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O wnership Structure, Fraud, and Corporate Governance

Stephen R. Goldberg, Dori Danko, and Lara L. Kessler

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his article dis- cusses national differences in corporate ownership structures, the types of fraud each of these structures incentiv- izes, and governance techniques to miti- gate wrongdoing. In the first section, the article describes two ownership systems.

A dispersed own- ership system has widely disseminated shares and no domi- nant shareholder or group of sharehold- ers. This is more com- monly the share own- ership pattern in the United States and the United Kingdom. A concen- trated ownership system is more common in continental Europe.

In this system, one shareholder, family, or group of sharehold- ers has majority or dominant control of companies. Addi- tional capital may be provided by minority shareholders and banks. In the next two sec- tions, the article addresses why

different types of fraud are more prevalent under each sys- tem. Dispersed ownership sys- tems encourage earnings man- agement so executives benefit from short-term performance measures. Concentrated con- trol encourages appropriation of private benefits of control.

The fourth section discusses basic corporate governance

techniques to protect shareholders and which methods have greater efficacy under each system. Finally, the article concludes with implications of the discussion for shareholders, board members, and executives.

OWNERSHIP SYSTEMS

Generally speak- ing, the free market world divides into two alternative cor- porate ownership sys- tems. (See Exhibit 1.) Dispersed ownership systems are more common in English-speaking countries such as the United States and United Kingdom, where capital tends to be raised on stock and bond markets from widely dispersed investors.

Concentrated ownership sys- tems are more common in con- tinental Europe, where capital tends to be raised from families or other private sources.

A dispersed ownership system has widely disseminated shares and no dominant shareholder or group of shareholders. This is more commonly the share ownership pattern in the United States and the United Kingdom. A concentrated own- ership system is more common in continental Europe. In this system one shareholder, family, or group of shareholders has majority or dominant control of companies. Different types of fraud are incentivized under each system. Dispersed ownership systems encourage earnings man- agement, so executives benefit from short-term performance measures. Concentrated control encourages appropriation of private benefits of control. Corporate governance is designed to protect shareholders’ interests. Corporate owner- ships systems have implications on the efficacy of governance techniques. © 2016 Wiley Periodicals, Inc.

Editorial Review

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Dispersed Ownership and Fraud

Coffee (2005) discusses why different types of scandals occur in different countries.

He argues the answer relates to the structure of share owner- ship. However, it should not be forgotten that companies with various capital structures exist in all countries. So the analysis and suggestions reported here address national and regional tendencies.

In the United States, fol- lowing the stock market bubble in 2000, there was a number of financial restatements and reports of financial fraud (Enron and WorldCom were the iconic U.S. frauds). Europe also had scandals, but their scan- dals characteristically differed from the United States. Only European firms cross-listed in the United States had earnings management scandals similar to U.S. firms. Differences in share ownership structure account for differences in the type of fraud encountered, who the perpetra- tors are, and the number of scandals at a point in time.

In dispersed ownership systems such as in the United States, managers tend to be the wrongdoers. Corporate manag- ers tend to manage earnings motivated by compensation systems focusing on short-term performance. In concentrated ownership systems, the rogues tend to be controlling owners.

Parmalat S.p.A. is the iconic European example of fraud.

Controlling shareholders extract benefits from private control. Although gatekeep- ers failed at both Enron and Parmalat, they failed in differ- ent ways. As a result, different reforms may be effective in dif- ferent countries.

In the United States begin- ning around 1990, a substantial change began to take place in methods of executive compen- sation, earnings management, and financial restatements.

There was a significant increase in restatements with a more rapid increase around the year 2000. One study found “firms lose on average 25 percent of market value over the period examined and this is concen- trated in a narrow window

surrounding the announcement of the restatement” (Richard- son, Tuna, & Wu, 2002). This magnitude of market reaction suggests that market partici- pants frequently view restate- ments as indications of fraud.

Revenue recognition errors have been found to be a leading cause of restatements and are taken by the market as an indi- cation of cheating. According to Coffee (2005), prior to the late 1990s management held back recognition of revenues to create reserves that could be increased and decreased to smooth earnings. Beginning in the later 1990s, the manipula- tion of choice became shifting earnings from future periods to accommodate unrealistic market expectations of growth.

This change in earnings man- agement was prompted by a relatively abrupt change in executive compensation from a cash-based remuneration sys- tem to an equity-based system without any change in com- pensating corporate controls to counter the perverse incentives created by reliance on stock options.

Characteristics of Alternative Corporate Ownership Systems

Dispersed Ownership System Concentrated Ownership System

• Dispersed share ownership • Controlling blockholder

• Strong securities markets • Weaker securities markets

• High levels of disclosure and transparency • High private benefits of control

• High share turnover • Lower disclosure and transparency

• Market for corporate control • Possible auxiliary role played by banks and noncontrolling blockholders

Exhibit 1

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In 1990, the median income of a CEO of a Standard &

Poor’s (S&P) 500 industrial company was $1.25 million.

Ninety-two percent of com- pensation was in cash, and 8%

in equity (Hall, 2003). In 2001, the median income of a CEO of an S&P industrial 500 was over $6 million, with 66% in equity. Stock options of this level are strong incentives for short-term financial manipula- tions and accounting games- manship. Research has found a positive correlation between in-the-money stock options and financial restatements (Efendi, Srivastava, & Swan- son, 2007), as well as securi- ties fraud (Denis, Hanouna,

& Sarin, 2006). Research also shows that higher equity incen- tives are associated with CEOs selling more shares following release of earnings reports that meet or exceed analysts’ fore- casts, and engaging in various forms of earnings management (Cheng & Warfield, 2005). In 2004, the ratio of CEO com- pensation was approximately 531:1 in the United States, 25:1 in the United Kingdom, 16:1 in France, 11:1 in Germany, 10:1 in Japan, and 21:1 in Canada.

Also, equity was a much lower percentage of total compensa- tion in all other countries.

Several explanations have been given for higher U.S. CEO pay and the shift to equity- based compensation. Tax laws were amended in the early 1990s, limiting the deductibility of cash compensation, thus encouraging a shift to equity compensation. Others argue that much of the change is due to institutional investors in the United States pressuring boards to shift toward equity performance-based compen- sation to align executive and

shareholder incentives. Argu- ably, the previously higher cash-based compensation dis- couraged risk taking to avoid possible reductions in earnings and to avoid bankruptcy, but encouraged companies to maxi- mize size, regardless of profit.

Total compensation was corre- lated with size of company.

The shift to equity-based compensation increased execu- tives’ incentive to maximize share value. Asymmetric infor- mation possessed by manage- ment encouraged manipula- tions to report earnings growth.

Although earnings spikes were not sustainable, manag- ers could exercise options and bailout after the manipulation but before it became known.

Few analysts downgraded pub- lic companies in the months prior to earnings restatements (Griffin, in press), yet there was evidence that short sellers were able to recognize overstated earnings and profit (Desai, Krishnamurthy, & Venkatara- man, 2004). Thus, short sellers were able to identify gover- nance failures, and corporate gatekeepers were not.

Concentrated Ownership and Fraud

In contrast to dispersed ownership, most European companies have a controlling shareholder or shareholder group. Controlling sharehold- ers do not require indirect measures of control such as stock options to provide incen- tives for management. They rely on command and control to directly monitor and replace management. Therefore, corporate management has less discretion to manipulate earnings and less incentive to create an earnings spike since

compensation is less related to stock price. Also, controlling shareholders rarely sell their control block of shares into the public market. If they consider selling their shares, it will be through a privately negoti- ated sale. Generally, sales price would reflect a control pre- mium well above market price.

As a result, shareholders in Europe have less incentive and concern regarding share price.

In sum, fewer accounting irreg- ularities occur in Europe due to less use of equity compensation and less concern about short- term stock price.

Although accounting irregularities remain relatively infrequent in Europe, those experiencing accounting irregu- larities were frequently listed subsidiaries of U.S. companies or U.S.-style conglomerates awarding stock options (e.g., Vivendi Universal, Royal Ahold, Skandia Insurance).

Another reason for the fewer European restatements of financials could be less rigorous regulatory oversight in Europe and therefore less requirement to restate financials. However, this does not overshadow the lower incentive to manage and overstate earnings.

The point is not that Euro- pean managers are more ethical than U.S. managers. The point is that concentrated ownership offers a different kind of temp- tation, that is, the temptation of private benefits of control.

Research demonstrates that private benefits of control vary significantly by country (Dyck

& Zingales, 2004). Depending largely on legal protections of minority shareholders, private benefits of control were found to vary from −4 to +65%. The market does not appear to dis- cern on a real-time basis what

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benefits are expropriated. A technique used in emerging markets to expropriate private benefits of control has been referred to as “tunneling.” Tun- neling includes self-dealing transactions such as through transfer pricing, excessive com- pensation, taking of corporate opportunities, and asset sales.

Another approach is through financial transactions that dis- criminate against minorities, such as dilutive equity offer- ings and minority freeze-outs.

Tunneling techniques may be legally precluded in more developed countries. Various operational techniques used in developed countries to extract benefits from minority shareholders include forcing the company to buy or sell to a corporation independently owned by the controlling share- holder. Firms within a corpo- rate group tend to have more related-party transactions than firms that are not members of a controlled group. Controlling shareholders use these trans- actions to transfer resources from companies in which they have lesser cash flow rights to companies in which they have greater cash flow rights.

Thus, differences in moti- vations arising from various capital structures encourage national differences in forms of financial misconduct and atten- dant governance challenges.

These differences have implica- tions for national variations in corporate governance and legal controls to protect shareholders.

Parmalat’s fraud was largely on the balance sheet.

Over $17 billion in assets disap- peared or were fictitious. Over

$2 billion was paid to affili- ated persons and shareholders.

Private benefits were siphoned off through related-party

transactions to benefit con- trolling shareholders. This differs from short-term stock manipulations occurring in the United States (e.g., Enron, WorldCom). Parmalat is a clear example of audit failure.

Referring to Parmalat and Hol- linger International (a Dela- ware corporation controlled by Canadians), Coffee (2005) emphasizes that controlling shareholders may misappropri- ate assets but have less reason to fraudulently manipulate earn- ings. Since different systems of ownership encourage different types of fraud, the roles of gate- keepers such as auditors differ across legal regimes and gover- nance systems.

ROLE OF CORPORATE GOVERNANCE IN REDUCING FRAUD

Corporate governance is the system by which cor- porations are directed and controlled. It provides the structure through which company objectives are set, the means of attaining objec- tives are determined, and performance is monitored.

Better corporate governance improves the likelihood of cor- porate success, which includes higher shareholder return, the well-being of employees, and good corporate citizenship.

By improving investors’ confi- dence, good corporate gover- nance also aids in the function- ing of capital markets.

Governance failures have occurred in both dispersed ownership and concentrated ownership regimes. Monitors such as auditors or securities analysts in dispersed owner- ship systems have failed to detect manipulated earnings. In dispersed ownership systems,

perpetrators are managers, and the victims are the sharehold- ers. Monitors in the concen- trated ownership systems failed to prevent or report expro- priation of private benefits. In the concentrated ownership systems, the perpetrators are controlling shareholders, and the victims are minority share- holders.

From shareholders’ view- points, corporate governance are mechanisms that encourage managers to make decisions to maximize owners’ value. As indicated in Exhibit 2, there are two agency conflicts potentially reduced by good corporate gov- ernance. In a dispersed owner- ship system such as the United States, there is a separation of ownership from management.

Within this system, the objec- tive of corporate governance is to encourage the agent/man- ager to act in the owners’/prin- cipals’ interests by maximizing owners’ wealth. In a concen- trated ownership system, the dominant shareholder makes decisions for all shareholders and therefore is effectively an agent for minority sharehold- ers. In this case, the objective of corporate governance is to encourage the agent/dominant shareholder to act in the best interest of all shareholders/

principals including minority shareholders.

Potential gatekeepers or monitors for corporate report- ing and shareholder protection include boards of directors, auditors, financial analysts, and bankers. Exhibits 3 and 4 list corporate governance mechanisms that are internal and external to companies, respectively. A governance chal- lenge in a dispersed ownership system is to design a system in which auditors are required to

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Primary Governance Objective Under Share Ownership Systems

Dispersed ownership system: Concentrated ownership system:

• Characterized by: separation of ownership and management.

• Characterized by dominant/controlling shareholder.

• Objective: to encourage manager to act in the shareholders’ interests by maximizing owners’

wealth.

• Objective: to encourage dominant shareholder to act in the interests of all shareholders including minority shareholders.

Exhibit 2

Internal Corporate Governance Mechanisms

• Characteristics of board of directors

• Equity ownership structure:

• Controlling shareholders

• Activist shareholders

• Block shareholders

• Shareholder rights

• Transparent communications Exhibit 3

External Corporate Governance Mechanisms

• Market for corporate control

• Legal/regulatory system

• External gatekeepers:

• Independent auditors

• Securities analysts

• Bankers Exhibit 4

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report to a truly independent audit committee rather than to the managers responsible for hiring and possibly firing them. The Sarbanes-Oxley Act takes this approach. An independent audit committee is not as effective for a concen- trated ownership system where the audit committee serves at the pleasure of the controlling shareholder. In a concentrated ownership system, the board is subservient to the controlling shareholder. The auditor can- not effectively escape control of the party it is expected to monitor. Auditors can do little to prevent unfair related-party transactions, squeeze-out merg- ers, or coercive tender offers.

The size of the board should be optimal for interaction of members. Compensation should encourage alignment of board and shareholder interests for long-term decision making.

All appropriate skills should be represented. The board should decide whether the CEO and chairman of the board should be separate persons to allow for better oversight or should be the same person to encourage efficient decision making.

Equity ownership struc- ture refers to concentration of ownership. In a concentrated ownership system, there is a controlling or dominant share- holder or group of sharehold- ers. In this system, perfect alignment exists between own- ership and management. When ownership is widely dispersed, managers may be entrenched in the sense that it is difficult to maintain a coalition of share- holders to influence or change management. According to the Economist (2013), shareholders have increasingly flexed their muscles since widespread flaws in corporate governance were

revealed in the financial crisis of 2008. Public outrage gave rise to greater shareholder scru- tiny of excessive compensation and abuse of executive power.

Governance has been weakened by the growth of passive index funds (Econo- mist, 2015, p. 11). Index funds and exchange-traded funds mimic markets’ movements and generally do not consider how firms are managed. Also, institutional portfolio inves- tors tend to sell firms’ shares rather than manage problems.

Private equity firms argue that their model of concentrated ownership makes more sense.

An alternative approach is activist hedge funds. These funds buy small stakes in firms and act essentially as political campaigners trying to get other shareholders to cooperate in obtaining board representa- tion, cutting costs, spin-offs, and giving cash back to share- holders. Activists have existed since the 1980s; however, their influence has grown in recent years. They fill a void and run funds with at least $100 billion in capital and in 2014 attracted a fifth of all flows into hedge funds. In 2014, they launched 344 campaigns against public companies. However, about a tenth of large American firms and an even greater percentage of smaller firms still use tactics such as “poison pills” and stag- gered boards to protect poor management. The Economist argues that private equity firms are one way of fixing poorly performing firms, but activists have an advantage. They can influence misfiring firms typi- cally with a stake of about 5%.

The Economist (2015, pp. 21–24) argues that activism has become mainstream. Since 2011, activists have assisted

in bringing down CEOs at Proctor & Gamble and Micro- soft and brought about the breakup of Motorola, eBay, and Yahoo. They have won board seats at many public corporations. Since 2009, 15%

of S&P 500 firms have faced an activist campaign to change a board member, a firm’s strategy, or management. It is estimated that 50% of S&P 500 firms have had an activist on their share register during this period. Eighty percent of activist interventions are in the United States, where the cul- ture and legal system are better suited to shareholder revolts than those in Europe or Asia.

Of about 8,000 hedge funds, only 71 are activists. These are, on average, larger funds with about 4% of the hedge fund total or approximately $120 billion under management.

Typically, hedge funds hold their positions in companies for less than a year. Bigger bets are held for longer periods up to about four years. Activists have considerable clout, although in total their ownership amounts to only 1% of the value of the S&P 500 index. Activists provide a way for lazy money (index funds and diversified portfolio management) to fix ailing firms and are more effi- cient than private equity firms, since no takeover premium is paid. Activist positions typi- cally outperform the S&P 500.

Activists’ demands are usually some combination of the fol- lowing: a buy-back, the spin- off of a noncore subsidiary, and the search for a merger partner.

A study of activism from 1994 through 2007 by Harvard Law School’s Lucian Bebchuk and updated by the Economist for more recent years concludes

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that activist intervention on average leads to a sustained, albeit modest, improvement in performance and shareholder returns. Only 76 firms in the S&P 500 persistently under- perform the market, suggesting that the U.S. activist market appears saturated. The concern is that activists may now attack well-run firms.

Shareholders’ rights refers to protections in law or in com- panies’ articles of incorpora- tion or corporate bylaws. They might include minority rights in the case of a takeover and requirements for arm’s-length transactions with controlling shareholders. Strong share- holder rights inspires raising widely dispersed share owner- ship. Weak shareholder rights are more characteristic of countries with concentrated share ownership.

In dispersed ownership regimes, managers have much more information about corpo- rate transactions than diverse shareholders. It is impossible for shareholders to object to man- agement actions if they are not aware. This challenge of infor- mation asymmetry between management and shareholders is resolved by timely transpar- ent disclosure. Transparency includes high quality financial reporting as required under U.S.

generally accepted accounting principles (GAAP) or Inter- national Financial Reporting Standards (IFRS), as well as reporting of relevant matters such as executive compensation and conflicts of interest with the board and executives.

An external governance mechanism is the market for corporate control, also known as the takeover market. If governance is poor, the gap is wide between actual value

as reflected in stock price and potential value. This creates an opportunity for a buyer such as a private equity firm to buy the shares of the company, replace current management with higher quality leaders, and make a profit. In a dispersed ownership system, the market for corporate control (i.e., the takeover market) exerts the ultimate discipline.

Another external gover- nance mechanism is the legal or regulatory environment in which the company is located.

This includes what laws exist and are enforced. Are minority shareholders protected from the vagaries of the controlling shareholders?

Securities analysts are more effective in a dispersed owner- ship system where markets are more liquid and prices are set in a relatively efficient market.

In concentrated ownership regimes, shares are more thinly traded likely limiting analyst coverage. Even if analyst cover- age were equivalent, predictions of future earnings would be less meaningful if the control- ling shareholder is in a position to squeeze out minority share- holders.

As discussed earlier, a controlling shareholder affects auditor independence. The Sarbanes-Oxley Act resolu- tion increases independence of the board. However, in a concentrated ownership sys- tem, the board is subservient to the controlling shareholder.

The auditor cannot effectively escape the control of the party it is expected to monitor. Audi- tors can do little to prevent unfair related-party transac- tions, squeeze-out mergers, or coercive tender offers. The only protection for minority owners would originate from statutory

protections. Statutory protec- tions include supermajority votes, mandatory bid require- ments, or other prophylactic rules, which better protect minority shareholders.

To overcome the challenge of controlling shareholders influencing the selection and work of the auditor, Coffee (2005) suggests a couple of approaches. Minority share- holders select the auditor, and the auditor reports to minority shareholders, or, alternatively, minority shareholders have a say on the selection, reten- tion, and compensation of the independent directors and auditors.

If predatory behavior by controlling shareholders is widespread, why would inves- tors buy minority interests in companies? Other actors may replace gatekeepers that play a role in a dispersed legal owner- ship regime. Universal banks that typically hold large blocks of noncontrolling shares may play a role in protecting minor- ity shareholders. In continental Europe, labor representatives, through their legal rights to codetermination with share- holders, play a protective role.

Another protective mechanism is cross-monitoring by noncon- trolling blockholders.

CONCLUDING COMMENTS

Public policy implications are intrinsic to the preceding discussion. There is reason to believe that professional agents that serve as shareholders’ gate- keepers work less well in con- centrated ownership regimes than in dispersed ownership regimes, but there are at least some compensating mecha- nisms. Dispersed ownership creates incentive for managers

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to manipulate earnings. Con- centrated ownership encour- ages low-visibility extraction of private benefits. Governance working well in one system may not in the other. Corporate governance techniques should consider incentives for wrong doing created by firms’ owner- ship structures.

REFERENCES

Cheng, Q., & Warfield, T. (2005, April).

Equity incentives and earnings man- agement. Accounting Review, 80(2), 441. Retrieved from http://ssrn.com/

abstract=626848

Coffee, J. C. (2005). A theory of corporate scandals: Why the USA and Europe

differ. Oxford Review of Economic Policy, 21(2), 98–211. Retrieved from http://ssrn.com/abstract=906398 Denis, D. J., Hanouna, P., & Sarin, A.

(2006). Is there a dark side to incen- tive compensation? (August 17, 2005).

Journal of Corporate Finance, 12(3), 381–692. Retrieved from http://ssrn .com/abstract=1448840

Desai, H., Krishnamurthy, S., & Venkata- raman, K. (2004). Do short sellers target firms with poor earnings quality?

Evidence from earnings restatements.

Retrieved from http://ssrn.com/abstract=

633283

Dyck, A., & Zingales, L. (2004). Private benefits of control: An international comparison. Journal of Finance, 59(2), 537–600. Retrieved from http://www .jstor.org/stable/3694907

Economist. (2013, March 9).

Economist. (2015, February 7). p. 11.

Economist. (2015, February 7). pp. 21–24.

Efendi, J., Srivastava, A., & Swanson, E. P. (2007). Why do corporate manag- ers misstate financial statements? The role of option compensation and other factors. Journal of Financial Economics, 85(3), 667–708. Retrieved from http://

ssrn.com/abstract=978059

Griffin, P. A. (in press). A league of their own? Financial analysts’ responses to restatements and corrective disclosures.

Journal of Accounting, Auditing, &

Finance. Retrieved from http://ssrn.com/

abstract=415560

Hall, B. J. (2003). Six challenges in designing equity-based pay. Journal of Applied Corporate Finance, 15, 21–33. Retrieved from http://ssrn.com/

abstract=424170

Richardson, S. A., Tuna, A. I., & Wu, M.

(2002, October). Predicting earnings management: The case of earnings restatements. Retrieved from http://

ssrn.com/abstract=338681

Stephen R. Goldberg, PhD, CPA, is a Professor of Accounting at Grand Valley State University. Dr. Goldberg recently retired as a Book Reviewer for the JCAF after many years of service. Dori Danko, MBA, CPA, is an Instructor of Accounting at Grand Valley State University. Lara L. Kessler, JD, CPA, is an Associate Professor of Accounting at Grand Valley State University.

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