Sucheta Dalal :The long and short of corporate governance
Sucheta Dalal

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The long and short of corporate governance  

April 12, 2010

Investors, economists and financial analysts assume that the deluge of corporate information is accurate. It is the basis of their decisions, their forecasts and their analysis. But is this correct? Are managers actually acting in the best interest of their shareholders and providing accurate information?
Amid the financial carnage of the recent recession, many countries are considering financial reform. In the United States Senate, a new Bill has just been introduced and is under debate. Even emerging markets have introduced reforms. For example, in Bahrain, a code of corporate governance has not yet been implemented, but may be close to being finalised. In the UAE, the Ministerial Resolution No (518) of 2009 Concerning Governance Rules and Corporate Discipline Standards (Rules) has been introduced and will become effective at the end of April.
To determine what these Bills are supposed to do and the probability of their success, it is wise to look at the concept of corporate governance. Corporate governance is one of those phrases like ‘rule of law’. Its definition is relative depending on the situation and who is talking about it and where.
Rather than try to define what ‘corporate governance’ is, it is more profitable for investors to understand what it is trying to do. What is its economic purpose? The whole point of corporate governance is to solve the principal-agent problem. Principals and agents are a short hand for all sorts of legal relationships. These include management and shareholders, employers and employees, partners and even citizens and their government.
The principal-agent problem is best described in game theory. It is simple. Agents cheat. Or at least that is the view of the principals. Agents are supposed to act for the benefit of their principals. Their economic incentives are for them to act for themselves. Anyone looking at the outrageous pay packages of investment bankers will see a perfect example.
It is not only in business. In government, the problem is especially severe. In almost any country with a vaguely free press, there are constant stories about government corruption. Even the most powerful dictator is not immune. All government leaders have to act through agents. Over time these agents, even in police states, will act for their own benefit.
The struggle between principal and agent is also very unequal for the simple reason that the agent has the information and the principal does not. This asymmetry of information means that the agent’s incentive is to spin, distort or even falsify the information in his favour. So all principals—including the most powerful dictator and every investor—have to assume that some of the information they receive is not accurate. 
Large swaths of any legal system are devoted to solving the principal-agent problem, especially in corporate law. But law is not the only disincentive. The markets also provide incentives and disincentives. Generally there are six categories that help control the actions of managers. Three are economic. They include: (1) Business failure. If the manager manages incompetently, the firm will go bankrupt. (2) The market for corporate control. If the manager fails in his duties, the company could be taken over or sold. (3) Direct managerial financial incentives. If the manager does well, he will be rewarded, if not fired. Three are legal. (4) Managerial duties. Most corporate codes impose certain duties, which can be enforced either by private individuals or the State. (5) Corporate governance oversight. This usually means oversight by a board of directors or something similar that have both the power and responsibility to control management. (6) Shareholder empowerment. Depending on the design of corporate structures, shareholders at least theoretically have the power to remove management. Often shareholders are too diverse and disorganised to exercise power although the so-called corporate raiders often fulfil this role.
Emerging markets including the Middle East and Gulf have special problems. The legal systems in these countries are still developing. Both laws and courts are often new and untested. Enforcement lacks expertise, sufficient budgets and is often uneven. Then there is the problem of corruption and government interference. In these situations, businesses rely less on law and more on trust. In these systems without strong rules, family firms and
state-owned firms predominate.
For investors, the problem is that the normal mechanisms of control basically don’t work. Although family-owned companies can go under, state-owned companies can’t. Neither state nor family-owned companies can be sold. Family-owned companies are usually managed by family members and state owned companies by political appointees. So neither can really be fired nor are they motivated by pure financial gain. Corporate codes might be enforced against family companies, but state-owned companies are usually exempt. Neither the family nor the state as majority owners are likely to use their shareholder votes to change directors or management. Management in these firms is also more likely to use their advantage over information to either limit or distort.  
Information is essential for investors, but the most important information is whether the information itself is true.

(The writer, William Gamble, is president of Emerging Market Strategies and can be contacted at [email protected]or [email protected]).

-- Sucheta Dalal