Much to our chagrin, we saw last month how a simple, harmless English summer sport, which began in the meadows of Kent and Sussex in the 18th century and was founded on the principles of “fair conduct and sportsmanship”, got entangled in the lure of money, betting, gambling, amorous relationships, glamour, politics, TRPs et al. And as the events concerning the Indian Premier League (IPL) unfolded, a spate of issues and concerns have surfaced, which squarely fell into the domain of “corporate governance”, reminding us of cases like Enron, Satyam and the like. This article is not about cricket, but it is about such issues and their deeper relationship with corporate governance, business ethics and the sustainability of a business enterprise. It is about those fundamental questions that the governing boards of any enterprise should be aware of and know the answers to. What are they?
An important question to ask is: How is the enterprise making its money? This question seems very simple, straightforward and even childish, and is usually not asked, especially when the enterprise is doing very well (remarkably well at times), because it is often assumed that everybody knows the answer to this question. Peter Baring, chairman of Barings Bank, did not think it necessary to ask this question when his Singapore office under Nick Leeson was making remarkable profits. The Enron board did not ask this question between 1995 and 2001, a period when the company seemed to perform brilliantly on Wall Street. Nor did the Satyam board ask this question. However complex the business of an enterprise may be, clear, transparent and fairly audited accounts should reveal the way it makes money. But it will not do so, if creative accounting is resorted to; if business expediency requires the creation of numerous shell investment companies or special purpose vehicles; or if there are a large number of layered and structured offshore entities in tax havens to route foreign funds and obfuscate the money trail and the ownership. All of this turns an enterprise into a “black box”. Sustainable enterprises, on the other hand, are not black boxes. These black boxes may be money-making machines in the short run, and those responsible for running these may be hailed for their financial wizardry and business strategy, but corporate history is replete with examples of failures of such businesses.
Every enterprise has a business model, which guides its business priorities. These models are not fortuitous, but are often chosen by design and the predilection of the person behind the enterprise. So the next important question to ask is: Who are the people behind the enterprise? There can be good business models run by good people; bad models run by bad people and good models run by bad people or vice versa. The quality of the model and the people running it are functions of the quality of governance and integrity and ethics of the executive managers. The background of the people behind the enterprise, especially of the person who has conceived the model and is running it, or the chief executive; their beliefs and lifestyles; their desire to grow rich and flaunt high connections are all important.
Their behavioural patterns are determined by greed, hope, uncertainty, fear and hubris, so well portrayed by Aeschylus, Sophocles and Aristotle. These traits shaped Ramalinga Raju’s Satyam, Kenneth Lay’s Enron, Robert Maxwell’s Maxwell Communication Corporation, Mike Milliken’s Drexel Burnham Lambert and Harshad Mehta’s broking firm. Quite the contrary, we have examples of great and enduring business enterprises shaped by the visionaries who stewarded them.
Enterprises and their boards often have to deal with business transactions in which there are conflicts of interest between an executive’s or a director’s private interests and his/her duties to the enterprise or to the board. This can often impair the integrity, independence and quality of the decisions. If not managed in a transparent and legal manner, these conflicts lead to corrupt practices and can be a drain on the financial resources of a company. Only well-governed companies and institutions have ways and means to deal with such situations effectively.
So here’s another question: Is the board or the the audit committee aware of the conflicts of interests and the related party transactions that the board members or executives have entered into, and does the enterprise have well-established, transparent mechanisms to deal with them?
Brand value and goodwill accounting are areas in which things can go awfully wrong. It is useful to ask: How is the brand valued? Brand value is an intangible asset that represents the extra value ascribed to a company by virtue of its brand and reputation. One may arrive at a number by a mathematical formula based on free cash flow, earnings before interest and taxes (EBIT) and sales projections. But brand value is more than a number. Common sense dictates that trust and consistency, which are the basis of brand equity, cannot be built in a day or by glamour or glitter. But there is no dearth of financial engineers who bypass common sense and produce impressive make-believe numbers of brand value of a not-so-old enterprise on the basis of financial projections of next 10 years. This is what Jeff Skilling of Enron called “hypothetical future value accounting” and made Wall Street analysts believe in it. Attractive valuations, though illogical, lure investors, especially when alternative investment avenues are limited.
Leverage is necessary for businesses to grow. It is an enabler, but it is also a bar. So this brings us to the next question: How much leverage-dependent is the growth strategy? When people driving enterprises are in a tearing hurry to grow, demonstrate quick results and build empires, they choose to use leverage, grow inorganically and get into an acquisition spree. Initial successes with the inorganic growth strategy help win plaudits for their enterprises and for them too. The assumption behind the increasing leverage is unlimited availability of liquidity, and the ability of the acquired businesses to service the incremental increases in debt. But neither the business nor the people have any control over domestic or global macro-economic conditions. Once these conditions reverse, the impact will be felt on interest rates and liquidity. The enterprise will suffer. Denis Kozlowski of Tyco International followed an aggressive acquisition strategy between 1991 and 2001, acquiring more than 1,000 companies. Once the dot-com bubble burst, Tyco could no longer sustain the leverage and the increase of business complexities. It had to resort to an accounting fraud, which was discovered in 2002. The fervour accompanying instant success is like Marich in the Ramanayana — if caution is not exercised in time, the result may be the abduction of Sita.
One could, of course, enlarge the list, but these five questions hold the key to ethically running a business enterprise. Businesses have failed because the board, the shareholders and the analysts did not know the answers. When enterprises fail, the board members are known to take refuge under the pretext that “the matter was not brought before the board and so we did not know”. The question to be asked at that point is: Did you ever ask and should you not have asked?
Views expressed are personal The author is a former executive director of Sebi and is currently associated with International Finance Corporation’s Global Corporate Governance Forum and the World Bank