Corporate governance is primarily understood as a set of rules through which corporations are governed. What are the implications of corporate governance and rules of corporate management for the role of business in society? What is the position of transitional countries in today’s system? Can a new approach to corporate governance create some new opportunities for sustainable development? What are the changes of corporate governance in transitional countries?
Understanding corporate governance.
Corporate governance in the narrow and broad senses.
The case of the Postal and Investment Bank in Prague—culture changes and conflicts.
Shareholders, stakeholders, and the problem of short-termism.
Changes in the global environment, society, and business environment, and even recent issues closely connected with the credit crunch have an impact on countries in transition. Transitional economies represented new markets for global companies in the 1990s, and the early years of the 21st century.
However, transition is not so straightforward. From the standpoint of global corporations, it is not just about the acquisition of new markets and a relatively cheap and qualified workforce. Global companies need to export and institutionalize new corporate governance measures.
Understanding Corporate Governance
Corporate governance “is the way in which are companies directed and controlled” (source: Cadbury Report, 1992). Over the years, corporate governance has become a much broader issue and includes other aspects of a corporation’s management. Many authors also include the broader role of business in society and do not limit their view solely to shareholders’ interests. Moreover, shareholders’ interests are difficult to administer and enforce because of dispersed ownership and the increasing role of institutional investors in wealth management.
Corporate Governance in the Narrow and Broad Senses
“Corporate governance is concerned with ensuring the firm is run in the interests of shareholders” (Allen, 2005, p164).
This view is concerned with value maximization for shareholders, and the underlying principle of the “invisible hand” coined by Adam Smith.
Companies must comply with certain rules and regulations and adhere to the directions agreed by the board of directors. They institutionalize and adhere to rules of executive compensation, and are monitored by financial institutions and banks. Company executives and managers on lower levels comply with set rules. This system should ensure that the gap between shareholders and managers is bridged (Jensen and Meckling, 1976) and that managers act in the interest of shareholders.
This principle (running the company in the interest of shareholders) is inherent in the legal systems of Anglo-Saxon countries, and law and regulations play a major role in corporate governance and the enforcement measures of the corporate world. However, there are differences between UK and US-based corporate governance. In the UK, the Cadbury Code interpretation, “comply or explain” is used, and rules are not strictly enforced but principles need to be respected. In the US, corporate governance is rules-driven. This creates a danger that the law must be broken down into rules and regulations for each company, so that companies are able to comply with them. Each measure is administered by a particular set of forms and reports. The danger is that the basic principles can become lost in this jungle of administrative forms, and that companies end up complying only with forms, and that may lead to a simple box-ticking approach. This would effectively mean that the original purpose is lost.
As we witnessed in the early years of the 21st century, this simplified approach and focus on shareholders does not work. Recent faults in the system only confirm that formal adherence to regulations without principles and a broader understanding of the context do not work.
“Corporate governance is concerned with ensuring that firms are run in such a way that society’s resources are used efficiently” (Allen, 2005, p165).
The Anglo-Saxon model is just one of those that is globally used. However, in other parts of the world, the functioning of companies has evolved from different societal principles.
With broader objectives, corporate governance does not concentrate solely on companies and their owners, but takes into consideration a broader spectrum of stakeholders (for example, shareholders, employees, government, environment, and local community). The objective is that everybody can potentially be better off by using resources accountably and in a reasonable manner. An often-used example in this context can be pollution. If firms took a broader view on corporate governance, they would change their behavior and produce a socially acceptable level of pollution. “In general, although it may not be possible to reach efficiency, it may be possible to achieve a better allocation of resources” (Allen, 2005, p.165). Modern companies now introduce new concepts that are approaching this broader view. These concepts started in the 1990s with the notion of the triple bottom line by J. Elkingdon (1998), which requires that companies now care for broader issues, and, furthermore, that their reports will detail their approach to economic, social, and environmental issues. This leads to broader issues of sustainability and corporate social responsibility (see also Sawitz and Weber, 2006).
In certain European countries (such as France and Germany), Japan, and more recently in India, the broader approach is stressed, and companies in these countries do not to take the creation of shareholders’ value as their major goal.
Again, the operationalization of goals may be a different issue and is practiced differently in companies. Many companies now produce reports on sustainability or corporate responsibility in line with their global reporting initiative (GRI). For example, German and French companies have recently focused on employees but not on all aspects of the sustainability movement.
The Case of the Postal and Investment Bank in Prague—Culture Changes and Conflicts
Prior to the changes that started in the 1990s, local control systems existed in transitional countries. However, the actual reality following these system changes is more complex, namely that there is a conflict with the traditional corporate governance that is now being implemented by new owners, such as international investors focusing on value for shareholders. The case of the Investment and Postal Bank of Prague illustrates several clashes between the different cultures, and the different perceptions of goals between a Czech bank and a global (in this case, Japanese) investor.
The Investment and Postal Bank of Prague (IPB) was established in 1990 as a then-new Czechoslovak bank, and it rapidly gained its market share. The bank’s management had two strategies remaining from its origins—a strategy of business development, and a strategy of ownership by its own management. The first strategy led to success in retail banking. At the same time, however, the credit expansion in the risky environment of a transforming economy, and the conflict of interest within IPB led to a crisis. The bank acted simultaneously as a creditor and an owner (through its subsidiaries) of a vast industrial empire.
In 1996, IPB had problems as an increasing proportion of bad debts in its portfolio began to appear. IPB was under pressure because of capital inadequacy, and faced a potential insolvency problem. While the bank itself did not perceive any problems, as it felt it had sufficient deposits from individuals, it was alleged in the press that Coopers & Lybrand, its auditors, were requesting additional provisions to cover bad debts for year-end 1996. The bank rejected Coopers & Lybrand and brought in Ernst and Young, who carried out a new audit for year-end 1996. The subsequent accounts for IPB for 1996 showed the bank earning a profit. Audit company, KPMG, was also asked to tender for the same audit, but according to one of its partners, “in the time that we were given, we refused to do it”, (PBJ, 2001). Although the new auditor, in 1997, approved the 1996 annual report, it required the bank to increase its share capital by CZK11 billion (about US$550 million). Furthermore, one of the extraordinary audits for 1997 showed that the value of the bank was negative. IPB managed to postpone the day when the problems would become apparent, all within the current legal framework. However, it was clear that the majority of these problems had already started in 1996 (Nollen et al., 2005).
The Czech state sold its minority share in IPB to Nomura in 1998 in the hope that a strategic partner would be found that could help to improve IPB’s capital adequacy situation by injecting CZK6 billion (about US$300 million). Initially, the public perceived Nomura’s entry as a positive signal and the bank’s deposits increased. Nomura, however, did not act as a strategic partner. Instead, it concentrated on selling off significant stakes in Czech industrial companies, which were held in portfolios of investment funds owned and managed by IPB.
The situation of the bank did not improve and it gradually started losing credibility. IPB ran into even more dramatic problems in February 2000, when many creditors started withdrawing short-term deposits. The Czech central bank (CNB) had to impose forced administration. The situation was finally resolved by selling IPB to another Czech commercial bank CSOB (Ceskoslovenska Obchodni Banka), which was one of the four original Czech banks that had carried over from the previous system (CNB, 2000c).
This case shows the conflict between the traditional (but in the Czech Republic still “new”) Anglo-Saxon approach, which strives mainly to increase value for shareholders, and the continental approach, with its roots in a broader stakeholder mentality, coming from the German tradition. The actions of the bank were in accordance with existing rules of law, but were they in accordance with good governance?
Shareholders, Stakeholders, and the Problem of Short-termism
Anglo-Saxon companies concentrate primarily on increasing value for shareholders. The management of these companies has strong incentives to act in the interests of their shareholders. In these cases, management behavior is often prone to short-termism and tends to ignore the long-term goals of social responsibility and development. Corporate governance as interpreted by such tradition is not the same globally. European and Asian companies do not have this unique goal of creating value for shareholders, and devote some energy to other aspects, such as ecology and social responsibility.
Again, depending on which country we have in mind, the relevant tradition applies. Some countries were very much knowledge-based. Should global companies be in the forefront of this initiative? Should there be any room for governments? What are the best practices? What are the needs of transitional economies? One of the needs of companies in transitional economies is frequently trying to gain new capital for future development, and, furthermore, to gain capital and funding through their more-capitalized Anglo-Saxon peers. Companies in transitional countries are being listed on foreign exchanges, where rules and regulations, and demands for documentation, are much more stringent. This also requires a large amount of effort in putting the case together, as well as convincing the authorities that the accounting system and internal rules of corporate governance of a company from a transitional country comply with the requirements of the British or American stock exchanges. The costs of compliance with stock-exchange rules are huge, and many companies incur these costs to demonstrate that they have good corporate governance and attract investors because of the perceived lower risk.
Can transitional economies bring something new to developed economies apart from new markets and new business opportunities? In view of corporate governance in the broad sense, such companies can also be a good opportunity to create new governance rules and practices, and not to slip into the simple box-ticking trap. On the contrary, corporate managers can make significant steps towards care for the environment and long-term sustainability, increasing the (positive) role of business in society.
Making It Happen
The rules of corporate governance need to be taken in the context of the whole society.
For Anglo-Saxon corporate governance please see the example of BT at www.btplc.com/societyandenvironment
For alternative corporate governance, please see the example of Toyota at www.toyota-industries.com/corporateinfo/governance
Obviously, these are examples of big companies, and it remains to be seen whether similar practices can be cost-efficient in smaller and medium-sized corporations.