acquirers. The JOBS Act provides the opportunity for EGCs to undertake a dual-track process instead of the traditional stand-alone mergers and acquisitions (M&A) process to comply with more relaxed restrictions on “test the waters” premarketing of the conventional IPO process. The JOBS Act has significantly changed the process for IPOs by EGCs in several ways, including the following: 1. Enabling EGCs and their authorized representatives to test the ­waters with institutional accredited investors and qualified institutional buyers by gauging their interest prior to (and after) filing a registration statement for any securities offering. 2. Allowing broker-dealers to issue research reports on EGCs before, during, or after IPOs regardless of whether the broker-dealer is ­participating in the offering by permitting research analysts to communicate with investors and management in connection with the IPO of an EGC; 3. Permitting EGCs to submit draft IPO registration statements to the SEC for confidential review prior to filing them publicly. 4. Excluding EGCs from complying with Section 404(b) of the SOX which requires the auditors of a public company to attest to and report on the company’s ICFR and by directing the SEC to decide whether any new rules that may be adopted by the Public Company Accounting Oversight Board (PCAOB) requiring mandatory audit firm rotation or changes to the auditor’s report and any other future rules adopted by the PCAOB be applicable to the audits of EGCs.



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5. Allowing EGCs to present no more than 2 years of audited financial statements in its IPO registration statement, as opposed to the current rules requiring 3 years of audited income statements and 5 years of selected financial data; by permitting EGCs not to present selected financial data pursuant to Item 301 of Regulation S-K (or, apparently, financial statements in any other registration statement) for any period prior to the earliest audited period presented in connection with their IPO; by exempting EGCs from complying with any new or revised financial accounting standards. 6. Exempting EGCs from complying with executive compensation-­ related disclosure provisions of the DOF including those pertaining to the advisory “say-on-pay” vote on executive compensation required under Section 14A(a) of the Exchange Act; the Section 14A(b) requirements relating to shareholder advisory votes on golden parachute compensation; the Section 14(i) requirements for disclosure relating to the relationship between executive compensation and financial performance of the issuer; and the requirement of DOF Section 953(b)(1), which will require disclosure as to the relationship between CEO and median employee pay. 7. Increasing the number of record holders a company may have up to 2,000 from the currently required 500, before it is required to publish annual and quarterly reports, and permitting EGCs to offer and sale unlimited securities under Rule 506 of Regulation D. In summary, the JOBS Act directs the SEC to amend Rule 506 of Regulation D and Rule 144A under the Securities Act to eliminate the prohibition on general solicitation in transactions effected under those rules. Thus, it is expected to ease requirements for IPOs and reduce compliance and reporting obligations post IPOs for EGCs. The main concern of the JOBS Act is that its relaxation of IPO requirements may be detrimental to investors and the capital markets by (1) reducing transparency and investor protection; (2) making securities law enforcement more difficult, which may reduce capital market safety and soundness; and (3) reducing publicly available information by exempting EGCs from currently mandated certain disclosure and other requirements. These concerns and related corporate governance challenges need to be addressed in order to maintain the sustainability of ESGs.

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Not-For-Profit Organizations Purpose of NPOs The primary purpose of nonprofits is to serve the public rather than to maximize shareholder wealth through earning profits. NPOs are created to serve the public, often individuals other than organizations, and are usually tax-exempt when complying with Internal Revenue Service (IRS) rules. NPOs have a fundamental difference from business corporations with respect to their relationship with their stakeholders. NPOs may receive grants, which are funds from their constituencies, to provide services to the community. Governance of NPOs is crucial in managing and monitoring their activities and balancing their budgets. NPOs receive their budgets through grants or contributions from their stakeholders or fees or membership dues charged for their services or memberships. Thus, NPO activities for generating funds are similar to the activities of profit-oriented business firms for generating revenue. Section 501(c) of the IRS code defines tax-exempt organizations as those that are operated for philanthropic purposes. The organization must serve the public good and not benefit a private shareholder or individual. The organization cannot be a lobbying organization, attempt to influence legislation by propaganda or otherwise, or be an organization participating in a political campaign.11 NPOs are required to pay taxes on their unrelated business income (UBI) when the revenue is generated from non-philanthropic services. Tax exemption is usually given to NPOs that meet and continue to meet IRS requirements. NPOs that wish to obtain federal tax-exempt status should file the request with the IRS and upon approval receive the exemption. Tax-exempt organizations can be subject to tax on revenue generated from engagement in a trade or business unrelated to their exempt purposes, and they must file an annual return with the IRS to maintain their tax-exempt status. Donations to tax-exempt organizations that have received approval by the IRS as 501(c) entities are tax-deductible by donors. Governance of NPOs The Ethics and Accountability Advisory Committee (EAAC) was organized to demonstrate the role of charitable organizations in American life



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and to strengthen NPO accountability, transparency, and governance.12 The EAAC has developed 33 principles regarding legal compliance and disclosure, effective governance, strong financial oversight, and responsible fundraising.13 The EAAC’s suggested legal compliance and public disclosure principles are the following: 1. A charitable organization must follow all federal, state, and international laws. 2. A charitable organization should write a code of ethics that everyone in the organization follows. Such an organization properly handles all matters related to conflict of interest. 3. A charitable organization needs to have a whistle-blower policy that protects the reporter of illegal activity. It needs to have a process to protect all data. It needs a board of directors that monitors assets, liabilities, and risks. A charitable organization must seek to disclose its operation methodology. The EAAC’s recommendations call for improvement within the nonprofit sector, more effective oversight, and changes in the law. The panel’s recommendations are as follows: • Effective oversight of the charitable sector requires vigorous ­enforcement of federal and state laws. • The annual information returns filed to the IRS by charitable organizations (Forms 990, 990-EZ, and 990-PF) should be improved by providing more accurate, complete, and timely information for federal and state regulators, managers of charitable organizations, and the public. • Congress should require charitable organizations with annual revenues of between $250,000 and $1 million to have their financial statements annually reviewed and those with more than $1 million audited annually by independent auditors. • Charitable organizations should provide more detailed information about their operations and performance of their programs to the public through their annual reports, website, or other means. • Charitable organizations should be discouraged from providing compensation to their board members. When such compensation

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is provided, it should be fully disclosed, including the amount, reason, and method of determining the reasonableness of the compensation. • A charitable organization should have a minimum of three members on the governing board to be qualified for recognition as a 501(c)(3) tax-exempt organization, and at least one-third of the members of the governing board should be independent to be qualified as a public charity rather than a private foundation. • Charitable organizations should adopt and enforce a conflict of ­interest policy, and the IRS should require them to disclose on their Form 990 series whether they have such policies.14 In the business environment, the board of directors represents the owners (shareholders) of the company. NPOs are typically owned by their members (e.g., trade associations, professional societies), their communities (e.g., social services, education, hospitals), or their constituencies (state, local governments). Thus, the board of directors or its equivalent, the board of trustees, represents the members, communities, or constituencies in an NPO. Regardless of the type of NPO and the nature of their ownership, the board has total authority over the organization, is directly responsible for its activities, and is ultimately accountable to its ownership, and delegates its authority to others to carry out the organization’s activities. In the business sector, the CEO manages the company; in NPOs, the CEO may be called executive director, president, general manager, superintendent, or director-general. The board grants its authority to the CEO. To regain public confidence, particularly that of donors, NPOs should improve their governance by demonstrating integrity, honesty, ethics, and transparency in their performance. Four major documents make up the governance documents of NPOs: two organization documents (mission statement and code of conduct) and two legal documents (charter and bylaws).15 1. Mission Statement. A mission statement defining an organization’s vision, mission, and goals is regarded as the most important document. It sets an appropriate tone for directors, management, and volunteers to direct their activities toward achieving the organization’s



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objectives. A mission statement is not a legal document per se but an important document describing an organization’s goals and the reasons for existence. 2. Code of Conduct. The organization’s code of conduct is currently required by law for NPOs; the SOX requires public companies to establish a code of conduct for their financial executives. Codes of conduct set an appropriate “tone at the top” and related guidance for directors, management, employees, and volunteers to follow while carrying out their responsibilities in dealing with sensitive information and avoiding conflicts of interest. 3. Charter. An organization’s charter, which is also referred to as articles of organization or certification of incorporation, is a legal document that should be filed with the Secretary of State of its state. This charter serves as the constitution of the NPO and a prerequisite for official status as a not-for-profit organization. For not-for-profit groups established as trusts, the official governance document is often called a declaration of trust or the trust instrument; it also requires periodic filings or reporting obligations. 4. Bylaws. Bylaws spell out the basic operating procedures and the way an organization is structured and governed. Bylaws establish rules and procedures for the selection of directors, the appointment of officers, meetings, voting, and indemnification. The 2008 release of the IRS’s best governance practices for tax-exempt organizations states that NPOs are required to comply with a set of rules and regulations to maintain their tax-exempt status. At the federal level, the IRS is authorized to grant NPOs tax-exempt status and to assess fines and penalties and revoke tax-exempt status for noncompliance with applicable laws, rules, and regulations. The majority of NPOs incorporated in the United States are required to file an annual information return with the IRS, called the Form 990. The primary purpose of this form is to enable NPOs to report relevant information regarding their finances, governance, operations, and programs. One requirement of the annual IRS Form 990 is that NPOs must list all of the members of its board.16 In 2017, the IRS added 29 “help icons” to the Form 990-EZ to assist NPOs to more effectively and easily complete the form. These help icons

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appear on the form 990-EZ relevant to smaller tax-exempt NPOs with gross receipts of less than $200,000 and assets of less than $500,000 at the end of their tax year. The 2015 Survey on Board of Directors of NPOs indicates that the skills, resources, and experience of directors are not sufficient to meet the needs of most NPOs.17 Specifically, more than a quarter of directors do not have a deep understanding of the mission and strategy of NPOs, about a third are dissatisfied with the board’s ability to evaluate organizational performance, and a majority do not believe that their fellow board members are very experienced or engaged in their work.18 Most of the governance challenges of NPOs are in the areas of board oversight effectiveness including the audit committee, board evaluation, succession planning, financial reporting, and auditing. To improve their governance, NPOs should consider the following suggestions: 1. Make the organization’s mission align with its charter, skills, and resources by ensuring that the selected mission is accepted and complied with by the board of trustees, executives, and other key stakeholders. 2. Develop goals, objectives, and strategies to achieve the established mission by setting an appropriate ton at the top in meeting the organization’s goals and objectives, select directors and appoint ­ ­executives who are committed to pursuing the organization’s goals, and develop key performance indicators (KPIs) to measure and ­ensure achievement of the selected goals and objectives. 3. Hold directors and executives accountable for meeting the selected KPIs and define explicitly the roles and responsibilities of board members and executives. 4. Establish appropriate board of trustees, board committees, and management processes to achieve the organization’s goals. 5. Regularly review and assess the performance of directors and executives and hold them accountable for fulfilling their responsibilities. 6. Observe the basic compliance requirements of Form 990 and the activities that a tax-exempt organization should limit to protect its tax-exempt status, by considering the various federal and state filing



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requirements pertaining to tax-exempt organizations, including the IRS Form 990 series of returns, charitable registrations and state sales tax exemptions and by reviewing the structure and core components of Form 990 and related schedules and consider common adjustments needed to reconcile Form 990 to financial statements prepared in conformity with GAAP. 7. Identify when a tax-exempt organization may be subject to UBI taxes and prepare the applicable filing requirements; consider the unique compliance requirements and restrictions related to private foundations to meet the tax-exemption requirements. Corporate Governance Reforms Relevant to NPOs Regulators in several states, including New York, California, and ­Virginia, are considering applying SOX provisions to NPOs. Many NPOs are adopting some of these provisions in order to improve their corporate governance, financial reporting, internal control, and audit activities, even though it is not required. Examples of NPOs that are implementing some of the SOX provisions are New York’s Juilliard School, which is adopting transparency and board involvement, and the International Swimming Hall of Fame in Florida, which is recruiting board members who can understand and review audits.19 The provisions of the SOX that would be more appropriate and applicable to NPOs are the following: 1. More vigilant and independent directors. More vigilant and independent directors on the board of trustees of NPOs can improve the effectiveness of their corporate governance. 2. Audit committees. The audit committees of public companies in the post-SOX era are important components of corporate governance in overseeing financial reporting, internal control, risk management, and audit activities. It is expected that NPOs will establish or revise their audit committee charter by adopting the requirements of the SOX regarding the independence and financial expertise of audit committees. 3. Improvements in the financial reporting process. NPOs can benefit significantly from those SOX provisions that require more transparent

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and timely financial reports in the areas of contingent liabilities and prevention of fraudulent financial activities. 4. Risk management and internal controls. Risk management assessment and internal controls are vital to the sustainable success of NPOs. SOX provisions, SEC rules, and PCAOB standards pertaining to ICFR are applicable and beneficial to both private companies and NPOs. 5. Audit quality. Recent corporate governance reforms, including SOX, SEC rules, and PCAOB standards, are intended to improve audit quality and strengthen the audit independence of public companies. The requirements for an integrated audit approach of the audits of both internal controls and financial statements are well-suited for NPOs. More independent and better-quality audits are also essential to the integrity, relevance, and transparency of the financial reports of private companies and NPOs. 6. Codes of conduct. Public companies are required to establish codes of conduct and business ethics for their employees in general and ­financial officers in particular. Section 406 of the SOX and the SEC-related rule require that public companies subject to the ­Exchange Act ­reporting requirements, except for registered investment companies, disclose whether they have adopted written codes of ethics for their principal executive, financial, or accounting ­officers, controllers, or persons performing under their supervisions.20 There is no doubt that every organization, private, public, or nonprofit, would benefit from the culture of promoting ethical conduct. 7. Whistle-blower programs. Public companies are now required to establish proper whistle-blower programs to facilitate employees voicing their concerns and reporting corporate wrongdoing to a­uthorities without the risk of retaliation or losing their job. The SOX created the opportunity for confidential and anonymous submissions of complaints by requiring the company’s audit committee to establish procedures for the receipt, retention, and treatment of such complaints.21 NPOs can benefit significantly from similarly appropriate whistle-blower programs. 8. Document destruction. Sections 802 and 1102 of the SOX make it illegal to knowingly alter, destroy, conceal, mutilate, cover up, or



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falsify any record, document, or other object to impair the document’s or object’s integrity or availability for use in official proceedings. PCAOB auditing standards also require the retention of audit evidence for at least 7 years. These requirements to preserve the ­integrity and availability of relevant documents, including audit evidence, are also applicable to NPOs. Governance Mechanisms The corporate governance mechanisms of NPOs are different from those of corporations discussed in the previous chapters. Unlike business firms, NPOs do not have the external corporate governance mechanisms of the capital markets, the market for corporate takeovers, or product market competitions. Thus, NPOs must rely primarily on internal governance mechanisms to assess performance, monitor and reward good performance, and monitor and discipline poor performance. The primary governance mechanisms of NPOs are their governing and advisory boards. The governing board is directly responsible and ultimately accountable for the organization’s affairs. In a large NPO with sufficient competent staff, the governing board provides more of an oversight function rather than the managerial function of directly making decisions. However, in a small NPO, the governing board may perform both managerial and oversight functions. The IRS Form 990 requires NPOs to document and report on three aspects of their governance including their governing body, certain governance policies such as conflicts of interest and disclosure of their board members and executives. Specifically, the governing body is defined as the group of persons authorized to make decisions on behalf of NPOs, and is commonly referred to as the board of trustees. The governing board should be composed of independent members and not be dominated by employees or others who are not independent. According to the IRS Form 990, a member of the board of trustees is perceived to be independent when the director is not compensated as an officer or other employee, does not receive total compensation exceeding $10,000 annually as an independent contractor, and is not involved in any financial transaction with the organization. The advisory board of an NPO typically provides advice rather than engaging in governing

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the organization. The advisory board often comprises volunteers rather than elected or appointed members. For example, in a state-supported university, the governing board is usually appointed by the state at the university level; the voluntary advisory board for all colleges and departments within the university (law, business, medical, engineering, and education schools) is composed of members of the community and student body. Unlike their counterparts in business firms, who are largely motivated by substantial compensation, volunteers serve on the board by committing their time, efforts, and even money because of their dedication, beliefs, and interests for good cause. Furthermore, the board of NPO organizations does not often have resources to hire advisers and relies on the commitment, dedication, and competence of its members for giving counsel. The NPO’s internal control structure should also prevent and detect errors, irregularities, and fraud, particularly employee embezzlements. Fraudsters perpetrate fraud and steal money even from NPOs. It is not uncommon that the funds donated or the grants and contributions to an NPO are appropriated and restricted for activities for achieving the intended philanthropic purposes. Thus, the NPO’s internal control system should ensure that appropriated funds are spent on designated programs to achieve the intended purposes. The directors or trustees of the NPO typically are volunteers or are appointed by the sponsoring organization to oversee the NPO’s activities and affairs. The chair of the board is also selected by the sponsoring organization or by directors for a limited number of terms. Often the board chair is rotated among the members of the board or trustees. NPOs, like business firms, organize their work through the establishment of committees. NPOs are normally managed and function through the committee assignments. The committees often have proper staff, make decisions, take actions, and report their activities to the board or trustees. The types, structure, and number of committee members depend on the size of the organization and the size of its board of trustees. The most common structured committees of NPOs are governance or nominating, development or fundraising, finance, budget, or audit operations, programs, personnel, and executives, as discussed in the next section.



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Board Committees The work of the board of directors or trustees is best performed and is more effective in the form of committees. The chair of each committee should present the committee’s findings and recommendations to the entire board for approval and action. The following board committees are relevant to NPOs: Audit committee, consisting only of independent directors or trustees, responsible for overseeing financial reporting, internal control, audit activities, and compliance with applicable laws, rules, and regulations. The AICPA has developed a tool kit to improve the audit committee effectiveness of NPOs.22 This kit provides audit committee charter metrics to assist NPOs to tailor their audit committee charter to their own specifications and size by using best practices. Executive committee, composed of officers and committee chairs that can act on behalf of the entire board between the board meetings if circumstances require Development/fundraising committee, which organizes and oversees fundraising events and capital campaigns Finance committee, which oversees financing and investment activities including budget and tax activities Nominating committee, which identifies the board members’ needs and makes recommendations to the board about vacant board positions Program committee, which is responsible for the organization’s programs and activities, the accomplishment of the programs, and its future initiatives Personnel committee, which develops compensation and benefit plans for the organization’s paid staff. Duties of the Board of Directors/Trustees Boards of directors or trustees are regarded as governing bodies primarily responsible for affairs. Members of boards of directors/trustees may provide oversight functions, depending on the organization’s size and activities, or engage in both oversight and managerial functions in smaller

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organizations. The board of trustees typically consists of several qualified individuals (7 to 9) who could be appointed by governmental bodies and/ or elected by members at large. The term of office for each trustee could be 3 years to ensure continuity of the board of trustees. The board of trustee should be led by the chair who resides at all meetings and appoints individuals to serve in advisory capacities. This section examines the duties and responsibilities of the boards of directors, their composition, member qualification, committees, and effective meetings. A large part of these discussions are from the publication of Society of Corporate Secretaries and Governance Professionals.23 The directors and trustees of NPOs have three major fiduciary duties: 1. Duty of obedience, which requires directors and trustees to carry out their assigned responsibilities in accordance with the organization’s rules, standards, and procedures as specified in its articles of incorporation, bylaws, and mission statements 2. Duty of care, which requires directors and trustees to exercise due care, diligence, and skill that an ordinary, prudent person would ­exercise under similar circumstances 3. Duty of loyalty, which requires directors and trustees to carry out their activities in pursuing the best interests of the organization by avoiding self-dealing and self-serving activities. Attributes of Board Members The effectiveness of the organization’s board depends on the attributes, personal integrity, competence, dedication, insight, and professional qualifications of its members. The following are the six important qualities of an effective board member: 1. Vision. The ability to see the big picture and establish the organization’s mission 2. Leadership. The ability and courage to set direction to achieve the organization’s mission and related goals 3. Stewardship. The sense of accountability and integrity to pursue the organization’s goals and serve the interests of the organization, its intended beneficiaries, constituents, and the public



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4. Skill. The knowledge and ability to provide an effective oversight of the organization’s operations, programs, activities, and performance 5. Diligence. The ability to exercise due care, dedication, and ­commitment to carry out oversight responsibilities in achieving the organization’s goals 6. Collegiality. The teamwork and respect of colleagues and their views. Internal Control in NPOs ICFR, operations, and compliance with applicable laws and regulations, particularly tax-exempt status, are important internal governance mechanisms of nonprofit organizations. Internal controls over fundraising and operations are important to ensure that donations, grants, and other financial support are properly accounted for and assets are safeguarded against misappropriation. ICFR of NPOs are designed to prevent, detect, and correct misstatements to improve the reliability, integrity, and quality of financial reports. Internal controls pertaining to compliance with applicable laws and regulations are essential in an NPO to ensure continuation of the tax-exempt status of the entity, as many NPOs benefit from such a status.

College and University Governance College campus governance is evolving as many universities are moving away from state-supported or sponsored colleges to self-supported units, and their top administrators enjoy high compensation. Indeed, the recent disclosures of compensation (pay and perquisites) of campus leaders resulted in resignations and indictments of universities such as American University and Texas Southern University.24 It appears that business scandals and outsourcing over outsized executive pay have reached the doors of academia, even as Congress is considering strengthening a federal prohibition on excessive compensation for leaders of universities and other charitable organizations.25 The university boards of trustees are getting more involved in their governance as evidenced by the board of Vanderbilt University in scrutinizing the budget and other financial items of the university and taking an active role in university affairs, including strategic planning, capital expenditures, and management compensation.26

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Colleges and universities are also under scrutiny for more effective governance. A report issued by a federal commission urges significant improvement in the governance of U.S. higher education by calling for the following: (1) public universities should measure student learning with standardized tests, (2) federal monitoring of colleges’ quality, (3) sweeping changes to the financial aid system, (4) public universities should find new ways of controlling costs, and (5) college tuition should not grow faster than median family income.27

Conclusion The corporate governance structure of private companies and NPOs plays an important role in the organization’s governance, financial reporting, and audit functions. NPOs are expected to improve their stewardship and accountability, which can be achieved through effective corporate governance. The important attributes of effective corporate governance of private companies and NPOs are independence of members of the board of trustees, written charters, and regular meetings of the board with management, officials, internal auditors, and external auditors. In the absence of the regulatory requirements for NPOs to reform their governance practices, NPOs should voluntarily adopt strong governance and accountability principles, guidance, and practices.

Endnotes 1. New York Times. October 11, 2006.Former Schools Chief of Roslyn Gets 4 to 12 Years in Fraud. http://www.nytimes.com/2006/10/11/ nyregion/11tassone.html 2. P.D. Broude. March 9, 2006. The impact of Sarbanes-Oxley on ­private and non-profit companies. https://www.hcca-info.org/Portals/ 0/PDFs/Resources/library/BroudePrebil_ImpactSOX.pdf 3. PricewaterhouseCoopers. 2005. 30% of Fast-Growth Private Companies Applying Sarbanes-Oxley Principles. http://www.barometersurveys .com/vwAllNewsByDocID/834B5ECEF36C79C685257026006F 2DC7/index.html



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4. Financial Accounting Standards Board (FASB). January 16, 2014. Private Company Decision-Making Framework. http://www.fasb.org/ jsp/FASB/Document_C/DocumentPage?cid=1176163703583&ac ceptedDisclaimer=true 5. Ibid. 6. Ibid. 7. M. Baker, and P. Gompers. 2003. “The Determinants of Board Structure at the Initial Public Offering,” Journal of Law and Economics 46, pp. 569–598. http://web.lexis-nexis.com/universe/document?_ m=8a7208820d2cbcad0519751aa4601057&_docnum = 1&wchp=dGLbVtb-zSkVA&_md5=64626dca298a35ef7732363 a9cc27a5f 8. Securities and Exchange Commission. 2003. SEC Rule 144. www .sec.gov/investor/pubs/rule144.htm 9. Securities and Exchange Commission. July, 2005. Securities offering reform. Release Nos. 33-8591; 34-52056; IC-26993; FR-75. www .sec.gov/rules/final/finalarchive/finalarchive2005.shtml 10. JOBS ACT. 11. Internal Revenue Service. Section 501(c). www.irs.gov/publications/ p557/ch03.html 12. Ethics and Accountability Advisory Committee. 2015. Principles for Good Governance and Ethical Practice. https://www.independentsector .org/wp-content/uploads/2016/11/Principles2015-Web-1.pdf 13. Ibid. 14. Ibid. 15. Society of Corporate Secretaries and Governance Professionals. 2005. Governance for nonprofits: From little leagues to universities. www.governanceprofessionals.org 16. Internal Revenue Service. 2014. 2014 Instructions for Form 990 ­Return of Organization Exempt From Income Tax (Washington, DC: Internal Revenue Service). 17. D.F. Larcker, N.E. Donatiello, B. Meehan, and B. Tayan. 2015. 2015 Survey on Board of Directors of Nonprofit Organizations. https:// www.gsb.stanford.edu/sites/gsb/files/publication-pdf/cgri-surveynonprofit-board-directors-2015.pdf 18. Ibid.

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19. C. Hymnowitz. June 21, 2005. “In Sarbanes-Oxley Era, Running a ­Nonprofit is Only Getting Harder,” Wall Street Journal. www.careerjournal .com/columnists/inthelead/20050622-inthelead.html 20. Sarbanes-Oxley Act. 2002. Section 406: Code of Ethics for Senior ­Financial Officers. www.sec.gov/about/laws/soa2002.pdf 21. Ibid. 22. American Institute of Certified Public Accountants. 2015. Audit committee series. https://www.aicpa.org/publications/financialmanagement reporting/auditcommitteetoolkits.html 23. Society of Corporate Secretaries and Governance Professionals. 2005. Governance for nonprofits. 24. J.S. Lubin, and D. Golden. September 26, 2006. “Vanderbilt reins in Lavish Spending by Star Chancellor,” Wall Street Journal. www .online.wsj.com 25. Ibid. 26. Ibid. 27. S. Dillon. August 11, 2006. Panel endorses Standards for Colleges. http:// legacy.sandiegouniontribune.com/uniontrib/20060811/news_ 1n11colleges.html

CHAPTER 4

Contemporary Issues of Corporate Governance Introduction Corporate governance has transformed from compliance with applicable laws, rules, and regulations to be integrated into corporate culture and business models. Many corporate governance challenges and issues have been encountered and addressed during this transition process. Globalization of financial markets, technological advances, and the 2007–2009 global financial crisis have caused many challenges for corporate governance. The globalization of capital markets and demand for investor protection requires consistency and uniformity in regulatory reforms and corporate governance practices. This chapter presents corporate governance challenges and issues ranging from investor confidence, nomination, and election of corporate directors to emerging issues associated with the board of directors’ effectiveness and the quality of financial and auditing processes. It also offers suggestions for turning the challenges into opportunities for bringing about corporate governance effectiveness.

Investor Confidence and Global Financial Markets Investor confidence in global financial markets is the key driver of economic growth, global competition, and financial stability in the sense that when confidence increases, consumers buy more goods, and investors are willing to invest at prevailing prices. This is a complex issue with no worldwide, well-established indicator. Investors are considered confident when stock prices are on an upward trend and the news about future stock performance is optimistic. The financial scandals of the early 2000s and

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the global 2007–2009 financial crisis have eroded investor confidence in global financial markets, contributing to the fear of terrorist attacks, the economic downturn in many countries, instability in the governments of some countries, and the bad news of pervasive global financial scandals. Nonetheless, it appears that the 2016 presidential election in the United States has restored investor confidence in financial markets. Investor confidence and public trust in public financial information and the financial markets can be influenced by technological advances, regulatory reforms, and the prosperity and sustainability of public companies, as discussed in this chapter. Effective regulatory reform creates an environment under which companies can operate in achieving sustainable performance, being held accountable for their activities, and providing protection for their investors. Regulatory reforms, in terms of their effectiveness and context, can be classified into three concepts: (1) a race to the bottom, (2) a race to optimality, and (3) a race to the top.1 The race-to-the-bottom concept suggests that global securities regulators, in an effort to attract issuers, deregulate to the point that issuers are provided with maximum flexibility for their operations at the expense of not securing adequate protection for investors. The race-to-the-top concept suggests that global securities regulators provide maximum protection for investors through rigid regulations and highly scrutinized enforcements at the expense of putting globally competing companies at a disadvantage with non-cost-justified regulations. The race-to-optimality concept is a hybrid of the first two concepts, in which both issuers (companies) and investors prefer a regulatory regime and jurisdiction that provides cost-justified investor protection. In real-world global competition, a combination of these three concepts may work best, as many provisions of the SOX have been globally adopted. Under the U.S. market–based corporate governance structure, shareholders’ value creation and enhancement is the primary objective of public companies. Globalization and technological advances have promoted tight competition among the world’s leading capital markets and thus regulations governing these markets can have a considerable impact on the balance of capital worldwide. Listing by foreign companies on U.S. markets increases access to capital. Furthermore, listing on U.S. markets provides greater



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investor protection and in turn a premium for companies listed. More than three-quarters of the 184 members of the International Monetary Fund (IMF) have experienced financial crisis, including the 1997–1998 Asian crisis.2 These crisis have continued into the twenty-first century. The IMF and the World Bank have assessed the strength of financial regulations in member countries and have set forth standards and prerequisite conditions for access to IMF funds. Globalization and information technology create profound challenges for businesses and regulators to protect investors worldwide. The speed with which financial transactions can be conducted and money can be moved around the world encourages regulators to establish global financial infrastructure and corporate governance. The IMF, the World Bank, the Basel Committee for Banking Supervision, the Organization for Economic Co-operation and Development (OECD), the International Organization of Securities Commission (IOSCO), and U.S. regulations (SOX and SEC rules) have taken initiatives to improve global corporate governance and provide guidance and sources of supervisory standards for national and international business and financial markets. Thus, countries and their companies that conduct business in global markets have to comply with the global standards of regulations and guidance provided by those organizations. Several initiatives have been taken in an attempt to roll back some SOX provisions despite the continuing corporate scandals. An article published on November 1, 2006, in The Wall Street Journal and entitled To Save New York, Learn From London points out the possibility of London taking over New York’s current standing as the global financial capital and states that the perceived overregulation (SOX) is a contributing factor to that change.3 Traditionally, New York has provided the broadest, most efficient, and most liquid capital markets worldwide and the most prosperous business environment for all businesses, particularly financial firms. The article argues four factors that shape the global financial markets—globalization, overregulation, frivolous litigation, and incompatible accounting standards. The first factor, globalization of the capital markets, will continue to play a major role as advances in technology and communication enable the establishment of financial markets anywhere in the world and more free flow of capital worldwide. The other three factors deserve more attention from U.S. lawmakers, regulators, and standard setters. First, it appears that

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the seeming overregulation in the United States is putting its markets at a global competitive disadvantage as (1) there are more than 10 federal, state, and industry regulatory bodies in the country compared with only one such body in the United Kingdom; (2) the British regulatory body appears to be more collaborative and solutions oriented than its U.S. counterpart; and (3) it has been estimated that the gross financial regulatory reforms driven by the SOX need to be revisited to promote the best practices of reducing frivolous lawsuits without eliminating meritorious ones. Finally, convergence to international accounting standards needs to be expedited.

Corporate Governance Challenges Corporate governance has evolved from shifting the focus on shareholder empowerment to stakeholder protection. This evolution has presented many challenges and opportunities for making improvements to ensure the effectiveness of corporate governance. Participants in PwC’s 2014 and 2016 Annual Corporate Directors Surveys provided insights and made observations on certain trends that are shaping corporate governance and that could influence the board of the future. PwC highlighted many current and potential corporate governance challenges, some of which are as follows4: • Directors are working together to improve gender diversity. Male and female directors have differing views about the importance of gender and racial diversity on their boards. Female directors are far more likely to consider board diversity important, with over 60 percent of them describing gender diversity as very important. • Thirty-six percent of directors say someone on their board should be replaced. Diminished performance due to aging, lack of expertise, and not being prepared for meetings are the top reasons for dissatisfaction with peers. • The percentage of directors who see impediments to replacing an underperforming director is growing. A higher proportion of directors say the biggest reason for these growing numbers is that board leadership feels uncomfortable addressing the issue. • Topping the list of director concerns regarding proposed and recent regulatory and shareholder initiatives are the CEO/median



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employee pay ratio disclosure and shareholder proposals for proxy access. Forty-two percent of directors are at least somewhat concerned about the impact of the new Department of Homeland Security/NIST cybersecurity framework, but many directors may not yet be aware of the protocols or their potential impact. Directors acknowledge that big data and cloud technologies are two areas that could consume more of their attention, with over a quarter saying they are not sufficiently engaged. Only 53 percent of directors say their company’s IT strategy and IT risk mitigation approach “at least moderately” take sufficient advantage of big data. Nearly half of directors have not discussed their company’s crisis response plan in the event of a security breach, and more than two-thirds have not discussed their company’s cybersecurity insurance coverage. Directors are less comfortable with their understanding of the company’s risk appetite; 51 percent say they understand the company’s risk appetite “very well,” over 10 percentage points less than 2 years ago. Despite increased director–stakeholder communications, directors still have many concerns. Ninety-four percent are at least “somewhat concerned” about the potential for mixed messages, and nearly 9 in 10 are concerned about the “agendas” of some investors. Directors also continue to be worried about violating Regulation Fair Disclosure (Regulation FD); 89 percent are at least “somewhat concerned.” More than half of directors have not held discussions about company protocols and practices in preparation for director–shareholder interactions. Almost half of directors have not discussed company protocols and practices regarding the process by which shareholders can request direct dialogue with the board, the particular directors who would participate in such a dialogue, and the permissible topics for discussion.

Global Corporate Governance With globalization working through local economies via deregulation and modern market reforms, the convergence of local financial reporting standards with international accounting standards has become

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imperative. Several initiatives have been taken during the past decade to improve corporate governance worldwide. Many of these initiatives are primarily national. No globally accepted set of corporate governance principles or a global regulatory framework governs corporations, financial institutions, or capital markets. Regulators in the United States, the SEC, IOSCO, and the World Federation of Exchanges have yet to agree on a global regulatory framework or a global corporate governance structure. The OECD’s international standards of corporate governance have not achieved acceptance to be included in the global regulatory framework. The International Corporate Governance Network (ICGN) was founded in 1995 by institutional investors, companies, financial intermediaries, academics, and other parties interested in the establishment of global corporate governance practices.5 The ICGN adopted corporate governance principles developed by the OECD as minimum acceptable standards for companies and investors worldwide and highly recommends that companies use the adopted principles as best practices. The ICGN’s principles are comprehensive enough to be applicable to corporations throughout the world. However, companies worldwide should establish their own corporate governance code comparable to ICGN principles and tailored to their political, cultural, economic, legal, and regulatory environment. In addition to the need for global corporate governance, the following are some of the other emerging issues: 1. Corporate governance reforms should create an environment in which public companies can operate in creating shareholders’ value, protecting the interests of other stakeholders, and rebuilding investors’ trust through effective enforcement of these reforms. Regulations must be cost-effective, efficient, and scalable. 2. Global corporate governance reforms should address the systematic risk involved in all business transactions, particularly the risk of business failures and potential insolvency, protect the interests of all stakeholders (investors, government, customers, creditors, suppliers, employees, society), promote accountability for businesses and their directors and officers, and encourage convergence and global cooperation and coordination.



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Supervision and Enforcement of Corporate Governance Global corporate governance reforms should be scalable and flexible for adoption by countries having different legal infrastructures and political and cultural environments, and be cost-effective and enforceable. Without effective supervision and enforcement, the letter of law and regulations has little meaning. An increased focus on the quality of supervision and enforcement in corporate governance has led to changes and reforms in many jurisdictions.6 A lack of independence and/or resources constrains the ability of many securities regulators to supervise and enforce corporate ­governance standards, as many securities regulators are less well-endowed than ­ ­banking regulators, and corporate governance is not typically among the priority areas for supervision and enforcement. Private supervision and enforcement can complement public supervision and enforcement, but in most countries are seldom used, except in some cases to obtain ­injunctions. A number of countries have, with some success, introduced arbitration procedures for resolving corporate governance disputes. The supervision and enforcement of rules on takeovers and m ­ andatory bids typically involve an interactive process between market participants and the supervisory authority. In some countries with mandatory bid rules, exemptions granted by the regulator have proved controversial and have been challenged in court. Rules regarding shareholder meetings are frequently supervised and enforced through private means, although ­public authorities can also be involved, in some cases through attendance at shareholder meetings.

Shareholder Challenging Issues Corporate governance reforms in the United States are generally intended to protect shareholders, even though they benefit other stakeholders, including creditors, customers, employees, suppliers, ­ government, and society, by providing some means of protecting their interests. This section presents several emerging and ­challenging shareholder issues pertaining to the nomination process, voting ­ ­system, proxy statements, and regulations, along with our suggested ­improvements in these areas.

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Nomination Process Traditionally, shareholders were not granted the right to place the names of director-nominees, or even resolutions regarding the election process, on the corporate ballot, although management uses the company’s assets (shareholder residual claims) to distribute those ballots to campaign for its candidates. Of course, shareholders can access management’s proxy card by filing a shareholder resolution; however, it is difficult to place a proxy card on the corporate proxy. The SEC issued its final rule entitled Facilitating Shareholder Director Nominations in August 2010 to facilitate shareholder right to nominate and elect directors.7 The SEC rules require a company’s proxy materials to enable shareholders to vote for a shareholder’s or a group of shareholders’ nominees for directors. The new rules require that certain adequate disclosures be made concerning nominating shareholders or groups and their nominees to inform and enable shareholders to effectively engage in directors’ nomination and election. The new proxy access rules require public companies to include shareholder nominees in their proxy statements, which provide an inexpensive means for shareholders to oppose management’s slate and to seek the election of up to a quarter of the seats that make up the entire board. The SEC adopted special exemptions from its proxy solicitation rules that enable shareholders to actively campaign in favor of election of their nominees. Specifically, the SEC rules do the following: 1. Allow large shareholders of shareholder groups, representing 3 ­percent of the voting shares, access to company proxy statements to ­nominate their director candidates (up to a quarter of the seats that make up the entire board). The nominating shareholder must have held at least 3 percent of the voting power of the company’s securities for at least 3 years. 2. Enable selected shareholders to nominate their candidates using the company’s funds and proxy machinery with personal costs to shareholders and grant shareholder access and the right to nominate directors under circumstances in which a “triggering event” (e.g., not considering shareholder views) has occurred and state law permits shareholder nominations.



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3. Enable shareholders to use the proposal process to establish procedures for the inclusion of shareholder director nominations in company proxy materials and permit shareholders to have their nominees included in the company proxy materials sent to all shareholders. The SEC proxy access rules are intended to promote shareholder democracy and create a balance of power-sharing among shareholders, management, and directors. One important unresolved issue concerning shareholder democracy is whether investors should be provided with the same access to the proxy as a company gives to its management team. A court case involving AIG by the U.S. Court of Appeals for the Second Circuit issued a ruling that permits shareholders in its jurisdiction to nominate directors, unlike the SEC rules that permit companies to reject any shareholder proposal pertaining to director election. Investor activists and organizations (e.g., the Council of Institutional Investors) have urged the SEC to sustain the recent decisions in the AIG case by permitting investors’ access to the proxy, provided a bylaw amendment is adopted. Regarding shareholder democracy and its role in the free enterprise system, Arthur Levitt, the former SEC chairman, states, “Shareholder capitalism enables our markets to thrive, our companies to grow and our economy to remain strong. And central to this system is the principle that shareholders can have a voice in the running of companies that they own.”8 In the United Kingdom and Europe, shareholders are granted the same right to use the proxy as management is. The adopted Regulation Systems Compliance and Integrity (SCI) by the SEC in 2015 requires key market participants—including the exchanges, clearing agencies and high-volume alternative trading systems—to establish comprehensive policies and procedures to ensure the capacity, resiliency, availability, integrity, and security of key automated trading systems.9 The SCI also requires corrective action and reporting when problems related to these systems do occur so as to protect investors from receiving misleading or incorrect corporate disclosures. The SCI entities are required to establish and maintain written policies and procedures to ensure the integrity, resiliency, security, and availability of their disclosure systems.

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Voting System The majority of U.S. public companies currently apply plurality voting, which permits uncontested management nominees to be elected to their boards without even a single vote, definitely with less than majority vote. Under the commonly practiced plurality voting, shareholders are allowed to either vote for a nominated director or withhold their votes, which enables nominated candidates to vote for themselves. A single affirmative vote, even by the candidate, is sufficient for a director to be elected, regardless of how many (majority) shareholders oppose the candidate. The majority voting system requires that uncontested board nominees receive more for votes than against votes to be elected or re-elected as directors, whereas under the plurality voting method, the nominees receiving the most for votes are elected to the board. Directors should be elected annually by a majority of the votes cast when, under state law, the company’s charter and bylaws permit majority voting. Alternatively, when state law requires plurality voting for directors’ elections, the company’s board can adopt policies requiring that directors tender their resignation if the number of votes withheld from them exceeds the number of votes for them. If such a director decides not to resign, he or she should not be re-nominated after the expiration of the current term. The company’s board should consider shareholder proposals that receive a majority of votes cast for and against. Two types of amendments to the plurality voting system can be made. The first is to amend the bylaws to switch from the plurality vote system to the majority vote system, which is referred to as the majority vote standard. For example, in January 2006, Intel’s board amended the company’s bylaws to replace its plurality vote standard with a majority vote standard for the election of directors. This move by Intel is viewed positively by its shareholders in holding its directors more accountable and in bringing democracy to its boardroom. The second type is to amend the company’s corporate governance principles by requiring that directors who receive a majority of withheld votes submit their resignation to the company’s board of directors, and the board then considers the resignation and makes a recommendation. The latter type is regarded as majority vote lite, or Pfizer-type majority withhold governance policy, and is criticized for



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failing to grant investors the right to vote no, enabling the board to make the final decision on director selections and not empowering shareholders. In recent years there has been an increasing trend toward the adoption of a majority voting system in the United States and other countries. The Committee on Capital Markets Regulation endorses majority, rather than plurality, voting.10 The committee wrote the first bipartisan report that supports majority rule to bring the U.S. shareholder election in line with that of other developed countries. The best practices of corporate governance suggest the adoption of a majority voting standard for director election that allows investors to vote no to underperforming incumbent directors. The majority vote lite or even the plurality voting system could be used only in rare cases when multiple nominees are nominated for the same directorship. Proxy Statements On March 29, 2010, the SEC adopted rules to provide investors with Internet availability of proxy materials.11 The SEC’s rules permit public companies and other persons to use the Internet to satisfy requirements relevant to the delivery of proxy materials. Under the existing SEC rules (Rule 14a-3), the proxy statement and annual report must be delivered in paper unless contested by shareholders to be delivered electronically (e.g., through e-mail). The proposed rules would provide two significant benefits: substantially reduce the cost of complying with the proxy rules and enable persons other than the company to use more cost-effective means to undertake their own proxy solicitations.12 The goal of the SEC in proposing the use of e-proxy is to simplify the process, reduce company costs of printing and making proxy materials, and make the process less tedious and more flexible for investors. Nonetheless, four issues pertaining to e-proxy deserve further consideration.13 The new rule allows the solicitation of proxy votes by simply mailing a postcard-type notice informing shareholders of the Internet location of the company’s proxy statement, permits shareholders to request a paper copy of the proxy statement if they desire, makes it less expensive and ­easier for institutional investors who are dissatisfied with incumbent directors to wage proxy contents for board representation, applies equally

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to public companies and others, such as dissident shareholders, in a proxy contest, and provides options to companies to either mail proxy material to shareholders or post them on their website. Shareholder Resolutions Shareholder resolutions are less likely to induce changes in the nominating and election process, as SEC rules allow companies to omit resolutions that would permit shareholders to list candidates for directors. The SEC rules should empower shareholders to replace underperforming directors and provide them with incentives to spend more time and effort in monitoring corporate activities and performance. More effective shareholder democracy is likely to increase market mechanisms for corporate control, reduce management entrenchment devices, and elect independent directors who focus on long-term sustainable shareholder value creation and enhancement. In 2016, 916 shareholder proposals were filed, of which only 61 went to a majority vote. The year before, 943 shareholder proposals were filed, from which 630 resolutions went to a vote and 75 resolutions won majorities.14 As of June 2016, 3,580 resolutions were filed, from which 440 went to a vote and 71 won majorities.15 Proposals that most often won majorities in 2005 were repeating classified boards, redeeming shareholder approval of poison pills, obtaining shareholder approval of golden parachutes, and adopting majority vote standards for director elections.16 In contrast, the common topics of U.S. management proposals, in 2005, were to increase authorized common stock, approve mergers and acquisitions, approve name change, adjourn meetings, approve board size, eliminate the supermajority requirement, approve nontechnical charter or bylaws amendments, repeal the classified board, and approve other business.17 In summary, there are three important issues relevant to s­hareholder democracy that deserve more attention from policy makers, r­egulators, investors, and public companies. These issues are majority vote for the election of directors, shareholder access to the proxy materials for the nomination of directors, and shareholder advisory vote on ­executive compensation (EC). Europe’s most powerful pension fund managers,



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who collectively manage assets of $765 billion from which more than $100 billion is invested in the United States, have warned U.S. regulators that shareholders’ rights should be strengthened so that confidence in U.S. capital markets is maintained.18

Challenges Facing Directors The 2016 Global Board of Directors survey addresses the following key five key areas of challenges and opportunities for the global boards of directors in the coming years; these are political and economic landscape, company strategy and risk, board governance and effectiveness, board diversity and quotas, and director identification and recruitment.19 The 2015–2016 National Association of Corporate Directors (NACD) Public Company Governance Survey indicates the following: (1) More than 46 percent of the surveyed boards were unprepared to respond to challenges from activist investors; (2) Corporate growth, strategic planning, and oversight are the biggest priorities for many boards; (3) Director turnover has recently increased; (4) Board gender diversity is gaining more attention; and (5) The majority of directors are not prepared to deal with cybersecurity challenges.20 Overall, the survey suggests that boards improve their effectiveness in the areas of board composition, succession planning, structure, risk oversight, EC, communication with investors, and strategic priorities. In 2016, the Rock Center for Corporate Governance at Stanford University, in collaboration with the Miles Group, conducted a nationwide survey to consider issues important to directors.21 The survey finds that boards in general rate their skills and expertise positively with some persisting challenges. Specifically the survey finds the following: (1) Overall, boards believe they have skills required to effectively advise and oversee their companies; (2) Board evaluation is making progress, with much improvements needed; (3) There are several prevailing challenges of trust level in fellow directors, honest feedback from directors, honest opinions in the presence of management, reaching a quick consensus, and differentiating between managerial and oversight functions; (4) board diversity and effectiveness; (5) creating independent board processes and environment; and (6) presenting detailed and relevant board

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reports on the achievement of short-term, medium, and long-term sustainability performance.22 Corporate governance reforms have addressed many important issues pertaining to directors, including director independence, nomination, compensation, composition, and evaluation. Nonetheless, several prevailing challenges facing directors have remained unresolved, as discussed in this section. Director Accountability and Liability Until recently, it was very rare, and almost unheard of, for outside directors of public companies to pay money from their own pockets to settle shareholder lawsuits relevant to their liability. In January 2005, former outside directors of Enron and WorldCom agreed to pay a total of $31 million ($18 million WorldCom and $13 million Enron) out of their own pockets, in addition to a total of $191 million paid by their D&O insurance ($155 million Enron, $36 million WorldCom) to settle securities class action lawsuits.23 These settlements are viewed by many as the start of a new litigation strategy, even though the settlement amounts are far less than the losses to investors resulting from corporate failures. Indeed, some institutional investors are taking lead plaintiff roles and attempting not only to hold directors and officers personally liable for incidents of fraud, but also to effect corporate governance changes.24 In the Walt Disney case, although the court did not find directors liable, it reinforced their responsibility for considering all material available information in making business decisions, as many aspects of directors’ conduct fell short of corporate governance best practices. Disney’s board was criticized for an inappropriate boardroom culture that allowed directors to be passive and the CEO to influence the board for personal benefit, the CEO’s excessive influence on independent directors’ actions and decisions, and the imperial CEO who acted unilaterally in making important decisions. While the court opinion indicates the governance failures at Disney, it stopped short of finding directors liable.25 The court’s opinion in the Disney litigation was perceived by many as “signals to investors that they should not look to the courts for protection from governance failures.”26 Thus, investors should rely on other external corporate governance mechanisms (e.g., capital markets) to discipline erring



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managements for failures. This court opinion of not holding directors liable for governance failure definitely underscores the need for reforms, such as majority shareholder voting, to enable shareholders to hold directors accountable. Not much progress has been made in the aftermath of the 2007–2009 global financial crisis in holding directors more accountable and liable for corporate misconducts that are detrimental to investors. Separation of the Chair of the Board and CEO Roles One of the most controversial and unresolved issues in corporate governance worldwide, particularly in the United States, has been CEO duality. The issue is whether the chair of the board should be distinct from the company’s CEO. Opponents of CEO duality argue that the separation of the roles of CEO and chairman avoids concentration of power and authority in one individual. CEO duality prevents the separation of leadership of the board from management of the business, and the oversight function assumed by the chair of the board of directors is totally distinct from the managerial function exercised by the company’s CEO. Proponents of CEO duality argue that the CEO, by serving as a bridge between executives and the board, can coordinate the oversight function with the managerial function ­effectively, the combined role of CEO and chair of the board can ensure the long-term well-being of the company, and the combined leadership of the board and management of the business better aligns management interests with those of shareholders. Generally speaking, the positions of board chair and CEO should be separated, particularly when the CEO can influence the nomination of the independent directors and has the ability and tendency to dominate the board leadership and process. In cases where there is CEO duality, the authors suggest that the lead director be in charge of managing and running the board. The establishment of the lead presiding director position has made independent directors (27 percent of boards have one) more effective and accountable in their oversight role of corporate governance, according to the 2016 survey of the Spencer Stuart Board Index.27 Nonetheless, the oversight responsibilities of lead/presiding directors can vary significantly from board to board or from time to time. In the case of the

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CEO duality practice, lead/presiding directors should be empowered to add substantial value in three roles: 1. Setting a more effective and robust agenda for the board and assessing the quality of briefing materials received from management 2. Orchestrating a richer and more thoughtful discourse with management 3. Providing ballast in turbulent times when the company is in a crisis or during a CEO transition.28 Executive Compensation EC has received considerable attention from regulators and investors, and much of incentive EC is linked to financial performance and reported earnings. While such incentive EC can encourage management to generate sustainable performance for creating shareholder value, it may lead to misreporting earnings to obtain excess pay because of erroneous reported financial results (earnings). One component of the EC with significant growth in recent years has been in stock-based compensation including stock options. EC has often focused on short-term performance, with no link to sustainable performance. Any cash compensation or short-term stock-based compensation can fail to create proper incentives to align manager interests with those of shareholders and thus to promote optimal risk taking by management. The perceptions that executives are overpaid and that their compensation is not linked to their performance, and more serious concerns about the timing of their stock option grants, have received considerable attention from lawmakers, regulators, boards, shareholders, and employees. EC laws are likely to continue for the foreseeable future. It is expected that the compensation committee will pay more attention to EC and stock option grant accounting practices. Effective compliance with various provisions of the SOX and the DOF and with SEC-related rules should assist companies to provide more timely, accurate, and reliable information about their EC and stock option grants. The DOF of 2010 addresses the issue of transparency and the structure of public companies’ EC, and thus, the future of EC is expected to focus on transparent, shareholder-approved,



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risk-adjusted, and sustainable-linked performance in terms of cash and equity compensation. The general consensus is that directors and shareholders who monitor these should determine the nature and extent of EC. However, compensation policies and practices that result in outsized and unjustifiable transfers of wealth from shareholders to the company’s directors and others will come under scrutiny, as those compensations must be fully disclosed, transparent, and limited to performance. As mentioned earlier, EC has often focused on short-term performance, and this cannot ensure alignment of manager interests with those of shareholders. Only when such compensation is linked to sustainable performance and stock prices reflect managerial performance will there be an alignment of interests. EC has increased substantially in recent years, with significant growth in both cash and stock-based components. The DOF of 2010 addresses the transparency and structure of public companies’ EC and thus the future of EC is expected to focus on transparent, shareholder-approved, riskadjusted and sustainable-linked performance in terms of cash and equity compensation. Section 304 of the SOX empowers the SEC to require top executives (CEO and CFO) of public companies to return to the company any bonus or other incentive-based compensation including bonus and equity received within 12 months of restated financial statements along with profits realized from the sale of stock during that period. In the postDOF period, a majority of high-profile public companies have adopted Say-on-Pay nonbonding votes by shareholders in approving top EC. Anecdotal evidence suggests that the median total compensation of CEOs of public companies in the Russell 3000 index increased 11.9 percent in 2014 compared with 2013 and over 34.7 percent compared with 2010.29 The best practices of corporate governance on EC suggest the following: 1. The ratio of the median of CEO compensation to non-CEO executives should be disclosed annually, the say-on-pay policy of shareholder approval should be implemented for all senior executives, there should be no tenure for senior executives—senior executives including the CEO and the CFO should not have multiyear contracts, or any contract in excess of 2 years must be approved by the company’s

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shareholders—senior executives’ performance should be reviewed annually, continuation of their employment and reappointment should be approved either annually or every few years, and senior EC should be linked to performance as a general pay-per-performance policy. 2. The senior EC package including salary, short-term bonuses, long-term incentives (stock options, restricted stocks), pension and postemployment benefits, and perquisites should be fully disclosed to shareholders. 3. The influence of outside consultants on the compensation committee decisions should be limited, and the entire board of directors should consider the recommendation of the committee in approving senior EC. Chief executives’ pay should be reasonable relative to their peers’ and should be limited to a predetermined and preferably relatively small multiple (5 to 10 times) of the compensation of the company’s top 20 most senior managers. 4. A clawback provision can be included in EC contracts that are triggered by any accounting restatements, fraud, or poor target performance. Board Diversity The issue of board diversity in terms of expertise, gender, race, and ethnicity has gained considerable attention of policy makers, regulators, investors, and corporations in recent years. Overall, director diversity has been enhanced only slightly in the post-SOX period as evidenced by the fact that the proportion of seats held by members of racial minorities and women continues to remain low in comparison with their representation in the nation’s management positions and the entire workforce. We expect that the trend toward increasing the demand for board diversity by gender and race will continue as companies add new independent directors to their boards and as the demand for individuals with a financial background to serve on boards increases. The relevance and value of female directors and executives can no longer be ignored. Recent statistics also indicate that women occupy about half of the workforce and hold slightly more than half of the management, professional, and other executive positions in the United States.30 The issue of diversity in the corporate boards and in the officers’ posts has recently gained



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attention of regulators as they address its importance in the upper echelons of public companies. Two initiatives have recently being taken in addressing the issue of gender diversity in the workplace in general and the boardroom in particular. The most prevailing initiative is board diversity quotas imposed by policy makers and regulators. For example, in March 2015, Germany adopted a quota that would require an increase in the number of women who serve on German companies’ supervisory boards by at least to 30 percent supervisory seats, whereas similar quotas are also in place in other European countries such as Austria, Belgium, Finland, France, Ireland, Italy, and Norway.31 The second initiative is through mandatory diversity information disclosure by public companies regarding their diversity-related governance strategies, measures, and practices. The European Union (EU) has considered some initiatives that would require up to 40 percent of corporate supervisory boards occupied by women.32 Both initiatives are intended to promote gender diversity in the boardroom. Section 342 of the DOF of 2010 directs the SEC to establish a new Office of Minority and Women Inclusion which is responsible for promoting diversity in management, employment, and all business activities, including boardrooms.33 The European Parliament, on April 15, 2014, issued a new directive that would require firms to disclose information on their nonfinancial sustainability performance including diversity.34 These global statistics suggest that female directors and executives are definitely underrepresented on the boards and in the C-suites of public companies worldwide. The issue of diversity in the workplace has recently received considerable attention in policy discussions and the popular press. DiversityInc has been conducting a diversity survey since 2001, and in 2015, more than 1,600 firms with at least 1,000 employees participated in the survey.35 DiversityInc does some specialty award lists including the Top 10 Companies for Global Diversity and the top 50 lists. Firms are evaluated for their diversity in the following four categories of diversity management.36 • Talent Pipeline consisting of the breakdown of the workforce, recruitment efforts, and existing talent • Equitable Talent Development including philanthropy, mentoring of diverse employees, movement of talent in the firm, and fairness regarding development and job opportunities

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• CEO/Leadership Commitment indicating a tone at the top ­promoting diversity, communicating diversity from the firm’s ­leadership, and providing visibility on the issues and a­ ccountability for results • Supplier Diversity providing how much is spent on promoting diversity with affiliated companies. Succession Planning One of the important challenges for public companies and their boards of directors is succession planning of executives who will lead the company in future. Highly publicized transitions at large companies such as ­General Motors (Robert Stempel), AT&T (Robert Allen) Eastman Kodak (Kay Whitmore), and Apple (Steve Jobs) underscore the importance of succession planning. Top executives including CEOs and CFOs play an important role in managing the company for the benefit of their shareholders. Thus the tenure and continuation of their function are important to the long-term sustainability of the company. The company’s nominating board committee should establish a proper succession planning process designed to ensure routine and effective planning for orderly succession to the company’s board and other senior executive positions. Costs and benefits of succession planning should be evaluated by the nominating committee of the board of directors. The realized benefits in a proper succession planning for top executives are a smooth transition, ability to appoint highly-qualified executives, utilization of talents of insiders, and encouraging investment in the company’s specific human capital. The potential costs of succession planning are the inappropriate commitment to appoint the heir apparent as top executives, which may cause hiring lessqualified executives and damaging the company’s credibility of its succession policy, lowering the incentives of executives to reach their highest executive talents and human capital. The best practices of succession planning and development to protect the interests of the company, its investors, board of directors, and employees, particularly executives, suggest the following37: 1. Adequate understanding and determination by the board of directors of the most significant challenges facing the company in the



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near future (next 5 to 7 years) and management knowledge, skills, and experiences needed to tackle these challenges 2. Developing succession planning by identifying a pool of internal and external candidates who meet the requirements, qualifications, and skills of executive positions 3. Selecting the most qualified potential candidates for executive positions; ensuring a smooth transition process by focusing on both the onboarding process and the first 12 months of the new executive (CEO) tenure.

Financial Reporting Challenges The challenges of financial reporting are numerous. This section focuses on some of the most prevailing challenges. A study that examines the financial reporting of public companies several years in the post-SOX period indicates that some companies are still taking liberties in reporting their financial statements.38 The study specifically finds that, among the Standard & Poor’s (S&P’s) 500 companies, (1) about 33 percent do not report their financial condition and results of operations accurately, (2) 64 percent report inaccurate pension information, (3) 28 percent use aggressive revenue recognition methods, and (4) 75 percent engage in some kind of off-balance sheet financing.39 Financial Restatements The wave of recent financial restatements by high-profile companies has raised serious concerns about the reliability of financial reports, the effectiveness of corporate governance and internal control, and the credibility of audit services. Financial restatements have remained a major contributing factor to eroding investor confidence and public trust in public financial information, even in the post-SOX era. On the surface, these financial restatements can be interpreted as financial problems with companies and reveal the fact that management and auditors were not able to detect the problems. Causes and effects of these restatements should be evaluated to determine their impacts on investor confidence and stock prices. Many of these restatements were driven from remediation actions

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taken to correct significant deficiencies and material weakness in internal control over financial reporting (ICFR). These restatements may cause short-term negative market reactions, but, in the long term, they should have a positive impact on stock prices as investors may take the view that changes made in improving the reliability of financial statements and internal controls are working in providing them with a true picture of company finances. Investor confidence in financial reports is adversely affected as restatements continue to grow at an increasing rate. For this reason, the SEC and the PCAOB should increase their efforts to reverse this trend. Enhanced Business Reporting The value relevance and information content of historical financial statements are being questioned as many investors and other users of financial reports do not use these statements in making financial decisions. A framework for enhanced business reporting (EBR) should be developed that will provide a structure for the presentation of both financial economic performance and nonfinancial environmental, social, and governance performance relevant to shareholders. This framework should integrate the financial and nonfinancial components of business reporting, including performance indicators, to better reflect the company’s financial and nonfinancial performance, opportunities and risks, and the complexities of business. The improved transparency provided by the EBR framework should ensure the effectiveness of the company’s corporate governance process. Stock Options Accounting Stock options are a primarily means by which companies can provide long-term incentives for their executives and key personnel to contribute to the long-term success of the company. Stock options have been used as a part of compensation plans to provide long-term incentive measures for directors, officers, and key personnel. Accounting for the recognition and pricing of stock options has been a matter of controversy, and recently, it has come under increased scrutiny by lawmakers (Congress), regulators (SEC), and standard setters (FASB, PCAOB). The FASB, in its Statement



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of Financial Accounting Standards (SFAS) No. 123(R), requires recognition of employee stock options as an expense. When the FASB was deliberating on accounting for stock options, many public companies opposed an accounting standard that would require expensing their stock options. Opponents argued that such a requirement would (1) substantially reduce their reported earnings, (2) compromise their ability to attract talented key personnel, and (3) put them at a global competitive disadvantage.40 Stock options can also enable opportunistic behavior by executives to enhance the value of their options through managing the timing of option grant dates. Backdating stock options to maximize option value can occur when grant dates and exercise prices of stock options are managed retroactively to precede a runup in underlying shares. Backdating practices of manipulating timing of option grants can be perceived as improper accounting, fraud, or insider trading, and, in any case, illegal if they are not properly disclosed to the shareholders. There is a wide range of backdating practices, including the following: (1) the selection of exercise prices based on market prices on dates earlier than the grant date; (2) allowing the option holder to obtain an exercise price equal to the lower market price of the stock at the grant date or during the period subsequent to the grant date; (3) preparation or subsequent modification of option documentation in order to manage a lower exercise price than the market price at the actual grant date; and (4) inappropriate selection of a grant date when all of the prerequisites to a grant had not yet occurred. Section 403 of the SOX and SEC-related rules were intended to reduce the opportunity of option grant backdating practices by requiring the reporting of an option grant on Form 4 within two business days of the date of the grant. The backdating of stock option grants has contributed to the delay by a large number of public companies to file their second quarter financial reports. A report from the SEC’s economist concludes that there is robust evidence that corporate executives manipulated the timing of their option grants with the intention of cutting their taxes.41 These tax-dodging schemes are adding to the severity of backdating practices. Internal Revenue Service rules require that executives who sell their shares granted by options pay ordinary income tax and payroll taxes for their in-the-money options for the difference between the exercise price and the strike price of options determined on the grant date. However, executives who choose to hold

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their exercised shares for at least 1 year may pay a lower capital gains tax of 15 percent compared with the highest federal marginal income tax of 35 percent. This significant difference between rates provides incentives for executives to exercise their options at a relatively low stock price. The SEC addresses executive stock option grant procedures and controls and takes enforcement actions against companies that improperly backdate their executive stock options. The PCAOB brings the issue of stock option backdating to the auditor’s attention when it conducts an integrated audit of financial statements and the internal controls. The PCAOB, in July 2006, issued its first Audit Practice Alert that advises auditors that backdating practices may have implications for the integrated audit of both financial statements and ICFR.42 Fair-Value Measurements On September 15, 2005, the FASB issued SFAS No. 157 entitled Fair-Value Measurements.43 SFAS No. 157 provides enhanced guidance for using fair value to measure assets and liabilities and expanded transparent information concerning the definition of fair values, the extent to which companies measure fair value for their assets and liabilities, the information used to measure fair value, and the impact of fair-value measurements on their earnings. The definition of fair value, in SFAS No. 157, focuses on the price that “would be received to sell the asset or paid to transfer the liability at the measurement data (at exit price), not the price that would be paid to acquire the asset or received to assume the liability at the measurement date (an entry price).” The key provisions of SFAS No. 157 are as follows: (1) enhanced guidance for using fair value to measure assets and liabilities; (2) proposed transparent disclosures concerning fair-value measurements; (3) disclosure of the effect of fair-value measurements on earnings; (4) clarification of the definition of fair value based on an exit price instead of an entry price on the measurement data; (5) requirement that fair value is a market-based measurement and not an entity-specific measurement; (6) market participant assumptions used in determining fair value should include the risk inherent in a particular valuation technique, the effect of a restriction on the sale or use of an asset; (7) clarification that a fair-value measurement for a liability reflects its nonperformance risk such as credit risk; and (8)



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disclosures concerning the use of fair value to measure assets and liabilities in interim and annual periods subsequent to initial recognition. Companies should assess the merits of these valuation approaches and choose one or a combination of these approaches in determining the fair value of their assets or liabilities. Any change in valuation technique is a change in accounting estimates rather than a change in accounting principle. It requires companies to maximize the use of market inputs (e.g., exchange markets, dealer market) and to minimize the use of the company’s derived input. The fair-value hierarchy set forth in SFAS No. 157 ranges from Level 1 (e.g., items with quoted prices for identical assets or liabilities in inactive markets) to Level 5 (e.g., items valued using substantial entity-derived inputs through extrapolation or interpolation data). Finally, SFAS No. 157 focuses on market-based measures, as opposed to entity-specific measures for fair value, by giving the highest priority to quoted prices in active markets. However, it permits the use of unobservable inputs for circumstances where there is no or little market activity for assets or liabilities being measured. Fair-value numbers like historical cost numbers are useful and relevant to investors only if they are reliable. The FASB, in response to investors’ need for expanded information concerning the use of the fair-value measures for assets and liabilities and their impacts on reported earnings, issued SFAS No. 157. The FASB’s recent accounting standards on fair value are expanding the application of fair-value measurements in financial reporting and the fair-value option for financial assets and liabilities. As the capital markets and the economy become more dynamic, the historical cost of assets becomes less relevant for making investment decisions. Fair-value measures require companies to show what an asset is worth today rather than what was paid for it or what its value will be in the future. Arguments can be made in favor of and against the use of fair value for financial reporting. Accounting Pensions and Other Postretirement Employee Benefits Providing postemployment benefits to employees and their accounting have been a challenge for public companies and are now becoming a struggle to survive. Some companies have eliminated, frozen, or amended their plans (e.g., Sprint, Nextel, Verizon, and IBM); other financially distressed companies (e.g., United Airlines, Pittsburgh Brewing) have

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shifted their pension obligations to the Pension Benefit Guarantee Corporation to subsidize pension funding. The FASB has initiated its two-phase project of improving accounting practices by requiring recognition of unfunded pension and other post-retirement employee benefits (OPEB) obligations. Many of the OPEB and pension plans were developed several decades ago, with observable costs and obligations for companies. Today, fulfilling OPEB and pension obligations diverts companies’ operating capital intended for growth, expansion, and operating purposes. To compete effectively in the global market and particularly with companies in countries where the labor is cheap and pension and OPEB plans are practically nonexistent, U.S. companies may have to reduce employees’ retirement benefits and freeze or terminate their defined benefit plans. The two sources of funding retirement are lifetime corporate pensions and private 401(k) employee contribution plans. Both sources are in crisis as baby boomers live longer and their income shrinks.44 About half of the nation’s workforce is not covered by any private sector retirement plan, 30 percent invest in employee contribution plans of 401(k)s, 10 percent have lifetime corporate pensions, and the remaining 10 percent have a combination of 401(k) and pension plans.45 In order to be able to maintain their standard of living after retirement, Americans with 401(k) and pension plans need to save 15 to 18 percent of their annual salary for 30 years by accumulating at least 6 to 10 times of their annual pay before retirement.46 On March 31, 2006, the FASB issued its phase-one proposal to improve accounting for pensions and OPEB.47 The issuance of SFAS No. 158, on September 29, 2006, entitled Employers’ Accounting for Decision Benefit Pension and Other Post Retirement Plans, completed the first phase of the FASB’s comprehensive project on pension, which specified that postretirement benefits are a type of deferred compensation.48 SFAS No. 158 requires companies to recognize a net liability or asset to report the funded status of their defined benefit pension and other postretirement benefit plans on their balance sheet. Companies are required to disclose the expected effect of SFAS No. 158 in their Form 10-Qs that are filed after September 30, 2006. SFAS No. 158 could have significant effects as many companies are required to recognize on their balance



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sheets the funded status of OPEB and pension plans. The FASB addresses the recognition of pension and OPEB costs on the income statements in its second phase. In the second phase, which is considered the overhaul of pensions and OPEB accounting standards, the FASB provides guidance for the proper recognition, measurement, presentation and disclosure regarding retirement benefits. Antifraud Program and Plan High-quality financial information is the lifeblood of the capital markets and that quality can be adversely affected by the existence and persistence of financial reporting fraud. Financial reporting fraud is a severe threat to investor confidence in financial information and thus capital markets. The persistence of this fraud is still a significant concern for the business community and the accounting profession, and has eroded investor confidence in corporate reports. From Enron and WorldCom in 2001, to Madoff and Satyam in 2009, and Olympus in 2011, over the past decade, financial reporting fraud has been a dominant news item. There has been ample evidence that financial reporting fraud has undermined the integrity and quality of financial reports and has contributed to substantial economic losses. Since the passage of the SOX, which was primarily intended to combat financial reporting fraud, the Department of Justice has obtained nearly 1,300 fraud convictions.49 Corporate malfeasance, executive misconduct, and fraudulent financial activities have contributed to the reported financial scandals of the past few years. Lawmakers (Congress), regulators (SEC), and standard setters (PCAOB, FASB) have responded to the pervasiveness of fraudulent financial activities that have eroded investor confidence and public trust in corporate America and its financial reports. In discussing the limitations of the SOX, SEC rules, and PCAOB audit standards in addressing antifraud programs and controls beyond financial statement fraud, PwC suggests a five-step antifraud program applicable to all sorts of fraud.50 Step 1. Establish a baseline for a project team to assess existing antifraud programs and controls, develop a remediation plan, and communicate with the audit committee and independent auditors.

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Step 2. Conduct a fraud risk assessment independently or integrated with the overall risk assessment process to identify the company’s risks and strengthen its effectiveness in preventing and detecting fraud. Step 3. Assess and test the design and operating effectiveness of internal controls to prevent and detect fraud. Step 4. Assign the internal audit function to address the residual risks that are not adequately mitigated by antifraud programs and controls. Step 5. Standardize the processes for fraud incident investigation and remediation and enable prompt responses to allegations or suspicions of fraud. The pervasiveness of fraud makes it incumbent on individuals to be wary of scams. Individuals who are knowledgeable about the standard fraud strategies and are able to recognize some of the disguises used by scammers can better protect themselves.51 Financial statement fraud (FSF) is a severe threat to investor confidence in financial information and thus capital markets. The Association of Certified Fraud Examiners estimates that business organizations lose about 5 percent of their revenues to fraud every year, which can exceed 3.5 trillion (USD) worldwide in 2015.52 The Committee of Sponsoring Organizations of the Treadway Commission (COSO) released its Fraud Risk Management Guide in September 2016, which suggests a comprehensive monitoring and assessment approach in managing fraud risk including FSF by all corporate gatekeepers, from the board of directors to management, internal auditors, and external auditors.53 Corporate antifraud policies and practices should establish antifraud deterrence, prevention, detection, and corrections mechanisms driven from the following three antifraud themes: 1. Corporate culture. Corporate culture should create an environment that sets an appropriate tone at the top, promoting competent and ethical behavior and reinforcing antifraud conduct, demanding to do the right thing always. 2. Control structure. An effective control structure should eliminate opportunities for individuals to engage in fraudulent activities.



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3. Antifraud policies and procedures. Sufficient and effective antifraud policies and procedures should be developed and implemented to ensure the prevention and detection of potential fraud. Global Financial Reporting Standards There have been extensive and inconclusive debates over the past several years on whether International Financial Reporting Standards (IFRS) are making steady progress to become globally generally accepted standards for financial reporting. The U.S. FASB and regulators (SEC) should work closely with their international counterparts, the International Accounting Standards Board (IASB) and the European Association for Listed Companies, to achieve convergence in financial reporting standards and practices. The FASB and the IASB have made significant progress by agreeing to conduct their major accounting standard projects jointly and convincing the SEC to allow foreign companies to use IFRS to raise capital in the United States. Thousands of listed companies throughout the world, particularly in the EU, presented their first annual financial statements in 2005 on a mandatory IFRS basis. In 2007, more than 100 countries required their public companies to prepare their financial statements under IFRS. Convergence between U.S. generally accepted accounting principles (GAAP) and IFRS has been gaining momentum. IFRS are being regarded as a ­principles-based approach to financial reporting that is flexible and sensible in dealing with different countries’ political, legal, and cultural environments. It appears that the time has passed for U.S. regulators, standard setters, the accounting profession, and public companies to advocate that companies worldwide use a version of U.S. GAAP. The current trends indicate a move toward the acceptance of IFRS throughout the world, even in the United States. Unlike U.S. accounting standards, which are rules based, IFRS are regarded as principles based. It is expected that U.S. accounting standards will move toward the principles-based approach. The use of such an approach in promulgating accounting standards necessitates the effective application of principles-based monitoring and enforcement of accounting standards as well as appropriate exercise of professional judgment. The use of principles-based accounting standards would assist both the FASB and the IASB in moving more quickly toward the convergence

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of accounting standards. Both leaders of the IASB and the FASB have predicted significant progress toward convergence in the global financial reporting process in recent years. The 2015 Memorandum of Understanding between the FASB and the IASB has resulted in the convergence of many accounting issues and standards, as presented in Exhibit 4.1.

Exhibit 4.1 Status of convergence in Accounting Standards between FASB and IASB Additional Information

Major Projects

Reported Status

Business Combinations

Completed

Mostly converged standards issued in 2007/2008

Consolidations

Completed

FASB efforts ongoing; not fully converged

Fair-Value Measurement Guidance

Completed

Mostly converged standards issued in 2011

Liabilities and Equity distinctions

Reassessed as a lower priority project

No longer on active agenda

Performance Reporting/ Financial Statement Presentation

Completed

Only with respect to reporting comprehensive income

Postretirement Benefits

Completed

Standards not converged in several important respects

Revenue Recognition

In process

Derecognition

Completed

Financial Instruments

In process

Intangible Assets

Not a priority

Leases

In process

Insurance Contracts

ED issued in July 2013

Several key differences. “Obstacles to finding a converged solution may be difficult to overcome.”

Investment Entities

FASB issued final standard in 2013

“The boards’ final requirements are similar but not identical.”

Similar disclosures, but derecognition models not converged



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Use of Derivatives Speculation Derivatives have been used to offset risk from fluctuations in interest rates and currency. A study shows that many high-profile companies (e.g., Procter & Gamble, Gibson Greetings) are using derivatives for speculative purposes by actively taking positions in interest rate and currency derivatives on the basis of likely market movements.54 These companies consider speculation a profitable activity, and their CFO (not CEO) compensation-related incentives are associated with the likelihood that the company engages in derivative speculations. Investors are not able to differentiate between derivatives used for risk management purposes from those used for speculation purposes. Companies with a governance structure that enables greater managerial power and fewer shareholder rights and those with stronger derivative internal controls are more likely to use derivatives for profit-making motives than for speculative purposes. Enterprise Risk Management Enterprise risk management (ERM) has recently received considerable attention from public companies, the business community, and the accounting profession. Financial scandals of the early 2000s and recent world events, including the September 11, 2001, terrorist attacks, have generated more interest in the issue of overall ERM. Natural disasters, such as hurricanes, earthquakes, and floods, require companies to design adequate and effective disaster recovery plans and assess their risk of occurrence and their consequence on operations. Companies should conduct risk assessment periodically to identify potential risks and design appropriate controls to mitigate their adversarial impacts. The board of directors, particularly the audit committee, should oversee the company’s ERM, and both internal and external auditors should be involved in assessing the risks of natural disasters and the protection of important electronic and other information by implementing guidelines provided in the COSO framework on ERM.55 The International Standards Organization, ISO 31000, risk management standard defines risk as an uncertainty that, if it occurs, will have an effect on objectives.56 The best practices of corporate governance suggest an effective risk oversight process of either board risk compliance

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committee or directors to work closely with management to understand, assess, and reach a consensus regarding the risks inherent in the corporate strategy. The board of directors should oversee the company’s risk appetite and access timely information on current and emerging material risk exposures, risk response strategies, and the implementation effective risk management processes. There are basically three general approaches to the effective board oversight of risk assessment and management: (1) establishing a risk compliance board committee by delegating all responsibilities to such a committee, (2) making the entire board of directors responsible for risk oversight, or (3) devising a combination of the first two alternatives by making the whole board responsible along with delegating specific roles and responsibilities to board committees. XBRL-generated Financial Reports Extensible business reporting language (XBRL) is an application of extensible markup language (XML) in business and financial reporting. XBRL is now commonly accepted as the electronic method of business and financial reporting worldwide. XBRL tools, techniques, and taxonomies have been developed by the XBRL International Steering Committee available at the XBRL website (www.xbrl.org). XBRL enables computer systems to assemble data electronically in instance documents, retrieve data directly from XBRL instance documents, and convert data to human-readable financial reports. The SEC, in 2004, established a voluntary XBRL filing program under its Electronic Data-Gathering, Analysis, and Retrieval (EDGAR) system. The Federal Deposit Insurance Corporation has implemented an XBRL filing system for all its banks, and European financial institutions are using XBRL in more than 25 countries. In the United States, both regulators (SEC) and standard setters (FASB, PCAOB) have taken initiatives to address online real-time financial reporting using the XBRL format and electronic or continuous ­auditing. Recently, the SEC has promoted XBRL voluntary reporting and provided a faster review for companies using XBRL. It is expected that XBRL taxonomies for different industries will be further developed, and the use of the XBRL format will gain more momentum in 2018 and onwards.57



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A move toward the global acceptance of XBRL for electronic ­business and financial reporting requires auditors to provide ­assurance by ­conducting an integrated audit on XBRL-generated financial ­statements. The objective of an integrated audit on XBRL-generated financial ­statements is the same as other financial statement audits: to express an ­opinion on the effectiveness of both the design and the operation of i­nternal controls over XBRL-generated financial reports, particularly the posting of XBRL instance documents on the Internet, and the fair ­presentation of XBRL-generated financial statements in conformity with the selected XBRL taxonomy (e.g., U.S. GAAP, IFRS). An important issue for regulators (SEC), standard setters (FASB, PCAOB), public companies, and the accounting profession is to decide whether to require public reporting on XBRL-generated financial statements and internal control reports at a point in time (periodic filing report dates, quarterly 10-Q, or annual 10-K Form), or on a real-time basis. The authors recommend that regulators and standard setters require public disclosures of both only at periodic report filing dates. Companies, however, should use XBRL-generated financial statements and related internal controls on a real-time basis for internal purposes. Users for XBRL information expect the XBRL files to completely and accurately represent the information contained within the traditional financial statements. As such, the primary risk associated with XBRL is providing data that is inconsistent with the corresponding financial statements. Typical risks include incorrect tagging, inconsistencies in amounts, and missing data. A secondary risk is that the XBRL-formatted information will fail to comply with the complex rules contained in the EDGAR Filer Manual. Other risks associated with XBRL filings include missed filing deadlines due to the added effort required by XBRL and failure to safeguard confidential information. Principles-based versus Rules-based Accounting Standards The rules-based approach was criticized for providing opportunities for management to find loopholes around the rules in order to manipulate financial information. Thus, the FASB released proposals on the use of the principles-based approach to standard setting in order to improve

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the quality and transparency of financial information.58 Principles-based accounting standards are expected to be more understandable, allow the use of more professional judgment by auditors on the quality of financial information, make it more difficult to structure transactions, and facilitate convergence in financial reporting. The principles-based approach requires accountants, management, and auditors to consider the substance of business transactions and the principles governing them rather than the specific forms and rules that may apply to them. The principlesbased approach promotes the use of participants’ professional judgment in the financial reporting supply chain, including management, accountants, auditors, legal counsel, and analysts, rather than attempts by these participants to interpret accounting rules and sometimes bend these rules. The SOX requires, among other things, the SEC to conduct a study on the adoption of a principles-based accounting system in U.S. financial reporting. On July 25, 2003, the SEC issued a study that suggests that U.S. GAAP are excessively rules-based; as such, they could produce financial information that is inconsistent with the underlying economic substance of events and transactions.59 Nevertheless, the study concludes that the exclusive use of a principles-based set of standards could result in the following: inconsistent accounting treatment of similar transactions, a lack of comparability of the financial results of different companies, and inadequate guidance or structure for exercising professional judgment by accountants, possibly creating implementation difficulties. The SEC’s study recommends a hybrid of focusing on an “objectivesbased” approach in establishing accounting standards. The SEC believes that the objectives-oriented approach to establishing accounting standards results in not only the presentation of more relevant, informative, and ­useful financial reports to investors, but also holds management and auditors accountable for assuring that the stated objectives of the standards are achieved. The use of this approach would also enable the FASB to react more quickly to emerging issues and trends because of less need to focus on complex rules and exceptions. Principles-based standards, while allowing more flexibility and professional judgment in applying accounting standards, may encourage variability in financial disclosures that reduces the comparability of financial statements. Rules-based accounting standards, however, may encourage



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companies to use them in engineering transactions to achieve particular results. Rules-based auditing standards can encourage auditors to focus primarily on technical compliance rather than professional judgment. There should be a right balance between rules-based and principles-based accounting and auditing standards to foster the quality, reliability, usefulness, and transparency of financial disclosures while reducing their complexity.

Emerging Auditing Issues The Center for Audit Quality and Audit Analytics gathered information about the emerging issues relevant to the auditing profession based on the 2014–2016 data of the communication between audit committees of the S&P’s 1500 and their external auditors.60 The 2016 Barometer report suggests growing trends in 2016 regarding the voluntary and enhanced disclosures in several audit areas of external auditor oversight, including external appointment, independence, tenure, engagement partner selection and rotation, and the evaluation of external audit activities.61 The report suggests that audit committees are continuing to respond to increased interest by investors, regulators, and other stakeholders in audit committees’ roles and responsibilities in overseeing external audit activities, performance, and audit quality. The emerging auditing issues in the post-SOX period and in the aftermath of the 2007–2009 global financial crisis are discussed in this section. Auditor Independence Auditor independence is the cornerstone of the auditing profession and influences auditor judgment and opinion on financial statements. The SOX and SEC rules have addressed auditor independence in several ways. The SEC has approved the PCAOB proposal addressing auditor independence in performing tax services. The PCAOB rules on ethics and independence prohibit independent auditors from offering two types of tax services for their audit clients: tax shelters and tax services to individuals within the client’s organization who are in a financial oversight role. The American Institute of Certified Public Accountants (AICPA), in October

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2005, issued Ethics Interpretation 101‑15, Financial Relationships. This interpretation provides the definition of direct and indirect financial interests by auditors in their client’s business and types that are considered direct or indirect. Auditor independence is monitored continuously by regulators and standard setters, as changes in legal, regulatory, business, and global environment create new challenges for auditors. Auditor Changes Emerging corporate governance reforms, including the SOX, SEC-related rules, and listing standards, require lead audit partner rotation every 5 years. Nevertheless, it appears that audit committees are seriously considering circumstances that warrant audit firm rotations, even though the existing corporate governance reforms do not require such. This issue is extensively, and yet inconclusively, debated in the literature. The general perception is that audit firm rotation can be very costly, complex, and ineffective without adding much to the objectivity and independence of financial statement audits. However, a recent report shows that in the post-SOX period (from 2003 to 2005) about 4,000 public companies changed their audit firms, which is roughly a third of all public companies, and, in particular, about 11 percent (1,430) changed their audit firms in 2005.62 This suggests that, in reality, public companies frequently change their auditors, and any mandatory rotation every several years (e.g., 10 years) may not be a bad idea. Changes in auditors may be classified into legitimate changes and manipulative changes. Examples of legitimate changes are ­appointing an auditor who would charge less, company growth beyond the ­capabilities of the audit firm, changes in senior executives, or ­acquisition by another company. Examples of manipulative changes are disputes between management and auditors over accounting policies and p ­ ­ractices. The e­xisting SEC rules require disclosure of a reason for changes in an ­auditor if it pertains to certain issues. The audit committee is now directly responsible for hiring, compensating, and firing external ­auditors. This ­responsibility should also extend to providing shareholders with ­transparent ­information regarding changes in auditors and justifiable explanations for such changes.



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Engagement Letters There is no requirement that the engagement letter (a written contract between the company and its independent auditor) must be signed by a member of the audit committee. Management has the authority to sign the letter. The authors recommend that the engagement letter be reviewed, approved, and/or signed by the chair of the company’s audit committee or a designated member of that committee. This practice ensures that a common understanding exists among the audit committee, management, and the independent auditor that the auditor works with management for the audit committee; it also assures that the audit committee regularly evaluates the performance of the independent auditor. Audit Failure A review reported on high-profile financial scandals (e.g., Enron, Global Crossing, WorldCom, Adelphia, Qwest, Parmalat, and Royal Ahold) suggests that they were the result of failures in business, financial reports, and audit functions. These scandals demonstrate that, as a company approaches business failure, the incentive to “cook the books” increases. If opportunities exist, management may engage in FSF and, through gamesmanship schemes, pressure auditors not to report discovered fraud, which, in turn, increases the likelihood of both reporting and audit failures. The PCAOB, as the watchdog of the auditing profession, should issue appropriate auditing standards, ethics rules, and quality control standards to assist auditors in improving the quality of financial audits, reducing audit failure, and, thus, protecting investors from receiving misleading audited statements. The issuance of the robust auditing standards on financial fraud can be very effective in reducing audit failures. To minimize audit failures and thus improve audit quality, the PCAOB issued its Concept Release (CR) in July 2015 by suggesting a portfolio of 28 considered audit quality indicators (AQIs). These AQIs are classified into three categories: audit professionals, audit process, and audit results, and are intended to improve audit quality and the mechanism to communicate audit quality to audit committees, investors, audit firms, and regulators including the PCAOB. The PCAOB uses the three

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guiding principles in the development of these 28 potential AQIs, which are as follows: (1) Quantitative AQIs are desired in order to maintain consistency and objectivity; (2) Considered AQIs should enable users to effectively evaluate audit quality; and (3) AQIs should be viewed as a holistic, integrated, and balanced portfolio in assessing and communicating audit quality. It is expected that the use of AQIs would improve audit quality and reduce audit failures.63 There is little doubt if any, that auditors caused the 2007–2009 financial crisis. Nonetheless, the 2010 inspection reports of the PCAOB suggest that auditors failed to fulfill their gate-keeping responsibility of protecting investors from receiving misleading financial reports by (1) not challenging the assumptions of valuation models, (2) allowing inadequate risk assessment of off-balance sheet transactions, and (3) not providing an early signal of financial difficulties and inability to continue as going concern.64 The PCAOB has formed new oversight initiatives to improve audit quality, which will reduce the likelihood of audit failures that might have contributed to the 2007–2009 financial crisis. These oversight initiatives are as follows65: 1. Analysis of Audits Affected by the Economic Crisis. The examination of audit deficiencies inspectors uncovered in inspections during the period 2007 through 2009 2. Root Cause Analysis. Identification of the root causes of audit deficiencies and actions needed to mitigate the identified audit deficiencies 3. Correction of Past Deficiencies. Implementation of adequate and effective audit quality control policies and procedures to prevent further occurrences of identified audit deficiencies to protect investors and to rebuild public trust and investor confidence in financial statement audits 4. Firm Management and Monitoring. Proper examination of audit firms’ management and monitoring process (appropriate tone at the top) by determining whether the supervision and monitoring systems are effective in detecting and preventing audit failures, complying with auditor independence requirements, and implementing performance review processes to ensure audit effectiveness 5. Supervision of Cross-border Audits of Multilocation Companies. Investigation of the quality control system of international audit firms in the global networks that audit multinational corporations by



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evaluating the quality of cooperation, communication, and coordination among affiliates in these networks 6. Increasing Access to Inspect Non-U.S. Registered Firms. Development of a model for cross-border cooperation with regulators in the EU and other countries worldwide to conduct joint inspections of audit quality of international audit firms 7. Enhancing the Auditor’s Reporting Model. Establishment of a more effective audit reporting model to communicate the quality of financial statements to improve the existing pass/fail model expressing an opinion of a fair presentation of financial statements in conformity with designated accounting standards. Integrated Audit Approach An integrated audit covers the audits of both ICFR financial statements. The PCAOB, in March 2004, adopted its Auditing Standard (AS) No. 2 regarding an integrated audit as directed by Sections 103 and 404(b) of the SOX. The SEC approved AS No. 2 in June 2004. Large public companies, known as accelerated filers, have been required to comply with (1) Section 404(a) of the SOX, which requires companies to annually provide their management’s assessments of the effectiveness of ICFR; and (2) AS No. 2 of the PCAOB, which requires an integrated audit for fiscal years ending after November 14, 2004. The large public companies hired registered public accounting firms in 2004 to conduct an integrated audit, which substantially increased the cost of audit. These companies have been through 2 years of integrated audit and have substantially improved their efficiency and reduced the Section 404 compliance costs by about 40 percent.66 The costs decreased in the second year because both auditors and companies gained experience with integrated audit. Also, a significant portion of the first-year implementation cost resulted from start-up costs. Public companies and their auditors were also challenged by inadequate staffing, insufficient training, and a lack of proper experience in conducting an integrated audit, as stated in the PCAOB report.67 The PCAOB has provided auditors with a set of recommendations to improve their audit strategies, policies, procedures, and training in effectively conduct an integrated audit financial statements and ICFR.

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Concentration of and Competition in Public Accounting Firms Public accounting firms play an important role in promoting efficiency of capital markets as they lend credibility to the financial statements of over 7,800 public companies trading on U.S. stock exchanges. More than 51 percent of these companies are audited by the Big Four public accounting firms (Ernst & Young, PwC, KPMG, and Deloitte & Touche) and about 49 percent by other public accounting firms (e.g., Grant Thornton, BDO). In the post-SOX period, the Big Four audit firms had a net loss of almost 800 audit clients to non-Big Four audit firms.68 However, in terms of market capitalization, the share of Big Four audits is 97.7 percent of total market capitalization or $17,561 billion compared with 2.3 percent or $405 billion as of September 30, 2006.69 Thus, healthy competition in public accounting firms is important to the sustainability of audit services provided by those firms. During the 1960s and 1970s, the eight largest auditing firms began to increase their international presence as the companies they audited increased their global operations. These auditing firms acquired or affiliated with other auditing firms in foreign countries, establishing international marketing arrangements under a common international brand name. The largest U.S. accounting firms began merging with each other in the late 1980s. This reduced the number of large auditing firms from eight to five. In 2002, the number of large auditing firms was again reduced, when Arthur Anderson ceased doing business. Today there are only four large auditing firms (the Big Four) and the auditor market is highly concentrated on these four firms. Accounting firms outside the Big Four are not competitive with the Big Four in terms of number of personnel, offices, and a presence in foreign countries.70 Section 701 of the SOX directs the Government Accountability Office (GAO) to study the factors that contributed to consolidation in public accounting firms in the 1980s and 1990s in the United States.71 The GAO report concludes that, while there is no evidence of adverse impact of consolidation of accounting firms, further concentration in auditing firms would not be good for healthy competition within the profession. Senator Chuck Schumer raised his concerns by stating that too much litigation can cause harm to competition in the marketplace.72



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Continuous Auditing The use of the Internet has had a significant impact on companies’ operations and financial reporting. The financial reporting process is moving toward electronic reporting as more companies use the XBRL format. Regarding the importance of XBRL for future financial reporting, Cox states, “I certainly agree with you [AICPA] that XBRL will do for business reporting what bar coding did for product distribution. But I believe its possibilities extend much further than that.”73 The use of the XBRL format allows investors to have online, real-time access to their company’s financial reports. The e-filing system using XBRL reporting is now required for financial institutions. It is the authors’ hope that public companies expeditiously move toward using electronic filing and financial reporting utilizing the XBRL format, which would result in reducing the cost of financial reporting, improving the accuracy and transparency of financial reports, and also necessitating the utilization of electronic, continuous auditing. The 2006 survey of PwC reveals that (1) half of the surveyed U.S. companies used continuous auditing techniques in 2006, which is up 30 percent compared with 2005, and (2) of those companies that do not yet have continuous auditing techniques in place, more than 31 percent have implemented plans to do so.74 This significant increase in the use of continuous auditing techniques will eventually change the way both internal and external auditors have traditionally conducted their audits. Confirmations Confirmations provide audit evidence about several management assertions, including valuation and allocation, existence, completeness, and rights, or even the absence of certain conditions (e.g., side agreements). Confirmation of accounts receivable is required under the existing auditing standards. Auditors should maintain control over confirmations to ensure the integrity and reliability of the process and reduce the possibility of receiving false or colluded information. Where electronic media is used during the confirmation process, auditors should verify the source and content. To do so and to ensure the integrity of the confirmation

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process, auditors can utilize service providers with a secure clearinghouse for confirmations. The use of a secure clearinghouse or a secure electronic confirmation solution (e.g., Capital Confirmation Inc.) can assist auditors in obtaining secure electronic confirmations where all the parties ­involved are preauthenticated. In this way, auditors can be assured that an appropriate person responded to the confirmation request. Auditor Liability Auditors have claimed that the auditor liability provisions contained in their audit engagements have been a common practice for controlling audit costs without adversely affecting the opportunities for shareholder class actions. The Investment Company Institute and the Federal Financial Institutions Examination Council have viewed this practice as unsafe and unsound. The SEC’s position is that auditor limited ­liability provisions, including indemnification, impair auditor independence. ­ However, the SEC has stopped short of requiring disclosures of any agreements that limit auditor liability. The PCAOB has yet to take any ­position on a­ uditors’ clauses in client engagement letters (e.g., limitation of ­liability, agreements to waive jury trial, and the use of ­alternative d ­ ispute resolution). The authors recommend that public companies ­disclose any ­auditors’ limited liability clauses to their audit committees and in their proxy statements to shareholders and that regulators (SEC) and standard setters (PCAOB) properly address the impacts of these clauses on auditor independence and objectivity. Auditor Communication with Those Charged with Governance Traditionally, independent auditors have communicated certain material and relevant accounting, financial reporting, and audit information to the audit committee. In the post-SOX era, auditors are more closely working with the audit committee as the committee is directly responsible for the appointment, retention, compensation, and oversight of independent auditors. However, the independent auditor working relationship with other commonly formed board committees (nomination, compensation), particularly the compensation committee, has yet to be addressed.



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As important gatekeepers, auditors should communicate with other gatekeepers, including the board of directors and corporate legal counsel. The Auditing Standards Board of the AICPA issued Statement of Auditing Standards (SAS) No. 114 entitled “the Auditor’s Communication with Those Charged with Governance” which superseded SAS No. 61, “Communication with Audit Committees.”75 SAS No. 114 requires auditors to conduct more robust two-way communication with those charged with governance concerning certain significant matters pertaining to the audit of financial statements of all nonissuers. SAS No. 114 also provides guidance on (1) which matters should be communicated, (2) who they should be communicated to, and (3) the form and timing of the communication. The PCAOB issued its AS No. 16 in 2015 that requires communication between auditors and audit committees. Audit Firm Rotation In the aftermath of the 2007–2009 global financial crisis, policy makers, regulators, standard setters, and the accounting profession worldwide have considered ways to improve audit quality in order to lend more credibility to published financial statements. Mandatory audit firm rotation (MAFR) has been suggested to ensure auditor independence and thus as the driving force in improving audit quality. The PCAOB, in August 2011, issued a concept release to solicit public comments on MAFR as a means of strengthening auditor independence, objectivity, and professional skepticism.76 MAFR is intended to limit the number of consecutive years (e.g., 5 years) for which a registered public accounting firm could serve as the auditor of a public company. The PCAOB held three public meetings in 2012 to discuss auditor independence and MAFR and extended the comment period several times in 2012, and it received over 600 comment letters. One of the major reasons stated by those who oppose MAFR is its possible implementation cost. The main benefit of MAFR is its possible enhancement of auditor independence. MAFR involves two important auditing issues of independence and competency. Supporters of MAFR claim it can improve audit quality by strengthening auditor independence skepticism and objectivity. However, MAFR can have an adversarial effect on audit quality by allowing less experienced

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auditors be assigned to audits. Eventually, after several years of debates over MAFR, public companies in the United States are not required to rotate their auditors every several years, unlike their counterparts in Europe. The MAFR idea initiated and promoted by the PCAOB sounds good theoretically but may not be feasible practically.

Conclusion Recent reforms have made significant improvements in corporate ­governance policies, structure, and the practices of public companies. ­Nevertheless, much more improvement needs to be made in several emerging corporate governance issues, as discussed in this chapter. The most prevailing challenges are related to director liability, the ­majority voting system, CEO turnover and succession, separation of the p ­ ositions of chair of the board and CEO, board independence and the role of lead directors, and directors’ and executives’ compensation and stock ownership. The emerging financial reporting issues are as ­follows: (1) whether the current financial reporting model is ­relevant to investors and ­analysts in a­ ssessing public companies’ financial ­performance and risk, (2) whether the c­ onvergence of U.S. GAAP with IFRS s­ tandards is h ­ elpful in e­ nhancing the usefulness of financial ­reports, and (3) whether financial audits add value by lending credibility to financial reports.

Endnotes 1. T. Ethiopis. September 2006. Statement by the SEC Staff: A Race to the top: International Regulatory Reform Post Sarbanes-Oxley. Available at https://www.sec.gov/news/speech/2006/­spch091106et.htm 2. PricewaterhouseCoopers. July, 2005. Investment management perspectives. www.pwc.com 3. C. Schumer, and M.R. Bloomberg. November 1, 2006. “To save New York, learn from London,” Wall Street Journal. p. A18. http:// online.wsj.com/article/SB116234404428809623.html 4. PricewaterhouseCoopers. 2014. “Trends Shaping Governance and the Board of the Future,” PwC’s 2014 Annual Corporate Directors Survey. https://www.pwc.com/us/en/corporate-governance/annual-



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corporate-directors-survey/assets/annual-corporate-directors-surveyfull-report-pwc.pdf. PWC. 2016. Board Governance in the age of Shareholder Empowerment: Insights from PwC’s Annual Corporate Directors Survey. https://www.pwc.com/us/en/corporate-governance/ annual-corporate-directors-survey.html 5. International Corporate Governance Network. July, 2005. Global Corporate Governance Principles. www.icgn.org/organization/documents/ cgp/revisedprinciplesJul2005.pdf 6. Organization of Economic Co-operation and Development (OECD). 2013. Corporate Governance: Supervision and Enforcement in Corporate Governance. https://www.oecd.org/daf/ca/SupervisionandEnforcementinCorporateGovernance2013.pdf 7. Securities and Exchange Commission (SEC). 2010. Facilitating Shareholder Director Nomination. [Release Nos. 33-9136; 34-62764; IC-29384; File No. S7-10-09]. https://www.sec.gov/ rules/final/2010/33-9136.pdf 8. A. Levitt. October 27, 2006. “Commentary: Stock populi,” Wall Street Journal. p. A14. https://www.wsj.com/articles/SB116191410503505582 9. SEC. February, 2015. Regulation Systems Compliance and Integrity. https://www.sec.gov/rules/final/2014/34-73639.pdf 10. The Committee on Capital Markets Regulation. November 30, 2006. Interim Report of the Committee on Capital Markets Regulation. http://www.capmktsreg.org/wp-content/uploads/2014/08/ Committees-November-2006-Interim-Report.pdf 11. Securities and Exchange Commission. March 29, 2010. Amendments to Rules Requiring Internet Availability of Proxy Materials. https://www.sec.gov/rules/final/2010/33-9108.pdf 12. Ibid. 13. Automatic Data Processing Inc. Brokerage Services Group. November 22, 2005. Letter sent by ADP to the chairman of the SEC regarding the e-proxy proposal. 14. Harvard. 2017. Shareholder Proposal Developments During the 2017 Proxy Season. https://corpgov.law.harvard.edu/2017/07/12/ shareholder-proposal-developments-during-the-2017-proxy-season/ 15. Ibid. 16. Ibid.

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17. Investors Responsibility Research Center. 2005. Most common topics of U.S. shareholder proposals. www.irrc.org 18. S. Johnson. January 22, 2007. “Pension Funds Urge Greater Shareholders’ Rights,” Financial Times. www.ft.com 19. Spencer Stuart. 2016. 2016 Global board of Directors Survey. https://www.spencerstuart.com/research-and-insight/2016-globalboard-of-directors-survey 20. NACD. 2016. 2015–2016 NACD Public Company Governance Survey. http://www.nacdonline.org/publicsurvey 21. Rock Center for Corporate Governance. 2016. 2016 Board of ­Directors Evaluation and Effectiveness. https://www.gsb.stanford.edu/ faculty-research/centers-initiatives/cgri 22. Ibid. 23. S. Taub. Former Enron Directors Will Pay $13 M. CFO. January 11, 2005. Available at http://ww2.cfo.com/risk-compliance/2005/01/ former-enron-directors-will-pay-13m/ 24. M. Bradford. February 14, 2005. “D&O Suits Increasingly Seek to Tap Personal Funds,” Business Insurance 39, no. 7, pp. 23–24. 25. Ibid. 26. L. Bebchuk. August 12, 2005. “The Disney Verdict Shuts Out Investors,” Financial Times. www.ft.com 27. Spencer Stuart Board Index. July 25, 2016. https://www.spencerstuart.com/~/media/pdf%20files/research%20and%20insight%20 pdfs/spencer-stuart-us-board-index-2016_july2017.pdf?la=en 28. Ibid. 29. J. Reda. 2015. Key Findings from CEO and Executive Compensation Practices: 2015 Edition: Market Performance and Pension Contributions Drive Rise in CEO Pay. https://www.ajg.com/knowledge-center/news/ 2015/key-findings-from-ceo-and-executive-compensation-practices2015-edition-market-performance-and-pension-contributionsdrive-rise-in-ceo-pay/ 30. Fenwick and West LLP. 2013. Gender Diversity in Silicon Valley: A Comparison of Silicon Valley Public Companies and Large Public ­Companies. http://fenwick.com/publications/pages/corporate-governance-survey-2013-proxy-season-results.aspx



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31. A. Smale, and C.C. Miller. March 6, 2015. “Germany Sets Gender Quota in Boardrooms,” New York Times. http://www.nytimes.com/ 2015/03/07/world/europe/german-law-requires-more-women-oncorporate-boards.html?_r= 32. Ibid. 33. Dodd-Frank Act of 2010. 34. European Parliament. April 15, 2014. Disclosure of non-financial and diversity information by certain large companies and groups. Text approved Part V. p. 312. 35. DiversityInc. 2016. About DiversityInc. http://www.diversityinc. com/about-us/ (accessed March 9, 2016). 36. Ibid. 37. S.A. Miles, and N. Bennett. September 11, 2007. Best Practices in succession Planning. Forbes. https://www.forbes.com/2007/11/07/ succession-ceos-governance-lead-cx_sm_1107planning.html 38. V. Germack. July–August, 2005. “How Good are Those Earnings . . . Really?” Directorship. pp. 14–21. 39. Ibid. 40. O. Reilly. August 14, 2006. “FASB Appears in a New Light on Stock Options,” Wall Street Journal. http://online.wsj.com/article/ SB115552025107534780.html 41. M. Maremont, and C. Forelle. December 12, 2006. “How Backdating Helped Executives Cut Their Taxes,” Wall Street Journal. online .wsj.com/article/SB116589240479347248.html 42. Public Company Accounting Oversight Board (PCAOB). July 28, 2006. Staff Audit Practice Alert No. 1: Matters Related to Timing and Accounting for Option Grants. www.pcaob.org 43. Financial Accounting Standards Board. September 15, 2006. ­Statement of Financial Accounting Standards No. 157, Fair Value Measurement. Norwalk, CT. 44. Press release. May 8, 2006. Baby boomers face retirement crisis as lifetime pensions wither and 401(k)s falter. www.pbs.org/frontline/ retirement 45. Ibid. 46. Ibid.

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47. Financial Accounting Standards Board. March 31, 2006. Exposure draft to improve accounting for postretirement benefit plans, including pensions. www.fasb.org 48. Financial Accounting Standards Board (FASB). September 29, 2006. Statement of Financial Accounting Standards (FASB) No. 158: Employers’ Accounting for Decision Benefit Pension and Other Post ­Retirement Plans. http://www.fasb.org/summary/stsum158.shtml 49. Z. Rezaee, and R. Riley. 2009. Financial Statement Fraud: Prevention and Detection. 2nd ed. Hoboken, NJ: John Wiley & Sons, Inc. 50. PricewaterhouseCoopers. November 3, 2005. Predicting the ­Unpredictable: Protecting Utilities Against Fraud, Reputation and ­Misconduct Risk. www.cfodirect.com/cfopublic.nsf 51. K. Blanton. 2012. “The Rise of Financial Fraud,” Center for Retirement ­Research at Boston College. http://crr.bc.edu/wp-content/uploads/ 2012/02/IB_12-5-508.pdf 52. Association of Certified Fraud Examiners (ACFE). 2015. “Report to the Nations on Occupational Fraud and Abuse,” 2015 Global Fraud Study. www.acfe.com 53. Committee of Sponsoring Organizations of the Treadway Commission (COSO). 2016. Fraud Risk Management Guide. https://www.coso.org/ documents/COSO-Fraud-Risk-Management-Final-92816.pdf 54. C. Geczy, B.A. Minton, and C.M. Schrand. November, 2005. Taking a view: Corporate speculation, governance, and compensation. ssrn.com/ abstract=633081 55. Committee of Sponsoring Organizations. September, 2004. 2004 Enterprise Risk Management. www.erm.coso.org 56. International Standards Organization. 2009. ISO 31000:2009, Risk Management—Principles and Guidelines (Geneva: International Standards Organization). 57. Extensible Business Reporting Language (xBRL). 2018. Taggings. Available at https://www.xbrl.org/home/taggings/ 58. Financial Accounting Standards Board. 2002. Proposal for a principles-based approach to U.S. standard setting. www.fasb.org 59. United States Securities and Exchange Commission. 2003. Study pursuant to Section 108(d) of the Sarbanes-Oxley Act of 2002 on the adoption by the United States Financial Reporting System of



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a principles-based accounting system: Office of the Chief Accountant and Office of Economic Analysis. www.sec.gov/news/studies/ principlesbasedstand.htm 60. Center for Audit Quality. 2016. 2016 Audit Committee Transparency Barometer. http://thecaq.org/sites/default/files/2016-audit-committeetransparency-barometer.pdf 61. Ibid. 62. F. Norris. July 28, 2006. “Deep Secret: Why auditors are replaced,” New York Times. http://www.nytimes.com 63. Public Company Accounting Oversight Board (PCAOB). 2015. Concept Release on Audit Quality Indicators, No. 2015-005, July 1, 2015. http://pcaobus.org/Rules/Rulemaking/Docket%20 041/­Release_2015_005.pdf 64. Public Company Accounting Oversight Board (PCAOB). 2011. Speech by James R. Doty Chairman of the PCAOB, “Looking Ahead: Auditor Oversight”. http://pcaobus.org/News/Speech/Pages/ 04042011_DotyLookingAhead.aspx 65. Ibid. 66. CRA International. 2006. Sarbanes-Oxley Section 404 costs and implementation issues: Spring 2006 survey update. www.crai.com 67. Public Company Accounting Oversight Board. November 30, 2005. Report on the initial implementation of Auditing Standards No. 2. An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements. PCAOB Release No. 2005-023. www.pcaobus.org 68. KPMG. November, 2006. Audit Market Share Analysis. www .kpmg.com 69. Ibid. 70. University of San Diego. School of Law. 2010. Call for Evidence-Auditors: Market Concentration and their Role. http:// www.sandiego.edu/law/documents/centers/ccsl/off-balance_sheet_­ transactions.pdf 71. United States Government Accountability Office. 2003. Accounting firm consolidation: Selected large public company views on audit fees, quality, independence and choice. GAO-03-1158. https:// www.gao.gov/assets/250/240007.pdf

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72. C. Cox. March 14, 2007. Speech by SEC Chairman: Remarks to the U.S. Chamber of Commerce’s First Annual Capital Markets ­Summit: Securing America’s Competitiveness https://www.sec.gov/ news/speech/2007/spch031407cc.htm 73. C. Cox. December 5, 2005. Speech by SEC chairman: Remarks ­before the 2005 AICPA national conference on current SEC and PCAOB developments. www.sec.gov/news/speech/spch120505cc.htm 74. PricewaterhouseCoopers (PwC). June 27, 2006. PwC’s 2006 State of the Internal Audit Profession Study: Continuous Auditing Gains ­Momentum. http://www.pwc.com 75. American Institute of Certified Public Accountants (AICPA). 2006. Statement of Auditing Standards (SAS) No. 114. The Auditor’s ­Communication with Those Charge with Governance. The Auditing Standards Board (ASB). www.aicpa.org 76. Public Company Accounting Oversight Board (PCAOB). August 11, 2011. Concept Release on Auditor Independence and Audit Firm Rotation: Notice of Roundtable. PCAOB Release No. 2011-006. Washington, DC: U.S. Public Company Accounting Oversight Board. pcaobus.org

CHAPTER 5

Future of Corporate Governance Introduction Corporate governance has traditionally been viewed as the mechanism for aligning the interests of management with those of shareholders. More specifically, the role of corporate governance has been to reduce agency costs and to create long-term shareholder value by focusing on the decision-monitoring responsibilities of the board of directors and the ­decision-management functions of senior executives. This role has ­recently evolved in creating shared value for all s­ takeholders, ­including ­shareholders and ­non-shareholding stakeholders such as ­creditors, ­suppliers, ­customers, employees, ­government, society, and the e­ nvironment. This chapter ­presents the f­uture of corporate governance in the context of b­ usiness ­sustainability and ­stakeholder model.

Corporate Culture A firm’s corporate culture plays a key part in setting the standard and ­enforcing corporate governance. Corporate culture should set an appropriate tone at the top promoting integrity and competency throughout the company. It also plays a role of “social control” as individuals are under pressure to act a certain way in front of their peers when there is a standard set of norms in the company. The board of directors and ­management have a fiduciary duty to create value for ­shareholders and ­protect the ­interests of other stakeholders. When executives are e­ncouraged and driven to make short-term profits, sometimes a ­culture of ­integrity withers away. Directors have oversight responsibility in workplace culture where they

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should facilitate an ethical and competent culture. The company and its ­directors and officers should state categorically that there would be no tolerance of v­ iolations of applicable rules, regulations, and standards and that there would be no retaliation toward whistle-blowers. It is essential that the board of directors oversees that the company is dedicated to ethics and ­compliance, as doing so will prevent irregularities, fraud, and scandals and could p ­ otentially reduce any l­iabilities if the c­ompany were to face any lawsuits. While directors should not i­nterfere with ­management’s ­responsibilities by micromanaging, they can always familiarize themselves with compliance guidelines and ­standards to p ­ rotect the c­ompany and its shareholders. Having a better understanding of the company’s culture and core values can allow the board to promote these in alliance with the c­ompany’s growth and strategy. Setting an ethical culture promotes ­corporate governance and gives the company an overall better public image. In the aftermath of the 2007–2009 global financial crisis, the board of directors can rebuild and maintain trust by focusing on more ­long-term achievable goals and sustainable performance. While the board of ­directors and executives have fiduciary duties to create long-term and sustainable value for shareholders, more often they fall prey to the ­pressures of ­obtaining short-term results, which may deviate them from the principle of achieving long-term goals. Corporate strategies should be developed and implemented that would allow the firm to withstand short-term p ­ ressures. The board’s priorities should be more focused on achieving sustainable performance. In order to rebuild trust, directors must always act in the best interests of the company, even if it means disagreeing with shareholders and risking re-election. However, effective and transparent communication with shareholders should be established in order to understand their concerns, ideas, feedback, and suggestions. Corporate governance has gained renewed interest and relevance in ­recent years and is now emerging as a central issue within global ­businesses. Corporate governance reforms and measures aim to ensure that m ­ anagers of public companies act in the best interests of the ­company and its shareholders, instead of their own interests or the majority shareholders. Good corporate governance is committed to transparency, leading to an increase in capital inflows from domestic and foreign investors. Good corporate governance also implies the need for a network of monitoring and



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incentives set up by a company to ensure accountability of the board and management to shareholders and other stakeholders. The strongest form of defense against governance failure comes from an organization’s culture and behaviors. Effectiveness depends on employees’ integrity and begins with the tone management sets at the top. In addition, boards should routinely oversee their own actions against the acceptable ­governance principles. Corporate governance is influenced by corporate culture by ­focusing on the value-increasing role of corporate governance ­participants, ­including the board of directors, management, auditors, fi ­ nancial a­ dvisers, legal c­ ounsel, standard-setting bodies and regulators, and i­ nvestors. A ­well-defined s­ haring of power between the board of ­directors, ­executives, and ­stakeholders contributes to the effectiveness of corporate governance in creating ­ ­sustainable shareholder value and protecting the ­interests of other stakeholders as well. Objectivity and independence should be highly emphasized to ensure an effective board that would not i­nappropriately r­enominate ­directors. As rebuilding trust requires both ­parties to ­participate, shareholders have the same opportunities as the board to do so, including focusing on long-term goals and refining p ­ riorities. ­Responsible voting and delegation can be achieved by the ­shareholders by informing themselves well of the candidates by reevaluating their abilities, diversity, ­qualifications, and experience before voting. Feedback from shareholders is highly encouraged to allow them to voice their concerns and make s­ uggestions, but they should also listen to the board’s input and their thoughts behind their decisions. Corporate culture, trust, and reputation can be significantly improved when the corporate charter of incorporation makes directors fiduciarily responsible to all stakeholders, as discussed under the “benefit corporation” concept in the next section.

Benefit Corporations Benefit Corporations (BCs) were recently incorporated under the ­corporate law to provide flexibility to social entrepreneurs to achieve the dual o­ bjectives of doing well and doing good by focusing on p ­ rotecting the interests of all stakeholders. The primary goal of corporations has evolved from maximizing profit to increasing shareholder wealth and now creating

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shared value for all stakeholders. The goalpost has recently been advanced to creating shareholder value, while protecting the ­interests of other stakeholders including society and environment.1 Until r­ecently, under the corporate law and in accordance with the shareholder theory, it has been well-defined and commonly accepted that shareholders are the owners of the firm and the board of directors and management have a ­fiduciary duty to act in their best interests.2 In the past decade, a number of firms (over 12,000 globally) that voluntary focused on profit-seeking and social mission have emerged as social enterprises or hybrid c­ orporations (HCs) in perusing their sustainability performance in all areas of ­economic, ­governance, social, and environmental (EGSS) activities.3 Recently, BCs have been formed as legal entities by way of ­legislation in more than 27 states, and the Delaware General Corporation Law has authorized the formation of public BCs with effect from August 1, 2013.4 BCs should be viewed in a broader framework of the free e­nterprise ­system by considering firms as a nexus of contracts between the company and its stakeholders with often conflicting interests. P ­otential conflicts of ­ interest can create information asymmetries and unique ­empirical ­settings to investigate differences among three groups of firms; (1) those with ­mandatory disclosures of their financial reports under the legal ­doctrine of “shareholder primacy and wealth maximization” and no ­disclosure of their environmental, social, and governance (ESG) ­sustainability p ­ erformance beyond financial reporting disclosures (CCs); (2) those with mandatory disclosures of financial performance as well as voluntary ­disclosures of their ESG disclosures (HCs); and (3) those with mandatory disclosures of both financial and nonfinancial sustainability key performance indicators (KPIs) under BC law. The major characteristics of the BCs are: (1) a requirement that a BC must have a corporate purpose to create a material positive impact on ­society and the environment; (2) an expansion of the duties of directors to require the consideration of nonfinancial stakeholders as well as the financial interests of shareholders; and (3) an obligation to report on its overall social and environmental performance using a comprehensive, credible, independent, and transparent third-party standard. Some of the several benefits of BCs are the ability to do the following: (1) gain the attention and market share of the socially conscious investors; (2) use the power of business and r­ esources



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to solve social and environmental ­challenges; (3) spur more trust in businesses by the public, shareholders, and potential employees and attract more customers to companies’ brands and products; (4) improve business, operational, and investment efficacy; and (5) assess, manage, and minimize Benefit corporations strategic, operational, fi ­nancial, ­ reputational, and compliance risks. These benefits can improve the financial and nonfinancial performance of BCs which are reflected in the quality of financial reporting, the cost of capital, and the value of the firm. The BCs’ structure is administered on a state-by-state basis by ­allowing the state’s benefit corporation statutes to be placed within ­existing state corporation codes. The justification for BCs is that the ­existing law prevents boards of directors from considering the impact of ­corporate decisions on other stakeholders, the environment, or society at large. Thus, boards of directors of BCs are required to consider the impact of their decisions on specific corporate constituencies, including ­shareholders, employees, suppliers, the community, as well as the local and global e­nvironment. More than 27 states have enacted laws allowing the ­creation of BCs for businesses that wish to simultaneously pursue profit and benefit society. This law: (1) allows entrepreneurs and investors to create for-profit Delaware corporations that are charged with ­promoting public benefits, (2) ­modifies the fiduciary duties of directors of BCs by requiring them to b­ alance public benefits with the economic interests of shareholders, and (3) requires BCs to report to their shareholders with respect to the advancement of public benefits and/other benefits to nonshareholders. There are two theories that can explain the economic function of BCs in maximizing the positive, and minimizing the negative, ­externalities of sustainability activities. First, the stakeholder theory that suggests BCs’ sustainability activities and performance enhance the long-term profits of the firm by promoting corporate governance effectiveness, ­corporate social responsibility (CSR) policies, and environmental initiatives. For ­example, BCs that employ robust internal and external corporate g­overnance ­mechanisms are managed more effectively and ethically, which enables them to be sustainable. Likewise, any environmental initiatives pertaining to reducing pollution levels or saving energy costs may r­educe contingent and actual environmental liabilities. Similarly, CSR activities may

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generate profit by establishing a better work environment and creating goodwill and reputation with consumers and society. More importantly, BCs can attract socially responsible investors (SRIs). The stakeholder theory can be aligned with the profit-maximization philosophy if management of BCs considers the interests of all stakeholders and society at large. The shareholders’ theory of CCs, on the other hand, suggests that management maximizes the interests of shareholders by engaging in activities that create shareholder value. Under the shareholder theory, management invests in all projects with the expected return of the higher cost of capital. However, under the stakeholder theory, management of BCs is required to balance the interests of all stakeholders in such a way to maximize a firm’s aggregate welfare of all stakeholders, assuming that maximizing welfare is in line with maximizing firm long-term value. The shareholder theory clearly stipulates that shareholders are the ­owners of CCs, and their board of directors and management have a ­fiduciary duty to act in their best interests in creating shareholder value. The separation of ownership and control under the shareholder theory for CCs has worked well in the United States and the United Kingdom and many other Anglo-Saxon countries for many years. However, the ­shareholder theory may not work in the BCs’ setting, where the board of directors of BCs is legally obligated to protect the interests of all ­stakeholders, and thus, shareholder wealth maximization is not the only goal of the board of directors. It should be noted that in some ­European countries (e.g., Germany) firms are legally required to protect the i­ nterests of all stakeholders according to the system of co-determination that ­enables employees and shareholders to have an equal number of seats on the supervisory board of the company.5 The purpose-driven disclosure is intended to refocus corporate reporting towards its relevance and usefulness to all stakeholders particularly shareholders. Global public companies in general and those in the United States are required to disclose a set of financial statements under the corporate mandatory disclosures regime and they disclose other ­financial and nonfinancial information through corporate voluntary disclosures. I­ ntuitively, management decisions to voluntary disclosure ESG and their effects on the overall corporate disclosures are made jointly under stewardship theory. The purpose-driven disclosure is designed to provide financial information



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on economic sustainability performance (ESP) and non-financial on environmental, social and governance (ESG) ­sustainability performance with ethics performance is integrated into ESP and ESG sustainability performance. As of now, disclosure of ESP information is mandatory in many countries whereas ESG information is t­ypically d ­ isclosed on voluntary basis except for large European companies starting in 2017 and Hong Kong listed companies in 2016. Voluntary disclosure is considered as any financial and non-financial i­nformation disclosed by management beyond mandatory fi ­ nancial ­reports consisting of strategic information (product, competition, customers), financial i­nformation (management earnings forecast, stock price) and n ­ on-financial ESG information.

Profit-With-Purpose Companies and Corporate Governance Public companies are being criticized for primarily focusing on profit maximization and thus shareholder value creation with a ­ ­ minimal attention to the impacts of their operations on society and the ­ ­environment.6 As ­corporate sustainability is gaining more attention and being integrated into the business culture and model, there has been a shift from the ­creation of shareholder value to the development of “sustainable shared value creation” to protect interests of all stakeholders. The concept of shared value is defined as “policies and practices that enhance the competitiveness of a company while simultaneously advancing the economic and social conditions in the communities in which it operates”.7 Under the shared value creation concept, management focuses on the continuous performance improvement of business operations in generating long-term value while maximizing the positive impacts of ­operations on society and the environment by measuring sustainable performance in terms of both ESP and ESG sustainability performance. Thus, corporate objectives have advanced from profit maximization to increasing shareholder wealth and now to creating shared value for all stakeholders. Business sustainability requires business organizations to refocus their business purpose to create shared value for all stakeholders. Business ­organizations should expand their mission to not only generate profit and

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create shareholder value but also ensure shared value for all ­stakeholders. The concept of shared value challenges the way we think about profits, philanthropy, sustainability and development. Sustainable shared value creation enables business organizations to integrate financial ESP with non- financial ESG into business culture and corporate environment. This concept suggests that shared value initiatives can be created in three ways: (1) producing products and services that increase shareholder wealth and meet societal needs including improved nutrition, education, health, and general well-being; (2) redefining productivity in the supply chain by investing in training and resources to create high-quality suppliers and improve ESP and ESG sustainability performance; and (3) ­developing material indicator taxonomies to effectively measure revenue, costs and value of the organizations. True measurement of all resources including financial, human, ­social and environmental capitals is both vital and challenge. Focus on all c­ apitals makes measurement crucial and the lack of standard performance indicators makes it difficult. Measurement of inputs and ESG activities such as the number of employee volunteer hours, initiatives to reduce greenhouse gas emission, the amount spent on community endeavors, or the total number of people trained or involved in a particular initiative or activity need to be reported to stakeholders. Business organizations and their ­executives have expressed the lack of effective measures as one of the major challenges in integrated sustainability reporting. These goals need to be linked to ESP and ESG sustainability performance, effectively m ­ easured and fairly and truly disclosed to all stakeholders. Following GRI G4 performance indicators, corporations frequently discussed goals around ESG performance; the sourcing of raw materials and inputs for production; product innovations that lead to positive environmental, health, or society impacts; e­ mployee safety, training and diversity; compliance with ethical principles and human rights standards; and community initiatives in the areas of health and ­well-being, education, employment and economic empowerment.

Corporate Governance and Business Sustainability Investors demand forward-looking financial and nonfinancial ­information and companies have strived to provide such information.



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Traditionally, public companies have focused on achieving their ­economic objective of making a profit and enhancing shareholder wealth by ­engaging in operating, investment, and financing activities to provide and ­distribute goods and services. This narrow focus on achieving economic performance has been criticized for ignoring other social, ethical, and environmental r­esponsibilities of corporations. The multiple bottom lines (MBL) ­objectives of economic, social, ethical, and ­environmental p ­ erformance have been advocated by global business and investment communities.8 With the MBL objectives, the primary goal is to achieve ­economic ­performance of creating shareholder value, while giving proper ­consideration to other measures and performance including social, ­ethical, and environmental. Sustainability performance and ­accountability r­eporting have gained a new interest during the recent ­financial crisis and the ­resulting global economic meltdown, which has sparked widening c­oncerns about whether big businesses (banks and ­carmakers) are sustainable in the long term in contributing to economic growth and prosperity of the nation. The ever-increasing erosion of public trust and investor confidence in the sustainability of large businesses, the widening concern about social responsibility and environmental matters, overconsumption of natural ­resources, the global government bailout of big businesses, and the ­perception that governments cannot solve all problems of businesses ­underscore the importance of a keen focus on sustainability performance and accountability reporting. The literature and interest in accountability and its connection with social responsibility and sustainability are growing. The Institute of Supply Management, in partnership with 500 companies, has developed Principles of Sustainability and Social ­Responsibility. In addition, International Organization for Standardization (ISO) developed ISO 26000 on business sustainability. Furthermore, more than 8,000 organizations worldwide (including Fortune 500) have adopted Global Reporting Initiatives (GRIs) for sustainable performance reporting.9 Globalization and economic, social, and technological developments in the twenty-first century demand a new type of corporate accountability reporting, reflecting KPIs on both financial and nonfinancial i­ nformation. The latest financial scandals and the subprime mortgage market crisis

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have raised questions and concerns about corporate accountability in ­recent years. It appears that public companies and their gatekeepers are not e­ ffectively fulfilling their fiduciary duties and professional responsibility to promote accountability, compliance, and transparency. An effective sustainability performance and accountability reporting model reflecting all aspects of business (e.g., economic, social, environmental, ethical, governance) in addressing the interests of all stakeholders is the bedrock of the capital market and business strategies. Significant opportunities exist for businesses to improve the value-relevance of their corporate reporting to better meet the needs of global investors and enhance investors’ understanding of their MBL sustainable performance. In today’s business environment, global businesses face close scrutiny and profound pressure from lawmakers, regulators, the investment community, and their various stakeholders to focus on sustainability measures and accept accountability and responsibility for their MBLs of economic, governance, social, ethical, and environmental (EGSEE) performance.10 Organizations worldwide recognize the importance of sustainability ­performance in creating shared value for all their stakeholders from shareholders to creditors, customers, suppliers, employees, government, ­society, and the environment. Over 14,000 public companies worldwide are now issuing sustainability reports on some or all five EGSEE dimensions of sustainability performance, and this trend is expected to ­continue well into the future. More than 6,000 European companies will be r­ equired to disclose their ESG sustainability as well as diversity information for their 2017 financial reporting and onward.11 Hong Kong listed companies are required to disclose environmental, social, governance, and diversity ­sustainability for their 2005 annual reports and onward.12 Business organizations have traditionally reported their performance on economic affairs, and their main focus on financial results has ­become irrelevant. In recent years, stakeholders, investors, regulators, global o­ rganizations, and the public at large have increasingly demanded ­information on both financial and nonfinancial KPIs in this platform of MBL accountability and sustainability reporting. The United ­Nations Global Compact, in its 2013 Global Corporate Sustainability Report, while underscoring the importance of business sustainability, calls on



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corporations worldwide to integrate 10 principles of sustainability ­pertaining to environment, human rights, fair labor, and anticorruption into their strategies and operations.13 Companies should strive to maintain good CSR in their everyday practices to minimize information asymmetry to all of their s­ takeholders. If a company withholds information about its practices, whether ­intentionally in efforts to minimize its effect on the bottom line or ­unintentionally as a result of not exercising due diligence on its processes, it may result in an increased perceived risk of the venture, decreased share price, concerns regarding management’s ability to lead the company, or even in so-called Black swan events: unforeseen events that have a major, and usually n ­ egative, impact on the company and usually could be seen clearly in hindsight if more attention had been paid. Thus, good CSR is important for a company to have in the short run to ensure v­ iability in the ever-changing marketplace. However, to build a strong company in the long run, business sustainability must be put into practice to p ­ repare for the future and mitigate the unforeseen or inescapable events that may occur even when a company follows CSR principles rigorously. One of the key features of putting business sustainability into practice is that when faced with problems from multiple stakeholders, a sustainable ­company can pivot its position to answer to the problem in the best ­manner possible. Sustainability performance is typically classified into financial and nonfinancial and grouped into the five dimensions of Economic (E), ­Governance (G), Social (S), Ethical (E), and Environmental (E), ­abbreviated as EGSEE.14 Although business sustainability ­continues to evolve, several dimensions of sustainability performance p ­ ertaining to social and environmental ­initiatives have gained widespread global a­ cceptance. These initiatives are an ethical workplace, customer ­satisfaction, just and safe working conditions, nondiscriminatory fair wages, workplace diversity, environmental preservation, clear air and water, minimum age for child labor, safe and quality products, c­ oncern for the environment, and fair and transparent business practices. Each i­ ndustry has its own applicable set of sustainability financial and n ­ onfinancial KPIs. Each business organization must carefully identify its own social and environmental responsibilities, given the context

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of the business culture in which it ­operates. The list of financial and nonfinancial sustainability KPIs depends on a variety of factors: industry, legal regimes, cultural diversity, corporate mission and strategy, corporate culture, ­political infrastructure, and managerial philosophy. Despite these disparate sustainability ­performance dimensions and their KPIs, sustainability has become an integral component of business. This section describes each of the EGSEE sustainability performance dimensions and their related KPIs. The true measure of success for corporations should be determined not only by their reported earnings, but also by their governance, social responsibility, ethical behavior, and environmental performance. ­Business sustainability has received considerable attention from policy makers, regulators, and the business and investment community over the past decade, and it is expected to remain the main theme for decades to come. The global trend toward business sustainability performance, reporting, and assurance encourages and ultimately rewards companies that focus on the five EGSEE dimensions of sustainability performance and strike a right balance between the triple bottom line of profit, people, and planet. Business sustainability can be successfully achieved when the following best practices are considered by companies worldwide: 1. Sustainability tone at the top in engaging in sustainability initiatives: The board of directors as representative of shareholders should ­consider the opportunities and challenges including risks offered by the global move toward sustainability and make sustainability i­ssues at the top of board agenda. This can be accomplished in three ways. First, SRIs place in proxy proposals a need for the ­election of at least one director with sustainability interests and skills. S­ econd is the creation of a board sustainability committee consisting of ­directors with adequate sustainability expertise. Third, the entire board of directors is being required to engage in sustainability issues and initiatives, being held accountable for achieving sustainability p ­ erformance, and to p ­ rovide the needed sustainability leadership. The board culture should be guided toward sustainability leadership, and the mindset of directors should be directed toward taking sustainability and ­sustainable ­strategic decisions to create shared value for all stakeholders, and move away from short-term value creation for only shareholders.



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2. Executive commitments for promoting sustainability: Corporate executives, particularly CEOs and CFOs, should have full commitment in achieving all the five dimensions of s­ustainability performance by moving away from greenwashing sustainability and moving toward a sustainability strategic imperative. This can be achieved either by active oversight function of the board of ­directors demanding sustainability performance from e­xecutives or by ­including a sustainability performance target clause in the executive ­compensation contract or for the labor market to r­ eward ­sustainability executive leadership and punish managerial short-termism. 3. Long-term sustainability investment strategies: Individual as well as institutional investors should focus on long-term and sustainable investments rather than short-term market movements including sustainability investment initiatives and innovation. 4. Integration of sustainability performance reporting and assurance into corporate reporting: 5. Adoption of a board definition of corporate sustainability as a p ­ rocess of achieving all the five EGSEE dimensions of sustainability performance in creating shared value for all stakeholders by generating r­evenue for shareholders and protecting the interests of other stakeholders.

Corporate Governance Performance and Reporting Disclosures of corporate governance measures and their effectiveness can attract institutional and individual investors to buy shares, which in turn may increase stock prices and lower the cost of equity capital, and thus improve financial and market performance. Theoretically, if effective corporate governance through smart regulations can encourage governance participants to improve their performance, and if their roles can be counted as value-added functions, then one would expect an improvement in corporate performance. However, overregulated corporate governance that would cause executives to become unjustifiably risk-averse or discourage talented and knowledgeable executives from taking managerial positions in public companies can be detrimental to the long-term sustainable success of a company by damaging innovation, entrepreneurial spirit, and corporate competitiveness.

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Corporate governance reporting has emerged since the passage of SOX and DOF Acts. Methodologies and standards of corporate reporting are yet to be established. A framework of corporate governance reporting and assurance is suggested by the GRI guidelines, which promote ­accountability reports.15 In 2002, about 600 companies worldwide i­ ssued sustainability reports in compliance with GRI’s reporting guidelines, and in 2016, more than 14,000 business organizations worldwide issued ­integrated sustainability reports on their ESG performance. It is expected that more companies worldwide issue integrated sustainability reports to disclose transparent and relevant information about their corporate ­governance principles, structure, mechanism, and functions.

Corporate Social Responsibility Performance and Reporting Recent sustainability initiatives have encouraged business organizations to focus more on their CSR. The CSR program is designed to minimize c­ onflicts between corporations and society caused by differences between private and social costs and benefits and to align corporate goals with those of society. The CSR programs are intended to create social value through ­corporate a­ ctivities (social value-added activities) and avoid ­conflicts b­ etween ­corporate goals and societal goals (societal consensus). Global ­business ­organizations are now ­taking initiatives to advance some social good beyond their own interests and compliance with applicable laws, rules, regulations, and ­standards. Simply put, CSR means enhancing c­ orporations’ ­positive impacts and minimizing their negative effects on society, minimizing harm to the environment and ­society, and creating positive impacts on the ­community, employees, customers, the environment, suppliers, and s­ociety. The true measure of success for corporations should be ­determined not only by their reported earnings, but also by their governance, social r­ esponsibility, ethical behavior, and environmental initiatives. CSR has ­received considerable attention from policy makers, regulators, and the business and investment community for the past decade and is ­expected to remain an important theme worldwide for d ­ ecades to come. Thus, public companies should engage in and report on their social activities in order to fulfill and disclose their commitments to a wide range of s­ takeholders (e.g., ­customers, suppliers, employees, regulators, and shareholders).



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Environmental Performance and Reporting The ISO’s 14,000 standards provide guidance for organizations w ­ orldwide to manage their environmental issues and report on their ­environmental performance.16 Environmental matters, particularly climate change, are currently receiving a considerable amount of attention from the socially responsible, and investment, community. Goldman Sachs, a leading global financial institution, regards a healthy environment as a n ­ ecessary factor for the well-being of society, the success of businesses, and a ­sustainable and strong economy, and as such, plays a constructive role to address the challenges facing the environment.17 Risks and ­opportunities of focusing on environmental issues should be considered by boards of d ­ irectors of public companies as the investing community values ­company e­nvironmental initiatives and responses in developing new green products. Thus, public companies should evaluate their environmental risk and performance and report to their constituencies regarding their environmental activities.

Ethics Performance and Reporting The 2007–2009 global financial crisis and the resulting economic ­meltdown and regulatory responses underscore breakdowns in ­corporate governance and in the ethical practices of corporations. ­ ­ Reported financial scandals (e.g., Enron, WorldCom) and inefficiencies in ­ ­corporate ­governance, which caused the 2007–2009 global ­financial crisis and prompted C ­ ongressional and regulatory responses, have e­ ncouraged ­business organizations and schools to place more attention on c­ orporate code of conduct, corporate governance, and professional ethics. The ­ethical conduct of many corporations during the financial crisis has been ­questioned. ­Adherence to professional ethics by corporate gatekeepers (the board of directors, management, and auditors) can significantly improve corporate performance and promote reliability of financial ­ ­reports. The scandals and the crisis and related regulatory responses and best practices have galvanized attention to a corporate code of ethics, professional ethics, compliance training programs, and ethical judgment. The existence and persistence of financial scandals by high-profile global companies underscore the importance of integrity, competency,

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and ethical behavior in business organizations. Ethics is a very sensitive issue that desires more attention in the business world. Ethics is driven by personal believes, societal norms, and moral principles and values and how these values are translated into behaviors and actions. ­Knowing e­ thics principles and values is not sufficient, but how these values guide us in doing the right things and how we use them consistently in e­ ver-changing situations is important. Ethics requires an understanding of ethical values and compliance with these in conducting ethical actions. The emerging corporate governance reforms of the SOX and the DOF require public companies to adopt a code of conduct for key financial officers. ­Public companies have adopted codes of conduct, offered employee training programs in ethics, and often appointed chief ethics officers to oversee the establishment and maintenance of the codes of ethics and ethics ­programs. The established codes of conduct and ethics programs address the following: 1. Avoidance and resolution of conflicts of interest between the ­company and employees. 2. Being responsible in complying with the established and applicable codes of business conduct. 3. Compliance with all applicable laws, rules, regulations, standards, and policies. 4. Emphasis on customer relations to enhance the company’s reputation. 5. Proper use of the company’s confidential information. 6. Encouragement of whistle-blowers to reveal dishonesty or wrongdoing. Studies show that companies exhibiting a pronounce emphasis on ­ethics and trust have higher employee retention rates and attract more prospective employees. Therefore, when companies take time to relate their values, reputation, and success with compliance in a meaningful way, it not only helps their organization fulfill the ESG, but it also turns out to be a shrewd business decision. The code of conduct serves as the primary means for an organization to communicate its commitment to ethical and legal conduct to both internal and external stakeholders: employees as well as vendors, customers, agents, and shareholders.18



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Corporations can have their code of conduct disclosed to employees and provide them ethics training; however, unethical business cultures that encourage ­employees to engage in unethical actions always prevail. Ethical tone at the top and ethical behavior and policies are important, because often employees “do as they see, not as they’re told.”19 One realworld example of unethical behavior is the most recent Wells Fargo issue. The company provides ethical training for employees encouraging them not to set up fake accounts and report any manager’s misconduct, but at the same time firing them for failing to meet the aggressive sales metrics.20

The Role of Institutional Investors in Corporate Governance Institutional investors are financial institutions that accept funds from third parties for investment in their own name but on such parties’ ­behalf. ­Institutional investors are a major force in many capital m ­ arkets. With the goal of optimizing returns for targeted levels of risk, as well as ­prudential regulation, institutional investors diversify investments into large ­ ­portfolios, many of them having investments in thousands of c­ ompanies. Some m ­ anagers pursue active investment strategies, but have ­recently been p ­assively managing against a benchmark, resorting to i­ndexing. Also, the investment chain has increased by outsourcing of ­management, ­drastically distancing investee companies from the ­owners. As a result of this, ­incentives do not always stimulate institutional ­investors to engage in monitoring the corporate governance practices of investee companies. The Investor Stewardship Group (ISG), consisting of several largest U.S.-based institutional investors and global asset managers, along with several of their international counterparts in 2017, issued its c­ orporate governance principles of stewardship framework for institutional ­investors.21 The ISG founding members, including BlackRock, CalSTRS, Florida State Board of Administration, GIC Private Limited, Royal Bank of Canada Global Asset Management, State Street Global Advisors, TIAA Investments, T. Rowe Price Associates, Inc., ValueAct Capital, and ­Vanguard, are a group of 16 U.S. and international institutional ­investors that invest over $17 trillion in the U.S. equity markets. The ISG was ­initially established to develop integrated and comprehensive standards of

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investment stewardship and corporate governance for members’ group. In 2017, the ISG issued its stewardship principles for institutional investors and corporate governance principles for U.S. listed companies. The ISG’s framework for U.S. Stewardship and Governance is not intended to substitute existing corporate governance reforms and l­isting standards including any existing federal or state law and regulation, or ­listing rules applicable to U.S. listed companies and institutional ­investors. The framework is intended to supplement and complement the ­applicable corporate governance reforms and measures and listing ­standards and is not static and will be evaluated and revised periodically with the consensus of its members in response to changes in corporate governance attributes.22 The framework, which went into effect from January 1, 2018, gives U.S. companies time to adjust to these standards prior to their 2018 proxy season. The Corporate Governance Principles designed in the ISG F ­ ramework 23 for U.S. Listed Companies are the following : Principle 1: Boards are accountable to shareholders as their elected representatives for the following: their sustainable financial and nonfinancial performance; directors should stand for election ­annually; directors who fail to receive a majority of the ­shareholder votes in an uncontested election should tender their r­esignation; shareholders who own a meaningful stake in the company for a sufficient time period should be able to nominate directors through the form of proxy access; and companies should disclose adequate information regarding their corporate governance and board practices. Principle 2: Shareholders should be entitled to voting rights in ­proportion to their economic interest through the following: adopt a one-share, one-vote standard, but not adopt share s­ tructures that create unequal voting rights among their shareholders; and e­ stablish mechanisms to end or phase out controlling dual or ­multiple class share structures at the appropriate time, while m ­ inimizing costs to shareholders. Principle 3: Boards should be responsive to shareholders and be proactive in order to understand their perspectives by doing the



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following: responding to a shareholder proposal that receives significant shareholder support; understanding the reasons for ­ and respond to significant shareholder opposition to management proposals; engaging in dialogue with shareholders on ­ ­ matters of significance, in order to understand shareholders’ views; and ­accepting the risk of not being reelected when they have p ­ ersistently failed to respond to feedback from their shareholders. Principle 4: Boards should have a strong, independent leadership structure by doing the following: overseeing a company’s strategy, assessing management’s performance, ensuring board and board committee effectiveness, and providing a voice independent from management that is accountable directly to shareholders and other stakeholders; establishing either an independent chairperson or a credible independent lead director; and reviewing the structure and explain how the division of responsibilities between the two roles is intended to maintain the integrity of the oversight function of the board. Principle 5: Boards should adopt structures and practices that ­enhance their effectiveness by doing the following: having a mix of direct industry expertise and experience and skills relevant to the company’s current and future strategy as well as diversity; ­having a majority of independent directors on the board; establishing fully ­ independent audit, executive compensation, and nominating and/or governance committees to perform certain tasks to fulfill their oversight r­esponsibilities; ensuring directors make the substantial time commitment required to fulfill their responsibilities and duties to the company and its shareholders; requiring directors to attend all board meetings, including the annual meeting, and explaining the reasons for poor attendance, if any, to shareholders; ensuring that there is a mechanism for ­individual directors to receive the information they seek regarding any aspect of the business or activities undertaken or proposed by management; and disclosing mechanisms to ensure there is ­appropriate board refreshment including a regular and robust evaluation process, as well as an evaluation of policies relating to term limits and/or retirement ages.

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Principle 6: Boards should develop management incentive structures that are aligned with the long-term strategy of the company by doing the following: identifying short- and long-term performance goals that underpin the company’s long-term strategy; integrating these goals into the management incentive plans and serving as significant drivers of incentive awards; and evaluating management incentive structures in order to determine whether they continue to incentivize management to achieve the goals of the new strategy.

Corporate Governance Relevant to Minority Shareholders An important policy issue concerning corporate governance is the ­potential to abuse related-party transactions (RPTs). Rather than b­ anning these transactions, jurisdictions have put management and ­ approval ­processes to minimize the negative potential resulting from the abuse of RPTs. Globally, International Accounting Standard 24 has ­introduced an important standard for transparency; however, this alone is not s­ ufficient. Some jurisdictions (Belgium, Israel, France, Italy, and India) have ­introduced requirements for ongoing disclosure of material transactions. Deciding which transactions are material has proved challenging, with indications that quantitative criteria could be more effective. When approving RFTs, the responsibility tends to be given to a ­committee of independent board members. There are often concerns on how to ensure effective independence of board members from controlling shareholders. Many jurisdictions have adopted corporate ­ ­governance a­ pproaches in response to these concerns. One approach is to give ­shareholders a say in approving certain transactions, with ­interested ­shareholders being excluded. A second approach has given minority ­shareholders the ability to vote directly for a board member of their choice. The last approach is where a controlling shareholder has a fi ­ duciary duty to the other shareholders and the company. An abusive RPT would be directly against the interests of noncontrolling shareholders, resulting in a breach of duty by the controlling shareholders involved. The controlling shareholders have certain duties to protect minority shareholders. A key feature is the duty of controlling shareholders not to



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infringe upon their minority rights, not to abuse the power of majority. A key principle in accordance with best corporate governance practices is that minority shareholders should be protected from abusive actions by, or in the interest of, controlling shareholders acting either directly or i­ ndirectly, and should have effective means of redress.24 Another key principle is that members of the board and key executives should be required to d ­ isclose to the board whether they have a material interest in any transaction or matter directly affecting the corporation. A third principle would require the board to fulfill key functions consisting of monitoring and managing potential conflicts of interest of management, board members, and shareholders; and including the misuse of corporate assets and abuse in RPTs.

Risk Management and Corporate Governance Risk-taking is a fundamental driving force in business and entrepreneurship; however, the cost of risk management failures is still often ­underestimated, both externally and internally, including the cost in terms of management time needed to rectify the situation. Corporate ­governance should, therefore, ensure that risks are understood, m ­ anaged, and communicated. Following the financial crisis and a number of ­prominent risk management failures or shortcomings, many companies have i­ncreased their attention to risk. While financial risk has, thus, been the focus of attention, the consequences of reputational risks are also becoming increasingly clear to companies. The strongest efforts to strengthen risk management can be observed at companies that have faced major risk issues in the recent past. Existing risk governance s­ tandards for listed companies still focus largely on internal control and audit functions, and primarily on financial risk, rather than the identification and comprehensive management of risk. Corporate governance standards should place sufficient emphasis on the identification of risks. Attention should be paid to both financial and nonfinancial risks, and risk management should encompass both strategic and operational risks.25

Banks’ Corporate Governance Effective corporate governance is crucial to the proper functioning of the banking sector as well as the economy as a whole. Banks serve a critical

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role in the economy by intermediating funds from savers and depositors to activities that support enterprise and help drive economic growth. The safety and soundness of banks is key to financial stability and economic health. Governance weaknesses at banks that play a significant role in the financial system can result in the transmission of issues across not only the banking sector, but the economy as a whole. Corporate governance determines the allocation of responsibilities by which the business and affairs of a bank are carried out by its board and senior management. These responsibilities include the following: set the bank’s objectives and strategies; select and supervise personnel; operate the bank’s day-to-day business; establish control functions; protect the interests of depositors; meet shareholder obligations; and align corporate culture, activities, and behavior with the expectation that the bank will operate in compliance with applicable laws and regulations. Effective corporate governance may permit the supervisor to place more reliance on the bank’s internal processes. Under this, supervisory experience underscores the importance of having the appropriate ­levels of authority, responsibility, accountability, and checks and balances within each bank, including those of senior management, but also of the board of directors and the risk, compliance, and internal audit functions. E ­ ffective implementation of effective corporate governance requires ­relevant legal, regulatory, and institutional foundations. A variety of ­factors, i­ncluding the system of business laws, stock exchange rules, and ­accounting standards, can affect market integrity and systemic stability. However these factors are often outside the scope of banking supervision. Regardless, supervisors are encouraged to be aware of legal and institutional ­impediments to effective corporate governance, and to take steps to foster corporate governance foundations where it is within their legal authority to do so. A report by the Basel Committee on Banking Supervision provides the following corporate governance principles for banks26: 1. The board has overall responsibility for the bank, including ­approving and overseeing the implementation of the bank’s strategic ­objectives, governance framework, and corporate culture. The board is also responsible for providing oversight of senior management.



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Board members should be and remain qualified, individually and collectively, for their positions. They should understand their ­ ­oversight and corporate governance role and be able to exercise sound, o­ bjective judgment about the affairs of the bank. The board should define appropriate governance structures and practices for its own work, and put in place the means for such practices to be followed and periodically reviewed for ongoing effectiveness. Under the direction and oversight of the board, senior management should carry out and manage the bank’s activities in a manner consistent with the business strategy, risk appetite, incentive compensation, and other policies approved by the board. In a group structure, the board of the parent company has overall responsibility for the group and for ensuring that there is a clear governance framework appropriate to the structure, business, and risks of the group and its entities. The board and senior management should know and understand the bank’s operational structure and the risks that it poses. 2. Banks should have an effective independent risk management function, under the direction of a chief risk officer, with sufficient ­stature, independence, resources, and access to the board. Risks should be identified, monitored, and controlled on an ongoing bank-wide and individual entity basis. The sophistication of the bank’s risk ­management and internal control infrastructure should keep pace with changes to the bank’s risk profile, the external risk landscape, and in industry practice. An effective risk governance framework requires robust communication within the bank about risk, both across the organization and through reporting to the board and ­senior management. The bank’s board of directors is responsible for overseeing the management of the bank’s compliance risk. The board should approve the bank’s compliance approach and policies, including the establishment of a permanent compliance function. 3. The internal audit function provides independent assurance to the board and supports board and senior management in promoting an effective governance process and the long-term soundness of the bank. The internal audit function should have a clear mandate, be accountable to the board, be independent of the audited activities, and have sufficient standing, skills, resources, and authority within

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the bank. The bank’s compensation structure should be ­effectively aligned with sound risk management and should ­ promote ­long-term health of the organization and appropriate risk-taking behavior. 4. The governance of the bank should be adequately transparent to its shareholders, depositors, other relevant stakeholders, and market participants. Supervisors should provide guidance for and supervise corporate governance at banks, including through comprehensive evaluations and regular interaction with boards and senior management, should require improvement and remedial action as necessary, and should share information on corporate governance with other supervisors.

Corporate Governance in the Aftermath of the 2007–2009 Global Financial Crisis Congress passed the DOF Act of 2010 in response to the global 2007– 2009 financial crisis.27 This act was intended to improve c­ orporate governance of large financial institutions. The DOF was passed to minimize the likelihood of future financial crisis and ­systemic d ­ istress of financial institutions by empowering regulators to r­equire higher c­ apital requirements, establishing systemic risk assessment and m ­ onitoring, developing a new regulatory regime for large fi ­ nancial firms, and mandating regulatory and market structures for ­financial ­derivatives. Ineffective corporate governance and inadequate regulation for financial institutions can be detrimental to the global economy and economic growth and stability. Proper and timely i­mplementation of the DOF provisions may prove to be instrumental in strengthening sound and efficient operation of financial institutions worldwide.

Corporate Governance Post Brexit On June 23, 2016, the United Kingdom voted to leave the European Union, and this contributed to volatility and uncertainty of the global capital market and public companies worldwide. The possible effect of the Brexit can be a global economic slowdown that could ­influence



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companies’ sustainability and growth. The Brexit can create s­trategic challenges for corporate governance and all corporate gatekeepers, ­ ­including ­directors and officers, in evaluating the validity of assumptions and e­ stimates about future growth. Possible changes in corporate governance in the post-Brexit era are to include employee representatives on the boards and to make shareholder votes on executive compensation ­legally ­binding to mitigate investor concerns for lack of proper monitoring and to encourage employee engagement in corporate governance.28 Thus, it a­ppears that the United Kingdom in the post-Brexit era is considering how European corporations are planning to respond to possible changes in corporate governance initiatives and practices triggered by Brexit. The important changes to be addressed are: (1) What are the short- and long-term issues that boards need to consider in the post-Brexit period? (2) What resources directors and executive would need to have to effectively address the possible changes? and (3) Whether and to what extent the convergence in corporate governance is feasible in this period.

Emerging Growth Companies’ Governance The JOBS Act was enacted on April 5, 2012, to enable emerging growth companies (EGCs) to go public without being subject to a full v­ igorous range of regulations applicable to conventional IPOs of publicly traded companies. The goal is to entice EGCs to go public and help EGCs to raise capital. EGCs, availing themselves of the JOBS Act’s Title I “IPO ­on-ramp” provisions, have generally adopted rigorous governance ­policies and procedures. Morrison and Forrester (2016) conducted a study to assess the corporate governance practices adopted by EGCs. The study presents data on an aggregated basis, considering all of the EGC IPOs ­undertaken in the 2013 to 2015 period. The key findings are as follows: (1) 84 ­percent of noncontrolled companies had a majority of independent directors at IPO pricing; (2) 71 percent had staggered or classified boards; (3) 62 ­percent separated the CEO and board chair positions; (4) 68 ­percent had all ­independent directors on the Audit, C ­ ompensation, and N ­ ominating and Corporate Governance Committees upon ­completion of the IPO; (5) 93 percent had a “financial expert” on the Audit Committee IPO pricing;

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(6) 40 percent had “­exclusive forum” provisions in bylaws; (7) 74 percent had “super majority” s­hareholder v­ oting provisions; (8) 46 percent allowed shareholders to take ­action by written consent under specified conditions; and (9) 22 percent were “­foreign private issuers.”29

Private Companies Governance Effective governance of private companies is vital to their long-term ­success and the opportunity to go public in the future. The g­ overnance models of private companies are in constant need of fine-tuning and ­enhancement. The top three governance challenges cited by private company directors include improving risk management oversight, ­ assessing innovation and emerging completion, and confirming/­ ­ establishing company strategy. Other key governance challenges for private c­ ompanies include a­ chieving regulatory compliance, leadership succession planning, and global ­compliance. The most visible challenges to board e­ ffectiveness include budget and resource constraints, ­conflicts of interest (including the p ­ resence of RPTs), and a compromised board due to an overrepresentation of controlling shareholders. Directors ­believe that fast-evolving technologies, such as big data and related ­analytical tools, may help spawn more relevant and efficient reporting for management and the board. Private company directors are looking to their governance p ­ rocesses and controls to improve Mergers and ­Acquisitions (M&A) outcomes, e­nhance financial risk and oversight, and optimize the finance organization through performance evaluation and succession planning.30

Family-Owned Governance Great family businesses are built on entrepreneurship vision, strategy, values of the family founder, and proper execution of business affairs. However, the sustainability of family businesses that endure across ­ ­generations depends on the corporate governance effectiveness of such businesses. Governance becomes vital to a family business as it grows and confronts new opportunities, challenges, and critical questions about its future d ­ irection. The growth and sustainability of a family business lies in



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the fine balance between the needs of the business and the expectations of family members. Effective governance of a family business can help improve the company’s performance and satisfy the expectations of family members.31 A family business may choose any one of a number of governance models such as an all-family board, a partially independent board, or an independent board, or even an advisory board. Whichever style of board is used, three elements serve as enabling forces: (1) clarity of roles, ­responsibilities, and how decisions are made; (2) an understanding of the culture (vision and values) and how this impacts decision ­making and ­implementation; and (3) communication, or the transparency and ­information flow that enables the board to fully understand the ­challenges and opportunities the business faces and adds real value as the company refines its strategy, grooms new leaders, and continues to grow. When building a strong board, family-owned businesses should follow these principles: • Develop a skills matrix, considering the future direction of the company, the expectations of stakeholders, and experience gaps within the existing business. Plot the attributes of existing ­directors against the desired skills, and look to fill gaps. Build a diverse board. Look for differences in background and perspective that will add to the richness of the conversation. • Recruit for fit as well as experience. Seek out a mix of directors who will be able, collectively, to raise tough questions and offer constructive advice. Implement onboarding and board/committee evaluation programs to ensure that directors will be able to hit the ground running and the board will achieve and maintain peak performance. Consider and help develop a plan for the next generation of family members to gain the experience needed to contribute to the board.

Future Initiatives in Corporate Governance There are many corporate governance challenges and issues, as discussed in Chapter 4. However, several corporate governance initiatives have been taken

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to address these challenges. This section examines many i­ mportant ­initiatives, including board composition and effectiveness, leadership c­hallenges, ­executive compensation, risk management, and strategic planning. Board Composition Generally speaking, directors individually and collectively should have sufficient knowledge and expertise to effectively fulfill their fiduciary duties as shareholders’ representatives. One way to ensure board effective composition is to require “refreshment” for directors. Shareholders as owners of their companies want to ensure that directors are capable of handling, and willing to handle, the board leadership and corporate governance challenges. Thus, periodic refreshment of the board with new blood is vital to board composition and effectiveness. The 2016 to 2017 Global ­Policy Survey conducted by the Institutional Shareholder Services (ISS) in ­August 2016 raised the following concerns regarding board ­nominating and r­ efreshment processes: (1) Over 68 percent of r­ espondents believe that a high proportion of directors with long tenure is a matter of concern; (2) About 53 percent reported an absence of newly appointed independent directors in recent years as a concern; (3) More than 51 percent pointed to lengthy average tenure as a potential problem; and (4) Other less problematic concerns are directors ages, lengthy average tenure coupled with underperformance, and a high overlap between the tenure of the CEO and the tenure of the nonexecutive directors.32 Suggested remedies for these perceived board refreshment concerns are mandatory retirement ages or term limits, board/director evaluations, continuous boardroom succession planning, and enhanced disclosure of these procedures Boards should be accountable to shareholders as their elected representatives to achieve sustainable financial and nonfinancial performance, and discontinue the ­reelection of long-tenured directors to encourage turnover and fresh blood, and mandatory diversity by using quotas and other best practice rules.33 Board Leadership The leadership of the board of directors is assumed by the chairperson of the board of directors. Boards should have a strong and independent



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leadership structure to effectively oversee a company’s strategy, assess management’s performance, and create sustainable shareholder value. Companies should establish either an independent chairperson or a credible independent lead director to ensure the effective leadership of the board of directors. The board of directors should consider whether the company has a CEO succession plan and whether such succession plan is operational. The CEO is typically a spokesperson for the company supported by a unified board. The CEO should consult with the board, ­particularly the chair or lead director, to coordinate all strategic decisions, actions, and performance. Executive Compensation: Say on Pay and Executives’ Performance DOF-imposed legislation requiring a shareholder advisory vote on executive pay. Executive compensation will continue to be an area of attention by directors because of the new SEC rule regarding disclosure of CEO/ median employee pay ratios. The board of directors should address the issues of what is the total compensation paid to the CEO and how does it compare with the CEO compensation paid by peer companies, and whether the CEO compensation package is sufficient to attract, ­retain, and motivate qualified executives. Typically, executive compensation c­ onsists of salary, short-term cash bonus, and long-term incentive pay in terms of value of stock options and restricted stock. Executive compensation schemes are linked to a firm’s sustainable performance and are ­approved by shareholders—which has received considerable a­ttention after the ­financial scandals. The provisions of the SOX that address ­executive compensation packages are as follows34: (1) prohibition of ­personal loans to directors and executives (Section 404), (2) reporting insider trading (­Section 403), (3) insider trading during pension fund blackout periods, and (4) forfeiture of certain bonuses and profits.35 The DOF requires say on pay as a nonbinding vote by the shareholders of a publicly traded company for approval or disapproval of the executive compensation program in that company. Under the DOF, public companies must disclose (1) the relationship between senior executives’ compensation and the company’s financial performance in the form of graphs and charts; (2) the ratio of the CEO compensation and the median total to employee compensation

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excluding the CEO compensation; and (3) whether employees or directors are allowed to hedge against a decrease in value of options included in their compensation scheme.36 One component of the executive compensation with significant growth in recent years has been in stock-based compensation including stock options. Executive compensation has often focused on the short-term performance with no link to sustainable performance. Any cash compensation or short-term stock-based compensation can fail to create proper incentives to align manager interests with those of shareholder and thus to promote optimal risk-taking by management. ­Nonetheless, stock-based compensation could align managerial incentives with shareholder interests if it is linked to sustainable performance and if stock prices reflect managerial performance. Executive compensation has increased substantially in recent years, with significant growth in both cash and stock-based components. Wall Street securities firms (e.g., Goldman Sachs and Morgan Stanley) released clawback provisions that affect not only executives but also their traders, if these traders put the firm at risk, “of substantial financial or legal repercussions.”37 Excessive and questionable executive compensation, whether caused by misconduct or by a lack of performance, can impose costs on shareholders if they are not subsequently recovered through clawbacks. ­Excessive executive pay has negative impacts on shareholder value, and correction through clawbacks will reverse these. Section 304 of the SOX requires compensation recovery from executives (CEOs, CFOs) of public companies where financial statements are restated because of fraud, misconduct, or violations of security laws. Section 304 of the SOX ­empowers the SEC to require top executives of public companies to ­return to the company any bonus or other incentive-based compensation ­including bonus and equity received within 12 months of restated financial statements along with profits realized from the sale of stock during that period. The DOF requires all U.S. public companies to incorporate clawback provisions that are caused by financial restatements into their executive compensation schemes. The DOF requires that all U.S. public companies incorporate so-called clawback provisions into incentive compensation arrangements for executive officers. It expanded the SOX provisions on clawback practices by requiring companies to implement



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and report on their policies and practices for recouping payments from current and former executives when published financial statements are subsequently restated because of a material noncompliance with financial reporting standards. The r­ ecouped pay is the amount paid based on misstated financial statements and is recoverable for the 3 years preceding the restatement date. The DOF requires national securities exchanges and associations to revise their listing standards to prohibit listings for any company that does not implement a clawback policy. The implementation of the clawback provisions requires public companies to recover any excess compensation resulting from the misstated financial statements during the 3-year period prior to the restatement. The SOX requires compensation recovery from only CEOs and CFOs, whereas the DOF mandates compensation recovery from all current and former executives of public companies. The DOF expanded events that trigger compensation recovery to any accounting restatements caused by material noncompliance with financial reporting standards including fraud and misconduct. The SEC is expected to issue rules to implement clawback provisions of the DOF, which mandates all public companies to maintain clawback policies. Some companies established such policies that mandate recovery for any inaccuracy in determining target earnings even if the level of restatements is not reached. Both the SOX and the DOF require recovery of excess pay only when financial statements are restated as a result of executives’ misconduct. Neither of the acts requires recovery that resulted from sales of stock made while the firm was inflating earnings. DOF provisions on clawback do not address the recovery of all types of excess executive compensation because they do not compel firms to recoup excess incentive-based compensation unless a restatement is required. Firm voluntary c­ lawback policies may ­demand recovery for any inaccuracy in d ­ etermining ­target earnings even if it did not reach the level of ­restatements. These ­voluntary clawbacks of nonachievement of earnings targets, disclosing confidential information, accepting a job with competitors, and any activities deemed harmful to the company are expected to receive widespread a­ cceptance and ­enforcement in the future. DOF requires recovery of c­ ertain incentive-based compensation (stock options), whereas d ­ iscretionary clawback can be applied to any incentive compensations including cash and equity. Clawback provisions,

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either mandatory for ­recovering ­erroneously awarded ­compensation or ­voluntary for ­recovering ­unachieved ­target ­performance compensation, affect s­tock-based c­ompensation ­arrangements and the corporate governance of public companies. While national securities exchanges and associations prohibit listing any company that does not implement the mandatory clawback policy to recover incentive-based compensation paid to current or former executives based on erroneous financial results, the voluntary clawback policy should be demanded and closely monitored by ­investors to ­ensure the alignment of management incentives with shareholder interests. Firm clawback policies can be found in proxy statements, ­corporate governance guidance, or compensation agreements. The event that triggers mandatory clawback for the recovery of compensation is an accounting restatement of the company’s financial statements that are affected by any material noncompliance with any financial reporting requirement under the securities laws. The recovery look-back period is 3 years from the date of the accounting restatement. The amount to be recovered is the excess incentive-based compensation (­including stock-based awards) over what would have been paid based on the ­restated amounts. Discretionary performance-type clawback provisions require stock-compensation awards to be clawed back based on certain predetermined operating or performance measures. Discretionary clawback policies should have provisions that are triggered by c­ertain threshold performance targets and should be designed to prevent ­underperformed executives from benefiting at the expense of s­hareholders. ­Examples of mandatory clawback triggers are violations of noncompetition and nonsolicitation agreements, and fraudulent behavior. Examples of discretionary performance-type clawback triggers are failures to achieve predetermined earnings targets or other performance measures such as social responsibility performance or environmental initiatives. Both ­mandatory and ­discretionary (voluntary) clawback require determination of what triggers the clawback and what are the effects of the clawback. The compensation committee of the board of directors is responsible for the determination of causes and effects of both mandatory and voluntary clawbacks. The compensation committee of the board of directors can influence clawback compensation schemes and awards in two ways by using its discretion of determining what events (financial restatements,



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nonachievement of earning targets) trigger the clawback and the effects of the clawback in terms of the actions taken by the company (recovery of cash or stock-based bonuses). Clawback provisions are applicable to both cash-based incentive compensation programs and stock-based compensation arrangements. Arguments in favor of both mandatory and discretionary clawback policies are that when a firm has to restate its previously erroneous financial statements or has failed to achieve target earnings, any incentive-based compensation paid to top executives based on either misstated earnings or nonachieved earnings should be given back to the firm. However, mandating such clawback policies through the DOF and related forthcoming SEC rules can provide incentives and enforcement needed to effectively implement such policies or may be perceived as an unnecessary and undesirable intervention by regulators into these firms’ compensation arrangements determined by the compensation committee of the board of directors. Whistle-Blowing Whistle-blowing is defined as, “the disclosure by organization members (former or current) of illegal, immoral, or illegitimate practices under the control of their employers, to persons or organizations that may be able to effect action.”38 Whistle-blowing programs should be established and monitored because the consequences of whistle-blowing are significant and can range from personal retaliation such as termination to substantial losses to a company. Under the SOX and the DOF, public ­companies must establish and enforce a whistle-blowing program. Typically, the audit committee is responsible for ensuring that it meets SOX and DOF requirements, and other related rules and regulations. The SOX initially created the opportunity for confidential and anonymous submissions of complaints by requiring that a company’s audit committee establish procedures for the collection and treatment of such complaints. The DOF is also intended to improve the effectiveness of corporate whistle-blowing programs by providing protection for whistle-blowers and offering rewards for the risk whistle-blowers take in reporting wrongdoers to the regulatory authorities. It provides new incentives for employees and others to blow the whistle when they b­ ecome

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aware of law violations and fraud within a company. Under ­Section 922 of the DOF Act, a person who provides “original information” about a securities law violation to the SEC, which then leads to a successful enforcement action with penalties of $1 million or more, is now entitled to collect between 10 and 30 percent of the total penalties imposed by the agency. SOX and SEC-related rules require that the audit committee establish and maintain appropriate whistle-blower programs for the receipt, process, and retention of complaints regarding internal control accounting and auditing matters.39 Such programs must establish procedures and mechanisms that encompass the confidential and anonymous submission of concerns on questionable accounting and auditing matters by e­ mployees. The SEC requires that the audit committee establish specific mechanisms tailored and suitable to the company’s circumstances and needs for whistle-blower programs. The whistle-blowing program must be established in compliance with both the SOX of 2002 and the DOF of 2010. S­ ection 301 of the SOX Act contains whistle-blowing provisions that require the audit committee to establish policies and procedures ­regarding the ­receipt, retention, and treatment of complaints regarding v­ iolations of accounting and auditing standards, and Section 806 ­prohibits retaliations against whistle-blowers.40 Section 806 of the DOF provides protections for whistle-blowers in securities fraud cases, and has directed the SEC to establish rules regarding confidential and anonymous submissions of violations of security laws and conduct of fraudulent and unethical activities by public companies.41 Whistle-blowers are protected and rewarded for informing the SEC of corporate wrongdoings. To facilitate the receipt, retention, and timely responses to ­complaints and other questionable financial matters, the audit ­committee should oversee the establishment of whistle-blower programs and ­procedures. The establishment of whistle-blower programs, policies, and procedures for receiving, investigating, correcting actions, and ­preventing further violations should go beyond the regulatory r­equirements of ­accounting, internal controls, and auditing-related matters, and cover all sorts of complaints, including those from customers, suppliers, investors, c­ reditors, employees, and other stakeholders pertaining to product



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quality, job satisfaction, and environmental matters. These policies and procedures should alert the audit committee of potential concerns ­before they cause serious consequences. Organizations with effective i­nternal audit functions can use their auditors to assist management under the direct oversight of the audit committee to establish whistle-blower programs, policies, and procedures to receive, investigate, and communicate complaint matters. In the case of the nonexistence of an internal auditing department or in other controversial circumstances, external service p ­ roviders can be hired to i­nvestigate complaint matters under the direct oversight function of the audit committee. In all investigative cases, the audit committee should ­consult with the organization’s legal counsel ­regarding procedures for receiving and handling complaints. Persisting challenges in corporate governance are as follows: • Compliance. Effective compliance with implementation rules of both SOX and DOF provisions as related to whistle-blowing and Foreign Corrupt Practices Act (FCPA) (anti-bribery, anti-money laundering) is a major challenge for public companies. • Board Leadership. CEO duality and the efficacy of separating chairman and CEO roles for differentiating between leadership of management oversight and management function is gaining new attention. • CEO Succession Planning. CEO succession planning is one of the most important and challenging responsibilities of the board of directors in the aftermath of the 2007–2009 global financial crisis. • Risk Assessment and Management. Effective risk assessment and management continue to be an important issue public companies face in the aftermath of financial scandals and crisis. • Executive Compensation. Executive compensation has been, and will be, an important agenda for the board of directors, ­particularly for the compensation committee, as long as the compensation of executives is perceived to be excessive and corporations fail to implement a Say-on-Pay nonbonding vote by shareholders in ­approving executive pay.

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Communication with Investors The board of directors should have ongoing communication with all stakeholders, including shareholders, creditors, employees, customers, and suppliers, to ensure that their voices are heard. Specifically, as representatives of shareholders, board of directors should communicate with individual and institutional shareholders. The 2016 U.S. Spencer Stuart Board Index suggests that investor attention to board composition, governance, and performance continue to be at the top of agenda for individual and institutional investors. The board’s commitment to ­ongoing dialogue with investors on corporate governance topics may help companies to do the following42: 1. Secure investor support as some investors view boards’ engagement practices as an indicator of effective governance. Particularly, a long-term dialogue with institutional investors can result in allies when a company faces strategic challenges or reputational risk. 2. Mitigate potential exposure to activism as continuous engagement with shareholders may reduce their concerns and the likelihood of expressing their concerns publically. 3. Counter check-the-box proxy voting as constructive communication can offset proxy advisory firms’ views and boost support for management proposals. 4. Identify emerging opportunities and enable the company to proactively take the lead.

Conclusion Public companies are witnessing several important trends in corporate governance in recent years. These trends range from how to engage with investors, navigate the proxy advisers, position their boards for sustainable and effective performance, and react to activists. Some other important corporate governance issues are pay for performance, say on pay, board independence and diversity, improvements for board committees, and the move toward business sustainability. The true measure of success for corporations should be determined not only by their reported earnings,



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but also by their governance, social responsibility, ethical behavior, and environmental performance. Important corporate governance issues in recent years are as follows: (1) proper risk assessment and management by integrating opportunities and strategies and risks based on total impact; (2) the emerging business sustainability of “doing well by doing good”; (3) focusing on long-term strategies, actions, and performance by avoiding short-termism; (4) creating the corporate culture of competency and integrity by setting an appropriate tone at the top; and (5) engaging with all stakeholders and creating shared value for all stakeholders, including shareholders.

Endnotes 1. Z. Rezaee. October, 2015. Business Sustainability: Performance, Compliance, Accountability and Integrated Reporting (Sheffield, ­ United Kingdom: Greenleaf Publishing Limited). 2. M. Jensen, and W. Meckling. 1976. “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics 3, pp. 305–360. 3. Z. Rezaee. 2015. 4. Delaware Law Series. August 14, 2013. DGCL Amended to Authorize Public Benefit Corporations. http://blogs.law.harvard.edu/corpgov/ tag/delaware-law/ 5. R. Schmidt. 2004. “Corporate Governance in Germany: An ­Economic Perspective.” In The German Financial System, Chapter 12 in eds. J. Krahnen and R. Schmidt. Oxford: Oxford University Press, pp. 386–424. 6. M.E. Porter, and M.R. Kramer. February, 2011. Creating Shared Value. Harvard Business Review. Available at https://hbr.org/ 2011/01/the-big-idea-creating-shared-value 7. Ibid, page 66. 8. Global Reporting Initiative (GRI). 2002. Sustainability Reporting Guidelines on Economic, Environmental, and Social Performance. www.globalreporting.org 9. Z. Rezaee. 2015. “Business Sustainability.” 10. Z. Rezaee. 2015.

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11. Ibid. 12. Ibid. 13. United Nations Global Compact (UN Global Compact). 2013. Global Corporate Sustainability Report 2013. https://www.unglobalcompact.org/docs/about_the_gc/Global_Corporate_­Sustainability_ Report2013.pdf 14. Brockett and Rezaee, 2012. 15. Global Reporting Institute. 2002. The Sustainability Reporting Guidelines. www.globalreporting.org 16. International Organization for Standardization. 2009. Environmental management: The ISO 14000 family of international standards. https://www.iso.org/files/live/sites/isoorg/files/archive/pdf/en/­ theiso14000family_2009.pdf 17. Goldman Sachs. 2005. Goldman Sachs Environmental Policy Framework. www.gs.com/our_firm/our_culture/social_responsibility/­ environmental_policy_framework/index.html 18. Corpedia, Inc. 2005. Best Practices in Code of Conduct Development. http://www.americanbar.org/content/dam/aba/administrative/­ litigation/materials/2014_sac/2014_sac/best_practices_in_code_ of_conduct_development_2013.authcheckdam.pdf 19. Ethics Game. 2016. The State of Ethics Education. http://ethicsgame. com/exec/site/downloads/ethicssurvey2016.pdf 20. M. Corkery, and S. Cowley. September 16, 2016. Wells Fargo Warned Workers Against Sham Accountants, but They Needed a Paycheck. https://www.nytimes.com/2016/09/17/business/dealbook/wellsfargo-warned-workers-against-fake-accounts-but-they-needed-apaycheck.html?emc=eta1&_r=0 21. Investor Stewardship Group (ISG). 2017. The Corporate Governance Principles of Stewardship Framework for Institutional Investors. https://www.isgframework.org and https://www.isgframework.org/ stewardship-principles/ 22. Ibid. 23. Investor Stewardship Group (ISG). 2017. Corporate Governance Principles for US Listed Companies. https://www.isgframework.org/ corporate-governance-principles/



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24. Organization for Economic Co-operation and Development (OECD). 2012. Related Party Transactions and Minority Shareholder Rights. https://www.oecd.org/daf/ca/50089215.pdf 25. OECD. 2014. “Risk Management and Corporate Governance,” Corporate Governance. OECD Publishing. http://dx.doi.org/ 10.1787/9789264208636-en 26. Bank for International Settlements. 2014. “Basel Committee on Banking Supervision,” Corporate Governance Principles for Banks. http://www.bis.org/bcbs/publ/d328.pdf 27. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. 111-203 (2010). 28. Glass Lewis. 2016. Post-Brexit Britain Looks to Europe for Corporate Governance Inspiration. http://www.glasslewis.com/ post-brexit-britain-looks-europe-corporate-governance-inspiration/ 29. Morrison and Foerster. 2016. Getting the Measure of EGC Corporate Governance Practices: A survey and related resources. http:// media.mofo.com/docs/pdf/150507-EGC-Survey/ 30. Forbes Insights. 2015. “Private Company Governance,” The Call for Sharper Focus. http://www.kpmg-institutes.com/content/dam/ kpmg/globalenterpriseinstitute/pdf/2016/private-company-governance.pdf 31. KPMG. 2015. How Boards Drive Value in Family-Owned B ­ usinesses. https://www.kpmg.com/US/en/IssuesAndInsights/Articles­ Publications/Documents/wcd-boards-drive-value.pdf 32. Institutional Shareholder Services (ISS). 2007. Board Refreshment Trends at S&P 1500 Firms. January 2017. http://files. constantcontact.com/27d4e85b001/3686b18f-fb2f-4238-bf3ed54acc29047b.pdf 33. Ibid. 34. Sarbanes-Oxley Act (SOX). July 30, 2002. https://www.sec.gov/ about/laws/soa2002.pdf 35. Sarbanes-Oxley Act of 2002. 36. Dodd-Frank Act of 2010. July 21, 2010. Dodd-Frank Wall Street R ­ eform and Consumer Protection Act. HR 4173 Subtitle Section 951.

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37. L. Moyer. February 10, 2012. “Goldman, Morgan Stanley Clarify Clawback Policies,” Wall Street Journal. http://online.wsj.com/ article/SB10001424052970204136404577209383447837986 .html?mod=djem_jiewr_AC_domainid 38. M.P. Miceli, and J.P. Near. February, 1985. “Organizational ­Dissidence: The Case of Whistle-blowing.” Journal of Business Ethics. 39. SOX Section 301. SEC. April 9, 2003. Standards relating to listed company audit committees. Rule No. 33-8220). https://www.sec .gov/rules/final/33-8220.htm 40. SOX 2002. Section 406. 41. Dodd–Frank Act of 2010. 42. Spencer Stuart. 2016. Board Composition and Performance: What Shareholders Want to Know? https://www.spencerstuart.com/~/ media/pdf%20files/research%20and%20insight%20pdfs/ssbi2016-board-composition-and-performance_26jan2017.pdf

Index AT&T, 106 Accountability reporting, 145–146 Ahold, 23, 33, 40, 58 AIG, 95 American Institute of Certified Public Accountants (AICPA), 66–67, 121 American University, 83 AMEX, 49 Anderson, Arthur, 126 Annual Corporate Directors Surveys, 90 Antifraud program and plan, 113–115 Apple, 106 Asia corporate governance, 43–48 family controlled or governmentowned model, 42, 48 in China, 43–45 in Hong Kong, 46–47 in India, 45–46 Japan, 47–48 Asian Crisis, 42 Association of Certified Fraud Examiners, 114 Audit Committee IPO pricing, 162 Auditing issues audit failure, 123–125 audit firm rotation, 129–130 auditor independence, 121–122 auditor liability, 128 auditor working relationship, 128–129 audit partner rotation, 122 concentration of and competition in public accounting firms, 126 confirmation of accounts, 127–128 continuous auditing, 127 engagement letter, 122 integrated audit approach, 125

Auditing Standards Board, 128 Audit quality indicators (AQIs), 123–124 Bank’s corporate governance, risk management, 157–159 Barometer report 2016, 121 Basel Committee on Banking Supervision, 89, 158 BDO, 126 Benefit Corporations (BCs), 139–143 BlackRock, 153 Blue Ribbon Panel, 67 Board of directors, 24–25, 28, 35, 37, 46, 53, 55–57 banks, 158–159 CEO succession planning, 171 communication with investors, 172 compensation schemes, 165, 168–169, 171 corporate culture, 137–140 effective leadership, 164–165 ethical practices, 151 fiduciary duty, 142 NPOs, 81–83 sustainability initiatives, 148–149 Board Effectiveness Rating, 17 Board leadership, 164–165 Brexit, 160–161 Business sustainability, 137, 143–148, 172–173 best practices, 148–149 codes of conduct, 152 CalSTRS, 153 Capital confirmation, 128 Capital markets, 23, 26, 29–31, 33–36, 38, 40, 52, 55, 57–58 Center for Audit Quality and Audit Analytics, 121

178 INDEX

CEO, 4–5, 18, 20, 37, 39–41, 45, 50, 66, 71, 74, 149, 166–167 China Banking Regulatory Commission, 44 China Insurance Regulatory Commission, 44 Assets Supervision and Administration Commission, 44 Shanghai Stock Exchange, 45 China Regulatory Commission, 43 code of corporate governance, 43 Company Law, 44 China Securities Regulatory Commission (CSRC), 43–45 College/university governance, 83–84 Combined Code on Corporate Governance, 33 Commission of European Communities, 41 Committee on Capital Markets Regulation, 97 Committee of Sponsoring Organizations of the Treadway Commission (COSO), 114, 117 Common law, 26 Concentrated ownership, 27–29, 38, 40, 50 Consumer Protection Act in 2010, 36 Convergence in Corporate Governance challenges, 50 compliance practices, 49 enhancement of shareholder value, 49 ICGN’s mission, 52 need for global structure, 48–49 OECD’s role, 52 principles for responsible investment (PRI) practice, 50–51 rules-based versus principles-based approach, 49 significant areas, 51–52 use of technology, 51 Corporate culture, 137–139 Corporate governance agency theory perspective, 2

assurance opinion, 12–14 legal definition, 2 ratings and rating agencies, 14–18 business sustainability, 144–149 challenges, 90–91, 171 communication with investors, 172 disclosures of performance and reporting, 149–150 emerging growth companies (EGCs), 69–72 initial public offering (IPO), 67–69 key performance indicators, 8–10 not-for-profit organizations (NPOs), 63–67 post Brexit, 160–161 profit-with-purpose companies, 143–144 performance evaluation, 1–5 private companies, 63–67, 69, 78 relevance to minority shareholders, 156–157 risk management, 157 role of institutional investors, 153–156 reporting, 5–8 XBRL format, 10–11 Corporate Governance Principles (ISG), 154–156 Corporate Governance Quotient (CGQ) score, 17 Corporate governance reporting (CGR), 1–2, 5–8, 11–12 Corporate governance. See also OECD board of director system, 24–25, 28, 35, 37, 46, 53, 55–57 capital markets, 23, 26, 29–31, 33–36, 38, 40, 52, 55, 57–58 corporate ownership and control, 29 definition, 28 dispersed share ownership and, 27 global trends, 33–34 historical perspectives, 24–27 legal system, 30–32 legal view, 24–25 multinational corporations, 54–57 reforms and best practices, 27–28 role of culture, 30

INDEX 179

sustainability performance, 23, 29, 37, 54 U.S and other countries, comparison, 28–32 Corporate library, 17–18 Corporate ownership, 29 Corporate social responsibility (CSR), 141, 147, 150 Credit Agency Reform Act (CARA), 18 Credit Analysis and Research (CARE), 15 Cross-border regulation, 29, 34, 36, 51–52 C-suite roles, 37 Culture, 30 Delaware General Corporation Law, 140 Deloitte & Touche, 126 Department of Justice, 113 Derivatives speculation, 117 Director issues accountability and liability, 100–101 areas of challenges, 99–100 CEO duality, 100–101 diversity, 104–106 executive compensation, 102–104 succession planning, 106–107 Dispersed ownership, 28, 35, 38, 40, 50 Diversity management, 105–106 DOF Act, 150, 152, 160, 165–167, 169–171 on executive compensation, 71, 102–103 DOF (Dodd-Frank) Wall Street Reform, 36–37, 52–53

Electronic Data-Gathering, Analysis, and Retrieval (EDGAR) system, 10 118–119 Emerging growth companies (EGCs), 161–162 Enhanced business reporting (EBR), 108 Enron, 23, 25, 33, 38, 40, 50, 58, 100, 113, 123, 151 Enterprise risk management (ERM), 117–118 Environmental performance and reporting, 151 Environmental, social, and governance (ESG), 37, 50–51, 140, 143–144, 152 E-proxy, 97 Ernst & Young, 126 Ethics and Accountability Advisory Committee (EAAC), 72–73 Ethics performance and reporting, 151–153 Europe corporate governance, 39–42 network-oriented approach, 41 shareholder rights directive, 40 stock ownerships, 27 European Corporate Governance Forum, 40, 50 European Exchange Rate Mechanism, 41 European Monetary Union, 41 Executive compensation (EC), 98, 102, 165–169 Extensible business reporting language (XBRL), 10–11, 118–119, 127 Extensible markup language (XML), 118

Eastman Kodak, 106 Economic, governance, social, and environmental (EGSS), 140 Economic, governance, social, ethical, and environmental (EGSEE) performance. 146–149 Economic sustainability performance (ESP), 143–144 Electronic confirmation solution, 128

Fair-value measurements, 110–111 Family-owned governance, 162–163 FASB accounting practices improvement, 112 on fair-value measurements, 110–111 financial reporting of private companies, 66–67

180 INDEX

FASB (Continued) on global financial reporting standards, 115–116 on stock options accounting, 108–109 on XBRL format, 118–119 Federal Deposit Insurance Corporation, 118 Federal Financial Institutions Examination Council, 128 Female directors, 90, 104–105 Financial Accounting Foundation (FAF), 67 Financial crisis 2007–2009, 1–2, 25, 36 auditing issues, 121 auditor’s role, 124 audit quality, 129 board of directors’ sustainable performance, 101, 138 corporate governance in the aftermath, 160 erosion of investor confidence, 88 Financial reporting challenges antifraud program and plan, 113–115 enhanced business reporting, 108 enterprise risk management, 117–118 Extensible business reporting language, 118–119 extensible markup language, 118 fair-value measurements, 110–111 financial restatements, 107–108 global standards, 115–116 other postretirement employee benefits, 111–113 pension accounting, 111–113 principles-based versus rulesbased accounting standards, 119–121 stock options accounting, 108–110 use of derivatives speculation, 117 Financial reporting disclosures (CCs), 140, 142 Financial restatements, 107–108 Financial scandals, 5, 9, 17, 87–88, 113, 117, 123, 145, 151, 165, 171 Adelphia, 123

audit failures, 124–125 Enron, 25, 123 Global Crossing, 25, 123 Parmalat, 123 Qwest, 123 Roslyn (New York) schools, 64 Royal Ahold, 123 WorldCom, 25, 123 Financial statement fraud (FSF), 114 Florida State Board of Administration, 153 Future initiatives, corporate governance board composition, 164 board leadership, 164–165 executive compensation, 165–169 whistle-blowing, 169–171 Generally accepted accounting principles (GAAP), 67, 77, 115, 119–120, 130 General Motors, 106 Germany corporate governance, 26 cultural and political differences, 28 two-tier board system, 28 GIC Private Limited, 153 Glass Lewis & Co., 18 Global Board of Directors, 99 Global corporate governance, 89, 91–93 Global Corporate Sustainability Report, 146 Globalization, 23, 33, 51, 58, 87–89, 91 Global Policy Survey, 164 Global Reporting Initiatives (GRIs), 12, 145, 150 Governance Metrics International (GMI), 17–18 Government Accountability Office (GAO), 126 Grant Thornton, 126 Great Recession, 41 Green products, 151 GRI G4 performance indicators, 144 Hybrid corporations (HCs), 140

INDEX 181

IBM, 111 Institute of Supply Management, 145 Institutional Shareholder Services (ISS), 18, 164 Integrated audit approach, 125 Internal control over financial reporting (ICFR), 35, 39, 42, 65, 108 Internal Revenue Service (IRS), 72–75, 77, 79, 109 Form 990, 74–77, 79 International Accounting Standards Board (IASB), 115–116 International Corporate Governance Network (ICGN), 28, 32, 52, 92 International Credit Rating Agency’s (ICRA), 15 International Federation of Accountants (IFAC), 53 International Financial Reporting Standards (IFRS), 10–11 International Monetary Fund (IMF), 89 International Organization of Securities Commission (IOSCO), 48–49, 89, 92 International Organization for Standardization (ISO), 145 International Swimming Hall of Fame, 77 Investment Company Institute, 128 Investor confidence in financial markets, 87–88, 107–108, 113–114, 124 Investor protection, 23, 26, 28, 30–31, 33–34, 48, 52, 57–58 Investor Stewardship Group (ISG), 153–154 IPOs, 161–162 ISO’s 14,000 standards, 151 JOBS Act, 161 Jumpstart Our Business Startups Act (the JOBS Act), 69–71 Key performance indicators (KPIs), 2, 5–6, 8–9, 76, 140, 145, 147–148

King Committee/ King Code, 8 KPMG, 8, 126 Legal System, 30 Levitt, Arthur, 95 Madoff, 113 Mandatory audit firm rotation (MAFR), 129–130 Mergers and Acquisitions (M&A), 162 Miles Group, 3 Moody’s Investment Service, 18 Multinational corporations (MNCs), 54–57 corporate governance challenges and opportunities, 56–57 International Accounting Standard No. 27, 54 parent–subsidiary corporate governance, 56 Multiple bottom lines (MBL), 145–146 NASDAQ, 49 National Association of Corporate Directors (NACD), 99 National Association of State Boards of Accountancy (NASBA), 67 Nationally Recognized Statistical Rating Organizations (NRSROs), 18 Nelson, Clifford C., 24 Nextel, 111 Non-shareholding stakeholders, 137 Not-for-profit organizations (NPOs), 29 audit committee charter, 81 board committees, 81–83 corporate governance, 63–67, 72–77 internal mechanisms and control, 79–81, 83 major documents, 74–75 purpose, 72 regulatory reforms, 77–79 NYSE, 49 Off-balance sheet financing, 107 Olympus, 113

182 INDEX

Organization for Economic Co-operation and Development (OECD), 28, 32, 52, 59, 89, 92 Other post-retirement employee benefits (OPEB), 112–113 Parmalat, 23, 33, 38, 40, 50, 58 PCAOB on auditor’s clauses, 121, 128 Audit Practice Alert, 110 audits of EGCs, 70 on company finances, 108 Concept Release (CR), 123 on stock options accounting, 108–110 on XBRL format, 118–119 Pension accounting, 111–113 Pittsburgh Brewing, 111 Post–Global Financial Crisis, 33, 53–54 Principle-based approach, 25 Principles-based versus rules-based accounting standards, 119–121 Principles for responsible investment (PRI), 50 Principles of sustainability and social responsibility, 145 Private companies corporate governance, 63–67, 69, 78 Proxy votes, 97 Purpose-driven disclosure, 142 PwC, 126–127 Race-to-optimality, 88 Ratings Professional, 12 Regulatory reforms, fundamental concepts, 88 Related-party transactions (RPTs), 156, 162 Risk Management (RM) process, 70 RiskMetrics, 17 Risk Opinion, 12 Rock Center for Corporate Governance, 99 at Stanford University, 3

Royal Bank of Canada Global Asset Management, 153 Russell 3000 index, 103 Sarbanes-Oxley Act (SOX), 150, 152, 165–167, 169–171 on auditor independence, 121 on executive compensation, 102 global corporate governance, 89–90 NPOs provisions, 77–78 private company reforms, 64–66, 69 Satyam, 23, 58, 113 Schumer, Chuck, 126 Securities and Exchange Commission (SEC) on auditor independence, 121 creation of limited liability provisions, 24 on executive compensation, 102, 165–167, 169 on global corporate governance, 89–90 investor protection, 26 on IPO prospectus, 67–69 on proxy statements, 97 on shareholder nomination process, 94–95 on stock options accounting, 108–110 Systems Compliance and Integrity (SCI), 95 whistle-blower programs, 170 on XBRL format, 118–119 Securities Exchange Act of 1934, 18 Shareholders as corporate governance participants, 1–3, 6–9, 15, 18–19 issues nomination process, 94–95 proxy statements, 97–98 resolutions, 98–99 voting system, 96–97 theory, 140, 142 value creation, 27–31, 53 Shenzhen Stock Exchange, 45

INDEX 183

Socially responsible investors (SRIs), 142, 148 SOX regulatory reforms, 35–36 role in corporate governance effectiveness, 25 Spencer Stuart Board Index, 101 Sprint, 111 Stakeholder-driven approach, 25 Stakeholder model audit committee, 171 benefit corporations (BCs), 139–142 board’s accountability, 155 board’s communication with investors, 172 code of conduct, 152 corporate accountability, 146 CSR programs, 150 family-owned businesses, 163 shared value creation, 137, 139, 143–144, 148–149, 172 sustainability performance, 147 transparency of banks, 160 Standard & Poor’s, 18, 107 Statement of Financial Accounting Standards (SFAS), 108–109 State Street Global Advisors, 153 Stock Exchange of Hong Kong, 46 Appendix of the Main Board Listing Rules, 46 Code on Corporate Governance Practices, 46–47 Companies Ordinance, 47 Corporate Governance Report (CGR), 46 Growth Enterprise Market Listing Rules, 46 Main Board Listing Rules, 46–47 Securities and Futures Commission (SFC), 46 Stock options accounting, 108–110 Sustainability performance, 140, 143–149 classification, 147

Tax-dodging schemes, 109 Technological advances, 26, 33, 35, 51, 87–88 Texas Southern University, 83 TIAA Investments, 153 T. Rowe Price Associates, Inc., 153 2013 Companies Act in India, 45 corporate social responsibility (CSR) committee, 45 Securities and Exchange Board of India, 46 UK Cadbury code 1990, 39, 49 combined code, 40, 42, 49 corporate governance, 27, 38–39 UN Financial Initiative, 50 UN Global Compact, 50 United Airlines, 111 United Nations Global Compact, 146 United Nations (UN) SecretaryGeneral, 50 United States board of director system, 28 corporate governance, 34–38 ownership of shares, 27 shareholder value creation, 28 Unrelated business income (UBI), 72 US GAAP taxonomies, 11 U.S. Stewardship and Governance, 154 ValueAct Capital, 153 Vanguard, 153 Verizon, 111 Voluntary disclosures, 142–143 Walt Disney, 100 Whistle-blower programs, 78 WICI, 11 World Bank, 89 WorldCom, 23, 25, 33, 38, 40, 50, 58, 100, 113, 123, 151 World Federation of Exchanges, 49, 92 XBRL, 127

OTHER TITLES IN OUR FINANCIAL ACCOUNTING AND AUDITING COLLECTION Mark Bettner, Bucknell University and Michael Coyne, Fairfield University, Editors • Accounting for Fun and Profit: A Guide to Understanding Financial Statements by Lawrence Weiss • Audit Committee Formation in the Aftermath of 2007-2009 Global Financial Crisis, Volume I: Structure and Roles by Zabihollah Rezaee • Audit Committee Formation in the Aftermath of 2007-2009 Global Financial Crisis, Volume II: Responsibilities and Sustainability by Zabihollah Rezaee • Audit Committee Formation in the Aftermath of the 2007-2009 Global Financial Crisis, Volume III: Emerging Issues by Zabihollah Rezaee • Accounting for Fun and Profit: A Guide to Understanding Advanced Topics in Accounting by Lawrence A. Weiss • Accounting History and the Rise of Civilization, Volume I by Gary Giroux • Accounting History and the Rise of Civilization, Volume II by Gary Giroux • A Refresher in Financial Accounting by Faisal Sheikh • Accounting Fraud, Second Edition: Maneuvering and Manipulation, Past and Present by Gary Giroux

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Emerging Issues in Corporate Governance Zabihollah Rezaee

Corporate governance has evolved as a central issue for public companies in the aftermath of the 2007–2009 global financial crisis. Corporate governance is a process (journey) of managing corporate affairs to create shareholder value and protect interests of other stakeholders. This book presents a road map for various functions and measures of corporate governance. The participants in the corporate governance process are the board of directors, executives, stakeholders, internal and external auditors, financial analysts, legal counsel, and regulators. This book is organized into four separate volumes; each volume can be utilized separately or in an integrated form. The first volume consists of five chapters that address the relevance and importance of corporate governance as well as the framework and structure of corporate governance. The second volume consists of four chapters that present the three prevailing corporate governance functions of oversight, management, and monitoring. The third volume consists of four chapters that address corporate governance functions performed by corporate gatekeepers, including policy makers, regulators, standard-setters, internal auditors, external auditors, legal counsel, and financial advisors. The fourth volume consists of five chapters that address the emerging issues in corporate governance, including governance for private companies and nonprofit organizations and convergence in global corporate governance. Zabihollah (Zabi) Rezaee is the Thompson-Hill Chair of Excellence, PhD coordinator, and professor of accountancy at the University of Memphis. He received his BS degree in Iran, his MBA from Tarleton State University in Texas, and his PhD from the University of Mississippi. Dr. Rezaee holds 10 certifications including CPA and has published over 220 articles, made more than 225 presentations, and contributed to 12 book chapters. He has published 10 books including two recent books on corporate sustainability. His most recent book on audit committee effectiveness was published in three volumes by Business Expert Press in July 2016.

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CORPORATE GOVERNANCE IN THE AFTERMATH OF THE GLOBAL FINANCIAL CRISIS, VOLUME IV

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