Corporate self-check could be financial saviour

Who would not be familiar with the Lehman Brothers’ fall from grace in September 2008 that sent shockwaves across the banking sector worldwide? What was once the global financial Goliath, with assets valued at an estimated $700 billion (Dh2.6 trillion), filed for bankruptcy and triggered the worst financial crisis the world has ever seen since the Great Depression of the last century.

While analysts have argued on the real reasons for the financial sector’s sudden vulnerability, a report about the Lehman account auditing by the US courts at that time, suggested that bank executives’ erroneous practices such as failing to adhere to risk management practices and manipulating financial statements, have contributed significantly to the turmoil.

Since then, voices calling for the need to monitor and evaluate the exercise of powers of administration in listed corporations, also known as "corporate governance," has become louder.

Are the failures and weaknesses in corporate governance arrangements to blame for the 2007/ 2008 financial crisis? Jan Bladen, Chief Operating Officer of the Dubai Financial Services Authority (DFSA) believes not.

“The recent case of yet another large bank (UBS) and yet another rogue trader demonstrates this very clearly,” he said.

Here, Bladen refers to the UBS fraud case where a trader had been accused of carrying out a $2.3bn "rogue trading" activity that rocked the Swiss bank in October 2011.

In a previous interview with a Dubai-based English-speaking newspaper in March 2007, a year before the financial crisis started, Bladen anticipated that the world would see major corporate failures within the next three years, “directly due to the lack of internal controls, risk management and weak corporate governance.”

Corporate governance non-compliance leads to disasters

Keen on preserving shareholders’ rights and adopt a healthy corporate methodology, the UAE gives utter importance to corporate governance and risk management. In addition to constantly organising dedicated events, conferences and seminars, the UAE is home to three corporate governance centres: Abu Dhabi Center for Corporate Governance (ADCCG), The Institute for Corporate Governance in Dubai (Hawkamah), and the GCC Board of Directors Institute (GCC BDI) in Dubai.

According to the “Survey on Corporate Governance Frameworks in the Middle East and North Africa” issued by the mission of the Organisation for Economic Co-operation and Development (OECD), these institutions are focused on national priorities, however several of them such as the Hawkamah Institute and the GCC Board of Directors Institute have a more regional reach.

“The UAE has made a giant step [towards insuring implementation of corporate governance procedures],” says Mahmood Ahmad, an Emirati expert in corporate governance affairs.

“The corporate governance regulation issued by the Securities and Commodities Authority has achieved justice and transparency at public shareholding companies, as well as increasing the practice of [financial] disclosures.”

Despite the UAE’s efforts in promoting corporate governance, some executives remained defiant as in the case of the Damas International’s Abdullah brothers (Tamjid, Tawfiq and Tawhid) who “borrowed” from the company’s coffers for their own gain.

In March 2010, the Dubai Financial Services Authority (DFSA) imposed a Dh13.5 million fine on Damas after it found that the company’s majority shareholders, the three Abdullah brothers, were guilty of making debit transactions from company accounts for personal use. The regulator also recommended the dismantling of the company’s board of directors, banned the Abdullah brothers from performing managerial roles at DIFC for 10 years, and ordered them to pay back Dh365m in cash, and return 1.94m gms of gold which was taken for personal use.

In an earlier interview with Alrroya Aleqtissadiya, Annan Fakhruddin, the CEO of Damas, said that the financial and legal issues emerging from the Abdullah brothers’ case prompted the company to develop and adopt a five-tier working strategy. Fakhruddin added that the company is strictly following DFSA’s financial and legal standards, strengthening corporate governance procedures, ensuring full transparency, as well as activating the role of internal auditing.

“The full set of Enforceable Undertakings issued by the DFSA are public documents, and should be carefully read by all Boards in the GCC,” says Sharon Ditchburn, Managing Director at Capital Advantage.

“These indicate a far deeper level of failure in Damas in terms of lack of control over the corporate assets, including cash and using assets as security for personal transactions. This case demonstrates failure by many parties who were responsible for internal and external monitoring – particularly given that information published by the company after listing indicated areas of non-compliance [to corporate governance].”

In order to maintain a stronger, cleaner and fairer economy, what should large corporations do?

“Simply put, effective controls, strong risk management (starting at the Board Level) along with common sense, corporate governance can only contribute towards building a strong economic environment,” responds Bladen of the DFSA.

However, Bladen sees that the challenge in the Middle East is no longer the development of corporate governance codes but their effective implementation, “which will not happen until regulators are given teeth (like the DFSA) and corporations recognise the real benefits that corporate governance brings to an enterprise and its shareholders,” he added.

Qualified board oversight, effective risk management are key

Many experts believe that the weak composition of the board of directors and their lack of objective independent judgment on corporate affairs, are main reasons why corporate governance have been off track.

In a report entitled “The Corporate Governance Lessons from the Financial Crisis”, the Paris-based Organisation for Economic Co-operation and Development (OECD) suggests that firms with more independent boards and higher institutional ownership tend to experience worse stock returns during the crisis period.

Dr. Shahid Malik, Associate Analyst - International Affairs at Political Risk Analysis Ltd, believes that firms with higher institutional ownership took more risk which resulted in larger exposure to the risk of default.

“While firms with more independent boards tried to raise more equity capital which led shareholders wealth transfer from existing shareholders to debt holders,” he added.

On another note, Sharon Ditchburn of Capital Advantage, suggests that the crisis indicates that institutions failed to perform their given roles.

“Institutions are not always fulfilling their role as shareholders – i.e., not voting effectively, placing too much reliance on third-party information (credit rating agencies, other analyst reports), and not employing people who have practical insight into how their investee companies should be operating,” she says.

In order to ensure the full adherence with corporate governance regulations, Mahmood Ahmad, the Emirati expert in corporate governance affairs, highly recommends that the boards of directors should play a key role here.

“It can be done through the development of company policies and strategies, motivate the company’s components from staff levels to administration levels, as well as monitor the executive management, impose auditing methods and protect the shareholders rights against the intentional and unintentional excesses of the management,” he said.

The remuneration of boards, a highly controversial issue

The remuneration of boards and senior management also remains a highly controversial issue, which most industry experts believe exacerbated the recent economic mess.

According to OECD’s report, CEO remuneration has not closely followed company performance. One study reports that the median CEO pay in S&P 500 companies was about $8.4m in 2007 and remains steady despite a weakening global economy.

While failure of ethics was evidenced by bad compensation practices, Sharon Ditchburn believes that compensation is only part of the story.

“Many failures occurred without people making millions – due to ego, fear, stress, poor information, etc. Dick Fuld [CEO of Lehman Brothers] made millions, but also lost millions more by Lehman’s failure. Nick Leeson [the trader who caused the collapse of Baring’s bank in the 1990s] didn’t make a huge amount from bonuses," she says.

Despite “who gets what”, some experts believe that compensation should be in line with the company and its shareholders’ long-term interest.

“The strategic importance and significance of executive compensation plan is considered as a significant influence on a company’s performance,” comments Dr. Shahid Malik of Political Risk Analysis Ltd.

“Executive pay programmes not only reflect a company’s strategy, they also have a great capacity to influence strategy. This is precisely the reason why companies pay so much attention to linking executive compensation to business performance,” he added.

In order to achieve justice, the Emirati expert Mahmood Ahmad stresses on the need to activate the shareholders’ role in determining the remuneration and allowances that are given to managers and members of boards.

“It has to be within an acceptable limit, and in line with the size of the company’s operations,” he said.

With around 60 per cent of all shareholders being institutions, who themselves hold large portfolios, DFSA’s Bladen confirms that it is very challenging for investors to understand each and every companies’ compensation plan.

“Further, and in my opinion, I sincerely believe that institutional investors are not concerned about the extent of executive compensation, so as to actually do something about it – What they are concerned about, and what they really care about, is the value of their shares, which is in majority driven by the economic performance of the organization,” he said.

“And, let’s face it, for most organisations the compensation of senior officers and the CEO is a minor part of the overall cost structure. The real issue is the growing concern about pay disparity, between the masses on one hand (look at the recent “Occupy Wall Street”) and CEO compensation on the other,” he concluded.