Corporate Governance

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Backgrounder: Corporate Governance

By Howard I. Golden, Esq.


Good corporate governance is simply a system by which a corporation is managed properly and efficiently. This benefits its shareholders and society as a whole. The rest is commentary about how to achieve this goal.

Related Case Study:
Angola
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 CEO’s royal lifestyle, it is fair to question whose interests were being served by 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? Probably not much worse, but 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 won’t guarantee efficiency in production or distribution, nor will it 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 a logical and accountable manner.

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?

1. It enhances a company’s returns: Well governed 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.

2. Leads to Societal gains: In many ex-communist countries, a belief that a nation of shareholders would be more intensely interested in promoting a healthy economic climate led to mass privatization projects in which millions of citizens also became shareholders. However, lack of corporate governance has eroded these gains and ironically, has promoted greater national cynicism. Proper corporate governance precludes corruption. A corrupt management is interested in redistributing the assets of a company to friends 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, 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 post-communist economies with its legacy of central planning and redundant workers.

3. 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.

4. Fairness to Shareholders: The company belongs to its shareholders, not to the President 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% of the adult population become shareholders as a result of coupon 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.

What you should watch out for in examining Corporate Governance issues?

I. 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?

2. Does the director‘s compensation encourage them to act in shareholders’ interests?

Will they get paid even if they don‘t show up at meetings?

Is the pay so low they have no incentive to do real work?

3. Do the directors have ownership positions which positively align their interests with shareholders’ interests?

Can they obtain shares through options?

Do they own any shares?

4. Are directors dependent on the cash compensation and perquisites from their directorship to an extent which precludes responsible action on the shareholders’ behalf?

If they sit as a representative of an investment fund, is the director’s fee considered part of their salary or does it go to the fund?

Is the pay so high, its loss would create an economic hardship?

II. Does the corporation provide appropriate reporting?

1. Are reports provided timely?

Timely filed with authorities?

Timely sent to shareholders?

- Note: When reports are often late, it usually is a red flag about other problems.

2. Are the reports accurate?

Do they disclose proposed changes in structure of corporate policy?

Are there footnotes explaining general accounting points?

Are the accounts in international accounting standards (IAS) or local standards which tend to hide information in general categories?

3. Are the reports adequate?

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.

4. Can the corporate statutes be accessed by all shareholders?

III. 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% or more), the less 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”.

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?

A basic problem with corporate governance in formerly communist regimes is the manner in which public companies became public. Their creation contrasts strongly to the manner public companies were created in Western countries. In ex-communist countries, companies sprung forth full 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 the 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 (Board of Directors, S.E.C. etc.) 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 US S.E.C. was created in 1933 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 try 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 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.

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 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 their 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, be certain to 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 which may itself depend on the patronage of individuals which 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, etc., 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? Thirdly, do the officials of the exchanges themselves promote and fight for better corporate governance for listed companies? When the Governing Regulatory Body refuses to step in, often the board or directors of the exchange itself, who are usually closer to the problem and understand the issues better in many small emerging markets, are capable of taking aggressive action to ensure that investors on their exchange benefit from their rights.

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 the S.E.C. 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 to “emerge” if their corporations continue to inefficiently 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.



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Corporate Governance Glossary


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.

Non-executive director: A director who is not actively involved in running any aspect of the company.

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.

Proxy: A vote, almost always in writing, which is cast by a substitute in place of the shareholder.

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.

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.

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.

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.



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Links


You can obtain more information about Corporate Governance from the following websites:

http://www.corpgov.net
A private site dedicated to the improvement of corporate governance in the United States.

http://www.ecgi.org
The European Corporate Governance Institute is a non-profit organization, which specializes in developing corporate governance rules within the EU legal framework.

http://www.worldbank.org/html/fpd/privatesector/cg
The World Bank’s web page. A wide range of articles, reports, and surveys of corporate governance practices in countries all over the world.

http://www.icgn.com
The international Corporate Governance Network is a coordinating body which contains information on Corporate Governance from a wide variety of different countries.

http://www.calpers-governance.org
Calpers is a large US institution which has been active for greater corporate governance in its portfolio and around the world. Its web page offers a wealth of information on their efforts and corporate governance in general.