CHAPTER 2: LITRATURE REVIEW 2.1 Corporate Governance Corporate governance is about how companies are directed and controlled.

It is concerned with holding the balance between economic and social goals and between individual and communal goals. The aim is to align as nearly as possible the interests of individuals, corporations and society (King, 2002). It is becoming difficult for companies to account for profitability alone. In a report by an international institutional investor, while South Africa ranked among the top five 25 emerging markets in terms of corporate governance, it rated poorly in terms of disclosure and transparency. The minimalist approach to corporate governance adopted by many local companies needs to change. There is a move from the single to the triple-bottom-line, which embraces the economic, environmental and social aspects of a companys activities. The King II Report on Corporate Governance, identifies what can be regarded as the seven characteristics of good corporate governance, viz: a. Discipline being the commitment by a companys senior management to adhere to behaviour that is universally recognized and accepted to be correct and proper. b. Transparency being the ease with which the outsider is able to make meaningful analysis of a companys actions, its economic fundamentals and non-financial aspects pertinent to that business. c. Independence the extent to which mechanisms have been put in place to minimize or avoid potential conflict of interest that may exist. d. Accountability individuals or groups in a company, who make decisions and take actions on specific issues, need to be accountable for their decisions and actions. e. Responsibility pertains to behavior that allows for corrective action and for penalizing mismanagement. f. Fairness being a system within the company that allows for balance in taking into account all those that have an interest in the company and its future. g. Social Responsibility being a well-managed company that will be aware of, and responds to, social issues, placing a high priority on ethical standards. It is a good corporate citizen who moves increasingly towards being nondiscriminatory, non-exploitative, and responsible with regard to environmental and human rights issues.

According to the King Report, corporate governance is essentially about leadership that is characterized by and ensures the following: _ Efficiency in order for companies to compete effectively in the global economy, and thereby create jobs. _ Probity because investors require confidence and assurance that management of a company will behave honestly and with integrity in regard to their shareowners and others. _ Responsibility as companies are increasingly called upon to address legitimate social concerns relating to their activities. _ Transparency and accountability - because otherwise leaders will not be trusted. The desired end-state of corporate governance climate of State Owned Enterprises like Eskom, is also governed by Protocol on Corporate Governance in the Public Sector and Public Finance and Management Act 1 of 1999, in addition to the King I and II code which are generally applicable to all companies. The Protocol was first published in 1997 with the view to inculcating the principles of good corporate governance, in the State Owned Enterprises, as was contained in King Report I. The Protocol was later revised with the publication of King Report II, to reflect the governments intention that the principles of the protocol should apply to all public entities and their subsidiaries. The objectives of Public Finance and Management Act 1 of 1999 (as amended by Act 29 of 1999), was to secure transparency, accountability, sound management of revenue, expenditure, assets and liabilities of government entities. According to Peters (2004), corporate governance comes down to relationships. It is about people interacting with other people. It is all about people interacting with products and technology and people interacting with systems. Governance at heart, is about human nature. The following figure shows the results of a survey conducted in the UK by PWC through MORI in 2004, in order to find out how employees feel about the way they work, what they are asked to do, and how their colleagues and bosses behave. Reference (Prepared by Lazarus Docter Mokoena (called Bonga) [Student No: 0555-418-7] Tel: 011-217 1187 (Work); 011-679 5486 (Home) Cell: 082 466 6896 SUPERVISOR: PROFESSOR M.H. CROSBIE

FINAL RESEARCH REPORT November 2005

In recent years, corporate governance has become an important topic for academics, institutional investors, and policymakers. There is a widespread belief that the quality of corporate governance and investor protection can affect the performance of firms and ecomonices. At the firm level, inadequate investor protection may reduce firm value and increase firms cost of capital. At the country level, inadequate investor protection may impede stock market development and undermine financial growth. Not surprisingly, the growing recognition of corporate governances importance has sparked substaial interest in measuring the quality of corporate-governance arrangements across firms and countries. Scholars have sought such measures to study the link between corporate governance and economic outcomes for both firms and economies. Policymakers-including those affiliated with the World Bank, the Organization for Economic Co-operation and Development (OECD), and the International Monetary Fund (IMF) - have been attracted to the promise of metrics that can facilitate efforts to improve countries investor-protection systems and to assess their progress in doing so. Finally, the growth of institutional investing and investors increased attention to corporate governance has induced shareholder advisers to develop governance metrics that could inform investment decisions in companies around the world. Sir Adrian Cadbury, chairman of the Cadbury Committee, defined the concept thus: Corporate governance is defined as holding the balance between economic and social goals and also between individual and communal goals. The governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interest of individuals, corporations and society. The incentive to corporations is to achieve their corporate aims and to attract investment. The incentive for states is to strengthen their economies and discourage fraud and mismanagement.

Experts at the Organisation of Economic Co-operation and Development (OECD) have defined corporate governance as the system by which business corporations are directed and controlled. Corporate governance is typically perceived by academic literature as dealing with problems that result from the separation of ownership and control. From this perspective, corporate governance would focus on: The internal structure and rules of the board of directors; the creation of independent audit committees; rules for disclosure of information to shareholders and creditors; and, control of the management. (A.C. Fernando 2009 p9) Corporate governance has also being widened to look at the relationship between the firm and all its stakeholders, instead of only its shareholders, since the firm operates as a unit of a bigger social entity. Corporate governance indices, that seek to look at value-decreasing activities leading to decreased return on shareholding assets, have been constructed for developed and emerging countries. In a study of the impact of governance mechanisms, Klapper and Love (2004) have argued that corporate governance is more relevant in firms that employ significant amounts of intangible assets. To this extent, one may expect to find a significantly higher impact of ownership variables on value or performance in firms that operate in very dynamic sectors than in basic industries. This argument needs to be empirically verified. Another element of debate in research, whether in corporate governance or the broader field of business management, has been how to assess firm performance. Profits, prices and rates of return are the most popular. Profitability however depends on many factors outside the direct control of firms and may not be a true measure of firm performance that can be attributable to firm specific characteristics. While the author does not question this measure of performance, there has been a burgeoning literature on an alternative measure of performance in terms of productive efficiency through both parametric and non-parametric analyses. The non-parametric analysis, which does not have a pre-specified production function, allows one to construct a production frontier based on similar inputs and outputs for a sample of firms, evaluating firms in the best possible light. Hence, one can envelop all data points and analyse for productive differentials using mathematical programming techniques. As opposed to a mean-variance technique, this alternative measure of performance uses an extreme-point

method which comes with its advantages and disadvantages. With the kind of analytical flexibility of this approach, a firms relative performance in getting the best value out of its assets can be ascertained. Needless to say, there are so many factors that lead to firm performance that are also outside the productive capacities of firms. In recent years, corporate governance has become an important topic for academics, institutional investors, and policymakers. There is a widespread belief that the quality of corporate governance and investor protection can affect the performance of firms and ecomonices. At the firm level, inadequate investor protection may reduce firm value and increase firms cost of capital. At the country level, inadequate investor protection may impede stock market development and undermine financial growth. Not surprisingly, the growing recognition of corporate governances importance has sparked substaial interest in measuring the quality of corporate-governance arrangements across firms and countries. Scholars have sought such measures to study the link between corporate governance and economic outcomes for both firms and economies. Policymakers-including those affiliated with the World Bank, the Organization for Economic Co-operation and Development (OECD), and the International Monetary Fund (IMF) - have been attracted to the promise of metrics that can facilitate efforts to improve countries investor-protection systems and to assess their progress in doing so. Finally, the growth of institutional investing and investors increased attention to corporate governance has induced shareholder advisers to develop governance metrics that could inform investment decisions in companies around the world. Sir Adrian Cadbury, chairman of the Cadbury Committee, defined the concept thus: Corporate governance is defined as holding the balance between economic and social goals and also between individual and communal goals. The governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interest of individuals, corporations and society. The incentive to corporations is to achieve their corporate aims and to attract investment. The incentive for states is to strengthen their economies and discourage fraud and mismanagement.

Experts at the Organisation of Economic Co-operation and Development (OECD) have defined corporate governance as the system by which business corporations are directed and controlled. Corporate governance is typically perceived by academic literature as dealing with problems that result from the separation of ownership and control. From this perspective, corporate governance would focus on: The internal structure and rules of the board of directors; the creation of independent audit committees; rules for disclosure of information to shareholders and creditors; and, control of the management. (A.C. Fernando 2009 p9) Corporate governance has also being widened to look at the relationship between the firm and all its stakeholders, instead of only its shareholders, since the firm operates as a unit of a bigger social entity. Corporate governance indices, that seek to look at value-decreasing activities leading to decreased return on shareholding assets, have been constructed for developed and emerging countries. In a study of the impact of governance mechanisms, Klapper and Love (2004) have argued that corporate governance is more relevant in firms that employ significant amounts of intangible assets. To this extent, one may expect to find a significantly higher impact of ownership variables on value or performance in firms that operate in very dynamic sectors than in basic industries. This argument needs to be empirically verified. Another element of debate in research, whether in corporate governance or the broader field of business management, has been how to assess firm performance. Profits, prices and rates of return are the most popular. Profitability however depends on many factors outside the direct control of firms and may not be a true measure of firm performance that can be attributable to firm specific characteristics. While the author does not question this measure of performance, there has been a burgeoning literature on an alternative measure of performance in terms of productive efficiency through both parametric and non-parametric analyses. The non-parametric analysis, which does not have a pre-specified production function, allows one to construct a production frontier based on similar inputs and outputs for a sample of firms, evaluating firms in the best possible light. Hence, one can envelop all data points and analyse for productive differentials using mathematical programming techniques. As opposed to a mean-variance technique, this alternative measure of performance uses an extreme-point

method which comes with its advantages and disadvantages. With the kind of analytical flexibility of this approach, a firms relative performance in getting the best value out of its assets can be ascertained. Needless to say, there are so many factors that lead to firm performance that are also outside the productive capacities of firms.

2.1.1 The Corporate Governance Concept Alexakis, Balios, Papagelis & Xanthakis (2006) contend that issues that corporate governance address can be found in the literature as early as 1776 (Smith) and 1932 (Berle and Means). According to the CIS (2008) corporate governance refers to the way in which companies are governed, and to what purpose. The Business Governance Handbook defines corporate and business governance as follows: the system that maintains the balance of rights, relationships, roles and responsibilities of shareholders, directors and management in the direction, conduct, conformance and control of the suitable performance of the company/business with honesty and integrity in the best long-term interests of the company, shareholders, and business and community stakeholders (Hendrikse and Hendrikse, 2004:102). The Business Governance Handbook definition is consistent with the South African King Report 2002 that emphasises the need for enterprise with integrity in the interest of the society, environment and stakeholders (CIS, 2008). The link between the aforementioned definitions and sustainability as well as RI is clear. Mangena and Chamisa (2008) state that South Africa was the first developing country to develop corporate governance code of best practice via the King Report of 1994. This report drew extensively from the U.K. Cadbury Committee of 1992. Local and international developments necessitated a revision of the code in 2002. A mechanism to be relied on for enforcement of the King Report 2002 is the provisions of the amended listing requirements of the JSE (Hendrikse and Hendrikse, 2004). Further local developments include the JSE Limited launching a Socially Responsible Investment (SRI) Index in May 2004 (Sonneberg and Hamann, 2006). Corporate governance is one of the four key categories in the SRI Index. The King III draft release was February 2009 (IOD SA, 2009). In a recent interview, Prof. Mervyn King underlines that sustainability is the primary and economic necessity for the 21st century and reporting thereon needs revision (Visser, 2009). Contemporary organisations face a sustainability challenge. Nature, society and business are inescapably interconnected in

complex ways that need to be understood by decision makers (IOD, 2009). Sustainability is the primary moral and economic imperative for the 21st century and it is one of the most important sources of both opportunities and risks for business (IOD, 2009:12). According to Perrini and Tencati (2006) corporate sustainability is the capacity of an organisation to continue operating over a long period of time and is dependent on the sustainability of its stakeholder relationships. Indeed, a new perspective of corporate governance promotes a shift from an exclusively shareholder perspective to a stakeholder perspective (Thiry and Deguire, 2007). Therefore, for sustainability to become main stream, organisations must integrate strategy, sustainability and governance (IOD, 2009). It is reasonable to argue that the amount of information regarding the relationship between governance and sustainability will also increase (Aras and Crowther, 2008). Organisations governance can be on a statutory basis, as a code of principles and practices, or a combination of the two (IOD, 2009). The USA has chosen to codify a significant part of its governance in an act known as the Sarbanes-Oxley Act while South Africa and the twenty seven states in the EU, including the UK, have opted for a code of principles and practices in addition to certain governance issues that are regulated (IOD, 2009). The statutory regime is regarded as comply or else while the principles-based approach is referred to as apply or explain. In reviewing the various definitions of corporate governance, it is evident that all definitions refer to the existence of conflicts of interest between insiders and outsiders arising from the separation of ownership and control (Alexakis, et al., 2006). The authors are referring to the agent-principal relationship. The seminal work of Jensen and Meckling (1976) defines an agency relationship as a contract under which one or more persons (the principle) engage another person (the agent) to perform some service on their behalf which requires delegating some decision making authority to the agent. According to Millson and Ward (2005) agency theory forms the backbone to corporate governance. Drobetz, Schillhofer & Zimmermann (2004) considers principle-agent theory as the starting point for any discussion on corporate governance. Agency theory argues that directors, seeking to maximise their own personal benefit, take actions that are advantageous to themselves but detrimental to shareholders (Tricker, 2009). A less optimal view of directors behaviour is therefore apparent. Tricker (2009) concludes that agency theory, because of its simplicity and the availability of both reliable data and statistical rigorous tests, has provided a commanding approach to corporate governance theory building.

Critics of agency theory speculate that it has been founded on a single, questionable abstraction that governance involves a contract between two parties, and is based on a uncertain conjectural morality that people maximise their personal utility (Tricker, 2009). The agency theory of corporate governance is depicted in figure 2.1.

Figure 2.1 The agency theory corporate governance (Tricker, 2009: 219).

Possibly in order to build an appropriate theory of corporate governance and in the quest to find evidence in support thereof, the simplicity of agency theory and the availability of data that could be subjected to statistical testing could actually be a liability. This is exactly what Ghoshal (2005) contends as reason for the predominance of agency theory which underlies the support for the shareholder value maximisation proposition. With other theories welldesigned statistical modelling is just not as straightforward. Ghoshal (2005) is particularly critical of agency theory in his paper that proposes that bad management theories are destroying good management practices. It is argued that a management theory that gains enough standing, irrespective of being right or wrong, can start changing the behaviours of managers that start acting in accordance with the theory (Ghoshal, 2005). Business schools have not been speared of criticism in that having propagated ideological inspired amoral theories; students are freed from moral responsibility (Ghoshal, 2005). When combining agency theory with transaction cost economics, versions of game theory and negotiation analysis, the picture of a ruthless business leader that is shareholder-value obsessed often emerges (Ghoshal, 2005). According to Ghoshal (2005) the process through which bad theories are destroying good practice is depicted in figure 2.2.

Figure 2.2 The process of bad theories destroying good practice (Ghoshal, 2005: 76).

In contrast to agency theory, stewardship theory believes that directors do not always act in a way that maximises their own personal interest. Directors have a fiduciary duty to act as stewards of the shareholders interest. Inherent in the concept of the company is the belief that directors can be trusted (Tricker, 2009: 224). Criticisms of stewardship theory point out that the situation in modern companies is very different from the 19th century model and also because the theory is rooted in law, it is normative (Tricker, 2009). The relationship between shareholders and directors under stewardship theory is depicted under figure 2.3.

Figure 2.3 The stewardship theory of corporate governance (Tricker, 2009: 224).

Perspectives on corporate governance at a societal level, or stakeholder theory, are concerned with values and attitudes about the appropriate relationship between the individual, the organisation, and the state (Tricker, 2009). According to Aras and Crowther (2008) the recent range of problems with corporate behaviour has arguably led to prominence being given to corporate social responsibility. The authors posit that part of this effect is to recognise the concerns of all stakeholders to an organisation. The inclusive approach to governance state that the board should take into account the legitimate expectations of the companys stakeholders (IOD, 2009). Overshadowing all theoretical perspectives of corporate governance are some basic unresolved issues at a meta-philosophical level (Tricker, 2009). All systems of governance must seek an appropriate balance between the interests of self and society. That applies to corporate governance just as it does to governance in other areas of society (Tricker, 2009: 231). Tricker (2009) concludes that although the significance of governance for the long term success of an organisation is understood, the theoretical underpinnings of the subject are weak and that the subject lacks a conceptual framework that adequately reflects the reality of corporate governance. The theoretical perspectives on boards and governance can best be seen as multiple theoretical lenses with which to view the subject (Triker, 2009). The finance model of the firm in which the central problem is how to construct rules and incentives to align the behaviour of managers with the interests of owners, needs to be supplemented with other models of corporate control including the stewardship, stakeholder and political models (Clarke and dela Rama, 2008).The field of research on corporate governance can be divided in two broader areas (Alexakis, et al., 2006:675):

the more theoretical area that tries to assess the effectiveness of the various corporate governance mechanisms and the degree that corporate governance results in reducing agency costs; and the more empirical area that attempts to empirically relate corporate governance indicators to the economic performance and growth of companies governed under this framework. This area includes equity prices and its expected returns, the cost of equity capital as well as various valuation measures. This study focuses more on the second area and a review of the literature related to this area of empirical work follows. Reference by J P OPPERMAN 18 November 2009

Corporate governance is traditionally thought of in the framework of large corporations, shareholders, and board private sector issues in developed economies and some of the major emerging markets. Many of these issues may seem to bear little relevance to broader development concerns that deal with day-to-day issues of poverty, job-creation, anticorruption, education, media, and political reform. Yet, corporate governance and development are strongly related. Just as good corporate governance contributes to the sustainable development prospects of countries, increased economic sustainability of nations and institutional reforms that come with it provide the necessary basis for improved governance in the public and private sector. Alternatively, corporate governance failures can undermine development efforts by misallocating much needed capital and resources and development fallbacks can reinforce weak governance in the private sector and undermine job and wealth creation. (CIPE 50517138 p 7).

2.1.2 Scope of Corporate Governance 2.1.3 Corporate Governance activities 2.1.4 Corporate Governance integration strategy Governance of State-Owned Enterprises

The critical question here is what is the role to be played by various leaders in implementing good corporate governance in state-owned enterprises? The roles in question here is that of the government, as a shareholder, and that of the board of directors of a state-owned enterprise. According to Khoza & Adam (2005) good corporate governance includes measures that enhance organizational integrity, transparency, and sustainable performance. If effective leadership underpins effective governance, it is imperative that the respective leadership roles required by the organization be understood so that they can be appropriately fulfilled. They contend that one of the unique challenges facing state-owned enterprises is the clarification of the role of government as shareholder and the role of the board. This in turn needs to cascade down into the organization in order to achieving greater clarity with regard to the roles of the board in relation to the roles of management. According to Yudelowitz (Business Day, 2005), Parastatal boards usually consist of those with a political agenda and businessmen as well as some technocrats. Each advocates a governance approach emanating from his own background, personal beliefs and style. In successful parastatals the players the minister, the director-general, chairman and CEO understand these complex dynamics and work with them while remaining conscious of their commercial, technical, social and political mandates. To promote this the board must be a leadership team in its own right, tasked with integrating apparently different points of view, providing coherence and making judicious trade-offs. It must also provide a context and perspective of other key stakeholder interest, for example the voting public, who are indirectly the owners of the parastatal. It must integrate the defined mandate of the executive committee (often focused on managing the balance sheet and competing commercially) with all other stakeholder interests and hence must take responsibility for its own leadership. This is true of all boards but especially so of parastatals because of multitude of complex variables at play.

2.5 Strategic Management Approach in the Implementation of Corporate Governance Programmes

Thompson & Strickland (2003) pointed out that a companys strategy consists of the combination of competitive moves and business approaches that managers employ to please customers, compete successfully and achieve organizational goals. In relation to good corporate governance, the relevance of strategy would answer the question as to what the game plan is that has been adopted by the organizational leadership to stake out its position in the society, to conduct its business on the day-to-day basis, to compete successfully and to achieve the broader organizational goals in line with the triple-bottom line concept. Thompson & Strickland (2003) state that crafting, implementing, and executing a strategy are top-priority managerial tasks for two of the following very big reasons: First, there is a compelling need for managers to proactively shape how the companys business will be conducted. Without a strategy, managers have no prescription for doing business, no road map to competitive advantage, no game plan for pleasing customers or achieving good performance. Lack of consciously shaped strategy is a surefire for organizational drift, competitive mediocrity, internal wheel-spinning and lackluster results. In order for good corporate governance climate to prevail on a sustainable basis in environment, it requires a conscious crafting of a strategy as to how it will be implemented in a way that is effective and that will affect the organization as a whole in terms of how it goes about doing its business and interacting and effecting all its stakeholders in a way that demonstrate good performance from triple-bottom line performance. Second, there is an equally compelling need to mould the efforts and decisions of different divisions, departments, managers, and groups into a coordinated, compatible whole. All the actions taken in different parts of the business need to be mutually supportive. Good strategy and good strategy execution are the most trustworthy signs of good management. In the same breath, good management and/or leadership in a state-owned cannot be judged only on the basis of well designed corporate governance programme(s), a combination of well a designed governance programme and the effective implementation thereof can be said to be the most trustworthy measure of performance. The standards of good management rest to a very large extent on how well conceived the companys strategy is and how competently it is executed (Thompson & Strickland, 2003). They pointed out that the strategy-making/strategy-implementing process consists of five interrelated managerial tasks:

I. Forming a strategic vision of where the organization is headed so as to provide long-term direction, delineate what kind of enterprise the company is trying to become, and infuse into the organization a sense of purposeful action. II. Setting objectives converting the strategic vision into specific performance outcomes for the company to achieve. III. Crafting the strategy to achieve the desired outcomes. IV. Implementing and executing the chosen strategy efficiently and effectively. V. Evaluating performance and initiating corrective adjustments in vision, long-term direction The above five tasks of strategic management can be summarized and depicted pictorially in diagram below: Reference (Prepared by Lazarus Docter Mokoena (called Bonga) [Student No: 0555-418-7] Tel: 011-217 1187 (Work); 011-679 5486 (Home) Cell: 082 466 6896 SUPERVISOR: PROFESSOR M.H. CROSBIE FINAL RESEARCH REPORT November 2005

2.1.5 Basic benefits of Corporate Governance Corporate governance is the system by which companies are directed and managed. It influences how the objectives of the company are set and achieved, how risk is monitored and assessed, and how performance is optimized. Good corporate governance structures encourage companies to create value (through entrepreneurism, innovation, development and exploration) and provide accountability and control systems commensurate with the risks involved. Recent research highlights the importance of corporate governance in emerging markets. La Porta et al (1997, 1998, 1999, 2000), demonstrate that, across countries, corporate governance is an important factor in financial market development and firm value. Corporate governance in needed to create a corporate culture of consciousness, transparency and openness. It refers to a combination of laws, rules, regulations, procedures and voluntary practices to enable companies to maximise shareholders long-term value. It should lead to increasing customer satisfaction, shareholder value and wealth. With increasing government

awareness, the focus is shifted from economic to the social sphere and an environment is being created to ensure greater transparency and accountability. It is integral to the very existence of a company. (A.C. Fernando 2009 p27) Corporate governance is important for state-owned enterprises (SOE), not only do corporate governance practices increase productivity in and competitiveness of SOEs, they also help to ensure that public funds invested in these enterprises are not mismanaged and are spent effectively. By creating more transparent and economically viable SOEs, corporate governance also helps to ensure that services are actually delivered to the public. Further, as state enterprises often provide a bulk of employment in some emerging markets and a variety of essential public services, good governances helps to prevent failures with devastating social impact. In many countries, corporate governance has been used as a means of not only improving the efficiency of SOEs, but also as a mechanism to improve their attractiveness to investors, thus increasing state income from privatization. Corporate governance is also important for state-owned enterprises (SOEs). Not only do good governance practices increase productivity in and competitiveness of SOEs, they also help to ensure that public funds invested in these enterprises are not mismanaged and are spent effectively. By creating more transparent and economically viable SOEs, corporate governance also helps to ensure that services are actually delivered to the public. Further, as state enterprises often provide a bulk of employment in some emerging markets and a variety of essential public services, good governance helps to prevent failures with devastating social impact. In many countries, corporate governance has been used as a means of not only improving the efficiency of SOEs, but also as a mechanism to improve their attractiveness to investors, thus increasing state income from privatization. (CIPE 50517138 p 26). In many developing countries, state-owned enterprises make up a disproportionate segment of the ecomony and suffer from a myriad of management and performance issues that limit their effectiveness and the role they are expected to play in generating growth. Often, these enterprises are found in strategic sectors such as infrastructure or trade, where their inefficiencies limit the private sectors ability to contribute to economic development. Working with unclear strategies and multiple lines of accountability, manager decision-making within SOEs becomes hostage to politics and conflicting bureaucratic interests, resulting in a situation

where multiple agencies and ministries vie to influence SOE management while ultimate accountability for decision-making is non-existent. By their non-transparent nature, SOEs are often plagued by political patronage, corruption, and waste, which limits their ability to modernize and build responsive and efficient programs of work. (CIPE 50517138 p 26).

2.2 Corporate Governance practices

2.3 Corporate Governance AND PERFORMANCE OF FIRMS

2.4 Corporate Governance PRACTICES IN ETHIOPIA Globally, many countries and economic groups developed standards and principles that are going to serve to foster Good Corporate Governance in their respective countries. The Ethiopian Government improved the governance from time to time significantly in recent years, with boards taking a more professional approach to governance, especially in public enterprises that come under the greatest public scrutiny. Boards in South Africa have to deal with greater complexity than their counterparts in Europe and North America, and increasingly face the spotlight as pressure to enhance governance standards mounts from shareholders, government, the media and other pressure groups. PPESA referred OECDs principles to develop the Code of Corporate Governance (2009) and contextualize it to suit the Ethiopian Public Enterprises environment. Code of Corporate Governance which is published by PPESA addresses many issues with the purpose of maximizing corporate value by enhancing the transparency and efficiency of public enterprises and thus establishing a system that promotes creative and progressive entrepreneurship. As it magnifies, corporate governance involves a set of relationships between a companys management, its board and shareholders and other stakeholders.  It is a set of accepted principles;  It is about commitment to values, ethical business conduct and transparency;  It is through which ethics, probity and public accountability are maintained;  It requires that the board must lead the company with integrity so as to entrench and enhance its license(including non-legal license) to operate;

 It is about leadership of efficiency, probity, responsibility and which is transparent and accountable.

Company law is crucial in market economies; it sets the legal environment for the creation and continuing operation of privately owned businesses. Good company law is especially critical in transition-economy countries. It can encourage new investmentand provide investor protectionby setting forth clear and objective rules for a companys ongoing internal governance; it can encourage entrepreneurship by making it easy to start up and register a company; and it can encourage businesses to come out of the underground economy into the publicly registered, taxpaying economy.

Ethiopias current company law is part of its Commercial Code, which has remained unchanged since its enactment in Imperial times (1960). It is patterned after the French Commercial Code as it was in effect in 1960. The company law was effectively suspended during the Communist Derg period (19751991), when formation of new limited liability companies was not permitted. The company law was restored to full effect under the present Government.

Although the current company law has been basically adequate for conditions to date, it needs to be updated. The present Government recognizes this and appointed a committee under the Department of Justice, which has been working on an updated version for more than 2 years with completion said to be hoped for by early 2007. The committee currently has a working draft but that draft is not publicly available.

One distinct issue involving company law is that of startup and registration of new companies. Although that has been a problem in the past, it is no longer so according to all persons who were interviewed, including practicing lawyers and accounting firm professionals, company officials, registry officials, and donors. That is due to implementation with donor help of revised and streamlined company registration procedures and forms in the Ministry of Trade and Industry.

The Ethiopian economy is at a stage of transformation. Reforms during the last couple of decades brought market economy, privatisation of state owned enterprises and openings in the financial system. Developments of the latest few years indicate a new phase of economic progress. There is a noticeable increase of exports. Investments and joint ventures with foreign investors are making progress. There is an emerging trend in the financial system from the purely collateral based lending to performance based financing of businesses. Over the past couple of years, ambitious investors are seen raising large amounts of capital from the public through offers of shares in new business ventures. All these indicate the emergence of new types of relations between and among businesses, investors, suppliers, and customers. These new trends and changes in the Ethiopian economy and business environment would need to be followed up by major changes in the way of conducting business in the country. Good corporate governance in its broad sense will be essential. Without it, necessary new relations between businesses, investors, financiers and foreign customers would not take place and economic development will be slower. Globally, many countries and economic groups developed standards and principles that are going to serve to serve to foster good corporate governance in their respective countries. Among these principles, the OECD (Organization for Economic Cooperation and

Development) principles of Corporate Governance were endorses by OECD Ministers in 1999 and have since become an international benchmark for policy makers, investors, corporations and other stakeholders worldwide. The OECD principles of Corporate Governance states: Corporate governance involves a set of relationships between a companys management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. Corporate governance is all about governing corporations. By their nature large modern enterprises are usually owned by one group of people (the owners or shareholders) whilst being run by another group of people (the management or the directors). This separation of ownership from management creates an issue of trust. The management has to be trusted to run the company in the interest of the shareholders and other stakeholders. If information were

available to all stakeholders in the same form at the same time, corporate governance would not have been an issue at all. (A.C. Fernando 2009 pp26-27) The standard of corporate governance in Ethiopia in general is very poor. The absence of an adequate legislative framework to regulate modern complex bank governance issues political parties' involvement in business enterprises, and the absence of an organized share market are among the characteristics of bank corporate governance in Ethiopia. Furthermore, there is a major credibility problem in the Ethiopian banking regulatory environment since the regulatory organ enforced rules discriminate between state and private banks. This book identifies the different aspects of bank corporate governance in Ethiopia such as ownership structures, board size and composition, accounting and auditing standards, succession planning, and their influence on bank performance by taking a sample of four private banks. By exploring best bank governance practices and international bank governance principles, this book recommends thorough reform and adoption or adaptation of good corporate governance principles in the Ethiopian banking sector. There are a number of tangible reasons for the Ethiopian business community to adopt good corporate governance as an effective tool of growth and transformation in the private sector. In fact, the issue of corporate governance is as urgent as the need to make the current growth and development in the sector sustainable in the framework of the private sectors development objectives. Moreover, the five year Growth and Transformation Plan (GTP) of the government makes it incumbent upon the countrys small and larger businesses to adopt globally relevant principles of corporate good governance without which the Plan may not be realized as expected.

Indeed if the past is any guide, the private sector is considered a key factor in the realization of the aims and objectives of the countrys development plan in the coming five years and beyond. Likewise, the fast pace of economic growth that was registered in the last seven or so years could only materialize thanks in part to the leading role played by the private sector although its potentials for growth have not yet been fully harnessed.

The concept or the practice of corporate governance was little known in the past since the private sector was not as developed as it is now or it was not integrated to the world market as it is at present. However, with the growth of the sector, the need for corporate governance was

increasingly felt in the last two decades since the government articulated the countrys economic development strategy as being led by the private-sector.

By formulating this policy, the government has been working on creating an enabling environment not only for private sector growth but also for the implementation of corporate governance if not corporate good governance. The Ethiopian business community led respectively by the Ethiopian and Addis Ababa Chambers of Commerce and Sectoral Associations had been making notable efforts to implement the principles of corporate good governance although the results are still far from being satisfactory as there have been formidable institutional, historical and economic challenges that were constraining these efforts. Now that the Ethiopian private sector is going through a period of speedy and sustainable growth despite the constraints, the time has apparently come to implement the principles of corporate governance in the context of the fast changing global economic reality and the challenges arising thereof as well in the framework of the five year GTP.

It would be relevant at this point to go back to the basic definition of corporate governance in general and then try to assess its implementation in light of the specific economic realities in Ethiopia. According to an unpublished research finding on the subject commissioned by the Private Sector Development Hub (PSD-Hub) and entitled, Background Development and Draft Ethiopian Code for Corporate Governance, corporate governance is defined as a conceptual framework for appropriate management and control of a company. It includes rules for relations between owners, boards, management and not least the stakeholders such as employees, customers and the public at large.

According to the findings of the same study, there are certain factors that make it urgent for the Ethiopian private businesses to adopt the principles of corporate governance. One of the reasons if not the fundamental reason, is the fact that most of the private companies in Ethiopia are dominated by different forms of family-based associations. Due to this fact, the Ethiopian business community has been characterized as being an insider economy where the control of companies is held by families and closed circles of partners.

Moreover the small family owned businesses which dominate the Ethiopian business scene are rarely organized along formal lines and this has severely constrained their potentials for

growing into bigger entities that could compete with international companies and thus better serve the interests of the private sector as well as that of the countrys economic development as a whole. Failure to apply the principles of corporate governance by these relatively small businesses is believed to be behind the prevailing serious shortcomings and inefficiency in the business enterprises and the economy as a whole.

The Ethiopian economy is currently undergoing deep transformations as a result of changes in the global and domestic economic environment. As we said above, there are positive signs of growth and transformation in the Ethiopian business community even though the traditional behaviors and management systems of most enterprises are making it difficult to optimize the potentials for further growth. The study quoted above indicates that, the transformation of the Ethiopian business traditions and culture into more formalized and balanced structures will be a necessary step towards private business sector-led economic development. The introduction and fostering of the principles of corporate governance at all levels of the business community will therefore play a major role in the process of future transformations in the sector as well as in the national economy as a whole.

According to the findings of the above quoted study, the introduction and development corporate governance in Ethiopia would represent a necessary if not a radical change in the ownership philosophies, management and operations of Ethiopian companies.

According to some estimates the number of privately held companies in Ethiopia varies between 65, 000 and 100 000. This is a small number by any reckoning for a country of more than 80 million people. Yet, most of these companies are small and medium-sized, familybased entities that are managed along traditional lines that have seriously constrained their growth. The adoption of the principles of corporate governance by these enterprises is therefore believed to be one of the chief remedies to transform these companies into more viable and more efficient entities. The introduction of good corporate governance is a critical pre-condition for raising the necessary capital, initiating cooperation and joint ventures, increasing exports and penetrating global markets as required by the GTP.

A recent survey of the state of corporate governance in the Ethiopian private sector enterprises has come up with the following conclusion. It was disclosed that the vast majority of the selected companies were not willing to cooperate in the study by providing the necessary data or by agreeing to be interviewed.. This was a reflection of the culture of undue secrecy and

mistrust these enterprises have developed in the past in order to protect themselves from real or imagined threats.

However, the limited feedback obtained from the small number of enterprises selected for the study revealed that there is a limited awareness and practice of corporate governance as well as unwillingness for disclosure. The survey however concluded that with awareness creation and exposure of the benefits to these enterprises, there is a good hope for future interest and application of the principles of good corporate governance.

The basic principles of corporate good governance to which the Ethiopian business community is expected to subscribe are, according to the draft study of the Code, respect for human rights, non- discrimination and commitment to peaceful and harmonious development, obligation to democratic values, institutions and laws, commitment to poverty alleviation and wealth creation, and care for the environment and the national resource of the country. Based on these principles the business organizations are also expected to uphold the basic values for governance that are, trustworthiness in al business relations, accountability to owners, employees and creditors, responsibility towards the stakeholders and to society at large, integrity ion all business undertakings, and transparency in communication and publishing. As indicated above, the Ethiopian business community is basically dominated by small and family owned enterprises. There are also a number of bigger corporations and large business undertakings. However, as far as the Code for Corporate Governance which is actually under preparation is concerned, all the business entities are expected to comply to the principles and values for a successful and long term private sector led development of the economy. We may perhaps add by saying that all members of the Ethiopian business community will in one way or another, contribute to the final shape of the Code by expressing their ideas and opinions through discussions and recommendation. Reference (The Business Community and Corporate
Governance By: Mulugeta Gudeta)

2.4.1 Corporate governance practices among Ethiopian public enterprises State owned enterprises (SOEs) in Ethiopia are widespread at all two levels of administration: Federal and Regional. They continue to act as the nerve centres of large swathes of the

Ethiopia economy and directly influence the lives of Ethiopia people in a number of ways. Ongoing processes of liberalisation, globalisation and privatisation have not caused a material difference in their position. The recent global slowdown has, if anything, strengthened faith in the strategy of reliance on SOEs and accentuated the role that they are expected to continue to play in the future. The purpose of this paper is to study the expanse of public enterprises in Ethiopia in terms of the levels of administration, form of organisation, ownership objectives and their weight in the Ethiopian economy. The paper makes an effort to assess also the importance of listed SOEs in stock markets as well as the extent of SOEs internationalisation. The paper is based on a

substantive supporting material, which has been laid down as Annexes 1 to 6. On grounds of resource efficiency these have not been reproduced as part of the report; they will be made available upon request by the Secretariat to Delegates who wish to consult them. The PPESAs Code of Corporate Governance applies to fully government owned and other public companies run under joint venture arrangements or otherwise in partnership with the private sector. It should however be used flexibly depending on the nature of the type of the company and ownership modality (enterprise, share company, joint venture, etc.) The term shareholder in the Code, therefore, should be taken to mean The Government in cases of enterprises and share companies fully owned by the government currently. The guidelines which follow set out principles of corporate governance aimed at companies with a unitary board structure, as practiced in Ethiopia. The Ethiopian government, in line with its commitment to encourage the private sector, has so far taken a broad-based economic reform programme. One of the reform measures is a privatization programme which has transferred so far over 280 enterprises. As long as public enterprises have to continue under state ownership until such a time that they would be privatized, it is necessary to provide them with appropriate guidance and support. Moreover, it is also necessary to support the public enterprises so as to enable them to be competitive and profitable. In order to arrive at the above mentioned goals, it has become necessary to merge the Ethiopian Privatization Agency (EPA) and the Public Enterprises Supervising Authority (PESA) with a view to coordinating the implementation of the privatization programme with the activities of public enterprises. Therefore, Privatization and Public Enterprises Supervising

Authority (now Agency and hence, PPESA) has been established by proclamation No. 413/2004. The agencys powers and responsibilities focus on two major areas i.e. implementing the privatization program as well as provide guidance and supervision to public enterprises. Major activities concerning privatization:  Undertakes the necessary preparatory work for the privatization of enterprises;  Determines the bid evaluation criteria for the selection of investors participating in the privatization programme and designs ways and means to encourage domestic investors;  Evaluates partnership proposals submitted by investors and seeks approvals from the Ministry of Trade and Industry;  Takes all necessary measures to publicize the privatization programme and its implementation;  Through post privatization monitoring it ensures compliance of investors obligations, and undertakes impact assessment of the privatization programme in general. Concerning supervision and guidance of public enterprises:  Undertakes project studies for the establishment of enterprises which may be of strategic significance and which are beyond the capacity of private investors; 

PUBLIC ENTERPRISES AND THEIR GOVERNANCE6 What is a Public Enterprise? A public enterprise (PE) is an enterprise of which more than half is owned by the state, directly or indirectly. This seemingly obvious definition was arrived at in the late 1980s after much international debate, and is important insofar as it is based on ownership rather than control. Thus, if 51 percent of enterprise A is owned by enterprise B, of which 51 percent is owned by enterprise C, of which 51 percent is owned by the state, all three enterprises are by definition public enterprises, even though the state owns only 26 percent of enterprise B and 13 percent of enterprise A. In effect, therefore, a private enterprise can be controlled by the government, and a public enterprise by private interests (although in most cases PEs are effectively

controlled by government). However, a definition based on ownership is the only one that permits public enterprises to be identified as a separate category. The criterion of effective control, on the other hand, would require a case-by-case analysis of the enterprise share structure, which would, moreover, have to be reviewed each time there is a shift in shareholders alliances. In many countries, especially the transitional economies, public enterprises have been the principal instruments through which the state has fulfilled its role. In developing countries their growth through the 1960s and 1970s was usually seen as indispensable for development, owing to the imperfections of the market mechanism in those countries. This original rationale for their existence was, however, stretched much too far in most countries, extending to state ownership of shoe manufacturing and ice cream factories on the grounds of national interest. Also, in many industries where the original rationale for public enterprises applied, rapid changes in technology and communications later intervened to render them unnecessary. Quite aside from ideological predilections and power shifts, the PE sector in most countries at the beginning of the 1980s was ripe for substantial pruning, rationalization, and privatization.

The Importance of Good Corporate Governance of PEs This book is not concerned with privatization per se. Privatization is the process of moving assets out of the public sector, and by definition is not part of the management of the public sector. Moreover, privatization entails special processes, skills, and considerations, and is in many ways a separate area in its own right. Instead, for those PEs that are slated to remain in the public sector indefinitely and those whose privatization takes a long time, efficient and accountable mechanisms must be in place to manage, control, and protect the enterprise assets. These functions of management, control, and asset protection are subsumed under the label of corporate governance, and corporate governance of PEs is an important dimension of public sector management. In the early 1990s, many countries made the fundamental mistake of viewing improvements in the corporate governance of PEs either as irrelevant to the basic policy of privatization or an obstacle to it. Their reasoning was peculiar: the worse off the public enterprises were, they thought, the greater would be the pressure to privatize them. The same frame of mind produced a headlong rush to privatize, for the equally peculiar reason that quick privatization

was a good thingno matter if it put valuable public assets in the hands of corrupt associates of public officials or enterprise managers, and at a tiny fraction of their true market value. These views affected primarily the transitional economies of eastern Europe and the former Soviet Union. In these cases, the rationale was mainly that rapid privatization was needed to make irreversible the change away from central planning. But the fallacy of viewing better governance of public enterprises as inimical to their eventual privatization has surfaced in other countries as well, and so has the failure to understand that quick and dirty privatization may or may not produce short-term efficiency gains but cause damage to the fabric of governance, which is far more costly in the long run.

Corporate Governance in the Context of Overall PEs Reform Improvements in corporate governance of PEs are the internal side of PE sector reform. In brief, there are five external measures of PE reform.7 Privatization, which reduces political influence on the management of the enterprise, transfers risk to the private owners, and can provide powerful incentives for efficiency gains, reduced waste, etc. Strengthened competition, through the removal of price controls, unnecessary regulation, and barriers to entry, compels better performance and enables a fairer assessment of the enterprises efficiency relative to its competitors. A hard budget constraint and removal of subsidies induce efficiency improvements in the enterprise. Financial sector reforms put the hard budget constraints into effect. Restructuring public enterprises consists mainly of the spin-off of competitive businesses and peripheral activities from the public goods core, the separation of operational functions from policy and regulatory functions, and the breakup of monopolies into smaller competing units. Good corporate governance reinforces the external reform measures, as it helps enforce financial discipline, entails transparent rules instead of personalized interventions, and protects public assets from undue appropriation by insiders. Improved corporate governance is particularly important in developing countries and transitional economies because the other checks on the behavior of managers, such as rating companies, public assessment by financial investors, and the capital market, are still undeveloped. Indeed, improvements in

corporate governance facilitate eventual privatization, but in the transparent and accountable manner necessary. Elements of Corporate Governance of PEs The main elements of corporate governance improvements are (i) corporatization; (ii) representation of the state by an agent; (iii) management improvements; (iv) the protection of shareholders interests by the board of directors; and (v) performance and management contracts. Corporatization In many countries, the distinction between the roles of owner (principal) and manager (agent) of a PE has become blurred, contributing to the poor performance of enterprises and in some cases to corruption. Separating the roles of principal and agent is the first step in improving corporate governance. Corporatization is the setting up of an independent legal identity for the enterprise, separate from the identity of the state as owner, and usually entails placing public enterprise operations under the rule of commercial law like private enterprises. Corporatization almost always results in a net increase in the efficiency of allocation and use of a countrys economic resources. This was shown, among many other examples, in the case of Canadian Railways; British Steel; the German railways in 1994; andpossibly the most striking example French telecommunications, which underwent a highly successful transformation in 1990 from a government department into France Telecom, a still public but corporatized entity functioning in a competitive environment. For transitional economies and developing countries, besides the efficiency gains, corporatization of state enterprises can help establish clear title, and sort out the web of relationships among enterprises, their subsidiaries, and government ministries. This is a first step to establishing a hard budget constraint on the enterprises. Clear title also facilitates the disposal of assets and enterprise restructuring. Corporatization has often been a first step to privatization. Some resistance to corporatization is to be expected but need not be a stumbling block if the process is open and well handled. In New Zealand, before every corporatization, company management invariably warned the Government of anticipated resistance from unions. The resistance, however, never materialized because the government effectively communicated to

the workers the reasons for and benefits of the corporatization process, and provided suitable compensation to redundant workers. Similarly, the changes in French telecommunications were perceived as a veritable cultural revolution at first. The Government brought together the public, customers, and employees to discuss the problems of the sector as a whole and to consider future directions; launched a wide-ranging internal and external debate; negotiated with the unions; waged an intensive public information campaign; and amended the corporatization plans to incorporate the results of the dialogue. In fact, experience generally shows that resistance to corporatization of PEs comes neither from the enterprise workers nor the general public if the process is managed well. Far stronger resistance comes from the enterprise management and from the sector ministry concerned one reluctant to face direct accountability, the other unwilling to accept loss of power and influence over the operations of the enterprise. This alliance between bureaucrats and politicians is a good illustration of Niskanens capture argument mentioned earlier, and corporatizationclearly separating the two interestsis in this case the best policy. For this reason, sector ministries should be excluded when designing the corporatization of enterprises in their sectors. Selecting an agent to represent the state and establishing oversight In its role as owner of an enterprise, the state must ensure that the enterprise is run and its investments are made with a view to maximizing the benefits to society. Of course, it must exercise that role through a specific entity. Different countries have attempted different solutions to the problem of who should exercise state ownership rights. Some have set up a public agency for the purpose, while others have split the responsibility among several existing agencies or entrusted the role to sector ministries or created a holding company. In general, the preferred solutions are those that establish a uniform set of procedures for all enterprises, without blurring lines of accountability or combining different roles in the same agency or relying on sector ministries. To illustrate the problem of confused accountability, the rgies autonomes of national interest in Romania are supervised directly by the relevant sector ministry, but with the involvement of other ministries, particularly the Ministry of Finance. The problem of multiple roles is exemplified by the case of the Russian State Property Committee (GKI). It holds the shares of both the PEs that are to be sold and those that are to remain in public hands, so that the

pressures of privatizing some enterprises often pushed the task of managing the assets of the others into the background. In New Zealand, the move to allow the sector ministries to exercise ownership rights failed for two related reasons. First, the public enterprise in effect captured the parent ministry. (The Ministry of Civil Aviation, for example, routinely supported Air New Zealands expansion plans.) Second, the shortage of business skills in government ministries prevented effective control. Indeed, experience has shown that the main opposition to a uniform organizational arrangement for PEs has come from the attempt to preserve old patterns of personal relationships between enterprise management and sector ministries. Austria and a few other countries tried to solve the problem of who should exercise state ownership rights by creating a holding company, that is, a corporation to hold the states shares in public enterprises as well as manage the enterprises themselves. Through such companies, those countries hoped to curb abuses by enterprise senior managers, and to reduce the operational interaction between the government and the state enterprises by interposing an intermediate layer. However, the holding company itself is not subject to effective governance by the state. Also, in practice a holding company tends to enlarge its influence by maximizing the budgets of the enterprises it owns, controlling competition, and protecting failing companies through cross subsidizationrather than managing the enterprises on the basis of efficiency and market criteria. Finally, state holding companies are normally supposed to be transitional, but pressures from various stakeholders tend to prolong their existence. International experience points to the longevity of both the holding companies and their subsidiary enterprises, due to their capacity to bargain for and sustain the flow of government subsidies. The best example is the Italian state holding company Instituto per la Ricostruzione Industriale (IRI). IRI was obliged by law to dismantle itself within five years of its start in 1948, but this obligation did not prevent it from becoming one of the largest industrial conglomerates in Italy over the next 40 years. Holding companies are therefore not a good general model. However, holding structures for managing decline in specific sectors might be feasible for a limited time, with appropriate accountability safeguards and an irrevocable sunset clause (following the German example of the Treuenhandtstalt, which managed the reform and restructuring of the industrial sector of the former East Germany).

On balance, experience suggests that governments should set up a central public agency to exercise state ownership rights in public enterprises but without great management responsibilities. New Zealand, in fact, chose this solution after ministerial oversight failed (as mentioned earlier). The Government created a single asset management agency that was close to, but separate from, the Treasury. The agency concentrated on performing the shareholder role, and hired staff with business skills who learned to identify early signs of failure. Because the same agency monitors many enterprises, it is able to take a national overview of all the corporations, and it has so far been very successful. Improving management of PEs The effectiveness with which public enterprises are able to adapt to competition and fulfill their mandate depends largely on the integrity and competence of their top managers. However, these are qualities for which PE management has not traditionally been known. In the context of increased autonomy, it is important, therefore, to improve PE management as well, by retraining managers or training new ones; bringing in new blood, improving selection, and focusing on performance. Training issues are discussed in Chapter 12. We review below the latter two: selection and performance evaluation. Entrenched personal relationships and opaque selection procedures are the most important problems that go with selecting top managers for PEs. It is a fact that governments exert substantial influence in the appointment or removal of senior managers of PEs. In France, for example, the Government in effect appoints the chief executives of Gas of France and Electricity of France by requiring board members to vote for a particular person. However, governments should have a major say in the selection, but not the only say. For example, in Canada, ministers participate with the PE supervisory board in selecting managers, who are then appointed by the cabinet. Transitional economies and many developing countries are moving away from the traditionally opaque and discretionary processes of recruitment toward more transparency. In Hungary, company directors are appointed by the privatization minister, but the appointments are screened by a parliamentary committee, and other countries have made the selection competitive to ensure a more open process. However, it would be unrealistic to expect longstanding personal connections between top bureaucrats and top PE managers to simply wither away with the introduction of new formal rules. It is important therefore also to skew actual

incentives in the right direction. In Poland, managers of enterprises in sectors open to privatization are given a percentage of the value they add to the firm in preparation for its privatization, as a strong positive incentive for efficiency. Concerning managers performance, the first reality to consider is the information asymmetry that exists between government outsiders and enterprise insiders. Without relevant information, performance evaluation becomes merely an elaborate snow job. It is accordingly necessary for the government, as it introduces performance evaluation for PE managers, to develop at the same time channels of reliable information, e.g., independent feedback by employees or consumers. It must also be possible to remove nonperforming managers. This is especially tricky in public enterprises because of the close personal connections of the management with high-placed bureaucrats, as noted earlier. In the transitional economies of eastern Europe and the former Soviet Union in particular, many enterprise managers have acted as if they were the owners. More generally, the balance of power between the sector ministries and the PE managers is often tilted in favor of the latter, who have direct access to assets and resources. To improve accountability and thus PE performance, four approaches can be helpful. Develop independent channels of information for the government, particularly among the clients of the enterprise. Empower one entity to remove nonperforming managers, separate from the sector diversity. Give sufficient status to that entity by raising its pay and prestige of its members, and assure it of the highest level political support; Decouple the managers from their traditional patrons in the ministries. Protection of shareholders by the board of directors In both public and private enterprises, the board of directors is the intermediary between the owners and the managers that protects shareholders interests by ensuring management performance and accountability. The state as owner can either delegate the control function to a board of directors, or can negotiate performance (or management) contracts. In general, the choice between performance contracts or boards of directors depends on the availability of competent persons of integrity to serve as members of boards on the one hand, and, on the other, on the governments capacity to prepare, monitor, and enforce performance contracts.

Performance and management contracts are discussed in the next section. Immediately below we summarize the results of international experience with boards of directors of PEs. The board of directors must be created in such a way as to ensure an arms length relationship between the PE and the government. With this in mind, some countries (e.g., Germany, Hungary, Netherlands, Poland, and Ukraine) have adopted a two-tiered board structure, while others (e.g., France, Italy, and Romania) follow a unitary structure. The two-tiered board consists of a supervisory board with nonexecutive members appointed by the government, and a management board with executive members nominated by the supervisory board itself (or jointly with the government). A unitary board has both executive and nonexecutive members. Generally, the unitary system is simpler, clearer, and avoids conflicts between the two boards. In developing countries, which often lack qualified persons to serve on enterprise boards, the system is also more realistic. However, the choice between a unitary and a two-tiered board depends on the characteristics of the country and the preferences of the government. The widespread adoption of the German model in eastern Europe, for example, is explained largely by the desire to involve workers in company governance (they select some of the members of the supervisory board). To be effective, all boards must walk a fine line between conflicting demands. They must exercise their legal oversight responsibility, but without stifling the initiative of the management; and they must represent the interests of the state, but without becoming involved in the operational affairs of the company. Their capacity to walk that line depends far less on the structure of the board than on the capacity of its members, the quality of the information and resources they have, and the degree of government support they receive. An examination of the way the boards of directors of public enterprises function in transitional economies and developing countries shows a number of common problems, most of which can be traced back to the difficulty of establishing effective board control over PE managers. This difficulty has four main causes. First, governance weaknesses make for easier capture of board members by enterprise managers (who control information, valuable assets, and patronage possibilities). In most developing countries, managers retain a great deal of leeway within the existing rules, and protected by their patrons in the sector ministriesare rarely punished for violating the rules.

 Second, lack of experienced board members weakens supervision. The limited availability of skills and the need to establish boards for a large number of PEs tax the systems capacity to staff the boards properly. Third, many countries draw PE board members from among current and former government employees, who do not have the business expertise required and may rely on the PE for political patronage or a source of future employment or both. Finally, in many countries, board members have insufficient incentives and resources. They are often very poorly paid, lack the necessary supplies, and do not have enough funds to travel and inspect company operations. Performance and management contracts The alternative to a board of directors is a performance or management contract. Performance contracts are agreements between governments and public managers; management contracts are between the government and private managers. Performance and management contracts respond to different needs and have distinct requirements. Performance contracts also go by other names, such as contract plans, program contracts, memorandums of understanding, signaling systems, and public utility licenses. In a performance contract, the government sets strategic objectives and the public managers decide on the operational strategy to achieve those objectives. The process of developing performance contracts is beneficial in itself, as it leads to a dialogue on facts and helps each party become familiar with the needs and problems of the other. Most performance contracts are indicative rather than prescriptive, and their success depends more on genuine commitment by both sides than on the degree of contract detail. Of the various experiences with performance contracts, generally the most disappointing have been in developing countries (especially in Africa). In transitional economies they have been of some utility. The effectiveness of performance contracts depends, among other things, on the availability of comprehensive and reliable information, strong administrative capacity, and a pool of highly competent and committed public managers. It is not surprising therefore that by far the most successful experience with performance contracts is that of the Republic of Korea and New Zealand (Box 6.1). More mixed has been the experience of the Peoples Republic of China (Box 6.2). A hypothetical illustration of how an actual performance contract is drafted is shown in Box 6.3.

Reference Nonministerial Government Bodies and Corporate Governance Of Public Enterprises It hardly matters whether a cat is black or white as long as it catches mice. Deng Xiaoping, 1963

2.4.2 Its impact on performance of Ethiopian public enterprises 2.5 THEORETICAL FOUNDATION OF THE RESEARCH 2.6 MAIN FOCUS OF THE RESEARCH 2.6.1 2.6.2 2.6.3 2.6.4 2.6.5

Corporate governance affects all sectors of the national economy, including enterprises in the private and public sectors and also those in the financial sector. This paper discusses issues in corporate governance in the State owned enterprises. It traces the incorporation of corporate governance practices into State owned enterprises and raises challenges that require attention. Despite the fact that most Ethiopian economies are now dominated by private sector enterprises, the State-owned enterprises (SOEs) still play a very important role in these economies. In Ethiopia, the SOEs still account for about one quarter of the countrys GDP approximately one third of all savings in the country on a gross basis. This simply implies that the public sector plays a critical role in the allocation of resources in Southern African States. This has considerable implications for corporate governance standards in the economy. In Ethiopia, the public-sector firms typically lack accountability for their performance.

Before concluding, it is imperative to point out the number of issues that have emerged from this discussion of corporate governance in Southern Africa. It is important to first of all point out that all the standards reviewed have included some standard requirements to protect the shareholders wealth, such as the need to have a board of directors characterized by independence, willingness to answer hard questions, a diversity of membership, transparency in decision-making and accountability. Furthermore, it is important for companies to link executive compensation and bonuses to financial, social and environmental performance of the firm and to align them to community expectations of fair and reasonable compensation. The standards also point to the need for companies to adopt plans for their environmental, social and financial operations, including effective evaluation tools. Within the board, the standards insist on including non-executive directors in all the standing audit, nominating and compensation committees. This is encouraged in order to protect the shareholders from expropriation. While these standards may be enforced in listed companies, they are hard to enforce in companies not listed on stock exchanges, unless various other pieces of legislation, including the Companies Acts, are revised to include corporate governance issues. There is also a need to synchronize legislation on the capital markets to ensure that the problem of multiple regulators can be removed and to include mortgage markets. In some countries, the stock exchanges are self-regulated. It is important to have regulators to protect the interests of investors. To enhance compliance with standards, it is also important to strengthen the Companies Acts in all countries, since many firms are not listed or quoted on the various stock exchanges. Furthermore, in many instances, even though accounting bodies exist in nearly all countries, they also tend to be self-regulated. This is another area that requires regulation. Thus, it can be concluded that, generally, Southern Africa faces a regulatory challenge. NEPAD has shown that there can be political will in enforcing good governance practices. However, it is important to strengthen the APRM in order to help standardize the business environment in Southern Africa, as countries appear to be at different stages of implementing the corporate governance standards. NEPAD should help adapt the OECD and King Report standards in all the countries. Thus, the second challenge is that of political will. The third challenge involves governments creating enabling macro and micro economic environments

for formulating incentives to attract investment and being in constant dialogue with the private sector to remove any misconceptions that may develop. It is important for governments to guarantee property rights because they are the only institution that can do that. The fear in Zimbabwe that political governance problems might creep into economic governance needs to be clarified, especially since this goes for every country in the sub region. Enterprises in the extractive sector also face the challenge of improving their corporate social responsibilities. The negative picture so far painted about their pay practices, their attitudes towards the environment and the general perception created of their concentration on profit maximization needs to be improved so that firms in the extractive sector can also be seen as good corporate citizens.

CHAPTER 2: LITRATURE REVIEW 2.1 Corporate Governance Corporate governance is about how companies are directed and controlled. It is concerned with holding the balance between economic and social goals and between individual and communal goals. The aim is to align as nearly as possible the interests of individuals, corporations and society (King, 2002). It is becoming difficult for companies to account for profitability alone. In a report by an international institutional investor, while South Africa ranked among the top five 25 emerging markets in terms of corporate governance, it rated poorly in terms of disclosure and transparency. The minimalist approach to corporate governance adopted by many local companies needs to change. There is a move from the single to the triple-bottom-line, which embraces the economic, environmental and social aspects of a companys activities. The King II Report on Corporate Governance, identifies what can be regarded as the seven characteristics of good corporate governance, viz: a. Discipline being the commitment by a companys senior management to adhere to behaviour that is universally recognized and accepted to be correct and proper. b. Transparency being the ease with which the outsider is able to make meaningful analysis of a companys actions, its economic fundamentals and non-financial aspects pertinent to that business.

c. Independence the extent to which mechanisms have been put in place to minimize or avoid potential conflict of interest that may exist. d. Accountability individuals or groups in a company, who make decisions and take actions on specific issues, need to be accountable for their decisions and actions. e. Responsibility pertains to behavior that allows for corrective action and for penalizing mismanagement. f. Fairness being a system within the company that allows for balance in taking into account all those that have an interest in the company and its future. g. Social Responsibility being a well-managed company that will be aware of, and responds to, social issues, placing a high priority on ethical standards. It is a good corporate citizen who moves increasingly towards being nondiscriminatory, non-exploitative, and responsible with regard to environmental and human rights issues. According to the King Report, corporate governance is essentially about leadership that is characterized by and ensures the following: _ Efficiency in order for companies to compete effectively in the global economy, and thereby create jobs. _ Probity because investors require confidence and assurance that management of a company will behave honestly and with integrity in regard to their shareowners and others. _ Responsibility as companies are increasingly called upon to address legitimate social concerns relating to their activities. _ Transparency and accountability - because otherwise leaders will not be trusted. The desired end-state of corporate governance climate of State Owned Enterprises like Eskom, is also governed by Protocol on Corporate Governance in the Public Sector and Public Finance and Management Act 1 of 1999, in addition to the King I and II code which are generally applicable to all companies. The Protocol was first published in 1997 with the view to inculcating the principles of good corporate governance, in the State Owned Enterprises, as was contained in King Report I. The Protocol was later revised with the publication of King Report II, to reflect the governments intention that the principles of the protocol should apply to all public entities and their subsidiaries. The objectives of Public Finance and Management Act 1 of 1999 (as amended by

Act 29 of 1999), was to secure transparency, accountability, sound management of revenue, expenditure, assets and liabilities of government entities. According to Peters (2004), corporate governance comes down to relationships. It is about people interacting with other people. It is all about people interacting with products and technology and people interacting with systems. Governance at heart, is about human nature. The following figure shows the results of a survey conducted in the UK by PWC through MORI in 2004, in order to find out how employees feel about the way they work, what they are asked to do, and how their colleagues and bosses behave. Reference (Prepared by Lazarus Docter Mokoena (called Bonga) [Student No: 0555-418-7] Tel: 011-217 1187 (Work); 011-679 5486 (Home) Cell: 082 466 6896 SUPERVISOR: PROFESSOR M.H. CROSBIE FINAL RESEARCH REPORT November 2005

In recent years, corporate governance has become an important topic for academics, institutional investors, and policymakers. There is a widespread belief that the quality of corporate governance and investor protection can affect the performance of firms and ecomonices. At the firm level, inadequate investor protection may reduce firm value and increase firms cost of capital. At the country level, inadequate investor protection may impede stock market development and undermine financial growth. Not surprisingly, the growing recognition of corporate governances importance has sparked substaial interest in measuring the quality of corporate-governance arrangements across firms and countries. Scholars have sought such measures to study the link between corporate governance and economic outcomes for both firms and economies. Policymakers-including those affiliated with the World Bank, the Organization for Economic Co-operation and Development (OECD), and the International Monetary Fund (IMF) - have been attracted to the promise of metrics that can facilitate efforts to improve countries investor-protection systems and to assess their progress in doing so. Finally, the growth of institutional investing and

investors increased attention to corporate governance has induced shareholder advisers to develop governance metrics that could inform investment decisions in companies around the world. Sir Adrian Cadbury, chairman of the Cadbury Committee, defined the concept thus: Corporate governance is defined as holding the balance between economic and social goals and also between individual and communal goals. The governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interest of individuals, corporations and society. The incentive to corporations is to achieve their corporate aims and to attract investment. The incentive for states is to strengthen their economies and discourage fraud and mismanagement. Experts at the Organisation of Economic Co-operation and Development (OECD) have defined corporate governance as the system by which business corporations are directed and controlled. Corporate governance is typically perceived by academic literature as dealing with problems that result from the separation of ownership and control. From this perspective, corporate governance would focus on: The internal structure and rules of the board of directors; the creation of independent audit committees; rules for disclosure of information to shareholders and creditors; and, control of the management. (A.C. Fernando 2009 p9) Corporate governance has also being widened to look at the relationship between the firm and all its stakeholders, instead of only its shareholders, since the firm operates as a unit of a bigger social entity. Corporate governance indices, that seek to look at value-decreasing activities leading to decreased return on shareholding assets, have been constructed for developed and emerging countries. In a study of the impact of governance mechanisms, Klapper and Love (2004) have argued that corporate governance is more relevant in firms that employ significant amounts of intangible assets. To this extent, one may expect to find a significantly higher impact of ownership variables on value or performance in firms that operate in very dynamic sectors than in basic industries. This argument needs to be empirically verified.

Another element of debate in research, whether in corporate governance or the broader field of business management, has been how to assess firm performance. Profits, prices and rates of return are the most popular. Profitability however depends on many factors outside the direct control of firms and may not be a true measure of firm performance that can be attributable to firm specific characteristics. While the author does not question this measure of performance, there has been a burgeoning literature on an alternative measure of performance in terms of productive efficiency through both parametric and non-parametric analyses. The non-parametric analysis, which does not have a pre-specified production function, allows one to construct a production frontier based on similar inputs and outputs for a sample of firms, evaluating firms in the best possible light. Hence, one can envelop all data points and analyse for productive differentials using mathematical programming techniques. As opposed to a mean-variance technique, this alternative measure of performance uses an extreme-point method which comes with its advantages and disadvantages. With the kind of analytical flexibility of this approach, a firms relative performance in getting the best value out of its assets can be ascertained. Needless to say, there are so many factors that lead to firm performance that are also outside the productive capacities of firms. In recent years, corporate governance has become an important topic for academics, institutional investors, and policymakers. There is a widespread belief that the quality of corporate governance and investor protection can affect the performance of firms and ecomonices. At the firm level, inadequate investor protection may reduce firm value and increase firms cost of capital. At the country level, inadequate investor protection may impede stock market development and undermine financial growth. Not surprisingly, the growing recognition of corporate governances importance has sparked substaial interest in measuring the quality of corporate-governance arrangements across firms and countries. Scholars have sought such measures to study the link between corporate governance and economic outcomes for both firms and economies. Policymakers-including those affiliated with the World Bank, the Organization for Economic Co-operation and Development (OECD), and the International Monetary Fund (IMF) - have been attracted to the promise of metrics that can facilitate efforts to improve countries investor-protection systems and to assess their progress in doing so. Finally, the growth of institutional investing and investors increased attention to corporate governance has induced shareholder advisers to

develop governance metrics that could inform investment decisions in companies around the world. Sir Adrian Cadbury, chairman of the Cadbury Committee, defined the concept thus: Corporate governance is defined as holding the balance between economic and social goals and also between individual and communal goals. The governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interest of individuals, corporations and society. The incentive to corporations is to achieve their corporate aims and to attract investment. The incentive for states is to strengthen their economies and discourage fraud and mismanagement. Experts at the Organisation of Economic Co-operation and Development (OECD) have defined corporate governance as the system by which business corporations are directed and controlled. Corporate governance is typically perceived by academic literature as dealing with problems that result from the separation of ownership and control. From this perspective, corporate governance would focus on: The internal structure and rules of the board of directors; the creation of independent audit committees; rules for disclosure of information to shareholders and creditors; and, control of the management. (A.C. Fernando 2009 p9) Corporate governance has also being widened to look at the relationship between the firm and all its stakeholders, instead of only its shareholders, since the firm operates as a unit of a bigger social entity. Corporate governance indices, that seek to look at value-decreasing activities leading to decreased return on shareholding assets, have been constructed for developed and emerging countries. In a study of the impact of governance mechanisms, Klapper and Love (2004) have argued that corporate governance is more relevant in firms that employ significant amounts of intangible assets. To this extent, one may expect to find a significantly higher impact of ownership variables on value or performance in firms that operate in very dynamic sectors than in basic industries. This argument needs to be empirically verified. Another element of debate in research, whether in corporate governance or the broader field of business management, has been how to assess firm performance. Profits, prices and rates of

return are the most popular. Profitability however depends on many factors outside the direct control of firms and may not be a true measure of firm performance that can be attributable to firm specific characteristics. While the author does not question this measure of performance, there has been a burgeoning literature on an alternative measure of performance in terms of productive efficiency through both parametric and non-parametric analyses. The non-parametric analysis, which does not have a pre-specified production function, allows one to construct a production frontier based on similar inputs and outputs for a sample of firms, evaluating firms in the best possible light. Hence, one can envelop all data points and analyse for productive differentials using mathematical programming techniques. As opposed to a mean-variance technique, this alternative measure of performance uses an extreme-point method which comes with its advantages and disadvantages. With the kind of analytical flexibility of this approach, a firms relative performance in getting the best value out of its assets can be ascertained. Needless to say, there are so many factors that lead to firm performance that are also outside the productive capacities of firms.

2.1.1 The Corporate Governance Concept Alexakis, Balios, Papagelis & Xanthakis (2006) contend that issues that corporate governance address can be found in the literature as early as 1776 (Smith) and 1932 (Berle and Means). According to the CIS (2008) corporate governance refers to the way in which companies are governed, and to what purpose. The Business Governance Handbook defines corporate and business governance as follows: the system that maintains the balance of rights, relationships, roles and responsibilities of shareholders, directors and management in the direction, conduct, conformance and control of the suitable performance of the company/business with honesty and integrity in the best long-term interests of the company, shareholders, and business and community stakeholders (Hendrikse and Hendrikse, 2004:102). The Business Governance Handbook definition is consistent with the South African King Report 2002 that emphasises the need for enterprise with integrity in the interest of the society, environment and stakeholders (CIS, 2008). The link between the aforementioned definitions and sustainability as well as RI is clear. Mangena and Chamisa (2008) state that South Africa was the first developing country to develop corporate governance code of best practice via the King Report of 1994. This report

drew extensively from the U.K. Cadbury Committee of 1992. Local and international developments necessitated a revision of the code in 2002. A mechanism to be relied on for enforcement of the King Report 2002 is the provisions of the amended listing requirements of the JSE (Hendrikse and Hendrikse, 2004). Further local developments include the JSE Limited launching a Socially Responsible Investment (SRI) Index in May 2004 (Sonneberg and Hamann, 2006). Corporate governance is one of the four key categories in the SRI Index. The King III draft release was February 2009 (IOD SA, 2009). In a recent interview, Prof. Mervyn King underlines that sustainability is the primary and economic necessity for the 21st century and reporting thereon needs revision (Visser, 2009). Contemporary organisations face a sustainability challenge. Nature, society and business are inescapably interconnected in complex ways that need to be understood by decision makers (IOD, 2009). Sustainability is the primary moral and economic imperative for the 21st century and it is one of the most important sources of both opportunities and risks for business (IOD, 2009:12). According to Perrini and Tencati (2006) corporate sustainability is the capacity of an organisation to continue operating over a long period of time and is dependent on the sustainability of its stakeholder relationships. Indeed, a new perspective of corporate governance promotes a shift from an exclusively shareholder perspective to a stakeholder perspective (Thiry and Deguire, 2007). Therefore, for sustainability to become main stream, organisations must integrate strategy, sustainability and governance (IOD, 2009). It is reasonable to argue that the amount of information regarding the relationship between governance and sustainability will also increase (Aras and Crowther, 2008). Organisations governance can be on a statutory basis, as a code of principles and practices, or a combination of the two (IOD, 2009). The USA has chosen to codify a significant part of its governance in an act known as the Sarbanes-Oxley Act while South Africa and the twenty seven states in the EU, including the UK, have opted for a code of principles and practices in addition to certain governance issues that are regulated (IOD, 2009). The statutory regime is regarded as comply or else while the principles-based approach is referred to as apply or explain. In reviewing the various definitions of corporate governance, it is evident that all definitions refer to the existence of conflicts of interest between insiders and outsiders arising from the separation of ownership and control (Alexakis, et al., 2006). The authors are referring to the agent-principal relationship. The seminal work of Jensen and Meckling (1976) defines an agency relationship as a contract under which one or

more persons (the principle) engage another person (the agent) to perform some service on their behalf which requires delegating some decision making authority to the agent. According to Millson and Ward (2005) agency theory forms the backbone to corporate governance. Drobetz, Schillhofer & Zimmermann (2004) considers principle-agent theory as the starting point for any discussion on corporate governance. Agency theory argues that directors, seeking to maximise their own personal benefit, take actions that are advantageous to themselves but detrimental to shareholders (Tricker, 2009). A less optimal view of directors behaviour is therefore apparent. Tricker (2009) concludes that agency theory, because of its simplicity and the availability of both reliable data and statistical rigorous tests, has provided a commanding approach to corporate governance theory building. Critics of agency theory speculate that it has been founded on a single, questionable abstraction that governance involves a contract between two parties, and is based on a uncertain conjectural morality that people maximise their personal utility (Tricker, 2009). The agency theory of corporate governance is depicted in figure 2.1.

Figure 2.1 The agency theory corporate governance (Tricker, 2009: 219).

Possibly in order to build an appropriate theory of corporate governance and in the quest to find evidence in support thereof, the simplicity of agency theory and the availability of data that could be subjected to statistical testing could actually be a liability. This is exactly what Ghoshal (2005) contends as reason for the predominance of agency theory which underlies the support for the shareholder value maximisation proposition. With other theories welldesigned statistical modelling is just not as straightforward. Ghoshal (2005) is particularly critical of agency theory in his paper that proposes that bad management theories are

destroying good management practices. It is argued that a management theory that gains enough standing, irrespective of being right or wrong, can start changing the behaviours of managers that start acting in accordance with the theory (Ghoshal, 2005). Business schools have not been speared of criticism in that having propagated ideological inspired amoral theories; students are freed from moral responsibility (Ghoshal, 2005). When combining agency theory with transaction cost economics, versions of game theory and negotiation analysis, the picture of a ruthless business leader that is shareholder-value obsessed often emerges (Ghoshal, 2005). According to Ghoshal (2005) the process through which bad theories are destroying good practice is depicted in figure 2.2.

Figure 2.2 The process of bad theories destroying good practice (Ghoshal, 2005: 76).

In contrast to agency theory, stewardship theory believes that directors do not always act in a way that maximises their own personal interest. Directors have a fiduciary duty to act as stewards of the shareholders interest. Inherent in the concept of the company is the belief that directors can be trusted (Tricker, 2009: 224). Criticisms of stewardship theory point out that the situation in modern companies is very different from the 19th century model and also

because the theory is rooted in law, it is normative (Tricker, 2009). The relationship between shareholders and directors under stewardship theory is depicted under figure 2.3.

Figure 2.3 The stewardship theory of corporate governance (Tricker, 2009: 224).

Perspectives on corporate governance at a societal level, or stakeholder theory, are concerned with values and attitudes about the appropriate relationship between the individual, the organisation, and the state (Tricker, 2009). According to Aras and Crowther (2008) the recent range of problems with corporate behaviour has arguably led to prominence being given to corporate social responsibility. The authors posit that part of this effect is to recognise the concerns of all stakeholders to an organisation. The inclusive approach to governance state that the board should take into account the legitimate expectations of the companys stakeholders (IOD, 2009). Overshadowing all theoretical perspectives of corporate governance are some basic unresolved issues at a meta-philosophical level (Tricker, 2009). All systems of governance must seek an appropriate balance between the interests of self and society. That applies to corporate governance just as it does to governance in other areas of society (Tricker, 2009: 231). Tricker (2009) concludes that although the significance of governance for the long term success of an organisation is understood, the theoretical underpinnings of the subject are weak and that the subject lacks a conceptual framework that adequately reflects the reality of corporate governance. The theoretical perspectives on boards and governance can best be seen as multiple theoretical lenses with which to view the subject (Triker, 2009). The finance model of the firm in which the central problem is how to construct rules and incentives to align the behaviour of managers with the interests of owners, needs to be supplemented with other models of corporate control including the stewardship, stakeholder

and political models (Clarke and dela Rama, 2008).The field of research on corporate governance can be divided in two broader areas (Alexakis, et al., 2006:675): the more theoretical area that tries to assess the effectiveness of the various corporate governance mechanisms and the degree that corporate governance results in reducing agency costs; and the more empirical area that attempts to empirically relate corporate governance indicators to the economic performance and growth of companies governed under this framework. This area includes equity prices and its expected returns, the cost of equity capital as well as various valuation measures. This study focuses more on the second area and a review of the literature related to this area of empirical work follows. Reference by J P OPPERMAN 18 November 2009

Corporate governance is traditionally thought of in the framework of large corporations, shareholders, and board private sector issues in developed economies and some of the major emerging markets. Many of these issues may seem to bear little relevance to broader development concerns that deal with day-to-day issues of poverty, job-creation, anticorruption, education, media, and political reform. Yet, corporate governance and development are strongly related. Just as good corporate governance contributes to the sustainable development prospects of countries, increased economic sustainability of nations and institutional reforms that come with it provide the necessary basis for improved governance in the public and private sector. Alternatively, corporate governance failures can undermine development efforts by misallocating much needed capital and resources and development fallbacks can reinforce weak governance in the private sector and undermine job and wealth creation. (CIPE 50517138 p 7).

2.1.2 Scope of Corporate Governance 2.1.3 Corporate Governance activities

2.1.4 Corporate Governance integration strategy Governance of State-Owned Enterprises The critical question here is what is the role to be played by various leaders in implementing good corporate governance in state-owned enterprises? The roles in question here is that of the government, as a shareholder, and that of the board of directors of a state-owned enterprise. According to Khoza & Adam (2005) good corporate governance includes measures that enhance organizational integrity, transparency, and sustainable performance. If effective leadership underpins effective governance, it is imperative that the respective leadership roles required by the organization be understood so that they can be appropriately fulfilled. They contend that one of the unique challenges facing state-owned enterprises is the clarification of the role of government as shareholder and the role of the board. This in turn needs to cascade down into the organization in order to achieving greater clarity with regard to the roles of the board in relation to the roles of management. According to Yudelowitz (Business Day, 2005), Parastatal boards usually consist of those with a political agenda and businessmen as well as some technocrats. Each advocates a governance approach emanating from his own background, personal beliefs and style. In successful parastatals the players the minister, the director-general, chairman and CEO understand these complex dynamics and work with them while remaining conscious of their commercial, technical, social and political mandates. To promote this the board must be a leadership team in its own right, tasked with integrating apparently different points of view, providing coherence and making judicious trade-offs. It must also provide a context and perspective of other key stakeholder interest, for example the voting public, who are indirectly the owners of the parastatal. It must integrate the defined mandate of the executive committee (often focused on managing the balance sheet and competing commercially) with all other stakeholder interests and hence must take responsibility for its own leadership. This is true of all boards but especially so of parastatals because of multitude of complex variables at play.

2.5 Strategic Management Approach in the Implementation of Corporate Governance Programmes

Thompson & Strickland (2003) pointed out that a companys strategy consists of the combination of competitive moves and business approaches that managers employ to please customers, compete successfully and achieve organizational goals. In relation to good corporate governance, the relevance of strategy would answer the question as to what the game plan is that has been adopted by the organizational leadership to stake out its position in the society, to conduct its business on the day-to-day basis, to compete successfully and to achieve the broader organizational goals in line with the triple-bottom line concept. Thompson & Strickland (2003) state that crafting, implementing, and executing a strategy are top-priority managerial tasks for two of the following very big reasons: First, there is a compelling need for managers to proactively shape how the companys business will be conducted. Without a strategy, managers have no prescription for doing business, no road map to competitive advantage, no game plan for pleasing customers or achieving good performance. Lack of consciously shaped strategy is a surefire for organizational drift, competitive mediocrity, internal wheel-spinning and lackluster results. In order for good corporate governance climate to prevail on a sustainable basis in environment, it requires a conscious crafting of a strategy as to how it will be implemented in a way that is effective and that will affect the organization as a whole in terms of how it goes about doing its business and interacting and effecting all its stakeholders in a way that demonstrate good performance from triple-bottom line performance. Second, there is an equally compelling need to mould the efforts and decisions of different divisions, departments, managers, and groups into a coordinated, compatible whole. All the actions taken in different parts of the business need to be mutually supportive. Good strategy and good strategy execution are the most trustworthy signs of good management. In the same breath, good management and/or leadership in a state-owned cannot be judged only on the basis of well designed corporate governance programme(s), a combination of well a designed governance programme and the effective implementation thereof can be said to be the most trustworthy measure of performance. The standards of good management rest to a very large extent on how well conceived the companys strategy is and how competently it is executed (Thompson & Strickland, 2003). They pointed out that the strategy-making/strategy-implementing process consists of five interrelated managerial tasks:

I. Forming a strategic vision of where the organization is headed so as to provide long-term direction, delineate what kind of enterprise the company is trying to become, and infuse into the organization a sense of purposeful action. II. Setting objectives converting the strategic vision into specific performance outcomes for the company to achieve. III. Crafting the strategy to achieve the desired outcomes. IV. Implementing and executing the chosen strategy efficiently and effectively. V. Evaluating performance and initiating corrective adjustments in vision, long-term direction The above five tasks of strategic management can be summarized and depicted pictorially in diagram below: Reference (Prepared by Lazarus Docter Mokoena (called Bonga) [Student No: 0555-418-7] Tel: 011-217 1187 (Work); 011-679 5486 (Home) Cell: 082 466 6896 SUPERVISOR: PROFESSOR M.H. CROSBIE FINAL RESEARCH REPORT November 2005

2.1.5 Basic benefits of Corporate Governance Corporate governance is the system by which companies are directed and managed. It influences how the objectives of the company are set and achieved, how risk is monitored and assessed, and how performance is optimized. Good corporate governance structures encourage companies to create value (through entrepreneurism, innovation, development and exploration) and provide accountability and control systems commensurate with the risks involved. Recent research highlights the importance of corporate governance in emerging markets. La Porta et al (1997, 1998, 1999, 2000), demonstrate that, across countries, corporate governance is an important factor in financial market development and firm value. Corporate governance in needed to create a corporate culture of consciousness, transparency and openness. It refers to a combination of laws, rules, regulations, procedures and voluntary practices to enable companies to maximise shareholders long-term value. It should lead to increasing customer satisfaction, shareholder value and wealth. With increasing government

awareness, the focus is shifted from economic to the social sphere and an environment is being created to ensure greater transparency and accountability. It is integral to the very existence of a company. (A.C. Fernando 2009 p27) Corporate governance is important for state-owned enterprises (SOE), not only do corporate governance practices increase productivity in and competitiveness of SOEs, they also help to ensure that public funds invested in these enterprises are not mismanaged and are spent effectively. By creating more transparent and economically viable SOEs, corporate governance also helps to ensure that services are actually delivered to the public. Further, as state enterprises often provide a bulk of employment in some emerging markets and a variety of essential public services, good governances helps to prevent failures with devastating social impact. In many countries, corporate governance has been used as a means of not only improving the efficiency of SOEs, but also as a mechanism to improve their attractiveness to investors, thus increasing state income from privatization. Corporate governance is also important for state-owned enterprises (SOEs). Not only do good governance practices increase productivity in and competitiveness of SOEs, they also help to ensure that public funds invested in these enterprises are not mismanaged and are spent effectively. By creating more transparent and economically viable SOEs, corporate governance also helps to ensure that services are actually delivered to the public. Further, as state enterprises often provide a bulk of employment in some emerging markets and a variety of essential public services, good governance helps to prevent failures with devastating social impact. In many countries, corporate governance has been used as a means of not only improving the efficiency of SOEs, but also as a mechanism to improve their attractiveness to investors, thus increasing state income from privatization. (CIPE 50517138 p 26). In many developing countries, state-owned enterprises make up a disproportionate segment of the ecomony and suffer from a myriad of management and performance issues that limit their effectiveness and the role they are expected to play in generating growth. Often, these enterprises are found in strategic sectors such as infrastructure or trade, where their inefficiencies limit the private sectors ability to contribute to economic development. Working with unclear strategies and multiple lines of accountability, manager decision-making within SOEs becomes hostage to politics and conflicting bureaucratic interests, resulting in a situation

where multiple agencies and ministries vie to influence SOE management while ultimate accountability for decision-making is non-existent. By their non-transparent nature, SOEs are often plagued by political patronage, corruption, and waste, which limits their ability to modernize and build responsive and efficient programs of work. (CIPE 50517138 p 26).

2.2 Corporate Governance practices

2.3 Corporate Governance AND PERFORMANCE OF FIRMS

2.4 Corporate Governance PRACTICES IN ETHIOPIA Globally, many countries and economic groups developed standards and principles that are going to serve to foster Good Corporate Governance in their respective countries. The Ethiopian Government improved the governance from time to time significantly in recent years, with boards taking a more professional approach to governance, especially in public enterprises that come under the greatest public scrutiny. Boards in South Africa have to deal with greater complexity than their counterparts in Europe and North America, and increasingly face the spotlight as pressure to enhance governance standards mounts from shareholders, government, the media and other pressure groups. PPESA referred OECDs principles to develop the Code of Corporate Governance (2009) and contextualize it to suit the Ethiopian Public Enterprises environment. Code of Corporate Governance which is published by PPESA addresses many issues with the purpose of maximizing corporate value by enhancing the transparency and efficiency of public enterprises and thus establishing a system that promotes creative and progressive entrepreneurship. As it magnifies, corporate governance involves a set of relationships between a companys management, its board and shareholders and other stakeholders.  It is a set of accepted principles;  It is about commitment to values, ethical business conduct and transparency;  It is through which ethics, probity and public accountability are maintained;  It requires that the board must lead the company with integrity so as to entrench and enhance its license(including non-legal license) to operate;

 It is about leadership of efficiency, probity, responsibility and which is transparent and accountable.

Company law is crucial in market economies; it sets the legal environment for the creation and continuing operation of privately owned businesses. Good company law is especially critical in transition-economy countries. It can encourage new investmentand provide investor protectionby setting forth clear and objective rules for a companys ongoing internal governance; it can encourage entrepreneurship by making it easy to start up and register a company; and it can encourage businesses to come out of the underground economy into the publicly registered, taxpaying economy.

Ethiopias current company law is part of its Commercial Code, which has remained unchanged since its enactment in Imperial times (1960). It is patterned after the French Commercial Code as it was in effect in 1960. The company law was effectively suspended during the Communist Derg period (19751991), when formation of new limited liability companies was not permitted. The company law was restored to full effect under the present Government.

Although the current company law has been basically adequate for conditions to date, it needs to be updated. The present Government recognizes this and appointed a committee under the Department of Justice, which has been working on an updated version for more than 2 years with completion said to be hoped for by early 2007. The committee currently has a working draft but that draft is not publicly available.

One distinct issue involving company law is that of startup and registration of new companies. Although that has been a problem in the past, it is no longer so according to all persons who were interviewed, including practicing lawyers and accounting firm professionals, company officials, registry officials, and donors. That is due to implementation with donor help of revised and streamlined company registration procedures and forms in the Ministry of Trade and Industry.

The Ethiopian economy is at a stage of transformation. Reforms during the last couple of decades brought market economy, privatisation of state owned enterprises and openings in the financial system. Developments of the latest few years indicate a new phase of economic progress. There is a noticeable increase of exports. Investments and joint ventures with foreign investors are making progress. There is an emerging trend in the financial system from the purely collateral based lending to performance based financing of businesses. Over the past couple of years, ambitious investors are seen raising large amounts of capital from the public through offers of shares in new business ventures. All these indicate the emergence of new types of relations between and among businesses, investors, suppliers, and customers. These new trends and changes in the Ethiopian economy and business environment would need to be followed up by major changes in the way of conducting business in the country. Good corporate governance in its broad sense will be essential. Without it, necessary new relations between businesses, investors, financiers and foreign customers would not take place and economic development will be slower. Globally, many countries and economic groups developed standards and principles that are going to serve to serve to foster good corporate governance in their respective countries. Among these principles, the OECD (Organization for Economic Cooperation and

Development) principles of Corporate Governance were endorses by OECD Ministers in 1999 and have since become an international benchmark for policy makers, investors, corporations and other stakeholders worldwide. The OECD principles of Corporate Governance states: Corporate governance involves a set of relationships between a companys management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. Corporate governance is all about governing corporations. By their nature large modern enterprises are usually owned by one group of people (the owners or shareholders) whilst being run by another group of people (the management or the directors). This separation of ownership from management creates an issue of trust. The management has to be trusted to run the company in the interest of the shareholders and other stakeholders. If information were

available to all stakeholders in the same form at the same time, corporate governance would not have been an issue at all. (A.C. Fernando 2009 pp26-27) The standard of corporate governance in Ethiopia in general is very poor. The absence of an adequate legislative framework to regulate modern complex bank governance issues political parties' involvement in business enterprises, and the absence of an organized share market are among the characteristics of bank corporate governance in Ethiopia. Furthermore, there is a major credibility problem in the Ethiopian banking regulatory environment since the regulatory organ enforced rules discriminate between state and private banks. This book identifies the different aspects of bank corporate governance in Ethiopia such as ownership structures, board size and composition, accounting and auditing standards, succession planning, and their influence on bank performance by taking a sample of four private banks. By exploring best bank governance practices and international bank governance principles, this book recommends thorough reform and adoption or adaptation of good corporate governance principles in the Ethiopian banking sector. There are a number of tangible reasons for the Ethiopian business community to adopt good corporate governance as an effective tool of growth and transformation in the private sector. In fact, the issue of corporate governance is as urgent as the need to make the current growth and development in the sector sustainable in the framework of the private sectors development objectives. Moreover, the five year Growth and Transformation Plan (GTP) of the government makes it incumbent upon the countrys small and larger businesses to adopt globally relevant principles of corporate good governance without which the Plan may not be realized as expected.

Indeed if the past is any guide, the private sector is considered a key factor in the realization of the aims and objectives of the countrys development plan in the coming five years and beyond. Likewise, the fast pace of economic growth that was registered in the last seven or so years could only materialize thanks in part to the leading role played by the private sector although its potentials for growth have not yet been fully harnessed.

The concept or the practice of corporate governance was little known in the past since the private sector was not as developed as it is now or it was not integrated to the world market as it is at present. However, with the growth of the sector, the need for corporate governance was

increasingly felt in the last two decades since the government articulated the countrys economic development strategy as being led by the private-sector.

By formulating this policy, the government has been working on creating an enabling environment not only for private sector growth but also for the implementation of corporate governance if not corporate good governance. The Ethiopian business community led respectively by the Ethiopian and Addis Ababa Chambers of Commerce and Sectoral Associations had been making notable efforts to implement the principles of corporate good governance although the results are still far from being satisfactory as there have been formidable institutional, historical and economic challenges that were constraining these efforts. Now that the Ethiopian private sector is going through a period of speedy and sustainable growth despite the constraints, the time has apparently come to implement the principles of corporate governance in the context of the fast changing global economic reality and the challenges arising thereof as well in the framework of the five year GTP.

It would be relevant at this point to go back to the basic definition of corporate governance in general and then try to assess its implementation in light of the specific economic realities in Ethiopia. According to an unpublished research finding on the subject commissioned by the Private Sector Development Hub (PSD-Hub) and entitled, Background Development and Draft Ethiopian Code for Corporate Governance, corporate governance is defined as a conceptual framework for appropriate management and control of a company. It includes rules for relations between owners, boards, management and not least the stakeholders such as employees, customers and the public at large.

According to the findings of the same study, there are certain factors that make it urgent for the Ethiopian private businesses to adopt the principles of corporate governance. One of the reasons if not the fundamental reason, is the fact that most of the private companies in Ethiopia are dominated by different forms of family-based associations. Due to this fact, the Ethiopian business community has been characterized as being an insider economy where the control of companies is held by families and closed circles of partners.

Moreover the small family owned businesses which dominate the Ethiopian business scene are rarely organized along formal lines and this has severely constrained their potentials for

growing into bigger entities that could compete with international companies and thus better serve the interests of the private sector as well as that of the countrys economic development as a whole. Failure to apply the principles of corporate governance by these relatively small businesses is believed to be behind the prevailing serious shortcomings and inefficiency in the business enterprises and the economy as a whole.

The Ethiopian economy is currently undergoing deep transformations as a result of changes in the global and domestic economic environment. As we said above, there are positive signs of growth and transformation in the Ethiopian business community even though the traditional behaviors and management systems of most enterprises are making it difficult to optimize the potentials for further growth. The study quoted above indicates that, the transformation of the Ethiopian business traditions and culture into more formalized and balanced structures will be a necessary step towards private business sector-led economic development. The introduction and fostering of the principles of corporate governance at all levels of the business community will therefore play a major role in the process of future transformations in the sector as well as in the national economy as a whole.

According to the findings of the above quoted study, the introduction and development corporate governance in Ethiopia would represent a necessary if not a radical change in the ownership philosophies, management and operations of Ethiopian companies.

According to some estimates the number of privately held companies in Ethiopia varies between 65, 000 and 100 000. This is a small number by any reckoning for a country of more than 80 million people. Yet, most of these companies are small and medium-sized, familybased entities that are managed along traditional lines that have seriously constrained their growth. The adoption of the principles of corporate governance by these enterprises is therefore believed to be one of the chief remedies to transform these companies into more viable and more efficient entities. The introduction of good corporate governance is a critical pre-condition for raising the necessary capital, initiating cooperation and joint ventures, increasing exports and penetrating global markets as required by the GTP.

A recent survey of the state of corporate governance in the Ethiopian private sector enterprises has come up with the following conclusion. It was disclosed that the vast majority of the selected companies were not willing to cooperate in the study by providing the necessary data or by agreeing to be interviewed.. This was a reflection of the culture of undue secrecy and

mistrust these enterprises have developed in the past in order to protect themselves from real or imagined threats.

However, the limited feedback obtained from the small number of enterprises selected for the study revealed that there is a limited awareness and practice of corporate governance as well as unwillingness for disclosure. The survey however concluded that with awareness creation and exposure of the benefits to these enterprises, there is a good hope for future interest and application of the principles of good corporate governance.

The basic principles of corporate good governance to which the Ethiopian business community is expected to subscribe are, according to the draft study of the Code, respect for human rights, non- discrimination and commitment to peaceful and harmonious development, obligation to democratic values, institutions and laws, commitment to poverty alleviation and wealth creation, and care for the environment and the national resource of the country. Based on these principles the business organizations are also expected to uphold the basic values for governance that are, trustworthiness in al business relations, accountability to owners, employees and creditors, responsibility towards the stakeholders and to society at large, integrity ion all business undertakings, and transparency in communication and publishing. As indicated above, the Ethiopian business community is basically dominated by small and family owned enterprises. There are also a number of bigger corporations and large business undertakings. However, as far as the Code for Corporate Governance which is actually under preparation is concerned, all the business entities are expected to comply to the principles and values for a successful and long term private sector led development of the economy. We may perhaps add by saying that all members of the Ethiopian business community will in one way or another, contribute to the final shape of the Code by expressing their ideas and opinions through discussions and recommendation. Reference (The Business Community and Corporate
Governance By: Mulugeta Gudeta)

2.4.1 Corporate governance practices among Ethiopian public enterprises State owned enterprises (SOEs) in Ethiopia are widespread at all two levels of administration: Federal and Regional. They continue to act as the nerve centres of large swathes of the

Ethiopia economy and directly influence the lives of Ethiopia people in a number of ways. Ongoing processes of liberalisation, globalisation and privatisation have not caused a material difference in their position. The recent global slowdown has, if anything, strengthened faith in the strategy of reliance on SOEs and accentuated the role that they are expected to continue to play in the future. The purpose of this paper is to study the expanse of public enterprises in Ethiopia in terms of the levels of administration, form of organisation, ownership objectives and their weight in the Ethiopian economy. The paper makes an effort to assess also the importance of listed SOEs in stock markets as well as the extent of SOEs internationalisation. The paper is based on a

substantive supporting material, which has been laid down as Annexes 1 to 6. On grounds of resource efficiency these have not been reproduced as part of the report; they will be made available upon request by the Secretariat to Delegates who wish to consult them. The PPESAs Code of Corporate Governance applies to fully government owned and other public companies run under joint venture arrangements or otherwise in partnership with the private sector. It should however be used flexibly depending on the nature of the type of the company and ownership modality (enterprise, share company, joint venture, etc.) The term shareholder in the Code, therefore, should be taken to mean The Government in cases of enterprises and share companies fully owned by the government currently. The guidelines which follow set out principles of corporate governance aimed at companies with a unitary board structure, as practiced in Ethiopia. The Ethiopian government, in line with its commitment to encourage the private sector, has so far taken a broad-based economic reform programme. One of the reform measures is a privatization programme which has transferred so far over 280 enterprises. As long as public enterprises have to continue under state ownership until such a time that they would be privatized, it is necessary to provide them with appropriate guidance and support. Moreover, it is also necessary to support the public enterprises so as to enable them to be competitive and profitable. In order to arrive at the above mentioned goals, it has become necessary to merge the Ethiopian Privatization Agency (EPA) and the Public Enterprises Supervising Authority (PESA) with a view to coordinating the implementation of the privatization programme with the activities of public enterprises. Therefore, Privatization and Public Enterprises Supervising

Authority (now Agency and hence, PPESA) has been established by proclamation No. 413/2004. The agencys powers and responsibilities focus on two major areas i.e. implementing the privatization program as well as provide guidance and supervision to public enterprises. Major activities concerning privatization:  Undertakes the necessary preparatory work for the privatization of enterprises;  Determines the bid evaluation criteria for the selection of investors participating in the privatization programme and designs ways and means to encourage domestic investors;  Evaluates partnership proposals submitted by investors and seeks approvals from the Ministry of Trade and Industry;  Takes all necessary measures to publicize the privatization programme and its implementation;  Through post privatization monitoring it ensures compliance of investors obligations, and undertakes impact assessment of the privatization programme in general. Concerning supervision and guidance of public enterprises:  Undertakes project studies for the establishment of enterprises which may be of strategic significance and which are beyond the capacity of private investors; 

PUBLIC ENTERPRISES AND THEIR GOVERNANCE6 What is a Public Enterprise? A public enterprise (PE) is an enterprise of which more than half is owned by the state, directly or indirectly. This seemingly obvious definition was arrived at in the late 1980s after much international debate, and is important insofar as it is based on ownership rather than control. Thus, if 51 percent of enterprise A is owned by enterprise B, of which 51 percent is owned by enterprise C, of which 51 percent is owned by the state, all three enterprises are by definition public enterprises, even though the state owns only 26 percent of enterprise B and 13 percent of enterprise A. In effect, therefore, a private enterprise can be controlled by the government, and a public enterprise by private interests (although in most cases PEs are effectively

controlled by government). However, a definition based on ownership is the only one that permits public enterprises to be identified as a separate category. The criterion of effective control, on the other hand, would require a case-by-case analysis of the enterprise share structure, which would, moreover, have to be reviewed each time there is a shift in shareholders alliances. In many countries, especially the transitional economies, public enterprises have been the principal instruments through which the state has fulfilled its role. In developing countries their growth through the 1960s and 1970s was usually seen as indispensable for development, owing to the imperfections of the market mechanism in those countries. This original rationale for their existence was, however, stretched much too far in most countries, extending to state ownership of shoe manufacturing and ice cream factories on the grounds of national interest. Also, in many industries where the original rationale for public enterprises applied, rapid changes in technology and communications later intervened to render them unnecessary. Quite aside from ideological predilections and power shifts, the PE sector in most countries at the beginning of the 1980s was ripe for substantial pruning, rationalization, and privatization.

The Importance of Good Corporate Governance of PEs This book is not concerned with privatization per se. Privatization is the process of moving assets out of the public sector, and by definition is not part of the management of the public sector. Moreover, privatization entails special processes, skills, and considerations, and is in many ways a separate area in its own right. Instead, for those PEs that are slated to remain in the public sector indefinitely and those whose privatization takes a long time, efficient and accountable mechanisms must be in place to manage, control, and protect the enterprise assets. These functions of management, control, and asset protection are subsumed under the label of corporate governance, and corporate governance of PEs is an important dimension of public sector management. In the early 1990s, many countries made the fundamental mistake of viewing improvements in the corporate governance of PEs either as irrelevant to the basic policy of privatization or an obstacle to it. Their reasoning was peculiar: the worse off the public enterprises were, they thought, the greater would be the pressure to privatize them. The same frame of mind produced a headlong rush to privatize, for the equally peculiar reason that quick privatization

was a good thingno matter if it put valuable public assets in the hands of corrupt associates of public officials or enterprise managers, and at a tiny fraction of their true market value. These views affected primarily the transitional economies of eastern Europe and the former Soviet Union. In these cases, the rationale was mainly that rapid privatization was needed to make irreversible the change away from central planning. But the fallacy of viewing better governance of public enterprises as inimical to their eventual privatization has surfaced in other countries as well, and so has the failure to understand that quick and dirty privatization may or may not produce short-term efficiency gains but cause damage to the fabric of governance, which is far more costly in the long run.

Corporate Governance in the Context of Overall PEs Reform Improvements in corporate governance of PEs are the internal side of PE sector reform. In brief, there are five external measures of PE reform.7 Privatization, which reduces political influence on the management of the enterprise, transfers risk to the private owners, and can provide powerful incentives for efficiency gains, reduced waste, etc. Strengthened competition, through the removal of price controls, unnecessary regulation, and barriers to entry, compels better performance and enables a fairer assessment of the enterprises efficiency relative to its competitors. A hard budget constraint and removal of subsidies induce efficiency improvements in the enterprise. Financial sector reforms put the hard budget constraints into effect. Restructuring public enterprises consists mainly of the spin-off of competitive businesses and peripheral activities from the public goods core, the separation of operational functions from policy and regulatory functions, and the breakup of monopolies into smaller competing units. Good corporate governance reinforces the external reform measures, as it helps enforce financial discipline, entails transparent rules instead of personalized interventions, and protects public assets from undue appropriation by insiders. Improved corporate governance is particularly important in developing countries and transitional economies because the other checks on the behavior of managers, such as rating companies, public assessment by financial investors, and the capital market, are still undeveloped. Indeed, improvements in

corporate governance facilitate eventual privatization, but in the transparent and accountable manner necessary. Elements of Corporate Governance of PEs The main elements of corporate governance improvements are (i) corporatization; (ii) representation of the state by an agent; (iii) management improvements; (iv) the protection of shareholders interests by the board of directors; and (v) performance and management contracts. Corporatization In many countries, the distinction between the roles of owner (principal) and manager (agent) of a PE has become blurred, contributing to the poor performance of enterprises and in some cases to corruption. Separating the roles of principal and agent is the first step in improving corporate governance. Corporatization is the setting up of an independent legal identity for the enterprise, separate from the identity of the state as owner, and usually entails placing public enterprise operations under the rule of commercial law like private enterprises. Corporatization almost always results in a net increase in the efficiency of allocation and use of a countrys economic resources. This was shown, among many other examples, in the case of Canadian Railways; British Steel; the German railways in 1994; andpossibly the most striking example French telecommunications, which underwent a highly successful transformation in 1990 from a government department into France Telecom, a still public but corporatized entity functioning in a competitive environment. For transitional economies and developing countries, besides the efficiency gains, corporatization of state enterprises can help establish clear title, and sort out the web of relationships among enterprises, their subsidiaries, and government ministries. This is a first step to establishing a hard budget constraint on the enterprises. Clear title also facilitates the disposal of assets and enterprise restructuring. Corporatization has often been a first step to privatization. Some resistance to corporatization is to be expected but need not be a stumbling block if the process is open and well handled. In New Zealand, before every corporatization, company management invariably warned the Government of anticipated resistance from unions. The resistance, however, never materialized because the government effectively communicated to

the workers the reasons for and benefits of the corporatization process, and provided suitable compensation to redundant workers. Similarly, the changes in French telecommunications were perceived as a veritable cultural revolution at first. The Government brought together the public, customers, and employees to discuss the problems of the sector as a whole and to consider future directions; launched a wide-ranging internal and external debate; negotiated with the unions; waged an intensive public information campaign; and amended the corporatization plans to incorporate the results of the dialogue. In fact, experience generally shows that resistance to corporatization of PEs comes neither from the enterprise workers nor the general public if the process is managed well. Far stronger resistance comes from the enterprise management and from the sector ministry concerned one reluctant to face direct accountability, the other unwilling to accept loss of power and influence over the operations of the enterprise. This alliance between bureaucrats and politicians is a good illustration of Niskanens capture argument mentioned earlier, and corporatizationclearly separating the two interestsis in this case the best policy. For this reason, sector ministries should be excluded when designing the corporatization of enterprises in their sectors. Selecting an agent to represent the state and establishing oversight In its role as owner of an enterprise, the state must ensure that the enterprise is run and its investments are made with a view to maximizing the benefits to society. Of course, it must exercise that role through a specific entity. Different countries have attempted different solutions to the problem of who should exercise state ownership rights. Some have set up a public agency for the purpose, while others have split the responsibility among several existing agencies or entrusted the role to sector ministries or created a holding company. In general, the preferred solutions are those that establish a uniform set of procedures for all enterprises, without blurring lines of accountability or combining different roles in the same agency or relying on sector ministries. To illustrate the problem of confused accountability, the rgies autonomes of national interest in Romania are supervised directly by the relevant sector ministry, but with the involvement of other ministries, particularly the Ministry of Finance. The problem of multiple roles is exemplified by the case of the Russian State Property Committee (GKI). It holds the shares of both the PEs that are to be sold and those that are to remain in public hands, so that the

pressures of privatizing some enterprises often pushed the task of managing the assets of the others into the background. In New Zealand, the move to allow the sector ministries to exercise ownership rights failed for two related reasons. First, the public enterprise in effect captured the parent ministry. (The Ministry of Civil Aviation, for example, routinely supported Air New Zealands expansion plans.) Second, the shortage of business skills in government ministries prevented effective control. Indeed, experience has shown that the main opposition to a uniform organizational arrangement for PEs has come from the attempt to preserve old patterns of personal relationships between enterprise management and sector ministries. Austria and a few other countries tried to solve the problem of who should exercise state ownership rights by creating a holding company, that is, a corporation to hold the states shares in public enterprises as well as manage the enterprises themselves. Through such companies, those countries hoped to curb abuses by enterprise senior managers, and to reduce the operational interaction between the government and the state enterprises by interposing an intermediate layer. However, the holding company itself is not subject to effective governance by the state. Also, in practice a holding company tends to enlarge its influence by maximizing the budgets of the enterprises it owns, controlling competition, and protecting failing companies through cross subsidizationrather than managing the enterprises on the basis of efficiency and market criteria. Finally, state holding companies are normally supposed to be transitional, but pressures from various stakeholders tend to prolong their existence. International experience points to the longevity of both the holding companies and their subsidiary enterprises, due to their capacity to bargain for and sustain the flow of government subsidies. The best example is the Italian state holding company Instituto per la Ricostruzione Industriale (IRI). IRI was obliged by law to dismantle itself within five years of its start in 1948, but this obligation did not prevent it from becoming one of the largest industrial conglomerates in Italy over the next 40 years. Holding companies are therefore not a good general model. However, holding structures for managing decline in specific sectors might be feasible for a limited time, with appropriate accountability safeguards and an irrevocable sunset clause (following the German example of the Treuenhandtstalt, which managed the reform and restructuring of the industrial sector of the former East Germany).

On balance, experience suggests that governments should set up a central public agency to exercise state ownership rights in public enterprises but without great management responsibilities. New Zealand, in fact, chose this solution after ministerial oversight failed (as mentioned earlier). The Government created a single asset management agency that was close to, but separate from, the Treasury. The agency concentrated on performing the shareholder role, and hired staff with business skills who learned to identify early signs of failure. Because the same agency monitors many enterprises, it is able to take a national overview of all the corporations, and it has so far been very successful. Improving management of PEs The effectiveness with which public enterprises are able to adapt to competition and fulfill their mandate depends largely on the integrity and competence of their top managers. However, these are qualities for which PE management has not traditionally been known. In the context of increased autonomy, it is important, therefore, to improve PE management as well, by retraining managers or training new ones; bringing in new blood, improving selection, and focusing on performance. Training issues are discussed in Chapter 12. We review below the latter two: selection and performance evaluation. Entrenched personal relationships and opaque selection procedures are the most important problems that go with selecting top managers for PEs. It is a fact that governments exert substantial influence in the appointment or removal of senior managers of PEs. In France, for example, the Government in effect appoints the chief executives of Gas of France and Electricity of France by requiring board members to vote for a particular person. However, governments should have a major say in the selection, but not the only say. For example, in Canada, ministers participate with the PE supervisory board in selecting managers, who are then appointed by the cabinet. Transitional economies and many developing countries are moving away from the traditionally opaque and discretionary processes of recruitment toward more transparency. In Hungary, company directors are appointed by the privatization minister, but the appointments are screened by a parliamentary committee, and other countries have made the selection competitive to ensure a more open process. However, it would be unrealistic to expect longstanding personal connections between top bureaucrats and top PE managers to simply wither away with the introduction of new formal rules. It is important therefore also to skew actual

incentives in the right direction. In Poland, managers of enterprises in sectors open to privatization are given a percentage of the value they add to the firm in preparation for its privatization, as a strong positive incentive for efficiency. Concerning managers performance, the first reality to consider is the information asymmetry that exists between government outsiders and enterprise insiders. Without relevant information, performance evaluation becomes merely an elaborate snow job. It is accordingly necessary for the government, as it introduces performance evaluation for PE managers, to develop at the same time channels of reliable information, e.g., independent feedback by employees or consumers. It must also be possible to remove nonperforming managers. This is especially tricky in public enterprises because of the close personal connections of the management with high-placed bureaucrats, as noted earlier. In the transitional economies of eastern Europe and the former Soviet Union in particular, many enterprise managers have acted as if they were the owners. More generally, the balance of power between the sector ministries and the PE managers is often tilted in favor of the latter, who have direct access to assets and resources. To improve accountability and thus PE performance, four approaches can be helpful. Develop independent channels of information for the government, particularly among the clients of the enterprise. Empower one entity to remove nonperforming managers, separate from the sector diversity. Give sufficient status to that entity by raising its pay and prestige of its members, and assure it of the highest level political support; Decouple the managers from their traditional patrons in the ministries. Protection of shareholders by the board of directors In both public and private enterprises, the board of directors is the intermediary between the owners and the managers that protects shareholders interests by ensuring management performance and accountability. The state as owner can either delegate the control function to a board of directors, or can negotiate performance (or management) contracts. In general, the choice between performance contracts or boards of directors depends on the availability of competent persons of integrity to serve as members of boards on the one hand, and, on the other, on the governments capacity to prepare, monitor, and enforce performance contracts.

Performance and management contracts are discussed in the next section. Immediately below we summarize the results of international experience with boards of directors of PEs. The board of directors must be created in such a way as to ensure an arms length relationship between the PE and the government. With this in mind, some countries (e.g., Germany, Hungary, Netherlands, Poland, and Ukraine) have adopted a two-tiered board structure, while others (e.g., France, Italy, and Romania) follow a unitary structure. The two-tiered board consists of a supervisory board with nonexecutive members appointed by the government, and a management board with executive members nominated by the supervisory board itself (or jointly with the government). A unitary board has both executive and nonexecutive members. Generally, the unitary system is simpler, clearer, and avoids conflicts between the two boards. In developing countries, which often lack qualified persons to serve on enterprise boards, the system is also more realistic. However, the choice between a unitary and a two-tiered board depends on the characteristics of the country and the preferences of the government. The widespread adoption of the German model in eastern Europe, for example, is explained largely by the desire to involve workers in company governance (they select some of the members of the supervisory board). To be effective, all boards must walk a fine line between conflicting demands. They must exercise their legal oversight responsibility, but without stifling the initiative of the management; and they must represent the interests of the state, but without becoming involved in the operational affairs of the company. Their capacity to walk that line depends far less on the structure of the board than on the capacity of its members, the quality of the information and resources they have, and the degree of government support they receive. An examination of the way the boards of directors of public enterprises function in transitional economies and developing countries shows a number of common problems, most of which can be traced back to the difficulty of establishing effective board control over PE managers. This difficulty has four main causes. First, governance weaknesses make for easier capture of board members by enterprise managers (who control information, valuable assets, and patronage possibilities). In most developing countries, managers retain a great deal of leeway within the existing rules, and protected by their patrons in the sector ministriesare rarely punished for violating the rules.

 Second, lack of experienced board members weakens supervision. The limited availability of skills and the need to establish boards for a large number of PEs tax the systems capacity to staff the boards properly. Third, many countries draw PE board members from among current and former government employees, who do not have the business expertise required and may rely on the PE for political patronage or a source of future employment or both. Finally, in many countries, board members have insufficient incentives and resources. They are often very poorly paid, lack the necessary supplies, and do not have enough funds to travel and inspect company operations. Performance and management contracts The alternative to a board of directors is a performance or management contract. Performance contracts are agreements between governments and public managers; management contracts are between the government and private managers. Performance and management contracts respond to different needs and have distinct requirements. Performance contracts also go by other names, such as contract plans, program contracts, memorandums of understanding, signaling systems, and public utility licenses. In a performance contract, the government sets strategic objectives and the public managers decide on the operational strategy to achieve those objectives. The process of developing performance contracts is beneficial in itself, as it leads to a dialogue on facts and helps each party become familiar with the needs and problems of the other. Most performance contracts are indicative rather than prescriptive, and their success depends more on genuine commitment by both sides than on the degree of contract detail. Of the various experiences with performance contracts, generally the most disappointing have been in developing countries (especially in Africa). In transitional economies they have been of some utility. The effectiveness of performance contracts depends, among other things, on the availability of comprehensive and reliable information, strong administrative capacity, and a pool of highly competent and committed public managers. It is not surprising therefore that by far the most successful experience with performance contracts is that of the Republic of Korea and New Zealand (Box 6.1). More mixed has been the experience of the Peoples Republic of China (Box 6.2). A hypothetical illustration of how an actual performance contract is drafted is shown in Box 6.3.

Reference Nonministerial Government Bodies and Corporate Governance Of Public Enterprises It hardly matters whether a cat is black or white as long as it catches mice. Deng Xiaoping, 1963

2.4.2 Its impact on performance of Ethiopian public enterprises 2.5 THEORETICAL FOUNDATION OF THE RESEARCH 2.6 MAIN FOCUS OF THE RESEARCH 2.6.1 2.6.2 2.6.3 2.6.4 2.6.5

Corporate governance affects all sectors of the national economy, including enterprises in the private and public sectors and also those in the financial sector. This paper discusses issues in corporate governance in the State owned enterprises. It traces the incorporation of corporate governance practices into State owned enterprises and raises challenges that require attention. Despite the fact that most Ethiopian economies are now dominated by private sector enterprises, the State-owned enterprises (SOEs) still play a very important role in these economies. In Ethiopia, the SOEs still account for about one quarter of the countrys GDP approximately one third of all savings in the country on a gross basis. This simply implies that the public sector plays a critical role in the allocation of resources in Southern African States. This has considerable implications for corporate governance standards in the economy. In Ethiopia, the public-sector firms typically lack accountability for their performance.

Before concluding, it is imperative to point out the number of issues that have emerged from this discussion of corporate governance in Southern Africa. It is important to first of all point out that all the standards reviewed have included some standard requirements to protect the shareholders wealth, such as the need to have a board of directors characterized by independence, willingness to answer hard questions, a diversity of membership, transparency in decision-making and accountability. Furthermore, it is important for companies to link executive compensation and bonuses to financial, social and environmental performance of the firm and to align them to community expectations of fair and reasonable compensation. The standards also point to the need for companies to adopt plans for their environmental, social and financial operations, including effective evaluation tools. Within the board, the standards insist on including non-executive directors in all the standing audit, nominating and compensation committees. This is encouraged in order to protect the shareholders from expropriation. While these standards may be enforced in listed companies, they are hard to enforce in companies not listed on stock exchanges, unless various other pieces of legislation, including the Companies Acts, are revised to include corporate governance issues. There is also a need to synchronize legislation on the capital markets to ensure that the problem of multiple regulators can be removed and to include mortgage markets. In some countries, the stock exchanges are self-regulated. It is important to have regulators to protect the interests of investors. To enhance compliance with standards, it is also important to strengthen the Companies Acts in all countries, since many firms are not listed or quoted on the various stock exchanges. Furthermore, in many instances, even though accounting bodies exist in nearly all countries, they also tend to be self-regulated. This is another area that requires regulation. Thus, it can be concluded that, generally, Southern Africa faces a regulatory challenge. NEPAD has shown that there can be political will in enforcing good governance practices. However, it is important to strengthen the APRM in order to help standardize the business environment in Southern Africa, as countries appear to be at different stages of implementing the corporate governance standards. NEPAD should help adapt the OECD and King Report standards in all the countries. Thus, the second challenge is that of political will. The third challenge involves governments creating enabling macro and micro economic environments

for formulating incentives to attract investment and being in constant dialogue with the private sector to remove any misconceptions that may develop. It is important for governments to guarantee property rights because they are the only institution that can do that. The fear in Zimbabwe that political governance problems might creep into economic governance needs to be clarified, especially since this goes for every country in the sub region. Enterprises in the extractive sector also face the challenge of improving their corporate social responsibilities. The negative picture so far painted about their pay practices, their attitudes towards the environment and the general perception created of their concentration on profit maximization needs to be improved so that firms in the extractive sector can also be seen as good corporate citizens.