BM-5301C - Corporate Governance

International Corporate Governance

M Muzamil Naqshbandi (PhD)

UBD School of Business & Economics,
University of Brunei Darussalam
muzamil.naqshbandi@ubd.edu.bn

To provide quality education and nurture innovative and caring leaders to contribute to the community.
 International Corporate Governance
“the collection of control mechanisms that an organization adopts to prevent or
dissuade potentially self-interested managers from engaging in activities detrimental
to the welfare of shareholders and stakeholders”.

The governance system that a company adopts is not independent of its environment.
Reliability of
Capital Market Robustness of legal Enforcement of Societal and
accounting
Efficiency system regulations cultural values
standards

Differences in these factors affect:

Type of governance mechanisms required to
Prevalence and severity of agency problems monitor and control managerial self-interested
behavior.

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 1. Capital Market Efficiency
Markets set the prices for labor, natural resources, and capital.

Inefficient markets distort prices and lead to poor corporate decisions.

In inefficient markets, shareholders cannot rely on markets to punish management for poor
decisions.

Accurate pricing helps firms make rational decisions about allocating capital to its most efficient
uses.

Efficient markets act as a disciplining mechanism on corporations and hold them to high
standards; or else they are punished by the market.

Rajan and Zingales (1998) studied the relationship between capital market efficiency and
economic growth across countries.
• Efficient capital markets >> Industries that require external financing grow faster in countries
with efficient capital markets.
• A well-developed financial market >>competitive advantage for firms that rely on external
capital for growth.

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 Efficient markets v/s inefficient markets
Markets set the prices for labor, natural resources, and capital.

Efficient capital markets also act as a disciplining mechanism on corporations. Inefficient

players fizzle out.

Increased risk to the economy when family-owned businesses operate with minimal external
oversight and when their objectives are to extract rents at the expense of shareholders or
stakeholders.

Foreigners invest less money in companies that insiders control and that reside in countries
with weak investor protections and lower transparency.

Influential wealthy families, large banking institutions, other companies, or governments

provide capital; may have ulterior motives and; may bring increased risk to the economy when
they operate with minimal external oversight

Family-controlled business groups are more prevalent in countries with weak capital markets
and serve as an important source of financing in these countries

Efficient capital markets can serve as a disciplining mechanism on managerial behavior when
they are appropriately used in compensation contracts.
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Family-controlled business groups in selected countries

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Percent of Listed Companies
 2. Legal Tradition
▪ A country's legal tradition affects the rights afforded to business owners
and minority shareholders.
▪ Common concerns of business owners and minority shareholders:
o Protection of their property against expropriation,
o Predictability of how claims will be resolved under the law,
o Enforceability of contracts,
o Efficiency and honesty of the judiciary.
o How the legal system protects their ownership rights and
discourages abuse by controlling owners.

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 Legal Tradition
▪ A system that provides strong protection helps mitigate the prevalence and
severity of agency problems
▪ A corrupt or weak legal system does the opposite, causing agency problems.
▪ Also, political corruption has a negative impact on economic development.
▪ A corrupt government provides worse protection of property rights and that
bureaucratic delay in granting licenses can deter investment in technological
advancement.
▪ Countries whose legal systems are based on a tradition of common law
afford more rights to shareholders than countries whose legal systems are
based on civil law
▪ Creditors are afforded greater protection in common-law countries.
▪ Governance systems are more effective in countries that combine common-
law tradition with a reliable enforcement mechanism.
▪ Also, companies operating in countries whose legal systems protect minority
interests have higher stock market valuation.
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How can an organization survive in markets
with weak legal protection?

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 Survival in markets with weak legal protection
▪ If the legal system is corrupt, unpredictable, or ineffective, alternative
disciplining mechanisms are necessary in the governance process.
▪ If contracts are not enforced through traditional legal channels, they could
be "enforced" by the threat of not engaging in future business with the
other party.
▪ Firms could place directors on the boards of companies that are important
suppliers or customers to monitor management and to ensure that
contracts are honored.
▪ These mechanisms would enable the firms to bypass the legal system and
to ensure that shareholder and stakeholder interests are protected.

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3. Reliability of accounting standards

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 Benefits of reliable accounting standards
Reliable accounting standards are critical in ensuring that financial statements
convey accurate information to shareholders.
– Investors rely on this information to evaluate investment risk and reward.
– Reliable accounting standards help shareholders measure performance and
detect agency problems.
– BoD uses the information to structure appropriate compensation and
incentives.
– Research based on a sample of companies in 21 countries showed that
firms that adopted international accounting standards exhibited less
earnings management, more timely recognition of losses, and higher-
quality measurements of net income and equity book value (Barth et al.,
2008)
– Ernstberger and Vogler (2008) found that German companies that adopted
international accounting standards had a lower cost of capital than
companies that continued to use GAAP
– Transparency in financial disclosure contributed to higher national
economic growth rates through efficient resource allocation. (Francis et al.,
2009).
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 Reliability of accounting standards
Problems with less reliable
accounting standards
Inaccurate information and
low levels of transparency
can lead to poor decision
making and reduce the
efficiency of capital markets.
If accounting standards lack
transparency, financial
reporting will suffer,
compensation incentives will
be distorted, and
shareholders and
stakeholders will be less
effective in providing
oversight.
To improve the integrity of financial reporting,
regulators have devised standards that are based
on the expert opinions of economists, academics,
auditors, and practitioners.
Rule-based accounting
systems (United States and
Japan):, they prescribe
detailed rules for how
accounting standards should
be applied to various
business activities.
Principles-based accounting
systems (in many European
countries): they outline
general accounting concepts
but do not always dictate the
specific application of these
concepts to business
activities
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 Shortcomings of accounting standards
▪ The adoption of reliable accounting standards does not guarantee the integrity of
financial reporting.

▪ Principles-based accounting systems provide less-strict guidance and are subject to

management interpretation.

▪ Also, compliance with accounting codes does not necessarily lead to increased
transparency or better corporate performance.

▪ Institutional features of the business environment-including ownership characteristics,

board attributes, and protection of minority rights by the legal system-are also
important contributors to effective governance.

▪ If accounting rules are unreliable or external auditors cannot be trusted to verify their
proper application, countries will require a substitute mechanism to discourage agency
problems. These might include severe legal penalties for abuse and vigilant
enforcement mechanisms.

▪ Investors, customers, and suppliers might circumvent financial reporting information

and only rely on companies trusted over time through long interaction or family
relationships.

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4. Enforcement of regulations

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 Enforcement of regulations
▪ Legal and regulatory mechanisms alone cannot protect the interests of minority
shareholders.
▪ Government officials must be willing to enforce the rules in a fair and consistent
manner.
▪ Regulatory enforcement mitigates agency problems by dissuading executives from
engaging in behaviors such as insider trading, misleading disclosure, self-dealing, and
fraud because they acknowledge a real risk of punishment.
▪ Countries with developed securities regulations and legal enforcement mechanisms
have a lower cost of capital.
▪ Controlling for macroeconomic and firm-specific factors, the differences in securities
regulation and legal systems explain about 60 percent of country-level differences in
cost of capital.
▪ The importance of regulatory enforcement is greater in countries whose economies
are not integrated into international capital markets (such as Brazil, India, and the
Philippines) than in those whose economies are integrated (such as Belgium, Hong
Kong, and the United Kingdom).
▪ When a country's economy is integrated into international capital markets, the
efficiency of those markets can partially make up for deficiencies in the country-
specific securities regulation and legal system. 15
 Enforcement of regulations
▪ Regulatory enforcement also contributes to investor confidence that
management will be monitored, and property rights will be protected.
▪ Bushman and Piotroski (2006) found that companies apply more
conservative accounting in countries where public enforcement of
securities regulation is strong.
▪ Researchers have found that participation in equity markets increases
when countries adopt insider trading laws because the laws put outside
investors on more even footing with insiders who have access to
nonpublic information.
▪ If regulatory enforcement is weak or inconsistent, shareholders cannot
expect to have their interests protected by official channels.
▪ Therefore, they have to take a more direct role in governance oversight,
either through greater rights afforded through the bylaws and charters or
through direct representation on the board.

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5. Societal and cultural values

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 Societal and cultural values
▪ The society in which a company operates also strongly influences
managerial behavior.
▪ Cultural values also influence the relationship between the company and
its shareholders and stakeholders.
▪ Corporations in Korea have a responsibility to society as a whole, beyond
maximizing shareholder profits.
▪ This cultural norm-the concept of shame, or "lost face "becomes a
disciplining mechanism that deters self-interested behavior, similar to the
threat of legal penalties in other nations.
▪ In Russia, personal display of wealth is tolerated, and corruption is widely
seen as an inevitable aspect of the business process. Executives there
might be more likely to take self-interested actions because they do not
risk the same level of scorn as executives in Korea.
▪ If cultural norms do not act as a successful deterrent, and explicit
government regulation and enforcement are likely.
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 Societal and cultural values
▪ Social attitudes that shapes governance systems is the role of the corporation in society.
▪ Some countries tend toward a shareholder-centric view, which holds that the primary
responsibility of the corporation is to maximize shareholder wealth.
▪ Actions such as improving labor conditions, reducing environmental impact, and treating
suppliers fairly are seen as desirable only to the extent that they are consistent with
improving the long-term financial performance of the firm.
▪ Other countries tend toward a stakeholder-centric view, which holds that obligations toward
constituents such as employees, suppliers, customers, and local communities should be held
in equal importance to shareholder returns.
▪ The United States and the United Kingdom are two countries that predominantly embrace
the shareholder-centric view.
▪ German law is based on a philosophy of codetermination, in which the interests of
shareholders and employees are expected to be balanced in strategic considerations.
▪ The Swedish government encourages full employment through consequences that make it
difficult to carry out large-scale layoffs, even though such a policy runs the risk of decreasing
firm profitability.
▪ The Japanese are known for job protection and rewarding employees for tenure.

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 Corporate governance in America
• The United States has the largest and most liquid capital markets in the
world.
• The most important governance regulatory body in the United States is
the Securities and Exchange Commission (SEC).
• US Congress created the SEC through the Securities and Exchange Act of
1934 to oversee the proper functioning of primary and secondary financial
markets, with an emphasis on the protection of security holder rights and
the prevention of corporate fraud.
• The SEC has the authority to regulate securities exchanges (such as the
New York Stock Exchange [NYSE], the NASDAQ, and the Chicago
Mercantile Exchange), bring civil enforcement actions against companies
or executives who violate securities laws (through false disclosures, insider
trading, or fraud), ensure the quality of accounting standards and financial
reporting, and oversee the proxy solicitation and annual voting process.

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 New York Stock Exchange (NYSE).
▪ Companies are required to comply with the listing requirements of the
exchanges on which their securities trade.
▪ The NYSE requires that a listed company have at least 400 shareholders,
maintain a minimum market value and trading volume in its securities,
and demonstrate compliance with the following governance standards:
▪ The listed company's board is required to have a majority of
independent directors.
▪ Nonexecutive directors must meet independently from executive
directors on a scheduled basis.
▪ The compensation committee of the board must consist entirely of
independent directors.
▪ The audit committee must have a minimum of three members, all
of whom are "financially literate" and at least one of whom is a
"financial expert."
▪ The company must have an internal audit function.
▪ The chief executive officer (CEO) must certify annually that the
company is in compliance with NYSE requirements. 21
 Corporate governance in China
▪ The Chinese model of corporate governance >> from a communist regime to a capitalist economic system.
▪ The Chinese government owns a full or controlling interest in many of the country's largest corporations.
▪ Although the government seeks to improve the efficiency of its enterprises, it balances these objectives
against stakeholder concerns.
▪ These include maintaining high levels of employment and ensuring that critical industries-such as banking,
telecommunications, energy, and real estate-are protected from excessive foreign investment and
influence.
▪ Chinese companies issue three types of shares:
• those held by the state,
• those held by founders and employees,
• and those held by the public.
▪ Shares held by the public fall into three categories: A-shares, B-shares, and H-shares.
❑ A-shares trade on the Shanghai Stock Exchange and the Shenzhen Stock Exchange on mainland
China. Ownership is restricted to domestic investors, and shares are denominated in renminbi.
❑ B-shares also trade on the Shanghai and Shenzhen markets but are denominated in foreign
currencies.
❑ H-shares trade on the Hong Kong Stock Exchange and are available to foreign investors. H-shares are
denominated in Hong Kong dollars. The ownership restrictions placed on these markets have
created vastly different liquidity levels, and it is not uncommon for A-shares and H-shares to trade
at divergent valuations
❑ Limited float and ownership restrictions limit the influence of public shareholders in China.
Refer to: The A-H Premium and Implications for Global Investing in Chinese Stocks. URL:
https://pages.stern.nyu.edu/~jcarpen0/pdfs/A-H.pdf 22
 Corporate governance in India
• In 1990’s India liberalized its economy.
• With these reforms came pressure to improve governance standards.
• Large companies were encouraged, although not required, to adopt the standards of the Code.
• Securities and Exchange Board of India (SEBI) commissioned the Kumar Mangalam Birla Committee
to propose standards of corporate governance that would apply to companies listed on the Indian
stock exchange. These reforms were incorporated in Clause 49 and applied to all publicly traded
companies.
• Clause 49 requires:
• A majority of nonexecutive directors on the board.
• If the chairman is an executive of the company, at least half of the directors must be
independent;
• if the chairman is a nonexecutive, the requirement for independent directors is reduced
to one-third.
• Board members are limited to serving on no more than 10 committees across all boards
to which they are elected.
• Companies are required to have an audit committee consisting of at least three members,
two of whom must be independent directors.
• The CEO and CFO must certify financial statements.
• Extensive disclosure requirements for related-party transactions, board of directors'
compensation and shareholdings in the company, and any financial relationships that
might lead to board member conflicts.
• Companies are required to include a section in the annual report explaining whether they
are in compliance with these standards. 23
Corporate governance in Malaysia

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