European Business Environment Corporate Governance by Daniel Wülbern Page 2

This essay describes the problematic of corporate governance systems, which, if they are weak, distort the efficient allocation of resources, undermine opportunities on a level playing field and, ultimately, hinder investment and economic development. Recent high profile scandals, financial crises and institutional failures in Russia, Asia and the United States have brought corporate governance issues to the fore in modern western, as well as developing countries, transitional economies, and emerging markets. Firstly, I will give a definition of corporate governance and introduce the OECD Principles, which are the foundation of all corporate governance systems. Secondly, I discuss the driving forces and the importance of corporate governance. I will then concentrate on national differences and recent developments, where I am particularly looking at the UK and Germany. A special chapter about the Anglo-American influence follows and leads to the last chapter, which covers the current situation and possible future effects of applied corporate governance systems in developing and transitional countries.

The purpose of this paper is not to go deep into legal details of corporate governance, but reveal its importance for society (stakeholder), economy (corporations and capital markets) and future development of emerging market economies.

During my research I found many definitions of corporate governance. The IMF defines it very succinct: “Corporate governance refers to the framework of rules and regulations that enable the stakeholders to exercise appropriate oversight of a company to maximize its value and to obtain a return on their holdings.” The corporate governance movement started roughly 15 years ago and was spearheaded by the World Trade Organization (WTO). The main aim was to help companies grow across borders by persuading investors and creditors that they can confidently invest in their country. However, this development got significantly more momentum when the OECD introduced international corporate governance principles nearly 4 years ago now.

The OECD Principles of Corporate Governance 1

These principles, based on the Milstein Report ² , where endorsed in may 1999 by 29 OECD member nations. They represent the first inter-governmental accord on the common elements of effective corporate governance. The four core principles are:

¹ The principles are available in full text at www.oecd.org/

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• Fairness

• Transparency

• Accountability

• Responsibility

Fairness means the protection of shareholders’ rights (Principle I) and the equitable treatment of them (Principle II). Thereby participatory rights on key corporate decisions are ensured and laws that protect the rights of minority and foreign shareholders are included in the legal framework.

Transparency ensures that investors and shareholders get information about the performance of the company. As financial information may be unreliable, internationally prescribed and accepted accounting standards are necessary to promote uniform disclosure and enable comparability.

Accountability implies a legal duty on the part of directors to the company and its shareholders. As elected representatives, directors are held to be in a fiduciary relationship to shareholders and the company. Their duties of loyalty and care require that they avoid self-interest and act diligently and on a fully informed basis.

Responsibility forces corporations to act responsibly and ethically outside of the law and regulations, with special consideration of the interests of stakeholders (particularly employees).

The core elements of corporate governance can be shown graphically as the four corners of a rhombus:

² Business Sector Advisory Group, Report to the OECD on Corporate Governance: Improving Competitiveness and Access to Capital in Global Markets dated 20th April 1998.

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No matter what view of the corporate objective is taken, effective governance ensures that boards and managers are accountable for pursuing it. The role of corporate governance is of broad importance to society for a number of reasons:

• Promotion of the efficient use of resources both within the company and the larger economy. Debt and equity capital should flow to those corporations capable of investing it in the most efficient manner and with the highest rate of return.

• Assisting companies (and economies) in attracting lower-cost investment capital by improving both domestic and international investor confidence that assets will be used as agreed.

• Making sure that the company is in compliance with the laws and regulations.

• Providing managers with oversight of their use of corporate assets. Thus making it more likely to respond rapidly to changes in business environment, crisis and periods of decline.

• Reducing corruption in business dealings.

Why do corporations and nations need corporate governance?

When firm ownership is separated from control, the manager’s self interest may lead to the misuse of corporate assets. Corporate financiers (pensions funds, mutual funds, banks or even governments and individuals) need assurances that their investments will be protected from misappropriation and used as intended for the agreed corporate objective. Corporate governance concerns thus the relationships between corporate managers, directors and the providers of equity capital. It also encompasses the relationship of the corporation to stakeholders and society. More broadly defined, corporate governance includes the combination of laws, regulations, listing rules and voluntary private sector practices that enable the corporation to:

• Attract capital,

• Perform efficiently,

• Achieve the corporate objective (raison d’être),

• Meet both legal obligations and general societal expectations.

Corporate governance is to a large extent a set of mechanisms through which outside investors protect themselves against fraudulent asset diversion by the managers or insiders. In effect investors will avoid investing in countries, where they have to fear losses due to non-existing protection through laws and regulations, i.e. effective corporate governance institutions.

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Dramatic transformations are underway in at least five crucial areas that characterize the internal organization and external environment of the public corporation: (1) the nature of work; (2) the capital market; (3) product-market competition; (4) organizational forms; and (5) regulatory environment.

I will explain three areas in more detail, for a tabular overview which covers all areas and its implications for corporate governance, please refer to the Appendix.

The nature of work

Peter F. Drucker ³ and Jeremy Rifkin ⁴ identify the period starting soon after World War II as the turning point in the nature of work. Key differences are:

• Knowledge is now the key factor of production and value creation,

• Whereas workers used to serve machines and capital, today machines and capital serve workers,

• Whereas workers were historically selected for their skills of exertion, dexterity, and endurance, today skills of perception, attentiveness, and decision-making are valued.

As specialized human capital becomes more central and critical to the production process, individuals with such capital become more powerful in the organization. Importantly, these individuals are also much more difficult to monitor and control.

The capital market

The most profound change in the capital market over the past two decades has been its transformation from a conglomeration of regionally and nationally segmented markets into one integrated, international market. An IMF survey ⁵ illustrates this huge change: International trade of stocks and bonds in Japan rose from less than two percent of GDP in 1975 to almost ninety-six percent in 1997. In the United Kingdom, the international trading of securities amounted to almost 700% of that country’s gross domestic product in 1990. Crossborder trade in equities grew at a rate of about twenty-eight percent per year from 1980 to 1990, and annual volumes now approach $1.5 trillion per year. Finally, the number of US shareholders rose from 8.5 million in 1977 to 120 million by 1996.

Perhaps the most significant innovation in financial products has been in the area of derivative securities. The estimated total value of the derivatives market as of June 1998 was seventy trillion dollars. Interestingly, the institutional context of financial markets is becoming more homogenous worldwide.

³ Peter F. Drucker, Post capitalist society (1993)

⁴ Jeremy Rifkin, The end of work: the decline of the global labour force and the dawn of the postmarket era (1995)

⁵ INTERNATIONAL MONETARY FUND, International capital markets: developments, prospects and key policy issues, world economic and financial surveys, 187 (1998). www.imf.org