In recent years, corporations have had significant problem

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Preventing Shareholder Leakage

• W. Steve Albrecht, Associate Dean
• Ned Hill, Dean

Marriott School of Management, Brigham Young
University
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• In recent years, corporations have had
  significant problems that have shaken investor
  confidence. Losses worldwide have exceeded
• 15 trillion
• Transparency International concluded that
  unethical corporate behavior has destroyed more
  wealth than all the worlds terrorist acts
  combined.

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In the United States, the effects have been
dramatic
5049
5000
4000
3000
2000
1114
1000
The NASDAQ Bubble
2004
2003
2002
2001
2000
1999
1998
1997
1996
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Example of Shareholder Loss
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Example of Shareholder Loss
Adelphia
The company filed bankruptcy on June 25, 2002 and
its stock price bottomed after it was de-listed
from the NASDAQ.
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Largest U.S. Bankruptcies
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Fraud InternationallyTransparency International

• 1. Iceland
• 2. Finland
• 2. New Zealand
• 4. Denmark
• 5. Singapore
• 5. Sweden
• 7. Switzerland
• 8. Norway
• 9. Australia
• 10. Austria

• 15. Hong Kong
• 17. United States
• 21. Japan
• 32. Taiwan
• 39. Malaysia
• 40. Korea
• 78. China
• 126. Russia
• 158. Bangladesh
• 158. Chad

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Causes of problems

• There have been numerous ethical problems in
  corporations that have caused this leakage in
  shareholder value. This presentation will
  consider some of the most egregious.

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Types of Shareholder Leakage

• Misstated financial statements
• Enron
• Global Crossing
• WorldCom
• HIH
• Livedoor
• SK Global
• Daewoo
• Parmalat

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Types of Shareholder Leakage

• Financial statement restatements

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Example of financial statement fraud

• Complaint The goal of this scheme was to
  ensure that (the company) always met Wall
  Streets growing earnings expectations for the
  company. (The companys) management knew that
  meeting or exceeding these estimates was a key
  factor for the stock price of all publicly traded
  companies and therefore set out to ensure that
  the company met Wall Streets targets every
  quarter regardless of the companys actual
  earnings. During the period ___ to ___alone,
  management improperly inflated the companys
  operating income by more than 500 million before
  taxes, which represents more than one-third of
  the total operating income reported by (the
  company).

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Complaint in Fraud CaseExpert Witness

• The participants in the illegal scheme included
  virtually the entire senior management of (the
  company), including but not limited to its former
  chairman and chief executive officer, its former
  president, two former chief financial officers
  and various other senior accounting personnel.
  In total, there were over 20 individuals (all but
  three were accounting majors) involved in the
  earnings overstatement schemes.

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Types of Shareholder Leakage

• Executive loans and corporate looting
• Adelphia (John Rigas)
• Tyco (Dennis Kozlowski)
• Samsung Group (Lee Kun-hee)
• Daewoo (Kim Woo-chang)
• Livedoor (Takafumi Horie)

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Types of Shareholder Leakage

• Insider Trading
• Martha Stewart
• Sam Waksal
• One Tel executives in Australia

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Types of Shareholder Leakage

• Special favors and deals to friends
• IPO favoritism
• Spinning
• Laddering
• Other quid pro quo transactions
• Enron paid several hundred million in fees,
  including fees for derivatives transactions.
• In October, 2001, 16 of 17 security analysts
  covering Enron rated it a strong buy or buy.
• Example Alliance Capital purchases 7,583,900
  shares of Enron for the Florida Retirement Fund
  in just months prior to bankruptcy
• At Alliance Capital, we place a premium on
  investment research. We carefully select
  securities based on our proprietary research.
• Alliances Harrison (WSJ, 12/13/2000) Enron has
  so many parts, nobody knows how they put it
  togetherEnron was a faith stockThe company
  (Enron) seemed on a deliberate path not to give
  full information.

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Types of Shareholder Leakage

• Executives who dont tell the truth or cheat
• RadioShack (2006)
• David Edmondson lied about his resume
• Arrested for drunken driving several times
• The RadioShack Corporation board of directors is
  aware of the matters raisedand has previously
  given due consideration to them. The board of
  directors reaffirms its support for David
  Edmondson in fulfilling his role as chief
  executive.
• Stock price dropped because of inaction and
  Edmondson was forced out.
• Toyoko Inn Co. executives (President Norimasa
  Nishida) removed required disabled parking in 60
  of 122 hotels in Japan for additional hotel
  rooms, smoking corners and bigger lobbies

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Types of Shareholder Leakage

• Obscenely high amounts of executive pay
• Analog Devices CEO Jerald G. Fishman (2006)
• Owed 144.7 million in deferred compensation and
  stock options
• Paid 6.48 interest on deferred compensation when
  average was 4.64 (Earned 8.7 million on
  deferred compensation last year in interest)
• During past 5 years, stock has lost 6.55
  annualized
• NYSE CEO Richard Grasso received 144 million in
  excessive pay and stacked Compensation Committee
  with friends

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Types of Shareholder Leakage

• Excessive salaries (year totals)

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Types of Shareholder Leakage

• Obscenely Rich Retirement Perquisites
• Henry A. McKinnel, Jr. CEO of Pfizer Corp
• Will retire in 2008 and will get 6.5 million a
  year for life (71 million present value)
• Jack Welch, General Electric
• Lifetime use of a palatial Manhattan apartment
  complete with wine, flowers, cook, housekeeper
  and other amenities
• Access to General Electric's Boeing 737 jets,
  helicopters and a car and driver for Welch and
  his wife
• Tickets for Jack and his wife at a number of top
  sporting events and the opera.

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Types of Shareholder Leakage

• Bribing Political Officials
• Glovis Co (Logistics unit of Hyundai Motor
  Co.)CEO Lee Ju-eun and his son created a 10
  billion won slush fund to lobby government
  officials and politicians
• Hyundai fund family mmebers Chung Mong Koo
  (chairman) and his son, Chung Eui Sun (chairman
  of KIA), are accused of setting up slush fund to
  lobby lawmakers
• Such bribes hurt companies and countries
• The literature reveals that significant
  improvements in governance can triple a countrys
  income per capita in the long run and decrease
  mortality and illiteracy. Countries with good
  governance encourage their citizens to
  participate in productive rather than
  diversionary activities (e.g. bribery). Large
  increases in productivity, in turn, lead to high
  growth rates.

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Types of Shareholder Leakage

• Not having good internal controls
• Not assessing risks
• Not having a good control environment
• Not having appropriate control procedures
• Segregation of duties
• Proper authorizations
• Physical controls
• Independent checks
• Documents and records
• Lack of information and communication
• Not monitoring risks and controls

Preventative Controls
Detective Controls
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Example of Poor ControlsSumitomo Corporation

• Large Fraud of 2.6 Billion over 9 years
• Year 1 600K
• Year 3 4 million
• Year 5 80 million
• Year 7 600 million
• Year 9 2.6 billion
• In years 8 and 9, four of the worlds largest
  banks were involved and lost over 500 million

Some of the organizations involved Merrill
Lynch, J.P. Morgan Chase, Union Bank of
Switzerland, Credit Lyonnaise, Sumitomo, and
others.
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Cost of Poor Controls

• Fraud Losses Reduce Net Income for
• If Profit Margin is 10, Revenues Must Increase
  by 10 times Losses to Recover Affect on Net
  Income
• Losses. 100 Million
• Revenue...1 Billion

• Fraud Reduces Income by a multiple

Revenues 100 100 Expenses 90 90 Net
Income 10 10 Fraud 1 Remaining
9 To restore the 1 of lost income, need
10 more dollars of revenue.
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Cost of Poor Internal Controls

• General Motors
• 436 Million Fraud
• Profit Margin 10
• 4.36 Billion in Revenues Needed
• At 20,000 per Car, 218,000 Cars

• Bank
• 100 Million Fraud
• Profit Margin 10
• 1 Billion in Revenues Needed
• At 100 per year per Checking Account, 10
  Million New Accounts

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Problems in Korea

• Irregularities over the use of public funds that
  were injected into the troubled financial sector
  following the 1997-98 Asian Crash
• 290 company executives, bank managers,
  bureaucrats and shareholders have been indicted
  for alleged public fund-regulated fraud
• The government has 167.8 trillion won to save
  ailing banks
• Recovered only 75.8 trillion won
• Taxpayers will shoulder 67 trillion won (Each
  South Korean will have to pay 1.4 million won
  because of the loss of funds)

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Problems in Korea

• Business fraud and corruption have cost the
  average Korean citizen thousands of dollars in
  lost taxes, income, investments and jobs
• Daewoo (1997-98) was the biggest corporate
  failure in global corporate history to
  datesparked numerous bankruptcies
• Kim Woo-chang, former CEO, was arrested and
  charged with accounting fraud and embezzlement.
  He alleged inflated Daewoos financial statements
  by 40 billion
• Korea Deposit Insurance Corporation has paid
  29.6 billion to bail out Daewoo affiliates.
• 347,000 investors lost 2.9 billion (3 trillion
  won)

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Problems in Korea

• SK Globals CEO, Chey Tae-won, was jailed for
  fraud in 2004.
• Doosans chairman, Park Yong-sung, and his three
  brothers were convicted in Frbruary, 2006 of
  embezzlement and accounting fraud
• Lee Kun-hee, chairman of Samsung Group, donated
  800 billion won of familys wealth to compensate
  for illegal donations, illegal issuance of
  convertible bonds, and other scandals

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Japanese Example

• Double financial statement fraud
• Livedoor placed 30 million of fictitious orders
  toValueClick to help it post a bogus profit
• Livedoor then booked 300 million in bogus orders
  to more than offset the 30 million increase in
  expenses created by the ValueClick orders
• It is also alleged that company officials spread
  false information in order to drive up the share
  price of a subsidiary

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Japanese Example

• January 16, 2006, prosecutors raided the
  headquarters of Tokyo-based Livedoor Co.
• Former president Takafumi Horie and three other
  executives were arrested
• Horie indicted for fraud

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Japanese Example

• Shockwaves
• As the investigation began, Livedoor lost 2/3 of
  its market value
• In one week, the share price plummeted from 696
  to 256

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Japanese Example

• Shockwaves
• During 2005, prime minister Junichiro Koizumi
  publicly supported Hories political agenda
• Koizumi felt that Horie symbolized the broader
  economic reform and entrepreneurship that he
  supported
• Koizumis involvement with Horie has turned out
  to be a major embarrassment
• Opposing politicians have begun to openly
  attacked Koizumi

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Shareholders benefit when corporations are better
governed

• Research by Roger Williamson, MIT (Studied 5,200
  companies--When a company adopted
  regulator-imposed changes (e.g. whether
  corporation has a majority of independent
  directors), they found that market valuation of
  those companies rose by an average of 40.

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Shareholders benefit when corporations are better
governed

• Research by Asbaugh-Skaife, Collins, Kinney and
  LaFond found that firms with internal control
  deficiencies have significant higher risk and
  that remediation of internal control deficiencies
  is followed by significant reductions in the cost
  of equity capital (from 50 to 150 basis points).
  They found that having strong internal controls
  is being valued by the capital markets.

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Shareholders benefit when corporations are better
governed

• Walt Disney stock is up 17 since last October 1
  after departure of Michael Eisner, former CEO who
  was widely criticized for his pay and being
  unresponsive to shareholders.

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Shareholders benefit when corporations are better
governed
DJIA
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Good corporate governance

• Australian Stock Exchange (Corporate Governance
  Recommendations and Best Practices)
• Lay solid foundations for management and
  oversight
• Formalize and disclose the functions reserved to
  the board and those delegated to management.
• Structure the Board to add value
• A majority of the board should be independent
  directors. The chairperson should be an
  independent director. The board should establish
  a nominating committee.

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Good corporate governance

• Australian Stock Exchange (Corporate Governance
  Recommendations and Best Practices)
• Promote ethical and responsible decision-making
• Establish a code of conduct to guide the
  directors, the chief executive officer, the chief
  financial officer and other key executives
  regarding (1) the practices necessary to maintain
  confidence in the companys integrity and (2) the
  responsibility and accountability of individuals
  for reporting and investigating reports of
  unethical practices.
• Disclose the policy concerning trading in company
  securities by directors, officers and employees.

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Good corporate governance

• Australian Stock Exchange (Corporate Governance
  Recommendations and Best Practices)
• Safeguard integrity in financial reporting
• Require the chief executive officer and the chief
  financial officer to state in writing to the
  board that the companys financial reports
  present a true and fair view, in all material
  respects, of the companys financial condition
  and operational results and are in accordance
  with relevant accounting standards.
• The board should establish an audit committee.
• Structure the audit committee so that it consists
  of (1) only non-executive directors, (2) a
  majority of independent directors, (3) an
  independent chairperson, who is not chairperson
  of the board, and (4) at least three members.
• The audit committee should have a formal charter .

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Good corporate governance

• Australian Stock Exchange (Corporate Governance
  Recommendations and Best Practices)
• Make timely and balanced disclosures
• Establish written policies and procedures
  designed to ensure compliance with Listing Rule
  disclosure requirements and to ensure
  accountability at a senior management level for
  that company.
• Respect the rights of shareholders
• Design and disclose a communications strategy to
  promote effective communication with shareholders
  and encourage effective participation at general
  meetingsRequest the external auditor to attend
  the annual general meeting and be available to
  answer shareholder questions about the conduct of
  the audit and the preparation and content of the
  auditors report.

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Good corporate governance

• Australian Stock Exchange (Corporate Governance
  Recommendations and Best Practices)
• Recognize and manage risk
• The board or appropriate board committee should
  establish policies on risk oversight and
  management. The chief executive officer and the
  chief financial officer should state to the board
  in writing that (1) the integrity of the
  financial statements is founded on a sound system
  of risk management and internal compliance and
  control which implements the policies adopted by
  the board and (2) the companys risk management
  and internal compliance and control systems is
  operating efficiently and effectively in all
  material respects.
• Encourage enhanced performance
• Disclose the process for performance evaluation
  of the board, its committees and individual
  directors and key executives.

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Good corporate governance

• Australian Stock Exchange (Corporate Governance
  Recommendations and Best Practices)
• Remunerate fairly and responsibly
• Provide disclosure in relation to the companys
  remuneration policies to enable investors to
  understand (1) the costs and benefits of those
  policies and (2) the link between remuneration
  paid to directors and key executives and
  corporate performance.
• The board should establish a remuneration
  committee.
• Clearly distinguish the structure of
  non-executive directors remuneration from that
  of executives.
• Ensure that payment of equity-based executive
  remuneration is made in accordance with
  thresholds in plans approved by shareholders.

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Good corporate governance

• Australian Stock Exchange (Corporate Governance
  Recommendations and Best Practices)
• Recognize the legitimate interests of
  shareholders
• Establish and disclose of code of conduct to
  guide compliance with legal and other obligations
  to legitimate stakeholders.

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Overview of Sarbanes-Oxley

• Created PCAOB
• Places limits on auditor services (8 prohibited
  services)
• Requires audit partner rotation every 5 years
• Increases liability of auditors
• Requires management to certify financial
  statements
• Management and auditor must provide an assessment
  of internal controls

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Overview of Sarbanes-Oxley

• Requires officer code of ethics
• Restricts (prohibits) officer loans
• Includes officer and director blackout periods
• Requires a financial expert
• Requires annual evaluations of board and
  committees

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Questions?