A Comparative Study of OECD's Principles of Corporate...
Transcript of A Comparative Study of OECD's Principles of Corporate...
MSc Finance & International Business Author:
Leena Ronkainen (280786)
Academic Advisor:
Morten Balling
A Comparative Study of
OECD's Principles of Corporate Governance of 2004
and Finnish Corporate Governance Code of 2008
Department of Business Studies
Aarhus School of Business
University of Aarhus
May 2010
ABSTRACT
Importance of corporate governance is increasing as a result of recent financial
crisis and corporate failures. Global organizations like Organisation of Economic
Development (OEDC) and national governments are working together with market
players to review and promote best practices of corporate governance. OECD
published revised principles of corporate governance (Revised Principles) in 2004.
Finland revised Finnish corporate governance code (FCGC) in 2008 and is again in
process of amending the code. FCGC is incorporated into statutory legislation on
listed companies and takes the ‘comply or explain’ –approach. This thesis aims to
contribute to the knowledge of Finland’s corporate governance landscape for listed
companies. Firstly, existing theory concerning corporate governance is surveyed
and an agency theory perspective is taken for the analysis. From agency theory
perspective, separation of ownership and management has resulted in a situation
where owner ‘principal’ delegates the decision making power to management
‘agent’. In the analysis, Finnish corporate governance code and also related
statutory regulation are compared to OECD’s Revised Principles. The thesis seeks
answers to the following research questions: (i) How Revised Principles have been
taken into consideration in FCGC? and (ii) How FCGC approaches the issues with
information asymmetry and agency costs? The analysis shows that Finnish
corporate governance code aligns well with Revised Principles. Detailed disclosure
recommendations are emphasized in FCGC, reducing information asymmetry
when enforced efficiently. As a result, agency cost issues such as monitoring costs
will decrease. Taken aside the agency perspective, Revised Principles go in more
depth into roles and importance of stakeholders in corporate governance, whereas
stakeholders are not soundly incorporated in the FCGC. Further research could be
done to increase the empirical knowledge of corporate governance practices in
Finland.
KEY WORDS: Corporate governance, agency theory, Information asymmetry,
OECD, Finland.
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1 Introduction ................................................................................................... 4 1.1 Problem Statement ................................................................................ 6 1.2 Structure of the Thesis ........................................................................... 7
2 Literature Review .......................................................................................... 8 2.1 Corporate Governance........................................................................... 8 2.2 Agency Theory..................................................................................... 10 2.3 Transaction Cost Theory...................................................................... 13 2.4 Stakeholder Theory.............................................................................. 14 2.5 Institutional Investors ........................................................................... 17 2.6 Remuneration of the Management....................................................... 18 2.7 Role of Board ....................................................................................... 19 2.8 Disclosure ............................................................................................ 21 2.9 Enforcement of Corporate Governance ............................................... 23
3 OECD and Revised Principles .................................................................... 24 4 Finland and Corporate Governance ............................................................ 27
4.1.1 Regulatory Environment in Finland ............................................... 27 4.1.2 Corporate Governance Code........................................................ 30
5 Analysis of Revised Principles and FCGC .................................................. 33 5.1 Basis for an Effective Corporate Governance Framework ................... 33 5.2 Rights of Shareholders and Key Ownership Functions ........................ 35
5.2.1 General Meeting ........................................................................... 36 5.3 The Equitable Treatment of Shareholders ........................................... 38 5.4 The Role of Stakeholders in Corporate Governance............................ 40 5.5 Disclosure and Transparency .............................................................. 42 5.6 The Responsibilities of the Board......................................................... 44
6 Agency Perspective on FCGC .................................................................... 47 6.1 Information Asymmetry ........................................................................ 47 6.2 Agency Costs ....................................................................................... 50
6.2.1 Bonding Costs............................................................................... 50 6.2.2 Monitoring Costs ........................................................................... 51 6.2.3 Residual Loss ............................................................................... 52
7 Discussion................................................................................................... 55 BIBLIOGRAPHY................................................................................................. 59
Appendix 1: Finnish Corporate Governance Code - Summary of Recommendations
List of Tables: Table 1: Revised Principles summarized Table 2: Summarized Finnish corporate governance on information asymmetry Table 3: Summarized Finnish corporate governance on agency costs List of Figures: Figure 1: The firm as the nexus of contracts Figure 2: General governance structure of Finnish companies Figure 3: Compliance to FCGC in Helsinki Stock Exchange
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1 Introduction
Importance of corporate governance codes and interest on the discipline are
increasing. Companies like Enron have collapsed because of unsustainable
management or governance scandals. Also, the recent economical crisis and
downfall of financial institutions all over the world have raised interest of the
general public on enforcement and best practices of corporate governance.
Global organizations, like Organisation of Economic Co-operation and
Development (hereinafter OECD), World Bank, International Monetary Fund, and
national governments have been active on setting frameworks and best practices.
In United Kingdom, corporate governance was influenced largely by the Cadbury
Report1 and several other committee reports2. Sarbanes Oxley Act was introduced
in United States in 2002. Both UK and Sarbanes Oxley Act have had an impact on
the corporate governance landscape in Europe. Many large multinational
companies are listed both in some stock exchange in Europe and in United States.
There is a debate whether corporate governance practices are globally converging
or not. World’s capital markets have become more integrated on a global scale and
cross-listing in stock-exchanges is more common. Companies have access to
foreign capital and foreign shareholders have become common in major stock
exchanges. Due to wide variety of company ownership structures and corporate
cultures in the world, local governments and stock exchanges are in the root of the
practical enforcement of corporate governance. OECD published the Principles of
Corporate Governance in 1999. Before making the principles, it had consulted
national governments, private corporations and international organizations. OECD
updated the principles in 2004 and these are referred hereinafter as Revised
Principles. OECD (2004, p. 13) emphasizes that principles should be considered
as more of a reference point than a prescription national legislation. 1 Sir Adrian Cadbury published Report of the Committee on the Financial Aspects of Corporate Governance in the year 1992 2 To mention the most important reports: Greenbury (1995), Hampel (1998), Turnbull (1999, and revised in 2005), Myners (2001), Higgs (2003) and Smith (2003)
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The aim of this thesis is to compare Revised Principles and Finnish Corporate
Governance Code (hereinafter FCGC). In this thesis, the corporate governance
discussion is limited to publicly listed companies. Taking into consideration the
comparative nature of the thesis, it is important to explore how OECD and Finnish
Securities Market Association, which published FCGC, define corporate
governance.
OECD (2004, p11) defines corporate governance Revised Principles as follows:
“Corporate governance involves a set of relationships between a company’s
management, its board, its shareholders and other stakeholders. Corporate
governance also provides the structure through which the objectives of the
company are set, and the means of attaining those objectives and monitoring
performance are determined.”
Securities Market Association3 notes there is no clear definition of corporate
governance available and takes their view on corporate governance system as
follows: “In general it means a corporate governance system which defines the
corporate executive, that is, the role of the board of directors and hired directors,
duties and their relations to the shareholders. Simply, Corporate Governance
means a system which helps managing and controlling the enterprise.”
As a starting point, the both definitions mostly agree that corporate governance
system is built on relationships between the board, managers and the
shareholders. In addition, both emphasize systems importance as a means of
managing and monitoring the company. Both of the parties also mention that good
corporate governance practice enhance company’s success. OECD mentions
stakeholders in the definition, whereas FCGC does not.
3 Securities Market Association web page (2009) viewed on 17.12.2009, Source: http://www.cgfinland.fi/content/blogcategory/15/142/lang,en/
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1.1 Problem Statement
Currently, limited amount of research is available concerning Finnish corporate
governance landscape. FCGC, applied to companies listed in Helsinki Stock
Exchange, has increased the access to information on Finnish corporate
governance practices. Listed companies in Finland were required to issue a
corporate governance statement for a financial period commencing on September
2008 or later. In practice, this means that the most of year 2009 annual financial
disclosures have included a corporate governance statement on compliance (and
explanations on departures) of FCGC. Extensive literature, at least in Finnish,
exists on Finland’s statutory regulation on company activities, and the goal of this
thesis is to contribute on this topic on the general level of the corporate governance
code. Due to ‘comply or explain’ –approach adopted in the FCGC, the thesis will
focus on FCGC as a complement of the statutory legislation, and will not go into
detail on corporate governance practices in individual listed companies or
departures from the Finnish Corporate Governance Code published in 2008.
The thesis takes a deductive approach to the subject; theory is surveyed and
applied in analysis of the Revised Principles and FCGC. There are many
perspectives that can be chosen to explore corporate governance in practice. The
thesis aims to discuss how Revised Principles and FCGC encounter the corporate
governance issues that are emphasized in agency theory. Agency theory will be
discussed in more details in the literature view. The below research questions
abridge the main ideas of the thesis:
(i) How Revised Principles have been taken into consideration in FCGC?
(ii) How FCGC approaches the issues with information asymmetry and agency
costs (i.e. monitoring and bonding costs, and residual loss)?
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1.2 Structure of the Thesis
The thesis structure is summarized in the brief descriptions of chapters below. The
thesis is a broad comparative case study built in an essay form.
Chapter 2: Theory is surveyed from existing academic literature. After considering
general definitions of corporate governance, following topics are discussed in more
detail: agency theory, transaction cost theory, stakeholder theory, institutional
investors in corporate governance, management compensation, board of director’s
role and disclosure. In addition, enforcement of corporate governance is
considered.
Chapter 3: OECD’s Principles of Corporate Governance are discussed and the
main structure of the Revised Principles is summarized in a table.
Chapter 4: The chapter gives a general picture of Finland’s company law
concerned with corporate governance and describes corporate governance
landscape in Finland. The actual recommendations of FCGC are summarized in
Appendix 1.
Chapter 5: The analysis uses primary and secondary data: Revised Principles and
FCGC are used as primary material for the comparison, but also available research
on the topic is considered. Important component in the comparison is also
Finland’s Limited Liability Companies Act because it does form the basis for the
corporate governance in Finland.
Chapter 6: Next, key areas of the analysis from an agency theory perspective are
considered especially concerning the Finnish Corporate Governance Code. The
statutory law and recommendations essential in reducing information asymmetry
and agency costs are summarized in tables.
Chapter 7: The main results and limitations of the thesis are discussed and further
suggestion for future research.
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2 Literature Review
2.1 Corporate Governance
There is a wide range of definitions for corporate governance. According to Shleifer
and Vishny (1997, p. 737), corporate governance deals with the way in which
suppliers of finance to corporations assure themselves of getting a return on their
investment. Shleifer and Vishny (1997, p. 738) note that understanding corporate
governance can help major institutional changes in developing economies. Jensen
(1993, p. 850) noted there are only four control forces operating on the company to
resolve issues resulting from a divergence between managers’ decisions and those
that are optimal for society: (1) capital markets, (2) legal/political/regulatory system,
(3) product and factor markets, and (4) internal control system headed by the
board of directors. In other words, the groups that assure company is operating
optimally in its corporate landscape are investors, stakeholders like government,
employees, customers, suppliers and board of directors.
Solomon (2007, p. 12) notes that definitions of corporate governance fall along a
spectrum. The agency theory concentrates to relationships between the company
and its shareholders, whereas broader definition of stakeholder theory considers
the relationships of other stakeholders as well. Solomon adds that accountability
has become an essential part on the corporate governance discipline. Solomon’s
(2007, p. 14) view on corporate governance can be placed on the broader end of
the spectrum: “the system of checks and balances, both internal and external to
companies, which ensures that companies discharge their accountability to all their
stakeholders and act in a socially responsible way in all areas of their business
activity”. Solomon assumes that companies maximize shareholder value in long
term taking into account the other stakeholders. Nowadays, social responsibility is
closely connected with this view.
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Corporate governance discussion is tightly connected with corporate law discipline.
All companies from sole proprietorship to the limited liability have been given a
legal framework from which they can form their company structure and activities.
Until the introduction of Limited Liability Acts, the shareholders had unlimited
liability of their company’s debt. The reduced risk with limited liability created the
basis of today’s capitalism and corporate financing markets. Mallin (2007, p. 11)
describes that corporate governance area is complex as it includes aspects like
legal structure and culture differences.
Van der Berghe (Cornelius and Kogut [eds] 2003, p. 489) recommends a double
track for development of corporate governance: while basic corporate governance
are universal, their translation and practical implementation needs to be
differentiated according to firm type and the relevant governance challenges and
problems associated with that type. Cornelius and Kogut (2003, p. 2) make a
difference between corporate governance and corporate governance system: A
system of corporate governance consist of those formal and informal institutions,
laws, values, and rules that generate the menu of legal and organizational forms
available in a country and which in turn determine the distribution of power – how
ownership is assigned, managerial decisions are made and monitored, information
is audited and released, and profits and benefits are allocated and distributed.
In the following chapters of the literature view, the theoretical base and research on
corporate governance will be introduced: agency theory, transaction cost and
stakeholder theory, role of boards, institutional investors, management
compensation, enforcement of corporate governance, the role of board of directors
and disclosure.
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2.2 Agency Theory
The issues related to separation of owning and managing the company were
discussed already long time ago. Widely quoted pioneer in corporate governance
research, and especially agency theory, is Adam Smith4 cited by Jensen and
Meckling (1976, p. 305): “The directors, - - being manager of other people’s money
than their own, it cannot well be expected that they should watch over it with the
same anxious vigilance which the partners in private copartnery frequently watch
over their own.” The empirical research for the separation of ownership was
continued further by Berle and Means (1932, p. 129) who confirmed directors have
considerable power over the company, while shareholders have limited means to
remove directors before next election. They also raised their concern on the proxy
voting of shareholders that may lead to separating the power even further from the
principal, when management or committee seeking control has chosen the proxy.
The shareholder as ‘principal’ delegates the decision making power to company
directors who act as ‘agent’ of the owner. Assuming that company’s goal is
maximizing shareholder’s wealth, agents may in practice drive their own goals like
ensuring high performance incentives, perquisites and taking unnecessary risk
instead of making strategically sound decisions for the maximization of long term
shareholder wealth. Agency perspective in corporate governance is to minimize
these conflicts of interest and their costs. Agent may be shirking which can lead to
moral hazards where principal does not have complete information on the actions
of the manager. In other words, there are hidden actions by the agent. Solomon
(2007, p. 144) explains that the information asymmetry leads to situation where
managers know more about company’s activities and financial situation than
investors do. The role of information disclosure is discussed further in its own
chapter. Also adverse selection exists because principal cannot fully evaluate the
agent’s abilities and qualities when delegating the decision making power. In other
words, there is hidden information inaccessible by the principal.
4 Original quote is from Adam Smith’s (1776) book ‘The Wealth of Nations’ p. 192.
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Jensen and Meckling (1976, p. 308) emphasize that it is “impossible for the
principal or the agent at zero cost to ensure that the agent will make optimal
decisions from the principal’s viewpoint”. This summarizes the relevancy of agency
problems. Jensen and Meckling classify agency costs in monitoring costs, bonding
costs and residual loss. Bonding costs relate to situations where principal pays the
agent to expend resources to make sure that the agent will not take actions
harming the principal’s investment or, if these particular actions are taken, principal
would get compensated. Principal experiences monitoring costs when trying to limit
the conflict of interests caused by imperfect contract with the agent. Residual loss
is the loss in principal’s welfare due to divergence of agent’s decisions and those
which would be in benefit of shareholders. In practice, bonding and monitoring
costs and residual loss are overlapping and interdependent.
In context of countries with low legislative shareholder protection, the applicability
of agency theory have been challenged by La Porta et al (1999, p. 511 and 2002,
p. 1163), who found that in large firms are often run by controlling shareholders.
These directors or managers may be placed to monitor management, but in some
cases they may expropriate non-controlling i.e. minority shareholders. OECD’s
(2004, p. 12) preamble to the Revised Principles recognizes also the issue of
power of certain controlling shareholders over the minority shareholders.
Jensen (1983, p. 334) goes further to separate literature concerning agency theory
to principal-agent literature and positive theory of agency. Principal-agency view
addresses the same contracting problem in a more mathematical approach on risk
sharing and the optimal contract. Principal-agent relationship can be applied also
to employer-employee or similar relationships. In comparison, positive agency
theory consists more on non-mathematical and empirically oriented approach on
contracting environment and technology on monitoring. Positive agency theory is
concerned, for example, on describing corporate governance mechanisms that
may be helpful tools in decreasing information asymmetry, or how to reduce
manager’s self-interested activities when there is a conflict of interests between
agent and principal.
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Tricker (2009, p. 218) describes how in practice the complexity of ownership from
holding a share in a company directly has extended to mutual funds and proxies
which may add another level of conflicting objectives to the simple principal-agent
modeling. Clarke (2007, p. 24) considers agency problems further and suggests
that agency theory underestimates the complexity of relationships between
shareholder, board and management. These result in a double agency dilemma.
Research by La Porta et al (1999, p. 511) and Becht and Röell (1999, p. 1055)
conclude that there may be conflict between the interests of large controlling
shareholders and the minority shareholders. They agree that in United States the
main agency problem is between managers and dispersed shareholders, whereas
in continental Europe large block holders exercise control over the management.
Van der Berghe (Cornelius and Kogut [eds] 2003, p. 484) points out that managing
corporations in a global networked economy is far more complex than managing a
single company with one principal and one agent.
Taking the perspective of shareholders who diversify their risk in investing to a
portfolio of securities, the principal’s willingness to take risk may be larger than for
the agent. Portfolio investors have diversified at least the variation of the short-term
value of the stock, whereas managing director’s remuneration and future service
contract is much more dependent on the success of the company. Wiseman and
Gomez-Mejia (1998, p. 133) suggest that agents may show signs of risk-seeking
as well as risk-averse behavior. Manager may have variety of risk preferences,
depending on the situation and the decision to be made.
Hill and Jones (1992, p. 135) discuss the power shifts between principal an agent
when the contracting opportunities are limited. If agents experience substantial
losses when exiting from the relationship, the principal has the power. However, if
the principals have a shortage of agents to choose from, the power shifts to the
agent. This is an important aspect of principal-agent relationship, as business
environment is dynamic in reality and there may be inefficiencies in the short run in
managerial labor market. In long run, success of the firm is considered as
affirmative information of manager’s talent.
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2.3 Transaction Cost Theory
Transaction cost theory is based on the idea that companies can internally
undertake activities more economically rather than contracting them externally.
Ronald Coase and Oliver Williamson have contributed greatly to development of
transaction cost theory. According to Solomon (2007, p. 21), the theory
incorporates human behavior on how company organizes its activities. It is based
on the fact that companies are nowadays so large that they substitute the market in
determining allocation of resources. Companies internalize transactions to reduce
risks and to protect their competitive advantage. Instruments used in transactions
can be called governance mechanisms. As firm grows in size and experience
diseconomies of scale, some activities are more cost efficient when outsourced.
Also small firms may consider outsourcing book-keeping, payroll or other activities
which are not adding value if kept internal.
Transaction theory assumes bounded rationality, in other words limitations in
human cognitive abilities. The contracts made can never be perfect as there is
always unpredictability in future outcomes. Williamson (1985, p. 181) notes also
that human behavior can be self-interest seeking or opportunistic: Economic
agents make calculated efforts to mislead and disclose information in selective and
distorted manner. Williamson summarizes issues in world of governance as
follows: Planning is necessarily incomplete (bounded rationality), unguarded
promise may break down (opportunism), and the pair-wise identity of the parties
matter because of asset specifity.
Eisenhardt (1989, p. 64) notes that transaction cost theory is more concerned with
the boundaries of the company, variables of asset specificity and small numbers
bargaining. In comparison, agency theory is interested in cooperation of different
parties regardless of organizational boundaries and independent variables of risk
attitudes, outcome uncertainty and information systems.
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Limited Liability
CompanyCreditors
CommunitiesOther contractual parties
CustomersShareholders
Employees
Management
Auditors
2.4 Stakeholder Theory
Stakeholder theory is concerned with broader definition of corporate governance:
Business activities influence the surrounding society, not only the owners of
company shares. Stakeholders like banks, customers, suppliers, employees and
municipalities have established contracts with the company or are affected by the
company’s activities. Van der Berghe notes (Cornelius and Kogut [eds] 2003,
p. 486) that, in modern business environment, corporations need to increasingly
cope with other critical stakeholders and board members have included the duty of
balancing the interests of all stakeholders. John and Senbet (1998, p. 372) note
that corporate governance deals with mechanisms by which stakeholders of a
corporation exercise control over corporate insiders and management in such way
that their interests are protected. Managers are in a special position as they have
direct control over the company, in comparison for example to creditors who have
indirect control.
According to Fama (1980, p. 290) managers are “coordinating the activities of
inputs and carrying the contracts agreed among inputs”. In this way, transaction
cost theory and incomplete contract theory of the firm5 link the agency theory and
stakeholder theory. Quoting Jensen (1983, p. 327): “The behaviour of organization
is the equilibrium behaviour of a complex contractual system made up of
maximizing agents with diverse and conflicting objectives.” The nexus of contracts
is illustrated in the following Figure 1.
Figure 1: The firm as the nexus of contracts [adapted from Timonen (2000, p. 36)]
5 Coase (1937) “The Nature of the firm” and Williamson (1975) “Markets and hierarchies”
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Mallin (2007, p. 49) describes how shareholder wealth increases from the residual
cash flow which means profits remaining after the other stakeholders like loan
creditors have been paid. In other words, maximizing the use of resources should
in fact benefit other stakeholders as well. Jensen and Meckling (1976, p. 319) refer
to residual loss when they explain the other side of the coin: Agents’ decisions may
reduce the principals’ residual cash flow. Also Blair (Cornelius and Kogut [eds]
2003, p. 57) notes that shareholders are indeed residual claimants: whereas
stakeholders receive fixed amounts specified in contracts, shareholders get what is
left over. In addition, other stakeholders are protected by their contract, in
comparison to shareholders who have limited liability in total of the amount they
have invested to the shares.
According to Shleifer and Vishny (1997, pp. 751-752), the courts in OECD have
generally accepted the idea that managers have a duty of loyalty to shareholders.
They justify the idea on the fact that shareholders investments are sunk, whereas
stakeholders like employees are paid immediately for their efforts and can threaten
to quit if their investment is in danger of expropriation. In other words, many
stakeholders, other than shareholders, are better assured that they get a return for
their investment. In comparison to shareholders, creditors have a better legal
protection in case of default due to contractual nature of the investment. It is good
to keep in mind that shareholders of listed companies have limited liability. In case
of default, the amount of losses is limited to the investment of the shares, whereas
some stakeholders like chief executive officer may even face criminal prosecution
on intentional misconduct. For example the 2002 Sarbanes-Oxley Act in United
States is known from the imposed criminal penalties to chief executive officer and
chief financial officer. Tirole (2001, p. 23) mentions that also regular employees
have sunk investments: For instance in form of housing arrangements and
foregone alternative opportunities. Van der Berghe (Cornelius and Kogut [eds]
2003, p. 486) states that “corporate governance should aim at optimizing the (long-
term) return to shareholders while satisfying the legitimate expectations of
stakeholders.”
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Agency theory is more profit-seeking compared to stakeholder theory’s perspective
of social responsibility. Agency theory is not primarily concerned with, for example,
the relationship between employees and the company. Bainbridge (2008, p. 51)
explains that maximizing shareholder value is also in the benefit of the board: “If
management fails to maximize the shareholders residual claim, an outsider can
profit by purchasing a majority of the shares and voting out the incumbent board of
directors”. Bainbridge also notes that the contractual relationship of employees and
shareholders is different: employee relationship with the company is often subject
to periodic renegotiation, whereas shareholders have indefinite relationship – until
the shareholder transfers the relationship by for example selling the share.
Often the agency theory and stakeholder theory are considered opposite views, but
Solomon (2007, p. 27) points out that there are similarities between the two
theories. Asymmetric information is a disadvantage to all stakeholders including
the shareholders. Managers are also a stakeholder group and have the most
power to affect allocation of resources. Stakeholder theory emphasizes that
managers interest should align also with other stakeholders, not only with
shareholders.
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2.5 Institutional Investors
La Porta et al (1999, p. 474) note that when ownership of stocks is more
concentrated to others and minority shareholders exist, control rights of the
company are not distributed evenly. They encourage research to focus on the
incentives and the opportunities of these controlling shareholders to both benefit
and expropriate the minority owners. La Porta et al (1999, p. 491) added that
controlling shareholders can be also families or the state.
Jensen (1993, p. 867) does not limit the investor activism to only large
shareholders: active investors hold large debt and/or equity stakes in the company
and actively participate in its strategic direction. Jensen’s point links closely the
stakeholder theory as creditors do not attend for example board meetings, but still
often affect to governance of the corporation. This chapter will concentrate more on
shareholdings of institutional investors which as themselves are a heterogeneous
group.
According to Gillian and Starks (2003, p. 4), the emergence of institutional
investors as shareholders has become an important external control mechanism
that affects governance. In diffused or dispersed ownership, individual shareholder
would need to bear large monitoring costs, when simultaneously rest of the
shareholders would free-ride on the benefits of monitoring the management.
Institutional investors often standardize the monitoring activities to achieve
economies of scale. This may also lead to free-riding of monitoring, as monitoring
will benefit also those shareholders who are not sharing costs of the monitoring
activities.
Gillian and Starks (2003, p. 10) describe that in 1980’s public pension and union
funds began submitting shareholder proposals to companies, later they negotiated
directly with the management and pressured companies through media. These are
not the only way institutional investors can influence the company, they can simply
buy shares or sell them. They also point out the ongoing debate on the
appropriateness and the effectiveness on the activism by institutional investors.
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2.6 Remuneration of the Management
Agency theory pointed out the need for monitoring of management. Another way to
bring into line the interests of shareholders and management is incentive
alignment. According to Chan (2008, p. 129), executive compensation packages
consist generally from four parts: base fixed salary, annual bonus, stock options
and restricted stock grants, and long term incentive plan. These can be described
also as explicit incentives. Managers may also enjoy perquisites, like company
cars or golf club memberships, which may not always be so visible to
shareholders.
Chan (2008, p. 131) notes that, as principal does not have all the needed
information about agent’s activities, an outcome-based contract is called for.
Agent’s behavior is however not the only factor that affects outcome: economy,
legislation and competition among other macro-environmental factors influence the
performance of the corporation. Chan simplifies that the risk is moved to the risk-
averse agent with the performance-based contract and, due to agent’s self-
monitoring, agency costs are reduced. Chan (2008, p. 133) summarizes also that
researchers6 have found only “little support for the alignment of executive and
shareholder interests with optimal contracting focus of agency theory”. However,
Hartzell and Starks (2003, p. 2372) find a strong positive relation between
institutional concentration and the pay-for-performance sensitivity of managerial
compensation. The optimal contracting view is also challenged by Bebchuk and
Fried (2003, p. 73) who argue that board of directors favor high remuneration for
executive management because the latter can influence director’s compensation
and nomination. Managers wish to perform will in order to keep their post as CEO.
Poor management performance can bring about proxy fights or even take-over.
Managers of other firms may consider that they can manage the firm’s assets more
profitably and seek to take over the company. Managers also aim to maintain their
own reputation and ensure their human capital is still competitive in the managerial
labor market. 6 For example: Gomez-Mejia and Wiseman 1997; Tosi et al. 2000
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2.7 Role of Board
Board of directors is very important point to consider as it monitors the
management of the company and should consider the benefit of shareholders in
company’s strategic decisions. The role of board is to act as a mediator between
the shareholders (principal) and the everyday managing of the company (agent).
Bainbridge (2008, p. 161) recaps the essence of board as follows: “the modern
board - - is properly understood as a production team whose product consists of a
unique combination of advice giving, ongoing supervision, and crisis management”.
The general classification for board types is unitary and two-tier board. Unitary
board is defined as a single governing body whereas two-tier boards have
managing board for operational management decisions and a supervisory board
for strategic decisions and supervising the management board. Shareholders
usually select the directors to the unitary board and two-tier board system’s
supervisory board. In turn, supervisory board selects the members of the
management board. As an exception, for instance German companies’ employees
select the supervisory board. Solomon (2007, p. 79) states that unitary boards are
common in Anglo-Saxon style of corporate governance.
Jensen (1993, p. 866) criticizes the common practice in US for CEO to hold the
position of board chairman: “Without the direction of an independent leader, it is
much more difficult for the board to perform its critical function.” By this function he
means hiring, monitoring, compensating and removing the managing director/CEO.
Indeed, if the board chairman is also the CEO, it is possible that he or she tries to
negotiate better compensation package. CEO should not be involved in the
decision making process that involves hiring or firing himself or herself. However,
the involvement on decisions concerning directors own interest is usually tightly
regulated in the Limited Liability Acts. Jensen (1993, p. 864) argues that boards
are motivated more on minimizing downside risk rather than maximizing value – in
fear of class action suits or other legal liabilities. Jensen also mentions that board
may base their decisions partly on avoiding adverse publicity from media.
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According to Mallin (2007, p. 128), board may delegate various activities by
appointing sub-committees. However, board cannot delegate its responsibility as a
whole. Already in Cadbury report in 1992, it was recommended for board to
establish audit and nomination committees. Higgs (2003, p. 19) reported that audit
and remuneration committees are very common in listed companies: One firm of
FTSE 100 did not have audit or remuneration committee, and 15 percent of FTSE
350 did not have audit committee7. Mallin (2007, pp. 128-131) defines roles of
audit, remuneration, nomination and risk committees. Audit committee reviews the
audit scope and ensures that auditors are objective. It is considered the most
important subcommittee. Remuneration committee reviews and recommends,
within agreed terms of reference, the cost and framework of executive
remuneration. Remuneration is a relevant topic in the recent financial crisis as loss
making banks or corporations pay high management bonuses. Nomination
committee evaluates the balance of competences of board members (or
candidates). Risk committee assesses the risk like use of derivatives and level of
risk monitoring internally. In UK, Turnbull report in 1999 emphasized the
responsibility of board concerning internal controls of the company.
Coming back to the role of board and its responsibilities, Clarke (2007, p. 37)
explains the importance of business judgment rule. Business judgment rule
provides directors more discretion to make decisions in good faith: “As long as
there is not evidence of fraud, gross negligence or other misconduct, directors will
not be held responsible for a business judgement if it proves to be mistaken.” The
decision-making of the company is complex and the element of risk-taking in
business activity is important when looking for long-term growth opportunities.
7 Please note that the snapshot data was drawn in July 17, 2002 for Higgs Review.
21
2.8 Disclosure
According to Solomon (2007, p. 66), disclosure covers accountability to
shareholders, several descriptions concerning board, training, induction and
directors’ evaluation. It is more related to qualitative information on the way the
company is managed. It can also be voluntary corporate communication like web
pages and management forecasts. Publicly listed companies often need to
disclose more information to the potential investors than small family owned
companies.
Healy and Palepu (2001, p. 410) summarize the issues on information and agency
frame work as follows: “(i) role of disclosure and financial reporting regulation in
mitigating information and agency problems, (ii) the effectiveness of auditors and
information intermediaries as a means of increasing the credibility of management
disclosure and uncovering new information, (iii) factors affecting management
decisions by managers on financial reporting and disclosure, and (iv) the economic
consequences of disclosure.”
According to Solomon (2007, p. 145), frequent and relevant disclosure of
information narrows the information asymmetry gap and gives a better position for
shareholders. However, the information is also available to potential investors who
can free-ride on this information. In turn, annual general meetings of shareholders
are often accessible only to current shareholders. Disclosure of standardized
information reduces the transaction costs of searching information for monitoring
and evaluating company performance.
Solomon emphasizes (2007, p. 171) that external auditing, as a corporate
governance mechanism, helps shareholders to monitor and control the company
activities from distance. In other words, it may decrease issues with information
asymmetry. On the other hand, auditing company often offers consultancy services
to the company. This may compromise the independence or objectivity of the
auditors. According to Solomon (2007, p. 172), the regular audit activities often
lead to close relationships between the auditor and the management.
22
Information asymmetry played a big role in collapse of Enron and auditors did take
part in the creative financial reporting of the financial condition. Suppliers of finance
like banks rely on the assurance of the auditors that published information
describes the state of company’s financial position. Financial media provides their
part of the investor information by analyzing the disclosures and information on the
market. Financial analysts collect data from public and private sources and make
forecasts or recommendations on the stock.
Richardson (2000, p. 325) notes that, due to information asymmetry between
principal and agent, managers may be able to manage earnings. He suggests
reasons for earnings management: avoiding violation of debt covenants and
maximizing management bonus. In large corporations, managers often withdraw
considerable benefits via perquisites and may avoid disclosing the complete
picture to shareholders.
Boards can be driven to consider the remuneration policies carefully by requiring
corporations to disclose their remuneration decision making process and policies.
This indeed narrows the information asymmetry and monitoring costs on
managerial compensation, and allows shareholder’s to take action if incentive
packages are evaluated excessive.
Miller (2002, p. 189) found substantial and pervasive increase in disclosure during
periods of increased earnings. Miller’s sample was 80 listed US companies, and he
considered voluntary disclosures. He argues that when the earnings increases
cease, the magnitude of voluntary disclosure returns to the same level as in flat
earnings period. Study on Monitoring and Enforcement Practices in Corporate
Governance in the [European Union] Member States by RiskMetrics Group (2009,
p. 59) notes that transparency requirements on disclosure can lead to competitive
disadvantage. Very detailed information allows for example competitors to analyze
company strategies and competitive advantages too much in depth.
23
2.9 Enforcement of Corporate Governance
Building blocks of corporate governance framework need to be enforced
effectively. Otherwise corporate governance code, or even legislation, does not
have desired effect on corporations’ overall practices. Market environment, where
company operates, is regulated and supervised by authorities and also stakeholder
relations are controlled by laws. Private enforcement is also important as individual
parties make sure their contracts are enforced in an agreed way. From legal point
of view, principal has delegated agent the management of principal’s property.
Company’s operations are organized in form of contractual relations. Stakeholder
theory refers to a wide range of contracts between the company and bank,
employees, customers or suppliers. These regulations and contractual
relationships create the framework in which company operates. Corporate
governance is a part of this framework: There are both obligatory and voluntary
elements involved. Enforcement should be efficient in order to achieve the goals of
the set codes or recommendations.
Corporate governance can be enforced by law or by more voluntary approach.
Common voluntary approach is ‘comply or explain’. Legislation on disclosure of
information usually covers financial information, audit function and, for example,
annual general meetings. Agency theory point of view on corporate governance
enforcement is to enhance monitoring, reduce asymmetry of information and the
conflicts of interest between the principal and agent. This in turn reduces agency
costs. From stakeholder perspective, it guarantees that mechanisms for control
and operative management are in place. Solomon describes (2007, p. 186) that
particular country’s legal framework dictates how corporate governance
enforcement is set. Common law systems prefer often voluntary initiatives whereas
countries with codified legal system choose government-led corporate or
commercial law framework changes. The comprehensible allocation of roles and
power among the authorities are essential for implementation of corporate
governance in practice. In addition, enough resources need to exist for the
authorities to monitor the implementation.
24
3 OECD and Revised Principles
OECD published Principles of Corporate Governance for the first time in 1999. It
has raised awareness of corporate governance practices in OECD member
countries and as well as among non-members. With a new mandate by OECD
Ministers in 2002, a review of the principles was carried out including surveys
directed to member countries, comments from Regional Corporate Governance
Roundtables including also non-member countries and help of World Bank and
other sponsors. Prior to making the Revised Principles, OECD consulted many
international bodies such as World Bank and governments of member states in
order to gain a converged view on the governance guidelines and suggestions for
improvement. Revised Principles were published in the year of 2004.
OECD also recognizes that principles may not fit all the countries due to variety of
corporate, social and cultural structures. Revised Principles take voluntary
approach to corporate governance and many OECD member and non-member
countries over the world have used in building and evaluating their legal
frameworks and best practices. In the preamble of the Revised Principles,
corporate governance practices are seen as one key element in improving
economic efficiency and growth and also enhance investors’ confidence. Revised
Principles (2004, p. 12) “focus on governance problems that result from separation
of ownership and control.” Without under-estimating the relevance of other
stakeholder parties in sustainable business operations, the focus of Revised
Principles supports the agency theory approach that this thesis has taken. OECD
emphasizes that other issues relevant to company activities, like environmental,
anti-corruption or ethical concerns, have been included more soundly in different
OECD and other international organizations’ instruments.
25
Solomon (2007, p. 189) mentions a weakness of OECD principles: They have no
legal or regulatory power by itself. Kirkpatrick and Jesover (2005, p. 127) note that
the principles have a focus on publicly traded companies. However, other
companies are also encouraged to apply the principles. From global perspective, it
is important that OECD principles are adaptable to various types of corporate
structures. According to Mallin (2007, p. 33), World Bank and International
Monetary Fund use OECD principles to prepare assessments of corporate
governance in individual countries. Through world wide application of the
principles, the framework is influential in global scale.
OECD emphasizes the responsibility of national governments in shaping effective
regulatory frameworks that provide also flexibility for markets to respond to
continuously evolving business environment and expectations of shareholders and
other stakeholders. Revised Principles were chosen to form a framework for the
analysis of the Finnish Corporate Governance Code, because they allow better to
account for country specific business environment’s characteristics, and the
statutory regulation that are rooted in the Finnish corporate governance landscape.
26
Table 1 summarizes the Revised Principles key areas. The principles are
complemented by the separate annotation part which includes explanation and
more details on each principle.
The areas of Revised Principles: The corporate governance framework should: I. Ensuring the basis for an effective corporate governance framework
“- - promote transparent and efficient markets, be consistent with the rule of law and clearly articulate the division of responsibilities among different supervisory, regulatory and enforcement authorities”
II. The rights of shareholders and key ownership functions
“- - protect and facilitate the exercise of shareholders’ rights.”
III. The equitable treatment of shareholders
“- - ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights.”
IV. The role of stakeholders in corporate governance
“- - recognize the rights of stakeholders established by law or through mutual agreements and encourage active cooperation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises. “
V. Disclosure and transparency “- - ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company“
VI. The responsibilities of the board “- - ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders“
Table 1: Revised Principles summarized (adapted from Jesover and Kirkpatrick
(2005, p. 130))
27
4 Finland and Corporate Governance
4.1.1 Regulatory Environment in Finland
Finnish legislation is based on civil law system. Legislation concerning Finnish
listed companies is the Limited Liability Companies Act (624/2006 as amended,
hereinafter FLLCA) and Securities Markets Act (495/1989 as amended, hereinafter
SMA). Companies listed in NASDAQ OMX Helsinki Ltd (hereinafter Helsinki Stock
Exchange) should follow with Rules of the Stock Exchange8, which are compliant
with the aforementioned Finnish law. According to the study on corporate
governance in European Union by RiskMetrics Group (2009, p. 96 of Appendix 1),
the Finnish market is very heterogeneous with big global players like Nokia
governed by the same framework as many more small domestic companies listed
in the Helsinki stock exchange. Same study (2009, p. 26) notes that stock
ownership is concentrated in the hands of foreign investors. According to OMX
Nordic Exchange web pages9, 128 companies were listed in Helsinki Stock
Exchange in 2009.
According to a decree by Ministry of Finance (393/2008), company shall provide an
explanation if departing from the applicable10 governance code. Internal control of
the company is referred in FLLCA (§6, item 2) as board of directors is responsible
on the control of company’s accounts and finances. The general manager shall
handle the compliance with law on the accounts and financial affairs. It should be
mentioned at this point that Finnish Ministry of Justice Working Group on FLLCA
left in purpose the corporate governance issues to self-regulation of businesses:
Best practices can change faster than it’s feasible to change legislation.
8 Rules of the Stock Exchange entered into force 16.03.2009. Original Finnish document used to familiarize with the rules and the unofficial translation of the document by NASDAQ OMX Helsinki was used for referencing in the text. 9 Yearly Nordic Statistics 2000-2009 in an Excel form, 2010, Source (viewed 5 March 2010): http://nordic.nasdaqomxtrader.com/digitalAssets/67/67432_yearly_nordic_statistics_2000_2009.xls 10 FCGC applies providing it does not conflict with statutory regulation in the company’s domicile
28
reporting
appointment
Shareholders
Auditors Supervisory Board
Employees
Board of Directors
Management
SuppliersCustomers Creditors
In agency theory, the purpose of a company is to maximize shareholder value,
whereas Finnish law (FLLCA §1, item 5) allows the articles of association to define
other purpose for the company. FLLCA (§1, item 8) states that managers shall act
with due care and promote the interest of the company. Generally this means
fiduciary duty to shareholders, but it may allow interpretations. In the analysis, it is
assumed that listed companies’ purpose is to maximize shareholder value. Figure
2 illustrates the general governance model in Finnish companies.
Figure 2: General governance structure of Finnish companies [adapted from
Laitinen & Ruuhela (1997, p. 319)]
Articles of Association have an important role in forming the governance practices
and basis for corporate operations in Finland. Articles of Association are obligatory
for a limited liability company. In general, shares in Finland contain both of the
following rights:
1) Property rights (e.g. dividend, pre-emptive rights and registering of shares)
2) Administrative rights (e.g. right to receive information, using right to put item
on agenda of general meeting, right to speak and to make questions, and to
contest decisions)
29
Before going more in detail on corporate governance in Finland, a brief description
of general meeting and extraordinary general meeting is given. These will be
further discussed in the analysis of corporate governance codes. FLLCA states
that general meeting is to be held within six months of the financial period’s end. In
addition, FLLCA require that at least one statutory auditor is appointed by the
annual general meeting. Auditors are regulated by the Finnish Auditing Act. FLLCA
(§3, item 2) also lists items that fall within scope of ordinary general meeting and
extraordinary general meeting. Ordinary General meeting shall include decisions
on the following items: (1) adoption of the financial statements; (2) the use of profit
shown on the balance sheet; (3) the discharge of board of directors and managing
director from liability; (4) the appointment of the board; (5) other matters that shall
be decided in the general meeting according to articles of association.
An extraordinary general meeting shall be held if (1) articles of association require;
(2) board considers it necessary; (3) shareholder or auditor demands; or (4)
supervisory board considers it necessary and it is competent under articles of
association, decide on the holding of extraordinary meeting. Referring to the third
point, an extraordinary meeting is held if a total of tenth of shareholders (or less if
company’s article of association states so) demand so in writing. This enhances
also the rights of minority shareholders, if they succeed to gather 10 percent of the
shareholders to demand extraordinary meeting. (see FLLCA §3, item 3-4)
30
4.1.2 Corporate Governance Code
The adoption of euro and reduction of barriers of capital flows have increased the
amount of potential investors and access to funds also in Finland. These have
increased pressure on enhancement corporate governance system, and changed
the business environment. Investors’ access to information about Finnish corporate
culture and financial information has been an important target in building the
corporate governance code in Finland. According to statistics from Euroclear
(2010), the foreign and nominee-registered11 portion of the shares issued has been
47-53 percent in the last 10 years and 45.7 percent in March 2010.
European Commission requires annual statement on structure and practice of
corporate governance on comply or explain -basis. This disclosure requirement
applies to stock listed companies. They released also directives aiming to
harmonize transparency and disclosures. Directive 2006/46/EC require listed
companies to publish a corporate governance statement and it has been applied in
Finland. European Union in itself and European Commission’s directives
harmonizing the company law evidently converge the corporate governance in the
member states.
Finland’s first corporate governance guidelines, published in 1997, were based on
voluntary application for listed companies. Corporate governance recommendation
for listed companies was published in 2003. The current revised FCGC issued by
Securities Market Association12 came into force on 1.1.2009 and additional
corporate governance statement guidelines were published in 200913. Revising the
code was driven by private actors having public support due to European
Commission Directive to be harmonized in Finland. The code is a complement to
the Finnish statutory legislation.
11 Custodial nominee account: Book-entry securities owned by a foreign individual, corporation or foundation may be entered in a special book-entry account. (not available for Finnish-owned share) 12 Central Chamber of Commerce of Finland, Confederation of Finnish Industries EK and NASDAQ OMX Helsinki Ltd established Securities Market Association in 2006. 13 Remuneration Statement Guideline in October 23, 2009 and Corporate Governance Statement Guideline in November 2, 2009 available in Securities Market Association’s web pages.
31
In brief, FCGC framework consists of recommendations in the areas of general
meeting (recommendations 1-4), board (5-17), board committees (18-33),
managing director (34-36), other executives (37-38), remuneration (39-44), internal
control, risk management and internal audit (45-47), insider administration (48),
audit (49-50) and communications (51-52). The recommendations are stated in
Appendix 1. FCGC includes an explanatory section under each recommendation.
The introductory part of FCGC includes general description on the corporate
governance in Finland, also a brief description on shareholder’s rights based on
the statutory regulation. According to FCGC (2008, p. 6), ownership structures and
governance practices vary among the listed companies. In international terms,
most of the companies listed in Helsinki Stock Exchange are medium or small-
sized companies.
Introductory chapter of FCGC further explains the comply or explain principle as
follows:
“The company may depart from an individual recommendation of the Code due to,
e.g. the ownership or company structure or the special characteristics of its area of
business. A clear and comprehensive explanation will consolidate the trust in the
decision made by the company and make it easier for the shareholders and
investors to evaluate the departure.” (see FCGC 2008, p. 6)
Interestingly, OECD’s Revised Principles are based on non-binding, voluntary
adaptation in member countries, but they do not particularly emphasize to adopt
this comply or explain –approach. They do mention it, but only on annotation
concerning their recommendation on disclosure and transparency:
“In several countries, companies must implement corporate governance principles
set, or endorsed, by the listing authority with mandatory reporting on a “comply or
explain” basis. Disclosure of the governance structures and policies of the
company - - is important for the assessment of a company’s governance.” (see
OECD 2004, pp. 53-54)
32
A recent study by Helsinki Stock Exchange gives an overview on the effect of the
above recommendations. Seppänen14 (2009, p. 7) reviewed the listed companies’
compliance with the FCGC: currently all the listed companies publish the required
information on their website as required by FCGC recommendation 52 on
disclosure. Figure 3 illustrates the compliance to FCGC with companies
categorized in small cap, mid cap and large cap. It must be noted that the amount
of listed companies in the review was 125, whereas annual report of Nasdaq OMX
stated that there were 128 listed companies at the end of the year. However, this
may be explained due to timing of the survey in October, not at year-end.
13
2313
39
18
19
0 10 20 30 40 50
Large Cap
Mid Cap
Small Cap
Number of companies
Depart
Comply
Figure 3: Compliance to FCGC in Helsinki Stock Exchange (adapted from
Seppänen, 2009, p. 9)
14 Janne Seppänen is the Head of Surveillance of NASDAQ OMX Helsinki Stock Exchange
33
5 Analysis of Revised Principles and FCGC
5.1 Basis for an Effective Corporate Governance Framework
According to OECD’s Principals, framework should promote transparent and
efficient markets, be consistent with rule of law and clarify the responsibilities of
authorities involved. In addition to making recommendations, FCGC has taken task
to give foreign investors a general view on the Finnish corporate governance
system. OECD explains the basis of the framework in the annotation and notes
that framework may need to be adjusted as new experiences accrue and business
circumstances change. As already mentioned before, Finnish legislators have
deliberately left corporate governance for self regulation, providing it does not
conflict with FLLCA or other compelling legislation. The FCGC applies to
companies listed in Helsinki exchange, given it is not conflicting with statutory
regulation in the domicile of the company.
Revised Principles encourage authorities building the framework to consult with
corporations and other stakeholders. Securities Market Association has duty to
administer the code. For example, following European Commission’s
recommendation on remuneration of directors of listed companies15, Securities
Market Association set up a working group, consisting of lawyers, representatives
from chamber of commerce, investors, corporations e.g. Nokia and from stock
exchange, to investigate a need for changes in the FCGC. The working group is
currently waiting for comments on their proposal and the goal is to publish the
updated corporate governance code in June 2010.
Revised Principles annotation describes that division of the responsibilities among
authorities should be clear. However, some recommendations of FCGC are based
on law or other compelling regulation. Company may not depart from these
statutory items.
15 30.4.2009 dated Commission Recommendation complementing Recommendations 2004/913/EC and 2005/162/EC as regards the regime for the remuneration of directors of listed companies
34
The mandatory implementation of corporate governance code is a recent adoption
to statutory law, and as a result the distribution of responsibilities among authorities
is slightly unclear. Finnish Financial Supervisory Authority (hereinafter FFSA) does
refer in their web pages16 to the corporate governance code for listed companies
and considers some areas of FCGC of particular relevance: competence and
independence and remuneration of board members, internal control and risk
management. Keeping in mind that FFSA has jurisdiction over the issue, it has not
established major monitoring system on the compliance of the code. Therefore, the
responsibility so far has remained with the Helsinki Stock Exchange to monitor that
the listed companies follow their rules of the exchange. As Helsinki Stock
Exchange is a private body, it does not have the formal legal authority and
enforcement. However, sanctions from Helsinki stock exchange apply. FCGC
Recommendation 51 states that the law [Securities Market Act 392/2008] requires
the company to present corporate governance statement either in the annual report
by the board of directors or as a separate report. FCGC (2008, p. 6) refers also to
the Rules of Helsinki stock exchange which include obligations related to good
corporate governance practices and disclosure.
Non-binding nature of OECD Principles is also reflected in FCGC. The FCGC
follows the ‘comply and explain’ –principle. This principle does not necessarily
increase convergence of corporate governance practices: Alternative of not
complying is available for the company, as long as they explain the departure. In
addition, company may choose a very general explanation on the departure.
Revised Principles note that flexibility of the corporate governance framework
allows companies to operate in broadly different circumstances. FFSA published a
report on regulatory outlines of corporate governance in 2005. The report stated
that the Finnish corporate governance framework builds on Revised Principles,
guidelines issued by Basel Committee on Banking Supervision and the
Recommendation for Corporate Governance of Listed companies.
16 Finnish Financial Supervisory Authority [in Finnish Finanssivalvonta] 2005, Source (viewed 2 December 2009): http://www.finanssivalvonta.fi/en/Listed_companies/Listing/Corporate_Governance/
35
5.2 Rights of Shareholders and Key Ownership Functions
According to Revised Principles’ annotations (2004, p. 32), the “section can be
seen as a statement of the most basic rights of shareholders, which are recognized
by law in virtually all OECD countries.” In Finland the basic shareholder rights are
covered in FLLCA. OECD’s Principles’ CG framework should protect and facilitate
shareholder rights including registration and transfer shares. FLLCA has provisions
on rights related to shares and on annual general meeting. Companies are
required to maintain a register of shares and the register shall be available in
company’s head office to access for everyone.
Revised Principles state that capital structures and arrangements that enable
shareholders to obtain a degree of control disproportional to their ownership shall
be disclosed. European Commission Directive 2004/109/EC states that investors
should notify no later than 4 days if they exceed the threshold of holding 5 percent
of shares. Finnish Securities Market Act (§2, item 9) has more strict legislation on
notifying with flagging announcement on the threshold of holdings without undue
delay. In the articles of association, the company can set even a lower threshold of
holdings that need to be notified. In Finland, shareholders can require a minority
dividend if one tenth of shareholders do so. FLLCA (§13, item 7) states that articles
of association may restrict the right to minority dividend to be decided only on the
consent of all shareholders.
Concerning institutional investors, Revised Principles (2004, pp. 36-37) do not
advocate particular investment strategies for institutional investors, and state that
they should disclose their voting policies in respect to their investments. FCGC
(2008, p. 7) notes that it may be interest of the company and the shareholders if
“the board is aware of the opinion of shareholders with significant voting rights on a
matter under preparation for the general meeting”. They also emphasize that
insider regulations of Helsinki Stock Exchange must be considered. In addition,
shareholders are allowed to communicate with each other on issues concerning
shareholder rights – except cases that may result on abuse.
36
5.2.1 General Meeting
Revised Principles (2004, p. 18) state that shareholders should be able to
participate effectively and vote in general meetings and should also be informed of
the rules. In Finland, shareholders entered into the share register before ten days
of the general meeting have the right to attend. Articles of Associations may
contain a clause of need to notify of attendance not to be later than ten days before
the meeting. Shareholders may exercise their rights via proxy and if required,
shareholder or proxy may also have an assistant at the general meeting. FLLCA
(§5, item 8) states that proxy document or otherwise reliable evidence shall be
produced by the representative. This means in practice also that the company
cannot limit the selection of proxy to their preferences.
Shareholders have the right to be timely informed on corporate changes and
should have an opportunity to participate in general meetings. FCGC
recommendation 1 on general meeting contains some obligations by the EU
directive (2007/36/EC) on the exercise of certain rights of shareholders. The aim of
the directive is to improve access to take part in voting in general meeting. The
directive has been applied in Finland; most of it was already included in the
statutory regulation. Recommendation 1 concerning general meeting includes
notion that company should make every effort to ensure possibility to participate in
the decision making of general meeting (e.g. arranging simultaneous translation in
general meeting for foreign investors). In FCGC recommendation 3, it is explained
that, by exercising shareholders right to present questions in general meeting,
owners can get detailed information on the items on the general meeting agenda.
Furthermore, recommendation 3 mentions that the presence of the auditor at the
general meeting allows shareholders to ask details on the financial statements.
37
FCGC recommendation 1 includes very detailed description on what information
should be included in the notice of the general meeting. Invitation to the annual
general meeting shall be delivered no earlier than two months and no later than
one week before the meeting. Shareholders have the right to request information
on an item on general meeting agenda or suggest a relevant item on the agenda, if
shareholder notifies the board well in advance. According to the Helsinki exchange
rules (2009, p. 39), any board’s proposals for general meeting that have a material
effect on the security’s value need to be disclosed. The proposals of board of
directors and other relevant information like annual report and auditor’s report shall
be available in the head quarters of the company or in their website. The same
information shall be sent without delay to shareholder if requested. (FLLCA §5,
item 19 and §5, item 21)
Revised Principles (2004, p. 58) do not contain exclusive recommendations of
board composition, but they take an approach of describing best practices. FLLCA
(§6, item 9 and §6, item 21) states that majority of board’s directors are appointed
by the general meeting, however company’s articles of associations may state on
another way of appointing the remaining minority. In turn, FCGC recommendation
8 emphasizes that the complete board of directors is appointed by general
meeting. For instance, the general meeting does not select the board of directors,
when there is a supervisory board that appoints the board of directors. According
to the RiskMetrics Group (2009, p. 94 of Appendix 1), it is unusual among Finnish
companies that board of directors would be appointed by anyone else than annual
general meeting. RiskMetrics Group (2009, p. 100) describe that in general the
board directors election is conducted as bundle election. Shareholders present in
the general meeting, may ask to conduct election of board of directors individually.
However, the ability to influence the result is limited unless there are alternative
director candidates. FCGC recommendation 11 advises that shareholders shall be
informed about new director candidates and their biographical details on the
company website. As a result, informed owners have a possibility to evaluate the
candidate before making decisions in the general meeting.
38
5.3 The Equitable Treatment of Shareholders
OECD’s Revised Principles emphasize that all shareholders should be treated
equally according to the share classifications, insider trading and abusive self-
dealing should not be allowed and top management and board members should
disclose to the board if they have a material interest on the matters affecting to the
corporation.
Revised Principles describe that all shares should carry the same rights, within any
series of a class. On the rule of law level, FLLCA (§3, item 3) includes
requirements on equal treatment of shareholders, unless otherwise provided in the
company’s articles of association – referring to classification of shares. FCGC
(2008, p7) notes that principle of equal shareholder rights does not prevent using
of majority rule. However, decisions favoring majority of shareholders at cost of
other shareholders is forbidden by law (see FLLCA §1, item 7). Referring to the
statutory legislation, FCGC points out that the articles of association of some listed
companies contain some clauses restricting the voting rights.
Revised Principles highlight the use of voting instructions for custodians or
nominees and other provisions like pre-emptive rights to share issues. FLLCA (§9,
item 3) has provisions on pre-emptive rights. In addition, Securities Market
Association has published a model of notice of annual general meeting17 and
abstain vote18 –sum up in order to guide international investors on the voting
procedures and nominee or custodian voting in Finnish companies.
The disclosure recommendations and requirements, that are analyzed in more
detail in chapter 5.5 Disclosure and Transparency, are promoting the shareholders’
access to information for example concerning decisions made in annual general
meeting. These recommendations support equal right to be informed about the
company’s financial position and decisions taken in the general meeting also for
17 Model available in the website of Securities Market Association’s committee of listed companies http://www.cgfinland.fi/images/stories/pdf/LYNK/AGM2010/yhti%F6kokouskutsumalli__eng_agm2010.pdf 18 http://www.cgfinland.fi/images/stories/final%20abstain%20votes%20sum%20up%20200209.doc
39
those shareholders that are unable to attend the meeting. FCGC (2008, p9)
emphasize that especially companies with international shareholders should use
reasonable means to promote participation possibilities. The new ongoing
proposal19 for the code is that articles of association may state that shareholder’s
attendance by mail, telecommunication or via other technical aid shall be possible.
Annotations of Revised Principles (2004, p. 42) describe that, while existence of
controlling shareholder can reduce the agency problem of monitoring, weak
shareholders should have the right for derivative and class action law suits.
FLLCA (§22, item 7) states that shareholders have the right for to bring an action
on behalf of the company if 1) it is likely that company will not claim damages, 2)
shareholder(s) possess minimum of tenth of shares, and 3) it is proven that non-
enforcement of the claim for damages would be against principle of equal
treatment. However, shareholder taking the action shall bear the legal costs and
shall have the right to be reimbursed by the company.
Revised Principles (2004, p. 44) annotate that insider trading and abusive self-
dealing should be prohibited. Concerning insider trade regulation, FCGC refers to
Guidelines for Insiders issued for listed companies by Helsinki Stock Exchange.
The guidelines state insiders are always personally responsible on complying with
the regulations. The guidelines contain operational modes for: identifying insiders,
management of insider information and trading by insiders. In addition, the
Securities Market Act has regulation on insider register and trading. FLLCA (§8,
item 6) states annual report shall contain information on loans, liabilities and
commitments to related parties if they exceed EUR 20,000 or five per cent of
equity. In annotations of Revised Principles (2004, p. 45), members of the board
and executives are recommended to disclose any material interest on matters
affecting the company. FCGC recommendation 14 states majority of the directors
shall be independent of the company, at least two to be independent of significant
shareholders. FCGC (2008, p. 11) gives examples of non-independency: service
contracts, co-operation relationships or employee of a present auditor.
19 Securities Market Associations proposal for amendments to FCGC dated 23 March 2010
40
5.4 The Role of Stakeholders in Corporate Governance
Revised Principles state that the rights of the stakeholders that are established by
law or mutual agreements should be respected. OECD Revised Principles mention
that developing performance-enhancing mechanisms for employees should be
permitted. In Finland, basis of employment contracts in industry sectors are mainly
negotiated by labor unions which also provide legal assistance for their members.
Other compensations and benefits are negotiated usually between employers and
employees. According to Vanhala (1995, p. 31), typical Nordic feature seen also in
Finland is the strong position of trade unions. The unionization rate is high for both
employers and employees. She mentions also the dualization of Finnish labor force
between those with permanent employment relationship and those who have a
temporary job contract.
OECD’s (2004, p. 12) preamble of Revised Principles describes how in some
countries employees have important legal rights irrespective of their ownership
rights. In addition employees contribute to the long term success and performance
of the corporation. The Finnish Limited Liability Companies Act (§6, item 9) rules
that, if the articles of association state so, a minority of board may be appointed
according to some other procedure than general meeting. FCGC recommendation
12 notes that, for example, articles of association may include clauses on
employees’ right to appoint directors to the board. Interestingly, study by Weil,
Gotshal and Manges LLP (2002, p. 3) notes that the greatest difference in
corporate governance practice among EU member states relates to the role of
employees which is in included statutory regulation. In Finland, Act on Personnel
Representation in Company Administration (725/1990 as amended) and Act on
Co-operation within Finnish and Community-wide Groups of Undertakings
(335/2007 as amended) go in more detail on employee involvement. These are
supervised by Ministry of Employment and the Economy.
41
Before employers make decisions on issues that greatly influence personnel (e.g.
like collective dismissal of workforce), they shall go through the particular issues,
including their reasons, effects and alternatives, with employees that will be
affected. Cooperation parties are the employer and chosen employee
representatives. European Works Council is also mandated by law in Finland.
Statutory regulation does allow employees to represent in unitary or supervisory
board. If articles of association state so, employees may even appoint a member of
the board.
Revised Principles add that stakeholders should be allowed to obtain information
on the effective redress for violation of the rights and so-called whistle blowing
practices shall be enabled. In Finland, protection of workers is safeguarded with
the rules of termination of job contracts that forbid termination on employee-
specific grounds, except in cases of serious neglect of employee’s obligations. In
practice it may, however, prove difficult to continue normally if for example whistle
blowing activities has caused some kind of discrimination of the particular
employee in the social network of the corporation.
Revised Principles state that enforcement of creditor rights and insolvency
framework should be established. OECD (2004, p. 12) recognizes that creditors
play an important part in corporate governance and can be external monitors over
the corporate performance. Companies may need to compromise the short run
creation of residual profit due to for example loan interest payments and covenant
agreed with creditors. However, the debt financing enables the company to make
capital expenditure for investment in the future cash flows. Finnish Limited Liability
Companies Act includes provisions on insolvency and creditor rights, for example
in case of minority dividend, merger, a demerger, a change of business form and
the dissolution.
42
5.5 Disclosure and Transparency
Disclosure and transparency section in Revised Principles notes the timely and
accurate disclosure of material information. Accuracy refers to standards of
accounting and financial or non-financial disclosure and annual audit should assure
that the disclosures represent the financial position and performance of the
company. It should also include information on company objectives, share
ownership and voting rights, remuneration of directors, related party transactions,
risks and issues regarding stakeholders. Disclosure channels should allow
shareholders to access the information efficiently.
European Union harmonized the financial statements of the listed companies and
the International Financial Reporting Standards (IFRS) -regulation has been
applied to Finnish accounting regulation. European Commission Directive
2004/109/EC aims to harmonize disclosure and increase the comparability and
transparency in EU member states. Finnish statutory law permits use of IFRS20 in
the financial statements. Finnish listed companies shall prepare annual accounts
and a table section in interim report according to international financial reporting
standards as referred to in the Accounting Act (1336/1997 as amended) and
Accounting Ordinance (1339/1997 as amended). Accounting Ordinance regulates
the production of financial information and to some extent the disclosure as well.
FFSA is responsible for supervising the compliance. Helsinki Stock Exchange has
disclosure rules harmonized accordingly with NASDAQ OMX Nordic Exchange.
According to Miihkinen (2008, p. 386) Finnish managers consider compliance with
applicable laws and the true and fair view requirement important and a matter of
honor. It may also be a result of so called small circles of business in Finland,
where many managers of the big companies know each other. Miihkinen (2008, p.
407) finds managers, in sample of Finnish listed firms, interpret voluntary
disclosure recommendations to have mandatory characteristics. This is an
important insight keeping in mind that FCGC has taken a voluntary approach.
20 IFRS is an internationally used set of accounting standards developed by an independent organisation, International Accounting Standards Board.
43
FLLCA complements the accounting legislation and, for example, has additional
provisions on the annual report. FCGC (2008, p. 6) aims to harmonize the
disclosure practices of listed companies. Referring to Revised Principles’ (2004,
p. 56) notion of channels for disseminating information that should provide equal
access, the corporate governance statement and other information disclosures
shall be published in company website in Finland.
Most of the FCGC recommendations apply to the parent company of a group,
however FCGC (2008, p. 6) emphasizes that recommendations on supervision,
control, disclosure cover the entire group of a company. In addition, FCGC’s
recommendation 52 has extensive list of the disclosure of information for investors
concerning, to mention few, board committees, directors’ of the board,
management organization, stock holdings’ of directors, remuneration policy and
board’s evaluation of short-term risks. These allow the potential and current
investors to valuate their securities effectively. FCGC recommends that a separate
corporate governance statement shall be disclosed in connection with the financial
statements. The code includes detailed requirements on the information that shall
be published before the general meeting.
OECD’s Revised Principles explain also that audit should be done in an objective
manner in order to ensure shareholders and the board that the financial statements
fairly represent the state of the company. In addition, auditors should be
accountable to the shareholders. Finland has implemented the European
Commission Directive (2006/43/EC) concerning statutory auditors. In Finland,
auditors are required to certify that the corporate governance statement is
consistent with the disclosed and audited annual accounts.
The ongoing proposal for new FCGC includes more detailed recommendations on
the company’s remuneration policy. In brief, company is recommended to disclose
in the corporate webpage information about: board member remuneration
(supervisory board if applicable), remuneration policy of other executives and CEO,
and financial benefits of the CEO and chairman of the board and other board
members that have an employment relationship or service contract.
44
5.6 The Responsibilities of the Board
Revised Principles state that corporate governance framework should ensure
company’s strategic guidance, effective monitoring of management by the board
and the board’s accountability to the company and the shareholders. Revised
Principles also specify certain key functions that the board should fulfill.
Confirmed by RiskMetrics Group (2009, p. 92 of Appendix 1), majority of Finnish
corporations have a unitary board, but FLLCA (§6, item 1) states that company
may have a supervisory board. FLLCA (§6, item 8) does not limit the number of
board members. However, if there are fewer than three directors, at least one
deputy shall be appointed. According to FLLCA at least one of the board members
shall be resident of European Economic Area, unless registration authority has
granted an exception. FLLCA (§6, item 10) forbids appointment of minors or
persons with restricted legal competency.
FLLCA (§6, item 20) states that the board of directors shall appoint the managing
director. Also, FCGC’s recommendation 34 specifies that board has the
responsibility to approve a written service agreement of the managing director. In
addition recommendation 43 explains the board decides the remuneration of the
managing director. According to Helsinki Stock Exchange rules of disclosure, all
share-based incentive programs shall be disclosed to provide investors information
on the employee motivation as well as dilution effects of the incentive program.
FCGC recommendation 36 states managing director shall not be elected as
chairman. Concurrently, FCGC does mention that some special circumstances, like
company’s business area or ownership structure, may justify combining the roles of
board chairman and managing director. This is due to the fact that FLLCA allows
appointment of general manager as chairman. In these situations, FCGC
recommendation 36 specifically mentions that the company must report and
explain the reasons for the departure of the recommendation. Recommendation 9
concerning board composition states that the board should contain both genders.
In general, members of board of directors in Finland are non-executive.
45
FCGC’s recommendations 14 and 15 concern independent members of board: in
order to avoid conflict of interests, majority of board members shall be
independent. This agrees with Revised Principles (2004, p. 65): “The board should
be able to exercise objective independent judgement on corporate affairs.”
The one of the most important role of the board is to monitor the company in the
interest of shareholders. FCGC recommendation 46 describes that the “board
ensures that the company has defined the operating principles of internal control
and monitors the function of such control”. It is worthy of mentioning that statutory
legislation already requires that the annual board report contains an evaluation of
major risks and uncertainties. FCGC recommendation 47 states that the
organization of internal audit function shall be disclosed. This allows the
shareholders and also other stakeholders to evaluate the state of internal control in
the company. FCGC defines the internal control as established by COSO
(Committee of Sponsoring Organizations of the Treadway Commission). It must be
noted that organization of internal auditors was not part of the working group
making the code, perhaps it is one reason why internal control is left mostly to self-
regulation and companies are recommended to describe internal control system.
FCGC recommendation 3 states that, in addition to managing director, the
chairman of the board and adequate number of board members to attend the
general meeting. As mentioned before, any shareholder attending the annual
general meeting may ask questions concerning the items in the general meeting
agenda. This often requires responses from managing director, various
board/committee members and thus the attendance is important.
Finnish statutory law does not call for board committees. According to Mähönen
and Villa (2006, p. 141), FLLCA does not contain specific clauses on dividing the
tasks to board members. Unless division of tasks is specified in the Articles of
Association, also relevant committees can be established by board decision.
FCGC recommendations 51-52 contain specific descriptions on the disclosure of
the composition and operations of the board and board committees. Mähönen and
Villa (2006, p. 323) note that especially listed companies have established a
46
practice of committees in order to ensure effectiveness of board. However, board
of directors shall be responsible of the decisions and this decision making cannot
be replaced by the committees’ decisions.
FCGC has a number of recommendations (18-33) on committees established by
the board. Especially audit committee with at least three members is
recommended or, otherwise, either the board shall fulfill the duties or company
needs to assign them to some other committee. It is also recommended that at
least one member of the audit committee has sufficient expertise on the area. The
audit function in Finland is regulated by Auditing Act. Mähönen and Villa (2006,
p. 323) mention that the most common committees are audit, nomination and
remuneration committees.
FLLCA (§6, item 4) states that a board member shall be disqualified from the
consideration of a matter pertaining to a contract if the member will derive essential
benefit in the matter which may not be benefit for the company. Mähönen and Villa
(2006, p. 326) give an example of a possible situation. The member of the board of
company A is appointed as CEO of company B of which contract is on the agenda
of board meeting. The member knows there is a great amount of air in B’s contract
price compared to other competitors. He would have a responsibility firstly to
disqualify from the decision making in A’s board and, in addition, to notify that the
contract is not in the benefit of the company A and they should ask for other offers
to compare the price.
Referring to class action or derivative suits discussed earlier, Mähönen and Villa
(2006, p. 303) note the threshold for filing a suit against the board is high. The
rationale for the business judgment rule is that a board should be able to exercise
full managerial discretion without the threat of an impending lawsuit for a poor
decision. Moreover, so long as a conflict of interest is not apparent, the business
judgment rule often insulates the board from potential liability for business
decisions. In order to ensure the transparency of the board decisions, FLLCA (§6,
item 6) states the responsibility for board is to document the meeting minutes
which document board meeting agenda, decision and discussed topics.
47
6 Agency Perspective on FCGC
6.1 Information Asymmetry
Information asymmetry causes most of agency problems. If there would be perfect
knowledge about agent’s doings and capabilities, principals would be able to
evaluate the manager and many agency issues would disappear. Disclosure
requirements that are regulated by law are efficiently monitored by Finland’s
Financial Supervisory Authority. The financial information disclosed quarterly
should a true and fair view of the company’s financial status for the principal. This
is further assured by a legal requirement of an external auditor.
Information asymmetry increases when managers may try to selectively disclose
the information or use creative accounting methods to affect the numbers. The
correctness of the disclosures is confirmed by statement of an external auditor. As
discussed in disclosure chapter, Finland has still relatively small market for
financing and also market for management is quite small. Managers consider the
correctness of financial disclosure a serious matter as they want to maintain their
reputation. FCGC has detailed recommendations on disclosure and thus reduces
information asymmetry between principal and agent.
Comply or explain approach allows flexibility for the governance practices given
how heterogeneous listed companies in Helsinki Stock Exchange are. Authorities
do follow up on compliance to the code, but the analysis of the departure
explanations is left to the shareholders and other providers of finance. There is a
wide amount of financial information and corporate governance process
explanation available for principals to start with just by clicking to the company web
pages and browsing the financial disclosures and corporate governance statement.
Also, companies can give a very general explanation on the departure from FCGC.
48
In reality, principals’ knowledge of how to analyze all available data is sometimes
limited. Therefore, it can be challenging to acquire needed information to reduce
information asymmetry from shareholder’s perspective. In this case, analyst reports
in financial media may be useful if the subjectivity of analyst opinions is taken into
account. Principal’s critical media reading skills are essential nowadays.
Presence of foreign investors is large in Helsinki Stock Exchange and FCGC has
recognized this by making the code more informative on Finnish corporate
governance practices. Due to high percentage of foreign investors in Helsinki Stock
Exchange, disclosures are often made available in English or Swedish in additional
to Finnish. Also simultaneous translation and meeting material are available often
in general meetings, making it easier for foreign principals to take part in the
decision making process. Disclosure according to International Financial Reporting
Standards is also reducing also the cost of monitoring for foreign and institutional
investors with increased comparability of data.
Rules of Helsinki Stock Exchange state that shareholders shall be informed about
any board proposals that have material effect on the value of security. All the listed
companies should therefore reduce information asymmetry that directly affects the
security value. Shareholders shall also be informed of the decisions and issues
dealt with general meeting even if they could not attend. FCGC promotes
shareholders equal access to information. It must be noted that the strategic
decisions of the board are only a part of the picture. As discussed, information
asymmetry exists throughout the company: board-CEO, CEO-employees and for
example company-creditor relationships.
Adverse selection is reduced by recommendation to make the biographical
information on the new board candidate available for shareholders. Shareholders
may request even to conduct board member election as an individual instead of
usual bundle election. However, adverse selection from principal’s point of view
does not reduce when only one new board member candidate is proposed by the
board’s nomination committee with no alternative choice available. Also, adverse
selection is more apparent when board is recruiting the CEO. FCGC does
49
recommend including a description of board committees, and possible nomination
committee needs to explain their activities in the corporate governance statement.
From principal’s perspective, the description rarely includes enough details to
evaluate the selection process thoroughly.
The areas of Revised Principles:
Statutory and FCGC recommendations to reduce information asymmetry
I. Ensuring the basis for an effective corporate governance framework
• FFSA supervises statutory disclosure compliance • Flexibility of comply or explain approach • Helsinki Stock Exchange supervises general compliance on
FCGC, but so far has not analyze departures • SMA administers FCGC and revises the code, if needed, with
cooperation of different stakeholder parties (e.g. ongoing amendment on remuneration disclosure)
II. The rights of shareholders and key ownership functions
• Flagging announcement without undue delay • Shareholder register available for everyone • Right to request information in general meeting agenda’s items • Ability to ask questions and right for speaking in general meeting • FCGC’s detailed recommendation on timely notice of annual
general meeting on company web page • FCGC recommends board is aware of controlling shareholders
opinion on proposal III. The equitable treatment of shareholders
• Regulation of insider trading and minority protection in law • English or Swedish disclosure in many companies due to level of
foreign ownership • All disclosures and memorandum of general meeting are
recommended to appear on company webpage to allow equal access to information
IV. The role of stakeholders in corporate governance
• Regulation and recommendations on disclosure of business activities with related parties that are high in commercial value
• Recommendations refer to insider regulation and other legislation
V. Disclosure and transparency
• Disclosure requirements of listed companies • Availability of auditor’s report on annual financial disclosures on
company webpage • Adoption of IFRS in most listed companies
VI. The responsibilities of the board
• Statutory regulation on disclosure on information and board proposals that have material effect on the value of security
• Statutory regulation of disclosing evaluation of short term risks and uncertainties annually in director’s report
• Attendance in general meeting to enable answering to questions • Publish biographical data of board members in the corporate
governance statement and new member candidates on webpage
Table 2: Summarized Finnish corporate governance on information asymmetry
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6.2 Agency Costs
Agency costs occur largely as a result of information asymmetry. One of the
purposes of both Revised Principles and FCGC to reduce information asymmetry
and thus agency costs. FCGC code complements the statutory legislation and
especially Limited Liability Companies Act which is the basic framework for
company operations in Finland. Basic rights and equal treatment of shareholders
are in law. Principals have assurance that their investment is in accordance of the
legal framework.
Transfer and registration of shares is governed by law. Shareholders have the right
to see the share register. In addition, company must notify if one shareholder
possess 5 percent or more of the shares without undue delay whereas EU
regulation gives 4 days time. Shareholders need to be informed also if there is any
capital arrangement that allow disproportionate amount of control compared to
owned shares. This allows shareholders to continuously evaluate their ownership
and control position on the company.
6.2.1 Bonding Costs
Alignment of interests of agent and principal, when setting up the principal-agent
relationship, is in the core of the bonding costs. In both Revised Principles and
FCGC, shareholders in general meeting appoint the board of directors, and
delegate to them the power of hiring, monitoring, compensating and firing the Chief
Executive Officer. Board or the possible nomination committee then is responsible
for the service contract of the CEO. Principal uses available disclosures to evaluate
whether the bonding costs are acceptable. Given the importance of general
meeting as a voice channel for shareholders, it is difficult to directly influence the
bonding costs in an established corporation. The occasion when principal has the
right to voice out differing opinion is mostly at general meeting. In practice
however, the direct amount of bonding costs occurred when searching and setting
up relationship with the management or new board members is not disclosed as
such.
51
Moral hazard of agent’s shirking at work may be reduced by management
remuneration arrangements in their service agreements. The recommendation to
disclose remuneration practices is already in the current FCGC; however the
working group established by Securities Market Association is proposing a
separate recommendation on the disclosure contents of remuneration which is
more clear and detailed than current. If the proposal is amended to the new FCGC,
it means that companies need to explain if they depart from the recommended
practices of disclosure. Also, it gives a view on the general level of compensation
and perhaps reduces bonding costs as such when the general remuneration level
in the managerial market and composition of service contracts is comparable.
Currently, Securities Market Association has a published guideline on
remuneration, but the companies are not obliged to use it or even explain if they
depart from it. This amendment would therefore improve principals’ ability to
evaluate the compensation practices of both board and CEO, i.e. how well the
agent’s interests are aligned with principals’ interests.
6.2.2 Monitoring Costs
Enforced shareholder rights give incentive for individual principal to monitor the
agent. Equal treatment of shareholders is mainly regulated by law. However, there
is possibility to have classification of shares and restrictions on voting rights
provided by the articles of association. Institutional investors have an important role
in monitoring as well and FCGC takes that into account by stating that, while
preparing the items in the agenda of general meeting, board should be aware of
opinions from shareholders with significant voting rights. FCGC has no
recommendations concerning institutional investor practices, whereas Revised
Principles mentions institutional investors should disclose their voting policies. In
the presence of controlling shareholders, small shareholders can free-ride with the
benefits. Non-controlling shareholders may face costs to monitor that the
controlling shareholder is not expropriating cash flow. FCGC recommends that
shareholders shall be allowed to communicate with each other, except when this
results in abuse. Coordination of monitoring activities may decrease the costs.
52
The core of shareholder rights in FCGC and also Revised Principles involves
around the annual general meeting. Notice of the general meeting shall be
available to all shareholders and they have a right to request information on an
item in the agenda or propose one. Company shall make effort to provide
shareholder the possibility to attend the meeting. This may reduce the cost of
monitoring which principal bears when making arrangement to attend the general
meeting. Even more significantly, monitoring costs will be reduced if the new
proposal for attending general meeting with technical means or mail is accepted.
However, this would still call for shareholders to demand amendments in the
articles of association, thus making the concrete changes to proceed slowly in
practice.
Shareholders have the right to present questions in the general meeting to board,
management or auditor. By being active in general meeting, principal can get
qualitative ad hoc information from the business operations and internal controls.
Principal can also express concerns or opinions that agent would not pay attention
to in other occasions. General meeting appoints the board of directors and auditor
who are expected to monitor the company and assure the quality of financial
disclosure. Both FCGC and Revised Principles emphasize the importance of
having independent members in the board. Compensation for the board members
shall be accepted by the general meeting which can be interpreted as a control of
the monitoring costs – as well as auditor’s fees. Accounting Act (§2, item 7-9)
requires disclosing the total amount of CEO’s and board compensation as well as
the auditor’s fees.
6.2.3 Residual Loss
There are some ways for the principal to minimize the residual loss. Finnish
legislation gives shareholders have the right to request a minority dividend which is
a right to take their part of the possible earnings. The equal distribution of the
residual loss among shareholders is also covered by the law: Majority rule is the
basis for decisions, however the decisions shall not expropriate minority in benefit
of the majority.
53
There are provisions on shareholders pre-emptive rights for example in case of
issuing new shares. The principal can raise class actions suite if the board has
made an inappropriate decision. This is at shareholders own cost firstly, but the
expenses shall be reimbursed by the company if the court orders so.
There are recommendations on related parties. Accounting Act (§2, item 8)
requires the disclosure of business activities with related parties and their value, if
they exceed EUR 20 000 or five percent of the company equity value. This enables
principal to get assured that there is no significant expropriation of cash flows to
related parties. Minor related party activities may still exist. The need to disclose
the activities with related parties should already limit the agent’s unjustified
business activities with related parties and limit residual loss.
Debt financing and strong creditor rights are by definition important components
affecting the amount of residual loss what is bared by the principal: The creditors
obtain more cash flow than the shareholders in companies with high debt to equity
ratio. There is also a positive side as high debt financing often limits agent’s
possibilities to expropriate cash.
One area of corporate governance that is largely left to self-regulation of market
and individual companies is the internal control processes. Statutory law requires
board to include evaluation of risks and uncertainties in director’s report of the
quarterly results. FCGC recommends companies to disclose an explanation of their
internal control function. Especially in large corporations with many subsidiaries, an
efficient internal control system is essential from principal’s perspective. It is
board’s responsibility to establish internal control system. There is a need to have
a monitoring system for the day-to-day business operations. These daily processes
form the engine of the cash creation. If the processes are not monitored, there is
an increased risk for occurring residual loss as the principal rarely has any
influence in daily operations of the company.
54
The areas of Revised Principles:
Statutory and FCGC recommendations to reduce agency costs
I. Ensuring the basis for an effective corporate governance framework
• FLLCA, SMA and other legislation create the basic framework for company activities and interaction between principal and agent
• FLLCA states that managers shall act with due care and promote the interest of the company.
• Management’s fiduciary duty to shareholders • Comply or explain approach and legislation allow flexibility and
leave establishment of corporate governance to self regulation II. The rights of shareholders and key ownership functions
• Statutory regulation on general meeting and shareholder’s rights • Clear rules for transfer and registering shares • Legislation and FCGC recommendations on proxy voting • Legal provisions on pre-emptive rights • Right to ask questions, comment and propose items on agenda
of general meeting • Right to appoint board and decide/accept board remuneration • Right to appoint auditor in general meeting • Statutory right for class action or derivative suites • Right to request extraordinary general meeting with one tenth of
shareholdings III. The equitable treatment of shareholders
• Equitable treatment of shareholders in statutory regulation • Possibility to require a minority dividend in law • FCGC recommends company shall make effort in assuring equal
participation possibilities of shareholders in general meeting • By law, shareholders shall be informed about capital
arrangement which allow disproportionate control. IV. The role of stakeholders in corporate governance
• FCGC does not have separate recommendation on stakeholders • Statutory regulation and rules of stock exchange establishes the
rights and roles of stakeholders
V. Disclosure and transparency
• Disclosure recommendation on description of board committee tasks.
• Disclosure of board and CEO remuneration policies VI. The responsibilities of the board
• Recommendation for board committees in order to assure efficiently carried tasks.
• Board responsible for decisions as a whole, committees proposals require approval of board
• FCGC recommends chairman of the board is not CEO, statutory legislation however allows it.
• Recommendation of majority in board to consist of independent members.
Table 3: Summarized Finnish corporate governance on agency costs
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7 Discussion
The aim of this thesis was to study the following issues from an agency theory
perspective: (i) How Revised Principles have been taken into consideration in
FCGC? and (ii) How FCGC approaches the issues with information asymmetry and
agency costs (i.e. monitoring and bonding costs and residual loss)? The previous
chapter summarized the agency theory perspective in Finnish corporate
governance landscape in terms of information asymmetry and agency costs. The
remaining discussion will go in more detail on other aspects of the thesis.
Revised Principles aim to harmonize the governance practices and to provide a
framework for the member countries to start with. In addition they enable
comparison of codes and establishment of best practice. Finland’s stock exchange
requires listed companies to apply their corporate governance code and, as FCGC
converges with OECD in general level, it would be of further interest to compare
other stock exchange’s regulation and study if there is convergence in the practice.
According to FFSA, framework of FCGC is based on Revised Principles, guidelines
issued by Basel Committee on Banking Supervision and the Recommendation for
Corporate Governance of Listed companies. In addition, EU Directives and
national legislation have influenced the code in contents and the voluntary
approach FSA has chosen. Also, Revised Principles are non-binding for OECD
member countries. It is interesting to consider the voluntary or non-binging
approach from a consolidated or global level. Even if the world’s stock exchanges
applied same corporate governance code with comply or explain principle, it would
not directly result to convergence of corporate governance practices in reality as
individual departures are allowed as long as they are accounted for and explained.
Wording of the ‘comply or explain’ –approach makes it difficult to define exactly
how many departures are allowed before the company is not considered compliant.
56
FCGC has been incorporated into statutory regulation of listed companies only
recently and the monitoring practices and division of are yet to be fully efficient.
Helsinki Stock Exchange conducted review on the compliance in October 2009 and
final conclusion is that all listed companies have applied the code, however
explanations on departures have not been analyzed in detail. Future research
could further analyze the individual companies’ corporate governance statements
that are available in company websites.
There are also differences between Revised Principles and FCGC. Revised
Principles includes stakeholders in the definition of corporate governance, whereas
FCGC does not. FCGC assumes the stakeholders’ roles and contractual
relationships are considered in other instances like statutory regulation. Also
Revised Principles note that stakeholder issues are covered by other OECD
instruments. Another difference is to do with institutional investors: Revised
Principles opt for publishing investment policy whereas FCGC only states that
board is recommended to be aware of controlling shareholder’s opinion taking into
account the insider trading regulation. Legal environment does consider the
contractual relationships and stakeholder rights; therefore overall corporate
governance landscape does cover the perspectives for nexus of contracts and
stakeholders.
Activity of institutional investors such as pension funds has already had some
academic attention in Finland. Further research could study if corporate
governance has influence on the investment decisions of these institutional
investors, or are investors already so well risk-diversified in their portfolios that at
least, in short term, changes in governance are not among their decision-criteria for
buying or selling shares. From another point of view, there is relatively high
percentage of foreign ownership in Finnish listed companies: It would be
interesting to study the division of power between domestic and foreign
shareholders in Finland.
57
FCGC does not include detailed recommendations on organization of internal
control; however it recommends disclosure on how the internal control and risk
management is organized. Similarly, Revised Principles agree with FCGC that it is
the board’s responsibility to organize and oversee the internal control. Revised
Principles does not call for disclosure of internal control processes, however they
mention that some countries have provided for the board to report on the internal
control function.
Monitoring processes in the company, such as internal audit, are recommended to
be disclosed. However, it is in practice difficult for principal to monitor the agent if
the principal has delegated the monitoring to the board, and insufficient information
on the monitoring processes is disclosed. Delegation of bonding activities such as
board setting the service contract of CEO, is itself decreasing bonding costs of an
individual principal. It would be even more costly for principals to organize
themselves into establishing the management organization. They appoint the
external auditor and the board of directors in general meeting and can use the
meeting to express their opinions and make questions concerning the company
activities.
It can be concluded that FCGC recommendations have an emphasis on disclosure
practices. Improvements in disclosure decrease information asymmetry, but
companies can use comply or explain and offer general explanations on the
departure. This does not decrease agency costs. However, the wide variety of
externally audited financial information and further analysis by financial media will
evidently decrease agency costs as individual shareholders can use the available
information to evaluate the financial status of the company – they need not to make
great and costly effort to acquire the information. It would be interesting to analyze
further if the incorporation of FCGC in statutory regulation has actually increased
the quantity and quality of financial disclosure in Finnish listed companies.
58
Director remuneration is a current topic in Finland and global scale. The goal of
Securities Market Association in Finland is to publish an amended Finnish
corporate governance code in June to be applied already in end of 2010. The
proposal includes more detailed disclosures on remuneration practices. If amended
to FCGC, the remuneration disclosure would enable principals to further evaluate
the remuneration practices and voice their opinion in general meetings. In long run,
this may result in more efficiently used bonding costs and reduction of residual loss
when principal is aware of the compensation of management. In the root of the
business operations, principals cannot completely monitor the use of cash flow in
the company: There always is the trade-off between optimal monitoring needs and
optimal agency costs.
Limitation of this thesis is related to the approach taken in the analysis: Making
simplified assumptions of agency theory in order to analyze practicality corporate
governance. Agency theory’s assumptions have been challenged by La Porta and
other researchers, and the importance of social responsibility and accountability
has also increased in corporate governance. Topics for further research have been
already pointed out in this discussion. In addition to already mentioned, influence of
Finnish state ownership in listed companies would be of interest. This thesis
concentrated on the relationship of shareholders and management in general
corporate governance landscape in Finland. Environmental legislation, role of
stakeholders and enforcement of corporate governance practice in individual
companies has been left out. It would be fascinating also to know if the
enforcement of corporate governance code has actually changed any governance
practices in listed companies. The thesis has contributed to research knowledge of
general corporate governance landscape in Finland and the future interest can turn
to other theoretical models and most importantly empirical research on the
governance practices in Finnish companies.
59
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