This article has been written by Roshni Agarwal, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) and has been edited by Oishika Banerji (Team Lawsikho).
It has been published by Rachit Garg.
Table of Contents
Corporate governance refers to the overall control over activities in a corporation. It is concerned with the formulation of long-term objectives and plans, to achieve them and to ensure a proper management structure (organization, system and people) for the enterprise and assigning responsibilities to its various constituencies. It also involves making sure that the structure and functions of the corporation are such that its integrity is maintained. For our purpose, the structure to ensure corporate governance includes the board of directors, the management, shareholders and creditors among others. The role of each of these stakeholders is crucial to guarantee responsible corporate performance. This article is dedicated to discussing corporate governance in multinational companies in detail thereby highlighting important aspects associated with it.
All about Multinational Corporations (MNCs)
Multinational Corporations (MNCs) are the result of private foreign investment which can be categorized as:
- Portfolio investment
- Direct foreign investment
Portfolio investment involves purchasing of foreign bonds and stocks for the purpose of interest and dividend as return on investment. Here, the investor is primarily a creditor whose main concern is the income to be earned on his investment. He is not interested in acquiring any control over the management of an enterprise.
Direct foreign investment
Direct Foreign Investment can be new equity capital reinvested earnings or net borrowing from a parent company or its affiliates. It is an investment made with the aim of acquiring a lasting interest and effective voice in the management of an enterprise. Direct investment also generally involves the transfer of packages of resources which, in addition to capital, include technological, managerial and marketing expertise. When a company goes in for foreign direct investment, it involves itself in international business and becomes an international company or an MNC.
Therefore, a multinational corporation, as per se, can be defined as a corporation whose ownership is scattered in more than one country. Products/services are generated or served in more than one country and finances, both investment and cash are integrated for use effectively and efficiently over a number of countries.
Further, a Multinational Enterprise (MNE) is defined as one that has operating subsidiaries, branches or affiliates located in foreign countries. When the ownership of MNEs is dispersed internationally on a large scale, then, they are known as transnational corporations. One characteristic of multinational enterprises which has surfaced from all the definitions is that it is an undertaking which owns or controls productive or service facilities in more than one country. Firms that participate in international business, however large they may be, solely by exporting or by licensing technology are not multinational corporations or multinational enterprises.
International corporate governance or corporate governance in multinationals
Corporate governance in MNCs is about global consistency in international business rules. These rules, in a less comprehensive manner primarily mean the accountability of the board of directors to the shareholders and the ways by which improvement in the same can be brought. More comprehensively, these rules cover wider issues which have a bearing on the business operations and the rights of shareholders and other stakeholders. Under such, governance would include areas such as international alignment of accounting standards, rules for the efficient functioning of a corporate control market and the governance of securities markets, notably the issue of insider trading. All these things are looked after by the Securities and Exchange Board of India (SEBI) in India.
Thus, SEBI sets governance standards so that fair treatment is ensured to the subsidiaries of MNCs which are being established in India by looking after foreign institutional investment, mergers and acquisitions, research and publications and international relations. Further, SEBI also looks after policy registration, regulation and monitoring of foreign institutional investors and substantial acquisition of shares.
The essence of corporate governance is to safeguard the interests of shareholders and stakeholders. A variety of factors that are inherent to any given business environment shape corporate governance systems in MNCs as:
- Efficiency of local capital markets
- Protection afforded by the legal system
- Enforcement of regulations
- Societal and cultural values
This theory defines the relationship between the principal and the agent as a ‘contractual relationship’ in which the principal employs an agent to do activities on their behalf. The agent is also delegated with certain decision-making rights by the principal. But, when the ownership and control rights of an enterprise are separated, there are high chances of conflict of interests arising between the principal and the agent as the principal wants maximization of their own interests, while the agent wants the highest return with little effort.
MNCs usually have parent-subsidiary structure. The parent-subsidiary corporate governance structure is shaped by both the host and home countries:
- Legal, political, cultural, and regulatory systems
- The business practices and historical patterns of countries
- The global capital, labor, and managerial markets
- Global institutional investors
- The boards of directors.
Parent-subsidiary corporate governance
The governance objectives of the parent company of a multinational enterprise are different from that of a usual enterprise because of the multi-level and multi-legal characteristics of MNEs. The governance goals of MNEs are not limited to efficiency optimization and cost minimization but are focused more on the management target of extensionality, namely to establish a stable cooperation between the parent company and the subsidiaries. The subsidiaries are subject to the control and guidance of the parent company but are also independent. This makes the implementation of decision making throughout the enterprise more scientific and results in efficiency optimization.
Thus, the multi-dimensional governance path of multinational companies is based on common collaborative governance between parent and subsidiary companies. The interests of the parent and subsidiary companies should be coordinated and all of them must be subject to the maximization of the overall interests. When the subsidiary is wholly owned by the parent company but is managed independently by a manager who has little or no ownership in the MNC or the subsidiary, then the effectiveness of parent-subsidiary corporate governance becomes crucial by way of monitoring and controlling managerial actions of the subsidiary.
The control and restraint mechanism of the parent company
Many times, conflict of interests arise between the parent company and its subsidiaries. This is because the parent company wants to exercise absolute control over its subsidiaries, while the subsidiary company wants to exercise certain independent options. Proper settlement of this issue will help both the parent and the subsidiary companies to play their best role. The relationship between the parent and the subsidiary companies can be balanced by the type of control the parent company exercises over its subsidiaries which can be as:
Under such a system of exercising control, the parent company holds the majority of the board of directors of the subsidiary company.
In this, the parent company exercises overall control over its subsidiaries.
Flexible measures taken between the above two types according to the actual situation of the host country and its subsidiaries.
Scholars of the internalization theory explore the challenges associated with managing the contractual relationship that a particular MNC has with entities in its external environment such as customers, suppliers, foreign subsidiaries and business partners. This theory helps in understanding the cross-border relation between the MNC and its business partners and/or its subsidiaries. This relationship may be affected by information asymmetries and the self-serving behavior of the transacting parties. From this vantage point, internalization scholars conceptualize corporate governance in MNCs as a nexus of bureaucratic controls that supersedes market inefficiencies by coordinating economic activities across national boundaries in a more efficient manner.
According to the internalization theory, MNCs retain the ownership and control of the subsidiaries it sets up in foreign countries for protecting and leveraging firm-specific advantages (FSAs) from the foreign countries in which it has established its subsidiaries. FSAs are proprietary knowledge assets that the MNC can develop as well as exploit in order to survive, earn profit and grow.
The term ‘knowledge assets’ refers to the accumulated intellectual resources of a particular organization. It is the knowledge possessed by an organization (MNC in this case) and its workforce (can be understood as the foreign subsidiaries) in the form of information, ideas, learning, understanding, insights, cognitive and technical skills, and capabilities. Workforce, databases, documents, guides, policies and procedures, software, and patents are all repositories of an organization’s knowledge assets.
Further, FSAs are contrasted with country-specific advantages (CSAs). CSAs include those country-level institutional conditions that may affect an MNC’s decision to develop or exploit its FSAs. These CSAs range from the quality of the overall institutional environment of the subsidiary in the foreign country to the availability of skilled labor in that country, technological know-how of the people working in the subsidiary or the natural resources available in that particular country.
Early researchers conceptualized corporate governance in MNCs as a one-time decision made afresh only at the time when an MNC entered a new market. But, recent studies have stressed on the dynamic aspects of the approaches of the MNCs in managing their global operations. Thus, an MNC may possess FSAs that make certain modes of entry into a foreign market efficient at a specific point of time, but these same FSAs can dissolve later on. This can happen because of the developments in the field of information and communication technologies, enhanced patent rights, and new management systems emerging, which may reduce the transaction costs between the suppliers and their customers.
In addition to these external factors, when an MNC establishes subsidiaries in other countries, it needs to incur governance costs. These governance costs are the costs related to the governance of relationships between the HQ (parent company) and its subsidiary/subsidiaries. Over time, these costs may also reduce the long-term efficiency of owning a foreign subsidiary. But, anyways researchers have identified four main types of governance costs that are likely to emerge upon the establishment of a foreign subsidiary by an MNC namely:
- Bargaining costs:
These costs emerge in the renegotiations of an MNC’s agreement with its various subsidiaries.
- Monitoring costs:
These costs are associated with HQ’s need to establish systems aimed at reducing shirking and performance ambiguity among the people working in its foreign subsidiaries.
- Information costs:
These emerge in the communication failures between HQ and its subsidiaries. They may also reduce the HQ’s effectiveness.
- Bonding costs:
These stem from the need to establish commitments between HQ and its subsidiaries through a series of activities.
All you need to know about the Board of Directors
The size of the board of directors of an MNC should be reasonable. It should be determined on the basis of the governance costs and the governance benefits of the particular MNC. A smaller size of the board of directors serves advantages such as low variable cost, small chance of free-riding among directors, fast communication among them and disadvantages such as insufficient knowledge while solving complex problems related to the company, low ability of the directors in the board to control risk and mistakes made in decision-making.
On the other hand, expansion of the size of the board of directors establishes the company’s governance on the scientific governance mechanism and thus achieves better governance results. But, with the expansion, communication among the directors becomes difficult resulting in free-riding behavior of some directors which puts more burden on the honest and hardworking directors. This will eventually have a negative effect on the overall efficiency of the board. So, the board of directors of an MNC should be a balanced senior management team composed of people from various different knowledge backgrounds and work experiences, different industry backgrounds and different interest groups.
Economic market environment
For effective corporate governance in MNEs, the economic market condition of the host country is the most important basic factor among all kinds of environmental factors that an MNC has to pay attention to before establishing a subsidiary in any country. Multinational enterprises must study the economic conditions and trends of target countries so that it gains knowledge about the market size and development prospects for establishing a subsidiary in a particular country.
According to different levels of economic development in different countries, different governance models should be formulated for the governance of transnational corporations. This is indeed a big challenge. GDP and distribution patterns of social wealth should also be taken into account. The former reflects a country’s overall economic strength while the later reflects a country’s economic performance and development prospects in that country. Complete understanding of the host country’s economic status and development trends in that country is the key to effective governance of multinational enterprises.
The corporate governance and future expansion of a multinational enterprise is affected by the social and cultural environment of the foreign countries in which they establish their subsidiaries. This is because each country has its own unique cultural environment. So, operating in different countries requires enterprises to adapt to different cultures. The cultural difference between the culture of the host country and that of the home country resulting in a difference between the main culture and the subculture of multinational companies poses a further problem. This is because the culture of a particular region cultivates a group of people’s manner of thinking, their cognition and behavior.
Thus, when people belonging to different cultures enter multinational companies, their values and ways of thinking, to a large extent, naturally influence the policies formulated by them and their way of implementing tasks assigned to them in the multinational company. This correspondingly brings challenges in governance. The educational level of countries also plays an important role in the corporate governance of MNCs. If the educational level of the target country is low, the parent company bears more governance pressure and cannot rely on local talents too much.
What can good corporate governance offer multinationals
Good corporate governance enhances competitiveness and makes it easier for businesses to access capital markets, which supports the expansion of financial markets and the economy. A company’s governing bodies can make decisions more effectively when corporate governance practices are improved, which should increase the effectiveness of the company’s financial and business operations. Enhancing corporate governance also strengthens the accountability framework, reducing the possibility of corporate officers engaging in fraud or self-dealing. In addition to enabling businesses to avoid expensive litigation, a good structure of governance should assist in ensuring compliance with relevant laws and regulations.
Strong governance norms promote easier access to money and support economic expansion. Additionally, corporate governance has broader institutional and social elements. The implementation of the values of justice, openness, accountability, and responsibility to both shareholders and stakeholders should be the main focus of well-designed norms of governance. Businesses need an excellent institutional environment in addition to good internal governance in order to be managed effectively and ethically. A functioning judiciary, free press, and secure private property rights are therefore vital for putting corporate governance laws and regulations into practice.
Good corporate governance ensures that businesses can be held accountable for their activities and that the business environment is fair and transparent. On the other hand, poor corporate governance results in fraud, and corruption. Also crucial to keep in mind is the importance of corporate governance in state-owned firms, cooperatives, and family businesses. Corporate governance originated as a method of managing contemporary joint stock corporations. No sort of business, only effective governance can produce long-term successful results. The integrity of businesses, financial institutions, and markets, as well as the health and stability of our economies, depend on effective corporate governance.
Good corporate governance, by reducing risk, lowers the cost of capital and thus creates higher firm valuation boosting real investments. Effective corporate governance mechanisms if employed in MNCs ensure better resource allocation and good management raising the return to capital. Good corporate governance also significantly reduces the risk of nation-wide financial crises. It removes mistrust among different stakeholders, reduces legal costs and improves the social and labor relationships.
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