CORPORATE GOVERNANCE The Prime Cause of its poor state in Pakistani Listed Companies Dr Safdar A Butt Karachi Stock Exchange (KSE) outperformed all exchanges in developing countries over the past five years – yet the total number of companies listed at KSE has actually gone down from 701 at end 2002 to 654 at end 2007. This simply means more companies are getting themselves unlisted (or being removed from the list by appropriate authorities) than new companies joining the list. While the KSE index has grown from 2,701 at end 2002 to 14,075 at end 2007, indicating a remarkable annual growth rate of 31. 2%, the total paid up share capital of these companies has grown only negligibly if we do not count the bonus issue shares. At the end of 2004, total market capitalization was Rs 1,723 billion and at end 2007 it stood at Rs 4,330 billion; yet the total funds raised through rights or new issues during this period were only Rs 79 billion (inclusive of share premiums). What is this a sign of? Would it be a lack of investors’ confidence in companies? Why is there such a lack of public confidence in companies listed at the best performing exchange in the developing world? In one phrase: perception of poor corporate governance at these companies.

Do not be misled by the notion that corporate governance being a nascent area, general public in Pakistan would not be making any investment decisions on the basis of companies’ performance in this area. Without being formally aware of the term corporate governance, whatever an investor expects from the company which he is investing his money in relates to the manner in which the corporate body governs itself. Just as a villager needs to regularly inhale oxygen without being aware of its scientific name, investors act on their perception of each company’s corporate governance profile when they make their investment decisions.

Corporate Governance is attracting a lot of attention in the developed world. While there have not been any scandals of Enron or WorldCom proportions in Pakistan yet, it is not to say that companies in this country are not exposed to the ills of poor corporate governance policies. The regulators in Pakistan have already brought out a voluntary Code of Corporate Governance while an Institute of Corporate Governance has also been set up through assistance from IFC. All this will certainly lead to improving the situation in the long run, but considerably more needs to be done now.

There are three distinct objectives of writing this article. The first is to attempt to define corporate governance. The second is to highlight what I consider to be the main cause of the rather poor state of corporate governance among Pakistani listed companies. I wish to clarify that I do not intend to cover all the problems relating to corporate governance in Pakistan – that would require a much longer discourse. My focus is just on one area which I consider to be the prime cause.

My third objective is to present a proposal that would help improve the situation, if not substantially solve the problem in so far as it relates to my focus area. Having sat on the boards of four listed companies for over a decade and later having observed the performance of stock exchanges in the country as an academician for another decade, I have come to believe that the best way to define corporate governance, both as a field of study and a management phenomenon, is to take the stakeholders’ perspective route.

For this purpose, the first step is to classify stakeholders. We can classify stakeholders in a listed company in two different ways. The first is on the basis of their respective roles in the company. On this basis we can say the stakeholders are owners, lenders, employees, business associates and society at large. Owners include all sorts of shareholders like those who do or do not control the company, individuals as well as institutional investors, long term holders as well short term players, those with voting rights and those without them, etc.

For the purpose of this classification, I use the term Lenders to include only those who extend financial advances to the company, rather than credit for services rendered or trade goods supplied. These may be formal financial institutions or individuals (those who buy bonds, or grant loans through asset management firms). Employees of course include executive directors, senior managers and all others who are on the pay roll of the company. Business Associates are company’s suppliers and clients while the Society includes public at large as well as the government.

All these stakeholders (owners, lenders, employees, business associates and society) stand to benefit or lose from a company’s performance and state of affairs. Another potent way of classifying stakeholders is on the basis of how much opportunity they have to protect their respective interests. On this basis, stakeholders either have full opportunity, a limited opportunity or relatively no opportunity to protect their interests. Now if we try to list the stakeholders, using both of the above bases of classification in one table, it would appear as follows: CLASSIFICATION OF STAKEHOLDERS Classified on |Classified on basis of opportunity to protect individual interests | |basis of Role | | |in the Company | | | |Those with |Those with a |Those with | | |Full Opportunity |Partial Opportunity |Virtually No opportunity | |Owners |Controlling Shareholders |Institutional Investors with Board |Minority and individual shareholders with| | | |representation |no board representation | |Lenders |Financial institutions with |Buyers of listed bonds with trustee |Other lenders | | |elaborate lending contracts |arrangements | | |Employees Executive Directors |Senior Managers |Other employees | | | | |on regular or | | | | |contract terms | |Business Associates |Suppliers who sell only on cash |Major Suppliers and clients with |Smaller suppliers | | |terms |contracts |and | | | | |smaller clients | |Society | |Government |Public | | | | |at | | | | |large | Every class of stakeholders has its own particular interests. The interest of the owners lies in sustainable growth in the net worth of the company, lenders require security of their investment and assurance of timely interest payments, employees want continued employment at attractive terms, business associates seek opportunities to further their own profits while the society looks up to the company to be a good citizen. Quite understandably, the interests of these stakeholders often clash with each other.

For example, the interest of owners is often best served by depriving the other stakeholders of their rightful dues. Inadequate salaries to employees, lower prices to suppliers, higher charges to clients, tax avoidance, disregard of social obligations, all contribute to higher profits for the company. And then, there is the overall interest of the company, which I refer to as the collective interest of all the stakeholders, namely the continued profitable existence of the company. Decisions made by a company affect all the stakeholders; yet only a few of them have influence on the company’s decision-making process. Now those stakeholders (like controlling shareholders, larger institutional lenders, executive directors, etc. who have greater influence on the company’s decisions, can ensure the protection of their interests without having sufficient regard for the interests of all the other stakeholders, or of the collective interest of the company. The decision-makers in developing countries like Pakistan are not always likely to stop at mere protection of their narrow interests. They often cross the line and try to enrich themselves by actually depriving other stakeholders of their rightful dues. There is therefore a need for a mechanism that will ensure that: a. the individual interest of each stakeholder is served and protected, b. the collective interest of all the stakeholders is served and protected, c. no stakeholder is allowed to expropriate the interest of other stakeholders, and d. o single stakeholder enjoys a monopoly over the decision making process of a company. Corporate Governance is that mechanism. I therefore define Corporate Governance as “the mechanism used to conduct the affairs of a corporate body in order to serve and protect the individual and collective interests of all its stakeholders”. So, is Corporate Governance a simple extension of Agency Theory? Not really. Agency theory covers only the agent-principal relationship. If we were to say that corporate governance is only about protection of individual interests of each stakeholder, we would be confining the discussion to the application of agency theory.

But a very important aspect of corporate governance is the protection of the collective interest of all stakeholders. This takes corporate governance well beyond the simple application of agency theory. Protection of collective interests of all stakeholders brings the focus on the company – something that is simply ignored by the agency theory as propounded by psychologists and management scientists alike. To protect and serve the collective interest of all stakeholders, decision makers of a company must extend their vision well beyond operational management of its affairs. They should venture into the very important realms of strategy development and risk management.

When I talk of the mechanism used to conduct the affairs of a corporate body, I include all laws, professional codes, industrial practices and management techniques. When I state the first objective of using these tools as protecting and serving the individual interests of each stakeholder, I refer to the appropriate application of the various agency theories that abound. And when I say that the second, equally important, objective is to protect and serve the collective interest of all stakeholders I extend the list of basic tools (laws, professional codes, industrial practices and management techniques) to include strategy development, image building and risk management. SCOPE OF CORPORATE GOVERNANCE Stakeholders |Objectives / interests |Tools / Techniques | |Individua|Shareholders |Sustainable growth in net worth |General Management | |l | | |Legal frame work | |Interests| | |Professional Codes | | | | |Industrial practices | | |Lenders |Security / timely interest payments | | | |Employees |Continued employment at good terms | | | |Business Associates |Continued business at good terms | | | |Society |Good citizenship by the company | |Collective Interest of all stakeholders |Continued profitable existence |Strategic Management | | | |Risk Management | | |Maintenance of reputation | | | |Growth | | Causes of poor corporate governance in Pakistan The prime source of poor corporate governance in Pakistan, or any where else, is the board room where all strategic decisions are taken. Almost the entire thrust of codes or legislation on corporate governance is on board room practices.

It is believed, and not unduly so, that good corporate governance can only emerge from responsible board rooms. Now, what happens in the board room naturally depends on the people who are there in the board room. This brings us to the board structure and composition. If a board is not balanced in terms of representation, talents, power and attitudes, its performance will not measure up to the standards of good corporate governance, i. e. it will fail to protect and serve the individual interest of each stakeholder and the collective interest of all stakeholders. The prime cause of poor state of corporate governance in Pakistan – and most developing economies – is the absence of balanced boards.

The sad aspect of this state of affairs is that this absence of balance in board structures is more often by design than unavoidable circumstances. Balance of representation means all the stakeholders should have adequate representation on the board. With only shareholders allowed to vote in directors, and controlling shareholders stage-managing AGMs in an orchestrated manner, most companies in Pakistan lack a balance of representation. A small percentage of listed companies may have long term creditors represented on the board, but the other stakeholders like employees (other than executive directors), business associates and public at large are seldom represented on the board. Neither the Companies

Ordinance, nor the Articles of Association of most companies provide for any mechanism that would ensure representation of all stakeholders at a board. Sadly, the Code of Corporate Governance issued by Securities & Exchange Commission of Pakistan (SECP) also fails to address this serious lapse. For as long as we leave the election of directors in the hands of only one class of stakeholders, a balance of representation on the board will remain a dream – and the boards will continue to perform contrary to the spirit of good corporate governance. Balance of talents means having a blend of all the necessary talents and technical expertise needed to lead the company.

This requires the presence of managerial, legal, financial, operational, social, marketing and industry-specific technical experts on the board. The argument that companies have managers who carry these skills does not hold well. If the board does not have the talent to understand and scrutinize the proposals made by the managers, it will simply not be able to perform its basic function of control. While it is understandable (if not pardonable) that shareholders in Pakistan refuse to allow a balance of representation on the board, the alarming absence of balance of talents in most boards is truly surprising. This can only be attributed to the desire of controlling shareholders to have no opposition at the board.

Balance of power means having an adequate number of truly independent non-executive directors on a board who enjoy sufficient power to overturn the proposals put forward by executive or representative non-executive directors. Perhaps this requires a bit of explanation. An executive director is part of company’s management, while a non-executive director (NED) sits only on the board and takes no part in company’s day to day operations. Now an NED may be a representative non-executive director (RNED) or independent non-executive director (INED). A representative NED represents a particular stakeholder and acts only for the protection and furtherance of interests of that stakeholder, e. g. a director nominated by a lending institution on a debtor company’s board.

Similarly, non-executive directors nominated by majority shareholders often – and in case of Pakistan always – act only to serve the interest of that group of shareholders. An independent NED does not represent any particular stakeholder and is expected to act for the collective interest of all stakeholders. Very sadly, INEDs are totally missing from the boards of most listed companies in Pakistan. This means these boards do not have a balance of power. With each director representing only a particular interest, and virtually no one looking after the collective interest of all stakeholders, the quality of corporate governance is bound to suffer.

The balance of attitudes means having diversity at the board that ensures presence of a wide range of social, moral and managerial attitudes of directors. If all, or majority of, the directors are timid, complying sort of individuals with no courage to stand up to the chairman, the board will inevitably become a rubber stamp board. Similarly, if the majority of directors are radicals with no one to mitigate the impact of their adventurous spirit, the company can land into more trouble than it can handle. A good board requires a balanced combination of people who are motivated differently: some by profit, some by caution, some by social justice, some by excellence, some by growth, some by experimentation, etc.

Another aspect of attitudes is the style of handling matters: some are bold persons who insist on being fully convinced before they vote on a proposal, some believe in just going along with the majority, some only aim to protect their jobs, some simply do not care. In an ideal attitude-balanced board, all of the directors will be bold and righteous and yet excellent team players. We must accept the fact that boards of Pakistani listed companies are far from that ideal situation. To repeat an earlier observation, for as long as we leave the election of directors in the hands of only one class of stakeholders, a balance of attitudes on the board will remain a dream – and the boards will continue to perform contrary to the spirit of good corporate governance. The prime cause of poor governance in Pakistani listed companies is unbalanced boards.

And the prime cause of lack of balance in Pakistani boards is absence of sufficient number of INEDs, who have: a. the knowledge and talents to participate meaningfully in board proceedings, b. an understanding of the individual interests of all stakeholders and are willing to work for their protection, c. the independence and courage to differ with the management where it is necessary, and d. the power to over-rule the representative directors where the collective interest of all stakeholders so demands. Since companies are not keen to discuss their boards with academicians, my efforts to talk to directors of listed companies have not been successful. The only source left is to go through the published annual reports.

As behooves companies with minimum regard for corporate governance, only a tiny percentage of annual reports give any information in excess of statutory minimum. A not-so-cursory look at the published list of directors of most listed companies in Pakistan reveals that the following trends are prevalent: a. Majority of the directors are family members or close associates of controlling shareholders. b. Directors who are technically designated as independent non-executive directors are seldom independent. In almost all cases they are representative directors, protecting the interest of a particular stakeholder. Usually only two classes of stakeholders are represented on the board: the controlling shareholders and major lenders. c. No attention is paid to having a pool of talents at the board.

The general preference is to have well paid managers (who are subservient to the controlling stakeholder) over having competent and qualified INEDs. d. No attempt is made to ensure that the board comes in touch with other stakeholders and learn about their preferences and interests. Why are there no INEDs on boards of Pakistani companies? One very apparent reason for absence of INEDs on Pakistani boards is of course the attitude of the controlling stakeholders. However, this is not the only reason. There is a genuine dearth of well qualified and competent persons who are willing to act as INEDs. The reasons are: a. Non-executive directors are paid only meeting fees.

Generally no salaries or perks are paid to company directors in Pakistan. Directors’ fees typically range between Rs 500 to Rs 5,000 ($7 to $70) per meeting and most companies have no more than the prescribed minimum number of meetings per annum, i. e. four. This is hardly an incentive for any professional to join a board, or to pay any real attention to what transpires at board meetings. b. The law does not protect INEDs. The Companies Act treats all directors equally responsible, regardless of their role. If the executive directors choose to bring only selected information before the board on the basis of which a decision is made, all directors are held liable for its consequences.

There have been a significant number of cases where SECP has ruthlessly handled INEDs in the name of bringing discipline to board proceedings. Given the paltry meeting fees and heavy potential for penalties, professionals are understandably reluctant to join company boards. c. Professional people do not like being ineffective, or not listened to. If there is only one INED (the minimum number recommended by the Code of Corporate Governance issued by SECP) on a board, he often finds himself ignored at board meetings. His comments and views are frequently omitted from board meeting minutes because “the company does not want to give an impression to the world that its board is divided”. d.

One of the reasons INEDs are effective in the West is the backing they receive from institutional investors who have a significant holding in the company. Quite often, institutional investors are instrumental in getting truly independent non-executive directors appointed. They then support them, listen to them and supply them with whatever information (or influence) they require to do their jobs well. In Pakistan, institutional investors rarely make long term investment in listed companies. Even NIT (the government sponsored mutual fund) has no formal long term strategy in this regard. This means NEDs are nominated on the board of a company only by a financial institution that has loaned heavy amounts to the company.

This immediately takes away the “independence element” from the appointment, as such directors inevitably assume the posture of representative directors. Due to the special nature of NIT, it does nominate directors on the boards of quite a few companies. But these directors are often full time employees of NIT whose primary responsibility is not being a director. They are engaged in some law or finance related duties in NIT and are assigned the additional responsibility of being a director on some companies. These nominees rarely measure up to the standards required of independent directors. So what can or should be done? There is an immediate need to promote, strengthen and support the INEDs. And by INEDs, I mean Independent NEDs not just NEDs.

There are two aspects of this issue: the first is to ensure that controlling shareholders are somehow persuaded to elect sufficient number of truly INEDs on their boards – and the second is to ensure that there are sufficient incentives for suitably qualified and competent persons in the country to come forward and be assigned the onerous responsibility of being INEDs. In developing countries, it is often believed that the only way to get good behavior from citizens, corporate or individual, is to pass a law. Unfortunate and sad as it may sound, the history bears out this observation. No amount of preaching from SECP or professional bodies like ICAP gets any response from companies – yet a mere possibility of a fine does wonders. Only the force of law made companies take steps to improve the contents of their annual reports.

Only after the issuance of Code of Corporate Governance (CCG), did companies start having audit committees – although they are still far from granting true independence to these committees. So I believe that the best way to prompt controlling shareholders to behave more responsibly is to legislate. The first step would be to revise the present Code of Corporate Governance along the following lines: a. Adherence to the Code of Corporate Governance should be mandatory, not voluntary. b. CCG should have specific guidelines on the constitution of boards. It is proposed that: • The number of executive directors should not be more than one third of total number of board members.

This means at least two-thirds of the board directors should be non-executive directors (NEDs). And no less than half of the NEDs should be independent non-executive directors INEDs). • This means on average, no more than one-third of the directors would be EDs, no more than one-third would be RNEDs and no less than one-third would be INEDs. This should bring some balance of representation and power on the board. • Specific criteria (qualification, experience, background, etc. ) should be laid down for all directors, but in particular for INEDs. Similarly, roles of each class of directors (EDs, RNEDs and INEDs) should be defined more elaborately. c.

Specific recommendations should be made for remunerating INEDs suitably, for example: • Average remuneration for INEDs should be around 33% of the average remuneration of executive directors. • If INEDs perform any additional task like chairman/membership of special committees (e. g. audit committee, remuneration committee, nomination committee, CG Compliance committee, etc. ) they should be suitably compensated. • In addition, INEDs should be accorded some protection by the law. The current practice of treating all directors alike is unfair and devoid of natural justice. d. The possibility of allowing companies to have two-tier boards should be seriously explored.

The first tier, to be called Management Board, may comprise entirely of executive directors plus one or two representative directors from the controlling shareholder while the second tier to be called say Supervisory Board should have only NEDs, perhaps with the exception of CEO. Rules may be framed allowing: • the shareholders to vote in the entire Management Board, and • all the stakeholders (including shareholders, lenders, employees and civil society) to vote for election of directors on the Supervisory Board. Defining the electoral college for civil society may be difficult, but I am sure a solution can be found if there is sufficient will. • the Chairman who must be non-executive and elected by shareholders, to be common on both the boards. A proposal

While the Institute of Corporate Governance, established through assistance from IFC, is yet to produce any tangible results, I wish to make another proposal that could speed up the pace of improvement in the state of corporate governance in Pakistan. This proposal is based on the observation that only the presence of truly independent non-executive directors supported by long term investing companies can bring about a meaningful difference to the present sorry state of corporate governance in Pakistani companies. This proposal has two distinct steps. First Step The government should make it mandatory for all financial institutions and mutual funds having investment funds in excess of say Rs. ne billion to invest no less than 20% of their total available funds on a long term basis. The test should be that at any time, at least 20% of their portfolio should represent holding in companies for an average of not less than 3 years. An incentive can also be offered to mutual funds and investment companies for holding shares for a period over three years, e. g. any dividends received from shares held by a mutual fund or investment company for over three years may be exempted from corporation tax. This will promote institutional investors’ interest in listed companies. Gradually, they will start playing the role which their counterparts in the West are playing so well.

With presence of knowledgeable representatives from institutional investors, the company boards will start behaving more responsibly. Second Step NIT could play a far more active role in improving the corporate governance state of listed companies than it is currently doing. But perhaps, this is outside its present scope of responsibilities. It is proposed that the government should float a new investment company (or a mutual fund). Its equity can come from companies like NBP, NIC and State Life that are sitting on mountains of investable funds. The new investment company (IC) should have the following explicit mandate: • It should invest primarily in listed companies on long term basis.

It must hold shares in companies for considerable duration, long enough to exert a meaningful influence on the boards of such companies. • It should hold sufficient number of shares in companies to earn a right to get at least two directors elected on the boards of such companies. Like the NIT, the new IC could be granted a right to purchase 10 to 15% of all new issues of shares. • It should employ a team of well qualified, competent, experienced and honest professionals who would draw a decent salary from the IC but have no responsibility except to act as INEDs at the boards of companies in which the IC has a holding. In order to ensure proper performance from these INEDs, none of them may be made a director of more than six companies. The directors placed by the IC should be categorically informed that they are expected to act as independent, non-executive directors (INEDs) looking after the interests of all stakeholders, rather than representative directors protecting the interest of the IC alone. They should attend every meeting of their respective boards, take an active part in its deliberations, scrutinize every proposal put forward by the executive directors, take external professional help where needed, and to generally ensure that the controlling shareholder does not get away with any improper act. In addition, they may act as members (or chairmen) of the various committees constituted by their respective boards.

They should write periodic reports on the performance of their “ward companies” which the IC may share with the company where necessary. • The IC can join hands with rating companies and start a system of formal rating of “boards of directors” of its investee companies. This could be confidential but its mere presence will infuse considerable responsibility into boards. • It is hoped that presence of these INEDs on the boards of various companies will bring about a balance of representation and power on those boards. The IC could do even more. While nominating these directors on the board of various companies, the IC should also pay attention to getting a balance of attitudes and talents on those boards.

This means the IC must carefully study how the board of each of its investee companies is constituted, so that it may nominate that particular talent or attitude that is missing from a particular board. What is really important for the country is not how much money in poured into the secondary markets (trading of already issued shares at KSE) – but how much money companies are able to get from general public for their new projects. The above proposals will go a long way in restoring the confidence of investing public in listed companies so that the bulk of public money will go to the companies – not speculators at stock exchanges. The author is Dean of Faculty of Management Sciences at Mohammad Ali Jinnah University, Islamabad