All the financials of a company can look good. The prospects for its products might seem great, and products in the pipeline may appear to be even more impressive. But a poor corporate governance structure leads to managers stealing profits from shareholders and setting up the company for massive failure.
A rather famous classic case involves Enron, which was one of the world's largest energy companies. Enron execs were allowed to override Enron's code of ethics that forbade practices involving self-dealing by executives - and they were able to do this with board approval. Boards are supposed to be on the side of shareholders, but it's clear that in this case they were not.
Specifically, Enron's CFO acted on behalf of Enron (which is acceptable for a CFO) in transactions with companies for which he served as partner (totally unacceptable - major conflict of interest!). He was thus able to transfer large amounts of wealth from Enron to himself. These partnerships also served to hide rather large debt obligations that really belonged to Enron.
The permission of such activities is not simply the result of one-off mistakes or omissions on the part of the board of directors. Rather, they are the result of a culture of non-independence and poor checks and balances.
Investors that don't consider the corporate governance structures of the companies in which they invest are the next potential victims of such shenanigans. In the past, we've looked at Charles Brandes views of what corporate governance should look like. In a future post, we'll discuss how ordinary investors can go about getting information on how well a company's corporate governance structure is working, so that they can reduce the chances of falling victim to such egregious activities.