Corporate Governance: An Introduction

Few topics are more central to the international business and development agendas than corporate governance.
A series of events over the last two decades have placed corporate governance issues as a top concern for both the international business community and the international financial institutions. Spectacular business failures such as the infamous Bank of Credit and Commerce International scandal, the United States' savings and loan crisis, and the gap between executive compensation and corporate performance drove the demand for change in developed countries.
More recently, several high profile scandals in Russia and the Asian crisis have brought corporate governance issues to the fore in the developing countries and transitional economies.

These scandals illustrate that the lack of corporate governance enables insiders, whether they be company managers, company directors or public officials, to ransack companies and/or public coffers at the expense of shareholders, creditors and other stakeholders (employees, suppliers, the general public, and so forth). Yet, in today's globalized economy, companies and countries with weak corporate governance systems are likely to suffer serious consequences above and beyond financial scandals. What is increasingly clear is that how corporations are governedcommonly referred to as corporate governancelargely determines the fate of individual companies and entire economies in the age of globalization.

Globalization and financial market liberalization have opened up new, international markets with the possibility of reaping stunning profits. Yet it has also exposed companies to fierce competition and to considerable capital fluctuations. National business communities and company managers are learning that in order to expand and be internationally competitive they need levels of capital that exceed traditional funding sources.

Failure to attract adequate levels of capital threatens the very existence of individual firms and can have dire consequences for entire economies. Lack of sufficient capital, for example, erodes firms' competitiveness eliminating jobs and hard-won social and economic gains thereby exacerbating poverty. Firms unable to attract capital run the risk of becoming suppliers and vendors to the global multinationals or, worse yet, being left out of international markets entirely, while entire economies run the risk of not being able to take advantage of globalization.

Yet, recent financial crises provoked by corruption and mismanagement have made attracting sufficient levels of capital particularly challenging these days. These crises cost investors billions of dollars and sabotaged companies' financial viability. They also contributed to increased shareholder activism and competition for investment. Investors, especially institutional investors, are now making it clear that they are not willing to foot the bill for corruption and mismanagement. Before committing any funds, investors increasingly require evidence that companies are run according to sound business practices that minimize the possibilities for corruption and mismanagement. Moreover, investors and institutions in Bogot or Boston, Beijing or Berlin, want to be able to analyze and compare potential investments by the same standards of transparency, clarity and accuracy in financial statements before investing. In fact, being a credible business that can withstand the scrutiny of international investors is more than just a matter of global marketing: it has become essential for local companies and for entire economies to grow and prosper.

The bottom line is that investors seek out companies that have sound corporate governance structures. Corporate governance is the body of "rules of the game" by which companies are managed internally and supervised by boards of directors, in order to protect the interests and financial stake of shareholders who may be located thousands of miles away and far removed from the management of the firm. Just as good government requires transparency so that the people can effectively judge whether their interests are being served, corporations must also act in a democratic and transparent manner so that their owners can make educated decisions about their investments. This is what corporate governance is all about.

Corporate governance helps companies and economies attract investment and strengthens the foundation for long-term economic performance and competitiveness in several ways. First, by demanding transparency in corporate transactions, in accounting and auditing procedures, in purchasing, and in all of the myriad individual business transactions corporate governance attacks the supply side of the corruption relationship. Corruption drains companies' resources and erodes competitiveness driving away investors. Second, corporate governance procedures improve the management of the firm by helping firm managers and boards to develop a sound company strategy, and by ensuring that mergers and acquisitions are undertaken for sound business reasons, and that compensation systems reflect performance. This helps companies to attract investment on favorable terms and enhances firm performance.

Third, by adopting standards for transparency in dealing with investors and creditors, a strong system of corporate governance helps to prevent systemic banking crises even in countries where most firms are not actively traded on stock markets. Taking the next step and adopting bankruptcy procedures also helps to ensure that there are methods for dealing with business failures that are fair to all stakeholders, including workers as well as owners and creditors. Without adequate bankruptcy procedures, especially enforcement systems, there is little to prevent insiders from stripping the remaining value out of an insolvent firm to their own benefit. This happened on a wide scale during many of the privatization efforts in transitional and emerging markets with disastrous results.

Fourth, recent research has shown that countries with stronger corporate governance protections for minority shareholders also have much larger and more liquid capital markets. Comparisons of countries that base their laws on different legal traditions show that those with weak systems tend to result in most companies being controlled by dominant investors rather than a widely dispersed ownership structure. Hence, for countries that are trying to attract small investors--whether domestic or foreign--corporate governance matters a great deal in getting the hard currency out of potential investors' mattresses and floorboards who, collectively, may be a significant source of large sums of long-term investment.

What's more, instituting corporate governance practices greatly enhances the public's faith in the integrity of the privatization process, and helps ensure that the country realizes the best return on its investments. This will, in turn, stimulate employment and economic growth.

Although instituting corporate governance is clearly beneficial for firms and countries, the rapid pace of globalization has made the need urgent. Doing so requires that firms and national governments make some fundamental changes. Companies must change the way they operate, while national governments must establish and maintain the appropriate institutional framework. Some of the key changes involve adopting international standards of transparency, clarity, and accuracy in financial statements so that investors and creditors can easily compare potential investments.

Efforts to improve corporate governance by establishing international standards began roughly 15 years ago and has recently gained enormous momentum. The movement was spearheaded over a decade ago by the World Trade Organization and by its member countries to develop standards that will help companies grow across borders by persuading investors and creditors that they can confidently invest in their country or region. To this end, international accounting bodies and national associations of accountants have worked to develop an international set of accounting standards.

In addition, the World Bank, the Organization of Economic Cooperation and Development (OECD), most of the regional development banks, and the various national development agencies have either launched or expanded corporate governance programs in the last several years. Similarly, business-related organizations like the Center for International Private Enterprise, an affiliate of the US Chamber of Commerce, have placed corporate governance at the top of their list of concerns. Think tanks and business associations throughout the developing world and in the transitional economies are also focusing resources on corporate governance.

Corporate governance is also receiving substantial attention in developed countries. In the United States, there is substantial unease over the "independence" of independent audits as witnessed in the recent publicity surrounding violations of rules prohibiting auditors to invest in companies that they audit. The Enron bankruptcy is a case in point. More generally, advanced industrial societies realize that in order to attract investment, and compete internationally, they need to reform and strengthen corporate governance. Hence, in recent years, the Cadbury Commission in the United Kingdom, the Vienot Commission in France, and the OECD have all issued new corporate governance guidelines.

The OECD guidelines make a good starting point in developing a corporate governance code. The OECD's core principles are:

The Rights of Shareholders

These include the right to secure ownership registration, to transfer shares, to obtain corporate information, to vote in shareholder meetings and for members of the board, and to share in corporate profits.

The Equitable Treatment of Shareholders

All shareholders, including minority and foreign shareholders, should be treated equitably and have a means of redress. Insider trading should be prohibited and Board members and managers must disclose material interests in corporate transactions.

The Role of Stakeholders in Corporate Governance

A governance framework should recognize that corporate interests are served by the involvement of stakeholders through the protection of their rights and disclosure mechanisms.

Disclosure and Transparency

Corporations should make accurate, independently audited, and timely disclosures in all material matters regarding the corporation including the financial situation, performance, ownership and governance.

The Responsibilities of the Board

The corporate governance framework should ensure that the board of directors effectively monitors corporate managers and executives and remains accountable to the shareholders.

Although these guidelines have helped companies and economies attract investment and improve performance, financial scandals and capital flight continue to buffet virtually all regions of the world. Existing guidelines should, therefore, be considered as useful starting points to institute corporate governance.

In order for corporate governance measures to have a meaningful impact in any economy, a set of core democratic, market institutions, including a legal system to enforce contracts and property rights. needs to be up and running. Yet, in most developing economies, even the most basic democratic, market institutions may be weak. Given these circumstances, instituting corporate governance in developing and emerging markets requires more than merely exporting well-established models of corporate governance that function within the developed economies. Special attention needs to be given to establishing the necessary political and economic institutions that are tailored to a country's specific needs and that give corporate governance some teeth. A good beginning is to develop a corporate governance code that can be enforced through capital markets and through credible independent auditors. Simultaneously, legal and regulatory systems can be simplified and strengthened to maximize enforcement.

Finally, pressure on the emerging markets and developing countries to adopt corporate governance standards is increasing from both the international financial institutions and market participants. The choices many business communities face is to either develop their own set of corporate governance codes and standards, based on the general OECD guidelines, or face the very real possibility that their own governments will adopt these codes without private sector input. Fortunately, there is still time for the private sector to act and in many countries they are doing so. In fact, members of the private sector in a whole host of countries such as Romania, Colombia, Egypt, Kenya, and Indonesia are currently developing innovative ways to institute corporate governance.