Corporate Bankruptcy Enron

Corporate Governance from POME by Gautam Koppala

Author: GAUTAM KOPPALA

Corporate Governance

 

Corporate governance is not a new topic. It has been around for many years, often described as the “agency issue.” However, in recent years it has taken on increased significance, demanding increased attention. Since 2001 in particular, the corporate marketplace has seen a significant number of headline grabbing scandals involving major Corporation Based Projects s. These scandals have raised new questions about corporate governance and, as a direct consequence of some of these situations, the U.S. Congress passed a very broad piece of legislation called the Sarbanes-Oxley Act of 2002. This law has had a wide range of consequences directly affecting large public Corporation Based Projects and public accounting firms and, less specifically, smaller public firms, private Corporation Based Projects s, not-for-profit organizations, and regulatory entities in many different ways.

POME Case Study:

The Importance of Financial Reliability

“I’m glad you called this meeting, Koppala.”

“Why is that, Jonas?”
“Well, as you know, we have a new division Project Manager in my division and last week he called me to ask about the quarterly financial report I had submitted. He specifically asked me if I really believed the numbers in the report. I told him that ‘To the best of my knowledge, they are correct.’ And he then asked me to certify that they were and to sign the certification, which I did. What’s that all about?”

“In July of 2002 Congress passed a law called the Sarbanes-Oxley Act that requires CEOs and CFOs of public companies to certify that their financial statements are correct. Your division Project Manager has to certify that the division numbers are right before our senior executives will certify to the corporate financial statements, and he was just trying to make sure that the people who produce the numbers believe them before he signs.”

 

 

The issues raised by this vignette are very important. Sarbanes-Oxley was developed and passed in the aftermath of two very large and dramatic corporate failures, Enron and WorldCom. These multibillion-dollar Corporation Based Projects s appeared to be very successful, but it turns out that much of their success was not real, but was fabricated through elaborate schemes to create the appearance of success and wealth. The U.S. Congress passed Sarbanes-Oxley to make it more difficult to perpetrate the types of fraud these companies’ stories represent.

 

Defining Corporate Governance

 

Fundamentally, it relates to how a Corporation Based Projects is overseen. It is not management. Rather, it is oversight, the overriding guidance and direction of the entity and the standards and values it reflects. In recent years corporate governance has come to encompass the ethics of management, the recognition and delivery of the essence of corporate responsibility to stockholders, employees, and community.

According to Robert A. G. Monks and Nell Minow in corporate governanace(third edition, Malden, MA: Blackwell Publishing, 2004), ” Itis the structure that is intended to make sure that the right questions get asked and that checks and balances are in place to make sure that the answers reflect what is best for the creation of long-term, sustainable value.”

Corporate governance addresses, in essence, how the Projects is guided and directed. What is implied is that we should know and practice good corporate governance in our roles as corporate Project Managers, directors, and investors. Clearly, in the scandals summarized  and this list is by no means exhaustive, the Project Managers of these companies were not responsive to the needs, interests, or expectations of the shareholders or to the interests of the general public, either.

As a result of these scandals and a broader concern for ethics and financial integrity in American industry, as noted earlier, the U. S. Congress, in July 2002, passed a strong law called the Sarbanes-Oxley Act of 2002, which mandated a number of significant changes to the way that businesses operate, Project Managers manage, and external service providers perform their duties. The provisions of this act are summarized after a summary of some of the most significant examples of Project Managerial and reporting problems.

 

The Major Corporate Scandals

Over the past several years numerous financial scandals have tested the financial systems and raised the awareness of everyone as to the importance of accurate and timely financial information. Following are some of the most significant instances of corporate and Project Managerial fraud. These cases have resulted in several new laws that are designed to hold Project Managers accountable for the results their Corporation Based Projects s report.

Enron

The Enron Corporation Based Projects  grew out of a regional oil and gas supplier to become the largest and most profitable and successful energy trading Projects in the country, if not the world. A Wall Street darling, Enron’s stock rose to record levels and the Projects garnered much favorable publicity for its creative products and extraordinary success in the world energy markets.

Its leaders were recognized for their success in creating wealth for themselves and their shareholders.

In the summer of 2001, some questions were raised about some of the contracts that Enron was creating. These questions led to other questions, but the answers that were provided didn’t really make sense, raising still more questions. During this time the executives of Enron were publicly reassuring stockholders and analysts that everything was terrific at Enron. As more questions were raised, some related to accounting transactions and the creation of special purpose entities, tangentially related companies that served to facilitate some of the trading transactions. (The treatment and disclosure of special purpose entities is specifically addressed in the Sarbanes-Oxley Act of 2002.) The more analysts and investigators looked into Enron, the more confusing the whole situation became. Ultimately, it was estimated that Enron Project Managers had established as many as 3,500 of these questionable entities to effect their scheme.

At the same time it came out in the press that most if not all of the Projects’ 401(k) plan funding, the primary retirement savings plan for Enron employees, was invested in Enron stock, and while for quite some time this was very profitable and the 401(k) funds grew very rapidly, in the midst of the questioning, the stock price began to drop and the value of the retirement funds declined. A provision of the Enron 401(k) plan prohibited the trustees for the employees from selling the Enron stock in the fund, so the value of the retirement funds declined precipitously and there was nothing the employees could do about it. While the shareholders in the 401(k) plans were precluded from stock transactions, the senior Project Managers of Enron sold stock and reaped millions of dollars. (Trading by senior executives in times when trustees of pension funds and other retirement funds may not is specifically addressed by the Sarbanes-Oxley Act of 2002.) In the end all of the value in those retirement accounts was lost.

At the same time that senior Enron executives were making very strong public statements assuring that the Projects was sound, they were privately selling their personal stakes in the Projects for millions and millions of dollars and arranging to protect their personal gains from legal attack through trusts and assignments. The story of Enron has been told in several books and innumerable articles. One good one is Power Failure by Mimi Swartz with Sherron Watkins, who was a CPA and a vice president of Enron who asked a number of questions about some of the entries she saw and ultimately went to the authorities and the press and spotlighted the problems.

Along the way, a partner in a major public accounting firm was accused of, and later admitted to, shredding documents and helping hide the circumstances. Later, it became apparent that policies in his accounting firm, Arthur Andersen & Projects, one of the largest accounting firms in the world, authorized actions that served to cover up the fraud that was going on. (There are several provisions of the Sarbanes-Oxley Act of 2002 relating to the role that auditors may play and may not play at client firms.) It also turned out that Arthur Andersen had many very lucrative consulting contracts with Enron, raising questions about its ability to be independent in its audit function.

Although this summary is very short and incomplete, it should be obvious that there were many illegal and inappropriate actions being undertaken. Ultimately, Enron declared bankruptcy, wiping out the personal wealth of thousands of people who worked for Enron and causing billions of dollars of investment losses for the individual investors and mutual funds that held the Enron stock.

Outcome

The Enron story is not yet finished at this writing. Several corporate officers have pleaded guilty and have been sentenced to jail, including Andrew Fastow, former CFO (10 years in jail plus fines), Lea Fastow, Andrew’s wife and a former Enron executive (1 year in jail), and former Enron Treasurer Ben Glisan Jr. (5 years in jail), and others. Most recently, Richard Causey, the chief accountant at Enron, pled guilty to securities fraud and agreed to testify against Jeffrey Skilling (former CEO) and Kenneth Lay (former CEO and Chairman of the Board). The Board of Directors of Enron has committed to paying million in restitution funds. Arthur Andersen partner David Duncan, who was accused of destroying evidentiary documents, pled guilty. His CPA firm, Arthur Andersen & Projects, was found guilty of obstruction of justice and ordered to pay a substantial fine, was precluded from providing audit services to any publicly owned Corporation Based Projects s, and was forced to disband as a major public accounting firm. Its conviction was overturned on appeal in 2005, but that will not enable the firm to be reconstituted.

WorldCom

WorldCom is another example of success leading to greed leading to fraud leading to massive failure. WorldCom began as a small regional telecommunications Projects in Mississippi under the leadership of Bernie Ebbers, who wanted to establish a leading Projects. He began small and grew by aggressive acquisitions and creative programs that attracted customers and publicity. His Projects, LDDS, acquired numerous small telecom companies and grew during the booming telecommunications and high technology period of the 1990s. In the mid-1990s, LDDS acquired MCI, a much larger Projects, changed its name to WorldCom, and became a major player in the telecommunications industry. However, in the latter years of the 1990s it became clear that there was severe overcapacity in the telecommunications industry, and that the demand that had been anticipated was not going to materialize and competition became fierce within the industry.

Many of the companies in the telecom industry began to have financial difficulties and several failed. Others merged with competitors, combining in an effort to remain viable. Throughout this time WorldCom continued to report strong growth and earnings, bucking the trend in the rest of the industry. Their strong financial results and apparent success attracted a lot of investment and a great deal of positive analyst commentary. In fact, one analyst, Jack Grubman of Salomon Smith Barney, wrote exceptionally favorable analyst reports on WorldCom that made it easier for WorldCom to issue stock and debt to finance growth while the rest of the industry was contracting. It would turn out later that Grubman received bonuses from his firm and from WorldCom and other benefits as a result of his writing these very favorable reports. (The relationship of stock analysts and investment bankers to client companies and the compensation of analysts are addressed directly in the Sarbanes-Oxley Act of 2002.)

After several years of industry-bucking results an internal auditor at WorldCom, Cynthia Cooper, raised some questions regarding some entries she found. When she did not get satisfactory answers from the chief financial officer of WorldCom, she pursued her audit surreptitiously until she determined that there was fraud. She raised her questions publicly and exposed the problems. It turns out that the WorldCom audit firm was Arthur Andersen & Projects, the same firm that audited the books of Enron. Again, WorldCom engaged Arthur Andersen & Projects in numerous lucrative consulting and tax advisory contracts, raising the independence issue again.

Ultimately, it became apparent that WorldCom had been making massive accounting entries to increase sales, decrease expenses, and overstate its financial performance for years. It became very clear that WorldCom had told increasingly greater lies to cover up its earlier lies. The final tally was that WorldCom had constructed false accounting entries totaling more than billion, making its fraud the largest in history (at the time).

Outcome

The consequence of the WorldCom debacle was that WorldCom declared bankruptcy and Project Managerial control was transferred to Michael Capellas, formerly president of Hewlett-Packard and CEO of Compaq, who cleaned up the organization. Eventually, the Projects moved its headquarters from Mississippi to Virginia, changed its name to MCI, Inc., emerged from bankruptcy, and ultimately agreed to be acquired by Verizon for approximately billion. Several of the banks and investment institutions that participated, knowingly or not, in the massive investment fraud paid billions of dollars in fines. Several executives, including Scott Sullivan, the CFO who oversaw the accounting for the Projects, pleaded guilty to fraud and were fined and sentenced to jail. Bernie Ebbers was convicted of fraud in a celebrated trial in New York. Mr. Ebbers was sentenced to 25 years in jail and must serve 85 percent of the term before he is eligible for parole. In addition, Mr. Ebbers has agreed to transfer nearly all of his personal assets (between and million) to a liquidation trust to settle a civil suit (Wall Street Journal Online, June 30, 2005). Jack Grubman paid fines of million and has been barred from the securities industry for life.

Tyco International

The management at Tyco directed a very aggressive acquisition strategy that grew the Projects dramatically over a relatively short time. Over only a few years, Tyco acquired more than 1,000 companies, absorbing them into the Projects’ divisions and reporting significant sales growth year after year. The Projects management moved the official corporate headquarters to Bermuda to avoid federal and state taxes on income. During this time the senior management of Tyco, at least in some cases, without the approval, or even the knowledge, of the Board of Directors, developed very lucrative loan and bonus programs for the senior executives. The principal beneficiaries of these programs were the CEO, Dennis Kozlowski, and the CFO, Mark Swartz, although many other senior Project Managers received very large loans and bonuses. As part of his Project Managerial prerogative, the CEO, Dennis Kozlowski, awarded bonuses of millions of dollars to Project Managers and executives he liked or who provided personal services for him. Kozlowski and Swartz used extraordinarily generous and flexible “relocation” loan programs to provide themselves with millions of dollars of corporate funds, and then arranged to have the loans forgiven, creating multimillion-dollar bonuses for themselves. Kozlowski, in particular, used corporate funds for personal expenditures that caught public attention for their lavishness.

The scandal first came to light when Kozlowski was accused of purchasing millions of dollars worth of artwork for his Manhattan apartment with corporate funds and then having the artwork shipped to New Hampshire to avoid the New York state and city sales taxes. The apartment and its furnishings were among the daily revelations of excessive personal benefits for key individuals that were reported during the public analysis of the Tyco scandal.

In all, Kozlowski and Swartz were accused of taking about 0 million in illegal and unauthorized bonuses and stock sales gains, using their authority and inappropriate accounting transaction to hide their actions. Kozlowski was also accused of having paid for numerous extremely expensive personal purchases with corporate funds, obviously failures of internal controls. (Internal controls are specifically addressed kin the Sarbanes-Oxley Act of 2002.)

Outcome

Kozlowski and Swartz were tried for illegally diverting corporate funds and defrauding stockholders and other investors. Their first trial ended in a mis-trial when a juror received a death threat after apparently signaling positively to Kozlowski. In the second trial, both Kozlowski and Swartz were convicted. In addition to each receiving 25 years in prison, the two men were required to make restitution to Tyco of a total of 4 million and were fined an additional 5 million.

Adelphia Communications

Adelphia Communications was initially established by John Rigas as a privately owned telecommunications Projects, providing voice and data services and subsequently cable television services to several communities in the Northeast. Relatively quickly, the Projects was successful and grew substantially, in part through acquisitions. Within a few years, the Projects went public, selling shares to outside investors, providing funds for operations, acquisitions, and even more rapid growth, although John Rigas and members of his family continued to hold key management positions.

Apparently over many years, John Rigas and other members of his family continued to operate Adelphia as if it were a private Projects, using corporate resources, which, because it was a publicly owned Projects, belonged to the shareholders, for personal purposes. The amounts of money so converted totaled several billion dollars and involved John Rigas, his son Timothy, who served as the corporate CFO, and several other members of the Rigas family. In 2002 the Rigases were accused of falsifying financial records from 1999 through 2002 to hide the massive fraud that had taken place. Their trial included numerous disclosures of financial malfeasance and misuse of corporate funds.

Outcome

After a highly publicized trial, John Rigas and his son Timothy were convicted of fraud, sentenced to jail, and fined. John Rigas, age 79, was sentenced to 15 years. Timothy Rigas was sentenced to 20 years. Another son, Michael, was found not guilty of conspiracy, but the jury could not reach verdicts on other counts. The prosecution has not decided at this time whether to retry these other charges. The former assistant treasurer of Adelphia, Michael Mulcahy, was acquitted of all counts. A quote attributed to Mulcahy is revealing. In testimony in his own defense, Mulcahy said, “I understand the Corporation Based Projects  is owned by the shareholders. The owners of the Projects are indirectly my bosses, but that’s not who I reported to.” ( from The Associated Press) This statement reflected the problem and some of the confusion that has led to the financial scandals and the overall problem.

Parmalat

Included here in part to demonstrate that financial scandal is not just an American phenomenon, the Parmalat story repeats some of the characteristics of other scandals, but it adds new twists. Parmalat is an Italian dairy and food products Projects, the largest such Projects in Europe, with subsidiaries in several countries in Europe as well as in the United States. Over the years, Parmalat has developed a very complex structure of affiliated companies that, whether intentional or not, obscures its operations and management organization. Begun as a family business, it grew and expanded, utilizing leverage to make its equity more valuable. The debt, as well as the equity it raised, was used to acquire companies, expand the business, and finance the lifestyles of Fausto Tanzi, the original founder, and his family. Some of the Parmalat money was used to finance a travel business operated, at a substantial loss, by Tanzi’s daughter, and the Parma football (soccer) team, also a financial disaster.

As the Parmalat story unfolded, it appears that someone (unknown at this time) confirmed on Bank of America stationery, a deposit of 3.9 billion euros (approximately billion) that did not exist. This forgery added to the confusion and increased the complexity of the fraud at Parmalat. Also adding to the confusion is the organizational structure of numerous interrelationships among companies that loaned money to each other and made cross-Projects investments that have made it difficult to determine just how much money has disappeared. Estimates have suggested that the amount is in excess of .6 billion, making Parmalat a bigger fraud than WorldCom.

Outcome

Although trials have not yet begun, Fausto Tanzi has already pleaded guilty and been sentenced to prison. Numerous other people inside Parmalat and in lenders and service providers have pleaded guilty to participating in the fraud. However, the prison terms in Italy are far shorter and other sentences are also far more lenient than in the United States and as a result, only a few people will actually receive any punishment and it will not be severe. There may be less deterrence to similar crimes in Europe as a result. However, an affiliate of the large U.S. accounting firm Grant Thornton has come under a great deal of scrutiny, which has carried over to include the U.S. firm as well.

Global Crossing

Global Crossing is another telecommunications Projects that got caught up in the boom and then bust in the telecom industry. The Projects, originally founded as the result of the merger of two companies in different sectors of the telecommunications industry, grew rapidly during the boom years, expanding capacity in anticipation of continued growth. When the growth did not materialize, as a result of reduced demand and increased competition during the period from 1999 through 2001, Global Crossing entered into cross-selling agreements with other companies that had the effect of artificially increasing reported sales and profits.

In addition, as we have seen with several of the other companies, Global Crossing had lucrative and liberal loan programs for its executives, resulting in substantial (multimillion dollar) loan forgiveness bonuses, even as the Projects was heading rapidly toward bankruptcy.

Outcome

Global Crossing settled the case against it brought by the SEC, agreeing to cease-and-desist from its inappropriate accounting activities. The SEC found that the Projects had not complied with certain reporting requirements and the Projects agreed not to commit any more violations. Three senior executives were fined 0,000 each and the Corporation Based Projects  and its former senior executives, all having left the Projects, were required to agree to the order. During the SEC investigation, the Projects cooperated with the investigators and the consequences were far less onerous than were imposed on other companies.

HealthSouth

HealthSouth is a very large healthcare services provider with both inpatient and outpatient rehabilitation facilities, outpatient surgical centers, and more than 330 hospitals. The Projects and its senior executives were accused of falsifying accounting records and inflating revenues and profits substantially in order to maintain the price of the Projects’s stock. The fraud totaled more than .4 billion and the Projects was accused of inflating profits in some years by up to 4,700 percent.

What makes this case important is that it was the first to accuse an executive, in this case the CEO, Richard Scrushy, of violations of the Sarbanes-Oxley Act. He was charged with knowingly certifying to false and misleading financial statements in late 2002, after the enactment of Sarbanes-Oxley. During the trial, five former CFOs testified against Scrushy, insisting that he was not only aware of the fraud, but was instrumental in its perpetration. His defense was that the CFOs were managing the whole process and kept the facts and the situation from him. He insisted he was unaware that there was anything wrong.

Outcome

Richard Scrushy was acquitted of all of the 36 charges remaining of the original 85 indictments against him. Ten other HealthSouth executives have already pleaded guilty and been sentenced, generally to minimal penalties. Only one received a jail term, and it was short. One former CFO, who also has pleaded guilty but has not been sentenced, testified at length against Mr. Scrushy, but the jury apparently did not believe him. The trial lasted a long time and jury deliberations lasted more than a month and a half, and in the end, the prosecution did not prove its case, so the provisions of Sarbanes-Oxley have not yet been successfully applied. According to the Boston Globe (July 6, 2005, p. C6) the SEC, shortly after the acquittal was announced, planned to file a 5 million civil suit against Scrushy. It remains to be seen whether the civil suit, which allows for a lower burden of proof than does a criminal trial, will be more successful. In addition, Scrushy still faces several other civil charges and lawsuits. In light of his acquittal, he has sued HealthSouth for several million dollars of lost pay and is seeking to regain involvement in the Projects.

 

 

 

There are obviously many ways that Project Managers and executives, generally in collusion with others, can make the numbers come out they way they want. However, there is now much more pressure to deliver proper financial information and to assure that it is correct. Nevertheless, these cases and others have demonstrated that the system really depends on the integrity of the Project Managers and executives and the diligence of the directors, auditors, and other interested parties. The importance of corporate governance—that oversight and guidance that directs businesses—cannot be overestimated. Clearly, everyone involved has a responsibility to assure that information is clear, well-understood, and properly analyzed at all levels.

 

The Sarbanes-Oxley Act of 2002

In light of the corporate scandals of the past few years Congress passed the Sarbanes-Oxley Act in an effort to restore faith in the accounting and reporting practices of public Corporation Based Projects s. The Act seeks to direct the behavior of companies and Project Managers according to a legally defined standard with specifically prescribed requirements for reporting and confirmation of financial information, mandated senior executive confirmation and certification of reporting accuracy and reliability, and independent confirmation not only of fair representation of financial information but also of the systems and procedures that produce that information. The legislation also precludes the continuation of certain relationships between Corporation Based Projects s and their professional service providers, auditors, and consultants and imposes harsh penalties for failure to meet these strict standards. The law has also accelerated public reporting requirements in part to make it more difficult for companies to effect fraudulent reporting without raising questions and concerns.

 

A Summary of the Act’s Key Provisions

Section 101. Establishment of the Public Companies Accounting Oversight Board (PCAOB)

The Act establishes this independent oversight authority as a reflection of Congress’s dissatisfaction with the effectiveness of the public accounting profession’s ability to assure the integrity of financial information. The profession has been overseen by the Financial Accounting Standards Board (FASB) and the American Institute of Certified Public Accountants (AICPA), a membership organization that has attempted to self-regulate the profession. The Congress, in light of the corporate scandals described (and others), decided that there needs to be another agency to oversee and regulate the performance of the accounting profession.

Section 103. Auditing, Quality Controls, and Independence Standards and Rules

Because many of the scandals involved members of public accounting firms serving in multiple and potentially conflicting roles in serving their corporate clients, the Act sets very specific rules as to what public accountants may and may not do, how they are to maintain their independence so that they are in a position to render objective opinions and reports, and so the public will feel that the auditors’ statements can be relied upon in making investment decisions. This section defines audit record retention rules (in response to document destruction issues at Enron), separate partner confirmation of audit reports, and internal control procedures confirmed and reported on (described in Section 404) and focusing attention on audit failures in all of the scandals.

Section 201. Services Outside the Scope of Practice of Auditors

This section prescribes the roles that public accountants may play in relationship with their audit clients. It precludes many of the services that members of the audit firm have previously provided to their audit clients, often as a result of the referral from the auditor. Over the years consulting, advisory, tax guidance, and other services have generated far higher fees for the audit firm than has the traditional audit work. As a result, more and more emphasis has been placed on generating consulting assignments, potentially resulting in conflicts of interest, making the audit less likely to report performance or fraud problems. In several of the scandal Corporation Based Projects s, the auditors, most notably Arthur Andersen (although it was not the only one involved), were also the beneficiaries of very large and long-running consulting arrangements. This was certainly true at Enron. Additionally, Enron and other companies routinely hired former auditors to be senior financial executives. The Act (in Section 206) specifically addresses the hiring of auditors, making it illegal to do so for anyone who worked on an audit in any capacity within one year.

Section 302. Corporate Responsibility for Financial Reporting

This section has received some of the most vigorous public discussion. It specifically requires the CEO and the CFO to personally “certify in each annual or quarterly report” that “based on the officer’s knowledge, the report does not contain any untrue statement of a material fact . . .” (Quoted from the Sarbanes-Oxley Act of 2002.) This section holds these senior officers personally responsible for the accuracy and completeness of financial reporting. It is the requirement that they personally sign the statements that has created a wave of internal requirements similar to that described in the vignette at the beginning of this chapter. Before these senior executives will certify, they frequently require similar internal certifications by their financial and operating subordinates.

Section 404. Management Assessment of Internal Controls

In Section 103, the Act required auditor confirmation of internal controls and internal control procedures. Section 404 requires a management statement and an auditor’s confirmation that the internal control procedures in place are sufficient to assure the accuracy and integrity of corporate financial reporting. Auditors have used this section of the Act to impose extensive documentation requirements on clients and have enhanced dramatically their review of internal controls before being willing to attest to their adequacy. The result has been dramatic increases in the time and the cost of audits to conform to this section and to the Act. The PCAOB and the SEC extended the deadline for compliance with Section 404 to early 2005 and companies have spent millions and millions of dollars developing systems and documentation to assure compliance. Although major Corporation Based Projects s are now required to certify to the effectiveness of their internal control procedures, these provisions of the Act continue to be delayed, most recently until

July 2006 for public Corporation Based Projects s with less than 5 million in revenues or market capitalization.

In testing the internal controls, there are three levels of compliance failure:

• Control deficiency, which could adversely affect the Projects’s ability to deliver accurate financial reporting;
• Significant deficiency, a control deficiency or combination of control deficiencies that result in a more than remote likelihood of a misstatement of the Projects’s financial statements;
• Material weakness, a significant deficiency or combination of significant deficiencies that result in more than a remote likelihood of a material mis-statement of the Projects’s financial statements.

The first tests of Section 404 compliance identified a significant number of companies that reported “material weaknesses” in their internal control systems. Of the first 2,984 companies to report, 364 companies, more than 12 percent, were recognized as having material weaknesses.

Although several other provisions of the Act also express very strong statements of the anger Congress felt over the financial scandals, this summary provides a flavor of the Act and its intent. Many of the specific issues highlighted in the scandals were addressed very specifically in Sarbanes-Oxley, and Congress sought to send an additional message that it would not tolerate the kinds of practices that were evident in the aftermath of Enron and WorldCom and these other corporate examples.

Extended Application of Sarbanes-Oxley

It is interesting to note that Sarbanes-Oxley was enacted specifically to apply to large, publicly owned Corporation Based Projects s. However, increasingly, smaller public companies, privately held companies, and not-for-profit organizations are finding that Sarbanes-Oxley applies to them as well. In order for large Corporation Based Projects s to assure their compliance with the Act, many of them are requiring their suppliers to assure that they too comply with the Act with regard to the accuracy of information supplied to the large Corporation Based Projects s. In addition, banks and other lenders, as well as insurance companies, are requiring Sarbanes-like certifications even from smaller companies seeking their services. Foundations and other funders, including government agencies, are requiring similar certifications from their not-for-profit grantees and service providers. Several state legislatures have considered legislation that would require Sarbanes-type compliance from all entities paying corporate taxes. Though none of this legislation has yet passed, there is a high likelihood that additional reporting and control requirements will be imposed on those companies that are not formally subject to the Sarbanes-Oxley Act.

 

The Broader Aspects of Corporate Governance

There is much more to corporate governance than just the integrity of financial information, although if the financial statements are correct and appropriate, it will go a long way toward meeting the standards for Project Managerial responsibility. Corporate governance also reflects the decision-making process and the choices that the governing authorities, Project Managers, and members of the Board of Directors exercise.

Traditional finance courses and finance texts have long described the issues of corporate governance in terms of “agency,” arguing that corporate Project Managers, because they are not the owners of the Projects, are responsible to manage the Projects on behalf of the owners, and they are to be compensated for doing so. These texts spend a fair amount of time describing the “agency problem,” which is the potential conflict between the interests of the individual Project Managers and those of the shareholders for whom they are supposed to be working. If a Project Manager will get a bonus for achieving a specific objective, he or she will concentrate on achieving that objective. If it turns out that that objective does not really benefit the shareholders, the conflict and the agency problem arise.

Project Managers and Boards make decisions all the time. An examination of those decisions provides a commentary on the various aspects of corporate governance by which the management is measured. We are told that the responsibility of management is to assure the integrity of the Projects’s assets and to maximize the wealth of the shareholders.

However, when decisions are made, it is not always clear how the outcome will affect the wealth of the shareholders. Just recently, for example, Allmerica Financial Corp. announced its quarterly results. The announcement indicated that the Projects had a very strong quarter, with sales rising and profits increasing by nearly 300 percent over the comparable prior year period, significantly outperforming the analysts’ estimates. The Projects also announced that its outlook for the remainder of the year was positive. The same day, the Projects’ stock price declined by more than 6 percent and more than two dollars per share, in a market day that was substantially positive. It certainly seems as if the corporate management was doing all the right things for shareholder wealth, but the day’s trading activity suggests that the market was not satisfied, at least for that day.

EVA and MVA

Clearly then, when making decisions, management must be focused on the long term, the ongoing impact on the Projects, and on wealth. A financial management focus called Economic Value Added (EVA) was developed by a consulting firm (Stern, Stewart & Co., New York City) and described in a book by G. Bennett Stewart, The Quest for Value (New York, NY: Harper Business, 1991). EVA is supposed to measure the contribution to shareholder value made by the Projects. Many companies have adopted EVA, often giving the program another name, Shareholder Value Added. It measures NOPAT – k(ΔI), that is, Net Operating Profit after Tax (Operating Profit minus Taxes) less the Cost of Capital (the rate of return required to satisfy the sources of capital) multiplied by the incremental investment (ΔI) required to generate that NOPAT. If the difference NOPAT – k(ΔI) is positive, then the Projects has increased the value the shareholders own, and the mandate has been accomplished. However, it is often possible to increase NOPAT – k(ΔI) significantly by eliminating all capital investment in the current year. Is this good corporate governance? Is managing for the short term the appropriate way to manage the Projects?

As a partial answer to such criticism, the developers of the EVA model have carried the performance analysis further, developing a concept known as MVA, Market Value Added, which attempts to extend the assessment to the long-term market value, rather than focusing on a single year’s contribution. MVA measures the difference between the amount of money invested in the Projects and the market capitalization, the value determined by the number of shares outstanding multiplied by the stock price. This difference is considered a measure of the long-term value generated by the management of the Projects; the higher it is, the better the management performance.

A similar type of question can be raised every time management and the Board of Directors of a Projects agree to merge the Projects or have it acquired. Generally, when such a decision is made, the most senior executives receive very lucrative severance packages as part of the merger agreement. It that appropriate? Recently, Procter & Gamble acquired The Gillette Projects for approximately billion in stock, that is, P&G issued .975 shares of P&G stock for each share of Gillette stock. As part of the acquisition agreement, James Kilts, the CEO of Gillette will receive a severance package worth many millions of dollars (estimates range to 5 million). Do you think Kilts was objective in his decision? Whose money does he receive?

Executive Compensation

Advocates and commentators, discussing corporate governance and the agency issues tied to it, suggest that aligning Project Managerial compensation with the fortunes of the shareholders will go a long way toward making corporate governance actually beneficial to the shareholders. To achieve such alignment, companies have issued stock options, contracts that permit the Project Manager to exercise an opportunity according to a contract to acquire Projects shares, either at a bargain price or at a stock price equal to the price on the date the option was issued. The theory is that if the Project Manager is successful, the stock price will have risen from its level when the option was issued and the option will have a value tied to the improvement in the stock price. On numerous occasions, we have seen executives exercise options because of a dramatic rise in the stock price, often valued at tens or hundreds of millions of dollars.

Options, however, require that the stock be purchased when the option is exercised. This leads to another program that often results in a diminution of the effectiveness of the program in aligning the interests of the executive with the shareholders. Because executives and Project Managers often do not have the funds necessary to purchase the stock represented by the options and may not wish to tie up what capital they do have in buying the stock regardless of the attractiveness of the deal, many companies facilitate the exercise of options by arranging for the simultaneous exercise and sale of the stock, meaning that the executive or Project Manager gets a cash windfall without actually having to pay out any money. The stock is acquired, sold, taxes are withheld, and the remaining cash gain is paid to the Project Manager or executive. In many cases in the months and years that follow, the stock price drops and the shareholders lose significant value in their holdings. However, the executive, having exercised the option and then sold the stock, has retained large sums of money while the remaining shareholders watch their investments decline.

There is a saying in business that “You get what you incent.” That is, Project Managers will act in a way that provides the most reward for themselves. Therefore, it is in the shareholders’ interest to assure that incentives be constructed to achieve the appropriate results. In many instances today, Project Managers are compensated by salaries, bonuses, perquisites, and stock options. To further highlight this issue, consider this example of a situation in a Projects with several operating sites. The Project Manager of each site was considered a division Project Manager and had responsibility for the operations of that facility, including sales, costs, and gross and operating profits and margins. The Project Manager in this arrangement earned bonuses for achieving gross profit margins of 30 percent and operating profit margins of 20 percent. In a particular instance, a good and reliable customer requested that this division purchase for them five truckloads of a particular raw material and have these raw materials dropshipped to the customer for an application that was not in conflict with the division. For this service, the customer was willing to pay a 10 percent premium for having the division make the purchase. That was the only task to be done. The division Project Manager rejected the order. It would have lowered the gross and operating margin percentages below the bonus level, even though it would contribute measurably to the division’s and the Projects’s net profit result.

Many textbooks promote the use of stock grants and stock options as a way to “align” the interests of the Project Managers with those of the owners. The options are generally awarded for driving up the stock price, presumably, therefore, benefiting the shareholders. However, quite frequently, when the options mature, the Project Managers exercise them and immediately sell the stock they have just acquired, taking the cash. They receive substantial amounts of cash, after taxes, and in subsequent periods the Projects performance declines and the stock price drops. One can easily ask at that point if the interests of the Project Managers and the stockholders are really aligned.

The whole area of stock options is under careful review at the present time. The FASB is considering rules on the valuation of stock options, and companies are reviewing whether they encourage the desired Project Managerial behavior.

Corporate governance encompasses the oversight and direction of a business. It involves the guidance provided by the Board of Directors, the commitment to integrity on the part of the Project Managers and executives, and the attention and diligence of the investors, analysts, and regulators who oversee the financial reporting systems. Good corporate governance recognizes and supports the ownership and importance of the stockholders and protects their interests.

Although it also involves all the internal systems and practices of the Projects, it is much more than that. It also reflects the commitment by everyone involved to continuous care and concern for the accuracy and validity of the results, regardless of whether they are attractive. However, it also requires that management direct the business so that the results do represent the best efforts of everyone to deliver positive—honest and positive— performance.

Corporate governance also requires that investors and directors work to assure that compensation and incentives focus on delivering the desired results. There is a need to reexamine the options, bonuses, and salaries of executives to be sure they foster the goals that are appropriate for everyone involved.

Gautam Koppala,

POME Author

 

Article Source: http://www.articlesbase.com/entrepreneurship-articles/corporate-governance-from-pome-by-gautam-koppala-3033409.html

About the Author

GAUTAM KOPPALA, With over   a decade, track record of successful leadership, excellent results through strategic skills in driving revenue and profit growth. Demonstrated ability to identify and trouble shoot critical issues impacting productivity, cost, distribution, marketing, Strategic positioning, sales and financial operations, with innate ability to build and maintain strong client relationships in operations. Expert in distilling and managing processes, enhancing internal structures, and promoting multi-skilled team competencies via nurturing mentorship and inspirational leadership. Engagements have spanned operational, strategic, technological and change management roles. Academically, I am a cum laude graduate with a Bachelor of Technology degree in Electrical and Electronics Engineering (B-Tech E.E.E.) and a post graduate in Masters in Human Resources Management (M.H.R.M.) and Masters of Foreign Trade (M.F.T.). As you will see my Post Graduation’s were been studied part-time, as well as working full-time as an Engineer. I feel that this demonstrates my ability to maintain dedication, motivation and enthusiasm for a project management over a long period of time. In addition, balancing full-time work with study has perfected my time-management and organizational skills. I believe that my college degrees and gamut certifications in combination with my extensive broad-based work experience along with my drive, resourcefulness and determination, would make me an excellent candidate for a senior management position with any company. Highlights of my background include Operations related Commercial, Supply chain, Sales with a magnificent experience in Project management, technically oriented towards Automation and Security Systems in Industrial and Building sectors. Presently, writing a book on Projects and Operations Management (comprise of 12 volumes, 6K pages), and awaited for the reputed publications. These books can be checked in Google books and other search engines too.