Biggest corporate failures, the underlying agency problem, and the corporate governance measures.

• Author: Maskara, Pankaj K.

1. INTRODUCTION

   Economic growth and enhancements in production efficiency over the last couple of centuries can arguably be attributed to the widespread separation of ownership and management during this time. The benefits of this phenomenon have been counted numerous times in the economics literature. The prime disadvantage of this separation is the agency problem introduced in the system because of misaligned interests of the owner and the manager. The literature is ripe with theories and empirical results that highlight the consequences of the agency problem. Several methods and tools have been promoted that help reduce the inefficiencies introduced by this problem. In this paper, we document the effects of agency problem on the overall economic system as witnessed by the global recession that started in 2008. We argue that the roots of all corporate failures can be traced to agency problems and the several methods that have been promoted in the literature as effective ways to mitigate agency problems have failed repeatedly to the detriment of the shareholders. We study the root causes of biggest corporate failures in history up to and including Bear Stearns and Lehman Brothers and document that the widely used measures of corporate governance in the academic literature, the governance index and the entrenchment index, would have misclassified majority of the companies that ultimately failed as companies with good corporate governance. We suggest that the change in the value of these measures over time for our sample companies would have performed better in identifying them as companies with deteriorating governance than the level of indices at any given point of time. Firms that ultimately failed showed decreasing levels of corporate governance as they approached their ultimate demise even though based on their governance index they would still have been classified as well-governed firms right before they failed.

2. CORPORATE FAILURES

   The classic example of corporate failure that found its way to textbooks on corporate finance in the late nineties is that of Barings Bank. A rogue trader named Nick Leeson was single-handedly able to bring down a 233-year-old bank in 1995. The bank was finally sold to ING for one British pound. The report published by the Board of Banking Supervision of the Bank of England identified three main causes for Baring's failure: 1) unauthorized and concealed trading activities 2) Serious control failures and managerial confusion within the company 3) lack of detection by external auditors, supervisor, or regulators (Bair, 1995; HM Treasury, 1995).

   Thirteen years later history repeated and the Barings' story came into limelight once again because of a similar incident that took place at Soceite Generale, the leading 145-year old French bank. In 2008, Jerome Kerviel, a derivatives trader at Societe Generale, took derivatives positions that far exceeded his approved limits and ultimately cost the bank over $7 billion. The causes identified by the bank in its internal study were almost identical to those identified by the report on Barings' failure. The difference between ING and Soceite Generale was that 'Risk' magazine had named Societe Generale as the best equity derivatives operation in the world in the prior year.

   Though the similarity of the causes behind the two failures mentioned above never escaped detection we contend that the reported causes were just the symptoms of a bigger underlying problem--the agency problem. It is common practice in the corporate world now to offer performance bonuses to managers/employees to align the interest of the shareholders with those of the managers. Performance pay is the most widely accepted tool used to mitigate agency problem. Unfortunately, performance pay creates problems of its own that are manifested in situation like those of Barings' Bank, Societe Generale and several others (to be discussed later). It grants a call option to the agent on the performance of the company. The agent shares profits with the principal but does not have to share in the losses. This creates perverse incentives for the agent to take undue risk. Consequently, agents like Nick Leeson and Jerome Kerviel take positions that far exceed the limits approved for them and conceal the unauthorized positions. By taking bigger positions, they increase the value of their call option.

   At the same time, the supervisors who as the agents of the owners have the responsibility to enforce internal control processes ignore red flags because they also share in the payoff of the call option of the rogue employee. As will be apparent later in our examples, the external agents like auditors of the company also suffer from agency problem when they ignore red flags.

   Historically, external auditors were brought into existence to manage agency problems. They were introduced into the system to safeguard the interests of the owners along with creditors and other stakeholders. Today the external auditors themselves suffer from agency problem. As the agents of the shareholders of a company, they are expected to look after the interests of the shareholders but their future appointment as consultants and auditors are strongly influenced by the management. Therefore, external auditors have repeatedly been cited as the contributing parties to corporate failures.

   The demise of Enron and Arthur Anderson readily explains the consequences of agency problems encountered in relationships involving external auditors. Enron's executives engaged in self-dealing when they traded with partnerships in which they or their relatives were partners. They also abused their personal expense accounts and lent themselves hundreds of millions of dollars on behalf of the company. Arthur Anderson knowingly helped the company in its fraudulent activities because Enron was one of Andersen's largest clients and Andersen earned ten million dollars from Enron in annual auditing and other fees. Instead of reporting these activities to the appropriate authorities, Andersen helped Enron continue its questionable practices by allowing it to treat off-balance sheet activities favorably and it called for mass destruction of Enron documents rather than assist SEC in the investigations ex post. Enron's executive also inflated expectations of future cash flows and sold their shares in the company at inflated prices. These acts of self-dealing, abuse of personal expense accounts, loans to self, insider trading and misrepresentation of off-balance sheet activities were all a result of agency problem. Additionally, failure by Arthur Andersen to report these activities and mass destruction of Enron documents were partly a manifestation of agency problem between Arthur Andersen employees and its shareholders.

   In a related episode, WorldCom followed Enron into bankruptcy in 2002. Coincidently, Arthur Andersen was also the external auditor of WorldCom. However, in this case after discovering the irregularities in WorldCom's financial statements regarding capitalization of expenses, Arthur Andersen advised WorldCom's audit committee that the company's financial statements were not reliable. Consequently, the board of directors at WorldCom replaced Andersen with KPMG as WorldCom's external auditor (Tran, 2002). The Board of directors at any company is designed to be the first line of defense against agency problem. The board is appointed by the shareholders primarily for safeguarding the interest of the shareholders but the management unduly influences the compensation, appointment, and...