McBride Financial Services Governance Evaluation The accounting scandals of the early 21st century had a significant impact

on investor confidence in financial markets. WorldCom executives used their company like a personal bank machine; as did Tycos Dennis Kozlowski. Both are currently serving prison terms. Enron collapsed, having hidden most of its losses from the books. Enrons auditor, Arthur Andersen, at the time one of the Big Five auditing firms, was forced out of business. Enron had adopted unusual accounting procedures, and essentially forged their earnings reports to Wall Street. HealthSouth was another firm that engaged in cooking the books to look better on Wall Street. Governance, or more specifically the lack thereof, was found to be one of the root causes of this series of accounting scandals that had shaken financial markets. Enron, for example, had been a blue chip stock and its failure was especially catastrophic for market confidence. The government moved in with a series of measures to shore up corporate governance. They passed the Sarbanes-Oxley Act (SOX), and the SEC enacted further measures to shore up governance on listed companies. Several factors led to these scandals. The first is the relationship between auditing firms and the companies they audit. The Big 5 auditing firms all had consulting divisions. Usually, the company would have consulting work for the same firms they audited. The consulting work was far more lucrative, creating an apparent conflict of interest. Ultimately, all of the Big 5 ended up with several accounting scandals, both major and minor, on their rap sheet. Another contributing factor was the lack of standards for corporate boards. There were essentially no standards enforced to ensure that boards of directors undertook the oversight they were supposed to. Agrawal & Chadha (2003) found that there is a correlation between companies whose boards did not have any financial experts and the restatement of earnings. Restatement of earnings is a basic indicator of governance the board would ideally be aware of the companys situation such that these deviations in earnings would be caught before the numbers were released. When restatement occurs, the numbers were only discovered later. So higher levels of restatement are directly associated with a boards level of financial ignorance. Another, deeper antecedent is the myopia of quarterly earnings. Listed companies place significant emphasis on their earnings, in order to protect their stock price. Market overreaction to quarterly misses trims shareholder value, the one thing above all else that executives are supposed to protect. This effect becomes compounded when executive compensation is tied to stock prices in the form of either shares or options. Originally, this concept came into vogue as a means to align executive interests with those of the shareholders, under the belief that this alignment would avoid self-interest on the part of executives. When combined with Wall Streets overemphasis on quarterly numbers, however, honest business practice started to give way to an ethic of doing whatever it takes to beat the numbers. IBM, for example, once recorded a sale of a business three days before quarters end to show that it beat the street, when in fact the companys underlying businesses had underperformed for the quarter (Byrne, et.al, 2002). McBride can easily fall into two of these problems. Hugh McBride is at risk of building a board of ciphers. He does not seem to want a board that has ample qualifications, and plans to keep them as far away from the companys operations as he can. This runs against the entire point of having a board, and will erode governance dramatically. Hugh essentially views this as his most desired scenario. His lip service to SOX is an example of his general contempt for governance, and this puts him at serious risk

of having a board incapable of enacting the governance McBride Financial needs. The other problem is that of quarterly myopia. McBride is focused on his stock options, to the point where he feels offering the same to his board would dilute the value of the options hes been given. This may as well result in a lack of governance, in particular in conjunction with Hughs view that the board should not be involved in the company. The lack of equity on the board means that they have no vested interest in the company. Hugh, on the other hand, has significant interest in the companys stock price. This is exacerbated by the fact that he has options. Unlike stock, options have time value. This can increase the risk of executive malpractice as the options grow closer to expiry, in order for the executive to achieve a bump in the stock price, however short and artificial, in order to realize some gains from the calls. The corporate governance industry has exerted some influence over American corporations. In the wake of the accounting scandals, investors are skittish about firms they suspect as having poor governance, as governance is viewed now as another form of risk. The result is that companies must work hard to secure favorable corporate governance ratings in order to avoid the appearance of poor governance. Given that there are several different systems, keeping up solid scores across the board could prove difficult. Another impact has been a rise in shareholder activism. From retail investors to major institutional investors such as CalPERS, shareholders are standing up for their rights increasingly since the wave of scandals. This can at times compromise the course of business. Executives and boards must now be wary of ensuring that their governance is strong, as a low score may spur activism on the part of the shareholders. Additionally, firms have beefed up their governance. As accounting scandals can threaten a companys entire market cap, the role of the CFO has expanded, to the point where the job now often entails strategy and other tasks not previously associated with the role (Hines, 2004). Boards now generally have at least one financial expert on them, again as part of improved oversight in corporate America and fear over the ever-watchful eye of the corporate governance industry. This can have strong implications for McBride. Under their present course, their governance score would likely be poor. This can have several effects on the company. The share price could erode, if Wall Street loses confidence in McBrides governance mechanisms. Furthermore, a poor governance score could attract the attention of regulators, who may dig deeper into McBrides dealings. This is especially worrisome in light of Hughs flippant attitude towards SOX. Regulators would undoubtedly take a dim view if McBride financial fudged its SOX compliance. There are several governance rating methodologies in the financial system right now, and no universal system. One leading system is the ISS Corporate Governance Quotient Rating. This is based on two numbers. One is a comparison between the firm and its relevant index; the other against its industry sector. The comparisons are based on eight core topics: board structure & composition; charter and bylaw provisions; audit issues; anti-takeover practices; executive and director compensation; progressive practices such as board performance review; director and officer stock ownership; and director education. There are 61 variables in total (Brown, 2004). This system would have a significant impact on McBride should they not adopt my recommendations. Three main topics relate to the board, and in McBrides case he is aiming for a board that would score miserably in all three topics. In the other topics, McBride would not score high enough to offset, and as a result would have a low quotient. ISS is one of the leading ratings systems and would have an impact on some of my recommendations.

For example, the recommendations would need a heavy focus on the board. This is the largest component of the ISS rating, so it would become a major component of my governance strategy. I would also increase emphasis on compensation packages. Not only is this at the root of some of Hughs poor decisions, it is also one of the main topics. So in that way, ISS would guide some of the points of emphasis in my recommendations. Another leading system is S&P. The Standard & Poors system features for main categories, pertaining to ownership, shareholders, the board, and transparency (Brown, 2004). The scores are then weighted globally, as opposed to by sector or index the way ISS does. This system would impact McBride in that there is additional focus on ownership, shareholder rights and transparency. The latter seems to be a weak spot for Hugh, and the same problems persist with regards to board issues. The S&P system impacts my recommendations because of the emphasis it places on transparency and shareholder rights. I would ensure that McBride build into its governance system improved transparency and shareholder participation. Moreover, I would work to curtail Hughs greed, which will likely occur at the compensation level, switching out options. Corporate America has had mixed reactions to the governance rating industry. There are a few complaints, chief among them being the lack of consistency. As the industry is in its formative years, there has been constant shift and alterations in the different rating systems. For a company, this makes them a bit of a moving target, a source of frustration even for those who are committed to good governance. Another complaint is that the additional regulations inhibit productivity. All of these systems place additional burden on corporations, both structurally and financially. Having no clear cut dominant system only adds to the complexity. Another complaint has been the use of relativity to derive some of the ratings. As firms improve their governance, ultimately they will trend towards high scores across the entire spectrum of listed companies. This means that as the bar is raised, a company with solid but stable governance scores can lose ground. This may give the appearance of a reduction in governance when that is not the case at all. McBride will not respond favorably to the idea of corporate governance ratings. Judging by his reactions to Sarbanes-Oxley, he will be dismissive and flippant about the notion of improving governance at first. He will not likely see the value in the ratings. Moreover, he will likely try to work around them, by attempting to find a way to achieve a good score without actually engaging in good governance practices. However, the system is designed for this type of behavior. Governance is now a standard form of risk assessment, a fact that has led to the rise of the governance rating industry. When McBrides poor governance scores are revealed, the result will be a decline in stock price. Ultimately, Hugh values money more than power. One of his major reasons for not offering equity or options to the board was because he did not want to dilute his own holdings. Thus, when governance issues cause a decline in the value of McBrides stock, Hugh will pay attention as his options will be worthless. The final result will be that Hugh overhauls the governance of the company, however reluctantly, in an attempt to salvage some value in his remaining and future options. Or put another way, his interests will be realigned with those of the company.

References Agrawal, Anup & Chadha, Sahiba. (2003). Corporate Governance and Accounting Scandals. University of Alabama. Retrieved October 16, 2008 from http://www.afajof.org/pdfs/2004program/UPDF/P666_Corporation_Finance.pdf Byrne, John A.; Lavelle, Louis; Byrnes, Nanette; Vickers, Marcia, & Borrus, Amy. (2002). How to Fix Corporate Governance. Business Week. Retrieved October 16, 2008 from http://www.businessweek.com/magazine/content/02_18/b3781701.htm Brown, Matthew. (2004). The Ratings Game: Corporate Governance Rating and Why You Should Care. Global Corporate Governance Guide 2004. Retrieved October 15, 2008 from http://www.globalcorporategovernance.com/n_namericas/080_093.htm Ali, Paul; Ali, Paul A. U.; & Gregoriou, Greg N. (2006). International Corporate Governance After Sarbanes-Oxley. John Wiley & Sons, pp.476-487. Hines, Matt. (2004). Execs Outline Importance of CFOs. ZDNet. Retrieved October 15, 2008 from http://news.zdnet.co.uk/itmanagement/0,1000000308,39174600,00.htm