Corporate governance legal indicator survey

2005 Legal Indicator Survey on Corporate Governance

To complement its assessment of corporate governance legislation, the EBRD launched the 2005 Legal Indicator Survey. The aim of the Survey was to assess how the legislation, together with the local institutional framework, in each country works to create a functional (or dysfunctional) corporate governance legal regime. The 2005 Legal Indicator Survey was financed by the Government of Italy.

The case study methodology

The methodology employed in the 2005 Legal Indicator Survey followed on from previous surveys. Accordingly, it involved working with leading corporate governance lawyers  (0.1Mb) in the region. These law firms were provided with two broadly similar hypothetical case studies involving a related-party transaction, Corporate governance legislation and practice for listed and unlisted companies vary. For this reason it was determined to set two case-study scenarios  (0.1Mb) where a minority shareholder - in an unlisted and listed company - suspects that the company entered in a transaction with another entity controlled by the company’s management. The transaction caused the company damage valued at €2 million. In these scenarios the minority shareholder is faced with two problems:

• Determine whether the transaction was entered into and on what terms.

• Obtain some form of redress through a private action in court or otherwise.

An extensive questionnaire was designed to establish how effective each country’s legal system is in protecting a minority shareholder’s interests.  Law firms were asked to respond to the questionnaire as if they were advising the minority shareholder on how best to protect their rights and preserve the value of their financial investment in the local company. The questionnaire focused on three main areas:

• Mechanisms by which the minority shareholder can find out whether the transaction had been entered into (disclosure)

• Tools for redress (redress)

• Institutional environment in which such disclosure and redress tools have to be used.

Scoring methodology of the Survey

The majority of the questions in the questionnaire provided multiple-choice responses. Each question was individually scored on a range of 1 to 10 (one representing the lowest and 10 the highest score). It reflected a 10-point progression from a clear "yes" to a clear "no" (or from 'extremely low' to 'very high').

In addition, narrative text responses regarding most areas of inquiry assisted in obtaining further information within each hypothetically. It also had an impact on the scoring of related questions (for instance, by reinforcing other answers or indicating contradictions). Narrative explanations were not scored individually.

Core areas and principal criteria

Ultimately, the questions of each case study were merged to measure and test critical core areas: the extent to which the minority shareholder could obtain disclosure and redress.

Each core area was individually scored by aggregating the scores of constituent questions. Core areas were weighted to measure the degree of effectiveness of the principal criteria used to measure effectiveness.

The principal criteria

The following principal criteria were used to gauge the effectiveness of corporate governance:

• Speed is the most straightforward factor. In disclosure cases, it refers to the average time between the initial filing of proceedings with the court and the issuance of an executable court order, taking into consideration an appeal by the defendant. In redress cases, it concerns the period from the initial filing of the proceeding to the issue of a court’s executable judgement, again taking into consideration an appeal by the defendant.

• Simplicity relates to the smoothness of proceedings. More precisely, respondents were asked to assess how clear, simple and straightforward the proceedings relating to the available actions were. The guidance offered by judicial precedents in interpreting the law was also considered here, as it simplifies law enforcement by increasing legal certainty.

• Enforceability relates to the carrying out of the executable judgement in cases where the other party fails to implement it, and extends far beyond corporate governance. Respondents were asked to assess the ease of enforcing a judgement in favour of the minority shareholder.

• Costs include the legal and administrative fees which a plaintiff may face in order to start a case. A few questions were also designed to determine the rules on attorney’s fees in shareholder suits, as - especially in publicly held companies - the prospect of having to pay attorney’s fees and possibly even the winning defendant’s fees provides a great disincentive to shareholder suits.

• Institutional Environment relates to the capacity of a given legal framework to provide the basic guarantees that are needed for legislation to be effectively implemented and enforced. It includes a number of factors regarding disclosure and redress: the perceived reliability of a company’s books; the requirement to have corporate financial information audited; the presence of international auditing firms in the country; the perceived independence of statutory auditors; the perceived degree of competence and experience of courts and prosecutors; the availability of up-to-date legislation; the ease with which the defendant can delay the proceedings and the perceived influence that might be exercised on courts and prosecutors by a powerful defendant. With regard to both disclosure and redress Transparency International’s Corruption Perception Index 2005 was also taken into account.

Scope and dimension of case studies

The scope and dimension of the Survey was limited by the subject matter and therefore the findings of the survey must be treated with caution. First, they reflect the views of a limited number of practitioners within each country.  Second, they address a very specific set of circumstances and must be considered within the boundaries of the case studies. Third, assessing effectiveness by necessity is far more difficult and subjective than finding out what the laws on the books state in a given country, It deals with hard to measure variables such as courts’ competence, simplicity of procedures, ease of enforcement and so on.

Corporate governance legislation differs widely in their design and substance. While it may be possible to test the entirety of a corporate governance regime (if only one such regime were being tested), to examine a number of regimes under a single exercise requires the consideration of many variables and alternative possibilities that arise from those differences in legislation. The results of any such testing would produce an incoherent final product. In addition, any attempt to consider a large number of variables requires them to be “weighted” (allocating particular areas a greater scoring potential than others based on perceptions of relative importance). The exercise of weighting, however, is subjective and if a survey extends into too many areas, the temptation and opportunity to weight results, and thereby distort them, increases.

Accordingly, it was determined to focus the Survey on one of the most critical issues in corporate governance: the possibility for a minority shareholder in both a listed and unlisted company to effectively obtain information on the transactions undertaken by the company and, in case, initiate proceedings (before a court or an arbitration panel) to effectively obtain redress. The broad purpose of this methodology is to test whether and the extent to which the law may be effectively applied in practice. More particularly, that test should embrace critical factors involved in that usage, such as time, cost, barriers to efficient application, the adequacy of the institutional capacity (particularly the courts), and general effectiveness.

Results of the Survey

The essential results are presented in various graphic forms to illustrate both the performance of each country separately and an overall comparative view, as follows:

• the degree of effectiveness scored by each country in each of the ‘principal criteria’  (0.1Mb) (speed, simplicity, enforceability, costs, institutional environment); in a weighted average between the two cases; and

• Comprehensive country-by-country analysis of the results of each case study  (0.2Mb)  using multiple criteria and presented in graphic form.

• Comprehensive country-by-country analysis of the various component of the institutional environment  (0.1Mb) presented in graphic form.

Read more about the Survey:

• Corporate Governance in Action - where do we stand?  (0.2Mb) by Gian Piero Cigna in International Corporate Governance Review March 2006;

• Assessing the effectiveness of corporate governance legislation  (0.3Mb) by Gian Piero Cigna and Prof. Luca Enriques, in Law in transition, Spring 2006;

• Annex 1.2. Corporate Governance  (0.2Mb) by Gian Piero Cigna and Prof. Luca Enriques, in Transition Report 2005.

For additional information, please contact the EBRD’s corporate governance specialist, Gian Piero Cigna, at cignag@ebrd.com