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Contents

1.1 INTRODUCTION.. 3

1.2 RECENT CORPORATE SCANDALS. 3

1.3  THE US MODEL.. 4

1.4 THE UK MODEL.. 7

1.5 CONCLUSION.. 10

1.6  REFERENCES. 11

 

 

1.1 INTRODUCTION

Different countries have different approaches for corporate governance depending on the nature of their economy. Some countries use rule based approach while others prefer principle based approach. There are still some other countries which usually use the mixture of two approaches in order to fit their economy. These different approaches to corporate governance have worked in some countries while in other countries they have failed. For instance the period between 1990 and 2002 witnessed many corporate collapses which made different countries to come up with new regulations in order to prevent occurrence of such failure in future.  Some of the companies that fell include Enron in 2001, World com in 2002 and Parmalat in 2004 (lecture 5 notes).These corporate collapses had adverse effects on lives of many people. For example, shareholders lost their investments, employees’ of the companies lost their jobs, evaporation of the company security pension, suppliers of the goods to the company lost their market and both international and local communities felt the impacts of the companies that have collapsed. In short, almost everybody is affected by the collapse of the companies and it is therefore important to look at what causes these corporate collapses in order to come up with rules and regulations in order to prevent such occurrence in future. In an attempt to understand different corporate approaches that are used by different countries, this study will critically evaluate the US rule-based approach and the UK principle based approach and see how these approaches have been used in order to deal with the past corporate collapse.

1.2 RECENT CORPORATE SCANDALS

The period between 2000 and 2004 witnessed several corporate scandals that agitated the need for strict rules in the corporate governance in order prevent occurrence of such corporate scandals again. Enron was the first company to have a corporate scandal in 2001 where the company managers used special purpose entity to enrich themselves and by deceiving the shareholders. The management also used the same entity to remove the liabilities of the company from the financial report. This led to the fraud scandal of about $ 30 million which left the company in bankruptcy. World Com Telephone Company also found itself in a similar accounting scandal where the managers used window dressing technique to inflate the company’s profit. The plan which was facilitated by the company’s CEO allocated a cost of about $ 3.8 billion just within a period of fifteen months. This left the company in financial crises. Other companies such as Parmalat and Xerox also experienced similar scandals that led to the bankruptcy of these companies.

1.3 THE US MODEL

In July 2002, an act was signed in US in order to react on the corporate collapse which had taken place from 1990 to 2002. The period witnessed a period of abuse of many ethics of corporate governance both in US and in other European countries (Sama and Shoaf, 2005, pp.177-185).  The act was signed even without involving business community in the country and it defined an approach that was strict and based on rules which was to be applied in the corporate governance in the country. The approach provided in the act prevent the companies from using those rules that are not pleasant which can lead to the corporate collapse. By 2002, there were many scandals that involved transparency in many Companies leading to the collapse of these corporations. According to Miller (2011, pp.71-78), the purpose of this act was to restore the confidence of the investors and to make companies and their executives to be accountable for business operations, corporate governance and companies’ financial reporting. The US model does not provide flexibility among the companies but mainly ensure that there is enforceability of those strict rules that are important to prevent the collapse of the companies. This model minimizes loopholes in the company’s management where the companies are not supposed to choose which rules they would like to apply and which rules they would not like to apply. Provisions of mandatory rules in this model ensure that companies do not have an option on the rules they will apply but they are supposed to follow what has been set for them. Wang (2010, p.885) point out that mandatory regulations that have been set by various acts have shown positive results in many companies. Companies that are applying those mandatory restrictions  in their internal control have reported positive results  which shows that internal controls that are mandatory can be an effective policies for corporate governance that can rescue companies from corporate collapse. Stephen and Jon (2010, p.60) argues that Sarbanes-Oxley and Dodd-Frank rules provided by the government are helping the shareholders to monitor and observe directors which has resulted to change of behaviors among many directors.

According to Aigbe (2010,p.1253), after the passing of the SOX rules, many companies that have high asymmetry of information have reported abnormal profits while company with low asymmetry of information have reported low profits. This shows that these strict rules have improved efficiency in corporate governance. Santanu and Mahmud (2011, p.5) note that when the set rules are followed and the board of directors carry their responsibility of effective monitoring of the company, weakness of internal control are well addressed. This will also ensure that the interests of the shareholders and managers are well aligned thus improving quality of the financial information of the company.

Feleaga et al (2011, pp.145-152) notes that most of the corporate system of governance in US are a replica of what is happening in the stock exchange of New York. However, the stock exchange operates with laws that are set in the corporate laws. According to corporation laws, corporations are independent entities which have right to decide on all the issues affecting the company. These issues regards to ownership, shareholders wealth’s preservation and how the capital will be used within the company. Feleaga et al (2011, pp.145-152) continues to argue that corporation is also responsible for commitments that arises as it conduct its business. However, investor’s ownership in the company and ownership of the firm’s net assets are separate. In corporation, investors do not have powers to make a decision on the entity’s behalf without approval. CEO is the person who can make such a decision within the limit of the corporate law. In the US model, corporate is used which provide a more precise and clearer model for running corporations.

 

According to Young (2009, p.35), the US model of the corporate governance is based on the principle of agency theory. This is where the investors give some of their powers of control to the board of directors expecting to get returns from the operations of the corporation. The investors’ wealth is also guaranteed limited liability to the conducts of the directors. The owners of the company appoint the directors who as custodian of their wealth being guided by the corporation’s charter. Corporate boards act as the shareholders’ agents and they have a duty both individually and collectively to their principles (owners or shareholders of the company). However, the directors do not have fiduciary duties to other stakeholders such as employees, customers, Suppliers, community, creditors or even the environment directly. The managers who are appointed by the corporate boards are the one who have these duties to other stakeholders such as customers. Thus corporate directors have an indirect responsibility to the stakeholders as they are required to do so under the duty of care. According to the common law of Anglo-American and other regulatory laws that govern corporations in US, each position of responsibility is viewed like an office. The powers of each officeholder are set through some contractual mechanisms which defines responsibilities of each officeholder.

Ralph (2008) argues that despite the success of the model used the US corporate governance, the influence of the shareholders is still low compared with other developed countries. Shareholders have little share when it comes to the accountability of the directors. This argument is supported by  Kelly(2010,p.4) who argues that  acts which have been signed to address corporate failure such as Dodd-Frank  has not addressed many problems which could have led to the financial crisis that were experienced in 2008. Kelly (2010, p.81) continues to argue that those strict rules are just but a burden for compliance to the companies and yet they do not yield any results.

Though the rule based approach has many loopholes as we have seen above, the approach has many advantages that have made it to be applied in US and other countries for long time. First, the strict rules that are set by the company ensure that companies are following all the corporate ethics in their operations. For instance, directors of the company may not act irresponsible without any legal action taken against them. This will ensure that they carry all their duties according the corporate laws. This will minimize cases of embezzlement of the shareholders wealth; minimize the cases of fraud in the company and other misconducts that may lead to the failure of the company. Secondly, the strict rules that have been set will ensure that there is health competition among the companies since all the companies have to follow the set rules which will minimize any form of misconduct in the market such as unhealthy competition. Thirdly, enforcement of corporate rules will encourage company to adopt good corporate practices such as transparency, accountability among others which will raise the confidence of the investors and the public at large.

1.4 THE UK MODEL

The UK uses an approach that is principle based in their corporate governance. This type of approach allows flexibility among the firms and there is no strict rules firms must follow like the case of the rule based approach used in US. The firms have a choice to choose the type of rules which they would like to follow in their corporate governance. Again in this model firms are controlled by the market forces and the government like in the case of rule based approach. Though there are strict rules that must be followed by the firms, there are some general rules that have to be applied by each company in order to ensure that there is good governance among the firms. This approach leaves firms with permission to depart from the general rules if their case is exceptional or when the company has some reasons which may not allow it to follow the general rules of good governance. Despite the fact that companies are left with freedom to deviate from the general rules, there exist tools for enforcement in order to ensure companies are complying with the rules of good corporate governance. These enforcement tools ensure that the companies give an explanation why it chooses to divert from the general rules. This ensures that companies do not just choose to divert from the general rules without having a good reasons for doing so. The principle of compliance ensure that  a clear explanation is given to the authority why the firm has chosen to divert  so that the market authority can evaluate the specific circumstances that are facing that specific firms and know whether they are justifiable. This approach gives the company a lot of flexibility when they are making their report which ensures that they follow rules that suit their conditions.

Principle based approach has many advantages compared to rule based approach. First, principles can be easily generated to fit the situation of the company. Secondly firm can easily change as the market conditions changes which can improve the innovation and competition of the firm. In principle based approach, directors and managers can easily change the principles of the company in order to respond to any change that is happening in the market. The directors will not be limited like in the case of rule based approach where they have to adjust within the set rules that are set by the government. This will enable the company to adjust accordingly and prevent any loss that may have resulted from adverse economic conditions such as global financial crises. Thirdly this type of approach allows good relationship between regulators of the firm and the owners of the firm.           Ford (2008, pp.1-60) point out that principle based approach look more preferable to use than rule based approach in that it is more innovative, information based and pragmatic. The approach is also burdensome to the corporations that have to adjust their management in order to comply with the strict rules that have been set by the government. The method is also open-ended which allows companies to carry out innovation in order to increase their profitability.

According to Lain (2010, p.483), the world global financial crisis of 2008 reflected the weaknesses of the principle based approach used in UK corporate governance. Of late there is a lot of debate in the country about the ineffectiveness of the approach where many people argue that the approach give a very light touch to the regulation of the corporate governance. Phillip et al (2010, pp.56-59) argues that both public and investors are currently driving change of policy in UK after the 2008 financial crises. They continue to argue that failure by the British government to closely scrutinize and investigate the operations of the corporations has contributed greatly to the financial crisis. Phillip et al (2010, pp.56-59) recommends that shareholders need to be more aggressive in order to ensure that the company is governed appropriately by the directors. The fact that directors can choose principles to follow as allowed by the law, then it means that they can choose a wrong principle that may lead to the collapse of the company. In this UK model, directors and managers have permission to divert from the general rules if they have a reason to do so. This means that they may choose principle that shareholders do not like that may lead to corporate collapse if the directors and managers are not responsible. According to Anita (2010, p.4), global financial crisis highlighted the need for closer engagement between the directors and the shareholders.  He continues to emphasize the need for more participation among the shareholders where they will ensure that directors are performing their role effectively in the governance of the companies.

1.5 CONCLUSION

From the study, it is evident that both approaches of corporate governance have strengths as well as loopholes. For instance, the US rule based approach has ensured that corporate ethics are followed when the companies are carrying out their business though it does not allow flexibility. On the other hand, the UK principle based approach allows a lot of flexibility where company can chose which principles to apply but it does not ensure high compliance to the corporate ethics. Thus a mixture of the two approaches may be better than any of the two approaches alone.

1.6  REFERENCES

Aigbe Akhigbe, Anna D Martin, Melinda L Newman, 2010. Information Asymmetry Determinants of Sarbanes-Oxley Wealth Effects. Financial Management. Vol. 39, Iss. 3; p. 1253

Anita, Hawser,2010. Governance Code Puts UK Shareholders In The Hotseat. Global Finance. Vol. 24, Iss. 10; p. 4

Feleagă, Niculae; Dragomir, Voicu; Feleagă, Liliana, 2010.Legal Values and International Perspectives on Corporate Governance: Principle-Based Implementations vs. Rule– Based Systems.. Proceedings of the European Conference on Management, Leadership & Governance , p145-152, 8p

Ford, Cristie L. 2008.  New Governance, Compliance, and Principles–Based Securities Regulation. American Business Law Journal, Vol. 45 Issue 1, p1-60, 60p;

Iain MacNeil,2010. The Trajectory of Regulatory Reform in the UK in the Wake of the Financial Crisis. European Business Organization Law Review. Vol. 11, Iss. 4; p. 483 (44 pages)

Matt Kelly,2010. The Case for Governance Laws: Slow, Tortuous-and Worthwhile. Compliance Week. Vol. 7, Iss. 81; p. 4 (1 page)

Philip Hamill, Anne Marie Ward, Judith Wylie,2010. Corporate Governance Policy: New Dawn in Ireland and the UK. Accountancy Ireland. Vol. 42, Iss. 6; p. 56 (4 pages)

Ralph Walkling, 2008. U.S. Corporate Governance: Accomplishments and Failings A Discussion with Michael Jensen and Robert Monks1.Journal of Applied Finance. Vol. 18, Iss. 1; p. 133 (15 pages)

Sama, Linda M.; Shoaf, Victoria. 2005 . Reconciling Rules and Principles: An Ethics-Based Approach to Corporate Governance. Journal of Business Ethics, Part 2, Vol. 58 Issue 1-3, p177-185, 9p;

Santanu Mitra, Mahmud Hossain, 2011. Corporate governance attributes and remediation of internal control material weaknesses reported under SOX Section 404.Review of Accounting & Finance. Vol. 10, Iss. 1; p. 5

Scott E Miller,2011. Impact of the Sarbanes Oxley Act on Foreign Companies in the United States:  An Analysis International Journal of Management. Vol. 28, Iss. 1; p. 71 (7 pages)

Stephen B. Young, 2009.The ethics of corporate governance; The North American perspective. International Journal of Law and Management. Patrington:. Vol. 51, Iss. 1; p. 35

Stephen Davis, Jon Lukomnik, 2010. How to Improve Governance at Small Companies
Compliance Week. Vol. 7, Iss. 80; p. 60 (2 pages)

Xue Wang, 2010. Increased Disclosure Requirements and Corporate Governance Decisions: Evidence from Chief Financial Officers in the Pre- and Post-Sarbanes-Oxley Periods
Journal of Accounting Research. Vol. 48, Iss. 4; p. 885