THE IMPORTANCE OF CORPORATE GOVERNANCE FOR A WELL FUNCTIONING FINANCIAL SYSTEM: REFORMING CORPORATE GOVERNANCE IN DEVELOPING COUNTRIES

Transcription

1 THE IMPORTANCE OF CORPORATE GOVERNANCE FOR A WELL FUNCTIONING FINANCIAL SYSTEM: REFORMING CORPORATE GOVERNANCE IN DEVELOPING COUNTRIES Dr. Ozden Deniz* INTRODUCTION I. The Importance of Corporate Governance II. Reasons Why Corporate Governance Has Received More Attention Lately III. Challenges Faced by Developing Countries, Emerging Markets, and Transition Economies CONCLUSION INTRODUCTION This article discusses the importance of sound corporate governance and a proper investor protection framework for a well-functioning financial system. This article further discusses the reasons why corporate governance has received more attention recently and addresses the challenges faced by developing countries in reforming their corporate governance systems. I. The Importance of Corporate Governance When outside investors finance firms, there is always a risk that their investment will not materialize because managers or controlling shareholders expropriate them. 1 Corporate governance provides the mechanisms that outside investors use to protect themselves against * S.J.D., American University Washington College of Law, 2010; LL.M., Case Western Reserve University School of Law I would like to thank Professor Perry Wallace and Kyle Innes for their review and comments. The author may be contacted at ozideniz2@gmail.com. 1. Rafael La Porta, Florencio Lopez-deSilanes, Andrei Shleifer & Robert Vishny, Investor Protection: Origins, Consequences, and Reform, Financial Sector Discussion Paper No. 1, available at Fs01_web1.pdf (accessed May 10, 2012). 219

2 220 Duquesne Business Law Journal Vol. 14:2 expropriation by insiders. 2 One definition of corporate governance is given by Andrei Shleifer and Robert Vishny, who state that [c]orporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment. 3 Without protection for outside investors, corporations will have difficulty in raising the necessary capital at a reasonable price, and their growth will be limited because outside investors will not be willing to turn their funds over to corporations. 4 In this situation, firms have to find other ways to finance themselves, such as internal financing or bank financing. 5 Certainly, these have their limits and disadvantages. 6 Investor protection is an important element of a well-functioning financial system. Scholars argue that effective financial systems provide well-developed markets that serve as a direct source of capital. 7 A myriad of empirical studies (including firm-level, industry-level, individual country, and broad cross-country comparisons) indicate that a country s long-term economic growth is dependent upon a robust financial system. 8 Good corporate governance practices help to 2. Id. 3. Andrei Shleifer & Robert W. Vishny, A Survey of Corporate Governance, 52 J. Fin. 737 (1997). 4. Bernard S. Black, The Legal and Institutional Preconditions for Strong Securities Markets, 48 UCLA L. Rev. 781, 839 (2001). Black stated: If securities markets are weak, companies and countries will develop other ways to finance businesses. Bank financing is an obvious alternative. But bank-dominated financing produces strong banks, both financially and politically. The banks will resist legal changes that might strengthen securities markets. Family-run conglomerates are a second alternative. Once built, they reduce the need for a strong securities market. Insiders of family conglomerates and other already public companies will then fight against rules and institutions that limit self-dealing. Id. at Id. 6. Joseph E. Stiglitz, Globalization, Technology, and Asian Development, in Corporate Governance and Globalization vol. 2, 144 (Thomas Clarke & Marie dela Rama eds., Sage Publications 2006). Stiglitz stated that [i]f firms in the economy have high leverage, then the economy as a whole may be threatened with a financial crisis, the cost of which may be borne by taxpayers and workers, not just the firms and its lenders. Id. 7. Asli Demirguc-Kunt & Vojislav Maksimovic, Law, Finance, and Firm Growth, 53 J. Fin. 2107, 2108 (1998). 8. Ross Levine, Financial Development and Economic Growth: Views and Agenda, 35 J. Econ. Literature 688, 726 (1997); Robert G. King & Ross Levine,

3 2012 The Importance of Corporate Governance 221 improve the confidence of investors, 9 reduce the cost of capital, support the good functioning of financial markets, and give rise to a more stable source of financing. For instance, La Porta, de-silanes, Shleifer, and Vishny evaluated twenty-seven of the wealthiest economies around the world in order to determine the effect of investor protection and concentrated ownership structures on corporate valuation. 10 Their results show that the stronger the shareholder protection is in an economy, the higher the valuation is of that economy s corporate assets. 11 They further found that countries with more effective protection of minority shareholders also had a higher valuation of firms. 12 Further, an empirical study by Gompers, Ishii, and Metrick found [that] firms with stronger shareholder rights had higher firm value, higher profits, higher sales growth, [and] lower capital expenditures. 13 Another study by Klapper and Love shows that good governance is positively correlated with market valuation and operating performance. 14 In a survey conducted by McKinsey and Company, 15 the authors found that an overwhelm- Finance and Growth: Schumpeter Might Be Right, 108 Q. J. Econ. 717, (1993). 9. Organization for Economic Co-operation and Development, Corporate Governance, Policy Framework for Investment A Review of Good Practices 127 (2006), available at _1_1_1_1,00.html. 10. Rafael La Porta, Florencio Lopez-deSilanes, Andrei Shleifer & Robert Vishny, Investor Protection and Corporate Valuation 4,5 (Nat l Bureau Econ. Research, Working Paper No. 7403, 1999) (available at Id. at Id. at Paul Gompers, Joy Ishii & Andrew Metrick, Corporate Governance and Equity Prices, 118 Q. J. Econ. 107, (2003). Gompers, Ishii, and Metrick stated: Shareholder rights vary across firms. Using the incidence of 24 governance rules, we construct a Governance Index to proxy for the level of shareholder rights at about 1500 large firms during the 1990s. An investment strategy that bought firms in the lowest decile of the index (strongest rights) and sold firms in the highest decile of the index (weakest rights) would have earned abnormal returns of 8.5 percent per year during the sample period. Id. 14. Leora F. Klapper & Inessa Love, Corporate Governance, Investor Protection, and Performance in Emerging Markets, 10 J. Corp. Fin. 703, (2004). 15. McKinsey & Company, Global Investor Opinion Survey: Key Findings, nce/pdf/globalinvestoropinionsurvey2002.pdf, (July 2002). ( The survey is based on responses from over 200 institutional investors, collectively responsible for some

4 222 Duquesne Business Law Journal Vol. 14:2 ing majority of investors are prepared to pay a premium for companies exhibiting high governance standards. 16 There are several channels through which corporate governance affects a country s growth and development. Corporate governance can play an important role in strengthening the bargaining power of developing countries in order to attract foreign investment or to achieve long-term development efforts in emerging markets, transitional economies and developing countries. 17 For instance, Demirguc-Kunt and Maksimovic found that firms in countries which have active stock markets and high ratings for compliance with legal norms are able to obtain external funds and growth faster. 18 Good corporate governance is not only important to attract long-term foreign capital but also important to broaden and deepen local capital markets by attracting local individual and institutional investors and encouraging them to provide long term resources important for development. 19 The importance of good corporate governance goes beyond the protection of individual investors (foreign or domestic); it enhances the benefits of investments to society. Therefore, corporate governance is also a public policy concern. 20 According to a broader definition of corporate governance given by Stjin Claessens, corporate governance includes the relationship between shareholders, creditors, and corporations; between financial markets, institutions, and corporations; and between employees and corporations. Corporate governance would also encompass the issue of corporate social responsibility, including such aspects as the dealings of the firms with respect to culture and USD 2 trillion of assets under management [ ]their organizations manage an estimated USD 9 trillion AuM. ). 16. Id. 17. Enrique Rueda-Sabater, Corporate Governance and the Bargaining Power of Developing Countries to Attract Foreign Investment, in Corporate Governance and Globalization vol. 2, (Thomas Clarke & Marie dela Rama eds., Sage Publications 2006). 18. Demirguc-Kunt & Maksimovic, supra n. 7, at Demirguc-Kunt and Maksimovic used a sample drawn from 30 developing and developed countries [and estimated] a predicted rate at which each firm can grow if it relies on retained earnings and short term credit only. Id. 19. Magdi R. Iskander & Nadereh Chamlou, Corporate Governance: A Framework for Implementation 2 (World Bank Group 2000). 20. OECD, Policy Framework, supra n. 9, at 125.

5 2012 The Importance of Corporate Governance 223 the environment. 21 In summary, corporate governance has implications beyond a company s shareholders, including a company s employees, customers, creditors, and community, 22 and even the nation s entire financial system. II. Reasons Why Corporate Governance Has Received More Attention Lately The first reason why corporate governance has received more attention recently is that historically, corporate governance systems undergo rapid development in response to two stimuli: (1) economic needs; and (2) financial collapses, company failures, and scandals. 23 Recently, corporate shocks starting with the East Asian financial crises (among others) and followed by corporate governance scandals in the United States 24 and Europe have increased the attention on corporate governance reforms. 25 Since these crises occurred, several measures 21. Stijin Claessens, Corporate Governance and Development, in Corporate Governance and Globalization vol. 2, p. 6, 8. (Thomas Clarke & Marie dela Rama eds., Sage Publications 2006). 22. Int l Fin. Corp., Corporate Governance: The Foundation for Corporate Citizenship and Sustainable Businesses 3-4 (2009), docs/issues_doc/corporate_governance/corporate_governance_ifc_ungc.pdf. The International Finance Corporation found that: Effective corporate governance requires due diligence in rallying the support and commitment of the broad network of business stakeholders, including shareowners, employees, customers and communities. If stakeholders are adversely affected by a company s actions, shareowner value will suffer. With the growth in pension and insurance funds and other institutional investors, shareowners are increasingly also company stakeholders, such as employees or customers. Therefore, these groups needs are increasingly interconnected.... [The] responsible management of environmental, social and governance issues creates a business ethos and environment that builds both a company s integrity within society and the trust of its shareowners. Id. 23. Klaus J. Hopt, Modern Company and Capital Market Problems, in After Enron: Improving Corporate Law and Modernizing Securities Regulation in Europe and the U.S., 445, 451 (John Armour & Joseph A. McCharey eds., Hart Publishing 2006). 24. Paul Davies, Enron and Corporate Governance Reform in the UK and the European Community, in After Enron: Improving Corporate Law and Modernizing Securities Regulation in Europe and the U.S., supra n. 23, at Alberto Chong & Florencio Lopez de Silanes, Overview: Corporate Governance in Latin America, in Investor Protection and Corporate Governance: Firm

6 224 Duquesne Business Law Journal Vol. 14:2 have been introduced to improve worldwide corporate governance systems. 26 The problem is that regulators, by only responding to scandals and crises, only create short-term fixes (criticized as populist legislation) in the system, instead of solving the root problems to prevent future issues. 27 Certainly, the type and method of reform has not been uniform across nations. Different corporate governance systems lead to differences in the causes of and solutions to the failures. 28 Therefore, reforms that are adopted by one country may not be appropriate in another. 29 The second reason 30 why corporate governance has received more attention recently is globalization. With the effects of globalization and trade barriers dissolving, 31 a country s corporations performance can be measured against global standards 32 with increasing ease, while that same country s locally protected product marketplace disappears. Level Evidence Across Latin America, 1-84 (Alberto Chong & Florencio Lopez de Silanes eds., Inter-American Development Bank 2007). 26. Sung Wook Joh, The Korean Economic Crisis and Corporate Governance System, in Governance, Regulation, and Privatization in the Asia-Pacific Region 129, (Takatoshi Ito & Anne O. Krueger eds., U. Chi. Press 2004). 27. Armour & McCahery, Introduction : after Enron : improving corporate law and modernizing securities regulation in Europe and the US, in After Enron: Improving Corporate Law and Modernizing Securities Regulation in Europe and the U.S., supra n. 23, at Id. 29. Coffee, Jr., A theory of corporate scandals: why the US and Europe differ, in After Enron: Improving Corporate Law and Modernizing Securities Regulation in Europe and the U.S. supra n. 23, at Claessens, supra n. 21, at 3, (Also, another reason can be added as due to technological progress, [the] opening up of financial markets, [the liberalization of trade], and other structural reforms- notably, price deregulation and the removal of restrictions on products and ownership- the allocation within and across countries of capital among competing purposes has become more complex, as has monitoring of the use of capital. ). 31. Jeffrey N. Gordon & Mark J. Roe, Introduction, in Convergence and Persistence in Corporate Governance, 1, (Jeffrey N. Gordon & Mark J. Roe eds., Cambridge U. Press 2004). 32. Thomas Clarke & Marie dele Rama, Introduction to Corporate Governance and Globalization, vol. 1, xviii (Thomas Clarke & Marie dela Rama, eds., Sage Publications 2006). Clarke and dele Rama stated that some of the key characteristics of globalization include the liberalization of international trade; expansion of foreign direct investment; emergence of massive cross-border financial flows, increased competition in global markets; [and] impact of new technology, especially in the sphere of information and communications. Id. at xviii.

7 2012 The Importance of Corporate Governance 225 According to Jeffrey N. Gordon and Mark J. Roe, globalization [a]ffects the corporate governance reform agenda in two ways. First, it heightens anxiety over whether particular corporate governance systems confer competitive economic advantage[.]... Globalization s second effect comes from capital markets pressure on corporate governance[.]... Firms expanding into global markets often prefer to use stock, rather than cash, as acquisition currency. If they want American investors to buy and hold that stock, they are pressed to adopt corporate governance measures that those investors feel comfortable with. 33 The consequent issue is whether the established corporate finance and governance systems are sufficient to deal with the looming challenges in a globalized economy. 34 It has been commonly argued in the literature that globalization increases the pressure on insider systems to converge or transform into an outsider system. 35 On the other hand, others argue that early differences in economic systems (whether they were caused by different circumstances or historical anomalies) may 33. Gordon & Roe, supra n. 31, at Eric Lehmann & Jurgen Weigand, Does the Governed Corporation Perform Better? Governance Structures and Corporate Performance in Germany, 4 European Fin. Rev. 157, 190 (2000). 35. Alan Dignam & Michael Galanis, The Globalization of Corporate Governance 144 (Ashgate Publishing Co. 2009). Insider models operate using ownership concentration, illiquid markets, and in some countries, a large usage of complex shareholder structures. Apart from the U.S. and the U.K., most countries, including in continental Europe, have tended to utilize an insider model. There are a myriad of different types of insider systems. These are typified by the different systems in Sweden and Italy, Germany, Japan, and Austria. For more information see Markus Berndt, Global Differences in Corporate Governance Systems - Theory and Implications for Reforms 5 (Harv. L. & Eco., Discussion Paper No. 303, 2000), available at The outsider model is based on dispersed ownership, a clear separation of ownership and control, and liquid financial markets. The U.S. and U.K. are the most widely known systems that utilize an outsider model. This system is also called a market oriented model or the Anglo-Saxon Model. See Lutgard Van den Berghe & Liesbeth De Riffer, International Standardization of Good Corporate Governance, Best Practices for the Board of Directors 41 (Kluwer Academic Publishers 1999).

8 226 Duquesne Business Law Journal Vol. 14:2 continue to persist, even when the current economies have become very similar. 36 The third reason why corporate governance has received attention lately is that international development institutions are providing an effective role in promoting corporate governance standards around the world. One major institution is the Organization for Economic Cooperation and Development (hereinafter referred to as the OECD ), which has formulated its Corporate Governance Principles. 37 The OECD (2004) principles are divided into the following categories: (1) ensuring the basis for an effective corporate governance framework, (2) the rights of shareholders and key ownership functions, (3) the equitable treatment of shareholders, (4) the role of stakeholders in corporate governance, (5) disclosure and transparency, and (6) the responsibilities of the board. 38 The preamble to the principles states that they are nonbinding and do not aim at detailed prescriptions for national legislation. 39 However, OECD principles have real effect because of their status as best practices by the OECD, the World Bank, the European Bank for Reconstruction and Development, the International Organization of Securities Commissions, and the IMF, among others. 40 The fourth reason why corporate governance has received so much attention recently is privatization. Prior to privatization, many sectors were controlled by the state. However, since these sectors are now in the hands of private corporations, states must now create the proper regulations. With the privatization of these sectors, firms have turned to public markets to seek capital and increased the number of listed companies. 41 Privatized firms without an effective system of corporate governance have repeatedly failed to perform at optimum levels and have frequently been tunneled by corporate insiders. It is commonly argued in the literature that the effectiveness of privatization is greater when corporate governance works well... [and] with- 36. Bebchuk & Roe, A theory of path dependence in corporate ownership and governance, in Convergence and Persistence in Corporate Governance, supra n. 31, at Dignam & Galanis, supra n. 35, at Organization for Economic Co-operation and Development, OECD Principles of Corporate Governance ( (2004). 39. Iskander & Chamlou, supra n. 19, at Dignam & Galanis, supra n. 35, at Claessens, supra n. 21, at 3, 9-10.

9 2012 The Importance of Corporate Governance 227 out enforceable investor protection, privatization is less likely to succeed. 42 III. Challenges Faced by Developing Countries, Emerging Markets, and Transition Economies In advanced market economies, corporate governance policies, regulations, institutions, and laws have developed over centuries. In emerging markets, however, this system is either missing or too underdeveloped to address the corporate governance challenges they have encountered in a globalized economy. 43 These challenges are [made] all the more daunting because of the complexity of the ownership structure in the corporate sector, interlocking relationships between government and the financial sector, weak legal and judiciary systems, absent or underdeveloped institutions, and scarce human resource capabilities. 44 Furthermore, the enforcement of laws and regulations by market regulators, courts, and market participants are insufficient. Without the capacity to enforce contracts and define property rights effectively, corporate governance reforms mean nothing. In order to attract investors and strengthen the future of their financial system, many developing countries need to introduce corporate governance reforms (in addition to other reforms, such as protection of property rights, a well-functioning and independent judiciary, and a strong accounting profession). With better investor protection, more companies will be able to sell shares for a fair price and be able to use their country s reputation to their advantage. 45 Further, countries that 42. Simon Johnson & Andrei Shleifer, Privatization and Corporate Governance, in Governance, Regulation, and Privatization in the Asia-Pacific Region, volume 12, page numbers: 13-14,25. (Takatoshi Ito & Anne O. Krueger eds., U. Chi. Press 2004). Johnson and Schleifer stated that in the Czech Republic, management of newly privatized firms conspired with the managers of investment funds to strip assets and siphon off cash flow. Id. They continued: Belated attempts by the Czech authorities to control this process have proved difficult. The lesson from post-communist countries is that effective investor protection must accompany privatization. Id. 43. Iskander & Chamlou, supra n. 19, at Id. 45. Black, supra n. 4, at 781, Black stated, many institutions that support a strong securities market are weak or absent. Honest companies (except a few large companies that develop their own reputations) rarely issue shares to the public, because weak investor protection prevents them from realizing a fair price for their shares. This decreases the aver-

10 228 Duquesne Business Law Journal Vol. 14:2 are emerging from the heavy state control of industry have another central objective beyond investor attraction: the political ability to foster public confidence in a market economy (and private control of large firms). 46 However, it should be noted that some nations have not yet arrived at the point where their economies demand many large corporations. 47 CONCLUSION A better corporate governance model might be too costly for developing countries, and that cost increases with the constraint of change by local interest groups or politicians who benefit from the existing system. 48 However, it has been shown that effective corporate governance and investor protection has a positive effect on the development and growth of companies, as well as the economy as a whole. age quality of the shares that are issued, which further depresses prices and discourages honest issuers from issuing shares. Id. at Bernard Black & Reinier Kraakman, A Self-Enforcing Model of Corporate Law, 109 Harv. L. Rev (1996). 47. Gordon & Roe, supra n. 31, at Gordon & Roe, supra n. 31, at 161.