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Biggest corporate failures, the underlying agency problem, and the corporate governance measures.
Abstract:
Based on our study of the biggest corporate failures in history from Barings Bank to General Motors we contend that despite the seemingly varied reasons suggested by the media the underlying cause of corporate failures in majority of the cases was agency problem. The academic literature addresses this problem under the umbrella of corporate governance. Most studies in this literature measure corporate governance by the G-index developed by Gompers, Ishii, and Metrick (2003). We show that the G-index and/or the entrenchment index of Bebchuk, Cohen, and Ferrell (2009) would have misclassified majority of the firms that we study as well-governed firms. However, we also show that majority of the firms that ultimately failed showed deterioration in their corporate governance measure over time as they approached their ultimate demise. We therefore suggest that future studies rely not only on the level of Gindex or entrenchment index as a measure of corporate governance but the change in these indices over time.

Keywords: Technology Management; Technology Strategy, Product Life Cycle, Biotechnology, Technology Adoption, Healthcare

Subject:
Corporate governance (Analysis)
Economic growth (Analysis)
Authors:
Maskara, Pankaj K.
Eser, Zekeriya
Claassen, Bjoern
Pub Date:
09/22/2012
Publication:
Name: European Journal of Management Publisher: International Academy of Business and Economics Audience: Academic Format: Magazine/Journal Subject: Business, international Copyright: COPYRIGHT 2012 International Academy of Business and Economics ISSN: 1555-4015
Issue:
Date: Fall, 2012 Source Volume: 12 Source Issue: 3
Geographic:
Geographic Scope: United States Geographic Code: 1USA United States
Accession Number:
312171936
Full Text:
1. INTRODUCTION

Economic growth and enhancements in production efficiency over the last couple of centuries can arguably be attributed to the widespread separation of ownership and management during this time. The benefits of this phenomenon have been counted numerous times in the economics literature. The prime disadvantage of this separation is the agency problem introduced in the system because of misaligned interests of the owner and the manager. The literature is ripe with theories and empirical results that highlight the consequences of the agency problem. Several methods and tools have been promoted that help reduce the inefficiencies introduced by this problem. In this paper, we document the effects of agency problem on the overall economic system as witnessed by the global recession that started in 2008. We argue that the roots of all corporate failures can be traced to agency problems and the several methods that have been promoted in the literature as effective ways to mitigate agency problems have failed repeatedly to the detriment of the shareholders. We study the root causes of biggest corporate failures in history up to and including Bear Stearns and Lehman Brothers and document that the widely used measures of corporate governance in the academic literature, the governance index and the entrenchment index, would have misclassified majority of the companies that ultimately failed as companies with good corporate governance. We suggest that the change in the value of these measures over time for our sample companies would have performed better in identifying them as companies with deteriorating governance than the level of indices at any given point of time. Firms that ultimately failed showed decreasing levels of corporate governance as they approached their ultimate demise even though based on their governance index they would still have been classified as well-governed firms right before they failed.

2. CORPORATE FAILURES

The classic example of corporate failure that found its way to textbooks on corporate finance in the late nineties is that of Barings Bank. A rogue trader named Nick Leeson was single-handedly able to bring down a 233-year-old bank in 1995. The bank was finally sold to ING for one British pound. The report published by the Board of Banking Supervision of the Bank of England identified three main causes for Baring's failure: 1) unauthorized and concealed trading activities 2) Serious control failures and managerial confusion within the company 3) lack of detection by external auditors, supervisor, or regulators (Bair, 1995; HM Treasury, 1995).

Thirteen years later history repeated and the Barings' story came into limelight once again because of a similar incident that took place at Soceite Generale, the leading 145-year old French bank. In 2008, Jerome Kerviel, a derivatives trader at Societe Generale, took derivatives positions that far exceeded his approved limits and ultimately cost the bank over $7 billion. The causes identified by the bank in its internal study were almost identical to those identified by the report on Barings' failure. The difference between ING and Soceite Generale was that 'Risk' magazine had named Societe Generale as the best equity derivatives operation in the world in the prior year.

Though the similarity of the causes behind the two failures mentioned above never escaped detection we contend that the reported causes were just the symptoms of a bigger underlying problem--the agency problem. It is common practice in the corporate world now to offer performance bonuses to managers/employees to align the interest of the shareholders with those of the managers. Performance pay is the most widely accepted tool used to mitigate agency problem. Unfortunately, performance pay creates problems of its own that are manifested in situation like those of Barings' Bank, Societe Generale and several others (to be discussed later). It grants a call option to the agent on the performance of the company. The agent shares profits with the principal but does not have to share in the losses. This creates perverse incentives for the agent to take undue risk. Consequently, agents like Nick Leeson and Jerome Kerviel take positions that far exceed the limits approved for them and conceal the unauthorized positions. By taking bigger positions, they increase the value of their call option.

At the same time, the supervisors who as the agents of the owners have the responsibility to enforce internal control processes ignore red flags because they also share in the payoff of the call option of the rogue employee. As will be apparent later in our examples, the external agents like auditors of the company also suffer from agency problem when they ignore red flags.

Historically, external auditors were brought into existence to manage agency problems. They were introduced into the system to safeguard the interests of the owners along with creditors and other stakeholders. Today the external auditors themselves suffer from agency problem. As the agents of the shareholders of a company, they are expected to look after the interests of the shareholders but their future appointment as consultants and auditors are strongly influenced by the management. Therefore, external auditors have repeatedly been cited as the contributing parties to corporate failures.

The demise of Enron and Arthur Anderson readily explains the consequences of agency problems encountered in relationships involving external auditors. Enron's executives engaged in self-dealing when they traded with partnerships in which they or their relatives were partners. They also abused their personal expense accounts and lent themselves hundreds of millions of dollars on behalf of the company. Arthur Anderson knowingly helped the company in its fraudulent activities because Enron was one of Andersen's largest clients and Andersen earned ten million dollars from Enron in annual auditing and other fees. Instead of reporting these activities to the appropriate authorities, Andersen helped Enron continue its questionable practices by allowing it to treat off-balance sheet activities favorably and it called for mass destruction of Enron documents rather than assist SEC in the investigations ex post. Enron's executive also inflated expectations of future cash flows and sold their shares in the company at inflated prices. These acts of self-dealing, abuse of personal expense accounts, loans to self, insider trading and misrepresentation of off-balance sheet activities were all a result of agency problem. Additionally, failure by Arthur Andersen to report these activities and mass destruction of Enron documents were partly a manifestation of agency problem between Arthur Andersen employees and its shareholders.

In a related episode, WorldCom followed Enron into bankruptcy in 2002. Coincidently, Arthur Andersen was also the external auditor of WorldCom. However, in this case after discovering the irregularities in WorldCom's financial statements regarding capitalization of expenses, Arthur Andersen advised WorldCom's audit committee that the company's financial statements were not reliable. Consequently, the board of directors at WorldCom replaced Andersen with KPMG as WorldCom's external auditor (Tran, 2002). The Board of directors at any company is designed to be the first line of defense against agency problem. The board is appointed by the shareholders primarily for safeguarding the interest of the shareholders but the management unduly influences the compensation, appointment, and re-appointment of board members thereby making it beneficial for the board members to play along with the management. Additionally, management members often serve as board of directors at other firms. This allows for reciprocity behavior. Consequently, board members ignore the interests of the shareholders to preserve their personal interest. WorldCom's board members were aware of the financial situation at the firm but kept mum to the detriment of the shareholders.

Organization theory suggests that agency problem cannot be eliminated as long as the manager is not the 100 percent owner of the organization. When the manager is less than 100 percent owner of the company, he/she stands to gain 100 percent of some benefits for less than 100 percent of the costs because some of the costs are shared with other owners. This results in agency problem between majority shareholder managers and passive minority shareholders. Parmalat, an Italian milk company, filed for bankruptcy in 2004 and exemplified the helplessness of minority shareholders. Calisto Tanzi, the founder of Parmalat, transferred money to family firms and defrauded the company even though he was the majority shareholder because by defrauding the company, he was getting 100 percent of the benefits but the outside shareholders were sharing in the costs to the company. The external auditors, board members, the senior management of the company played along with Tanzi because it was in their best personal interest to do so.

3. THE GLOBAL FINANCIAL CRISIS OF 2008

We now focus on the financial crises that mired the global economy in 2008-2009. Several forms of agency problem contributed to the perfect storm that resulted in the global recession. The first remarkable corporate failure during the financial crisis was also the largest bankruptcy in history. Lehman Brothers had assets worth $639 billion when it filed for bankruptcy. The next largest bankruptcies were those of WorldCom and Enron (discussed earlier) with assets worth $104 billion and $66 billion, respectively. At the heart of Lehman bankruptcy were the mortgage-backed securities that symbolized the agency problems that plagued the housing market from 2003 to 2008. During this period, Lehman Brothers was one of the leading players in the mortgage origination business. Through its subsidiaries and affiliates, the company wrote mortgages to borrowers with questionable credit. Agency problems crept into the mortgage underwriting process at several stages. First, the loan officer, who was the agent of the bank, bent the rules to make it possible for borrowers with bad credit and no income to get a loan because his compensation was based on the number of loans he closed. The supervisors as agents of the company did not enforce internal control because their compensation would have been adversely affected. The loan originating company (hereafter referred to as bank) never intended to keep the loans on its books. It originated loans as an agent for Freddie Mae and Fannie Mae and earned origination fee on every loan. Though the bank, as an agent, was expected to look after the interest of the principal, Fannie and Freddie Mae in this case, and do due diligence before originating the loan, the bank itself had no exposure to the loan and therefore did not ensure that the money was lent to a creditworthy borrower.

Fannie and Freddie Mae themselves suffered from major agency problems due to the very basic design of the companies. They are both private companies backed by the government. The management of the company is an agent for two competing principals with diverse interests--the shareholders and the government. As the companies had implicit (now explicit) backing of the U.S. government, they were able to borrow cheaply in the debt market. It was in the best interest of the shareholders to capitalize on the lower cost of debt capital by increasing leverage. On the other hand, the government was left with the costs of debt guarantees and it therefore preferred lower leverage. The companies had a mandate to serve as a pipeline between the bond markets and homeowners by creating and selling securities. Instead, the companies bought and held securities and increased the size of their balance sheet to approximately $6 trillion. Bigger balance sheets allowed senior managers to negotiate higher compensation packages and resulted in higher power and status. The empire building behavior of the management was once again a classic manifestation of misaligned interests between the agent and the principal, the government.

In a related example, Fannie Mae suffered from a major accounting scandal in 2003-2004 when the top three executives stole over $115 million by "cooking the books." The scandal cost the company millions in fixing the accounting problems and over $400 million in fines. Yet the culprits did not receive jail time because the management was able to employ lobbyists and create new political committees. The management at Freddie and Fannie Mae routinely used company's resources to employ lobbyists to forward their interests instead of their principals' interests. Even in the recent aftermath of government's infusion of cash, Fannie and Freddie Mae still employed lobbyists to change government policies and forward the minority shareholders' and the management's interests using company resources which by then were majority owned by the government. Freddie Mae and Fannie Mae were not the only ones abusing company's resources, AIG, the recipient of the largest bailout in history kept spending money on lobbyists to loosen new restrictions placed on the mortgage industry even though the government had 80 percent ownership in the company based on the original AIG emergency loan agreement.

In some cases, banks did not sell the mortgages to Freddie and Fannie Mae but pooled mortgages, securitized them, and sold them as Mortgage Backed Securities (MBS). In such cases, the services of rating agencies were employed. The rating agencies, as the name suggests are agents of the investors, and are designed to perform due diligence on securities offered for sale. However, the rating agencies assigned AAA ratings to non-deserving securities because they feared losing business to other rating agencies. Consequently, banks like Lehman Brothers were able to shop for best ratings. The rating agencies even provided banks with handbooks on how to produce the riskiest security that qualified for AAA rating (Zingales, 2008). By doing so, they were harming the interests of the principal, the investors. Because of the AAA ratings assigned to the risky MBS, Lehman Brothers was able to increase its leverage significantly from around 15 times its equity in 2004 to 31.7 times its equity in 2008. It was able to increase the size of its balance sheet by almost $300 billion while adding only $6 billion in equity. This ultimately resulted in Lehman filing for bankruptcy in 2008. Similarly, Merrill Lynch and Bear Stearns had to undergo shotgun wedding to Bank of America and JP Morgan Chase, respectively. They also suffered from problems not different from those of Lehman Brothers but unlike in the case of Lehman Brothers, the government intervened in these cases and forced the faltering companies and their ultimate acquirers to the bargaining table. The misleading triple-A ratings assigned to the MBS not only hurt companies like Lehman Brothers, Merrill Lynch, and Bear Stearns they lead to the downfall of insurers like AIG also. AIG had written credit defaults swaps on the triple-A rated securities that ultimately soured. Payments on the credit defaults swaps strained the cash flow of AIG and the government had to inject unprecedented amounts of funds into AIG to prevent a systemic collapse of the financial sector.

When the stakeholders are too small individually and their representatives (i.e. board of members) are easily subject to manipulation, the responsibility of preserving the sanctity of the corporate form of organization falls squarely on the regulators. Unfortunately, corporations routinely hire the services of lobbyists to influence legislation and to preserve their interest. In such instances, the management can easily propagate their interests in the disguise of the company's interests. For example, Freddie Mae and Fannie Mae spent large sums of money on hiring lobbyists and were able to buy political influence in Washington that effectively made sure that the regulation committee assembled to regulate them would not be well funded. In the years preceding the financial crisis, the budget of the committee never was fully approved.

The government has been the biggest player in the recent financial crises. It has extended taxpayer funds to private companies in excess of a trillion dollars. However, it can be argued that the use of taxpayer's funds was in the spirit of preserving the health of the economy and financial well-being of the average taxpayer, the actions of the government over extended period have shown repeatedly that politicians, the agents, routinely undermine the interests of the taxpayers, the principals, for their personal interests. However, the agency problem inherent in the political system is a topic that deserves detailed mention separate from the current paper we therefore refrain from delving deeper into this topic.

4. CORPORATE GOVERNANCE LITERATURE

As our discussion above illustrates agency problem can be viewed from different angles and it manifests itself in a variety of ways, and multitude of environments. Shleifer and Vishny (1997) surveyed the corporate governance literature and discussed the agency problem in detail. They defined corporate governance as methods suppliers of finance to corporations use to assure themselves of getting a return on their investment. They studied several broad approaches to corporate governance including legal protection of investor rights, concentrated ownership, takeovers, and bank financing but refrained from identifying any of the approaches as superior to others and concluded that the existing body of knowledge

is insufficient to answer majority of the important questions on this topic. They suggested that the corporate governance systems even in the most developed economies like United States, Germany, Japan, and the United Kingdom are flawed. Events in the recent past have amply demonstrated that their conclusion was not far from truth.

Almost all of the issues that we discuss in this paper have been identified by the academicians in some way, form, or shape in the corporate governance literature. They discuss these issues under one or more of the following headings: legal protection from expropriation by managers, protection of minority rights, legal prohibitions against managerial self-dealing, expropriation by large investors of other stakeholders in the firm, state enterprises as manifestation of corporate governance failure, expropriation though transfer pricing, fraud, shirking, empire-building, insider trading, consumption of perquisites, pursuing of pet projects, and private benefits of control. The literature has recently produced several studies on the topic of corporate governance and efforts are underway to document the effect of corporate governance on multitude of topics like securities valuation (both debt and equity), information disclosure, firm performance, financial distress, public policy, cross-listing, financial development, and more. Despite the varied attempts to understand the causal effect of corporate governance on seemingly different topics, the approach to measurement of corporate governance in majority of the studies is strikingly similar. Almost all the recent studies in this literature quantify corporate governance of a firm in an index or a score along the lines of Gompers, Ishii, and Metrick (2003). Gompers et al (hereafter, GIM) created Governance Index (G-Index) based on 24 firm-specific provisions , and showed that firms with lower G-Index have higher firm value, higher profits, higher sales growth, and lower capital expenditures. Such firms also make fewer corporate acquisitions. They also showed that an investment strategy of buying firms in the lowest decile of the index and selling those in the highest decile would have earned an abnormal return of 8.5% per year during their sample period. Bebchuk, Cohen, and Ferrell (2009) created entrenchment index from 6 of the 24 provisions used in the G-index and showed that the entrenchment index fully explained the results documented by GIM. Brown and Caylor (2006) created Gov-Score based on 51 firm specific provisions and documented that a parsimonious index based on just 7 of the 51 provisions used in the Governance Score can fully explain their results. Majority of the studies since GIM (2003) have used G-index or entrenchment index as a measure of corporate governance. GIM (2003) has been cited by over 1,600 studies according to Google Scholar. Lucian Bebchuk's webpage lists over seventy-five studies that use the entrenchment index. Therefore, in this paper we attempt to study the effectiveness of the G-index and the entrenchment index in identifying the firms that ultimately failed primarily because of the agency problems that plagued them or their industry.

GIM grouped the components of their G-index in five major categories--Delay, Protection, Voting, Other, State. We briefly discuss the provisions in each of the categories below.

Delay: The provisions in this category allow firms to delay any takeover attempt by a hostile bidder. It includes blank check preferred stock that allows board of directors broad authority to make decisions on behalf of the shareholders. Classified Board (or staggered board) prevents the acquirer from gaining instant control of the board. Special Meeting limitations require higher level of shareholder support to call a special meeting. Limitations on Written Consent can either eliminate the right to take action by written consent, require unanimous consent, or require a higher level of threshold support.

Protection: The provisions in this category protect the management from job-related liability and compensate them following a termination. It includes Compensation Plans that allow management to cash out their options and accelerate payout of bonuses in case of acquisition. Director indemnification contracts allow for indemnifying officers and directors for legal expenses and judgments due to their conduct. Some companies have director indemnification in their bylaws and/or charters. Some charter amendments limit directors' personal liability for breach of duty of care. Executive severance agreements assure management of their positions or some compensation. Golden Parachutes compensate the management for termination or demotion pursuant to change of control.

Voting: The provisions in this category limit shareholder's rights in elections. It also includes limitations on shareholder's capability to amend bylaws and charter. Cumulative voting allows minority shareholders to concentrate their votes thereby helping them elect directors. Secret ballot (also called confidential voting) allows shareholder-employees and other shareholders to submit their proxy votes without the fear of management retaliation. Cumulative voting and secret ballot are the only two provisions in the G-Index, the absence of which increases the G-index. Supermajority laws require higher approval thresholds for mergers and acquisitions and unequal voting rights limit the voting rights of some shareholders while expanding those of others.

Other: The provisions in this category include antigreenmail, director's duties, fair price, pension parachutes, poison pill, and silver parachutes. Antigreenmail provisions prevent the company from buying stakes from large shareholders at premium in exchange for promise not to seek control for a specified period. Director's duties provisions allow directors to reject takeovers on the grounds other than shareholder interests. Fair price provisions limit the range of prices that a bidder can offer in two-tiered offers. Pension parachutes prevent acquirer from using surplus cash in pension fund to finance acquisition. Poison pill provisions give the shareholders of the target firms other than the bidder special rights regarding buying the shares in the target or bidder firm at steep discount thereby making the acquisition very unattractive for the bidder. Silver parachutes allow for severance payments to target firm's employees in case of change of corporate control.

State: Some states have Antigreenmail, director's duties, and fair price laws that have similar effect on shareholder rights as firm-level provisions discussed above. Twenty-five states had control share acquisition law in place in 1990 (26 states had it in 1991). This law is similar to the supermajority provision discussed above. If a firm is incorporated in a state with the above laws, the G-index treats the firm the same as other firms that have the relevant provisions in their bylaws or charter. Three states had Cash-out laws in 1990. This law allows shareholders to sell their share to the controlling shareholder for the highest price of recently acquired shares. Business combination law prevents certain transactions like asset sales and mergers between the large shareholder and the firm for a specified period. This is the only state takeover law in Delaware, the state where a majority of the large firms in U.S. are incorporated.

Even though there are 22 firm level and 6 state-level provisions, the G-index has a maximum value of 24 because 4 of the state-level provisions overlap firm-level provisions. For every provision that reduces shareholder rights, the G-index for the firm increases by one point. GIM document that the mean, median, and the mode value of the G-index in their sample was around 9 between 1990 and 1998 (see Table I). They grouped firms with G-index < 5 and labeled it democracy portfolio and those with G-index > 14 as dictatorship. This distinction suggests that firms in the democracy portfolio were least likely to suffer from agency problems and those in the dictatorship portfolio were most likely. GIM stated that the G-index is a proxy for shareholder rights. A lower value of the index suggests that the shareholders have more rights. Therefore, the agency problem between the shareholders (i.e. the principal) and the management (i.e. agent) should be lower for firms with lower G-index. To test the validity of this assumption we find the G-index for the firms listed in our discussion above. Since the G-index is available only for U.S. firms, we limit our discussion hereafter to the following firms only: AIG, Bear Stearns, Enron, General Motors, Lehman Brothers, and Merrill Lynch. Table II shows the G-index of the firms that ultimately failed. The results are very surprising. Four of the six firms would have found place in the democracy portfolio of GIM in 1990. The mean G-index of the six firms was 7.2 during 1990-98 compared to the mean G-index of 9 for GIM sample firms during the same time.

We next study if the observed low mean value of the G-index for our sample firms can be due to different firm characteristics of our sample firms as compared to those of GIM. According to GIM G-index is positively related to size, share price, trading volume, and institutional ownership. Because we study the biggest corporate failures in history, our sample firms are among the largest firms, listed on NYSE, and were heavily traded before their failure. Consequently, the mean G-index for our sample firms should have been much higher than the mean G-index observed by GIM. Additionally, G-index for our sample firms should also have been higher given the agency problems that ultimately led to their demise. Yet we find that based on the widely used measure of corporate governance our sample firms would have been classified as firms facing lower agency problems.

Since the financial crisis hit financial firms much more severely than other firms it is possible that our results are unduly affected by overweight of finance industry in our sample. However, GIM noted in their study that there was no industry concentration in their portfolios. Classifying firms into 48 industries as in Fama and French (1997), they found that their portfolios were broadly similar to each other in all years. Hence, the lower G-index observed for our sample firms cannot be attributed to the financial industry. Majority of the firms in GIM sample were incorporated in Delaware. All the firms in our sample were incorporated in Delaware during 1990-98. Hence, the observed differences in the G-index cannot be attributed to state laws. Since our sample size is so limited, we cannot draw any statistical inferences from our observation but the data suggests that G-index would have falsely grouped majority of our sample firms as well-governed firms prior to their failure. This observation casts doubts on the validity of G-index as a measure of corporate governance.

However, there is a redeeming feature of the G-index that we would like to highlight. Even though the magnitude of the G-index for our sample firms was below the mean for GIM sample firms, the mean G-index for our sample firms increased monotonically as the firms approached their ultimate demise. Except for Merrill Lynch, all the other firms in our sample had higher G-index in the years prior to their failure than in 1990. Merrill Lynch had very high G-index in 1990 and continued to have a high value until the end. Even though AIG was in the democracy portfolio of GIM, it would have dropped out of GIM's democracy portfolio after 2003 because the firm adopted golden parachutes. Bear Stearns would also have found place in GIM's democracy portfolio until 1993 but after that, the company adopted antigreenmail provisions, secret balloting, and fair price provisions. The G-index for Enron was 8 in 1990 but it increased to 9 after 1995. After 1998, the company changed its state of incorporation to Oregon from Delaware. Consequently, the G-index increased from 9 to 12 thereafter. General Motors would also have found place in the GIM's democracy portfolio until 2002 only. After that, the company adopted compensation plans. Lehman Brothers had a G-index of 3 in 1990 but the value increased to 6 in 1998 as the company adopted blank check provisions and compensation plans. The G-index increased further to 9 after 2002 before falling to 8 in 2006.

It is possible that the mean G-index increased across the board over the past 15 years and therefore the increase in G-index for our sample firms cannot be considered an indication of deteriorating corporate governance. To test this possibility we compare the growth in the average G-index for our sample during 1990-98 with that of GIM firms. We find that mean value of G-index for our sample firms increased from 6.2 to 8.0 over this period but the mean G-index of GIM firms decreased during this period from 9 to 8.9. This suggests that the monotonic increase in the average G-index of our sample firms was likely due to deteriorating governance at the firm level rather than universal deterioration of corporate governance across the board.

Using data from Lucian Bebchuk's webpage, we also study the entrenchment index for our sample firms. We present our results in Table III and find that our results are more pronounced when using this index. The mean entrenchment index for our sample firms was 0.8 in 1990 but it increased several folds to 2.8 in 2007. Except for Merrill Lynch that had the same entrenchment index during our entire sample period, all the other firms in our sample showed an increase in the entrenchment index as they approached their ultimate demise. The mean entrenchment index for S&P 500 firms reported by Bebchuk et al was 2.6 in 2002. The comparable mean for our sample firms was 1.2. As with the G-index, the entrenchment index would have misclassified our sample firms as well-governed firms (or failed to classify them as ill-governed firms) but the monotonic and highly noticeable increase in the mean value of the entrenchment index for our sample firms would have been a better indicator of the agency problems brewing in these firms.

5. CONCLUSION

Based on our study of the biggest corporate failures in history from Barings Bank to General Motors we contend that despite the seemingly varied reasons suggested by the media the underlying cause of corporate failures in majority of the cases was agency problem. The academic literature addresses this problem under the umbrella of corporate governance. Several recent studies have attempted to document the relationship between corporate governance and securities valuation (both debt and equity), information disclosure, firm performance, financial distress, public policy, cross-listing, financial development, and more. However, in majority of these studies corporate governance has been measured using an index along the lines of G-index developed by GIM. We show that the G-index would have misclassified majority of the firms that we study as well-governed firms. However, we also show that majority of the firms that ultimately failed showed deterioration in their corporate governance measure over time as they approached their ultimate demise. We therefore suggest that future studies rely not only on the level of G-index or entrenchment index as a measure of corporate governance but the change in these indices over time.

REFERENCES:

Bair, Sheila. C., "Lessons from the Barings Collapse", Fordham Law Review Vol. LXIV (1), 1995, 1-8.

Bebchuk, Lucian, Cohen, Alma and Ferrell, Allen, "What Matters in Corporate Governance", Review of Financial Studies, Vol. XXII (2), 2009, 783-827.

Brown, Lawrence D. and Caylor, Marcus L., "Corporate Governance and Firm Valuation", Journal of Accounting and Public Policy, Vol. XXV (4), 2006, 409-434.

Cremers Martijn K. J. and Nair, Vinay B., "Governance Mechanisms and Equity Prices", Journal of Finance, Vol. LX (6), 2006, 2859-2894.

Fama, Eugene F. and French, Kenneth R., "Industry Costs of Equity", Journal of Financial Economics, Vol. XLIII (2), 1997, 153-193.

Gompers, Paul, Ishii, Joy and Metrick, Andrew, "Corporate Governance and Equity Prices", Quarterly Journal of Economics, Vol. CXVIII (1), 2003, 107-155.

HM Treasury-Barings-Statement by the Chancellor, Hermes-U.K. Govt. Press Release, July 18, 1995.

Shleifer, Andrew and Vishny , Robert W., "A Survey of Corporate Governance", Journal of Finance, Vol. LII (2), 1997, 737-783.

Tran, Mark, "WorldCom Goes Bankrupt" Guardian, U.K., July 22, 2002

Zingales, Luigi, "Plan-B", The Economist's Voice, Vol. V (6), 2008, Article 4.

Pankaj K. Maskara, Nova Southeastern University, Ft. Lauderdale, Florida, USA

Zekeriya Eser, Eastern Kentucky University, Richmond, Kentucky, USA

Bjoern Claassen, Christian Brothers University, Memphis, Tennessee, USA

AUTHOR PROFILES

Dr. Pankaj K Maskara, CFA, earned his Ph.D. at the University of Kentucky in 2007. He earned the right to use the Chartered Financial Analyst designation in 2009. Currently he is an Assistant Professor of finance at Nova Southeastern University.

Dr. Zekeriya Eser earned his Ph.D. at the University of Kentucky in 2007. Currently he is an Associate Professor of finance at Eastern Kentucky University.

Dr. Bjoern Claassen earned his Ph.D. at the University of Mississippi in 2005. Currently he is an Associate Professor of finance at Christian Brothers University.
TABLE I: DESCRIPTIVE STATISTICS FOR GOVERNANCE INDEX OF GIM FIRMS

            1990   1993   1995   1998   Average

Min          2      2      2      2      2.0
Mean         9      9.3    9.4    8.9    9.2
Median       9      9      9      9      9.0
Mode        10      9      9     10      9.5
Max         17     17     17     18     17.3
Std. dev.    2.9    2.8    2.8    2.8    2.8

TABLE II: GOVERNANCE INDEX OF FIRMS THAT FAILED

From     To       # of          Bear              General   Lehman
Date     Date     years   AIG   Stearns   Enron   Motors    Brothers

Sep-90   Jun-93   2.75    5     5         8       5         3
Jul-93   Jun-95      2    5     7         8       5         3
Jul-95   Jan-98    2.5    5     8         9       5         3
Feb-98   Jan-00      2    5     7         12      5         6
Feb-00   Jan-02      2    5     8         12      5         6
Feb-02   Dec-03      2    5     8                 6         9
Jan-04   Dec-05      2    6     8                 7         9
Jan-06   Dec-07      2    6     8                 7         8
Time Weighted         5.2   7.3      6.3   5.6        5.7       13.3
Average

From     To       Merrill
Date     Date     Lynch     Average

Sep-90   Jun-93   14        6.7
Jul-93   Jun-95   14        7.0
Jul-95   Jan-98   13        7.2
Feb-98   Jan-00   13        8.0
Feb-00   Jan-02   13        8.2
Feb-02   Dec-03   13        8.2
Jan-04   Dec-05   13        8.6
Jan-06   Dec-07   13        8.4
Time Weighted               7.7
Average

TABLE III: ENTRENCHMENT INDEX OF FIRMS THAT FAILED

From     To       # of          Bear              General   Lehman
Date     Date     years   AIG   Stearns   Enron   Motors    Brothers

Sep-90   Jun-93   2.75    0     0         0       0         1
Jul-93   Jun-95   2       0     0         0       0         1
Jul-95   Jan-98   2.5     0     0         0       0         1
Feb-98   Jan-00   2       0     0         1       0         2
Feb-00   Jan-02   2       0     0         1       0         2
Feb-02   Dec-03   2       0     0                 0         2
Jan-04   Dec-05   2       1     0                 0         2
Jan-06   Dec-07   2       2     4                 2         2
Time Weighted             0.3   0.5       0.2     0.2       1.6
Average

From     To       Merrill
Date     Date     Lynch     Average

Sep-90   Jun-93   4         0.8
Jul-93   Jun-95   4         0.8
Jul-95   Jan-98   4         0.8
Feb-98   Jan-00   4         1.2
Feb-00   Jan-02   4         1.2
Feb-02   Dec-03   4         1.2
Jan-04   Dec-05   4         1.4
Jan-06   Dec-07   4         2.8
Time Weighted     4.0       1.2
Average
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