Introduction
Corporate governance and risk management are considered one of the most important factors influencing a company’s success. However, if managed poorly, they can also result in company failures and scandals. Poor corporate governance and risk management set wrong objectives, which have a negative effect on both stakeholders and shareholders. The current focus will be on several corporate scandals, such as Enron and Halifax Bank of Scotland, and examine the effects of corporate governance and risk management in those. As well as that, this paper will critically appraise corporate governance and risk management and the resulting social responsibility.
Corporate Governance
Corporate governance relates to the manner in which the business is governed. It is defined by relationships between the management, shareholders, and other stakeholders. Corporate governance also sets corporate objectives, activities, and behaviors (Peterdy, 2022). On the other hand, corporate governance is not involved in routine daily tasks. Corporate governance covers several dimensions: enterprise risk management, strategic planning, accounting and disclosure, talent management, and succession planning.
Traditionally, corporate governance undertakes decisions aligned with investors’ needs and wants. This leads to the main conflict involved in corporate governance, shareholder interests vs. stakeholder interests. As already stated before, shareholder interests concern the return on their investment. On the other hand, stakeholder interests primarily involve the needs of employees, customers, supply chain partners, and members of the corporation’s community. Needless to say, these interests are usually contradictory; what is good for shareholders is not always good for stakeholders and vice versa. Good corporate governance considers both accounts when making corporate decisions.
Good Corporate Governance Principles
Good corporate governance helps to build an environment of trust, transparency, and accountability necessary for fostering long-term investment. Successful, independent governance practices are among the key requirements to achieving and maintaining public trust and, more broadly, corporate confidence. Poor governance increases the likelihood of corporate risks and failures. Such failures may impose a significant public cost and increase contagion risks (Greuning and Bratanovic, 2020). In this instance, the importance of proper corporate governance cannot be denied these days.
Moreover, national authorities have been paying increasing attention to corporate governance, as corporations are now engaged in international trade, financial flows, and the stability of global markets (Greuning and Bratanovic, 2020). This attention can be attributed to several factors, such as the growth of institutional investors, the shift from traditional corporate governance goals in favor of stakeholder interests, financial globalization, and deregulation. International organizations, such as OECD, IMF, and World Bank, have declared strong governance the main priority and have taken initiatives to define good governance benchmarks. These benchmarks include but are not limited to “oversight by the board of directors, oversight by individuals who are not involved in the day-to-day running of the various business areas, direct supervision line and an independent risk management, compliance and audit functions” (Greuning and Bratanovic, 2020). These benchmarks ensure that good corporate governance techniques are established within the organization. According to Alam et al. (2019), the main corporate governance frameworks are the following:
- It should recognize the rights of stakeholders recognized by law and encourage active cooperation between shareholders (investors) and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.
- It should ensure the timely and accurate disclosure of all materials and documents regarding the corporation, including the company’s financial situation, performance, ownership, and governance.
- It should ensure the equitable treatment of all shareholders, including minority and foreign shareholders.
Over the past decades, many academic researchers have investigated links between corporate governance and firm financial performance. Most of these academic researches point out that good corporate governance positively impacts a firm’s financial performance (Kyere and Ausloos, 2021). The argument is that before investors think of investing in a corporation, they take into consideration the firm corporate governance mechanisms (Kyere and Ausloos, 2021). One role of corporate governance is to manage these conflicts between the principals and the agents. Good corporate governance, therefore, should have strong internal mechanisms to manage various interest groups, whence to reduce high agency costs.
Risk Management and Internal Control
Risk management is the process of identifying and assessing potential legal, financial, and strategic risks to the corporation to avoid or minimize their impact. It is a part of corporate governance. There are five steps in the risk management process, identification, analysis, response planning, mitigation, and monitoring. When the risk is not managed effectively, corporate governance deteriorates, and financial institutions incur huge losses such as those that exacerbated the global financial crisis. A better corporate governance framework tends to decrease the risk of financial problems (Rehman et al., 2021). The key risk management objective is to ensure that the company maintains an appropriate balance between risk and reward (Jurakulovna et al., 2021). The three main elements of effective risk management include an independent board, a firm-wide risk management function, and the auditor’s independent assessment of risk governance (Greuning and Bratanovic, 2020). A company can successfully undertake risk management with these elements fully in place.
Risk management is an essential step in the company management system. According to Renzi and Vagnani (2020, p. 105), “risk management has assumed increasing importance from a theoretical and a professional point of view.” It is a common opinion that the capability of both financial and non-financial companies to create value – while following strategies for growth and/or innovation in conditions of relatively low volatility about net incomes – requires the adoption of proper risk management (Renzi and Vagnani, 2020). Risk management and corporate governance go hand in hand to ensure the company’s successful future.
As well as that, adequate internal control also plays a major part in corporate governance and risk management. Internal control refers to the mechanisms and procedures that ensure financial integrity, accountability, and fraud prevention (De Villers and Dimes, 2020). Internal controls fall into three categories: detective, preventative, and corrective. Preventative internal controls include computer and server backups, training, and other preventive internal controls that block undesirable events from occurring. Detective controls are aimed at determining an error after it has already happened. Some examples of detective controls are internal audits, reconciliations, financial reporting, financial statements, and physical inventories. Corrective internal controls s are implemented after the internal detective controls discover a problem in order to solve it. These controls could include disciplinary action, report filing, and new policies. Internal controls are heavily involved with risk assessment and corporate governance by extension. Especially detective controls, where the risk assessment and audit take place, and corrective controls, where risk management takes place as a form of report filings and disciplinary control.
Corporate Failures
However, certain internal control weaknesses might contribute to the company’s failings. Business organizations have witnessed a series of corporate collapses, an increase in fraudulent practices, and accounting inconsistencies in highly successful firms such as Enron, Halifax Bank of Scotland, and British Home Stores. Corporate failures resulting from financial instability or scandal have serious negative consequences for all stakeholders, including employees, business partners, investors, capital markets, and society at large (Cole et al., 2020). The results of such failures can lead to widespread negative effects in the country or even across different countries, resulting in unemployment and tax revenue reductions. Furthermore, such effects can range from long-lasting negative reputational damage (Dupont and Karpoff, 2019).
Such corporate failures are a direct result of poor corporate governance techniques. Corporate governance has become a subject of global importance in the aftermath of corporate scandals, such as Enron, and its significance has further increased after the global financial crisis of 2007–2008 (Rehman et al., 2021). In order to analyze the relationship between poor corporate governance and corporate failure, the Enron scandal of 2001 should be examined.
Enron Corporate Scandal
The Enron scandal was one of the first corporate crashes of that scale. The scale of their perversion of accounting rules was massive and done so deftly that even regulators did not catch on to their criminal activity until the very end. In hindsight, had investors and regulators assessed their activities through a governance lens, perhaps some of the outcomes would have been different. Enron did not separate the CEO and Chairman of the Board role, and they were not predominantly diverse. Furthermore, they had several industry insiders and politicians who did not act consistently and aggressively in the company’s best interests. Enron was also trading futures contracts but was attempting to do so for profit as well as risk management. Many companies use the futures markets as a means to manage risk. For example, airline companies do that to set fuel prices and predict the costs. Enron, on the other hand, was trying to make more profit.
The notorious collapse of Enron, one of America’s largest companies, has focused international attention on company failures. In addition, it also presents the role that strong corporate governance play in preventing these failures (Ahmed et al., 2018). Several corporate governance problems have emerged due to Enron’s wreckage. Unregulated power in the hand of the CEO was an obvious problem that characterized Enron’s management. Referring to the benchmarks of good corporate governance, unlimited power in the hands of the CEO is certainly an aspect to avoid. A good corporate governance framework specifies that the board of directors and senior management should have a say in the decision-making process; thus, one cannot outweigh the other.
Another example of poor corporate governance in Enron is its poor risk management. Unethical trade took place in order to overuse risk management techniques and turn it into profit management. If the framework of good corporate governance was applied, an independent party would have done the audit and risk assessment. Therefore such unethical behavior would have been prevented. Overall, corporate governance in Enron was weak in almost all aspects, which resulted not only in financial losses but also was damaging to their reputation.
The Collapse of Halifax Bank of Scotland (HBOS)
In 2008 HBOS could embark on a £30bn merger and collapse just seven years later, with all of that value completely wiped out, into the arms of Lloyds, with a £20bn injection from the taxpayer to prevent it from crashing. According to the Guardian article (2013), the bank had very poor risk management that could not keep up with the pace of loan issues. In 2008 “the gap between loans and deposits reached £213bn” (The Guardian, 2013), which had poor ethical consequences for the stakeholders involved. The Financial Services Authority identified the problem in 2004 but failed to stop it.
According to the Bank of England report (2008), the management and governance arrangements adopted by HBOS were broadly appropriate for the federal structure of the firm that was created in 2001. However, they proved to be ineffective in their application. Failings in the firm’s management, governance, and culture directly impacted the poor quality and heavily concentrated nature of HBOS’s lending, especially in its Corporate and International Divisions. These failings were the underlying cause of the firm’s financial vulnerabilities. The Board delegated responsibility for the firm’s overall systems and controls to the CEO. One of the key factors in the demise of HBOS was the failure to establish an appropriate strategy for the bank, set in the context of clearly identified risks and measures to quantify and control risk. Approving the strategy, which was developed by the CEO and Group Finance Director in consultation with the Chairman, was the responsibility of the Board. The Board, however, played a limited role in the development of the bank’s business strategy. As well as that, HBOS internal control functions were ineffective, resulting in discrepancies between the papers and what was actually happening.
If HBOS had a better corporate governance framework, it would have a stronger board of directors, who would be able to control management actions in order to pursue a more beneficial approach for the bank. According to Greuning and Bratanovic (2020), HBOS failed the following benchmarks, oversight by the board of directors, oversight by individuals not involved in the day-to-day running of the various business areas, direct supervision line, and independent risk management, compliance, and audit functions. There was a lack of oversight by the board and independent individuals, as well as a lack of direct supervision and independent risk management. As a result, the bank failed with spectacular damage to its reputation and tremendous debt.
Corporate Governance and Social Responsibility
Failures of corporate governance have an effect not only on a company’s financial statements but also on its reputation, which sometimes has social implications. Despite plenty of research on corporate governance and corporate social responsibility, there is a lack of consensus on the nature of the relationship between these two concepts and how this relationship manifests across institutional contexts (Zaman, 2020). According to Kurniawan et al. (2018) Sustainability Report is a form of corporate responsibility that must be considered in economic, social, and environmental aspects and is considered important because it is able to show transparency to stakeholders who can increase public trust in the company, and can also increase company value. A good corporate governance framework and corporate social responsibility can assist the company in facing the challenges and risks as a strategy for increasing the firm value by building the right image from the stakeholders’ view.
Since good corporate governance focuses not only on shareholders but also on stakeholders, corporate social responsibility (CSR) is one of the strategies to increase firm value by building the right image from the stakeholders’ standpoint. CSR disclosure in the annual report strengthens the firm’s public image and becomes one of the considerations which be noticed by investors (Mukhtaruddin, 2018). Moreover, CSR deals with ethics and morals, which significantly affect stakeholder assessments and a standpoint on the company. CSR can be interpreted as a company committed to accounting for the impact of operations in social, economic, and environmental dimensions. When CSR is transparently included in corporate governance decisions, it enables the stakeholders to appreciate the company’s efforts, which positively impacts the company’s image. Furthermore, the discourse on CSR gets a good response from the company because corporate reporting on the economic, environmental, and social aspects is believed to improve and strengthen the firm’s image in society and increase the corporation’s chance to survive and sustain (Socoliuc et al., 2018). Good environmental management and social relationships can help a company to avoid public and government claims and accusations and improve its image and effect on companies.
Both HBOS and Enron’s poor corporate governance techniques led to public and social consequences. The public image of both companies has failed tremendously; in the case of Enron, it also had a negative impact on the industry in general. Enron scandal also resulted in increased unemployment levels following the company’s announcement of bankruptcy. Unemployment is a direct social consequence of poor governance. The bank scandal, however, resulted in a large number of customers losing their deposits. Moreover, it had a negative impact on the local government and the banking industry. HBOS was one of the biggest banks in the country; thus, the scandal had a vast negative economic effect.
As a result of these scandals, social responsibility now takes an active place in the corporate governance framework. CSR can protect the interests of the company itself, with the ease of society in accepting the company’s presence, and then the company’s operations can be run without interruption. When stakeholders believe and trust the company, it is considered more trustworthy. This, therefore, leads to increased investor confidence and more investment coming in. Thus, resulting in benefits for the shareholders as well. Consequently, it can be stated that when corporate governance takes social responsibility into account, it leads to a better image among the stakeholders, which leads to increased levels of investment and benefits for the shareholders. Overall, CSR is beneficial not only for stakeholders but for the shareholders as well, which is a direct point of good corporate governance.
Future Implications for Governance
Based on consideration of the social and ethical consequences of the abovementioned scandals, a truly socially responsible company would look like the following. CSR would be included in every step of the governance, such as issuing transparent reports and making social commitments and decisions that are focused on external and internal stakeholders first, as opposed to just focusing on the shareholder returns. Moreover, the company will follow a corporate governance framework, such as disclosure of all materials and documents regarding the corporation, including the financial situation, performance, ownership, and governance of the company. The board of governance and independent oversight, as well as a direct supervision line and independent risk management, compliance, and audit functions, would also be taken into account. This would lead to a socially responsible company with strong governance and control.
Conclusion
Corporate governance and risk management are considered one of the most important factors influencing a company’s success. Corporate governance covers several dimensions, including enterprise risk management, strategic planning, accounting and disclosure, talent management, and succession planning. It is defined by a set of relationships between the management, shareholders, and other stakeholders. Risk management is the process of identifying and assessing potential legal, financial, and strategic risks to the corporation in order to avoid or minimize their impact. Risk management is a part of corporate governance. Good corporate governance helps to build an environment of trust, transparency, and accountability necessary for fostering long-term investment. Functional, independent governance practices are among the key conditions to achieving and maintaining public trust and, more broadly, confidence in the corporation.
Business organizations have witnessed a series of corporate collapses, an increase in fraudulent practices, and accounting inconsistencies in highly successful firms such as Enron, Halifax Bank of Scotland, and British Home Stores. Failures of corporate governance have an effect not only on a company’s financial statements but also on its reputation, which sometimes has social implications. Both HBOS and Enron’s poor corporate governance techniques led to public and social consequences. As a result of these scandals, social responsibility now takes an active place in the corporate governance framework. Overall, CSR can improve company image and is beneficial not only for stakeholders but for the shareholders as well, which is a direct point of good corporate governance. Finally, following the corporate governance framework that involves CSR, risk management, and proper governance techniques will result in a successful future for the company.
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