Through its Petroleum Fund, Norway has an unprecedented opportunity for helping promote improved corporate governance practices around the world, writes B. Espen Eckbo, Professor of Finance at the Tuck Business School, Dartmouth College, US
As is well known, the Ministry of Finance – the owner of the Petroleum Fund – requires the Petroleum Fund to be highly diversified, adhering to the prudent investment principle of “don’t put all your eggs in one basket”. Accordingly, the manager of the Fund, Norges Bank, has invested 60 per cent of the Fund in bonds and 40 per cent in more than 3000 publicly traded companies in over 30 countries.
However, it is less well known that Norges Bank also engages in active long-term corporate governance. The latter may somewhat loosely be said to follow Mark Twain’s principle of “if you put your eggs in one basket – then protect that basket!”. For this purpose, Norges Bank has established a corporate governance group, headed by Henrik Syse and of which the author is a member. The group’s primary objective is to assist Norges Bank in its efforts to maximise the Fund’s long-term financial returns.
Active corporate governance implies that an owner uses its ownership stake – typically in cooperation with other large owners – to push for changes in the company. This is fundamentally different from decisions to exclude companies from the Fund’s portfolio. A decision to exclude stocks from the Fund is the domain of the Ministry of Finance’s Council on Ethics, not Norges Bank.
Active corporate governance is important because costly conflicts of interest may arise in some of the underlying portfolio companies of the Petroleum Fund. Whether the Fund’s ownership is in the form of stocks or bonds, it is important to be able to identify such conflicts of interest as early as possible, and to make reasonable proposals for solutions that minimise the costs to the Fund.
A corporate governance system represents a set of constraints on the possibilities and incentives for corporate management and the board to expropriate the rights of external investors. The risk of expropriation is clearly highest in poorly developed securities markets and in countries where the legal system is corrupt. However, recent corporate scandals in western countries – such as Enron and Worldcom in the US, and Parmalat and Ahold in Europe – have shown that problems related to investor expropriation also arise in countries with seemingly well developed capital markets.
Research has demonstrated that the design of a country’s corporate governance system is of utmost economic importance for the macro-economy. A particularly vivid illustration of this importance are the events that followed in the wake of the Asian currency crisis in 1997, and which led to a sharp decline in many countries’ stock markets. Research shows that the countries with poor corporate governance systems experienced the largest stock market declines. In many of those countries, outside investors’ contractual rights were routinely expropriated by strong corporate insiders.
For example, in Korea corporate assets were quietly transferred from conglomerates to outside companies where insiders had financial interests. In Russia, creditors were given virtually no legal protection for their bankruptcy claims. In Thailand, capital was secretly transferred to foreign accounts, and so forth. Research shows that a country’s corporate governance system was actually a more important explanatory factor for the stock market price decline than all of the traditional macroeconomic variables typically used to explain dramatic stock market declines.
Undertaking corporate governance activities such as monitoring management obviously entails costs. The problem in any stock market is that small shareholders (rationally) refuse to bear these costs. As a result, whenever the vast majority of a company’s shareholders are small, monitoring of management does not take place. In such firms the key monitoring role that shareholders are supposed to play breaks down.
In the absence of shareholder monitoring, management and other corporate insiders reign more or less freely. This freedom leads company insiders to often expropriate ownership rights. Research shows that when this occurs, there are tendencies for insiders to unduly influence the director election process, for company investments to shift in favour of management’s personal preferences rather than to maximise share value, for defensive strategies to be devised against acquisition of the company, etc.
The solution is to revive the corporate governance system. The primary catalysts for this solution are the large pension funds in the western world. Pension funds have a unique financial incentive to develop an active corporate governance strategy: Unlike typical mutual funds with a shorter time horizon, pension funds benefit from the more long-term improvements in a company’s corporate governance system. This also applies to the Petroleum Fund, which is run like a pension fund and which is now among the largest funds in the world.
Active corporate governance involves applying pressure directly on a company’s board of directors whenever governance problems are suspected. Understandably, directors are highly sensitive to such pressure from external investors. In order to succeed with such delicate pressure, the Fund must have expertise across disciplines such as financial economics, law and ethics. This is the reason why the corporate governance group in Norges Bank was established.
When applying pressure on the board to implement governance changes, it is important to focus on the governance system itself rather than on the personal characteristics of directors. Thus, when Disney CEO Michael Eisner was forced to resign as board chairman, the argument was that it is generally difficult to combine the role of CEO with the function of board chairman, irrespective of the qualities of the individual involved. In a modern governance system, the board represents the interests of the firm’s owners, which may from time to time conflict with those of the firm’s insiders.
By cooperating with other large pension funds, and by maintaining the reputation for integrity the Petroleum Fund enjoys among international investors, Norway has an unprecedented opportunity for helping promote improved corporate governance practices around the world. In the process, the Petroleum Fund helps safeguard its financial return in the long run.
