How To Build Investor Confidence Through Good Corporate Governance

Corporate Governance, once relegated as a nice-to-have, has never been higher on the agenda of companies than it is now. Tough new regulations have been drafted, originating in the US, to try and restore investor confidence that has been eroded not only by the volatility of the stock market but by a string of public governance failures such as those at Enron, WorldCom, Martha Stewart etc

The Sarbanes-Oxley Act (the Act), named after the two US senators who proposed the bill, is designed to restore investor confidence through the implementation of strong prescriptive measures centered around Corporate Governance.

The most important outcome of the Act is to make Directors personally and criminally liable for infringements of the Act, notably the misstatement of information within financial statements (referred to as Section 404), and roles and responsibilities of a firms Board of Directors.

Evidence of the enforcement of this Act is best illustrated by a number of high profile cases, brought to court prior to the Act's enactment, such as the ex-CFO of Enron, Andy Fastow, who has had his assets frozen and has been indicted him on 78 federal charges of money laundering, fraud, conspiracy and obstruction of justice.

The Act affects all companies listed on any U.S. Exchange, including non-US companies, but is being adopted throughout the world by countries such as Brazil, Mexico, Canada and to a certain extent almost every other country in the world. Companies hoping to list or be acquired would also do well to adopt many of the tenets within the Act if they wish such a move to be fruitful.

Though the Act is seen by many as a knee-jerk reaction to the scandals that have plagued the markets in recent years, much of what is being recommended is just good business practice with the oversight role of a companys board and its audit committee in achieving an effective control environment being promulgated by the COSO (Committee of Sponsoring Organizations of the Treadway Commission) internal control framework. COSO details that the control environment is influenced significantly by a firms board of directors and audit committee.

Boards should, and must, be held accountable for their actions and the influence they have on the ethical behaviour of Company employees.

The Cost of Compliance

The cost of the Act to all businesses has been high. Many firms have had to increase the size of their internal audit departments to cope with the provisions of Section 404 or recruit more members to the Board to comply with the governance requirements. Key-man or Directors & Officers (or Professional Indemnity) premiums have risen between 200 and 400% to guard insurance companies and underwriters against the increased likelihood that lawsuits may be brought against Directors.

Audit fees have jumped between 15 and 30% to cover auditors costs of increasing the size of audit teams needed to perform audits with extra assurance and to guard themselves about making incorrect judgments regarding the accuracy of financial statements.

For a start up business why is this important?

Traditionally in a start up phase the direction of a company is guided by its founding fathers. In the case of BioTech companies these are usually scientists with a basic understanding of finance. In order to gain the trust of either the market or Venture Capital firms an experienced financial practitioner, such as an ACA or CPA should be sought to add credibility and to enact control over the organization. The Act stipulates the need to have an expert on the Audit Committee with an expert being defined as someone who has the knowledge and experience to give assurance over both the internal controls and financial reporting environment.

It is never too early to start enforcing controls in spending at an organization. The inability to control costs or to come up with a sound business plan has caused the downfall of many firms. Most notably this has been seen in the dot-bomb bubble where billions of dollars of Venture Capital was spent on companies who had no experience in drawing up business plans that would ever generate a profit or had no controls over how the capital raised was to be spent.

Building a Board of Directors who have industry expertise and business acumen is just good practice. Diversification of these risks will only enhance a firms ability to navigate its way to success and avoid the pitfalls that plague start up firms.

The importance of good governance

1. Reputational impact mitigants - Reputational risks in terms of ethical behavior, restatement of financial statements (and any failures caught by Venture Capital firms in their due diligence work) can adversely affect a companies valuation

2. It will easier to attract good non-executive directors if they perceive that the likelihood of loss arising from taking a position is small (as they can be legally liable for non-ethical behavior of a firm). In fact there is a severe shortage of good non executive director candidates because the potential cost to them in case of legal actions outweighs the benefits associated with the position (i.e. the salary)

3. Good governance and a disciplined approach to financial controls can save you money (especially in control of expenditure)

4. Leads to potential reduction in both audit fees and insurance premiums through changing the control mindset of an organization

5. By implementing a more formal methodology for evaluating business risks and controls will enable CEOs to run their business more efficiently and effectively whilst reducing the likelihood of operational breakdown, litigation and fraud