Abstract
The paper questions the impact of rule-based governance in an environment with poor legal enforcement and general mistrust in the law-setting institutions. We conduct a quasi-experiment and a survey to prove that ‘law on books’ can still play a role by triggering the social norm of ‘obeying the law’. We furthermore expose and empirically confirm the role of the Corporate Governance Code as a signaling tool, and discuss why in a weak institutional environment the Code’s potential may be even stronger than in the developed market economies.
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Notes
With corporate governance we mean the set of mechanisms aiming to resolve the collective action problem among shareholders. For more, see Becht et al. (2003).
Hard law refers to legal obligation of a formally binding nature. Soft law contains non-binding provisions. The advantage of soft law is that it can be negotiated more easily and at less costs, can be adapted and replaced more easily (as the uncertainty about its effect is resolved) and allows its proponents to be more ambitious, potentially creating the path towards hard law over time (Shaffer and Pollack 2008).
A norm exists when almost everyone in a community agrees that they ought to behave in a particular way in specific circumstances, and this agreement effects what people actually do (Cooter 1998, p. 3).
Eiseneberg (1999) explores the interrelation between the law and social norms in regard to fiduciary duties, corporate governance and takeover rules that are not explicitly incorporated in the legal rules.
Firms can choose not to comply with a recommendation of the CG Code if they explain the reason for such deviation (i.e., comply or explain).
That is, the fact that most of the other actors (firms) do not act in the same way in the same situation (Kelley 1967 in Friedman et al. 2007).
The Hungarian Empire was part of the Austro-Hungarian Empire.
There were some attempts in the Kingdom of SHS to amend and rewrite a Civil Code which would be valid for the whole Kingdom of SHS. In October 1937 the Unified Commercial Code was published in the Official Gazette of the Kingdom of SHS. However, it was never used since a special act, which was to determine the act’s validity, was never enacted (Pretnar 1953, p. 24).
Official Gazette of Yugoslavia, No. 29/1978.
The institution of social ownership implied that, rather than by the State, the enterprises were owned by everybody—the society.
See Ivovic (2008).
See also Black (2001, pp. 2131–2134).
For example, in measuring the protection of investors in the region, Slovenia is ranked 3rd, Montenegro 6th and Croatia 26rd (http://www.doingbusiness.org/economyrankings/?regionid=2).
There are 2,448 cases in Slovenian courts that are older than 10 years; two of them date back to 1974. Due to the lengthy trials, Slovenia had to pay, up until July of 2006, approximately EURO 500,000.00 in damages to Slovenian entities. There are approximately 100 cases against Slovenia still pending at the European Court for Human Rights in Strasbourg and the number keeps increasing.
The corruption perception index in 2010 was 3.4 for Montenegro, 4.4 for Croatia and 6.4 for Slovenia. As a comparison, the corruption perception index for the less corrupt European countries (Denmark and Sweden) was 9.3. In 2007 (when our quasi-experiment was conducted), the corruption perception index was 6.6 for Slovenia, 4.1 for Croatia and 3.3 for Montenegro.
A working legal system can be categorised further into three kinds of components: (1) structural (the number and type of courts, presence of constitution, etc.); (2) substantive (rules, doctrines, statutes), and (3) cultural (people’s attitude towards law, education of judges and lawyers, etc.). For more, see Friedman (1969).
See also Sunstein (1996).
Even though respecting contracts and obeying rules overlap to a certain extent, they are not the same. We could say that by obeying rules, firms signal their credibility and trustworthiness in general, not just to the other contracting party. Still, we believe that the arguments made by Bohnet et al. (2000) in relation to contractual obligations can be extended to compliance with company law in general.
Human judgment regarding corporate reputation in fact depends on individuals’ perception of the environment and to its related interpretation of the information of the observed behavior (Dhir 2005).
The word “obligational” is taken from Eiseneberg (1999).
Quasi-experiments are experiments that lack random assignment of units to conditions but that otherwise have similar purposes and structural attributes to randomized experiments. In a one-group pre-test—post-test within-participants design, a single pre-test observation is taken on the group of respondents, treatment then occurs, and a single post-test observation on the same measures is taken on the same group (Shadish et al. 2002).
We thank Vlado Miheljak, a psychologist and professor at the Faculty of Social Sciences in Ljubljana, and Mateja Drnovsek from the Faculty of Economics in Ljubljana for their comments and suggestions in regard to our experiment. We thank Niksa Alfirevic from Split, Katarina Ott from Zagreb and Jelena Zvizdojevic from Montenegro for their help with the experiment. The mistakes are our own responsibility.
In Table 1, this version is labelled ‘law’. See also ‘Appendix 2’.
As argued by Eiseneberg (1999) the expectation about the other actors’ behavior re-confirms the obligatory nature of a law. A player will feel obliged to respect a norm depending on her expectation on what other actors will do. To put it differently, a norm is internalized by society when a sufficient number of actors change their behaviour so that tipping point is crossed (Eiseneberg 1999).
M stands for the Mean; t stands for the value of t statistics refereeing to the difference between mean values assigned to different categories (i.e., contract and legal rules).
The idea here is that, if non-compliance with the legal rule is generally attributed to the inefficiencies in the legal environment, managers will feel little social pressure to comply with the legal rules and, in turn, expect few reputational effects.
Statistical conclusion validity refers to the validity of the inferences about the correlation (covariation) between treatment and outcome. Internal validity refers to the validity of inferences about whether observed covariation between the presumed treatment and the presumed outcome reflects a causal relationship as those variables were manipulated or measured. In other words, statistical conclusion validity is concerned with errors in assessing statistical covariation, while internal validity is concerned with causal-reasoning errors. Construct validity is the validity of inferences about the higher order constructs that represent sampling particulars. External validity is the validity of inferences about whether the cause-effect relationship holds over variation in persons, settings, treatment variables, and measurement variables (Shadish et al. 2002).
The participants were split into two groups randomly. Both groups read the same ‘pre-treatment’ version in the first round. In the second round, the first group read the ‘law’version, while the second group read the ‘soft law’ version.
5 = I strongly agree, 4 = I agree, 3 = I am uncertain, 2 = I don’t agree, 1 = I definitely don’t agree; t stands for the difference between the mean values assigned to CG Code and hard law, respectively.
In 2004, only 14 out of 24 firms quoted on the official market of the Ljubljana Stock Exchange actually issued a declaration of compliance; the number of issued declarations increased to 29 (out of 30) in 2005, while in 2006 all of the companies with shares traded on the Ljubljana Stock Exchange issued a Declaration of Compliance (Cankar 2006).
If markets are efficient, firm reputation should not matter. The game theory models evidence that the higher the informational asymmetry in the markets, the more reputation (among other signaling and bonding devices) should matter in determining the choices of firm constituencies. Assuming that a firm wants to build a reputation, the reputation can be gained even in the finitely repeated games (Kreps and Wilson 1982).
We treat reputation as a general perception of firm quality, based on different signals such as information about firm management, financial performance, quality of product and services, long-term investment value, innovativeness, financial soundness, reliability to perform contracts and promises, ability to attract, develop and keep talented people, community and environmental responsibility and the use of corporate assets. These are the factors included in the Fortune reputation ranking.
See http://www.prfirms.org/resources/research/harris/page4.asp).
In a theoretical model concerning central bank operations, the authors show that discretion, which motivates the agents to reveal their type (i.e., by complying with a general rule), can sometimes increase the credibility of the agent beyond what a regime of rules can. They show that it is often difficult to discover information about market players when most of their behavior is constrained by rules.
See Black (2001, pp. 2133–2134), footnote 2 for a brief overview of the literature.
The authors used the sample provided by the Credit Lyonnaise Securities Asia (CLSA) that constructed corporate governance rankings for 495 firms across 25 emerging markets and 18 sectors.
Here again we follow Berglöf and Pajuste (2005). We assign 1 point for detailed disclosure (i.e., remuneration and ownership separately by board members), 0.5 points for limited disclosure (i.e., aggregate shares held by managers) and 0 otherwise. In principle, the companies should disclose this information in their annual reports according to the provisions of the Transparency Directive. At the time of our analysis, Slovenian law only required firms to disclose the aggregate remuneration of their board members and to report on larger (5%) changes in their ownership structure. However, the enforcement of the stated rules remains unsatisfactory, with no real sanctions imposed. Hence, any disclosure of the above-stated issues in Slovenia can be still regarded as voluntary.
The level of disclosure is however still above most of the other Central and Eastern European countries (see Berglöf and Pajuste 2005).
The authors distinguish between soft information, which can never be verified by the receiver but is just cheap talk, and hard information, which on the other hand can be verified by the receiver, but it is usually assumed that both the disclosure and absorption are costless. Information in reality is somewhere in between; each degree of softness is endogenous (p. 1217).
We should point out that in the fall of 2006 the Government of Slovenia published a Privatization program, according to which state funds will start to sell their shares in Slovenian companies in the following years.
For instance, in 2005 a group of experts in Slovenia examined the Corporate Governance Code for the first time. The proposed changes, (to name only the few most important ones) included a more precise definition of firm goal (since it was not properly defined in the Slovenian Company Law), a better disclosure of conflict of interest and of the independence of the Management and Supervisory Board members, also with reference to Co-Determination as a specific of Slovenian corporate governance. All the changes were well received and were incorporated into the disclosure documents by most of the companies.
As Cooter (1998, p. 595) stated: ‘In reality, a combination of expression and coercion accounts for the effectiveness of many laws’.
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Appendices
Appendix 1: Quasi-experiment, “Pre-treatment”
Your number (to be used for all answers) □
Company Y is a large and successful company with shares listed on the Stock Exchange in country X. More than 4,000 mostly foreign shareholders own the shares. Until last year, Mr. Jan Kovac, a well-known businessman with a good reputation in the local business environment, guided the company. Mr. Kovac retired last year, after serving the company for more than 40 years. Upon the suggestion of Mr. Kovac the Supervisory Board nominates as the new CEO a young economist, Tom Fus, who arrived in the company during Jan’s presidency and has been working closely with Jan since then.
Soon after retiring, Jan got bored. He wanted some new challenges. He often went for lunch with Tom and other Management Board members from company Y. One day at lunch, one of the Board members suggests that Jan should continue being active and should get a position on the Supervisory Board of company Y. Jan is enthusiastic. Thus, at the subsequent shareholders’ assembly, the Management Board suggests the shareholders should approve the nomination of Jan as a member of the Supervisory Board of company Y. The members of the Management Board believe that Jan’s experience in the field will contribute greatly to the company’s success. Since one of the ‘old’ Supervisory Board members just resigned due to medical problems, the shareholders approve the proposition. Consequently, the information is published on the company’s web page.
You are thinking of investing in company Y and you’ve been following the company and its activities.
State your agreement/disagreement with the following statements:
(5-I strongly agree; 4-I agree; 3-I am uncertain; 2-I don’t agree; 1-I definitely don’t agree)
Appendix 2: Law
Your number □
Company Y is a large and successful company with shares listed on the Stock Exchange in country X. More than 4,000 mostly foreign shareholders own the shares. Until last year, Mr. Jan Kovac, a well-known businessman with a good reputation in the local business environment, guided the company. Mr. Kovac retired last year, after serving the company for more than 40 years. Upon the suggestion of Mr. Kovac, the Supervisory Board nominates as the new CEO a young economist, Tom Fus, who arrived in the company during Jan’s presidency and has been working closely with Jan since then. Soon after retiring, Jan got bored. He wanted some new challenges. He often went for lunch with Tom and other Management Board members from company Y. One day at lunch, one of the Board members suggests that Jan should continue being active and should get a position on the Supervisory Board of company Y. Jan is enthusiastic. Thus, at the subsequent shareholders’ assembly, the Management Board suggests the shareholders should approve the nomination of Jan as a member of the Supervisory Board of company Y. The members of the Management Board believe that Jan’s experience in the field will contribute greatly to the company’s success. Since one of the ‘old’ Supervisory Board members resigned due to medical problems, the shareholders approve the proposition. Consequently, the information is published on the company’s web page. In proposing Jan as the member of the Supervisory Board, the managers misled the un-informed shareholders and voluntarily violated article 10 of the Companies Act which explicitly states that: ‘A person who has been member of the company’s Management Board or member of the management of associated companies within the last 3 years cannot be appointed to the Supervisory Board’. In fact, the legislator doubts the objectivity of an ex-board member in exerting supervision over his ‘old friends’. However, given the court delays in country X, it would take a shareholder more than 5 years to get redress for the violation (when finding out that he/she was misled). The managers of company Y believe that the benefits from appointing Jan to the Board greatly exceed the costs of potential court litigation.
You are thinking of investing in company Y. Thus, you’ve been following the company and its activities.
State your agreement/disagreement with the following statements:
(5-I strongly agree; 4-I agree; 3-I am uncertain; 2-I don’t agree; 1-I definitely don’t agree)
Appendix 3: Soft law
Your number □
Company Y is a large and successful company with shares listed on the Stock Exchange in country X. More than 4,000 mostly foreign shareholders own the shares. Until last year, Mr. Jan Kovac, a well-known businessman with a good reputation in the local business environment, guided the company. Mr. Kovac retired last year, after serving the company for more than 40 years. Upon the suggestion of Mr. Kovac, the Supervisory Board nominates as the new CEO a young economist, Tom Fus, who arrived in the company during Jan’s presidency and has been working closely with Jan since then.
Soon after retiring, Jan got bored. He wanted some new challenges. He often went for lunch with Tom and other Management Board members from company Y. One day at lunch, one of the Board members suggests that Jan should continue being active and should get a position on the Supervisory Board of company Y. Jan is enthusiastic. Thus, at the subsequent shareholders’ assembly, the Management Board suggests the shareholders should approve the nomination of Jan as a member of the Supervisory Board of company Y. The members of the Management Board believe that Jan’s experience in the field will contribute greatly to the company’s success. Since one of the ‘old’ Supervisory Board members resigned due to medical problems, the shareholders approve the proposition. The information is published on the company’s web page. In approving Jan as a member of the Supervisory Board, the shareholders have disregarded the fact that Jan may not be objective in supervising the Management Board since, due to past collaboration, Jan and the Management Board members are ‘old friends’. In fact, ‘proponents of good business practice’ do not recommend appointing an old manager to the Supervisory Board. On the other hand, Jan has substantial experience in the business, which may largely offset the drawbacks associated with eventual conflict of interests or lack of objective supervision.
You are thinking of investing in company Y. Thus, you’ve been following the company and its activities.
State your agreement/disagreement with the following:
(5-I strongly agree; 4-I agree; 3-I am uncertain; 2-I don’t agree; 1-I definitely don’t agree)
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Gregorič, A., Zajc, K. & Simoneti, M. Agents’ response to inefficient judiciary: social norms and the law in transition. Eur J Law Econ 34, 147–172 (2012). https://doi.org/10.1007/s10657-010-9215-6
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DOI: https://doi.org/10.1007/s10657-010-9215-6