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Author Pacific Perspective

Shirley J. Daniel


Improved corporate
governance is essential
to economic recovery


NEWS headlines are still disclosing significant financial frauds, not just in U.S. firms but in foreign firms as well. For example, Royal Ahold NV, a Dutch company that owns several large U.S. retail food chains, just increased the estimated amount that its profits have been overstated for the past three years to more than $900 million.

After the 1997 Asian Economic crisis, the United States looked smugly toward Asia and recommended more transparency, independent directors, audit committees, better financial reporting and corporate governance. However, since the WorldCom, Enron, and other financial failures of 2001 have come to light, the United States is not so smug. The SEC is still in the process of proposing rules that attempt to address our own corporate governance shortcomings.

Unfortunately, as we have seen since the Asian economic crisis, real changes in corporate governance are typically slow in coming, and as a consequence, lost investor confidence drags down economic recovery long after the financial problems come to light.

For example, Japan's reluctance to clean up bad loans in the banking sector still plagues its economic recovery. The Japanese keep hoping that economic growth will get them out of the predicament they've created by not recognizing the loan losses resulting from the burst of the bubble. Ironically, it may be their reluctance to undertake the painful write-offs and restructuring required that is preventing the growth and recovery they are waiting for.

South Korea's rebound from the Asian economic crisis bears some testament to the effectiveness of the "biting the bullet" approach. Both in Japan and the United States, until reforms are apparent to the broader population, investor and public confidence will not recover.

Despite the three-year "correction" that has brought the Dow from its January 2000 high of 11,723 to the current level of 9,117, investors are still "waiting for the other shoe to drop." Even interest rates that are at 43-year lows are not luring investment back into stocks sufficiently to put the stock market into a reliably steady growth trend.

The combination of low interest rates and poor stock prospects have been good for the residential real estate market. But the sustained lack of confidence in stocks has a detrimental trickle-down effect on the capital formation needed to support the birth of tomorrow's best new companies. New jobs are created by younger high-growth firms, not the Fortune 500. Venture capitalists have millions to invest in start-ups, but even three years after "the correction" they are still reluctant to deploy their capital since IPO exit strategy prospects remain so weak.

Despite protestations by corporations, accountants and lawyers; restoring investor confidence in markets will require demonstrative changes that the public perceives as meaningful improvements in corporate governance.

Now that investors realize that many of the financial manipulations were engineered not only by the operating firms but also the financial services and investment banking firms that represented them, the public is looking for a signal of real change in the system that supported these manipulations.

When it comes to investor confidence, perceptions become reality, because stock values are based on expectations of the future. While the Sarbanes Oxley Act was passed to address this problem, it remains to be seen whether the newly required written certifications and statements by corporate CEOs, CFOs and auditors will be enough to convince investors that corporate financial statements are accurate. After all, if an executive is willing to lie about the numbers, wouldn't he or she also be willing to sign a false certification?

The only real impact of the certifications required by Sarbanes Oxley are increased costs to firms who are trying to report accurately, as well as the driving out of competent and honest CFOs and CEOs who know there is no such thing as a 100 percent foolproof accounting system, even in the best of circumstances. Unfortunately, often the financial engineering that companies get involved with is an effort to compensate for poor financial results resulting from honest errors in management decisions. Such fraud and financial manipulations generally occur as a second stage to compensate for the "real" losses.

What does this mean to Hawaii? Many Hawaii firms and ventures are seeking capital infusions from investors both locally and on the mainland. Above all, investors value predictability. However, they know that nascent firms in evolving industries are inherently risky. They are willing to accept this risk. But what they don't want is unnecessary risk resulting from management dishonesty.

These potential investors will be looking for good managers with integrity as well as industry knowledge, and for good corporate governance systems and financial reporting processes that are transparent. Insider deals, special favors, undisclosed connections and relationships, and ethical conflicts that are discovered during the investor's due diligence process will be the "kiss of death" in today's sensitive market. In that respect, some Hawaii firms (similar to those in Japan) may have to abandon their old habits of doing "business as usual."


Shirley J. Daniel is the Henry A. Walker Jr. Distinguished Professor of Business Enterprise at the University of Hawaii at Manoa College of Business.

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