Introduction

In this article, Clive Hopewell, a partner with Charles Russell LLP and Head of its Middle East Office considers some of the lessons learned from the recent financial crisis and those factors driving corporate governance reform in the MENA region.

What is Corporate Governance?

Corporate governance can be defined, broadly speaking, as the internal systems and processes for ensuring proper accountability, probity and openness in the conduct of an organisation's business.

Back in the early 1990's, the UK was at the forefront of corporate governance reform and development. This was in part largely due to public concern over the excesses of the boards of newly privatised utilities during the Thatcher period. Corporate governance was very much in the spotlight following the publication of a number of important reports which have had an influence on the global corporate governance environment in which we operate today. These reports include the Cadbury Report (1992), the Greenbury Report (1995) and the Hampel Report (1998), ultimately resulting in the UK Combined Code (1998) which replaced the former codes of best practice.

Whilst there is, as yet, no generally applicable global corporate governance model, corporations work within the parameters set by national laws and regulations, along with the economic goals and expectations of their shareholders and other stakeholders.

The basic principles found in good corporate governance systems around the world include the following and are often implemented in practice by a combination of statutory rules and codes of best practice:

  • Transparency;
  • Accountability;
  • Fairness; and
  • Responsibility

Corporate Governance – Since the Financial Crisis

The economic crisis has revealed severe shortcomings in the corporate governance of larger companies (both public and private) and has placed corporate governance practices back under the spotlight. There has long been a failure to provide the checks and balances needed to cultivate sound business practices and the collapse of banking giant Lehman Brothers on 15 September 2008 can in part be attributed to failures in corporate governance which allowed a dangerously complacent and insulated business culture to develop.

Weak corporate governance arrangements which failed to safeguard against excessive risk taking are partly to blame for the economic crisis. Such failures remained hidden in a prosperous market but the downturn has revealed a number of flaws.

The key areas of weakness that have been highlighted in the various reports and investigations examining the reasons for the financial crisis are:

Remuneration, including incentives that failed to manage risk;

Corporate risk management and the underwhelming performance of audit, risk, remuneration and nomination committees;

Board of directors performance and the failure to ensure a balance of the skills, experience and independence required; and

The need for shareholders to be more proactive in engaging effectively with companies and monitoring the board.

As part of the recovery programme, various government bodies and trade organisations around the world have announced reviews and proposed changes to their corporate governance regimes.

Reform in the Middle East

It is the ideal time to learn from the mistakes made in the US and other leading economies in order to implement a reform of corporate governance in the Middle East. MENA corporate governance priorities mirror those in other regions of the world; however, the prevalence of concentrated ownership structures combined with the rapid rate of growth of companies and conglomerates in the Middle East does give prominence to specific issues.

Certain common characteristics of Middle Eastern companies present particular challenges in implementing a corporate governance policy that addresses all of their stakeholders. In particular, Middle East ownership structures favour family-owned and majority shareholder dominated companie. Corporate governance impacts all companies regardless of ownership structure, but family-owned companies require specific consideration.

It can be difficult in particular for family owned companies to demonstrate transparency and maintain strong internal controls especially, when trying to establish a clear dynamic between three distinct yet interdependent bodies of persons: the shareholders; the board; and the management, whose roles are often held by related parties. While tradition and strong family control remain important throughout the Middle East, it is necessary to support the current regime by implementing a governance system that is able to withstand growing competition and the need for efficient allocation of resources. The demonstration of transparency and maintenance of strong internal controls and reporting systems helps to win the confidence of investors and counter-parties especially in light of increasing globalisation.

The pattern of concentrated ownership also characterises that of publicly traded companies, with control being in the hands of the largest, or five largest shareholders. Ownership concentration perpetuated by family ownership or raising equity through rights issues, can mean that large and sometimes politically powerful shareholders are less likely to pursue corporate governance mechanisms. In turn this can have a negative impact on liquidity and trading. Transparency is vital to protect the interests of minority shareholders and other stakeholders.

Given the considerable growth in a number of Middle Eastern capital markets in recent years, the need for corporate governance reform is becoming more urgent. Investor confidence in corporate governance in the region is critical to the sustainability of capital market growth. Such reforms should focus in particular on transparency and disclosure, equitable treatment of shareholders and regulatory capacity building which is critical in ensuring compliance and enforcement.

In the public sector, state owned enterprises (SOEs) are prevalent in many Middle East economies. Such enterprises often have a strategic function in the economy and many of these SOEs are actively engaged in quasi-financial activities that are not subject to the rigors of transparency and financial accountability.

SOEs face particular corporate governance challenges due to the availability of soft credit and lack of commercial incentives. This can often lead to deficient financial discipline and political influence can distort market incentives and reduce the beneficial implications of competition.

Bahrain Corporate Governance

The Ministry of Industry and Commerce and the Central Bank of Bahrain established a National Steering Committee on Corporate Governance in 2006 in recognition of the benefit of good corporate governance well before the current financial crisis. Whilst the Bahrain Corporate Governance Code is not yet implemented it is understood to be close to being finalized. The Code supplements the Bahrain Company Law and is applicable to all Bahraini incorporated companies whose shares are listed on the Bahrain Stock Exchange. In addition the Code is highly recommended and intended to be used as a reference framework for all other companies (whether local or foreign) doing business in Bahrain. It has been stated that the Code is being developed to clarify and encourage the implementation of good corporate governance practices in the country.

The Code is not intended to replace the Bahrain Company Law but rather is intended to extend and supplement those corporate governance requirements already set out in the nation's commercial law. For example the Code recommends that the chairman of the board and the CEO should not be the same person and that at least half of the board of directors should be non-executive directors and that there should be rigorous procedures for appointment, training, and evaluation of the board.

Bahrain's Code broadly follows the UK 'comply or explain' model. This is a beneficial for the company as it affords the organisation the flexibility to implement a corporate governance system which takes account of its specific circumstances, including the size and nature of its business, its shareholding structure, or its exposure to risks and so on.

The Code sets out eight principles which form the key pillars of good corporate governance. The eight principles stated in the Code form the pillars of good corporate governance. Mirroring those areas of weakness highlighted above, the principles focus upon remuneration, the role of the board and increased communication with shareholders.

  • Principle 1: the company shall be headed by an effective, collegial and informed board.
  • Principle 2: the directors and officers shall have full loyalty to the company.
  • Principle 3: the board shall have rigorous controls for financial audit, internal control and compliance with law.
  • Principle 4: the company shall have rigorous procedures for appointment, training and evaluation of the board.
  • Principle 5: the company shall remunerate directors and officers fairly and responsibly.
  • Principle 6: the board shall establish a clear and efficient management structure.
  • Principle 7: the board shall communicate with shareholders and encourage their participation.
  • Principle 8: the company shall disclose its corporate governance.

Notably, in relation to principle 4 and under directive 4.5 of the Code, the chairman of the board has responsibility to ensure that each new director receives a formal and tailored induction to ensure his contribution to the board from the beginning of the term. This principle is to ensure board members have an adequate knowledge and skill base relevant to the business operated by their company. A lack of experience and understanding of banking by non-executives on the boards of some of the failed banks has been one of the key criticisms highlighted by recent reports into the Crisis.

Furthermore, principle 5 and directive 5.4 of the Code supplements the Company Law's requirement of shareholder approval of directors' remuneration by recommending full disclosure of all material facts to the shareholders. Directive 5.6 further states that remuneration of officers should be structured so that a significant portion of the total is linked to company and individual performance and aligns their interests with the interests of the shareholders and the company as a whole.

Conclusion

The implications of sound corporate governance practices reach far beyond shareholders' wealth; it affects the reputation of a country and the functioning of the domestic and global economy as a whole. As a result of Lehman's collapse and the subsequent financial crisis, the world over has to re-examine what went wrong and what needs to be done to ensure similar failure is prevented in the future. The key weaknesses revealed by the economic turmoil will be dealt with by different countries in different ways, specifically tailored to meet their unique governance challenges.

For the Middle East, this would seem to be the ideal time to take advantage of the opportunities that the financial crisis has brought to reform the corporate governance framework.

The objective of reform is to help restore market confidence and enable Middle Eastern countries to have access to international capital market financing and attract a higher quality of investment. This will hopefully lead to better enterprise performance productivity, competitiveness and ultimately, sustained economic growth and a more secure financial market. It is hoped that good corporate governance principles can lead to increased economic and financial integration of the MENA region with the rest of the world and improved economic prospects and performance.

Whilst the suggested reforms by US and European bodies go further and wider than the principles stipulated in the Bahrain Code, the Code provides a solid foundation for Bahrain authorities to build on and is certainly a step towards achieving good corporate governance in 'Business Friendly Bahrain'. However, it is important for executives who are responsible for enforcing the Code to understand the lessons that have been learnt from the recent financial crisis, both at home and abroad; in the end, no matter how well any code is written, its success is down to whether the key players have the right attitude towards implementation and enforcement.

Charles Russell advises on a full range of corporate governance and compliance issues, both for listed and private companies, as well as entities in non-business sectors. We recently produced the UK Corporate Governance Guide which forms part of the ICSA Directors Handbook. As a further illustration of our expertise in this area, Charles Russell recently hosted a corporate governance conference in association with KPMG Fakhro, EC Harris and the British Embassy in Bahrain.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.