Corporate Governance: Transparency
between Government and Business
By John D. Sullivan
Feb 12 - 18, 2001
There are few topics that are more central to the international
business and development agendas than that of 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.
In developing countries, the roots of what is now recognized as
corporate governance type issues can be found in the drive for privatization that grew in
the late 1970s and throughout the 1980s. Clearly, creating a sound corporate structure
should have been central to the success of privatization both from the point of view of
the government seeking to sell the firm and from the point of view of the potential
investors. In fact, some of the most telling failures in the early privatization
experiences can be traced back to a lack of sound regulatory structures that allowed
unwise business practices.
The Asian financial crisis has now driven the process even further. One
of the lessons learned out of the crisis is that weak or ineffective corporate governance
procedures can create huge potential liabilities for both individual firms and,
collectively, for society. In this sense, corporate governance failures can potentially be
as devastating as any other large economic shock. As M.R. Chatu Mongol Sonakul, the
Governor of the Bank of Thailand has observed:
There is no doubt in my mind that for the Asian economic crisis to be
solved in a sustainable and longlasting fashion, the government and the corporate sector
have to work together better. By this, I don't mean that not working together was the
cause of the recent economic crisis. Probably it was the other way around, working far too
well together and in collusion with each other.... The Asian financial crisis showed that
even strong economies lacking transparent control, responsible corporate boards, and
shareholder rights could collapse quite quickly as investor's confidence erodes.
As can be seen from Dr. Sonakul's observations, corporate governance is
at the very heart of the development of both a market economy and a democratic society.
That view may be a bit of a surprise to those who think mainly of corporate governance as
the issues of shareholder protection, management control, and the famous principal-agent
problems of such concern to management and economic theorists. The focus of this paper is
the concept of corporate governance as a key feature of the market system of competitive
enterprise. In addition, the paper shows why corporate governance should also be of direct
concern to those focusing on democratic development especially rule of law issues.
Corporate governance ultimately depends upon public-private sector cooperation to achieve
both goalsthe creation of a competitive market system and the development of
law-based democratic society. These concerns are not limited to developing countries, even
in the advanced industrial societies, there is a global trend toward strengthening
Corporate governance is typically perceived by academic literature as
dealing with "problems that result from the separation of ownership and
control." From this perspective, corporate governance would focus on how the internal
structure and rules of the board of directors, the issue of audit committees, reporting to
shareholders, and control of management. In fact, a recent academic survey began with the
"Corporate governance deals with the ways in which suppliers of
finance to corporations assure themselves of getting a return on their investment. How do
the supplies of finance get managers to return some of the profits to them? How do they
make sure that managers do not steal the capital they supply or invest it in bad projects?
How do supplies of finance control managers?"
From this point of view, corporate governance tends to focus on a
1. Shareholders elect directors who represent them.
2. Directors vote on key matters and adopt the majority decision.
3. Decisions are made in a transparent manner so that shareholders and
others can hold directors accountable.
4. The company adopts accounting standards to generate the information
necessary for directors, investors and other stakeholders to make decisions.
5. The company's policies and practices adhere to applicable national,
state and local laws.
Focusing on these types of internal control processes is quite natural
when the subject is corporate governance within the advanced market economies. Point
number five assumes that an external legal system is in place.
As noted earlier, when the subject of corporate governance is discussed
in the context of transitional or developing countries, however, it tends to involve
looking a much wider range of issues. The recent Asian economic crisis, the continuing
turmoil in Russia, and the recent experience of the Czech economy have combined to push
the issue of corporate governance from the sidelines to center stage. In Asia, what began
as a financial crisis is now viewed to be a crisis of corporate transparency involving
relationships between government and business, between holders of debt and equity, and the
legal remedies for bankruptcy and cronyism. Further, as seen in the daily papers, the lack
of adequate institutions in Russia have resulted in several highly publicized cases
involving allegations of asset stripping, stock register manipulation, and fraud. The
Czech Republic privatization programme has demonstrated the weakness of the voucher method
in the absence of sound corporate governance mechanisms since it resulted in a lack of
corporate restructuring and a consequent decline in competitiveness.
What these examples have in common is that they all involve the basic
rules of the economy and the relationship between these rules and the way companies are
governed. The issues involved include some very familiar topics:
Corporate transparency or full disclosure of financial
Conflicts of interest involving boards of directors and managers
Procedures for bankruptcy
Corruption and theft
Each of these issues pose grave challenges for both the functioning of
a market economy and a democratic society. Solving corporate governance problems such as
those listed above involves going beyond a narrow view of how owners and managers of
capital interrelate. In this sense, a broader definition should be adopted:
Corporate governance results from a set of institutions (laws,
regulations, contracts, and norms) that create self-governing firms as the central element
of a competitive market economy.
The key point in this definition is that the public and private sectors
have to work together to develop a set of rules that are binding on all and which
establish the ways in which companies have to govern themselves.
Building a market economy requires a complete overhaul of legal norms
to allow for innovation and initiative rather than predefining areas of allowable
activity. That is why corporate governance should be thought of as a mechanism for
creating self-governing organizations. However, it is equally important to emphasize that
a market economy is not simply the absence of governmental intervention.
Government is absolutely essential in setting up the framework of a
market economy. Without rules and structures of a binding nature, anarchy results. Under
such conditions business becomes nothing but "casino capitalism" where
investments are simply bets: bets that people will keep their word, bets that the firms
are telling the truth, bets that employees will be paid, and bets that debts will be
honored. What corporate governance is all about in larger terms is how a structure can be
set up that allows for a considerable amount of freedom within the rule of law.
Ultimately, these arrangements provide the basis for the establishment of trust, one of
the most important ingredients in business.
A useful first step in creating or reforming the corporate governance
system is to look at the principles laid out by the OECD and adopted by the governments
which are members of the OCED itself. In summary, they include the following elements.
I. The Rights of Shareholders
These include a set of rights including secure ownership of their
shares, the right to full disclosure of information, voting rights, participation in
decisions on sale or modification of corporate assets including mergers and new share
issues. The guidelines go on to specify a host of other issues connected to the basic
concern of protecting the value of the corporation.
II. The Equitable Treatment of Shareholders
Here the OECD is concerned with protecting minority shareholders rights
by setting up systems that keep insiders, including managers and directors, from taking
advantage of their roles. Insider trading, for example, is explicitly prohibited and
directors should disclose any material interests regarding transactions.
III. The Role of Stakeholders in Corporate Governance
The OECD recognizes that there are other stakeholders in companies in
addition to shareholders. Workers for example are important stakeholders in the way in
which companies perform and make decisions. The OECD guidelines lay out several general
provisions for stakeholder interests.
IV. Disclosure and Transparency
The OECD also lays out a number of provisions for the disclosure and
communication key facts about the company ranging from financial details to governance
structures including the board of directors and their remuneration. The guidelines also
specify that annual audits should be performed by independent auditors in accordance with
high quality standards.
V. The Responsibilities of the Board
The guidelines lay in some detail the functions of the board in
protecting the company, its shareholders, and its stakeholders. These include concerns
about corporate strategy, risk, executive compensation and performance, as well as
accounting and reporting systems.
It should be noted that the OECD guidelines are somewhat general and
that both the Anglo-American system and the Continental European (or German) systems would
be quite consistent with them. However, there is growing pressure to put more enforcement
mechanisms into those guidelines. The challenge will be to do this in a way consistent
with market-oriented procedures by creating self-enforcing procedures that do not impose
large new costs on firms. The following are some ways to introduce more explicit
Countries should be required to establish independent share registries.
All too often, newly privatized or partially privatized firms dilute stock or simply fail
to register shares purchased through foreign direct investments.
Standards for transparency and reporting of the sales of underlying
assets need to be spelled out along with enforcement mechanisms and procedures by which
investors can seek to recover damages.
The discussion of stakeholder participation in the OECD guidelines
needs to be balanced by discussion of conflict of interest and insider trading issues.
Standards or guidelines are needed in both areas.
Internationally accepted accounting standards should be explicitly
recommended. (Also see above regarding developing such standards.)
Internal company audit functions and the inclusion of outside directors
on audit committees needs to be made explicit.
A good example of model corporate governance procedures that builds on
many of these points is the General Motors guidelines which are frequently used as a code
of corporate governance by others. Interestingly, the pension funds have also become a
major source of improved corporate governance along the same lines. Specifically, the
California Public Employees' Retirement System (CalPers) has developed a very active
programme to promote good corporate governance and they, along with other pension funds,
are using their investment clout to force change. As noted earlier, CalPers' has taken
this approach in order to increase the returns on their investments by ensuring that the
firms are well run and that corporate strategies are well thought out. As more and more
pension fund investments flow into developing countries, these funds can be expected to
make similar demands in these countries.
The reason why it is important to take note of this trend is that,
traditionally, many in developing countries have cited the European experience as proof
that corporate governance issues only apply to countries that follow an Anglo-American
tradition, such as India for instance. Recent history would seem to show that, without
sound corporate governance procedures, including the larger institutional features
mentioned earlier, economic crises in developing countries are likely to become more
frequent. Many developing countries face rather stark choices: either create the type of
governance procedures needed to participate in and take advantage of globalization, run
the risk of severe (and frequent) economic crises, or seek to build defensive walls around
the economy. It should be noted that the last option usually entails the risk of keeping
out investors, new technologies, and lowers growth rates dramatically.
Another consideration in the debate over corporate governance systems,
is the risk that individual firms face. Unless a company is able to build the kinds of
governance mechanisms that attract capital and technology they run the risk of simply
becoming suppliers and vendors to the global multinationals.
Benefits to society
A strong system of corporate governance can be a major benefit to
society. Even in countries where most firms are not actively traded on stock markets,
adopting standards for transparency in dealing with investors and creditors is a major
benefit to all in that it helps to prevent systemic banking crises. 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.
Recent research has also 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 investorswhether domestic or
foreign-corporate governance matterss a great deal in getting the hard currency out of
potential investors' mattresses and floorboards.
Many economists and management experts make the point that competition
in product markets and competition for capital act as constraints on corporate behaviour,
in effect forcing good corporate governance. However, whether or not this is really the
case in developed market economies, competition is surely a much smaller factor in
transitional and developing countries. In many developing countries, competition in
product or goods markets is quite limited, especially where significant regulatory
barriers exist. These realities further underscore the importance of adopting the best
possible corporate governance systems in countries where the market system is
Corporate governance is also directly related to another topic that has
emerged to a position of great prominence world wide combating corruption. In many
societies this is not a subject that is easy to deal with, both because of political
sensitivities as well as potential legal action. Yet corruption has to be dealt with in
order to secure a position in the global economy and to secure the benefits of economic
growth. The recent signing of the OECD anti-bribery convention is the beginning, not the
end, of a concerted global anti-corruption campaign. Efforts to improve corporate
governance, especially in the provision of transparency in corporate transactions, in
accounting and auditing procedures, in purchasing, and in all of the myriad individual
business transactions is a large scale effort. Nevertheless, strengthening the corporate
governance standards along lines suggested above would be one place to start.
The point has already been made that improving corporate governance
procedures can also improve the management of the firm, especially in areas such as
setting company strategy, ensuring that mergers and acquisitions are undertaken for sound
business reasons, and that compensation systems reflect performance. However, it is also
important to note that good corporate governance systems also have to include improvements
in management systems. In many developing countries, there has been a tradition of very
centralized management usually involving the owners of the firms directly. Throughout
Latin America, for example, the family business groups have tended to dominate the
business landscape. This is now changing rapidly as a result of financial globalization,
adherence to the World Trade Organization's liberalization rules, and the increasing
integration of Latin America's regional markets. As a result, Latin America's firms are
increasingly adopting modern management techniques, financial accounting systems, and
business strategies. All of this requires delegation of authority, paying increased
attention to developing highly trained staff and use of management information systems in
lieu of the older centralized decision making structures. It is highly probable that these
trends will force similar changes throughout the Middle East.
One way to sum up the concept of corporate governance is to look at it
from the perspective of the corporate director. Increasingly directors are being held
liable for their actions or inaction, at least in the developed countries. What then does
a director need to be able to function and have a balanced view of the firm? According to
one seasoned corporate director, the following is the minimum essential information:
Operating systems, balance sheets, and cash flow statements that
compare current period and year-to-date performance to target performance and previous
Management comments about current performance that focus on explaining
the deviations from the target performance and revise performance targets for the
remainder of the year.
Information on the company's market share.
Minutes of management committee meetings.
Financial analysts' reports for the company and its major
Employee attitude surveys.
Customer preference surveys.
Key media articles on the company, its major competitors, and industry
The list not only sums up the key responsibilities of a board, it also
reinforces the argument that corporate governance reflects the underlying systems of law
and regulation. Most importantly, without sound and accurate accounting systems, how could
the director function? As seen in the OECD recently, maintaining these accounting
standards that all firms have to meet is a considerable challenge. The list also points up
that good corporate governance will bring with it modern management systems. For example,
reviewing the minutes of the management committee meetings implies that a functioning
management committee system is in place with delegation of authority and accountability.
Creating sound system of corporate governance is a high priority for
both the public and the private sectors. However, there may be a temptation for the
private sector to just say, "well, we'll let the government work this out and then
we'll follow the results." In some cases, there may also be a
temptationespecially for the countries with protected markets and a large state
sector to put off corporate governance reform until after the privatization process
and other types of reforms are fully completed. Experience would indicate that this would
be a very unfortunate decision. Both the private and public sectors have much to gain by
setting up clear and simple rules for all to follow. A sound corporate governance
structure will be a great inducement to international trade and investment. In addition,
sound corporate governance systems are a major advantage to those countries seeking to
fight corruption. In this sense, good corporate governance is a way for the private sector
to protect itself from outside demands and for the public sector to prevent undue
influence in governmental decision making.
However, it is vital to avoid simply copying other countries systems or
asking foreign experts to write model laws. Although the foreign donor community often
pushes this type of approach, it should be resisted. Throughout the Middle East a network
of extremely capable policy research institutes, think tanks, have been formed and others
will surely follow. Many of these centers have been formed with the backing of the
business leadership and are in a position to devise, adapt, and advocate for systems that
will be appropriate to the status of each country. In the process, not only will the
resulting policy reforms advance better systems of corporate governance, they will point
to the need for other reforms. The need for adoption of modern management systems
including areas such as knowledge management and strategic planning will become more
apparent in the process. As more and more countries in the region enter the WTO process
and further their participation in the global market, the demand for corporate governance
will surely grow. Its up to the policy research centers, the national business
associations, and others in civil society to work with governments to craft the best