Chapter 14

Corporate Governance in
Transition
INTRODUCTION
HISTORICAL PERSPECTIVE OF CORPORATE GOVERNANCE
CORPORATE GOVERNANCE: A GLOBAL PERSPECTIVE
CONVERGENCE IN CORPORATE GOVERNANCE
CORPORATE GOVERNANCE IN MULTINATIONAL CORPORATIONS
SUMMARY
KEY TERMS
REVIEW QUESTIONS
DISCUSSION QUESTIONS
NOTES

INTRODUCTION
Corporate governance has evolved from its role in reducing agency costs to
maximizing shareholder wealth and now to the emerging role of creating
shareholder value and protecting the interests of all stakeholders. The
twenty-first century is viewed as the era of corporate governance in
transition from a compliance requirement to a business imperative. The
corporate governance structure in different countries is also influenced by
the country's cultural, political, and historical factors as well as the legal
and regulatory environment. This chapter presents both historical and
global perspectives of corporate governance.
PRIMARY OBJECTIVES
The primary objectives of this chapter are to

 Realize that corporate governance is evolving and the structure varies

across countries, industries, and companies.
  Understand the history of corporate governance.
 Identify and list the cross-country factors that differentiate corporate
governance structure across different countries.
 Identify the challenges of the global business and financial markets.
 Provide an overview of corporate governance worldwide.
 Recognize the initiatives taken during the past decade to improve
corporate governance worldwide.
 Identify the issues to be addressed to promote convergence in global
corporate governance.
 Provide an overview of corporate governance issues related to
multinational corporations.

HISTORICAL PERSPECTIVE OF CORPORATE

GOVERNANCE
Traditionally, discussion of the corporate governance concept was
introduced in the three-book series by Berle and Means during the time of
the formation of the SEC in 1933. During that period, the primary corporate
governance issue centered around the requirement of public companies to
establish infrastructures to address the need for a separation of powers
between the company's management (agent) and its shareholders
(principals).1 According to Tricker, early American businesses were formed
without limited liability provisions for shareholders, which exposed
shareholders to personal bankruptcy caused by poor management
performance.2
The creation of limited liability provisions for corporations, driven by
significant growth in the number of shareholders investing in public
companies in the early 1900s, caused more distance between shareholders
and management in terms of location, knowledge, and access to the
company's day-to-day operations. These developments demand an
oversight role of the board of directors, as representative of shareholders,
without much attention being given to corporate governance. Early
references to the term “corporate governance” are documented in a speech
by Clifford C. Nelson, the president of the American Assembly in 1978, who
defined corporate governance as “a fancy term for the various influences
that determine what a corporation does and does not do or should and
should not do.”3 These influences at that time were commonly referred to as
corporate infrastructures to separate power between management and
shareholders.
The legal view of corporate governance initially appeared in the report of
ALI in 1984 titled “Principles of Corporate Governance.”4 Jensen and
Meckling in their well-cited paper titled, “Theory of the Firm: Managerial
Behavior, Agency Costs and Ownership Structure,” address the potential for
struggle and conflict of interest between management and owners, and the
need for maintaining equilibrium between these parties.5 The ultimate
responsibility for maintaining an appropriate balance between
management and the owners rests with the board of directors to oversee
managerial functions and ensure protection of investors' interests. To
maintain such equilibrium, it is important to ensure the independence of
the board of directors from management and to improve the board of
directors' oversight function through effective corporate governance.
CORPORATE GOVERNANCE: A GLOBAL PERSPECTIVE
Corporate governance has evolved from its role in reducing agency costs
that arise from the separation of ownership and control in public
companies to maximize shareholder wealth to the emerging role of creating
stakeholder value. Nevertheless, corporate governance structure varies
across countries, industries, and even companies. Corporate governance
structure can be differentiated across countries in terms of the degree of
ownership and control. For example, the corporate governance structure in
the United States, the UK, and Canada is characterized by widespread
ownership, and thus, the fundamental conflict of interest is between
decision control (management) and ownership control (widespread
shareholders). In other countries such as Germany and Japan, the
ownership is concentrated in the hands of a few blockholders (e.g., banks,
organizations), and thus, the potential conflict of interest is between
controlling shareholders and minority shareholders. The corporate
governance structures in different countries are also influenced by the
country's cultural and historical factors as well as the legal, regulatory, and
institutional environments. All industrial countries have established
corporate governance standards, guidelines, and best practices, including
listing standards (United States), the TSX and Dey Commission (Canada),
The King Report (South Africa), the Cadbury Commission and the
Combined Code (UK), and the OECD (Europe).
Global corporate governance ineffectiveness can be traced to the 1980s and
1990s in several industrialized countries. In the United States, the financial
scandals of several prominent companies such as ZZZZ Best, Webtech,
Waste Management, Sunbeam, and Cendant, as well as the savings and
loan debacle, raised concerns about the credibility of corporate governance.
In the UK, the corporate failures of BCCI, Maxwell, and Polly Peck and
Barings were reported. Canada endured the business failures of Canadian
Commercial Bank and Caster Holdings and Roman Corporation. Other
European countries had their share of business failures such as Credit
Lyonnais, Metalgesellschaft, and Schneider. The East Asian financial crisis
in 1997 also raised concerns about the effectiveness of corporate
governance, the reliability of financial reports, and the credibility of audit
functions in Asian countries. Corporate scandals at the turn of the twenty-
first century further increased the emergence of corporate governance
reforms and interest in aspects of corporate governance. Today, corporate
governance stands at the forefront of organizational thought, influencing
such areas as business ethics, auditing, executive compensation, and
director independence. Corporate scandals worldwide have ensured that
corporate governance interest and reforms are a global issue and are not
confined to the borders of the United States.
Cross-country factors that differentiate corporate governance structures
across different countries can be classified into (1) legal infrastructure, (2)
regulatory environment, (3) information infrastructure, and (4) market
infrastructure.6 A country's legal infrastructure can significantly influence
the corporate governance structure including its principles, internal and
external mechanisms, and functions. It provides legal protection for
investors with the right to elect corporate boards, appoint management,
vote on important corporate decisions, demand reliable and transparent
financial information, and hold directors and officers accountable for
corporate affairs. The legal infrastructure defines the legal rights of
corporations and fiduciary duties of their directors and officers. In the
United States, state and federal statutes constitute the legal infrastructure
for corporate governance. The rule of law and order is vital to the
effectiveness of corporate governance. Academic studies indicate various
types of national laws that shape the structure of corporate governance,
including corporate law, tort law, and bankruptcy law.7 Corporate law plays
a vital role in corporate governance by determining how companies are
established, and in defining the rights of shareholders and fiduciary duties
of directors and officers.
Securities law, determined by federal statutes, is also important in
protecting investor interests and rights by setting minimum requirements
for companies offering securities to the public and presenting investors
with accurate, relevant, and useful financial information. Although
bankruptcy law may not play an important role in the way the company is
governed, it defines the rights of creditors, investors, and other
stakeholders and any settlement procedures in deciding whether to
liquidate or restructure an insolvent company. Corporate governance in
crisis situations, including hostile takeovers and bankruptcy, is vital in
protecting the interests of both equity holders and debt holders. Vigorous
enforcement of corporate law significantly influences the effectiveness of
corporate governance and the context to which internal and external
mechanisms are implemented and the legal rights of shareholders are
protected. Examples of corporate governance attributes affected by
corporate law are the company's formation, rights of its shareholders,
fiduciary duties of its directors and officers, financial reporting and
disclosures, proxy rights at its annual shareholder meetings, voting
procedures, rights of its foreign creditors and shareholders, and rights of its
minority shareholders.
The market infrastructure consists of rules, regulations, and best practices
of determining how capital markets function. Market infrastructure can
influence corporate governance structure and practices; listing standards of
organized stock exchanges; governing independence of a company's
directors, its board committees, and their responsibilities; shareholder
voting process; and financial reporting requirements. In an active
competitive market, corporations strive to survive by adopting the most
effective corporate governance mechanisms to maximize their value, and
those corporations with poor performance and ineffectual corporate
governance would be replaced. In this context, market competition is
viewed as significantly influential and shapes corporate governance with no
justification for public or governmental intervention. Market correction
mechanisms resolve corporate governance problems by monitoring and
disciplining corporations' performance and behavior in a competitive
market. Examples of these market correction mechanisms are the capital
markets, the managerial labor market, and the market for corporate
control. For example, if investors are not satisfied with the company's
performance, they can sell their shares, and when many investors follow
suit, the company's stock price drops and forces management to change
course. In another example, in a competitive labor market, managerial
performance is affected by management reputation and tenure in the labor
market. Inefficient and poor-performing corporations will be a target for
takeover.
Globalization and IT enable the development of the global business and
financial market with profound challenges for businesses and regulators to
protect investors worldwide. The speed with which financial transactions
can be conducted and money can be moved around the world encourages
regulators to establish a global financial infrastructure. The International
Monetary Fund, the World Bank, the Basel Committee for Banking
Supervision, the OECD, IOSCO, and U.S. regulations have taken initiatives
to improve global corporate governance and provide guidance and sources
of supervisory standards for national and international business and
financial markets. Thus, countries and their companies that conduct
business in global markets have to comply with global standards of
regulations and guidance provided by those organizations. However, global
best practices in corporate governance are emerging.
The corporate governance structure is shaped by the availability, efficiency,
and effectiveness of both internal and external mechanisms. These
governance mechanisms and their collective functions differ from one
company to another, one industry to another, and one country to another.
Specifically, each country has its own corporate governance structure
tailored to and suitable for its legal, political, cultural, and regulatory
environment, business practices, financial systems, and patterns of
business performance successes. A review of industrial countries suggests
four distinct global corporate governance structures of the United States,
the UK, Germany, and Japan. Others are seemingly derivatives of these
four structures. For example, the Canadian corporate governance structure
is similar to the UK's structure, whereas Dutch and Swiss corporate
governance structures are closely modeled after the German structure.
CORPORATE GOVERNANCE IN THE UNITED STATES
Under the free enterprise system in the United States, the capital markets,
including bond and equity markets, are an important source of funds for
corporations and play a significant role in their corporate governance.
There is a two-way relationship between corporations and the capital
markets. On the one hand, the capital markets provide funds to
corporations and thus monitor their corporate governance to align the
interests of management with the interests of investors. On the other hand,
corporations provide relevant financial information to the capital markets,
which facilitates the efficiency and liquidity of the capital markets. Thus,
applicable rules and regulations are designed to ensure the protection of
investors and facilitate the liquidity and efficiency of the capital markets.
These rules, regulations, and laws have become an integrated component of
corporate governance in the United States, which under Regulation Fair
Disclosure requires full and fair disclosure of financial information to all
investors, levels the playing field for all capital market participants, and
prohibits insider trading by using proprietary insider information about
company affairs. The SEC was created in 1934 in the United States to
protect investor rights by requiring public companies to provide fair and
full disclosures of their financial conditions and results of operations.
The market for corporate control through friendly and hostile takeovers in
the United States has shaped corporate governance as a disciplinary
mechanism, and improved the corporate governance structure of target
companies by disciplining underperforming managers. The wave of hostile
takeovers in the 1980s raised serious concerns about the possibility of the
concentration of financial power in the hands of major corporations, which
caused state and antitakeover legislators to respond to the mass of takeover
activities.8 Furthermore, public companies have implemented various
antitakeover charter provisions, such as poison pill provisions, to prevent
aggressive hostile takeovers.
The boards of directors in public companies in the United States are
considered as the essential overseers that have fiduciary duties of
overseeing and monitoring corporations' affairs as well as representing and
protecting shareholder's interests. The effectiveness of the boards of
directors in their advisory and oversight functions is highly debated and
adequately addressed in recent developments and initiatives of corporate
governance reforms in the post-Enron era in the United States. The
majority of CEOs of public companies in the United States also serve as the
chairman of their board, which creates both incentives and opportunities
for them to (1) actively dominate the selection of outside directors, (2) exert
influence over outside directors, (3) set an agenda for their board meetings,
(4) manage their board activities, and (5) entrench management by
facilitating inside directors' influence over outside directors.
CEOs and other senior executives in the United States usually have a more
autocratic management style than their counterparts in other countries,
particularly Germany and Japan, in the sense that they have more power
over decision making, decision control, and information.9 This makes the
monitoring of senior executives by the board of directors more difficult and
less effective in the United States than in other countries. Executives in the
United States also typically own shares in their companies and receive
compensation packages designed to relate their pay more closely to their
performance and to align their interests with those of shareholders. That is,
executive ownership and contingent compensation plans (stock options)
are intended to establish bonding devices to create shareholder value.
The basic premise underlying the U.S. capital markets has been that the
integrity, liquidity, and efficiency of the market depends on the reliability,
transparency, and accuracy of financial information disseminated to the
market by corporations. The capital markets are efficient in sorting out bad
financial information from good information. Corporate management is
required to provide fair and full financial disclosures. If management is not
fulfilling its financial reporting requirements, dissatisfied shareholders
start selling the company's shares. When many investors flow this path, the
company's stock price will fall, and management would be forced to change
course. However, this premise may not work in reality because (1)
individual investors do not own a substantial portion of a corporation's
outstanding equity; (2) individual investors are not actively involved in
managing their investment portfolios and monitoring the corporation's
affairs; and (3) institutional investors' equity holdings are often indexed,
which would not give them the incentives or opportunities to discipline
underperforming companies in a timely fashion.
Concerns about the responsibilities and effectiveness of corporate
governance of public companies in conducting legitimate transactions and
producing reliable financial reports grew in the 1970s and 1980s, with the
increased incidence of business failures and disclosure of questionable and
illegal payments. Congress responded to concerns over incidents of
misleading financial reports, bribes, and business failures in the 1970s by
passing the FCPA in 1977. The FCPA requires public companies registered
with the SEC to have sufficient internal controls to ensure that transactions
are authorized by management, and financial statements are prepared in
conformity with GAAP. The FCPA was one of the first pieces of legislation
that significantly affected the structure of corporate governance by
requiring the establishment and maintenance of internal accounting
controls.
A number of bank failures in the 1980s received the attention of Congress
to improve the corporate governance system at banks and savings and loan
associations. The GAO (now Government Accountability Office) reported
that insider abuse and fraud contributed to bank failures and that a lack of
effective corporate governance provided opportunities for fraud and
abuse.10 Thus, Congress responded by enacting the FDICIA. The FDICIA
requires that management and independent auditors of depository
institutions report on the adequacy and effectiveness of their ICFR. The
FDICIA also sets forth requirements for the existence, composition,
responsibilities, and functions of audit committees in large banks and
savings and loan associations. Under the FDICIA, boards of directors of
large financial institutions are responsible for determining when their audit
committee is in compliance with the independent requirements and
whether members of the committee have the necessary qualifications,
experience, financial literacy in banking, and related financial management
to discharge their responsibilities. Although the requirements and
provisions of the FDICIA were designed to improve corporate governance
at large financial institutions, they set standards and benchmarks for all
public companies, many of which are later addressed in SOX. SEC rules on
corporate governance have primarily addressed its role in protecting
investors through the requirements of proxy statement disclosures of
information to shareholders, including the company's board of directors'
composition, responsibility, executive compensation, and relationship with
its independent public accountants.
Corporate governance in the United States has traditionally been shaped by
state law as determined in the company's article of incorporation, charter,
and bylaws in defining fiduciary duties of its directors. Federal government
through its legislation (e.g., the Securities Act of 1933 and the Securities
Exchange Act of 1934) aimed at financial disclosures and processes also
influences corporate governance. The passage of SOX has significantly
increased the role of the federal government, although some of the
provisions of SOX could have been implemented through market-based
mechanisms (auditor independence, director independence, executive
compensation). Market-based mechanisms failed to correct the corporate
malfeasance and misconduct of the early 2000s. As a result, investors lost
confidence, and Congress passed SOX to restore investor confidence in
corporate America, its governance, and financial disclosures. In summary,
the corporate governance structure in the United States is influenced by (1)
state statutes defining shareholder rights and fiduciary duties of directors
and officers, (2) federal statutes establishing financial reporting and proxy
statements, (3) court decisions in interpreting state and federal statutes, (4)
listing standards of national stock exchanges, and (5) best practices. U.S.
corporate governance, its structure, and its functions are thoroughly
examined in Chapters 1 to 13.
An important question, have recent corporate governance reforms
including SOX caused a capital shift from U.S. capital markets to non-U.S.
capital markets?, has been recently raised. High compliance costs of SOX
have promoted companies to decide whether their capital financing should
come from U.S. capital markets or from capital markets abroad with a
possibly lower degree of strictness and disclosure requirements.
Globalization and technological advances have promoted tight competition
among the world's leading capital markets (e.g., NYSE, LSE, Hong Kong,
Shanghai, Dubai) and thus regulations governing these markets can have a
considerable impact on the balance of capital worldwide.
There are more than fifty stock exchanges worldwide that assist companies
to conduct their IPOs. Stock exchanges in India, Italy, and South Korea
have recently attracted many domestic IPOs, and many state-owned
enterprises in China and France have done their fundraising domestically
and have listed their IPOs on their home exchanges. Companies have
traditionally listed on their domestic stock exchanges, and only about 10
percent of companies have chosen to list abroad.11 Indeed, in the first half of
2006, only 8 of the 110 IPOs in the United States listed abroad, of which 6
listed on London's Alternative Investment Market (AIM), raising $323
million in total. Thus, this perception that the high compliance cost of SOX
has forced U.S. companies to list their IPOs overseas is not warranted, and
the fact that smaller foreign companies choose to go public in their
domestic exchanges provides no justifiable evidence about the global
competitiveness of U.S. capital markets. Nonetheless, best practices of
corporate governance in the U.S. suggest that
1. Investors pay a premium for companies with effective corporate
governance.
2. Companies with effective corporate governance and shareholder
rights marginally outperform those companies with weak corporate
governance and investor rights.
3. Companies with effective corporate governance tend to benefit more
from regulations and rules than those with weak governance
primarily because of compliance costs.
4. Effective corporate governance improves market liquidity and
reduces share price volatility.
Technological advances and global competition have enabled companies
and their investors to “largely meet in the jurisdiction of their choosing….
[They] have choices about where to invest, where to raise capital and where
secondary trading is to occur.”12 Thus, companies can choose the regulatory
regime they desire to operate under, and investors have a choice of
safeguards and protections provided under different regulatory reforms.
Effective regulatory reform creates an environment under which companies
can achieve sustainable performance, be held accountable for their
activities, and provide protections for their investors. Regulatory reforms in
terms of their effectiveness and context can be classified into three concepts
of (1) a race to the bottom, (2) a race to the top, and (3) a race to optimality.
The “race to the bottom” concept suggests that global securities regulators,
in an effort to attract issuers, deregulate the points that provide issuers with
maximum flexibility for their operations at the expense of not providing
adequate protections for investors. The “race to the top” concept suggests
that global securities regulators provide maximum protection for investors
through rigid regulations and highly scrutinized enforcement at the
expense of putting companies in the global competition at a disadvantage
with non-cost-justified regulations. The “race to optimality” concept is a
hybrid of the first two concepts, in which both issuers and investors prefer a
regulatory regime and jurisdiction that provide cost-justified investor
protection.
In real-world global competition, a combination of these three concepts
may work best because many provisions of SOX have been globally
adopted, particularly those pertaining to strengthening auditor
independence, assessment of ICFR, the creation of an independent board to
oversee the accounting profession, and the strengthening of audit
committee requirements. Table 14.1 presents major provisions of SOX that
have reinvigorated regulatory reforms in other countries, suggesting that
regulations around the world are converging toward the key provisions of
SOX. These globally adopted provisions of SOX should promote integrity
and efficiency in cross-border financial markets rather than cause
competition disadvantage for U.S. financial markets and U.S. companies.
CORPORATE GOVERNANCE IN THE UNITED KINGDOM
The BCCI debacle in the late 1980s in the United Kingdom encouraged the
Cadbury Committee to examine accountability of boards of directors of
public companies to their shareholders and society.13The committee issued
its report in 1992, titled “Report of the Committee on the Financial Aspects
of Corporate Governance.” The Cadbury Report and related Code of Best
Practices made recommendations for improving corporate governance, the
oversight function of the board of directors, corporate accountability, and
financial reporting. Subsequently, the Greenbury report in 1995 addressed
director remuneration and its disclosure in companies' annual reports, and
the Hempel Report in 1998 examined corporate governance for UK
companies. The work of these three committees was collaborated in the
Combined Code on Corporate Governance (Combined Code) in 2003 and
adopted by the LSE and incorporated into its Corporate Governance: A
Practical Guide in 2004.14 The 2003 Combined Code made
recommendations for improving the corporate governance of UK public
companies and their financial reporting process. The Combined Code
recommends, and the LSE requires, that the annual reports of UK-listed
companies contain a report from the remuneration committee and a
statement of corporate governance, directors' responsibilities, internal
controls, and going-concern status.
Table 14.1 SOX Global Reach
Sources: Tafara, E. 2006, September. Statement by SEC Staff: A Race to the
Top: International Regulatory Reform Post Sarbanes-Oxley. International
Financial Law Review. Available
at: www.sec.gov/news/speech/2006/spch091106et.htm: Downes, D.
Revised 8th Directive, approved by Council of the EU. Accountancy
Ireland 38.3 (June 2006): 28(2).
The Financial Reporting Council (FRC) in the UK released a revised
Combined Code on Corporate Governance by incorporating many
recommendations of previous reports issued by Derek Higgs and Sir Robert
Smith.15 All companies incorporated in the UK and listed on the LSE are
required to report on whether and how they are applying the Combined
Code. The Combined Code is composed of both principles and provisions
that should be complied with by listed companies. The Combined Code as
of July 2003 contains the code, its principles and provisions, and related
guidance, including the Turnbull guidance on internal control, the Smith
guidance on audit committees, and the Higgs report on best practices. The
Combined Code is composed of fourteen main principles, twenty-one
supporting principles, and forty-eight detailed provisions.
Companies listed on the LSE must include in their annual report (1) a
narrative statement of how they have applied the principles of the
Combined Code; (2) a statement as to the extent to which companies have
complied during the reporting period with the provisions of the Combined
Code; and (3) for companies that have not complied with any provisions of
the Combined Code, complied with only some of the provisions, or
complied with the provisions for only part of the reporting period, a report
specifying the Combined Code provisions with which they have not
complied, if applicable for what part of the reporting period, and reasons
for any noncompliance. The 2003 UK Combined Code and the LSE listing
rules do not prescribe any form or content for the annual statement of how
the listed companies have complied with various provisions of the code to
provide flexibility to companies to tailor the code provisions into their
corporate governance policies and processes.
The UK Combined Code describes the responsibilities of the companies'
boards of directors which are to
1. Provide entrepreneurial leadership to the company in the context of
adequate and effective controls to assess and manage prudent
business risk.
2. Establish the company's strategic activities relevant to its financial
and human resources and ensure the company's objectives are met
and its management performance is reviewed.
3. Set the company's values and standards and ensure its obligations to
shareholders and other stakeholders are understood and met.
The role of independent, nonexecutive directors, regardless of the type of
corporate governance system (unitary, two tier, or oversight), is to oversee
the development of the company's strategy and monitor executives'
activities. There should be a balance between these two roles of
independent directors in the sense that placing too much emphasis on
strategic development makes nonexecutive, independent directors closer to
executive directors at the risk of undermining stakeholder confidence in the
effectiveness of the board. Overemphasizing the monitoring role may result
in resistance and resentment from executive directors, causing a lack of
cohesiveness and camaraderie.
Outside directors may assume the following responsibilities:
1. Develop, or participate in the development of, strategies.
2. Monitor the performance of management in achieving the company's
goals and objectives.
 3. Oversee the integrity, reliability, quality, and transparency of
financial reporting as well as the adequacy and effectiveness of ICFR.
4. Determine the level of remuneration of inside directors and senior
executives, and appoint and remove inside directors.
The major provisions of the Combined Code are
1. The board should meet regularly to effectively fulfill its duties.
2. Directors should release accurate, timely, and clear information.
Although management should provide such information, directors
should seek clarification and amplification.
3. The chair of the board should ensure that directors continuously
update their knowledge, skills, and familiarity with the company.
4. The chairperson should discuss governance and strategy with major
shareholders and ensure that their views are communicated to the
board.
5. The chairperson should meet with nonexecutive directors in executive
sessions without the executives present.
6. The board should annually evaluate its own performance, its
committees, and individual directors.
7. The positions of the chair of the board and the CEO should be
separated.
8. Directors' concerns about the running of the company or unresolved
proposed actions should be recorded in the board minutes.
The LSE Practical Guide to Corporate Governance requires listed
companies to include a statement in their annual report indicating their
compliance with the Combined Code. Such a statement must include
1. Types of decisions that are to be taken by the board and those that are
to be delegated to management
2. Reporting responsibilities of the board regarding the preparation of
accounts
3. The number of meetings of the board and its committees and the
individual attendance of directors
4. The board responsibilities for conducting a review of the effectiveness
of the group's system of internal controls
5. Performance evaluation of the board, its committees, and individual
directors
6. Proper justifications when the offices of the chair of the board and the
CEO are not separated
7. Major board committees (e.g., audit, nominating, compensation) and
their roles and responsibilities
8. The terms and conditions of appointment of nonexecutive directors
 9. Remuneration consultants' other connections with the company
10. Explanations of how external auditor objectivity and
independence is safeguarded when the auditor provides nonaudit
services
11. When the board does not accept the audit committee's
recommendation on the appointment, reappointment, or removal of
the external auditor, a statement from the committee explaining its
recommendation and the reasons why the board has taken a different
position
12.The steps taken by the board to ensure its directors, particularly
nonexecutive directors, develop a sufficient understanding of the
views of major shareholders about the company16
U.S. corporate governance reforms clearly separate the board's oversight
function from management's managerial functions, whereas under the UK
Combined Code directors are responsible for preparation of financial
statements and review of internal controls. Unlike the board of directors of
public companies in the United States, the board of UK companies is
usually composed of independent, nonexecutive directors, and the CEO
does not typically assume the position as the chairman of the board. Like
CEOs in the United States, CEOs in UK corporations possess the ultimate
power over information flow, which may cause a concentration of decision
making in the hands of CEOs. Senior executives, including CEOs, can own
shares in their companies, which in turn can provide incentives for them to
align their interests with those of shareholders. In UK companies,
contingent executive compensation plans (performance bonuses, stock
options) are often used to link executive incentives with company
performance. These plans, however, are established and administered
under the control of senior executives, which makes it difficult to assess the
effectiveness of compensation plans in contributing to the creation of long-
term shareholder value.
The UK approach to corporate governance reforms is more principles
based, which requires companies to “comply or explain why not.” This
flexible approach to corporate governance, coupled with the fact that UK
shareholders are in a much stronger position than their U.S. shareholders
to nominate directors and forward their resolutions, has recently made the
UK capital market more attractive to global IPOs. Different types of
corporate governance structure are exposed to different financial
misconduct and scandals. For example, a dispersed ownership system of
governance in the United States is prone to earnings management schemes
(e.g., Enron, WorldCom), whereas concentrated ownership systems are
more vulnerable to the appropriation of private benefits of control (e.g.,
Parmalat).17
UK convergence measures that are usually more stringent than U.S.
reforms are the requirements for (1) nonexecutive directors to meet at least
once per year to evaluate their performance; (2) independent nonexecutive
directors to compose at least 50 percent of the board, not including the
chair; (3) shareholders' approval of new corporate arrangements and
changes; (4) mandatory preparation of a corporate governance report,
along with a statement of compliance with provisions of the Combined
Code; (5) an executive session of the chair of the board with the company's
nonexecutive directors, without the company's executive directors present;
(6) the separation of the positions of CEO and chair of the board; (7) the
availability of a senior independent director to any shareholders to express
concerns not addressed by the company's officers; (8) directors'
responsibility for the preparation of financial statements and the review of
ICFR; (9) a shareholder advisory vote on executive compensation; and (10)
annual ratification of the independent audit form by shareholders.
CORPORATE GOVERNANCE IN GERMANY
German corporate governance is influenced by its legal environment, the
perception that corporations should act in the best interests of their
shareholders and other stakeholders, and the importance of internal
mechanisms and relationships to ensure corporate governance
effectiveness.18 Employees play an important role in German corporate
governance by actively participating and representing in the corporate
boardroom. German corporate governance is characterized by the two-tier
board of director system, which creates different rights and obligations for
directors of each board as specified in the German Stock Corporation Act
and the German Corporate Governance Code.
The German two-tier board of directors system consists of the management
board and the supervisory board. The management board is responsible for
managing the company for the benefit of a variety of stakeholders, whereas
the supervisory board oversees the management board. Directors of the
supervisory board are elected by the shareholders at the annual meeting,
and the supervisory board then appoints the directors of the management
board. The three major oversight functions of the supervisory board are to
(1) appoint and, when necessary, dismiss the directors of the management
board; (2) determine remuneration of members of the management board;
and (3) oversee the work and performance of the management board by
regularly receiving reports from the management board without giving
specific instructions to its members on how to run the company.
The supervisory board consists of representatives from the following four
groups of influential stakeholders: (1) shareholders—both individuals and
other corporations that typically own large blocks of stock and often have
the power to veto important decisions; (2) wealthy families, typically
relatives of the company's founder; (3) financial institutions, mostly large
commercial banks (e.g., Comerz Bank, Deutsche Bank, Dresdner Bank,
Hypo Vereinsbank); and (4) employees, who often make up half of the
representatives of the supervisory board. The dual responsibilities of
members of the supervisory board to act in the best interests of the
company while securing the interests of their own constituencies may
create conflicts of interest within the supervisory board that can potentially
influence its oversight effectiveness of the management board.
The market for corporate control in Germany is not as effective as it is in
the United States in the sense that although friendly takeovers are often
practiced, the occurrences of hostile takeovers are rare. There are several
reasons for the inactive market for corporate control in Germany,
particularly as it relates to hostile takeovers. First, German banks usually
own or control a large portion of the outstanding shares of public
companies, and by nature, they stand against hostile takeover bids. Second,
voting limitations in corporations' bylaws discourage hostile takeovers.
Finally, inadequate financial disclosures and a lack of transparent financial
reports make the assessment of the actual and potential values of target
companies difficult and inaccurate, which reduces opportunities for hostile
takeovers.
In Germany, there has been a lack of equity capital in the sense that capital
is provided in the form of debt from large banks. Banks are actually
involved in investing in and monitoring public companies, and laws are
established to provide protection for banks. Thus, the lack of active
participation by the capital markets in monitoring and disciplining public
companies is largely compensated by the monitoring exercised by banks.
German banks also provide long-term lending to corporations and, through
the lending process, perform consulting services. German banks can often
influence public companies' corporate governance in three different ways:
(1) as shareholders, by owning a substantial portion of corporations'
outstanding shares; (2) as lenders, by lending long-term funds to
corporations; and (3) by participating in the so-called deposited share
voting right by banks assisting shareholders who deposited their shares in
banks on how to vote.
Managerial share ownership and contingent compensation plans are rarely
used in the German corporate governance structure as a motivation or
bonding device to align management interests with those of shareholders.
Internal labor markets in Germany play an important role in monitoring
managerial decisions because, for large companies, half of their supervisory
directors are employees. Nevertheless, the external labor market in
Germany is not as effective as it is in the United States and UK. The
German Corporate Governance Code adopted in February 2002, allows
duality of the board in German companies, commonly referred to as the
two-tier board structure.19
The German code of corporate governance has traditionally provided
protection to creditors, particularly banks, controlling families, and labor.
There has been a lack of protection for investors, and the supervisory board
has not been very effective in providing adequate oversight of the
management board. However, two recent laws, namely, UMAG and Kap-
MuG, were established to promote protection for German shareholders.
KapMuG is aimed at penalizing companies that mislead investors by
allowing groups of ten shareholders to collectively bring class action
damages claims against companies that have provided false, misleading, or
incomplete financial information.20 UMAG is a broader law that makes it
easier for shareholders to vote their shares by eliminating the previous
requirement that shares be deposited when shareholders register for a
company's annual meetings, and instead only requiring that they own
shares on a specified date before the annual meeting. The two laws are
intended to enhance shareholder democracy in Germany and provide
protection for investors.
CORPORATE GOVERNANCE IN JAPAN
In Japan, the business structure is shaped and business practice is
dominated by networks of organizations called keiretsu. Banks in Japan
play an important role in the keiretsu system by (1) investing up to 5
percent allowed under the law in the group companies (practically in each
of the individual companies and in the group companies), (2) lending to all
companies within the group, and (3) assisting nonfinancial companies in
obtaining and providing substantial amounts of trade credit to the group
companies.21 Because the majority of outstanding shares (up to 90 percent)
are in the possession of keiretsu-affiliated financial institutions or keiretsu-
affiliated nonfinancial companies, the individual investors do not have
much of a voice in corporate governance. Furthermore, the major shares
owned by the keiretsu group are considered stable shareholdings, which
make takeovers almost impossible unless engineered by the keiretsu-
affiliated financial institutions to discipline or prevent poor performance by
an affiliated company.
The cultural and political environment in Japan today encourages
individual investors to place their savings in banks rather than to directly
invest in the capital markets by owning shares of a company's stock. This
pattern has allowed for the enlargement of banks and for banks to become
the main suppliers of capital for Japanese corporations. Lack of public
policy support for the capital markets, more stable shareholdings, less
liquidity in the capital markets, a lack of insider trading laws, and a lack of
full financial disclosures discourage investing in the Japanese capital
markets by individual investors; thus, there is no active role for the capital
markets to monitor corporations' governance. However, extensive
monitoring by keiretsu-affiliated institutions compensates for the lack of
monitoring by the capital markets and the market for corporate control. A
well-established relation between banks and corporations has been an
important corporate governance mechanism to improve company value.
This relation encourages management to observe guidelines established
by keiretsu-affiliated banks and banks to not interfere directly in the
management of the group corporations as long as their performance is
satisfactory.
Boards of directors in Japanese corporations are primarily composed of
insiders who are usually top executives of companies with no outside
directors representing small individual investors.22 That is, boards of
directors do not typically have a monitoring function. The president of a
Japanese company is equivalent to the CEO of a U.S. company with
managerial power to make decisions, whereas the position of the chairman
of the board is more or less symbolic, with not much decision management
or decision control. Managerial decision making in Japanese corporations
is more of a participative decision process, where lower managers provide
input through a consensus-building process. This consensus decision-
making process creates a collegial environment with a high potential for
mutual monitoring. Thus, consensus building, a collegial atmosphere, and
mutual monitoring are important corporate governance mechanisms in
Japanese corporations. Stock ownership and contingent compensation
plans (stock or stock options) are not commonly used as incentive plans for
top Japanese executives, whereas bonuses linked to performance are
effectively used to motivate higher performance by executives.
External labor markets, similar to U.S. capital markets, do not play a
significant role in the corporate governance of Japanese corporations.
Nevertheless, the internal labor markets are efficient because employees
tend to stay in one corporation throughout their working life. Corporations
reward and promote high-performance employees, and employees are
viewed as important stakeholders who are also entitled to the residual value
created by the company. The participation of employees in profit sharing,
decision making, and lifelong employment in the company have been
effective corporate governance mechanisms in reducing the potential
conflicts of interest between employees, management, and shareholders. In
2006, Japan took several initiatives to improve the infrastructure of its
capital markets by (1) establishing a cross-sectional framework of a wide
range of financial instruments and services (e.g., broadening the definitions
of investment schemes, including financial instruments); (2) strengthening
the quality of independent audits of financial statements; (3) enhancing
protections for investors; (4) improving disclosures through quarterly
reporting; (5) reporting to management and auditors on internal controls;
(6) providing for self-regulatory structures; and (7) increasing penalties
against market fraud.23
CORPORATE GOVERNANCE IN OTHER COUNTRIES
Corporate governance worldwide has recently made significant progress.
After many decades of European and American domination of global
markets, trades and investments are now flowing between the Middle East
and Asia. With oil prices riding high, Middle Eastern countries and their
investors and companies have funds to invest, and Asian countries have the
capability to attract such investments. It is inevitable that governments in
both Asia and the Middle East will create a more hospitable business and
investment climate for investments to reach their global potential. The
following pages discuss corporate governance in other countries, including
Canada, Singapore, and Australia, which have more worldwide relevance.
1. Corporate governance in Canada. In Canada, in 1994, the Dey
Committee recommended fourteen best practice guidelines for
corporate governance, including the suggestions that the majority of
directors be independent and that there be a separation of the roles of
chairman of the board and CEO.24 The Dey Committee, in 2003, urged
that the voluntary corporate governance guidelines be made
mandatory for companies listed on the TSX.25 The Joint Committee
on Corporate Governance was established by the Canadian Institute
of Chartered Accountants, the TSX, and the Canadian Venture
Exchange to conduct an ongoing examination of corporate
governance issues in Canada. The Joint Committee, in November
 2001, issued its final report titled, “Beyond Compliance: Building a
Governance Culture,” which recommends changes to several TSX
guidelines for corporate governance, and requires additional
disclosure requirements.26 The TSX requires that its listed companies
incorporated in Canada to disclose on an annual basis a Statement of
Corporate Governance Practices, which describes the company's
system of corporate governance, its comparison with each of the TSX
guidelines, and proper explanation of any differences or their
inapplicability. Thus, there is no formal requirement that a company's
governance procedures conform to the TSX corporate governance
guidelines, only the description of the system and any discrepancies.
Unlike U.S. public companies whose ownership is widely held and
significantly dispersed across a large number of investors, Canadian
companies' ownership is less widely held and less widely dispersed.
2. Singapore code of corporate governance. The Singapore code
of corporate governance (the Code) was developed in March 2001 by
a private sector committee appointed by the government and the
corporate governance committee, and was issued by the Ministry of
Finance in July 2005. All listed companies on the Singapore
Exchange are required to describe in their annual reports corporate
governance practices in compliance with the Code or any deviations
from the Code.27 Like the UK Combined Code, the Singapore code of
corporate governance has a unitary board system that requires all
directors to share responsibility for both the direction and the control
of the company. That is, the company's board of directors and
management are the same, as opposed to the board of directors in the
United States that has oversight responsibility or to a two-tier board
system in Europe where the supervisory board has oversight of a
management board. Similar to UK Corporate Governance Combined
Code, the Singapore code has fifteen “principles” and fifty-five
“guidance notes” in four major categories of board matters,
remuneration matters, accountability audit, and communication with
shareholders. Compared to the UK Combined Code, the Singapore
code has “guidance notes” instead of “provisions.” The Singapore
code is considered a voluntary code in the sense that the listed
companies are required to comply with the code or explain
noncompliance.
CONVERGENCE IN CORPORATE GOVERNANCE
The word “convergence” as used in the literature means the process of
moving toward a set of common objectives and principles.28 In accounting,
it has been used as the process of minimizing differences between the
national accounting standards, for example, U.S. GAAP and IFRS, in an
attempt to adopt a set of global uniformly accepted accounting principles
(GUAAP). Financial scandals of the early 2000s were not unique to U.S.
companies. The revelation of global financial scandals encouraged
regulators worldwide to recognize the need to address global corporate
governance deficiencies and work together to improve the quality,
reliability, and transparency of global financial reports.
Several initiatives have been taken during the past decade to improve
corporate governance worldwide. Many of these initiatives are primarily
national. There is no globally accepted set of corporate governance
principles or global regulatory framework that governs corporations, global
financial institutions, or capital markets worldwide. Regulators in the
United States, the SEC, IOSCO, and the World Federation of Exchanges
(WFE) have yet to agree on a global regulatory framework or a global
corporate governance structure. The OECD's international standards of
corporate governance have not achieved global acceptance to be included in
the global regulatory framework.
The corporate governance debate in the United States started in the 1970s
and received broader acceptance on the publication of the ALI's Principles
of Corporate Governance in 1994.29 Corporate governance became part of
the UK business process pursuant to the issuance of the Cadbury Report on
the financial aspects of corporate governance.30 The Cadbury Report
provided guidance only on the financial elements of corporate governance
and applied to companies listed on the LSE. The Commission of European
Communities suggests that the EU should actively coordinate the corporate
governance efforts and reforms of its member states. This coordination
should require each member state to (1) identify its corporate laws,
securities laws, listing rules, codes of conduct, and best practices; (2) make
progress toward designating a code of corporate governance, intended for
use at the national level, with which listed companies should comply or
disclose noncompliance; (3) coordinate its code or corporate governance
with other member states; and (4) participate in the coordination process
established by the EU.31 European corporate governance initiators require
separation of the positions of chairperson of the board and the CEO. U.S.
corporate governance reforms, however, do not require the separation of
the positions.
Many countries have established corporate governance reforms to improve
the quality of public information and the integrity of their capital markets.
A review of global corporate governance reforms suggests three distinct
governance reforms. First, corporate governance reforms in the United
States and Canada are shaped primarily by market mechanisms and best
practices with adequate oversight regulatory roles taken by governmental
agencies (both state and federal). Second, corporate governance reforms in
the UK and Australia are influenced primarily by market participants with
some regulatory compliance. Finally, corporate governance reforms in
France, Germany, and Japan are shaped primarily by the regulatory
framework designed by the central government. Several issues need to be
addressed to promote convergence in global corporate governance. The
first and most important issue is whether corporate governance principles
and provisions should be mandatory as a set of rules that all companies
must comply with as opposed to recommendations and disclosure practices
that require companies to disclose whether and how they complied with
recommendations. This issue should be addressed in determining what
approach will prevail in global corporate governance. In the United States,
emerging corporate governance reforms are regulated either by Congress
and regulators or mandated by national stock exchanges. Corporate
governance reforms in other countries (the Cadbury Report and the
Combined Code in the UK) are mostly in the context of recommendations
for best practices encouraging compliance rather than being imposed on
corporations.
The second issue is the rules-versus principles-based approach to corporate
governance convergence. The United States uses a rules-based approach,
whereas other countries, such as the UK, promote the principles-based
approach. The American approach is viewed as rules based in the sense that
SOX and SEC-related rules, as well as requirements of national stock
exchanges and best practices of corporate governance advocated by
professional organizations, all provide quantitative corporate governance
measures. These quantitative measures are designed to legislate and
standardize proper business conduct and business ethics. Although these
measures are necessary to provide guidance for promoting effective
corporate governance, they may not be adequate to achieve the intellectual
honesty needed to restore public trust and investor confidence in corporate
America. Thus, the principles-based corporate governance approach of
focusing on more qualitative measures is needed to ensure corporate
governance participants are acting in the best interests of the company and
its shareholders. In the case of Enron, its corporate governance met many
of the quantitative corporate governance measures (e.g., audit committee,
outside directors, internal audit function, independent auditors); however,
it lacked the qualitative measures of intellectual honesty, ethical corporate
culture, due diligence, good faith, and transparency.
U.S. corporate governance is traditionally geared toward increasing
shareholder value with little focus on protecting the interests of other
stakeholders. Thus, until recently, there was no guidance as to how the
board should treat stakeholders other than shareholders. Modern corporate
governance emphasizes both financial aspects of governance in increasing
shareholder value and an integrated approach that considers the rights and
interests of all stakeholders. Corporate governance should be viewed as a
dynamic and integrated approach of addressing financial, social,
environmental, and economic concerns of all stakeholders.
The principles-based approach to corporate governance is viewed by many
to be more effective than the rules-based approach for several reasons.
First, the principles-based approach is more flexible and relies on the
professional judgments and professionalism of corporate governance
participants to preserve the integrity, effectiveness, and quality of the
system. Second, global corporate governance mechanisms are moving
toward the principles-based approach of corporate governance and focus
more on both qualitative measures (due care, due diligence, good faith,
ethical conduct, straight thinking) and quantitative measures
(independence, outside directorships, financial experts, inside ownerships,
number of directors, rules, requirements) than a rules-based approach. As
rightly stated by SEC Chairman William Donaldson, “[A] ‘check the box’
[rules-based] approach to good corporate governance will not inspire a true
sense of ethical obligation. It could merely lead to an array of inhibiting,
‘politically correct’ dictates.”32 These principles-based approaches are very
broad and comprehensive without specifying rules in terms of the number
of independent nonexecutive directors and their term limits, but they are
steps in the right direction in improving accountability and reinforcing
investors' rights. It appears that convergence would be more feasible when
countries agree on the principles-based approach rather than having to
reconcile voluminous and often irreconcilable rules.
The third issue is the consensus on the primary purposes of global
corporate governance. The primary goal and focus of corporate governance
in the United States is on the creation and enhancement of shareholder
value, whereas in some other countries the protection of interests of all
stakeholders is the main goal. Convergence would be possible if all nations
agreed on the primary purpose of corporate governance as the
enhancement of shareholder value while protecting the interests of other
stakeholders.
One should not expect that convergence in corporate governance will be
possible for all provisions of corporate governance. Some provisions that
have already been converged or are good candidates for convergence are (1)
director independence where the majority of directors should be
independent; (2) the audit committee financial expertise requirement; (3)
the oversight responsibility of the audit committee to appoint, compensate,
dismiss, and monitor the work of independent auditors; and (4) board
committees and their oversight responsibilities (audit, compensation, and
nomination).33 Major differences that make convergence more difficult are
(1) CEO duality, where in many countries the position of the CEO and the
chairperson of the board are required to be separated, whereas there is no
such requirement in the United States; and (2) the independence
requirement for the majority or all members of various board committees.
The commission encourages the coordination and convergence of national
codes of corporate governance through high-level meetings of the European
Corporate Governance Forum typically chaired by the commission and
participation of representatives from all member states, European
regulators, investors, issuers, and academics. Technological advances and
globalization have developed to the point that, as pointed out by Tom
Friedman, the world is made “flat.”34 In a flat world, cross-border
investments are common as investors consider global markets in making
investment decisions. Regulators worldwide have collaborated to improve
the effectiveness of global corporate governance. First, the SEC has been
very active in developing financial dialogue with its counterparts in the EU.
The United States and EU should establish better cooperative efforts in
promoting the development of a principles-based regulatory framework
that is sensitive and responsive to different cultures, histories, political and
legal regimes, economic systems, and regulatory philosophies. Second,
economic developments in Asia, particularly China and India, will soon
have unprecedented effects on the global economy, financial markets, and
cross-border investments. The SEC and the Japanese Financial Service
Agency have had continuous dialogue to enhance the quality of regulatory
discussions and participation in the U.S.-Japan Financial Services Working
Group to discuss financial sector developments in both countries.35 Third,
SEC Chairman Cox, along with Treasury Secretary John Snow and Federal
Reserve Chairman Alan Greenspan, have participated in a U.S.-China Joint
Economic Committee to discuss with their counterparts a range of policy
issues and regulatory matters relevant to financial markets in both
countries and possible collaboration initiatives. Table 14.2 shows the
diversity of corporate governance attributes across countries. The following
issues should be resolved to facilitate global convergence in corporate
governance:
Table 14.2 Corporate Governance Attributes Across Countries
1. The Board System
1. Unitary board system where the board of directors and
management are the same (e.g., Singapore board system).
2. Two-tier board system where there are two boards, supervisory
and management, and the supervisory board has oversight over
the management board. The European two-tiered model of
corporate governance consists of an executive board and a
supervisory board. The executive board is composed of senior
executives and inside directors, and is primarily responsible for
managing the company. The supervisory board, however, is
typically composed of outside directors who represent
shareholders, employers, and lenders, and, appoints and
oversees the activities of the executive board.
3. Oversight board system where the board of directors appoints
management and oversees its activities (United States).
2. Compliance with the Code
0. Voluntary compliance where the listed companies are required to
comply with the code or explain noncompliance. That is, one size
does not fit all, no single model for all listed companies. The listed
companies should tailor their corporate governance practices to their
circumstances and choose the best-suited practices. The company
 should view the code as benchmarks and suggestions for good
governance practices and justify noncompliance, whereas
unjustifiable deviations from the code are penalized by the capital
markets (Singapore Code).
1. Compulsory compliance where the listed companies are
required to comply with the code and noncompliance will be
penalized. The U.S. compulsory compliance approach permits
no flexibility, which presents a one-size-fits-all approach to
corporate governance.
3. Corporate Governance Approach
0. Rules-based approach to corporate governance where corporate
governance reforms and listing standards are very rigid and
applicable to all listed companies, detailing requirements for
compliance and prescribed to a set of rules.
1. Principles-based approach to corporate governance where
corporate governance principles establish benchmarks and
norms for good governance practices but companies establish
their own corporate governance rules tailored to their
circumstances with adequate flexibility to set their own rules.
This approach may create more room for manipulation and
even noncompliance with minimum standards.
4. Director Independence
0. At least one-third of the board should be composed of
independent directors (Singapore code).
1. The majority of the board must consist of independent directors
(U.S. listing standards).
2. At least half of the board, excluding the chairman, must consist
of independent directors, whereas for smaller companies at
least two independent directors should be on the board (UK
Code).
5. Tenure and Time Commitment Two three-year terms as a norm
for outside directors and any term beyond six years subject to
extensive reviews.
Convergence in corporate governance is possible when all nations agree on
(1) a common goal of corporate governance to create long-term shareholder
value while protecting the interests of other stakeholders, and (2) a set of
mandatory corporate governance principles where consensus and
reconciliation are feasible. Reconcilable corporate governance principles
are (1) the majority of directors must be independent, nonexecutive
directors; (2) members of the audit, compensation, and nomination
committees must be independent; (3) nonexecutive, independent directors
do not receive compensation or fees other than their director fees; (4) the
audit committee, composed of truly independent directors, oversees
financial reporting, internal controls, and audit activities; and (5) the audit
committee is directly responsible for the appointment, retention, and
compensation of the external auditor. The most important step in the
convergence process is the statutory power to implement and enforce the
globally accepted corporate governance principles, rules, or best
practices. Table 14.2 presents attributes of corporate governance across
countries. Different nations have different enforcement processes, statutory
powers, and criminal sanctions for the violation of corporate governance
principles.
CORPORATE GOVERNANCE IN MULTINATIONAL
CORPORATIONS
Multinational corporations (MNCs) play an important role in the world
economy and in trade. As the number of MNCs increases and they continue
to be more important to the world economy and trade, their corporate
governance becomes essential in aligning the interests of their
headquarters with those of subsidiaries, which usually have divergent
political, economical, cultural, and environmental interests. IAS No. 27
states that a parent-subsidiary relationship arises when one enterprise (the
parent) is able to control another enterprise (the subsidiary) in which
control is defined as the power to govern the operating and financial
policies of the subsidiary, or the ability to influence substantially the
subsidiary's decisions.36
In purely domestic corporations, corporate governance mechanisms are
designed to align the interests of management and shareholders that arise
from the separation of ownership and control. In a multinational
corporation, corporate governance mechanisms are designed not only to
align the interests of subsidiaries with those of the parent company, but
also to align the interests of the management of the parent company with
the interests of both its majority and minority shareholders. Thus, the
potential conflicts of interest between the subsidiaries and the parent
company and the parent company and its shareholders create agency costs.
In an MNC, a parent company can be both an agent and a principal: an
agent in relation to its own shareholders, and a principal in relation to its
subsidiaries, with shareholders of the parent company being the ultimate
residual risk-bearing owners (principals). Thus, the agents should be
monitored, controlled, and bonded through a set of contracts that are costly
to write and enforce in order to align their interests with the interests of
shareholders.
In the absence of interest alignment, the management of subsidiaries may
make decisions to maximize their own interests, which may be detrimental
to the long-term performance of the parent company. Likewise, the
management of the parent company may make decisions that result in
reducing shareholder value. Thus, the nexus of contracts to reduce agency
costs constitutes the corporate governance structure between the parent
company and its subsidiaries, and between shareholders of the parent
company and its management. Both internal and external corporate
governance mechanisms of the company have evolved over time to monitor,
bond, and control management. These mechanisms are the capital markets,
the managerial labor markets, regulations, investors (particularly
institutional investors), and the board of directors, which may act
independently, substitutionally, and complementarily to align the interests
of stockholders and management. The parent-subsidiary corporate
governance structure is designed to align the interests of subsidiaries with
those of the multinational corporation's headquarters.
The parent-subsidiary corporate governance structure is shaped by both the
host and home countries' legal, political, cultural, and regulatory systems;
the business practices and historical patterns of countries; the global
capital, labor, and managerial markets; global institutional investors; and
the boards of directors. Other influential factors are the international
strategy of MNCs and the subsidiary's industry, size, and relative
importance to the entire system of MNCs. Particularly, when the subsidiary
is wholly owned by the parent company and is managed automatically
(independently) by a management who has little if any ownership interest
in the MNC or the subsidiary, then the effectiveness of parent-subsidiary
corporate governance becomes more crucial in monitoring and controlling
managerial actions of the subsidiary.
SUMMARY
Corporate governance has transformed from minimizing agency costs to
maximizing shareholder value and in the post-SOX era a compliance
requirement to a business imperative. Globalization and IT have made
cross-border investments possible and attractive to investors who consider
the global financial markets for their investment decisions. Effective
corporate governance can improve the attractiveness and efficiency of the
global financial markets. This chapter presented corporate governance in
transition, including historical and global perspectives of corporate
governance.
The key points of this chapter are

 The corporate governance structure can be differentiated across

countries in terms of the degree of ownership and control.
 Corporate law plays a vital role in corporate governance by
determining how companies are established and in defining the rights
of shareholders and the fiduciary duties of directors and officers.
 For companies listed on the LSE, the UK has established annual
reporting requirements on whether and how they are complying with
the Combined Code.
 The German board system is a two-tiered system that consists of a
management board and a supervisory board.
 The Japanese business structure is dominated by networks of
organizations called keiretsu that significantly influence the corporate
governance structure in Japan.
 Convergence of global corporate governance would be possible if all
nations would agree that the primary purpose of corporate
governance is the enhancement of shareholder value while protecting
the interests of other stakeholders.
 The most important step in the convergence process is the statutory
power to implement and enforce the globally accepted corporate
governance principles, rules, or best practices.
 In a multinational corporation, corporate governance mechanisms
are designed not only to align the interests of subsidiaries with those
of the parent company, but also to align the interests of the
management of the parent company with the interests of both its
majority and minority shareholders.

KEY TERMS
information infrastructure
keiretsu
legal infrastructure
market infrastructure
Regulation Fair Disclosure
UK Financial Reporting Council (FRC)
U.S. Goverment Accountability Office (GAO)
unitary board
REVIEW QUESTIONS
1. What are the primary responsibilities of the supervisory board in the
German board structure?
2. Briefly describe the board structure in Japanese corporations.
3. What are the four factors that can differentiate the corporate
governance structure from one country to another?
4. What factors help shape the corporate governance structure of
multinational corporations?
DISCUSSION QUESTIONS
1. Discuss the global corporate governance structure.
2. Explain the three commonly used approaches to regulatory reforms
in terms of their effectiveness and context.
3. Discuss the primary aspects of corporate governance in the UK.
4. Describe the new initiatives taken in Japan to improve the
infrastructure of its capital markets.
5. Are you expecting many changes in corporate governance reforms in
the Middle East and Asia?
6. Explain the types of board systems worldwide.
7. Compare and contrast rules-based versus principles-based
approaches of corporate governance.