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Sun 22 Apr 2007 12:00 AM

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Driving out the Gulf's 'mini-Enrons'

Why the region faces a corporate catastrophe if it does not improve governance.

We've all heard the arguments. The huge impending job shortage, the lack of infrastructural investment and political instability are all touted as the major stumbling blocks to the GCC's future economic development. But perhaps the biggest long-term threat to the region is its lack of focus on corporate governance. "There could be 20 or 30 ‘mini-Enrons' happening in the GCC right now but no-one knows about it," Andre Baladi, co-founder of the International Corporate Governance Network tells
Arabian Business

. And he could well be right. Despite companies and institutions across the GCC paying lip service to corporate governance drives, delegates at last week's Corporate Governance Forum (CGF) in Dubai warned that the region has a long way to go before it meets international standards of disclosure and transparency. And, if the GCC doesn't act fast, there could be a huge Enron-scale disaster waiting to befall the Middle East region.

In fact, speakers at last month's Gulf Regional Audit conference, said that the region's breakneck growth and lagging auditing controls made it prone to the factors which brought down Enron and Barings Bank.

While the rate at which the GCC has developed into a global centre of commerce has been nothing short of phenomenal, its corporate governance movement is struggling to keep up with the pace. "I'd like to think that companies in the region are aspiring to higher corporate governance standards but my experience is that they are eons behind the rest of the world in terms of disclosure and investor relations," says Darren Smith, vice president of the UAE's Gulf Capital Group (GCG).

To date, in a region where oil continues to fuel rapid commercial development, there has been no real need for an obligatory push towards better corporate governance. And, although GCC markets have suffered some recent security issues and fluctuations, they are yet to experience a catastrophic financial disaster that would "shock" them into action, according to Dean Rowan, chief risk officer at Bahrain's Gulf One Investment Bank. "We've had no Enrons, 9/11s, Madrids or Istanbuls [so] historically we've had a lack of focus on risk in the GCC," he explains.

"The GCC has been slow to price risk into its business operations primarily because of the stability of oil revenues and a lack of exposure to the fluctuations in business cycles that other global economies have faced," he continues. One of the biggest shortfalls of the region's corporate governance set-up is the low volume of financial information being sent out by companies to the investor community. With the exception of the KSA - which according to delegates at last week's forum, is head and shoulders above the rest of the GCC in terms of disclosure - the majority of the region's companies fail to live up to the international standard. According to Smith, a GCG report found that company-offering documents from the GCC (minus the KSA) had an average of 57 pages compared to 163 in "developed markets" and 122 in Saudi. "In developed markets, if a company has a major announcement to make, investor relations will communicate to a group of analysts, they will then write [reports] and communicate to the clients and the investor community. There is a huge lack of research in this region," says Smith.

Of course, by holding businesses and their financial dealings to account, the media also has a major role to play in generating an environment of openness and better corporate governance: After all, it was the media that essentially unearthed the Enron scandal - one of the biggest breakdowns in corporate governance in US history. According to Justin Connor, director of legal and regulatory affairs at Emirates International Telecommunications however, the Gulf suffers from a weak media sector.

"We have major problems with the independence of the media from the businesses that they are covering and problems with the degree that advertising revenue drives the media," he says.


David Cafferty, former internal auditor at ZADCO and Align Consulting (UAE) agrees that the media in this region fails to "force organisations into implementing best practice" corporate governance. While he admits that there is an increasing awareness of corporate governance in the region, Cafferty - a former UK police financial investigator and fraud examiner - also sees an inherent problem with the way GCC companies implement their strategies.

"I think there is too much of a trend in the GCC to look at what's new and hot and say ‘we should have some of that. I want to say that my company has world-class corporate governance so I've got to have this tick in the box, or this badge'. But that badge is never totally understood, it's never used as a vehicle for change and never goes past senior management," he explains.

There's no doubt that there is a genuine shift in the region towards a more transparent, open market. And, the GCC governments are making a concerted effort to address the lack of corporate governance. Last year, the Emirates Securities and Commodities Authority and the Hawkama Institute for Corporate Governance agreed to develop a framework for a new corporate governance code on UAE-listed companies.

Meanwhile, the BASEL II bank regime, due to be adopted globally by 2008, looks set to further tighten things up. The set of international standards will "force a change in the mindset" of how GCC businesses price risk according to Rowan. At the moment however, there is much work to be done before the region is operating at international levels of corporate governance.

As Rowan explains, corporations, regulators and governments must act now to prevent a potential financial crisis. Highlighting the importance of Foreign Direct Investment (FDI) to the GCC, Rowan says: "The amount of spend on infrastructure [needed] to support the GCC's population actually exceeds the total oil revenue for next year so in fact the region is capital deficient.

"FDI, a critical source of funds to the GCC, will not come unless people have the confidence in the framework and consistency [of the market] and understand that legal enforcement is taking place here," he adds. Smith believes that the current lack of research bodies and independent analytical organisations - vital catalysts in the improvement of the corporate governance environment - is a major hindrance in attracting institutional investors to the region.

"If institutional investors are going to broker with you they have to see research [and] independent analysis. The lack of research has contributed to market turmoil and inhibits institutions from coming to the region," he says.

The lack of institutions entering the GCC, due partly to the low level of corporate governance, could have a major effect on the GCC's markets in the future.When sophisticated markets decline, it is quite common to see the volume of trade increase. Mature institutional investors conduct due diligence and technical analysis to spot some alternative buying opportunities. According to Smith however, when the GCC markets fall, "volume completely dries up" due to an investor base that lacks the presence of sophisticated institutions. "They don't buy or sell anything and that contributes to market volatility," he says. Smith goes on to challenge GCC corporations to "reframe" the costs associated with corporate governance.

He also highlights the importance of sound corporate governance to the region's flourishing IPO climate.

"IPO issuers think of corporate governance as cost - and why bother to do it when it costs [so much]," he says.

"But what they need to understand is the cost of not implementing these standards because the GCC will not be able to attract significant institutional interest if corporate governance is not adopted on a regional basis.

Ultimately, institutions are willing to pay a premium for a well governed company - if corporate governance policies are sound, they will pay more." Fortunately for the region, with so much depending on the development of corporate governance, things are beginning to change.

Looking forward, Baladi says

he is optimistic about the future of corporate governance in the GCC since there are "over 50 conferences" on the topic across the Middle East this year - a sign that it is slowly creeping higher and higher up the agenda of corporate GCC.

Smith uses the example of UAE developer Emaar - its annual report for 2005 was a "world of difference" from its 2006 report - to show that companies are slowly becoming willing to disclose more information.

Today there remains a lot to be done, to prevent a lack of corporate governance holding back the region in the coming years. Debate and discussion between regulators and corporate governance bodies will hopefully turn into action. As the region shapes up for the possible launch of a single GCC currency, we may see the convergence of regulators across the region while international codes of practice are likely to increasingly play their part to appease international investors. While it may be too late to prevent an Enron-scale fraud from happening in the GCC, at least damage can be limited and lessons can be learned.

White-collar criminals: the Corporate scandals that shook the world

Enron

The US energy group — that claimed revenues of US$111bn in 2000 and employed 21,000 — became a symbol of fraud and corruption in 2001 when it was revealed that its financial condition was sustained by institutionalised accounting fraud. The company’s recorded assets and profits were found to be inflated or even non-existent, by placing debts into offshore entities that were not consolidated by its financial statements. The group completed other transactions to take unprofitable entities off its books. The resulting trial led to former chief executive Jeffrey Skilling (pictured) being sentenced to 24 years in prison and ordered to pay US$50m into a fund for Enron’s thousands of victims.

Parmalat

Italian dairy and food corporation Parmalat came close to disappearing in December 2003 following accusations of financial wrongdoing against founder Calisto Tanzi (pictured). The company defaulted on a US$185m bond payment in November 2003, prompting auditors and banks to scrutinise company accounts. While 38% of Parmalat’s assets were allegedly held in a US$4.9bn Bank of America account of a Cayman Islands subsidiary, the Bank of America reported that no such account existed. The investigation that followed found that the company had invented assets to offset as much as US$16.2bn in liabilities and falsified accounts over a 15-year period. The US$9.2bn company was forced into bankruptcy while Tanzi was charged with fraud and money laundering.

Barings

Barings was the oldest merchant bank in London until its collapse in 1995 when one of its employees — Nick Leeson (pictured) — lost US$1.4bn in speculation on futures contracts. The bank’s activities in Singapore in the early 1990s allowed Leeson to operate away from the supervision of its London office. He acted as the head of settlement operations and as floor manager on the Singapore International Monetary Exchange (SIMEX) meaning that he reported to an office inside the company that he himself ran. It transpired that Leeson was gambling on the futures market and covering his shortfalls by reporting losses as gains to Barings in London. Leeson created a hidden account and began trading aggressively in futures and options on the SIMEX. After two years of losses covered by the unknown account, auditors finally discovered the fraud, but it was too late to save the bank.

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