THE DAY-TO-DAY running of a corporation is entrusted to the management, who are supposed to act in the interests of the corporation—its shareholders and other stakeholders (such as workers). Under good corporate governance, a publicly held corporation is managed properly (not just in the interests of managers or majority shareholders) and efficiently. This benefits its shareholders and society as a whole.
When a chief executive in the U.S. spends $15,000 of his shareholder’s money to buy an umbrella stand, and millions of corporate dollars go to support a royal lifestyle, it is fair to question whose interests are being served: those of the executive or those of the shareholders. It also raises the question: Where were the directors who were supposed to be “watching the shop”? If this can happen time after time in the U.S., with its shareholders protection laws, oversight by the U.S. government’s Securities and Exchange Commission, and corporate activism, how much worse can corporate waste be in the nascent capital markets in developing and transition countries? How can one recognize the issues so that good reporting can educate those in emerging markets to control and prevent similar abuses?
Effective corporate governance will not guarantee efficiency in production or distribution nor magically create a profitable company; however, its absence almost always promotes the opposite. Even if one were to disregard the fairness issue—that shareholders entrust their capital to corporate managers and directors who are supposed to act as fiduciaries—society as a whole needs protection from waste and misallocation of scarce resources. Corporate governance promotes this general good by assisting corporations to act in an accountable manner.
Benefits of good corporate governance go beyond microeconomics: they can have a major effect on the path of capital inflows and, by implication, economic growth. Take the United States, for instance. As of 2003, the country was running a current-account deficit equal to roughly 5 percent of its GDP. In dollar terms, this equates to $500 billion. Even for a superpower, this is a large number. The United States needs to finance this amount by “borrowing” abroad. Anything that curtails this borrowing—including, in recent years, corporate scandals—can have (and is indeed having) important effects on the economy and its currency, the dollar. What applies to the United States applies even more so to less-developed nations. Russia’s equity market, for example, languished for years since investors had no confidence in how publicly traded corporations were being managed.
It is logical to assume that when managers and corporate boards are accountable for their actions and decisions through transparent oversight, there will be increased responsiveness to societal and shareholder needs. At the very least, this promotes the common good.
WHY IS CORPORATE GOVERNANCE NEEDED?
It enhances a company’s returns. Well-managed corporations can attract low-cost capital by inspiring investor confidence. This, combined with greater oversight of the use of such capital, usually provides a greater return on investment to the company and its shareholders. It leads to societal gains. In many formerly communist countries, the belief that a nation of shareholders would be helpful in promoting a healthy economic climate led to mass privatization projects in which millions of citizens also became shareholders. However, lack of corporate governance eroded these gains and, ironically, promoted greater national cynicism. Proper corporate governance precludes corruption. Corrupt managers are interested in redistributing the assets of a company to themselves, their friends, their and relations; a management governed by the proper controlling authority seeks to develop the company’s competitiveness in order to survive and thrive. This means, among other benefits to society, that there is a need to invest in worker training. A company’s skill in training and motivating its workforce usually leads to improved economic performance. This creates a more educated workforce, a crucial factor in the postcommunist economies, with their legacy of central planning and redundant workers.
It promotes restructuring. To restructure a company and become competitive in an increasingly global market, its directors and managers have to be incentivized. It is never pleasant to fire workers. This difficulty is enhanced in a homogenous society where the manager went to school with the workers and may still live in the same neighborhood. To carry out tough decisions and create proper incentives, a strong and independent supervising body is needed.
Fairness to shareholders. A company belongs to all its shareholders, not to the largest shareholder or its president or the chairman of its board of directors. The owners have a right to expect that their money will be properly handled. This is especially important in transition economies where many privatizations created shareholders out of people in the lowest economic strata of the society. For example, in the Czech Republic about 85 percent of the adult population became shareholders as a result of voucher privatization. These new shareholders knew, and still know, very little about how to create a proper control mechanism to ensure that the company was run according to their interests; in addition, they were too dispersed to act effectively, and the governing authorities did not take their rights as shareholders seriously. This allowed the old managers to remain in power and create fiefdoms, destroying rather than creating value. One effect of this was to prevent the emergence of a real capital market and consequently the slow death of the Prague stock exchange.
A basic problem with corporate governance in formerly communist regimes is the manner in which state-owned companies became public. Their creation contrasts strongly to the manner public companies were created in Western countries. In formerly communist countries, companies sprang forth fully grown as a result of privatization. Their shareholders were “reluctant capitalists”—the butcher, the baker, and the bus driver—who became owners of a company without having the sophistication, background, or even the interest to understand their rights, and conversely their obligations, as shareholders. Further, the company did not receive any new capital as a result of its change from state to private ownership. This fact burdens the supervisory authority with guarding the treasury for a large number of relatively disinterested parties, none of which has a large enough ownership stake to make it worthwhile to assist or to even become involved in the process.
In Western countries, capital markets developed as companies sought money for growth. The need to raise capital forced the offering company to make concessions to potential shareholders, often informed institutional investors, who were parting with real cash in return for a stake in that company’s future profits. Such a new or growing company made the conscious decision to be governed by the constraints of supervisory bodies (a board of directors, the S.E.C., and so on) in order to raise money. This process developed over tens of years, as financial scandals due to inadequate corporate government caused investors to flee the capital markets, which led to the business community accepting greater controls. The U.S. S.E.C. was created in 1934 as a reaction to the collapse of the stock market and the Great Depression, which itself was partially due to a speculative bubble caused by the lack of real corporate governance and adequate regulatory controls. In contrast, companies in formerly communist economies made no deals, implied or contractual, with their shareholders. They were instantly burdened with a diverse group of thousands of anonymous individuals, many of whom had no concept of what share ownership meant. Those companies certainly did not want supervision or regulatory constraints and often actively tried to avoid such supervision. This is logical, since these companies only got the burden of regulation without the benefit of new money. If these countries follow a similar economic pathway as most of the developed world did until today, the business community itself will demand better standards as it comes to understand that they are the key to creating capital-market conditions that will allow them to raise the money necessary to grow. On the other hand, in those formerly communist countries in which interest rates are high and savings are low, so that capital appears inaccessible (on reasonable terms), many managers who control firms have decided that it is better for their own financial benefit simply to divert the assets of the firm or even to let the assets gradually deteriorate over time rather than reinvesting profit to help the company grow. Thus, the economic environment provides no incentive for them to advocate good corporate governance rules: there is a cost, but little prospective benefit. This is especially true if the management is elderly, and it appears as if it will be a considerable length of time—beyond their time horizon—before capital markets will work sufficiently well to make the prospect of raising capital appear reasonable.
In other parts of the emerging world, capital markets have only recently been founded or are revitalized relics of stock markets founded under colonial regimes. As many of these new emergent economies grow, capital markets naturally develop as a home for the capital of the new middle class.
One of the most important jobs of any financial journalist is to inform the public of fraudulent activities in the capital markets in order to protect the public from losing its money to con men. To this extent, any journalist should make himself aware of the basic principles of corporate governance so he can sound the alarm when these standards are laxly applied.
When examining corporate governance issues, reporters should consider the position of the officials responsible for regulating the capital markets. First, are they independent, or do they depend on the political patronage of a governing party that may itself depend on the patronage of individuals who have interests in issuing companies? Second, do they have a true understanding of the role of the capital markets, including corporate governance issues, full disclosure, and so on, or are they relatively young, inexperienced, and basically approaching the issues from a bureaucratic, formalistic perspective instead of trying to really solve the fundamental problems facing these markets? Third, do the officials of the exchanges themselves promote and fight for better corporate governance for listed companies? When the governing regulatory body—often the board of directors of the exchange itself, who are usually closer to the problem and understand the issues better in many small emerging markets—refuses to step in, who is capable of taking aggressive action to ensure that investors on their exchange benefit from their rights? Fourth, is the court system capable of understanding and implementing the intent of the law?
Too often, the regulatory authority charged with supervising these markets is staffed by people with no capital-market experience or, worse, cronies and subordinates of businesspeople who are the major players in these markets. This situation allows pyramid schemes, such as MMM in Russia or FNI in Romania, to operate with relative impunity. While not always true, it happens often enough for a good journalist to at least question whether a regulatory agency is doing its job.
Strong and effective corporate governance is especially important in emerging economies since it promotes efficient use of corporate and societal resources in the company and the broader economy. Where resources are scarce, emerging economies will have more difficulty “emerging” if their corporations continue inefficiently to allocate resources. Debt and equity capital are much more likely to be given to corporations able to utilize it efficiently in producing goods and services.
CONTROVERSIES IN CORPORATE GOVERNANCE
The advantages of good corporate governance are so compelling that one might wonder how there could be any controversies surrounding the issue? Some of the controversy arises from the fact that there are those who benefit from bad corporate governance, in particular those who are stealing from their firms in one way or another (for example, through overinflated compensation systems).
But there are also some difficult trade-offs:
One of the reasons that some have advocated making takeovers more difficult is that some firms were practicing “greenmail,” threatening a takeover unless payments were made.
One of the motivations for litigation reform in the United States was that class-action suits were filed every time a stock declined in price, with the firm (shareholders) having to pay the suing law firm, whether guilty or not, to settle out of court, due to the high cost of litigation.
There are other controversies: should firms focus exclusively on shareholder value (a presumption in the U.S.,) or pay some attention to other stakeholders (e.g. workers), as in Germany? The issue is not well settled in the economics literature.
In many developing countries, there are allegations that abuses stem not so much from majority shareholders abusing minority shareholders, but from government-controlled banks providing funds to their “cronies” in corporations and not acting to ensure that the corporations use the money efficiently. (This was the often unproven allegation in East Asia.)
It is important to realize, however, that the system of corporate governance in any economy is not just the board of directors but the entire set of checks and balances and includes the banks, the media, the accountants, and the regulators. A good system of corporate governance attempts to make sure not only that management incentives are aligned with the interests of the shareholders but also that those who are supposed to be providing the checks and balances have the appropriate set of incentives. The recent corporate, accounting, and banking scandals in the United States reflect a failure of corporate governance, in which management incentives were not well aligned with those of shareholders, and those who were supposed to provide the checks and balances had their incentives more aligned with the interests of management than those who they were suppose to be protecting. Good reporting of corporate governance requires monitoring all of the elements of the corporate governance system.
TIPS FOR REPORTERS
Are the directors’ interests sufficiently aligned with, and dedicated to, creating long-term value for the company?
1. Do any board members have conflicting interests that may prevent them from effectively representing all shareholders?
Does a member represent the government or a union?
Does a major shareholder control the board?
Does a company affiliated with the director do business with the company?
2. Does the director‘s compensation encourage him or her to act in shareholders’ interests?
Will he get paid even if he does not show up at board meetings?
Is the pay so low she has no incentive to do real work?
3. Do the directors have ownership positions that positively align their interests with shareholders’ interests?
Do they own any shares?
Do they participate only in the up side (through options) and not bear any downside risk?
4. Are any directors dependent on the cash compensation and perquisites from their directorship to an extent that precludes responsible action on the shareholders’ behalf?
If they sit as representatives of an investment fund, are the directors’ fees considered part of their salary or do they go to the fund?
Is the pay so high that its loss would create an economic hardship?
5. Are directors required to show up at shareholder meetings?
Failure to attend such meetings shows disregard for the office.
6. Does the corporation provide appropriate reporting?
Are required reports provided in a timely manner?
Timely filed with authorities?
Timely sent to shareholders? Note: When reports are often late, it usually is a red flag about other problems.
Are the reports accurate?
Do they disclose proposed changes in the structure or corporate policy?
Are there footnotes explaining general accounting points?
Are the accounts in international accounting standards or local standards that tend to hide information in general categories?
Are the accountants reputable, or do they have conflicts of interest (for example, consulting contracts?)
Do they provide information about the real issues?
Do they give investors sufficient information to make informed investment decisions? Note: Communist accounting was not designed to assist in analysis; it was for reporting how the managers met “projected” results.
7. Are the corporate statutes accessible to shareholders?
Are management salaries/incentives transparent and appropriate?
Does the pension reflect only actual years worked, and is it commensurate with salary?
Is severance pay reasonable? (No golden handshakes?)
Are there loans from the corporation to management (or directors)?
Does the incentive system really create incentives?
Are incentives based on relative performance? Or does the manager do well if the stock market does well?
What happens when the market price goes down? Does compensation increase in some other form?
How easy is it for shareholders to participate?
1. Are there obstacles to voting?
Legal barriers, such as the need to notarize a proxy or inability to mail in proxies. Note: Proxy voting is usually legal, but the time and expense of notarizing a proxy for a small shareholder, added to the need to have the proxy personally presented by another shareholder, effectively prevents a majority of shareholders from participating in a corporate democracy.
Artificial barriers such as holding meetings in obscure, distant places at inconvenient times. Note: This is a red flag.
How is the notice of meeting delivered? In a legal advertisement published in an official bulletin that no one reads or sent by mail and/or published in a popularly read newspaper?
2. Can shareholders initiate actions?
What percent ownership is required to call shareholders meeting? Note: The higher the percent (10 percent or more), the less the ability of shareholders to participate.
Is the shareholders list available to others or is it a “business secret”?
Note: In Slovenia, one can pay a small fee and legally obtain the list; in the Czech Republic, shareholder names are considered to be a “business secret.”
How easy is it to replace management? To engage in takeovers?
Would shareholders be considered to be illegally “working in concert” if two or more pooled their shares to meet the percentage threshold to call a meeting?
3. What is the company’s attitude toward shareholders?
That they are a bothersome necessity?
Is the board staggered, or are all directors elected at the same time?
Is the company open to active participation?
4. How easy is it for minority shareholders to obtain representation
Is there cumulative voting?
5. Are outside “independent” directors really independent, or are they friends of the management? What role do outside directors play? How accountable are they to shareholders?
Are there other checks on the behavior of the corporation?
1. For example, does it borrow from a bank that is unrelated to the corporation? Or is the lending bank a large shareholder?
2. What recourse do minority shareholders (or bondholders) have if they are cheated?
How easy is it to file class action suits?
How easy is it for aggrieved shareholders (or bondholders) to file charges with the regulatory authority?
Will the regulatory authority respond promptly, or is it a nightmarish bureaucracy?
3. Are analysts provided information on the firm really independent, or are they in some way beholden to the firm (as in the United States, where those for whom the analysts worked made money effectively by keeping in good stead with the firms they were supposed to be “analyzing”).
4. How effective are the regulations on insider trading? On management short-selling the firm? Other abusive practices
LINKS FOR MORE INFORMATION
1. The European Corporate Governance Institute is a nonprofit organization that specializes in developing corporate governance rules within the EU legal framework. http://www.ecgi.org.
3. The international Corporate Governance Network is a coordinating body that contains information on corporate governance from a wide variety of different countries. http://www.icgn.org.
4. Calpers is a large U.S. institution that has been active for greater corporate governance in its portfolio and around the world. Its Web page offers a wealth of information on its efforts and corporate governance in general. http://www.calpers-governance.org.
GLOSSARY
CAPITAL MARKET. An organized system where ownership rights in corporations (shares or stocks) are bought and sold. Usually called a “stock exchange,” the system may have brokers present on a “floor” for hours like some commodity exchanges in the U.S., or it might electronically match buy and sell orders during a one-to-four-hour period.
CORPORATE ACTIONS. Usually a motion made by a shareholder, which, if approved by the majority of voting shareholders at the meeting in which the motion is made, causes the corporation to do a specific thing. This could be a change of corporate policy, or the obligation to give employees a certain type of pension.
INDEPENDENT DIRECTOR. A person who does not depend financially or through familial or business connections on the chairman of the board of the company’s business.
NONEXECUTIVE DIRECTOR. A director who is not actively involved in running any aspect of the company.
NOTICE OF MEETING. To convoke a shareholder or director meeting, formal notice requirements must be met. These requirements are found in corporate laws and the organizing documents of the company. The purpose of the notice is to give shareholders information about what will happen at the meeting, where it will be held, and when.
PROXY. A vote, almost always in writing, which is cast by a substitute in place of the shareholder.
S.E.C. (Securities and Exchange Commission). A legal body set up by the government to supervise the capital market. It may be part of the Ministry of Finance, the central bank, or some other state fiscal institution or be an independent organization called by some other name, but its purpose is to make certain that the market functions smoothly and that all investors are treated equally and fairly.
STAGGERED BOARD. Electing each director in a different year so that the entire board cannot be changed at one annual meeting. This prevents a takeover, or at least delays it and makes it more costly.