Raviting Rambles | Legal Versus Ethical compliance mechanisms in Corporate Governance: Can one survive without the other in Corporations?

Hello everyone and apologies for the delayed posting. A bit off the tangent as regards the tone set in the blog, but you must have noticed, i dabble a bit in Corporate Commercial Law and Practice!

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Corporate governance issues are always dealt with from a compliance viewpoint. A distinction is made in this post between legal and ethical compliance mechanisms and shows that legal compliance mechanisms have proven to be inadequate as they lack the moral valour to restore confidence and the ability to build trust. More so, legal compliance mechanisms are insufficient in addressing fraud and may not be dealing with the real and fundamental issues that inspire ethical behavior. Solely focusing on legal compliance mechanisms may result in an attempt to alternate “accountability” for “responsibility” and in addition to this, may result in an attempt to legislate morality. It is important to look at virtues and ethical principles in governance in order to establish practical responses grounded on the consistent use of core values and principles as well as commitment to ethical corporate practice. For more than two decades, corporate governance has invited a great deal of public interest due to its importance for the economic health of corporations and society in general. The headlines of the previous six years in particular have portrayed the despondent story of corporate ethics: WorldCom, Anderson, Enron, Merrill Lynch, Martha Stewart, Global Crossing, Qwest Communications, Adelphia Communications, Tyco International, Boeing, Rite Aid, Xerox and the National Housing Corporation, East Africa Portland Cement Company, CMC Holdings Ltd. – and specifically – CMC Motors Group, among others, closer home.

Dubious accounting practices, falling stock markets, abuses of corporate power, criminal investigations and corporate failures, indicate that the whole economic system on which investment returns are dependent has shown signs of failure which has undermined investor’s confidence. Some companies have grown dramatically in a relatively short time through acquisitions driven by inflated share prices and the affirmation of even brighter futures and as the case has been, many of these entities have now failed leaving hopeless creditors and shareholders wondering what was wrong with the company in the first place. In others, the checks and balances geared at protecting shareholder interests seem to have been shoved to one side, driven by a perception on the need to move fast in the pursuit of profitability. While it has been seen that some failures were as a result of fraudulent accounting and other illegal practices, a great majority of companies displayed evident corporate governance risks such as inexperienced directors, conflicts of interest, overly lucrative compensation to directors, or unequal share voting rights.[1] In the face of such malpractices, there has been a renewed emphasis on corporate governance.

Corporate governance covers distinct concepts and as seen from the definition adopted by Organization for Economic Cooperation and Development (OECD), “Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders and spells out the rules and procedures for making decisions in corporate affairs. By doing this, it also provides the structure through which the company objectives are set and the means of attaining those objectives and monitoring performance.”[2] Corporate governance therefore encompasses the relationship of a company to its internal and external stakeholders; the promotion of probity, transparency and accountability and fairness; reference to mechanisms that are used to control managers’ functions and to ensure that the actions taken by such managers and directors are consistent with the interests of key stakeholder groups.[3] Key to note in corporate governance therefore, is that it includes issues of transparency and accountability, the legal and regulatory domains, information flows, risk management mechanisms, and the roles and responsibilities of senior management and board of directors. Legal compliance mechanisms have been adopted by many Companies.

From an ethical point of view, the key issues of corporate governance revolve around relationships and building trust (both within and outside the organization). Harshbarger and Holden (2004) point out that while many corporate governance issues are not new, more so, the environment in which they exist is more strained than ever: significantly increased resources have been applied by law enforcers; a more hostile philosophy toward defiance of governance breaches has been aggressively countered; media focus has increased awareness among those stakeholders directly affected as well as the Corporate community in its entirety; shareholder rights are taken more seriously; and the courts have demonstrated willingness for a strict definition of “good faith”.[4] In addition to this, a number of factors that have further brought ethical issues into sharper focus include globalization, technological innovation and rising competition. It has also been seen that a company’s professional service delivery needs to take place in an environment where there is an increasing tendency towards individuality in operation, whereas society as a whole becomes more global[5]. These new realities of corporate governance show that no corporate entity or its agent is immune from fraud or fraudulent practices[6] and these realities have changed the mode of operation of companies; re-defining the baseline for what is considered prudent conduct for businesses and corporate executives[7].

Legal versus Ethical Compliance Mechanisms in Corporate Governance

On the mere extrapolation of the difference between law and ethics gives as the following differences. Specifically, law is concerned primarily with conduct and ethical requirements are centrally concerned with reasons, motives, intentions, and more generally with the character that expresses itself in conduct. Ethics therefore is concerned with what we are and not just what we do. Also, law is jurisdictionally limited since what is legitimately required in one state or country may differ from another, whereas ethical values are inclined to be more universal. Again, the overemphasis on legal compliance mechanisms could be at the expense of ethical reflection since people may desist from forming their own opinions and taking personal responsibility for the decisions they make and hence create indifference in the day to day operation of the business, for purposes of merely evading illegality. This leads to Corporations corresponding to the letter of the law which may not necessarily inspire or instill excellence.

 

Legal Compliance Mechanisms in Corporate Governance

Key to note in legal compliance mechanisms is the fact that corporate abuses that have been unraveled and that have caused public uproar are entirely legal, for example, companies that have filed misleading accounting statements that are in complete compliance with generally accepted International Financial Accounting Standards (IFA’s). This difficulty has been cited in many companies. Further, laws regulating companies are largely ambiguous due to the fact that they are mainly procedural, and courts have a hard time grasping abstract and sophisticated financial concepts (for example, special-purpose entities or complex derivatives), well-counseled executives have been able to evade from liability. The fact that criminal law will only hold them liable in extreme cases makes such violations hard to enforce. In such cases, middle level managers are not afforded any help from legal compliance mechanisms when receiving explicit instructions from directors to do acts that would otherwise be considered unethical or illegal and naturally, have resolved such dilemmas faced largely on the premise of personal reflection and their own individual values, and not through the reliance of corporate credos or company loyalty. Further, auditors’ credibility has been undermined due to misrepresentation of financial statements.

Hence, it is important to look at ethics in the business world, particularly ethics in financial systems, since therein lies greater incentives for unethical conduct. Due to the nature and magnitude of corporate scandals, renewed interest and highlight on legal compliance mechanisms has grown. In light of this, the US Sarbanes-Oxley Act of 2002[8] encapsulates proposals for increasing chief executive officers’ (CEO’s) accountability for financial statements, penalty for fraud are increased, officers of the company are mandated to sign off financial statements, roles of the audit committee are strengthened, and prohibits several types of non-audit consulting services provided by outside auditors. Under the Act, Auditors are required to give Audit reports to audit committees on adherence to critical accounting policies and practices, to bring to attention any material written communications with management (which could include disagreements as to the presentation of a company’s accounts) and to provide information on alternative treatments of financial information.

It then holds that the ethical functioning of financial institutions cannot be left to the imposition of ethical codes of conduct, however, the only way in which corporations can be ethical is for people therein to be ethical.

Ethical Compliance Mechanisms in Corporate Governance

Specific features of legal compliance programs are outweighed by the broader perceptions of the program’s orientation toward values and ethical aspirations.[9] What helps is the consistency between policies and actions as well as dimensions of the organization’s ethical climate such as ethical leadership, fair treatment of employees, and open discussion of ethics. Conversely, what is most injurious is an ethical culture that emphasizes unwavering obedience to authority and self-interest and the ill-conceived perception that legal compliance programmes are implemented only to protect the top level management from blame. The same regard is held in dealing with issues of ethical leadership and the character traits of effective business leaders in the culture of companies that adapted from simply good businesses into great solid companies that produced phenomenal and evened – out returns for their stakeholders and thus, the perception is that the great directors in Corporations were also people of integrity and good conscience, who put the interest of their shareholder and their employees ahead of their own self-interest. Trust, integrity, and fairness do matter and are crucial in the long run.

Corporate leads and entrepreneurs in a way forgot that business is all about ethical values and are now paying the price in a declining market trend with a loss in investor confidence. The realisation that many companies have played loose with accounting rules and ethical standards while allowing performance to be detached from worthwhile corporate values, is leading to a re-evaluation of corporate goals, values and purpose. What should and is slowly emerging is a new model of the corporation in which corporate cultures will change in a way that emphasises on integrity and trust. Such changes would include the diminishing of the sole focus on “shareholder value” which measures the performance of the company on the sole basis of share price; the elevation of the interests of employees, customers, and their communities; a reassessment of executive pay to create a sense of fairness; a resetting of expectations so that investors are more realistic about the returns a company can legitimately and consistently achieve in highly competitive markets.

The question that then begs whether corporate culture is likely that much of the effort being directed to formulaic conformity with the appearance of ethical probity? Will corporations be prompted merely to offer empty clichés in their public embrace of integrity?

Conclusion: One without the other?

Ethics is truly a vital element for corporations’ success and it will continue to serve as the blueprint for success. Companies must make a profit in order to survive and grow; however, the pursuit of profits must stay within both legal and ethical bounds.  Hence, with effective corporate governance based on core values of integrity and trust, Companies will have competitive advantage in attracting and retaining talent and generating positive reactions among external and internal stakeholders and also employees in the workplace, ensuring overall loyalty to the Company.