Analyze Corporate Governance in Emerging Markets

Finance in a Global Perspective (BSMM 8120)

Winter 2024

Instructor: Dr. Yunbi An

Submitted by: Tasnova Alam

ID: 110105914

Date of submission: February 6th, 2024

Corporate Governance in Emerging Markets

Corporate governance plays a crucial role in shaping the performance and sustainability of

businesses, particularly in emerging markets. These markets often face unique challenges,

including agency problems within public corporations. This case study aims to investigate

corporate governance within emerging markets, identify significant agency issues, and explore

potential remedies for these challenges.

Agency Problems in Public Corporations in Emerging Markets

Emerging markets are characterized by a unique set of challenges in corporate governance,

primarily stemming from agency problems. The agency problem, a classic dilemma in corporate

governance, refers to conflicts of interest between managers, or insiders, and shareholders, the

outside investors. In the context of emerging markets, these issues can be exacerbated due to

factors such as weak legal frameworks, concentrated ownership, and historical influences.

Management versus Shareholders' Interests: The conflict between managers' and

shareholders' interests is a significant indication of the agency problem. Insiders, who usually

possess major control rights, may prioritize personal gain over shareholder benefit. This can

emerge in a variety of ways, ranging from self-indulgent perks to outright misappropriation of

company funds. The prevalence of such behavior can undermine investor trust and hinder

economic growth.

Inadequate regulatory Framework: Limited legal and regulatory frameworks in many

developing markets might lead to agency problems. The lack of rigorous enforcement policies

may encourage company insiders to engage in opportunistic behavior.

Information Discrepancies: Discrepancies in information accessibility between managers and

shareholders can create a situation where unfavorable company details are concealed, resulting in
a significant erosion of trust from potential investors. This issue becomes particularly

challenging for companies in emerging markets, as insufficient information may impede not only

the company's growth but also hinder the overall economic development.

Remedies for Agency Problems: Addressing agency problems in emerging markets requires a

multifaceted approach, considering the unique challenges these markets pose. Several

governance mechanisms can help alleviate agency problems and enhance investor protection:

1. Independent Board of Directors: The appointment of an independent board of directors

serves as a cornerstone in corporate governance. Independent directors, not affiliated with

company management, bring an external perspective and act as fiduciaries for shareholders.

Studies indicate that the presence of outside directors correlates with a higher turnover rate of

CEOs following poor firm performances, suggesting that independent boards can be effective

in curbing managerial entrenchment and holding executives accountable. In emerging

markets with diffused ownership structures, management often influences the selection of

board members, emphasizing the need for stricter regulations and enforcement mechanisms

to ensure genuine independence.

2. Incentive Contracts: Incentive contracts, such as stock options, aim to align the interests of

managers with those of investors. By tying executive compensation to the company's

performance, managers are incentivized to prioritize actions that enhance shareholder wealth.

The design of incentive contracts requires careful consideration, and independent

compensation committees play a vital role in ensuring that these contracts are structured to

genuinely benefit both managers and shareholders. Recent instances of executive abuses

highlight the need for transparent and well-monitored incentive structures. Rigorous
 oversight prevents manipulation and ensures that these contracts genuinely serve their

intended purpose.

3. Concentrated Ownership: Concentrated ownership, where a few large investors hold

significant stakes, provides a powerful incentive for monitoring management. Large

shareholders can influence decision-making and hold management accountable for their

actions. While concentrated ownership can be beneficial for monitoring, striking a balance is

crucial. Excessive concentration may lead to its own set of problems, potentially enabling

dominant shareholders to prioritize personal gains over broader shareholder interests.

4. Accounting Transparency: Strengthening accounting standards is integral to mitigating

agency problems, particularly those associated with accounting fraud. Timely and accurate

financial reporting reduces the opacity that can be exploited by self-interested managers.

Greater accounting transparency reduces information asymmetry between corporate insiders

and the public, discouraging managers from pursuing self-serving actions that might be

hidden behind opaque accounting practices. Establishing and empowering independent audit

committees is crucial, as these committees play a vital role in ensuring that accounting

practices adhere to standards and are not manipulated for private benefits.

5. Debt: Debt serves as a disciplining mechanism for managers by limiting their discretion. The

obligation to pay interest and principal on time ensures that managers prioritize financial

prudence to avoid bankruptcy. Debt can serve as an alternative to dividends, compelling

managers to disgorge free cash flows to outside investors rather than engaging in wasteful

investments. However, a balanced approach is necessary to prevent excessive debt and its

associated risks.
6. Shareholder Activism: Activist investors, by actively engaging with the companies they

invest in, play a crucial role in influencing management decisions. They act as a check on

managerial actions and ensure that decisions align with shareholder interests. Studies show

that when hedge funds or activist investors intervene, targeted firms experience significant

share price appreciations, suggesting that shareholder activism can effectively enhance

shareholder value. In recent years, activist shareholders have expanded their focus beyond

financial goals to include social and political agendas, broadening their role in promoting

responsible corporate behavior.

7. Overseas Stock Listings: Overseas stock listings provide companies from emerging markets

with an opportunity to enhance their governance credibility. Listing in countries with strong

investor protection signals a commitment to upholding shareholder rights. Cross-listings

expose companies to global governance standards, potentially raising the bar for governance

practices. However, companies must ensure that the benefits outweigh the associated costs

and regulatory complexities.

8. Market for Corporate Control: The market for corporate control serves as a last resort

mechanism. If internal governance mechanisms fail to correct poor performance, an outsider

may mount a takeover bid, compelling restructuring and managerial changes. While hostile

takeovers are more common in certain jurisdictions like the United States and the United

Kingdom, their rarity in emerging markets can be attributed to cultural values and

concentrated ownership. Nonetheless, the increasing incidence of takeovers in some

emerging markets signals a gradual shift in attitudes. Takeovers initiated by companies with

poor investment opportunities might be a symptom rather than a cure for the agency problem.

Ensuring that takeovers lead to genuine improvements requires careful consideration.

Summary

The analysis explores agency problems within public corporations in emerging markets,

emphasizing the divergence between managers and shareholders' interests. Factors such as weak

legal frameworks, concentrated ownership, and historical influences exacerbate these issues. The

prevalence of agency problems, especially in the presence of free cash flows, hampers economic

growth and investor trust.

Remedies for agency problems include the establishment of an independent board of directors,

incentive contracts, addressing concentrated ownership, enhancing accounting transparency,

judicious use of debt, encouraging shareholder activism, considering overseas stock listings, and

recognizing the market for corporate control as a last resort.

Personal Thoughts

Addressing agency problems in emerging markets requires a multifaceted approach that

combines regulatory measures, corporate practices, and investor activism. The proposed

remedies, such as independent boards and incentive contracts, align with global corporate

governance best practices. However, implementing these measures in emerging markets may

face challenges due to cultural nuances, regulatory gaps, and resistance from entrenched

management.

The emphasis on transparency, whether through accounting practices or overseas stock listings,

reflects a commitment to aligning emerging market corporations with international governance

standards. It is crucial to strike a balance between concentrated ownership, which can be a

monitoring mechanism, and preventing it from leading to managerial entrenchment.

The evolving role of shareholder activism and the market for corporate control in emerging

markets signal a positive shift towards greater accountability. However, cultural and regulatory

factors unique to each market must be considered to ensure these mechanisms are effective.

Conclusion

In conclusion, the dynamics of corporate governance in emerging markets are complex,

requiring tailored solutions that balance global best practices with local considerations. As these

markets continue to evolve, a proactive and adaptive approach is necessary to foster sustainable

economic growth and build investor confidence.

References

 Ararat, M., Claessens, S., & Yurtoglu, B. B. (2021). Corporate governance in emerging

markets: A selective review and an agenda for future research. Emerging Markets

Review, 48, 100767.

 Eun & Resnick, "International Financial Management" (9th edition), McGraw Hill.

ISBN: 978-1- 259-71778-9