The Greatest Governance Failings of the 21st Century
Corporate governance has catapulted from the fringes to the fore since the turn of the millennium, with numerous scandals dominating headlines in recent years. Essentially, corporate governance is the system by which companies are directed and controlled. When governed well, companies can achieve an optimal balance of all their stakeholder’s interests. However, when corporate governance goes wrong, even the most large-scale businesses can suffer its destructive consequences. Outlined below are three of the most momentous governance scandals since the beginning of the 21st century.
Enron – 2001
It is impossible to list the most notorious governance scandals of recent years without beginning with the grandfather of corporate failings. Enron, a former giant of the energy sector and darling of Wall Street, suffered a collapse that shook the business world to its core in 2001. In August 2000, Enron had a market capitalization of $70 billion and was outperforming the S&P by more than 200%. By November 2001, the company was bankrupt.
The situation began in early 2001 when institutional analysts monitoring Enron questioned irregular accounting practices employed in the company’s latest Annual Report. The U.S. Securities and Exchange Commission (SEC) subsequently began an investigation which uncovered that Enron was concealing liabilities and toxic assets to the value of billions of dollars through mark-to-market accounting and special purpose vehicles.
The company’s senior executives basically measured the value of their securities based on its current market value instead of its book value. This allowed the company to build an asset and instantly claim its forecasted profits on their books even if the company had not yet generated any revenue from the project. If it transpired that actual revenues were inferior to those forecast, Enron simply transferred the asset to an off-books entity where the loss wouldn’t be reported, thereby having no negative consequences on Enron’s accounts. Furthermore, Enron were able to impose significant pressure on their auditor, Arthur Andersen, to overlook the irregularities. This allowed Enron to appear very profitable when in fact it was bleeding cash.
The fallout from the scandal was immense. Enron’s share price plummeted from $90.75 at its apex to $0.26 in a matter of months, leading to the filing of a $40 billion lawsuit from the company shareholders. The scandal is also believed to have been the prime motivation behind the introduction of the Sarbanese Oxley Act in 2002, which helps to protect investors from fraudulent financial reporting. Enron ultimately filed for bankruptcy on December 1st 2001 with $63.4 billion in assets, the single largest corporate bankruptcy in U.S. history at the time.
Lehman Brothers – 2008
On September 15, 2008, Lehman Brothers filed for bankruptcy having fallen victim to the subprime mortgage crisis. Images showing hundreds of smartly dressed workers, exiting the bank’s offices with their belongings in small cardboard boxes is the quintessential portrayal of the subprime mortgage crisis’ climax.
As the housing bubble began to accelerate in the early 2000’s, Lehman Brothers directed their attentions firmly on mortgage-backed securities and collateral debt obligations in order to provide those seeking to purchase real estate with loans. By 2007, Lehman Brothers had underwritten more mortgage-backed securities than any other firm, garnering a portfolio to the value of $85 billion, four times the firms shareholder value.
Being so highly geared meant that the firm was extremely sensitive to the housing market, leaving it at significant risk of collapse in the occurrence of a housing downturn. In order to disguise this fact, Lehman Brothers made repurchase agreements with banks in the Cayman Islands, effectively agreeing to sell them the firms liabilities with an agreement to repurchase them at a later date. Lehman Brothers then manipulated accounting standards to record these repurchase agreements as sales, allowing the firm to acquire cash in the short run without recording any liabilities.
However, when real estate values began to fall and the credit market began to tighten, Lehman Brothers found themselves in the fatal position of being unable to repay their repurchase agreements, as their own clients were defaulting on their loans. Despite ‘Hail Mary’ attempts at the final minute to agree a takeover with Barclays PLC and Bank of America, in September 2008 Lehman Brothers filed for bankruptcy with $639 billion in assets and $619 billion in debt.
The Lehman Brothers bankruptcy was a seminal governance failure that sent financial markets reeling in its wake and effectively marked the beginning of the Global Financial Crisis. It acts as a stark reminder that no company nor market is too big to fail.
Volkswagen – 2015
‘Dieselgate’ rocked the automotive world in in September 2015 when the U.S. Environmental Protection Agency (EPA) announced its belief that Volkswagen had installed software devices in diesel cars to defeat emissions testing. The announcement triggered a staggering fall from grace for the German firm famed for its precision engineering and drive to become the world’s best-selling car manufacturer.
Volkswagen allowed their lofty ambitions to blind them from their responsibilities towards their customers, shareholders, the environment, and society in general.
The EPA discovered that the company had installed illegal software, dubbed ‘defeat devices’, in polluting vehicles that could recognise when it was undergoing an emissions test and subsequently change its performance in order to pass. Volkswagen had intentionally set emissions controls in their diesel engines to turn on during laboratory emissions testing only. This allowed vehicles’ outputs of Nitric oxide output to conform with U.S. standards during testing, but actually emit up to 40 times more Nitric oxide when driving on the road.
In total, Volkswagen installed defeat devices in 11 million cars across the globe between 2009 and 2015, 500,000 of which were in the U.S. Volkswagen were forced to pay a heavy price for their governance failures in the aftermath of the scandal, most notably a mammoth $18 billion fine from the EPA. Volkswagen’s share value plunged 30% in the immediate aftermath of the scandal, constituting a loss of over $26 billion in shareholder value. As of writing, the fallout from the controversy has cost Volkswagen over $33 billion, taking into account fines, financial settlements and recall/ repurchase costs, a substantial figure when you consider that the GDP of many small nations is less.
The greatest price of Volkswagen’s actions, however, are the 59 estimated premature deaths that will occur as a direct result from excess pollution of illegal Volkswagen cars in the United States alone.
Lessons to be Learned
Enron, Lehman Brothers, and Volkswagen teach us that the absence of a sound corporate governance structure can hold disastrous consequences for any company, regardless of their size and revenues. Corruption, lost profits, reputational damages, and in extreme cases bankruptcy, are just some of the potential consequences for a company chooses to ignore its governance responsibilities. On a grander scale too, governance neglect can have large-scale ramifications. Lives can be lost and economies unbalanced through neglect of even a single company. Therefore, it is clear that businesses must remember their corporate governance duties if they, and society, are to thrive and succeed into the future. If not, they may just be the next name to join this list.
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