Before we delve into the role of the regulators in corporate governance, it is essential to contextualise the contemporary importance of the capital market.
Available data
1 all tell the same story - that capital markets all over the world are experiencing a staggering growth. The statistics also show that cross-border transactions in bonds and equities expressed as a percentage of Gross Domestic Product (GDP) have increased dramatically over the years and that this trend is expected to continue to grow.
We see this happening in our country too. In Malaysia, the value of funds raised in the capital market in 1993 was 4% of the country's gross domestic product (GDP); in 2003 it amounted to 13%. Whilst an annual average of RM4.5 billion was raised in the period of 1984-1993, in the subsequent decade, i.e. 1994-2003, the average had multiplied to RM30 billion per year. It is interesting to note too that in this time, the country has seen an increase of 34% in the funds raised in the capital market, almost three times the growth of bank lending.
2 It is only to be expected therefore, for the growth in this sector to accelerate in the coming years.
The strategic importance of the capital markets has been emphasised by the transformations in share ownership in recent years. In the last year itself, we have seen the volume of unit trust in circulation grow by 8.7%
3. More and more people are affected by and interested in the activities of the capital markets than 20, 10 or even 5 years ago.
As the economic, social and political importance of such markets has increased, so has the level of concern about their regulatory infrastructure. In order for the market to function properly, there has to be confidence about market integrity and a level playing field for all market participants. It is against this backdrop that the role of the regulator in the capital market in general and in corporate governance in particular, must be viewed. Corporate governance is not an end, it is a means to end. Markets which possess a reputation for good corporate governance engenders investor confidence, which in turn lowers the cost of capital to issuers, attracting still more investors and issuers to the capital market in what is almost a positive reinforcing loop. An effective corporate governance system is hence essential, both within an individual company and across the economy as a whole so that the cost of capital is lowered and companies are encouraged to use resources more efficiently, thereby underpinning growth.
The government has a significant role in corporate governance
A statutory regulator like the SC is an institution established by the government to carry out functions entrusted to it by statute. Hence it may be useful, before discussing the role of the regulators in corporate governance, to look at the role of government.
In this regard, perhaps I can refer to key conclusions from an APEC Policy Dialogue on Corporate Governance. Although the dialogue was held almost 5 years old, the key conclusions remain valid.
These are:
- Government has a fundamental role in ensuring that there is an appropriate legal and regulatory regime for corporate activity;
- Government can lead by example;
- Government can play an important role in facilitating the education of market participants;
- Effective enforcement is paramount;
- Institutions (e.g. courts, regulators) are critical and government needs to ensure their capacity to support good governance;
- Shareholders, particularly institutional shareholders and shareholder watchdog groups, can play a significant role in promoting good corporate governance behaviour; and
- Government and the private sector need to work in partnership to achieve good corporate governance practice.
From the above we can identify some of the roles that a statutory regulator can play in corporate governance.
The Role of the Regulator
Essentially, regulators have two primary tasks in ensuring that good corporate governance prevails. The first is to shape an effective regulatory framework, which provides for sufficient flexibility to allow markets to function effectively and to respond to expectations of shareholders and other stakeholders. The second is to carry out effective enforcement when there has been a breach of the law. There are also secondary tasks which regulators (particularly if like the SC, they have a developmental role) should take on such as facilitating education of market participants and promoting shareholder activism. But let me first focus on the primary responsibilities.
Putting in place the Regulatory Infrastructure for Corporate Governance
In articulating the importance of the corporate governance framework, let me quote the OECD Principles of Corporate Governance 2004 at page 29 -
To ensure an effective corporate governance framework, it is necessary that an appropriate and effective legal, regulatory and institutional foundation is established upon which all market participants can rely in establishing their private contractual relations. This corporate governance framework typically comprises elements of legislation, regulation, self-regulatory arrangements, voluntary commitments and business practices that are the result of a country's specific circumstances, history and tradition. The desirable mix between legislation, regulation, self-regulation, voluntary standards, etc. in this area will therefore vary from country to country. As new experiences accrue and business circumstances change, the content and structure of this framework might need to be adjusted.4
Securities markets by nature have always flourished on the basis of hybrid regulation - i.e., a combination of overt oversight by the regulator and self-regulation by the market itself. The strength of self-regulation lies in the fact that industry self-regulatory organisations can respond quickly and flexibly to regulatory challenges. Its weakness is in its self-same proximity to its regulatees (i.e., conflicts of interests) and the fact that sanctions imposed by self-regulatory bodies may not be of sufficient deterrent value. Put simply, the operative word in self-regulation is often conveniently assumed to be the self rather than the regulation.
In Malaysia, the view is and has always been that that the appropriate regulatory infrastructure which is most suitable to Malaysia's specific circumstances, should comprise elements of legislation (i.e. provisions contained in the Securities and Companies Acts); regulation (i.e. SC guidelines
5 and listing requirements by Bursa Malaysia) and self-regulatory arrangements, voluntary commitments and business practices, (i.e. the code of corporate governance
6 and industry best practices.
7)
Ordinarily, the regulatory infrastructure is developed in an evolutionary manner (the 'peace-time' measures). However sometimes in response to specific failures in the market, drastic or revolutionary changes are introduced (the 'war-time' measures).
In Malaysia the evolutionary process of strengthening the corporate governance regulatory infrastructure began long before corporate governance became a buzz word.
Examples are many, beginning perhaps with the introduction of securities legislation in the 70s. But just to cite some examples, we introduced mandatory requirements for independent directors in 1987, audit committee requirements in 1993 and a Code of Ethics for Directors was introduced by the Registrar of Companies in 1996. The framework for accounting and audit was also well developed by the time of the Asian Financial Crisis, with the process of adopting accounting standards starting from the 70s and the establishment of the Malaysian Accounting Standards Board as an independent standard setting body in 1997.
Despite these on-going measures to strengthen the regulatory infrastructure, during the Asian Financial Crisis, corporate abuses were brought to light under difficult economic circumstances and there was almost a unanimous call for regulatory reform.
It would therefore seem to be the case that significant regulatory intervention in the area of rule making is often triggered by governance crises. You would recall that Malaysia introduced a slew of measures during and immediately after the crisis. Neither Malaysia nor the rest of Asia was unique in this regard. Take for example the crises engendered by Enron in the US, where Congress promptly passed the Sarbanes-Oxley Act, imposing, among others, a wealth of new financial control and reporting requirements on public companies and the creation of a new oversight regulator for the accounting profession. Indeed, over the past half-decade, globally, in the wake of governance crises both at national and regional levels, we have seen far greater regulatory intervention into the affairs of corporate management and conduct than ever before. The OECD Report on Regulatory Reform
8 had this to say of regulatory reactivism in OECD economies:
". the volume and complexity of laws, rules and paperwork has reached an all time high . Regulatory inflation erodes the effectiveness of all regulations, disproportionately hurts small businesses and expands scope for misuse of administrative discretion."
It is for this reason that the relevance and appropriateness of the regulatory infrastructure needs to be constantly calibrated. When companies evidence high standards of governance, when market self-discipline is strong, less overt control from regulators is necessary and the business environment is therefore subjected to less regulation and granted greater flexibility. This was in fact the case in most developed jurisdictions before major corporate governance scandals put the spotlight on their regulatory framework and tough prescriptive measures were deemed necessary.
Hence, by historical observation alone, a cyclical pattern with respect to rule-making in response to governance crises emerges. Difficult times call for tougher, more prescriptive rules. Calmer times allow for some of these rules to be reviewed and removed where appropriate. I think the challenge for regulators in responding to crises is to ensure that regulatory intervention is timely yet strategic and balanced against the need to provide a conducive environment for business to flourish. Regulators need to walk a fine line between installing necessary regulatory control and by the same token not impeding, free enterprise and market innovation. Too great an emphasis on control would stifle creativity and create risk adverse markets.
To do this, a measured and long-term response is called for. This is exactly what Malaysia sought to achieve through 3 major strategic initiatives, namely -
- The Finance Committee Report on Corporate Governance (1999)
- The Capital Market Masterplan (2001)
- The Corporate Law Reform Programme (2003)
The Finance Committee Report was a collaborative response by regulators and industry on necessary reforms as a response to corporate governance weaknesses imposed during the crisis. The Masterplan built on the foundations Finance Committee Report, making 10 recommendations specifically on corporate governance out of a total of 152. While cost of regulation has always been a consideration, neither the Finance Committee Report nor the CMP undertook to quantitatively examine the impact of corporate regulation on the cost of doing business in Malaysia relative to the governance weaknesses to which their recommendations had sought to mitigate.
In this context, arguably the most important set of legal reforms currently underway are those pursuant to the Corporate Law Reform Programme (CLRP), which was announced in December 2003. The CLRP seeks to undertake a fundamental review of corporate law with a view towards, amongst others, modernising the law, harmonising the regulatory regime for statutory and non-statutory rules and strengthening the framework for regulatory enforcement and co-operation amongst regulators. In this regard, the SC is currently heading the Working Group on Corporate Governance under the auspices of the Corporate Law Reform Committee (CLRC). The Corporate Law Reform Programme represents an important opportunity to holistically reassess and examine the cost of corporate governance regulation and its impact on the business community.
Enforcement
No presentation on corporate governance by a regulator is deemed complete without the topic of enforcement, and rightly so, as that is the other primary task of a regulator.
I have mentioned that capital markets have traditionally relied on hybrid regulatory mechanisms - namely public enforcement by the oversight regulator, and private enforcement and self-regulation by the whole range of market participants themselves.
Public enforcement by oversight regulators such as the SC and the Companies Commission is key to sending the right signals to the market. The capacity and will to administer timely and consistent public enforcement and oversight, represents the acid test for regulators in the task of building market confidence.
The SC views very seriously breaches of corporate governance matters as this undermines the integrity of the stepped up over the years with an emphasis, in the recent years, on enforcing accountability and transparency.
For effective public enforcement, regulators need an array of enforcement options, including -
- Criminal sanctions;
- Civil sanctions; and
- Administrative penalties
Traditionally, regulators have tended to rely on the criminal enforcement route - and this option remains crucial for deterrence purposes - but increasingly the trend in many jurisdictions has been towards civil sanctions where the focus is equally on compensation for aggrieved persons as much as it is on deterrence. The SC for example has the power to bring civil actions for certain breaches of the Securities Industry Act 1983 and the Securities Commission Act 1983. Its powers to mete out administrative sanctions include reprimands, fines, and even the power to publicly 'name and shame' perpetrators. It is equally important that regulators have the power to hold 'reputational intermediaries', such as external auditors, corporate advisers and other professionals accountable in relevant cases, not just the company itself or its directors. Currently, the Companies Act 1965 remains very much reliant on criminal sanctioning options alone, but under the CLRP, we may well see a change in the enforcement landscape under the auspices of the CCM.
Enforcement actions by the SC in 2004 show the use of civil and administrative sanctions in addition to criminal prosecution.
- For instance, in addition to the normal range of criminal sanctions it typically imposes, the SC also brought 2 civil enforcement actions last year. The first was with respect to an insider trading case, which resulted in the payment of a civil penalty and disgorgement of profits. Disgorged profits, amounting to RM2 million, will go towards compensating affected investors. The second involved the SC seeking civil relief, including, among others, an order for the defendants to make restitution to aggrieved persons.
- But I also want to highlight that in the same year the SC had also focussed its action on market professionals and 'reputational intermediaries' - where an external auditor and an accountant of a public listed company were charged in the criminal courts.
Clearly our enforcement efforts have not gone unnoticed. I am pleased to note that international assessments of corporate governance in Malaysia such as the CLSA Emerging Markets Report show that there has been a year-on-year improvement in the area on enforcement.
There is however still room for further capacity and institution building, and for greater cooperation amongst key regulatory agencies involved in the enforcement of corporate governance. In this regard, a High Level Committee on Enforcement was formed last year comprising the SC, CCM and the Police with the objective of facilitating collaboration amongst regulatory agencies9.
Conclusion
While extremely important, there are clear limits to the relevance and scope of public enforcement - and boundaries beyond which private enforcement and intervention must take over.
The ultimate relevance and efficacy of many of the regulatory reforms implemented in Malaysia and elsewhere rests with the shareholders themselves and the attention they pay to the affairs of the companies in which they invest. Certainly, the investors have inherent incentives to monitor and engage companies on corporate governance matters far beyond that which is true of regulators - who must adopt a public policy stance in monitoring and enforcement.
In Asia, although various investor groups have emerged, they are relatively young, and institutional investor activism can be said to be still in its infancy. To take the agenda for developing the private enforcement framework forward however, it is crucial that institutional investors play a more important role in the self-regulatory framework - by attending meetings, participating and voting, not only with their feet. Needless to say, rules which impose shareholder-level controls on the tunneling of assets out of the company through related party transactions and self-dealing are pointless, without reciprocal participation from shareholders. The Malaysian Code on Corporate Governance10 exhorts institutional investors to make considered use of their voting rights in line with their fiduciary duties to their investing clientele. However, several economic and practical disincentives to activism, such as free riding 11 and the costs associated with monitoring 12 are contributory factors to institutional investor apathy. Unlike listed companies, institutional investors are not obliged to disclose in their annual reports their compliance with the Code.
In this context, institutional funds have a key role to play in promoting corporate governance. Indeed, greater transparency on the nature and extent of activism by such funds will further enhance public confidence in the framework.
On that note, I end by suggesting that government, statutory regulators and industry all have key roles to play in improving the corporate governance framework.
Thank you.
