The modern business corporation is one of the most powerful means for generating wealth and prosperity. But corporations can only be successful at fulfilling that role if they are well governed. Corporate governance infuses the democratic values of fairness, accountability, responsibility, and transparency into corporations. It maintains the integrity of business transactions by structuring the relations among investors, boards of director, managers and other stakeholders to maximize long-term value. It also is a powerful antidote to corruption that clarifies private rights and public interests, preventing abuses of both.
As developing countries begin to compete in global markets, they must put in place rules and principles that stabilize markets and support entrepreneurial innovation. Corporate governance has become a major issue in development, since it relates directly to the establishment of long-term productivity and sustained growth. The future of emerging markets depends on improving governance within and around corporations.
Governance issues rose in importance in the 1990s following the deregulation of markets and the liberalization of international trade and investment. In transition countries, too many examples of poorly managed, corrupt privatization processes harmed investors and undercut the value of privatized companies. Additionally, the world witnessed a number of failures in governance of individual companies and entire financial markets. These failures resulted in pressure for reforms.
A well-run corporation generates value for investors and lenders as well as for its employees, customers, and society as a whole. Good corporate governance contributes to a healthy business climate that encourages domestic and foreign investment, in turn creating jobs and increasing the welfare of a country’s citizens. Better private governance also accelerates the move toward more democratic and transparent public governance.
An effective corporate governance system relies on a combination of internal and external discipline to maximize corporate performance, minimize risk, and protect the interests of investors and stakeholders. The Organization for Economic Co-Operation and Development (OECD) laid out a set of basic principles to be used as universal guidelines. They outlined the basis for an effective corporate governance framework, rights of shareholders, equitable treatment of shareholders, role of stakeholders, disclosure and transparency, and responsibilities of the board.
When the OECD principles were first adopted in 1999, they were primarily intended to address the problem of separate ownership and control within corporations. But by the time the principles were revised in 2004 with input from non-OECD private sector representatives, the OECD had recognized two additional concerns of special importance to emerging markets: institutional framework for markets and protection of minority shareholders. While successful markers are founded on freedom of ownership and exchange, to function, they also require appropriate regulations and enforcement. This is often problematic in developing countries. What is more, majority owners frequently exercise control for their private benefit while harming the company and minority owners.
In order to create a healthy, competitive governance environment in emerging markets, certain institutional prerequisites of a market economy must be put in place. A strong system of private property rights must clearly define who owns what and how property may be exchanged. A strong, independent, and transparent judicial system is needed to enforce rules and resolve conflicts. Markets should be competitive and open to new entrants and barriers to entry should be removed, including administrative barriers and official monopolies.
Government agencies and regulatory structures should be reformed so that civil servants perform their jobs with highest integrity, regulators are bound by clear rules on conflict of interest and have well-defined limits to their authority, and regulations are simplified by eliminating excessive or conflicting laws and rules. Finally, governments should be transparent and should not restrict the flow of economic information so that businesses, the media, civil society organizations, and citizens able to access and share information freely.
Apart from this institutional framework of good governance, internal governance within firms must also be improved. Good internal governance is designed to solve problems created by the separation of ownership (shareholders) from control (management) in a joint-stock corporation. The key area of good corporate governance involves the board of directors. Directors must know how to perform their two overarching duties: the duty of care (be informed, act with reasonable care, and monitor company risks) and the duty of loyalty (act in the interests of the company and all its shareholders, avoid conflicts of interest).
Companies everywhere – but especially in emerging markets – should also take measures to ensure minority shareholders’ rights are protected. All shareholders should be guaranteed access to information and participation in decision-making, and a company must remain vigilant about preventing conflicts of interest, self-dealing, and insider trading.
Finally, the board and management must establish systems for accurate reporting, as well as internal controls that mitigate risk, secure compliance with laws, and provide confidence in financial and nonfinancial reports. A company must have transparent accounting standards, bolstered by internal and external audits of financial statements, and its leaders should promote and observe strong ethical standards.
The private sector must play a leading role in corporate governance reform at every level. Individual companies should adopt good practices, setting an example for their peers and competitors. Voluntary private sector associations can provide education and assistance, and in many cases establish standards for self-regulation. The private sector should also participate and be consulted in the creation of government policies and rules that affect markets, companies, or investors.
The starting point and the goals of reform differ widely from country to country because the initial conditions matter. Simply grafting international best practices onto any country’s institutional framework does not work. The incentives of managers, directors, and investors in the existing system should be assessed and then compared to how the incentives would look under proposed reforms. It is important to keep in mind that corporate governance functions as a system, with inter-related components inside and outside the firm. The various components must support each other for the system as a whole to work.
There is a growing consensus among policymakers, business leaders, and the public that corporate governance is an essential tool for improving corporate performance and advancing the overall development of market-oriented democracies. The potential benefits from governance reforms in emerging markets are enormous. Establishing trusted markets with sound institutional foundations and introducing governance principles to all types of businesses will stimulate commerce, investment, and entrepreneurship.
Russian Institute of Directors
John D. Sullivan, Ph.D.
Center for International Private Enterprise
Igor Belikov (IB): In 2004, the Organization for Economic Co-operation and Development (OECD) has updated its corporate governance principles originally formulated in 1999. Why was this new edition necessary?
John D. Sullivan (JDS): Two things drove the revision of the principles: first, it was felt that, given the corporate scandals that emerged in Enron, WorldCom, Parmalat, and a number of cases in developing countries, it was time to take a fresh look to see if new emphasis on any of the individual principles might be necessary. Secondly, it became obvious that the emerging markets don’t have the institutional structures of property rights, rule of law, and other essential institutions that are so strongly embedded in the OECD countries. So the non-OECD countries really needed additional guidance on the institutional structure necessary to make corporate governance work.
IB: What do you think is the most important thing in the 2004 edition of the OECD principles? Also, what is new in the 2004 edition compared to the 1999 one?
JDS: I think the most important thing was extending the reach of the OECD principles into the emerging markets. This came out, in part, as the result of an excellent series of OECD round table meetings as well as meetings that the Center for International Private Enterprise (CIPE) co-sponsored with the Global Corporate Governance Forum. The first thing recognized was the need for an emphasis on institutional reform, the rules and norms that creates market economies. There was also a feeling that the 1999 principles needed to be extended beyond companies traded on exchanges. If you look at the composition of companies that issue stock in developing countries, you find that many of them are not publicly traded (e.g., family firms). We need to bring them into the idea of corporate governance.
Additionally, the whole issue of the corporate governance relationship between banks and/or sources of debt and companies had to be looked at. Finally, and most importantly, it became obvious that in the second and third generation of family firms, there were some significant corporate governance issues that needed to be addressed. All these issues are addressed in the 2004 edition.
IB: Many people believe that the voluntary application of corporate governance principles should be replaced with more mandatory tools. What do you think of that?
JDS: Well, it’s not a one-size-fits-all approach. I don’t believe that there is a general consensus that all corporate governance principles should be made mandatory or that mandatory enforcement should be the norm in all cases. Clearly, there are some parts of corporate governance that have to be mandatory such as the requirements for independent audits. However, other standards need to be tailored to different types of enforcement, through stock exchanges for example. Corporate governance reform has to be tailor-made for the type of institutional framework that exists in different countries.
The approach that we use at CIPE, in cooperation with our partner organizations like the Russian Institute of Directors, is to become an expert as much as we can in all of these different trends. But then it is essential to go through a deliberate process of consultation with the business community in country; to identify obstacles, issues, things that need to be addressed, such as the family-firm structure, the publicly traded structure, the state-owned structure, or minority shareholders in non-traded companies. Each of these issues has to be dealt with on its own terms.
IB: Many people are not clear on the difference between corporate governance and corporate social responsibility. How do you define them?
JDS: Corporate governance has to do with how the company is managed and directed. Social responsibility, or corporate citizenship, which is the term that we prefer, has to do with how companies see their role in the society. It also has to do with how companies comply with or come to terms with issues like environmentalism, consumer satisfaction, workplace issues, and relationships with NGOs in their local communities.
IB: Businesses in Europe and in the United States tend to use different approaches to corporate citizenship. What are the main trends that you see?
JDS: I don’t think there are a lot of generalizations that one can make about Europe versus the United States. In certain European countries, it is, for example, quite common for companies to issue social responsibility reports. At the same time, one of our most competitive companies in the United States, Starbucks Coffee, issues an annual report that is very well-received and highly praised by the social responsibility community. And I would invite you to go to the Starbucks website and take a look at it (www.starbucks.com/aboutus/csrannualreport.asp). It covers a variety of different issue areas.
A number of websites now have been dedicated to cataloging and helping companies come to terms with all of the various approaches out there because there is no industry standard on what social responsibility is or is not. One of these websites, CRS Wire (www.csrwire.com), is an excellent starting point.
IB: In emerging and transition countries businesses are less rich than in advanced economies. Wouldn’t high social responsibility costs become too burdensome for them?
JDS: Again, that depends on what you mean by social responsibility or corporate citizenship. Certainly, we believe very much in the voluntary approach on a company-by-company basis. The big danger I see is when corporate citizenship becomes an additional tax. Now, certainly, the corporation has a role and a responsibility as a citizen to express its views and to pay its fair share. But to move from a voluntary corporate governance approach, where companies engage in order to help develop the communities they work in, I think is where developing countries really should have the greatest fear. A mandatory structure is simply going to increase the tax burden on companies, which, in turn, can only result in higher product costs, lower productivity, or fewer jobs.
IB: Can you show that voluntary social responsibility and corporate citizenship is economically effective?
JDS: Our approach at the Center for International Private Enterprise has always been to say that companies can become good citizens by joining business associations, think-tanks, and NGOs that help shape thinking of government and the general public on how to best develop society and the economy. It is especially vital in emerging markets that the business community takes a leadership role in helping to resolve problems by looking at barriers, by looking at what needs to be done to bring property rights to the average citizen, to allow people to be entrepreneurs. It’s a huge boost to productivity, and it’s a huge boost to economic growth.
This interview originally appeared in the Russian-language Company Management Magazine (www.zhuk.net) in December 2004.