The bad and ugly sides of firms

The bad and ugly sides of firms

Sam Choon Yin (June 2005)

Firms are a funny lot. They can be both useful and harmful to the society. On the positive side, we have seen numerous companies taking part in associations like the Business for Social Responsibility and United Nations Global Compact to promote best practices, engaging in areas of human rights, labour standards and environmental practices.

 

There are essentially good and bad managers in private sector organisations. Managers are subject to control of shareholders, board of directors, government and creditors, at least in a theoretical sense, although personality also plays a role in affecting their behaviour. Undoubtedly, managers are powerful persons whom are delegated the power to make decisions on behalf of the rightful owners. Although the firms make contractual agreements with the managers, in reality, knowing exactly what the managers are doing and up to is not easy for it is not possible to monitor them day in and day out. Doing so is inappropriate possibly stifling creativity and imposing excessive costs to the firms. Therefore, every firm faces a dilemma - the possibility that firm managers engage in activities that benefit merely themselves at the expense of the principals they supposedly represent – this calls for stricter control and monitoring mechanisms in place – and yet recognising the costs and difficulty in introducing and implementing monitoring mechanisms. Corporate scandals like those of the Enron Corporation and WorldCom in the United States, Daewoo Group in South Korea and HIH Insurance in Australia show that the current mechanisms to resolve this issue are still bounded with problems.

 

Two recent events suggest the need to have stronger controls on the firms, (1) the Asian financial crisis, and (2) the September 11, 2001 terrorist attacks on the United States. The 1997-98 Asian crisis revitalised the topic on corporate governance, calling for stronger mechanisms to align the interest of the agents with that of the principals. Self-interested agents coupled with low standards of corporate governance led to corporate problems, imposing financial burden on their shareholders and laid off employees. Examples of companies involved in scandals during this period include Hyundai, Bangkok Bank of Commerce and Daewoo Group. These cases revealed the fact that there was imbalance of power within private sector organisations with the corporate managers holding relatively more power than that of the board of directors (including independent directors), auditors and shareholders. Essentially, corporate managers have exclusive power to determine how company resources are to be used, to the extent that company funds could be inappropriately allocated but diverted instead to their own pockets. As Galbraith (2004) argues, private sector managers can determine their own compensation with the board of directors playing the role of merely approving the plan to the extent that the compensations could run up to millions and rising while the company share prices were on a decline.

 

Mizruchi (2004) points out that much of the research on corporate governance concerns the means by which owners (shareholders) can effectively monitor the managers’ behaviour to ensure fair returns from their investments. One mechanism involves the provision of equity to management but this has the effect of diluting the value of the remaining owners’ equity. Another mechanism involves appointment of a competent board of directors which, on behalf of the owners, is responsible for assisting and monitoring the management team. But the board itself, regardless of the composition and structure, needs to be monitored. The third approach subjects the firms to mergers and takeovers which may subsequently result in the removal of inefficient and unethical managers. But the market for corporate control cannot unravel the agency problem concerning the budgeting process (Jensen, 2003). Takeovers can also be disruptive and generally occur only after the firm has lost a significant proportion of its value and hence the root cause of the agency problem may not be adequately addressed. I have suggested an alternative approach to deal with corporate debacle, one that calls for the private sector organisations to emulate good management practices in the public sector. This is in view of the fact that there are some public enterprises that have bucked the common perception about them being inefficient and ineffective (Sam, 2005).

 

The 911 incident has also put firms in the limelight. Scenes of commercial planes rammed into the World Trade Centre and the Pentagon, killing about 3,000 people in the process would be remembered in many decades to come. Why it happened is still in doubt, and would occupy the minds of political scientists and others over the years. A realist might argue that the feeling of being marginalized - particularly in the seemingly US siding with Israel over the Israel-Palestine conflict – angered certain factions of the Muslim community, contributing either directly or indirectly to the attacks. A liberal on the other hand may attribute the attacks to the fact that the Middle East countries were not democratised at least to the level acceptable to the West. Liberals were of the view that democracies rarely right or even threaten each other for they believe in the principles of resolving conflicts via negotiation and compromise, not violence. One thing for sure though is that the incident has connections with organisations. However, we should not put the blame entirely on the firms for they might have got themselves involved unknowingly. Airline companies selling tickets to terrorists to fly from one place to another and financial institutions opening accounts for terrorists, thus allowing them to utilise services provided by the institutions, are some examples. Flight school might have trained terrorists without knowing that they were more interested in taking-off and landing rather than learning how to fly the plane.

 

More serious culprits are those firms which offer help to terrorists deliberately so that the latter could carry out destructive acts. This can come in the form of organisations providing financial resources to terrorist groups through privately owned financial institutions. US Senator Carl Levin, in this testimony in the aftermath of 911, revealed how money was forwarded to Al Qaeda via Al Shamal Islamic Bank which Osama bin Laden helped to establish. The interesting thing was that a client of Al Shamal Bank was able to set up a corresponding account with a US bank, allowing the client in the US to make use of services provided by the bank. As Levin admits, ‘We found that US banks often perform an inadequate review of the foreign banks seeking to open a correspondent account in the United States’. This is the problem that has hindered measures aimed at tackling money laundering. In a recent article, Schneider (2002, p. 9) has found that at least 50 percent of the finances to Al Qaeda terrorist cells were obtained through illegal and underground channels. It was estimated that of the US20-50 million dollars flowed to the group each year, 30-35 percent were obtained from drug businesses, 10-15 percent were obtained from classical crime activities (like blackmailing and kidnapping) and 10-15 percent from illegal diamond trading, while the remaining were obtained from donations and other sources (both legal and illegal).

 

Governments, with assistance from various international institutions, are taking a tougher stand to mitigate this problem. In November 2002 for example, the US government found Broadway National Bank guilty of felony changes for not filing suspicious activity reports on US$123 million in cash deposits, as well as failing to introduce measures in deterring money laundering. In Japan, financial regulator the Financial Services Agency (FSA) had ordered Citigroup Inc to suspend its private banking business. This was after the private bank had failed to implement adequate safeguards against money laundering (in addition to other violations like misleading customers about financial risks). The licence held by Citigroup to carry out private banking in Japan will be revoked by the Japanese government on 30 September 2005. Essentially, criminals and terrorists can launder money from illicit activities to their supporters through intermediaries such as Broadway and Citigroup. This is a more clear-cut case. In some circumstances, legitimate businesses and charitable organisations are involved, donating money to others connected to terrorist groups. Because of the legitimacy of such transactions, detecting them is more difficult.

 

Such negative perceptions about firms arising primarily from the Asian financial crisis and 911 incident are unfortunate. There are indeed positive aspects of private sector organisations that one should not disregard. One recent example concerns firms’ strong commitment and positive reaction to assist those countries hit by tsunami in December 2004. TNT for example provided the UN free use of its fleet of trucks to deliver aid supplies to Aceh Province. French telecommunications company, Alcatel SA helped to restore fixed and mobile telephone networks while Swiss-based Nestle SA gave more than 12,000 boxes of food aid. In fact, the very presence of business firms helps to reduce transaction costs, allowing individuals like you and me to make purchases of a variety of goods and services at prices possibly many times lower than were the case where we have to produce the goods ourselves. Let us not stereotype firms as necessarily bad. There are good managers around. The challenge is to introduce checks and balances to see that the larger group of people do not get harmed and penalised because of improper acts of a few.

 

References

Galbraith, John Kenneth, 2004, The Economics of Innocent Fraud: Truth for our time, Houghton Mifflin, Boston, US.

Jensen, Michael, 2003, Paying People to Lie: The Truth about the Budgeting Process, European Financial Management, Vol. 9, No. 3, pp.: 379-406.

Mizruchi, M.S., 2004, Berle and Means Revisited: The Governance and Power of Large US Corporations, Theory and Society: Renewal and Critique in Social Theory, October 2004, Vol. 33, Issue 5, pp. 579-617.

Sam, Choon Yin, 2005, Some commonalities between public sector and private sector management: Can emulating public sector management practices be a response to corporate scandals?, unpublished manuscript.

Schneider, Friedrich, 2002, “The Hidden Financial Flows of Islamic Terrorist Organisations: Some Preliminary Results from an Economic Perspective”. Paper presented to the DIW Workshop on ‘The Economic Consequences of Global Terrorism’, in Berlin 14-15 June 2002.