privatesectorP U B L I C P O L I C Y F O R T H E

Mierta Capaul

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Global debates about strengthening the protec-tion of shareholders have moved beyond codesto oversight and compliance. How can enforce-ment be strengthened? What alternatives docountries have for enforcing their corporategovernance laws and regulations? Should devel-oping and transition economies rely on courtsor regulators?

A lively debate is also under way about a sec-ond set of questionswhether voluntary com-pliance and choice can improve shareholderprotection in a country. Can the incentive ofattracting capital compel companies to volun-tarily comply with best practice? Is using a menuof options to create choice an effective way toimprove corporate governance practices? If so,under what circumstances? And can a countrysimply replicate approaches that have suc-ceeded elsewhere, or does the appropriate solu-tion depend on its level of development andother characteristics?

Reforms in the rulesThe World Banks corporate governance assess-ments reveal growing awareness around the worldof the importance of corporate governance.1

Almost all the countries assessed are undertakingreforms to bring their legal and regulatory frame-works into compliance with the Organization forEconomic Co-operation and Developments(OECD) principles of corporate governanceaset of nonbinding standards against which coun-tries performance can be measured.

Consider Romania, a country that undertookmass privatization. Since the vouchers were free,the new shareholders did not see themselves asowners and the privatized companies did nottreat them as investors. The result was wide-spread expropriation of minority shareholders.That started to change when shareholdersbecame more vocal. Romania recently adoptedregulations that significantly strengthen share-holder rights.

The Wor ld Banks assessments of corporate governance pract ices in

25 countr ies across f ive continents have revealed a general

commitment to comply with international pr inc iples . But the

necessary legal changes are s low and subject to pol it ica l compromise.

Moreover, most countr ies have a poor track record in enforc ing

exist ing laws and regulat ions. Expropriat ion of minority shareholders

continues to be a problem around the wor ld.

Minority Shareholders

What Works to Protect Shareholder Rights? Mierta Capaul(mcapaul@worldbank.org)

is a senior corporate

governance specialist in

the World Bank Groups

Investment Climate

Diagnostics Unit. She has

written a number of

corporate governance

assessments under the

joint World Bank

International Monetary

Fund ROSC (Reports on

the Observance of

Standards and Codes)

program. Before joining

the World Bank she was

the regional head of a

large financial

institution, covering

Ecuador, Guyana,

Suriname, Repblica

Bolivariana de Venezuela,

and the Caribbean.

M I N O R I T Y S H A R E H O L D E R S W H A T W O R K S T O P R O T E C T S H A R E H O L D E R R I G H T S ?

Still, changing laws and regulations is a slowand complex undertaking, and it requires muchnegotiation and compromise. Brazils dilemmaof how to treat minority shareholders in achange of control is a case in point. The corpo-rate law originally granted all owners of votingshares tag along rights (equal treatment in achange of corporate control, ensuring that thecontrol premium is equally distributed amongmajority and minority shareholders). In 1997,however, tag-along rights for minority share-holders were abolished to maximize state rev-enues from privatization. In the sale of the bankBanespa, for example, the government receiveda control premium of 912 percent.2 A corporatelaw reform proposed in 2001 would haverestored tag-along rights for all voting shares,but powerful business interests representingcontrolling shareholders successfully lobbiedagainst its passage. The compromise finallyreached requires that the purchaser offer atleast 80 percent of the share price paid to thecontrolling group to all voting shareholders.

Problems in enforcementIt is not just the quality of the law that matters.An important lesson from the corporate gover-nance assessments is that most developing andtransition economies fail to enforce their laws,rules, and regulations consistently and evenly.This failure was not anticipated by the OECDprinciples, which implicitly assume that coun-tries have an efficient legal and regulatoryframework in place and that courts and securi-ties regulators have the means and capabilitiesto enforce it. In reality, however, such practicesas self-dealing and insider trading are wide-spread. Such offenses mostly go unpunished,even if stiff penalties apply in theory.

Auditing is another area where weaknesses areapparent. Most countries surveyed delegate thesetting of accounting and auditing standards tothe accounting association. Compliance byissuers is generally monitored by the securitiesregulator or, as in South Africa, by the stockexchange, institutions that often lack the expert-ise to fulfill this obligation. Meanwhile, the pro-fessional conduct of accountants and auditors ismonitored by the professional accounting andauditing associationsand thus generally by the

very market practitioners being supervised.Moreover, professional associations usually lackthe means to impose effective sanctions. Auditorshave sometimes given unqualified opinions, cer-tifying that the accounts audited provide a trueand fair picture despite the many defects noted.The penalties for such behavior are low, andenforcement generally lax. None of the countriessurveyed has set the fines for such actions highenough to act as an effective deterrent.

Weak enforcement can also arise when theenforcement responsibility is divided among dif-ferent institutions, allowing issuers to conductregulatory arbitrage. For example, while theHong Kong Stock Exchange is the frontline reg-ulator for listed companies, the Securities andFutures Commission supervises such aspects astakeovers, insider dealing, and disclosure of inter-ests in securities. Since the listing rules are notstatutory and carry weaker sanctions, issuersreportedly sometimes attempt to structure trans-actions so that they fall under the purview of thestock exchange rather than the Securities andFutures Commission. A recent example is theBoto case, where a takeover was structured as asale of major assets governed by the listing rules.That allowed Botos majority shareholder to avoidsubjecting himself to the stringent takeover rules.While such transactions appear unfair to outsideinvestors, they do comply formally with the law.

In some countries minority shareholders areexpected to raise no questions about decisionsby majority shareholders even if they have theright to do so in theory. When minority share-holders did so during a takeover in Morocco in2000, it ignited a public controversy. The targetcompanys minority shareholders objected tothe valuation commissioned by the bidder andrequested a second opinion. While this requestis permitted by law, the press branded it outra-geous. Through the press, the oligarchs arguedthat the law should not allow just any share-holder to bring a merger or acquisition to astandstill. Minority shareholders questioningthe wisdom of management or controllingshareholders was considered unacceptable.

Alternatives for enforcementIf the courts and regulators fail to protect share-holders, there will be few shareholders. Under

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the concentrated ownership that results, the con-trolling shareholder rather than an outside insti-tution takes on the enforcement of shareholderrightsthrough the board of directors. In mostdeveloping and transition economies, regardlessof their legal heritage, companies follow a parlia-mentarian model of board representation inwhich directors represent the constituency thatelected them rather than all shareholders. Inmany countries majority shareholders exercisesignificant influence over boards, directly (asboard members) or indirectly (through boardmembers who report to them). Malaysia andSouth Africa are among the countries trying tosubject such controlling shareholders to statutoryrequirements and hold them liable for theiractions as shadow directors.3

Business groups are another alternativeenforcement mechanism in countries with aweak corporate governance framework. They actas intermediaries between individual entrepre-neurs and the imperfect market, so that transac-tion costs are minimized. Business groups growand diversify internally, constructing a web ofcompanies through pyramid structures andcross-shareholdings that support one another.At the apex of the group is a large enterprise con-trolled by a family (and often not listed on theexchange) that plays a corporate finance func-tion for smaller companies by financing suppli-ers and new firms and smoothing out incomeflows. Thus business groups ensure access tofinance in an environment where externalfinance may be impossible to obtain. This systemof internal corporate governance, while nottransparent, substitutes for a weak externalframework by replicating the functions providedby institutions in advanced economies.

SolutionsSo, how should a country strengthen enforce-ment of shareholder rights?

Courts or regulators?Should a country rely on courts or regulators forenforcement? In an ideal world both would playa part. In the countries assessed, however, courtsare often underfinanced, unmotivated, unfa-miliar with how the law applies to economicissues, and even corrupt (see Glaeser, Johnson,

and Shleifer 2001). Judges face a broad set oftradeoffs and focus less on issues of investor pro-tection than do specialized regulators, who tendto be more motivated and more knowledgeableabout securities laws and listed firms.

There is also the question of resources. InSouth Africa, for example, courts are so over-burdened that they simply lack the capacity tocope with commercial issues. For some coun-tries it may be preferable to rely on regulatoryagencies until the judicial system becomes moreefficient. But this approach works only if the reg-ulators can enforce sanctions without being sub-ject to automatic and lengthy appeal.

In Poland strict enforcement of the securitieslaw by a highly motivated regulator was associatedwith a rapidly developing stock market. In theCzech Republic hands-off regulation and relianceon the court system had the opposite effect.

A menu of options Legal frameworks and their enforcement arerarely perfect. What else can help improveshareholder protection? Should regulators relyon the companies themselves? After all, attract-ing capital at the lowest possible cost should pro-vide a natural incentive for companies tovoluntarily comply with good corporate gover-nance practices and even exceed the minimumrequirements.

An interesting lesson from the corporate gov-ernance assessments is that giving issuers achoice of corporate governance options canfacilitate reform. That has been the case inBrazil, where Bovespa, the So Paulo stockexchange, launched a new market segmentknown as the Novo Mercado in 2001.4 New list-ing segments have traditionally been introducedto encourage small and medium-size enterprisesto become listed. The listing rules for these seg-ments are usually watered-down versions of thosefor the main board. Not so in Brazil. The com-panies listed on the Novo Mercado must adoptthe one-share, one-vote principle, grant full tag-along rights to minority shareholders, abide byU.S. generally accepted accounting principles orthe International Accounting Standards, andhave a free float of at least 25 percent.5 The com-panies also must submit to arbitration to settleshareholder disputes.

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organizations. Nor do any of

the conclusions represent

official policy of the World

Bank or of its Executive

Directors or the countries

they represent.

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T h i s N o t e i s a v a i l a b l e o n l i n e :h t t p : / / r r u . w o r l d b a n k . o r g / V i e w p o i n t / i n d e x . a s p

viewpoint

The Novo Mercado was created to give issuersa choice of complying with higher corporategovernance standards than those legallyrequired and thus differentiating themselves inthe competition for capital at home and abroad.A listing on the Novo Mercado allows companiesto attract quality domestic and internationalinvestors and lower their cost of capital.Brazilian pension funds, for example, areallowed to invest a larger share of their assets incompanies listed on the Novo Mercado. TheNovo Mercado has raised the bar, becoming thenew standard that investors expect. But how suc-cessful it will be remains open to question. Withonly a small number of companies listed on theNovo Mercado, the jury is still out.

A menu of options approach based on dif-ferentiated market segments is most likely to beeffective in a country with relatively sophisti-cated corporate and securities laws and reason-able protection of basic shareholder rights, butwith weak confidence in the judicial system anda small number of investors. To be successful,the approach must include mechanisms allow-ing established companies to graduate fromthe main board to the corporate governancetier. Otherwise, that tier will be perceived as asmall cap market with low liquidity. Countrieswith more mature securities markets, a strongrule of law, and effective judicial enforcementshould focus on measures to improve the cor-porate governance standards of the market as awhole rather than establish a separate tier.

There are other ways to introduce choice.Many countries are working to improve corpo-rate governance by developing a national codeof best practice. By January 2003, 43 economieshad adopted a corporate governance code,including Brazil, Croatia, the Czech Republic,Hong Kong (China), India, the Republic ofKorea, Malaysia, the Philippines, Poland,Romania, the Russian Federation, and SouthAfrica. Such codes can be tailored to each coun-try. Some countries adopt a comply or explainrule requiring that companies comply with thecode or explain in their annual report why theyhave not done so. Thailand has taken an inter-esting approach, allowing companies that adoptthe code of best practice a discount on their list-ing fees.

Whatever the method, codes of best practicerepresent a market push to institutionalize andprofessionalize corporate governance. Theyimprove the image of companies that upholdthem and allow investors to sort good compa-nies from bad.

ConclusionThe corporate governance assessments showthat choice can facilitate reform. Allowing dif-ferent models of corporate governance to coex-ist permits investors with varying risk profiles tochoose the appropriate market and company toinvest in and allows market forces to pick the win-ners. When companies have the choice of listingtheir shares on a stock market segment withstricter corporate governance rules or of com-plying with a code of best practice, they can usethis option to signal to investors that they are dif-ferent. While establishing a corporate gover-nance market segment appears to be anattractive option only for middle-income coun-tries, codes of best practice seem to be importantregardless of a countrys level of development.

Notes1. For more on the World Banks corporate gover-

nance assessments, see http://www.worldbank.org/ifa/

rosc_cg.html.

2. Based on data from the Brazilian Securities and

Exchange Commission (Comisso de Valores Mobiliarios).

3. Shadow directors are controlling shareholders or

shareholders who exert significant influence over the

board even though they are not directors.

4. The transparency tier of the Bucharest stock

exchange is another example of a corporate governance

segment.

5. The free float is the share of capital that is not held

by controlling shareholders and can be easily purchased

by portfolio investors.

ReferenceGlaeser, Edward, Simon Johnson, and Andrei Shleifer.

2001. Coase versus the Coasians. Quarterly Journal of

Economics 116: 85399.