SMC University Zurich

Course

: Ethics, Corporate Governance and Company Social Responsibility

Assignment : 6 Date Student Professor : 24 May 2011 : Kulwant Kumar SHARMA : Dr. Jeffrey Henderson, Ph.D.

Assignment # 6, May 24, 2011, Doctorate of Management Mr. Kulwant Kumar Sharma

Most of the companies in emerging countries are family-owned and not listed in stock markets. Does this circumstance make a difference with regard to principles of corporate governance? How could familyowned companies attract capital through minority shareholders? What are the proper principles of corporate governance for these companies?

Topic 6 Assignment: Ethics, Corporate Governance & Company Social Responsibility

Introduction Discussions on corporate governance (CG) have covered mostly those companies which have dispersed holdings and are public listed. Non-listed companies (NLC) have not been in focus for CG and best practices debates. The OECD paper on CG of Non-listed companies in emerging markets is an useful document for these markets.

NLCs are mostly closely held companies whose shares do not trade freely in stock markets. This could be due to the small number of shareholdings or restrictions limiting their transferability (Hansmann/Kraakman, 2004). Prasad (2007) quoted industrialist Rahul Bajaj, that in India; more than 75 per cent of large listed Indian companies are family-owned. Family shareholding in these companies is significant (30 per cent upwards). The balance is largely public sector units or subsidiaries of multinational companies. Companies where the management has little or no stake in the company constitute less than 5 per cent of the large, listed companies. He further states that over 85% of businesses in the European Union and USA are family-run. In Italy the figure is as high as 99%. 40% of the US S&P 500 companies are family-run firms. The study of Prasad shows that there are conflict situations between family interests and minority shareholders interests. These vary from pricing of preferential issues, dividend decisions, conflict between family owners and depositors, lack of adequate exposure for one family, enrichment of one branch of family in management control at the expense of others and family succession deciding management succession.

Many of these large companies are by choice unlisted but have financial stakeholders (equity and/or creditors) besides their controllers. This includes companies, partially or completely, under founder/family control, with professional management although the founder/family may continue to play an important governance/shareholder role. The creation of a minority shareholder class is a fairly predictable event in the life cycle of a family company. Succession
Assignment # 6, May 24, 2011, Doctorate of Management Mr. Kulwant Kumar Sharma

through multiple generations results in more inactive shareholders and dilution of ownership (Visscher 2005). In another study by Chourov, using a sample of Canadian family firms, they found that when there is divergence between voting rights and cash flow rights, owner CEOs receive higher compensation than non-owners. The higher the divergence between voting rights and cash flow rights, the higher the excess compensation. Further analysis shows that only poorly governed firms are affected by the expropriation problem (Chouroy L 2010).

Financial Disclosure - An Economic Analysis The analysis provided in OECD report indicates that introducing a requirement of large private corporations to disclose publicly their financial statements is unlikely to achieve an appropriate balance between the costs and benefits. Requiring large private corporations to disclose publicly their accounts is likely to impose definitive and significant costs, while the benefits of the proposal are unclear. The costs could be from the adverse consequences for personal privacy, lack of commercial confidentiality, loss of personal property rights and increased direct costs. The benefits of disclosing more information are likely to accrue to the disclosing company. The NLCs may be family owned business where the main conflict of interest in family firms becomes the expropriation, often legal, of minority shareholders and creditors by the controlling shareholder rather than the common conflict of interests between professional managers and shareholders. This expropriation may take a wide variety of forms, some of which are legal in some locations but illegal in others. (Johnson, La Porta, Lopez-De-Silanes, & Shleifer, 2000).

Ownership and Financing Structures The OECD paper compares Listed Companies (LCs) and NLCs in Europe, in terms of ownership structure and financial ratios. From a performance viewpoint, while NLCs may face different CG problems than LCs, they resolve these equally well since performance differences are small between matched firms. Thus, one conclusion could be that the presence of block-holders in NLCs offers advantages in monitoring and control, and generates organisational benefits in terms of decision speed and unity of command. Moreover, NLCs may benefit from avoiding the cost of complying with reporting and other requirements that are imposed on listed firms, thus saving them resources, and potentially allowing them to focus on longer-term investment strategies. The OECD research given in the paper compares NLCs with larger LCs.

Assignment # 6, May 24, 2011, Doctorate of Management Mr. Kulwant Kumar Sharma

The Indian corporate sector has seen substantial and significant changes in the last ten years of liberalisation and globalization, specially in financial structures and CG. The CG is still based on Companies Act of 1956, which are under revision since 2004. CG remains a weak area with the issues of ownership and control, management integrity, accountability and transparency, succession and split still haunting majority of the Indian companies. Their number comprises of both public and private companies (other than listed companies), including the family - founded and managed business. These issues continue to impact the growth of the economy and the vitality of the business sector (Batra Sumant, OECD Paper 2006).

Family ties can be seen as providing bonds of trust that can substitute those that are supposed to be provided by the legal system. This has lead some authors (see, for example, Panunzi, Burkart, & Shleifer, 2002) to propose that family firms are more common in countries with weak protection of minority investors precisely because family ownership is a substitute for the legal protection of minority investors. But this is based on either of two implicit assumptions: (a) that agency problems do not exist when the agent and the principal are members of the same family, or (b) the family has internal mechanisms to deal with such problems whenever they exist (Pablo 2007).

National Variation in Financing Patterns As regards to the differences between LCs and NLCs, the research of OECD states that these are not significant in terms of their implications for financing patterns. Widely held firms should disclose, though it is difficult to define widely from closely held due to national differences. Degree of protection for minority shareholders remains a political decision, as as been elaborated in the paper. Differences are seen as in the United States assesses some listed firms with very infrequent trading similar to NLCs. As far as the policy on financing NLCs goes, access to external finance may not be different from that of LCs. In CG field, major issue of concern remains minority shareholders and their stake in the governance of NLCs. The OECD paper suggests that the best way to ensure effective access to external finance and low costs of capital, as well as CH, is to decrease the risks posed to creditors and providers of external equity by enacting investor protection laws and enforcing them. This will include easy collateral registries, information availability on borrowers and a reasonable disclosure on ownership.

Assignment # 6, May 24, 2011, Doctorate of Management Mr. Kulwant Kumar Sharma

Policy framework has to work on two objectives employing the capital assets in an effective and efficient manner and consumers or investors must have a choice to diversify. Mutual Fund industry provides one such avenue to diversify retail investments and lower the costs. The corporate performance from 2003 to 2010 shows glaring shortcomings in the CG all over the world. Banking and financial sectors were specifically criticized in various reports. It has shown situations where corporate governance might fail in its task to facilitate the achievement of both these fundamental goals (OECD paper quoting Buchanan and Yang, 2005). Transparency and accountability are keystones to achieving good CG and OECD principles can be applied to all NLCs.

The Role of the Law in Developing Efficient CG CG has become an important topic for both research and business practice in emerging and transition markets. NLCs will continue to play a significant role in a wide variety of economies special studies are needed to bring in CG in them. OECD research brings forward company laws to improve the performances of NLCs and encourage them to be more transparent. There is a consensus that the most pressing matter involves the abuse of minority interests by controlling shareholders. Company law is the most important source of CG techniques in the context of NLCs. Precise valuation methods, minority protection and fiduciary duties can be part of the company laws to regulate and encourage NLCs towards CG. There has been a debate on public disclosure and its effectiveness in informing the stakeholders about the companys financial health as many issues are not highlighted. This can be supplemented with a right of inspection of company ledger, books and other records. Enforcement is another approach to protect investors in non-listed companies. Company rules need to be flexible as one legal framework suitable for non-listed companies across the board would be difficult to achieve. There can be some optional guidelines to supplement the existing legal frameworks.

In spite of the issues of concerns bright out in the OECD paper, empirical evidence shows that at least some large, multinational NLCs do protect the rights of their minority shareholders, whether the law requires them to do so or not. This is even if the minority shareholders are not related to the core of the family. Pablo in his study explained that it is necessary to understand mechanisms NLCs use to align the incentives of all stakeholders (Pablo 2007).

Assignment # 6, May 24, 2011, Doctorate of Management Mr. Kulwant Kumar Sharma

Conclusion The debate on CG has mostly focused on listed companies particularly in countries with developed capital markets and companies with dispersed shareholdings. A leading CG issue concerns the appropriate design of a legal, institutional and regulatory framework that helps to align the interests of shareholders and managers of NLCs. Policy makers worldwide have looked to devise an effective framework that supplies proper incentives for the board and management to act in the interest of the company and its shareholders; and furnish investors with sufficient monitoring information. One of the primary risks shareholders face, is that they will end up in a situation where the controlling shareholder may use his or her position to deprive the noncontrolling shareholder of influence over major decisions. Many jurisdictions have legislation that can prevent abuse of non-controlling shareholders in both circumstances, and typically these measures apply to both non-listed companies and public companies.

Assignment # 6, May 24, 2011, Doctorate of Management Mr. Kulwant Kumar Sharma

References:
1. Chourou, L. (2010), Compensation of owner managers in Canadian family-owned businesses: expropriation of minority shareholders. Canadian Journal of Administrative Sciences / Revue Canadienne des Sciences de l'Administration, 27: 95106. doi: 10.1002/cjas.145

2.

Johnson, R., La Porta, R., Lopez-De-Silanes, F., & Shleifer, A. (2000). Tunneling. The American Economic Review, 90 (2), 22.

3.

OECD Corporate Governance for Non-Listed Companies. OECD 2006.

4.

Pablo MARTIN DE HOLAN (2007); Protected by the family? How closely-held family firms protect minority shareholders. Instituto de Empresa and INCAE, Madrid, Spain.

5. 6.

Panunzi, F., Burkart, M., & Shleifer, A. (2002). Family Firms.Unpublished manuscript, Boston, Mass. Prasad S.A.Murali (2007), The Functioning of the Audit Committee in Family-owned Companies.

7.

Batra Sumant, India: An Overview of Corporate Governance of Non-Listed Compaines; OECD Paper 2006 (Chapter 10).

8.

Visscher de Francois (2005), Minority shareholders: Handle with care; Published in Family Businesses: The Guide to Family Companies; http://www.familybusinessmagazine.com/

Assignment # 6, May 24, 2011, Doctorate of Management Mr. Kulwant Kumar Sharma