Chapter 18 Corporate governance in developing and transition

Chapter 18: Corporate governance in developing and transition economies

Transition Economies: • A transition/transitional economy is an economy which is changing from a centrally planned economy to a free market • Transition economies undergo economic liberalization, where market forces set prices rather than a central planning organization. • In addition to this trade barriers are removed, there is a push to privatize stateowned businesses and resources, and a financial sector is created to facilitate macroeconomic stabilization and the movement of private capital.

Problems Faced By Developing And Transition Economies ü Lower economic growth ü Dominant public sector ü Lack of effectiveness of privatization ü Lack of awareness among shareholders ü Greater government influence and less autonomy to enterprises ü Largest shareholders in most of the companies are the privatization funds ü Internal owners dominate more than a company's external owners ü External owners do not have enough voting power ü Concentration of ownership in the hands of few individuals and family-owned corporations

ü Capital markets are underdeveloped and do not facilitate the inflow of new capital ü Market transactions are often based on abuse of internal information and are often manipulative ü Redrawing property rights and contract laws are slow in coming ü Lack of well regulated banking sector ü Exit mechanisms bankruptcy foreclosure norms are absent ü Sound securities market does not exist ü Competitive markets have not developed ü Corruption and mismanagement abound ü Non-uniform guidelines

THE Why And Wherefore Of Corporate Governance • In most of the emerging economies, the lack of corporate governance enables insiders to enrich themselves at the expense of shareholders, creditors and other stakeholders. • Globalization and financial market liberalization have exposed companies to fierce competition and to considerable capital fluctuations. • For countries in transition, such as those of Russia and other Eastern European societies that are forced to adopt capitalistic norms of governance in preference to the socialist system. • Corporate governance is directly related to financing and investments. Importance of corporate governance can be explained through its main influences: creation of key institutions for economic transformation , effective allocation of capital and development of financial markets and contribution to GDP.

Corporate Governance Models

Types of Corporate Governance Models Countries with developed economies apply two different systems of corporate governance • Group based system -Insider system • Market-based -outsider system

Insider System üThe insider system ownership and control is concentrated in the hands of a small number of individuals, families, managers, directors, holding companies, banks and other non- financial corporations. üMost countries specially those governed by civil law , have concentrated ownership structures.

Advantages of Insider System ü Insiders have power and incentive to monitor management closely thereby minimizing the potential for mismanagement and fraud ü Due to significant ownership and control rights, insiders tend to keep their investment in a firm for long periods of time ü As a result, insiders tend to support decisions that enhance a firm’s long-term performance as opposed to decisions designed to maximize short -term gains.

Disadvantages of Insider System ü Insider systems lead a company to certain corporate governance failures ü Dominant owners or vote holders can bully/collude with management to expropriate firm assets at the expense of minority shareholders ü Lack of legal rights for minority shareholders put company at stake ü Managers with large share/vote holdings may use their power to influence board decisions that may directly benefit them at the company’s expense For Example: managers persuade boards to authorize excessive managerial salaries and benefits or to approve the purchase of over-priced inputs from a firm in which the manager owns large shares

Large share or vote holders have other means of damaging companies up their sleeves ü Large/dominant shareholders encourage the board to approve the purchase of a rival firm for the sole purpose of extending the company’s market share and muting competition ü Dominant shareholders convince the board to reject takeover offers for fear of losing control over the firm even though a takeover might improve the company’s performance. Family-owned or insider-controlled companies , shielded from market pressures enhances such dangers because they are not listed on the stock market.

Short view Insiders who wield their power ü ü ü Irresponsibly waste resources Drain company productivity levels Foster investor reluctance and illiquid capital markets Shallow capital markets In turn, deprive companies of capital Prevent investors from diversifying their risks

Mitsubishi Internal Control system

Outsider System In contrast to insider systems, owners in outsider systems rely on independent board members to monitor managerial behavior and keep it in check. Advantages : ü Independent board members tend to disclose information openly and equitably, assess managerial performance objectively, and to protect shareholders’ rights vigorously ü As a result, outsider systems are considered more accountable and less corrupt and tend to foster liquid capital markets.

Disadvantages of Outsider system Dispersed ownership structure has following disadvantages: ü Dispersed owners tend to be interested in short-term profit maximization ü Hence, they tend to approve policies and strategies that will yield short-term gains, but that may not necessarily promote long-term company performance this can lead to conflicts between directors and owners ü Due to frequent ownership changes shareholders may divest in the hopes of reaping higher profits elsewhere both of which weaken company stability.

ü Small-scale investors have less financial incentive to vigilantly monitor boardroom decisions and to hold directors accountable. As a result, directors who support unsound decisions may remain on the board when it is in the company’s interest that they be removed

Mitsubishi Corporate Governance Framework

What can be done: Merge Insider and outsider system As both insider and outsider systems have inherent risks , Corporate governance systems are designed to minimize these risks and to promote political and economic development Internal controls are arrangements within a corporation that aim to minimize risk by defining the relationships between managers, shareholders, boards of directors, and stakeholders These measures to have a meaningful effect, they must be buttressed by a variety of extra-firm institutions tailored to a country’s environment (referred to as external controls)

Modern Corporations disciplined by Internal and External agencies Internal agencies are formed by shareholders when they buy shares, as they are too scattered, they can not manage company. Directors and management act as internal agencies to shareholder. External agencies include government and non government institutions who govern system of companies e. g. stock market, auditing standards, banks etc. Figure 1 shows: Interplay between internal forces (which define the relationship among the key players in the corporation) and External forces (notably policy, legal, regulatory, and market) that together govern the behavior and performance of the firm.

ü The internal architecture defines the relationships among key players in the corporation In its narrowest sense, corporate governance can be viewed as a set of arrangements internal to the corporation that define the relationships between managers and shareholders ü External rules provide a level playing field and keep players in line These internal mechanisms for corporate governance are strengthened by external laws, rules, and institutions that provide a level, competitive play in field and discipline the behavior of insiders, whether managers or share- holders

Corporate Governance Challenges in Developing, Emerging and Transition Economies

Challenges ü Proper ruled based corporate system ü Dismantling pyramid ownership structure that allows insiders to control ü Establishing cross shareholdings between banks and corporations ü Establishing distinguished property rights system between owners and companies ü De-politicizing decision-making process and protect corporate from government if it is dominating ü Protecting and enforcing minority shareholders rights

ü Preventing asset stripping after privatization ü Finding active owners and skilled managers ü Educating investors about their rights and duties ü Encouraging corporate governance practices through benchmarking ü Establishing regulating bodies to facilitate good corporate governance and promoting it in family-owned businesses

Corporate Governance is Not only a Private Sector Affair • In many transition economies public sector companies contribute more to nation’s GNP, employment, income and capital. • They also often shape policies and rules. • If the public company has to privatized it must be corporatized before that. • Some public companies can not be privatize because; ü These are vital to the economy, so, it is benefitted for these to be corporatized ü And it will reduce political interference, nepotism, corruption, etc.

Successful Strategies – One Size Doesn’t Fit All • Most of the corporate governance practices are of western countries and there is great difference between the western/developed and developing/transition countries. • Even among the developing economies their culture, work ethics, employer-employee relationship, etc are different. • So, it is difficult to implement that practices as it is. • That’s why one code or practices doesn’t apply to all the countries’ corporations.

Current CG Settings in Transition Economies • The corporate sector has: ü No legal and institutional structures ü Dominant companies which discourages entrepreneurship ü Unpredictable environment and so, the managers depart their objectives. • The role of state is ambiguous , on one hand it has great political influence and on the other hand it does not have any legislation regarding CG. • From governance perspective state-owned firms are controlled by bureaucrats with no formal rules and ownership.

• There is lack of institutions associated with successful economies, as, institutions are the “rule of society”. • In this setup the institutions have three components; ØFormal ØInformal ØEnforcement mechanism • Institutions theory states that: “When formal institutions are weak then informal constraints play a great role in shaping the behavior”.

THE CORPORATION IN A GLOBAL SOCIETY

Introduction • World trade organization (WTO), IMF and WB playing an active role • Globalization is moving forward relentlessly , with freer movement of people, capital , jobs , trade and information

Factors that have played a key role in promoting international trade • Falling trade barriers • Political reforms have opened-up frontiers • More developing nations joining the bandwagon of global business • Emergence of new technologies and businesses spanning continents • Faster transport and communications • Special features of modern production

Doing business in a diverse world • Ethnocentric perspective • Geocentric perspective

Global codes of corporate conduct The United Nations Global Compact • A values-based platform designed to promote institutional learning. • Corporations are invited to voluntarily endorse core principles covering labor, human rights, and environmental standards. The OECD Guidelines for Multinational Enterprises • Code of conduct for corporations developed by member nations of the OECD. • The guidelines are voluntary, address employment relations, information disclosure, environmental stewardship, consumer interests, and the management of technology.

Global codes of corporate conduct The Global Sullivan Principles • The objectives are to support economic, social, and political justice by companies where they do business. • Calls on companies to support human rights and to encourage equal opportunity at all levels of employment. The Caux Principles • Emphasizes working for the common good and respect for human rights.

Role of Multinational Corporations: • Businesses in the present global society are carried on by multinational or transnational corporations, most of which are based in developed countries. • The home market was the company’s primary focus. Overseas operations were usually carried out by wholly owned subsidiaries controlled by home country nationals.

• Besides subsidiaries, a multinational corporation may have joint ventures with individual companies, either in its home country or foreign countries. • For example; • Gulf Nishat Apparel ltd. • Star Group of Company.

Corporate Governance a Pre requisite for Globalization • In order to be globally competitive in the new millennium, then good governance is an utmost necessity • The first requirement of corporate governance is professional management. • Few companies voluntary adopt “ corporate governance ” because in their perception these will add to their costs without bringing much tangible benefits and hence the government must regulate their adoption through institutions.

• Companies and public sector enterprises act in concert in this respect. Even if the government is not interested, private companies must adopt global corporate governance standards, because “globalization demands good corporate governance” • Another area of concern in the Pakistan is the lack of independent auditors. Due to this distrust in Pakistan, most of the multinational companies have insisted that the parent company’s auditor should also audit the subsidiary companies in Pakistan.

Conclusion • Global business opportunities have grown tremendously in recent times and important role is played by international organizations such as GATT, WTO, IMF, World Bank. • Corporations that are involved in the production distribution of goods and services for a worldwide market should not only live by and exhibit ethical principles and good corporate governance practices, but also should be seen to practicing them.