Tuesday, August 7, 2018

Американский Е́льцин (America’s Yeltsin)

слава россии!
слава США! 

слава олигархам!
Скорее всего, в США сделают то, что сделал Борис в России.

Saturday, August 4, 2018

Dubai and L'Affaire Abraaj - Realism Amid Emotion and Financial Fairy Tales

Perhaps Better to Wait Till the Dust Settles to Get a Clearer Picture?

As you might expect, in the wake of the Abraaj scandal, financial journalists are examining the impact on GCC markets and in particular Dubai. 

Nicholas Parasie at the WSJ took a look at Dubai earlier this week.  “Once Billed as a Financial Haven in the Middle East, Dubai Turns Investors Wary”   

As usual, I have a slightly contrarian view which I’d like to convey by responding to quotes from his article. The point of this exercise is not to cast doubt on the article, but use several of the points mentioned to highlight areas of difference. 

“Investors are questioning whether Dubai’s young financial center can police itself as the meltdown of its marquee private-equity firm highlights broader concerns about placing money in the region.”

That’s a perfectly natural human reaction.  I’ve got a problem so first let’s identify all the people who let me down and are responsible for my misfortune.  Perhaps, but perhaps not, I’ll eventually get around to examining my own behaviour. 

There’s another element.  Realistically, where is that well-policed market that Dubai should measure up to? That sought after “haven”? 

The Bernie Madoff scandal, the dot.com bust, the almost a Second Great Depression, Lehman, Libor all occurred in what are generally described as the “mature” “well regulated” markets in the OECD.  These scandals are widely attributed to regulatory and corporate governance failures which is the central “charge” against Dubai in L' Affaire Abraaj. 

Given the dollar magnitude and number of these scandals relative to those in Dubai, shouldn’t investors be questioning the ability of these “Western” markets to police themselves much more than questioning Dubai? If not, why not?  

Should Dubai be held to a higher standard?  If so, why?  

“Dubai was supposed to be a rules-based haven in the Middle East’s opaque financial world, but fears about corporate governance and conflicts of interest are rising."

I suppose if one didn’t look too closely but rather relied on the promotional advertising alone one might have imagined that Dubai was a “rules-based haven”.  But one would have had to be pretty oblivious.  It's like reading "The Art of the Deal" and thinking that the chap on the cover is America's #1 DealMeister.  In both cases your credulity would have gotten the better of the facts. 

I know that for some—usually bankers and investors--ten or fifteen years in the past is an age unknown probably before recorded time.  

But back in 2004 Ian Hay Davison, Chairman, and Philip Thorpe, CEO, both of the DFSA were summarily sacked. Ian by mobile phone.  Philip was "escorted" from the DFSA’s offices.  Both “lost” their jobs because they had the temerity to suggest that the real estate transaction for the Gate was freighted with conflicts of interest among certain high “personalities”.   Read it here.  If you read it in the Torygraph, you know it must be true. 

After the Dubacle--which in itself might have suggested causes more than just irrational real estate exuberance--, a number of high ranking officials were relieved of their positions.  One chap, the former head of the DIFC, was “encouraged” to return “bonuses” that were alleged to have been improperly obtained. There is of course more but those are two rather glaring examples.  A good rule of thumb is that if you suspect there are ethical issues at a regulator or in government departments or corporations, you should be wary of ascribing high standards to the jurisdiction.  Focus like this can simplify your due diligence greatly.  

“Unlike in the West, where corporate executives are often held accountable by supervisory boards, “there are no checks and balances in the Middle East in some companies,” she said.”  The “she” in this quote is Alissa Amico, a Paris-based former executive at the Organization for Economic Cooperation and Development.

Quite!  As to the “developed” Western markets, there are “checks and balances” indeed but mostly on paper. Rarely do independent board members take action to prevent corporate malfeasance.   In some cases, they appear to aid and abet it. See Hollinger. See Enron whose board composition on its face ticked every box in good corporate governance.  See Volkswagen and dieselgate.  For more on supervisory board failures in Germany read this article from Handelsblatt. 

The clear lesson here is that corporate structures and rules while a necessary condition are not sufficient to prevent malfeasance. People are the critical variable that make these structures and rules effective. If they are wanting, the entire structure fails.     

The longer it waits, the more Dubai’s ability to attract foreign capital could be at risk, said Oliver Schutzmann, chief executive of Iridium Advisors, an investor-relations firm.” The “it” in this quote is the DFSA.

No doubt immediate action might satisfy investors who no doubt are looking for vengeance. 

But a proper investigation needs to be conducted to determine the extent of the malfeasance, if any, and the parties involved.  

MF Global collapsed in late 2011.  In 2013 the US CFTC filed charges against the former Chairman and CEO that involved allegations of “misuse” of client funds similar to allegations against officers of Abraaj.  

There are risks to too-quick action.  
  1. Failure to punish all those, if any, who should be punished.  
  2. Failure to punish for all offenses.  The DFSA would look rather incompetent if it later turned out that there were transgressions more serious than “borrowing” client funds at Abraaj and that it failed to punish these. 
  3. Or if in the rush to take action, it inadequately prepared its case and wrongdoers, if any, were subsequently acquitted.  
As well, while vengeance may be  satisfying, it won’t result in investors being made whole.  Rather cold comfort for Mr. Jaffar: I’ll get a jail sentence against Brother Arif, but I still won’t get my US$300 million.  

It’s perfectly natural for investors who have suffered a loss or think they have to get quite emotional and thus irrational.  

Sadly, there’s often a tendency for others to get caught up in these emotions of the moment. Cooler heads are needed, but few are found. 
  1. False comparisons are made.  Dubai compared with the mythical conflict-of-interest free well-policed Western markets.  
  2. Double standards are applied. Dubai must be purer than Caesar’s wife.  
  3. Dire end of the world or end of the market predictions are made. No one will invest here anymore.  But why didn’t that happen after Hay/Thorpe, Bin Sulaiman, et al.? Or after the Dubacle?  Or in Bahrain after TIBC, Awal, GFH?  Or in Kuwait after TID and Global?  Or in KSA, after the typical SAMA response to prefer local banks over foreign in the TIBC and Awal affair? Or in the USA after the Almost a Second Great Depression? 
  4. Fundamental issues can be missed.  Nuances lost.  What really makes a market investable?  A fancy building, some imported be-wigged English-law judges, an impressive rule book? Or are other things more important?  
  5. Remedies are prescribed before there's enough information for a thorough diagnosis.  We really don’t know exactly the extent and type of malfeasance in L'Affaire Abraaj.  Is it equivalent to MF Global or Bernie Madoff?  Who was involved?  Yet, hobby horses are trotted out from the stable and vigorously ridden.  Sometimes very specific prescriptions given.
  6. Sometimes meaningless platitudes are given.  Meaningless because they are not specific.  “Regulators and boards need to step up their game.”  Or perhaps “work smarter not harder”.  Indeed, if only the UK had “stepped up its game” in the World Cup, they would have won.  If Abraaj had “stepped up its game”, no doubt it would have realized the sale of K-El and there wouldn’t have been a cashflow problem.  
  7. Can we be that far away from a suggestion to use Blockchain to “disrupt” old patterns of corporate governance? In some places it promises the disruption of courts. Why not corporate governance?  Let's step boldly forward together to the “bleeding edge of leveraging the Blockchain space to disrupt the existing paradigm of corporate governance”.

Wednesday, August 1, 2018

In Some Parts Apparently Scarier Than President Putin!

Extremely Scary Highschool Graduate (The Girl not the Man)

في بعض الأماكن على ما يبدو أكثر مخافة من الرئيس بوتين

в некоторых местах явно страшнее, чем президент Путин !!

If you're not prone to excessive fear, you can check out this scary story here.

On to law school!

Friday, July 27, 2018

Storm Signals in Private Equity

A Severe Warning Flag Given the Amounts Involved

Chris Schelling’s article in Institutional Investor flashes some very clear warning signals about PE.  

“Private equity sponsor-to-sponsor transactions are on the rise. But lately, some firms have begun selling companies to other funds in their stable — a far more worrying development.”  
Chris outlines the risks of both sorts of transactions:  
  1. a private equity firm selling a fine investment to another PE firm and 
  2. the more worrying one a private equity firm selling a fine investment from one of its own funds to another of its own funds. 
When "exits" aren't via trade sales or IPOs are they really exits?  Or are they symptoms of real problems?  When they represent a large percentage of declared but perhaps not real "exits", are the problems severe?

Let's look at these in order.
First inter sponsor sales.
One-third of all private equity “exits” in 2017 were the first type:  one sponsor selling to another sponsor.  Data for 1 H 2018 show a similar trend. 
There probably are some situations when these transactions can be economically justified in terms of value creation for the limited partner not just for the fund manager/sponsor.  
But such instances are clearly not one-third of all exits.   More likely to be for a fraction of that percentage.  3%? 
Essentially what the fund manager who sells is saying is that he can no longer increase the value of the investment.  What the fund manager who buys is saying is that he can.  
There could be special situations where this is true, e.g., a further increase in value of an investment requires that it be integrated with other companies that the selling fund manager doesn’t own and is unable to buy.  The buying fund manager may own those companies.  
But if the buying fund manager has no special advantage like that and is relying on making traditional operating or financial improvements to generate IRR, then:  
  1. The buying fund manager believes he has the skills to make a PE like return on the investment at his higher entry price 
  2. If the selling fund manager is realizing a profit that triggers carried interest, then the ultimate return on the investment must be such that two managers will separately and independently be able to generate PE like returns. That would be some investment! 
AA has a hard time believing that the probability of this happening is significant enough to justify one-third of all exits as sponsor to sponsor deals.  
As an aside, through this transaction, one or both of the fund managers may be displaying reasons why they are likely not to be good stewards of your money.
  1. If the first manager can't use traditional methods to enhance value but the second can, then an LP might wonder if it's particularly wise to be investing in the first manager's funds
  2. If the second manager is wrong and can't generate additional PE-like returns, then he's probably not a wise choice for LPs.
Naturally suspicious folks like AA would want to know if there are reciprocal deals.  Fund managers are helping each other out "exit" less than ideal investments.  Fund Manager A sells “fine” investment #1 to Fund Manager B.  Fund Manager B sells “fine” investment #2 to Fund Manager A.  Each generates an IRR which allows them to sell future funds, to earn carried interest, quiet current investor unease at lack of exits. Hopefully, the purchased investment turns out to generate a decent return or can be buried among other returns if it’s not so decent. 
In other words, are GPs passing around less than stellar investments among themselves?  Investments that they cannot place with a trade buyer or IPO?  That the volume of inter sponsor transactions is at one-third of all "exits" suggests something is not right.  When one factors in the rise intra sponsor sales, the red flag gets even bigger.
Or is the explanation the need to use so-called “dry powder” (uninvested funds) now perhaps as much as some US$1.5 trillion? LPs can't be happy seeing their univested funds earning cash returns that likely don't even cover the 2% management fee.
Fund managers are merrily raising more money.  One might question why any additional money needs to be raised, other than to increase GP's management fees—which as you know or should are independent of fund performance.  I
Interested in more on the topic of “dry powder”?  Check out this article by Melissa Mittleman from Bloomberg.  
An ocean of money looking for investments is more likely than not to be on average an ocean of particularly dumb money.  Overpayment and poor underwriting choices will be the result.  Limited partners’ future returns will be diminished. 
But even if firms have discipline to avoid these mistakes, they will generate lower returns for their LPs because of the earnings drag on the overall portfolio from cash holdings.  
So here's another worry for LPs to add to worries about asset quality, lower returns for a long-term commitment.

Second, intra sponsor sales.
But all this pales when one considers the even more troubling intra-sponsor sales. A sponsor sells a “fine” asset from one of its own funds to another of its own funds.   This is a major red flag.  
As before, there are no doubt excellent reasons why this should be done sometimes, but the incidence of these “sometimes” is likely to be less than observed demonstrations of probity by the political class.  That would take this to much less than the 3% for sales of “fine” investments from one sponsor to another sponsor.  
I’ve mentioned before that we were once approached by a prominent PE firm pitching us on their new fund and touting the return on a predecessor fund.  A closer look at that fund disclosed that its return was almost all generated by a single deal.  A sale of a “fine” investment from that fund to another managed by the same GP.  We, of course, declined the opportunity to invest and struck that firm off our list of “serious” firms.  No further due diligence needed.  When you don’t trust the people, due diligence really isn’t needed at all.  
And finally a shout out to Chris’s first comment:   
“A well-known GP in our portfolio has been known to say that PE performance “isn’t a return until you can buy a beer with it.”
Quite!   
But if your GP is generating beer rather than champagne returns, you might consider interviewing additional fund managers.  "Beer and pretzels" is the lowest stage of FY money among investment bankers.

Monday, July 23, 2018

Corporate Governance: It's Your Responsibility Too – Some Inconvenient and Uncomfortable Truths

Hate to Be Contrary But You Have A Responsibility for Corporate Governance

Warning:  This post contains some inconvenient and uncomfortable “truths” about your responsibility for corporate governance.  To make corporate governance work, you actually have to do something more than whinge about the failings of others.  Or issue calls for vague enhancements to corporate governance like calling on firms, auditors, regulators, and others to “step up their games”.     
Corporate governance generally focuses on roles and responsibilities of the board of directors, external auditors, and regulators.  Shareholders’ roles and responsibilities are not sufficiently discussed.  You can see this in the “founding document” of corporate governance the Cadbury Report (1992) which was sparked by perceptions of corporate misgovernance in Robert Maxwell’s companies. 
Typically the role of shareholder is summarized in a single sentence:  

“The shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place.”  
This post argues that there are clear defects in that formulation and more importantly shareholders’ responsibilities exceed those outlined therein.  If corporate governance is going to be built on this slender reed alone, should we expect brilliant results?  
First to the defects. 
As a practical matter, the shareholders’ role in “appointing directors and auditors” is generally to vote on the candidates proposed by the board of directors.  Often there is a nominations committee of the board generally structured to be “independent” of executive directors (e.g., senior management) that recommends candidates to the full board (which includes executive directors).  There’s a great deal of reliance on “independence” of the nominating committee here.  
In general boards have not demonstrated a lot of “independence”, but perhaps they are when we're not looking.  Or perhaps not.  The full board then decides whether to approve the candidate.  There’s a potential conflict of interest in this arrangement. The full board includes executive directors.  Management may therefore have a significant role in hiring those who are supposed to monitor its performance.   
But there’s more.  
Generally the board only recommends a single candidate for a position.  If there are 6 director slots open, shareholders get to vote on six candidates. If it’s time to appoint auditors, one firm is proposed. Shareholders have all the choice given voters in “democratic” elections in one-party states.  On a positive note for shareholders, a “no” vote doesn’t usually lead to unhappy consequences. In either case it is “take it or leave it” which probably explains why the directors’ recommended candidates win, except in extreme cases.   
There are two reasons for this state of affairs. 
  1. As a practical matter how would shareholders—usually an unwieldy large number--select potential board members or auditors?  Do they have the skills, contacts, knowledge?  How would consensus be achieved among shareholders over their competing candidates?  If consensus cannot be reached, there could be a plethora of candidates which could be as problematic as having only one candidate. 
  2. While individual shareholders generally have a right to nominate directors, the directors’ candidates have a much easier road to election.   If you look at a typical US proxy, shareholder resolutions are included in a separate section with management arguments as to why these should be rejected. When a hedge fund or other professional investor wishes to get its own slate of directors elected, it typically hires third parties to draft, print, and mail its own proxy to each shareholder.  Why does it incur this not inconsiderable expense? It doesn’t believe that management will give its slate a fair shake in the management proxy.  It can’t wait until the meeting to propose directors and make its case because “management” proxies will already have been voted for directors and most shareholders skip the AGM.  They do give management representatives the right to vote their shares, but realistically are management representatives going to vote for the insurgent slate of directors?   
  3. In some jurisdictions, if a shareholder owns 10% or more of the stock of a company, that shareholder can name a director and there is no requirement for other shareholders to support.  Differences in cumulative versus non-cumulative voting rights also affect the election of directors.  
  4. But in general shareholders’ oversight through the election of directors is more theoretical than real. 
Given the very practical limitations on shareholder selection of directors and the numerous cases of board “failure” in corporate governance, including by ostensibly “independent” directors, shareholders need to do more to protect their interests and to foster good corporate governance.   
This is key because people are the critical variable in good corporate governance.  It wasn’t Enron’s corporate governance structure that caused problems at Enron. It was people. 
Let’s run through what the “more” shareholders must do by way of questions.  
These will allow you to check just how real your commitment to corporate governance is.  Are you Augustine of Hippo or St. Augustine of Hippo?  
Do Corporate Governance Principles  Inform Your Investment Behaviour?
Let’s assume that indeed you are firm believer in corporate governance. Or at least claim to be whenever there is corporate governance failure. 
Among the good practice principles you endorse is that the roles of chairman and chief executive officer be separated and that the chairman be an independent director, not an executive of the firm. Do you refuse to invest in corporations where the roles are combined? 
Suppose your principles also include a requirement for strong risk controls and non-manipulation of markets.  If your bank holdings include one that like Sea World has “whales”, do you refuse to invest or divest your holdings?      
How many of your firmly held corporate governance principles can a firm violate before you take concrete action?   
Remember that the road to corporate governance failure is a slippery slope.  It begins with a first bending of one rule and eventually the breaking of more.  If the firm is highly profitable, can you easily justify poor corporate governance?  Sure they lost US$ 6 billion but they still made a profit. 
In applying your corporate governance principles, do you allow yourself more slack that the CEO of a firm?  You wouldn’t tolerate his breaking even a single rule, but you can let your own principles slide a bit and perhaps even quite a bit, depending on profitability.  
Do You Perform Proper Due Diligence Before Investing?
Do you read more than the glossy pitchbook they give you?  Consider more than the cut of their suits and flash of their MontBlanc cuff links?  Read beyond the gushing appellation “Goldman Sachs of the GCC” or similar in the local press.   Or a shrieking recommendation delivered by Brother Jim on the TV?  
Does that due diligence include checking on corporate governance?  And situations that might cause corporate governance to fail, i.e., distressed financial conditions? 
Do You Know How to Perform Due Diligence Properly?  
Have you bothered to learn how to do due diligence on an investment?
Do you know the tricks used to enhance the presentation of performance in sales pitches?  When you were presented with financial performance, did you check what standards were used for reporting?  A good rule:  No GIPS no investment.  Were there model portfolios included?  Projections to the past:  “Using our strategy on a proforma basis, over the past 10 years we would have earned an IRR of 35%”.  What they don’t say is:  Of course, we didn’t, but it sure looks good.  And if we pick the right time period, we can find a sweet spot IRR.”  
If they're lying to you or stretching the truth in their pitches, what should infer about their ethics and their corporate governance?  
Do you know a bit about financial statements so you can at least spot if cashflow is not in line with reported income?  Would you have noticed that despite Dubious Gas’s reported income, the KRG and Egypt weren’t paying DG what they owed it?  
Understand that under accrual accounting, there can be different methods of recognizing the same transactions both on the balance sheet and the income statement? 
Do you know what the role of auditors, regulators, stock markets are? And what reliance you can or cannot put on them to look after your interests?  
Know what to look for in corporate governance structures, if you're looking for one that is complete and well-structured?  
Do you know the “red flags” of corporate distress?  As stated in my previous post, unless a firm is set up as a criminal enterprise, corporate misgovernance is more likely to occur when management is dealing with a serious problem than when things are going well.  
Some practical examples, before investing in one of Abraaj’s funds, did you look to see where their parent, the management company, etc were incorporated?  Did you understand that offshore companies in the Cayman Islands and other similar jurisdictions are lightly regulated (first euphemism of this post and in a long time)?  Did you ask why? A plausible answer might have been tax planning, but the flag of light regulation should have caught your eye.  
Did you ask for audited financials?  A good but not necessarily foolproof way to check if the firm is in financial distress.  The sort of “occasion of sin” that might lead to corporate misgovernance.   It's also a good way to check on the business performance.  If the funds they manage are performing well, that is, have a flow of exits and good returns, the bonanza of carried interest fees should show up here.  
But they might have told you: “No PE firm publishes financials.  We’re a partnership.  Our partners don’t want their remuneration disclosed.”  Did you know that Charterhouse Capital Partners and associated companies publish financials and that you can obtain a copy at Companies House?  You don’t get individual details but you get an aggregate number.  
Ask about performance of their funds?  If you had asked about their flagship “infrastructure” fund (IGCF) you might have noticed rather dismal performance as Arkad has pointed out. The delay in closing the “sale” of Karachi Electric might have caught your eye. You might have noticed that the GOP wasn’t paying K-El.  Or that K-El had been in Abraaj’s portfolio for some time. Might you have wondered about their wisdom in plunking down a whale-sized amount to invest in power in the subcontinent?  Or wondered what made this investment different from others in the subcontinent?  Enron Dabhol.    
If you looked at that fund’s investments, you might wonder, as Sabah Al-Binali did, why a Private Equity firm was buying listed stocks and what this meant about their stated investment mandate and adherence thereto.   Assuming it was a pure private equity fund, if they won't keep to the mandate, what other promises might they not keep?
What Post-Purchase Investment Monitoring Do You Perform? 
The Abraaj scandal came to light because a few investors saw something that raised red flags and they acted on that information.   
Do you read the company’s financials and investor presentations carefully and not just rely on company press releases or puff pieces in the press for your monitoring?   Local press analysis often being little more than a regurgitation of the press release.  
Do you look for changes in behaviour or reporting by the firm that are red flags of potential problems? 
Do You Exercise Your Corporate Governance Rights?  
Do you attend the annual shareholders’ meeting?  Ask questions you have from your post-purchase monitoring?  Listen to the questions of other shareholders and management’s responses?  React and participate? 
Where there are proxy materials, do you actually read them?  Do you vote your proxy?  Do you do more than “tick” yes on the management recommendations?    
In some jurisdictions there aren’t proxies. Some of this information is in the audited annual report.  Or in separate corporate governance reports.   
If you've got a problem with information provided have you ever complained in the AGM (with auditors, representatives from the MOIC or equivalent, and directors present) that information in financials and disclosures is insufficient.  Ever make similar complaints in writing to your stock market or local regulator about insufficient, unclear or misleading disclosures?    
CONCLUSION 
At this point I imagine that some of you are thinking.  
But this is hard work. It’s unrealistic.   We don’t have the skills or time to do all of this. The auditors, the board, the regulators should do their jobs properly and we won’t have to.  Quite!  Police and neighbors should be keeping watch to prevent burglaries.   I shouldn’t have to lock my door. 
Or wait just a minute, AA.  Are you seriously arguing that if we do this, there won’t be corporate misgovernance?  
No!  But you may make it harder.  You may create an environment that encourages other shareholders to take similar actions.  
You may deliver a very clear message to board members that you are watching.  Auditors, regulators, the MOIC may be awakened to action.

On the other hand, you can decide that this is too much and not really your responsibility. You can remain among the sheep. That entitles you to bleat on-and-on about corporate misgovernance whenever you’re sheared.   

Thursday, July 19, 2018

Corporate Governance -- Easier Said Than Done


In the wake of the distress at Abraaj, there have been the usual calls to enhance corporate governance.  
As the title above indicates, AA has a contrarian view.  
In particular, I want to address two assumptions that seem to be held regarding this topic: 
  1. If only we adopt certain measures, we can greatly reduce and perhaps even eliminate instances of corporate misgovernance.  
  2. When corporate governance fails, the tendency is to blame third parties never oneself.  This “shifting” of responsibility seriously detracts from enhancing corporate governance. 
Corporate governance or lack thereof is the result of the interplay of three factors:  
  1. Governance systems 
  2. People 
  3. Situations 
GOVERNANCE SYSTEMS 
The primary focus in the pursuit of good governance appears to focus on establishing systems, perhaps because the difficulty of controlling the primary factor in corporate governance—people— is realized to be difficult. 
These systems are designed to: 
  1. Establish “rules of the road” for conduct generally in the form of codes of conduct or ethics.   
  2. Create organizational structures and limitation of personal authority/segregation of duties to (a) prevent individuals from exercising unfettered control over the corporate entity and (b) provide multiple review mechanisms to “catch” bad behaviour that has slipped through the ethical and  organizational “nets”.  
Rules establish standards of conduct.  Basically, these can be summarized as follows.  Don’t cheat, lie, or steal from the company’s owners and other stakeholders.  Don’t use your position to take advantage of the company’s owners or other stakeholders.  Discharge your duties as a faithful agent. Pretty simple and obvious “stuff”.   Presumably, this is the sort of moral sense we’d expect from board members, officers, and employees of a firm.  
And well might ask why do we need to tell people to be ethical unless we assume we’ve hired some pretty low lives.  Does any ethical person think it’s right to steal or lie?  
So if they’re so self-evident, what’s the need?  
  1. Ideally they provide clear unambiguous rules of conduct.  If insider trading is properly defined, to use one example, then there is little room for debate on what constitutes insider trading.  They also provide an inventory of responsibilities. 
  2. They can address gaps or ambiguities in the law or governmental regulations.  Also they can hold the board, officers, and employees to higher standards than mandated by the law or government regulations.  
  3. If crafted properly, they provide a legal basis for the termination of employment or other service.  If you find a “bad apple” you’ll want to get him or her out of your barrel ASAP.  
Examples of organizational structures and procedures (exercise of authority) are segregation of duties, including management of key review functions, dual control, requirements for independent directors, an independent chairman, etc. 
Review functions are both internal and external. Internal review includes internal audit, compliance, risk management, etc.  External review includes external auditors, including requirement for rotation of firms or audit partners; government regulation (chiefly for financial sector entities).
In some cases firms or governmental regulatory agencies have “whistleblower” programs for individuals to report inappropriate behaviour.  
But these measures while necessary are not sufficient.   
And unless there are glaring deficiencies, the benefit of adding additional measures is often likely to be marginal.  Using AA’s wayback machine, here’s a post from 2009 which shows that sometimes enhancement to existing measures can be theoretically useful.  
PEOPLE
No matter how good the system, if those charged with implementing it don’t follow it for whatever reason, corporate misgovernance can occur.  People are the critical variable. 
To set the stage, some examples of system failures due to people:  
  1. Wells Fargo had a fairly developed whistleblower program.  It received numerous complaints about unauthorized opening of customer accounts and credit cards.  There was no discernable impact on firm behaviour.    
  2. Enron had a 65 page corporate ethics manual, which if it were followed to the letter, would have prevented much, if not all, of its inappropriate behaviour.  
  3. For more examples, take a look at the Breeden report on Hollinger International.  Richard C. Breeden, former head of the US SEC, and his law firm have prepared other reports on corporate mis-governance, e.g., MCI,  WorldCom.  
Typically, an attempt is made to address the “people issue” by establishing “fit and proper” criteria for owners/partners of unlisted firms, board members, and senior managers; limitations on numbers of boards board members may serve on; requirements for a number of independent-of-management board members; and possession of relevant skills and experience. 
Enron had a distinguished Board: 15 independent directors, including a former regulator, a former British MP, a distinguished former accounting professor who served as head of its audit committee.  
If you were looking for the ideal board which on its face has all the “right” people–qualified with years of practical experience and as outsiders ostensibly independent—and every Corporate Governance box "ticked", Enron’s Board would be a very strong contender.  Yet, as per press reports, Enron’s Board “suspended” the Company’s Code of Ethics to allow the CFO to be a shareholder in an Enron-related offshore entity.  Articles here and here.  
Enron’s Chairman/CEO had a reputation for promoting corporate governance and ethics.  See the first page of the Enron Code of Conduct.   Read his stirring speech at a 1999 the University of St Thomas in Houston. 
What went wrong? 
People are not perfect.  
Laziness, self-interest, incompetence, a propensity to “go along to get along”, fear of displaying one’s ignorance, etc. are typical traits that lead to governance and other problems.  Add to that an increasing sense of entitlement at the senior that one deserves more and more.  In short human nature.
Efforts to fundamentally change human nature do not have a track record of success.  Nor do those that focus solely on changing behaviour.  
The Soviets brought the power of the state to bear in an attempt to create a new and better Soviet man.  Jamal Abdul-Nasser and his colleagues a new Egyptian, freed from the legacy of colonialism, and what was perceived to be the dead hand of tradition.  Various religions have sought to modify behaviour and have wound up neither achieving widespread practice of right thought, right speech, or at a minimum right action.   
Those working on corporate governance enhancement have to recognize (a) the limitation of the perfectability of man and (b) that enhanced systems will not solve the people element in corporate governance problems.   
That doesn’t mean that one doesn’t try, but that one needs to have a sense of practical limitations.  In short we will not eliminate corporate misgovernance.
SITUATIONS 
In extreme cases, corporate entities are set up as “criminal enterprises” from inception.  Systems may be put in place but there is no intent to adhere to them.  
In noncriminal corporations, there is an intent to adhere to control systems.  Much corporate mis-governance occurs in response to distressed circumstances.  These situations are the real tests of ethics.  
It’s easy to be ethical when the money is rolling in and the corporation is doing well.  
AA has not once been tempted to rob a 7-11.  But if my imagined investments in Dubious Gas went to zero (my entire portfolio), I lost my job, and couldn’t access money, I might like Jean Valjean steal to feed my family.   
The same in the corporate world.  
If an investment firm had an ongoing cash shortage and needed money to continue operations but couldn’t get it immediately from legal sources, might its managers decide to temporarily “borrow” some client funds to bridge a cashflow problem that they’ve persuaded themselves is a temporary state of affairs?  
No doubt making the argument that preserving the firm also preserves clients’ assets, doesn’t disrupt financial markets leading to economy-wide problems.  And also considering carefully the impact of failure on their reputations as well as the loss of the perks of their positions.  
It’s in these cases that people will try to subvert systems.  Often they can do so and do so for a long time.  
Interestingly, when corporate misgovernance occurs, opprobrium is generally directed at those whose misgovernance is followed by collapse of their firm.  
In other words, the market seems distinguish between two situations: “successful” misgovernance (not bad) and “unsuccessful” misgovernance (unconscionably bad).  
Misstating financials is considered a fairly serious breach of corporate governance.  
At the outset of the Latin Debt Crisis, all US money center banks and some large regionals were insolvent based on a proper valuation of their Latin Debt.  Not a single one of these banks produced accurate financials.  The Government and external accountants either were woefully ignorant of the true state of affairs or colluded in the charade.  Eventually, the banks were able to work their way out of insolvency with a helping hand from the US government.  
Enron mis-stated its financials.  Lehman misstated elements of its financials.  Sunbeam as well.  All crashed and burned.  The Boards and senior officers of Enron, Lehman, Sunbeam and other companies were pilloried for corporate malfeasance.    Their auditors were charged with dereliction of duty.  In one case a major auditing firm was destroyed.
On the other hand not a single word of opprobrium was directed at the banks or their auditors over the Latin American debt crisis.  
What’s the takeaway here?  
  1. For non-criminal firms, one can’t predict the response to corporate distress.  What level of distress will cause the system to bend and then break?  To cause normally ethically sound people to relax and then abandon their standards of conduct?  How can one devise a governance system that prevents that from occurring?  
  2. Some corporate mis-governance is apparently good, i.e, if the firm survives.  It’s a natural response of someone in a distressed situation to imagine all sorts of “good” reasons to justify breaking the rules.  
RESPONSIBILITY SHIFTING 
A general reaction to corporate governance problems is that management failed, the board failed, the auditors failed,  regulators failed.  Indeed, they may have.  
But there is additional culpability.  What about other stakeholders and market participants?  If they adopt this very convenient view that they are innocent victims, then corporate governance is the responsibility of others. If one has no responsibility, then one need take no action, other than complain about the turpitude, avarice, and incompetence of others.  
The next post will deal with the apparently inconvenient and uncomfortable responsibility of other market participants to promote corporate governance.