3. Boards of Directors in Emerging Markets

While boards are criticized in Western Markets for being highly overpaid cronies of management, the situation in emerging markets appears to be bleaker. Independent directors are difficult to find. Market forces and enforcement mechanisms that provide checks and balances in the West are absent. Functioning markets that would control corporate behavior do not exist. Personal liability of directors is not developed, and in the absence of clear interpretation and jurisprudence, difficult to enforce even when they are provided by law.

With the development of a class of directors who exhibit high standards of integrity, commitment and independence and who adhere to business ethics, the emphasis in reform can shift from enforcement to implementation.

Despite these drawbacks, the role of boards of directors and the private sector in the development of corporate governance standards cannot be underestimated. Especially in markets where regulatory systems and enforcement are not optimal, a strong pool of independent directors is invaluable and indispensable. With the development of a class of directors who exhibit high standards of integrity, commitment and independence and who adhere to business ethics, the emphasis in reform can shift from enforcement to implementation.

The challenge to accommodate this development lies in finding reform strategies that work. As stated by Klein et al. (2004) of the IFC/World Bank: “The OECD’s new Principles of Corporate Governance, approved in April 2004, are a welcome effort to set out the best possible standards. . . The task now is to make those high standards a reality for developing countries. The challenge is to create approaches that work well in developing countries, where some of the problems are different.”

3.1    Limitations of Legal Transplants

As with the introduction of most Western management practices, the transplantation of corporate governance models and oversight systems requires an understanding of the culture and history of a country (Gatian and Kenneth, 1996). Imposing independence requirements common in the West on the business elite in emerging markets may not always be feasible.

3.1.1    Conflicting Standards

Conflicting standards are a complicating factor for the introduction of corporate governance standards to emerging markets. In the Netherlands, a non-executive director who holds at least ten percent of the shares in the company does not qualify as an independent director under the rules of the New Tabaksblat Code.

The listing requirements of the NYSE concerning directors’ shareholdings do not “view ownership of even a significant amount of stock, by itself, as a bar to an independence finding.”[6] Since most joint stock companies in emerging markets have been created by mass privatization, share ownership and family relationships among directors, managers and employees are common. Hence, requiring directors not to be a shareholder or a family member may not always be a realistic and workable solution.

Both the NYSE and the NASDAQ use a benchmark of more than $100,000 in director’s compensation from a parent company to disqualify a non-executive director as being independent. This standard is too high for developing countries, where lower thresholds are more suitable.

Independent directors also require independent structures such as oversight committees (audit, nomination and remuneration committees), sophisticated internal control systems and highly qualified and independent external auditors and appraisers. Imposing independent oversight board committees on companies may only be effective when the supporting infrastructure is in place. Board committees do not strive in protecting investors in a business culture where the disclosure of information among directors is uncommon, where directors’ fiduciary duties are not well defined and where International Financial Reporting Standards (IFRS) and International Valuation Standards (IVS) are commonly not accepted and enforced.

3.1.2    Ownership Structures in Emerging Markets as a Limiting Factor

A factor that complicates the implementation of Western corporate governance standards in emerging markets relates to the ownership structure of companies. Emerging markets tend to have a greater concentration of ownership and cross-ownership than developed financial markets. Klein et al. (2004) suggest that sophisticated corporate governance systems common in developed countries that rely on dispersed share ownership patterns, may not be as effective in markets where ownership is concentrated in the hands of small groups of majority shareholders.


In Ukraine, 55.7 percent of capital assets of privatized companies were held by the state in 1997 (Pivovarsky, 2001). In Russia, at the close of the voucher privatization process, 56.3 percent of all shares were held by insiders, while outsiders had 23.3 percent and the state had 20.4 percent (Earle, 1998). Ownership concentration as a result of the mass privatization program measured by the average stake held by a “single largest owner” was between 38 percent and 59 percent in Czech Republic (Hanousek, et al., 2005).


The general meeting of shareholders is an instrument that requires dispersed ownership to be effective. Voting requirements in most company laws require a simple majority of votes registered at the meeting to pass resolutions for the election and dismissal of directors, the approval of dividends and the election of the accountant. Only in a few circumstances, such as changes in the legal status of the company, do company laws have greater voting requirements. While financial markets in countries with dispersed ownership are facing numerous problems with general meetings of shareholders (Maassen and Brown, 2005), the effectiveness of the instrument in protecting shareholders may be even more limited in emerging markets when most decisions can be made by a dominant group of shareholders.

With large block holders dominating the voting process at general meetings of shareholders, expropriation can take a variety of forms that may be perfectly legal under company law in emerging markets. According to La Porta (et al. 2000): “insiders simply can steal the profits. In other instances, the insiders sell the output, the assets, or the additional securities in the firm they control to another firm they own at below market prices. Such transfer pricing, asset stripping, and investor dilution, though often legal, have largely the same effect as theft. In still other instances, expropriation takes the form of diversion of corporate opportunities from the firm, installing possibly unqualified family members in managerial positions, or overpaying executives.”

3.1.3    Cumulative Voting and the Election of Directors

Another useful illustration of Western models’ limitations in protecting minority shareholders in emerging markets is cumulative voting. The system is designed to improve shareholder representation on boards to alleviate the effects of concentrated share ownership. Under a normal voting arrangement, each director is elected separately by a simple majority vote of shareholders present at and registered for the general meeting of shareholders. In contrast, cumulative voting is designed to ensure that minority shareholders can elect a representative to the board of directors.

According to Maassen and Brown (2005), cumulative voting originated in the US as an outgrowth of political reform. Although popular in the beginning of the 20th century, usage of the system has steadily declined since the 1950s. By 1992, only six states maintained mandatory cumulative voting, 44 provided for voluntary inclusion while one state, Massachusetts, prohibited cumulative voting (Gordon, 1994). Most jurisdictions, both in Anglo-Saxon and Continental-European countries, do not require mandatory cumulative voting (La Porta et al. 2000).

Its complexity is a compelling reason why lawmakers should be reluctant to make the system always mandatory for shareholders and their directors. While institutional investors may benefit from the system, smaller minority shareholders may not be able to use the system effectively. As stated by Klein et al. (2004), complex rules such as cumulative voting for minority shareholders are largely irrelevant for emerging markets.[7]  Shareholders should meet certain requirements that are often not feasible in emerging markets in order for the system to function. Among others, shareholders should have:

1.    Been educated about the system and fully understand its potential;
2.    A good understanding of the company law;
3.    Skills to strategically use cumulative voting and avoid manipulation;
4.    Access to shareholders’ lists;
5.    An interest in electing directors;
6.    Financial resources and skills to campaign for their candidates for the board of directors;
7.    Willingness to be actively engaged in contacting other shareholders prior and during the shareholders meeting.

Source: Based on Maassen and Brown (2005).

Even when these requirements have been met and the system is functioning, one can question the value of having one director on the board. Although these directors may represent the minority shareholders and be able to voice disconcern in the media about a company’s strategies, most board decisions can be made under law by a simple majority of directors present at the meeting without the consent of “minority directors.” As has been documented for the co-determination system in Germany, in which boards of listed companies are divided in representatives of shareholders and the employees, cumulative voting also may polarize the board (Gorton and Schmid, 2000).

3.2    The Inconclusive Relationship Between Board Characteristics and Corporate Performance

Another complicating factor in the introduction of Western legislation and standards to emerging markets is the growing body of evidence that disputes the relationship between board characteristics and the financial performance of corporations.

Boards composed of independent directors who are chaired by an independent non-executive chairman and who operate in independent oversight committees are not necessarily more effective than insider driven boards. Dalton et al. (1998) found no evidence of a systematic relationship between board composition and financial performance after they reviewed a large number of studies. Contrary to the conventional wisdom of corporate governance reformers, Donaldson and Davis (1994) state: ”We believe that it would be unwise at the present time to go along with calls to require boards of corporations to be dominated by non-executives.” Bhagat and Black (1999, 2000) found no convincing evidence that greater board independence correlates with greater firm profitability or faster growth. In an earlier study, the authors propose: “ . . the burden of proof should perhaps shift to those who support the conventional wisdom that a monitoring board – composed predominantly of independent directors – is an important element of improved corporate governance” (Bhagat and Black, 1997).

The few academic studies of boards of directors in emerging markets seem to support the inconclusive relationship between board independence and the performance of corporations. Peng (2004) found among 405 listed firms in China that outsider directors do make a difference in firm performance, if such performance is measured by sales growth, but that they have little impact on the financial performance of the corporation such as return on equity (ROE). In Russia, Peng et al. (2003) found little support for the hypothesis that non-executive board members and new managers are positively related to firm performance (based on a survey of 314 privatized firms).

On the other hand, Liang and Li (1999) found in China a positive relationship between the presence of outside directors and higher returns on investment. In addition, an impressive body of research has found strong relationships between corporate governance standards, firm performance (The Patterson Report)[8]  or the market value of corporation (McKinsey and Co., 2002b).

3.3    Partial Approaches to Corporate Governance Reform

An inherent problem with corporate governance reform in emerging markets is the inability of reformers to capture the complexity of variables that may determine the performance of boards and their corporations. A useful model to demonstrate this complexity is developed by Zahra and Pearce (1989). The model recognizes multiple relationships between contingencies, boards attributes, boards’ decision making processes and the performance of corporations (see also Illustration 2).


Illustration 2: The Complexity of Corporate Boards

Based on Zahra and Pearce, 1989.

Each of these variables - many of which are difficult to quantify – can determine the financial performance of corporations. Directors, for example, can be classified using a binary variable: Based on a list of criteria often found in corporate governance standards, a director is independent or not independent. Anything in between is extremely difficult to quantify and to measure. Hence, being an independent director not only means that one meets a list of independence requirements in relation to his/her position to management, directors and shareholders of a company. An equally important criterion of independence is the capability of a director to act independently of management and vested interests. Being able to act independently requires education in business and managerial skills.

Although reform of board structures in which directors operate is valuable, formal requirements are only part of the equation that makes boards successful in emerging markets. The requirement that boards be composed solely of independent directors does not make a board act independently of management. Requiring a board to have audit committees composed of only independent directors does not necessarily mean that the audit committee will be successful in developing and implementing an internal control system. Corporate governance reform requires a combination of structural reform and strategies that encourage the private sector’s acceptance of modern business standards.


3.4    A Lack of Ownership

According to Channell (2005), lack of ownership within the business community is a persistent problem related to the development of new commercial legislation in developing countries.

Under pressure from the international donor community, laws and corporate governance standards have been literally translated or adopted wholesale from other systems without the involvement of stakeholders affected by the new standards and legislation. As noted by Anderson (2005): “Experts from developed countries often give advice to developing countries about the policies, laws, and institutions that are needed to promote economic development. A frequent problem with their advice, however, is that the experts only recommend what they know, namely, what exists in their own countries.” Legal transplants also tend to be complex. The benefits of complex securities legislation based on, for example, the US 1933 and 1934 Securities Acts in a market with fewer than 100 listed companies and a total market cap of a few hundreds of million dollars may not outweigh the costs of education, implementation and enforcement.

Legal transplants are regularly a necessity for emerging markets that seek accession to the European Union (EU) or the World Trade Organization. The EU’s accession program requires candidate member states to literally adopt thousands of new laws and regulations in short periods of time to harmonize legislation with EU standards.

Due to time constraints and the limited capacity of governments to absorb all these changes, new laws and regulations are often enacted with little room for inclusive consultations, education and implementation. As a result, laws are not always introduced with careful and patient adaptation to the local circumstances. Reform strategies have not always been used effectively.


[6] See Final NYSE Corporate Governance Rules, Section 303A. In a similar vein, Nasdaq “does not believe that ownership of company stock by itself would preclude a board finding of independence.” See NASDAQ, IM-4200. Definition of Independence, Rule 4200(A)(15).

[7] Under prior Russian law, cumulative voting was required if the number of a company’s voting shareholders exceeded 1,000. A recent amendment to the Russian Law on Joint Stock Companies in March 2004 has made cumulative voting mandatory for all companies with a board of directors. A company is required to have a board of directors if it has 50 or more shareholders with voting rights.

[8] Available on www.thecorporatelibrary.com

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Maassen, G.F. (2002). An International Comparison of Corporate Governance Models. A Study on the Formal Independence and Convergence of One-Tier and Two-Tier Corporate Boards of Directors in the United States of America, the United Kingdom and the Netherlands.

Maassen, G.F. (2002). An International Comparison of Corporate Governance Models. A Study on the Formal Independence and Convergence of One-Tier and Two-Tier Corporate Boards of Directors in the United States of America, the United Kingdom and the Netherlands. Amsterdam: Spencer Stuart Executive Search.