Corporate United States – Executive Advisory Institute

November 14 2019

The Origins and Evolution of Corporate Governance

Fiona Lu Corporate Governance, Corporate History Board Governance, board of directors, Corporate History, Corporate Roles, Corporate United States, Dutch East India Company, LLC, origins of corporate governance

To understand the important job that board directors uphold, we must first take a look into the complex origins of how governance boards came to be. While the foundational pillars of governance have remained constant, the dynamics of how they operate have since evolved to encompass broader roles. We will examine the historical emergence of boards to gain an understanding of the framework of modern governance, providing a necessary foundation for directors today.

The role of boards of directors is and always has been to protect and enhance the well-being of its corporation. The overarching definition of governance can be stated as a system to control the decision making processes surrounding resource allocation and risk tolerance. Different governance structures have emerged and evolved to perform this definition, but ubiquitous commonalities between these structures remains — the presence of intermediaries operating control between multiple owners, periodic reports of fiscal status to owners and an elected authority to appoint the leader.

The first demands for such a structure can be dated back to the early 17th century, when the Dutch battled for control of trade in the East Indies. With the launch of the Dutch East India Company (Verinidge Oostindige Compagne or VOC for short) in 1602, the Dutch were the first to introduce a stock market to Amsterdam, transforming its regional market towns into a dominant financial center. The VOC was an aggregation of private trading companies into a single entity, where the economic participants and managing directors acted as shareholders whose liabilities were limited to the paid-in capital, or what is today known as a limited liability corporation (LLC).

The Dutch Become the Predecessors of Corporate Governance

Alongside being the world’s first LLC, the VOC set the precedent for many other business practices such as establishing the world’s first stock exchange (the Amsterdam Stock Exchange) and releasing the first initial public offering (IPO). These progressive changes to corporate trade and allocated wealth created demands for new management strategies, leading to the early semblances of a governance board.

Governance of the VOC was organized into six chambers based on various ports. Seventeen delegates were selected from the managing shareholders to represent each chamber, with the last seat in rotation. They convened to administer executive decisions such as defining general policy, delegating operations, etc.

The key feature of success in this early board was the carefully balanced representation of shareholder interests — an effective assurance that policies benefit the overall company. Another important feature of this board was that its directors did not originate from its passive shareholders, rather it was managed by the preexisting individual merchants that collectively held legislative and adjudicative power above the investors. This separation of ownership and control is a fundamental property that must be held in order to advance a company’s well-being, and we will see this as a common source of pitfall in boards moving forward.

Early Corporate United States

Shifting our focus to colonial America, as it strived towards an independent nation, they needed to learn how to operate as a confederation of states and redefine the roles of government. Examining the first 150 years of American history in the context of socioeconomic organization reveals the early origins of corporate America and how modern board practices came to be.

At the time the Declaration of Independence was written, large corporations were frowned upon for their unpredictable influences on the economy; hence only special corporations were allowed rights to formation under government authorization or a royal charter. However, the shifting power structures in post-revolutionary America incited national debate over private vs. federal control of corporations. In 1811, New York laid the groundwork for an incorporation law that established a simple procedure to register a corporation sans legislative permission and allowed investors limited liability. The incorporation law created a set of legal guidelines for corporations, including provisioning control to a board of directors and maintaining maximum capital under $100k. These policies reflect the formation of the modern board, as well as the ongoing dichotomy between corporate and political power.

February 13 2020

Scandal Outbreak Leads to Corporate Boardroom Reforms

Fiona Lu Corporate Culture, Corporate Governance, Corporate History, Crisis Management board of directors, board origins, corporate culture, corporate governance, Corporate History, Corporate Reform, Corporate United States, Enron Scandal, Institutional Shareholders, Sarbanes Oxley

The fundamental pillars of corporate governance revolve around independent, non-biased decision making that serve the best interest of the company, though early boards lacked the legal and structural framework to uphold these principles. As numerous scandals led to rising public scrutiny, the role of the the board evolved to encompass a separation of director interests from those of upper management to prevent the reoccurrence of corporate collapses at firms such as Enron Corp., WorldCom Inc., and Global Crossing Ltd.

Post WWII Developments

The economic boom following World War II allowed corporate power to flourish, making the role of governance boards increasingly important. During this period of market growth, corporate managers were leading the reigns while board directors and investors were expected to follow. With corporate powers mushrooming out of proportion, the board of directors served more of a symbolic role than actual oversight which led to an era of scandals and financial fraud, one of the most notable being the wreck of Penn Central.

Penn Central’s collapse in the 1960s was caused by its board’s misinformation, poor monitoring of capital and its further debt propagation of $100 million in dividend approvals. The story caused a widespread backlash against inside directors and fueled the shift in board structure from the advisory to oversight model. As more firms such as LTV, Ampex and Memorex came under fire for fraud and mismanagement, recognition grew for the significance of independent directors. Reform was on the horizon.

Things began to change in the 1970s when the Securities and Exchange Commission (SEC) introduced new regulations that cracked down on the structure of boards. In 1976, the SEC pushed the New York Stock Exchange (NYSE) to require audit committees be composed of independent directors with access to accurate accounting information and outside auditors should they see fit. Other legislative reform proposals placed emphasis on shareholder representation and the distinction between management and oversight members. This era of corporate governance reforms had the collective effect of reconceptualizing the board’s purpose and composition in favor of actively informed, nonpartisan decision-making.

The Rise of Institutional Shareholders

Moving into the 80s, corporate governance focus shifts back to shareholder’s rights and deregulation that corresponded with a political rightward shift. Lawmakers and corporate advocates let corporate governance reside to align itself with the market mechanisms. During this decade, “The Deal Decade,” institutional investors bought more shares and held more than 40% of the U.S. equity markets, giving them more control to exercise hostile takeovers. The cycle of mergers and acquisitions that ensued were mainly motivated by quick returns.

Fearing takeovers, executives and legal courts turned to the idea of independent directors to decide on hostile bids and compare them against the value of the company. In a series of cases, the Delaware Supreme Court gave boards permission to adopt a “poison pill,” a corporate finance technique designed to drive away hostile bidders by imposing them with high costs. Placing the responsibility on independent directors re-enforced the oversight and judgement role of directory boards.

The value of independence continued to grow at the turn of the century, as reflected by continued tightening of standards for disqualifying relationships of directors, reinforced legal frameworks for fiduciary duty violations and equity linked compensation rewarding vigilance. Beyond this, internal structure developments led to the formation of nominating committees to shift the power of director selection away from CEOs. In 1996, the federal government further established the board independence standard through Section 162(m) of the Internal Revenue Code which appended a set of eligibility criteria that prohibited former officers of a corporation or anyone who has received compensation, either directly or indirectly, from said corporation to act as directors. These IRS regulations divorced economic interest from corporate governance and became important guiding points for future evaluations of board independence.

Post 2000 Board Refocus

As the economy continued to grow in the early 2000s, the lack of robust legal standards, and growing market conditions ripened the scene for numerous cases of fraud, such as systematic financial mis-reportings and deceitful accounting practices. One of the most severe and prevalent forms of profiteering was stock option backdating. Following a 1972 revision (APB 25) to accounting standards, companies were able to report executive incomes in the form of “at-the-money” stock options as business expenses for the purpose of increasing executive compensation while misinforming shareholders. Many companies then discovered that by backdating stock option grants, they were able to generate additional income that was both tax-deductible and held an underlying lower stock price. This resulted in widespread earning overstatements and record falsifications.

Enron Scandal Leads to Sarbanes Oxley

Enron Corporation, a major energy, utilities and natural gas company, was exposed in major case of institutionalized accounting fraud that generated a vicious cycle of insider trading and money laundering among its executives. In 2001, Enron filed for bankruptcy and emerged from it in November of 2004, reorganizing under the name Enron Creditors Recovery Corp. and continuing its streak of fiduciary failure, high risk accounting and “off-the-books” activities — all of which was facilitated by their lack of independent auditors and board members. Enron’s board was comprised of members who held financial ties with the company and inappropriate conflicts of interest that fueled the wildfire of diverting funds, overstating profits, and growing debts.

In the wake of major scandals from Enron to Worldcom, the federal government cracked down on lax corporate laws which led to Congressional hearings that focused on the responsibility of board directors in such matters. Following the hearings, the Sarbanes-Oxley (SOX) Act of 2002 was quickly developed and passed which mandated, among other things, independent board audit committees, the creation of the Public Company Accounting Oversight Board (PCAOB) to regulate auditing processes, internal control tests, and required that CEOs and CFOs to attest to their financial statements. The principal goal of SOX was upholding financial integrity, though it accomplished sweeping accounting reforms beyond this by reestablishing the expected roles of corporate boards.

SOX continues to have a profound impact on capital markets and boardrooms today. By enforcing independent audit committees, it strengthens the board’s role in overseeing management’s accounting practices to separate conflicting interests and ensure that no misreportings slip through to the public. In addition, SOX imposes harsher punishments for securities fraud by sentencing up to 25 years in prison if top management knowingly signs off on falsified reports. The company also loses credibility and investor confidence when they publish the required accounting restatement stating management’s misconduct. Finally, SOX strengthens disclosure between companies and the public by closing the loopholes for off-the-books activities.