CHAPTER 1

The Emerging Market Context: Why Does It Matter?

Corporate governance is the “set of mechanisms used to manage the relationship among stakeholders that is used to determine and control the strategic direction and performance of organizations” (Lynall, Golden, and Hillman 2003). Corporate governance helps ensure that a firm’s strategic decisions are made effectively and in line with shareholders’ interests. It aligns owners’ and managers’ decisions. It is also a reflection of the firm’s values and beliefs. Efficient corporate governance mechanisms can be a competitive advantage for a firm.

Until recently, the need for corporate governance laid on the idea that when separation exists between firm ownership and its management, self-interested managers can take actions to benefit themselves, with firm stakeholders bearing the cost for this action. This scenario is typically referred to as the agency problem. Costs associated with the agency problem can include:

1. A)Financial restatement
2. B)Fraud related to bankruptcies
3. C)Stock option backdating
4. D)Earnings manipulation

Corporate governance is then implemented to decrease the risk of incurring agency costs.

According to a McKinsey study (Newell and Wilson 2002), institutional investors are willing to pay premiums for well-governed firms. Premiums go from a low of 11 percent in Canada to a high of 40 percent in Egypt. Foreigners invest less money in firms that insiders control and that are domiciled in countries with weak investor protection (Leuz, Lins, and Warnock 2009). Because institutional weakness makes law enforcement costly and more difficult to achieve, the quality of country-level institutions influences corporate governance at the firm level. High ownership concentration is a response to the lack of legal protection.

Weak corporate governance, ownership concentration, and limited protection of investors—all of them emerging market characteristics—intensify principal–agent problems and create unique agency problems where majority owners take advantage of minority ones. This has been labeled the “principal–principal” problem (Young et al. 2008).

In emerging countries, laws and regulations on accounting requirements, information transparency, and stock market transactions are absent or deficient. Hence, standard structures of corporate governance have little institutional support. Therefore, diversified business groups, family connections, and government contacts play a larger role in a firm’s governance activities and conflicts between majority and minority shareholders are the norm.

The expropriation from minority shareholders can take place in several ways:

1. A)Designating nonqualified individuals to key corporate roles.
2. B)Buying and selling at nonmarket prices from organizations related to majority shareholders.
3. C)Pursuing strategies that advance personal, family, or political agendas in detriment of firm performance objectives.

Hostile takeovers or a market for corporate control is the ultimate solution for this problem, but this mechanism does not exist in most emerging countries.

Institutional weakness also inhibits majority owners from sharing sensitive information with potential investors; building trust is difficult and this probably inclines controlling shareholders to prefer loyalty over aptitude when choosing among potential directors and top managers. A negative family dynamic in a context of low legal protection will probably increase the risk of expropriation for minority shareholders even if they are members of the founding family (González et al. 2015).

Research evidence has shown that principal–principal problems in emerging countries can be decreased by having multiple block holders (i.e., banks or private equity funds) that help monitor the firm and stronger legal institutions. On the other hand, expropriation of minority shareholders tends to increase with a family chief executive officer (CEO) and the political involvement of owners (Azoury and Bouri 2015; Jiang and Peng 2011).

Within emerging countries, most public firms are family owned, and the identity of large owners often determines the control structure of the firm. Family owners are more reluctant to draw equity from the stock market, fearing loss of control and family cohesiveness (Thomsen and Pedersen 2000). When families appoint an owner CEO, they have an information advantage over minority shareholders (Anderson and Reeb 2003a). In family-owned and -managed firms, the sharing of sensitive information with outside managers and investors is unlikely because of the weak institutional environment. Hence, the controlling family and its members serving in top management roles have information advantage over minority shareholders. Corporate governance practices designed to protect minority shareholders in Latin America are minimal (Castro, Brown, and Baez-Diaz 2009); more than 40 percent of the firms in this study did not have independent directors, and eight out of nine board members were insiders (they reclassified gray/affiliated directors—those with a business or family relationship to key shareholders—as insiders). These numbers probably reflect the degree of control that families still have on Latin American firms. In this same study, 79 percent of Mexican firms had a family as its main shareholder. That same figure was 48 and 43 percent for Brazil and Chile, respectively. Finally, these authors find that in Mexico 48 percent of sampled firms have a dual share structure. For Brazil it is 14 percent and for Chile 7 percent. A dual share structure means that there are two types of stock per firm: one with voting and the other without voting rights. This strategy is often used when controlling shareholders want to maintain control and can exacerbate conflicts between majority and minority shareholders.

Weak institutions contribute to the intervention of politicians in business activities (Hellman, Jones, and Kauffman 2000). Politically connected managers and owners can use their influence to reduce regulatory pressures or to gain preferential access to government contracts. On the other hand, politically connected managers and owners could also use the firm and its resources to serve political objectives to the detriment of minority shareholders. Controlling shareholders with political ties in Indonesia prefer the private benefits of control over external financing opportunities, although the latter would be beneficial to all shareholders (Leuz and Oberholzer-Gee 2006). Political connections in family firms can also result in excessive employment or in favoring employees with political connections rather than those that have the necessary skills.

Expropriation of minority shareholders is not easily observed in good times. But, during economic downturns, controlling shareholders may feel tempted to extract firm resources to protect their own wealth (Young et al. 2008). During the 1997 Asian financial crisis, even firms with a good reputation exploited their minority shareholders (Johnson et al. 2000).

Resolving principal–principal conflicts in emerging economies requires creative solutions. An institution-based view of corporate governance suggests that individual countries will need to work out answers appropriate to their own institutional conditions (Peng and Jiang 2010). Eliminating concentrated ownership structures in emerging markets is probably not ­realistic because of the scarcity in supporting institutions—takeover markets, effective boards of directors, and rule of law.