This paper develops a framework to analyze consequences of the fact that informal institutions play a greater role in corporate governance in emerging economies than in OECD economies (Peng & Heath, 1996). This role is ambiguous however: informal institutions can improve the functioning of corporate governance or they can undermine the formal corporate governance institutions, and we see both patterns across the BRIC economies. In contrast, the bulk of informal institutions are probably usually complementary in most OECD economies.
We will argue below that in China and India, the informal institutions for corporate governance are largely substitutive in that they compensate for ineffective formal corporate governance institutions but the goals are not in conflict with those of the formal institutions. However, Russia has competing informal institutions for corporate governance in that the effectiveness of the formal institutions is undermined through corruption and lack of enforcement and the goals of the agents in informal institutions conflict with the goals of formal institutions. Interestingly Brazil has accommodating informal institutions for corporate governance in that the effectiveness of the formal institutions is largely good, but informal institutions have different goals from the formal institutions and are used to get around what are seen to be overly restrictive formal institutions.
In terms of overall effectiveness of their formal corporate governance institutions, we see, in Table 3, a distinction between India, China, and Russia where effectiveness is low due to weak rule of law, poor enforcement, and high corruption, and Brazil where effectiveness overall is high, apart from the inefficiency of its judiciary, with a strong rule of law, strict enforcement, medium levels of corruption, and a low risk of expropriation.
Table 3 How effective are formal corporate governance institutions.
China
A favorable environment for firms and creating supportive goals between owners and local states and government officials (Ahlstrom, Bruton, & Yeh, 2008) has been constructed in China via informal institutions in a variety of ways. The informal institutions that compensate for unclear corporate ownership and rights of investors are those that build the legitimacy of private firms in the face of uncertain legal rights (Ahlstrom et al., 2008). As Ahlstrom and colleagues quote “There’s nothing to keep the [Chinese] Government from taking those private assets back … One year things are open and everyone can prosper; the next year the Government decides to collect everything for the state” Cao Si-yuan, senior adviser to former People’s Republic of China General Secretary Zhao Ziyang. The perceived governance danger in China is therefore not misappropriation or tunneling by concentrated owners vis á vis minority shareholders (although this may be an issue). Instead it is establishing private ownership rights as against the state, where the default position is that the state may assume ownership and control of all assets. For instance, many private businesses in China were founded before it was legal to possess private property, or when it was legal but bypassed many of the bureaucratic regulations for such businesses, combining state and private assets. The owners of private companies fear that the government might challenge their right to exist and appropriate assets. In the light of this, Ahlstrom and colleagues (2008) emphasize the various types of informal institutions that are used to establish legitimacy and to protect the firm in the light of unclear or ineffective formal institutions. These include cultivating relations with government officials, taking over ailing state-owned enterprises, donating services to the local community, and concealing the private nature of ownership (Ahlstrom et al., 2008).
Tipton (2009) argues that the Chinese state since the 1980s has the attributes of fairly high state direction (although lower than in the earlier period) alongside low state capacity and the ability to enforce the legal regime. According to Wang Hongying (2000) Chinese legal institutions have been either ineffective or irrelevant. Private ownership of companies has only relatively recently been made legal and has remained politically less favored than state or collective ownership and there remain ambiguities in enforcement of private ownership rights, which are susceptible to government intervention and expropriation. As Heugens and colleagues (2009) argue, China combines a situation of weak ownership protection and weak rule of law, in which concentrated ownership ceases to substitute and be an effective corporate governance strategy.
However, informal institutions can neutralize or compensate for these weaknesses in shareholder protection and rule of law. Tsai (2006) emphasizes “adaptive informal institutions and endogenous institutional change in China” in the area of private ownership of companies. Informal interactions between the local state and private entrepreneurs have underpinned and legitimized formal institutional reforms in favor of private property rights. The formal institution of state ownership has remained in place in many cases while the substantive role has changed dramatically. There has been “institutional conversion” where actors “quietly appropriate formal institutions to serve their own ends” (Tsai, 2006) when there is a gap between the original intentions of the formal institutions and the aims of local actors. This institutional adaptation or conversion can only occur when there is a convergence of aims and incentives between the enforcers of formal institutions and the creators of informal adaptations, in this case the local state and private owners of companies. Both local state and private owners mutually benefit from arrangements that transgress the formal institutional rules, and have ignored or not enforced those rules, creating substitutive institutions of private company ownership. For example, this has been done through disguising private ownership—wearing a red hat (dai hongmaozi)—where a business is registered as a collective enterprise whereas in practice it is privately owned and managed; or registering a private enterprise as an appendage to a state-owned one, a so called hang-on enterprises (guahu qiye). Red hat enterprises were particularly prevalent in the first decade of reform when privately-owned enterprises with more than eight employees were illegal. In many localities over 90% of collective enterprises were privately-owned but with disguises of red hats. Local party officials have been complicit in sanctioning this arrangement. In the Eastern provinces of Fujian and Zhejiang, large numbers of private firms were registered as collectives to avoid stifling regulations and have remained registered as such (Huang, 2005; Wank, 1996), whereas in Guangdong province, with its longer acceptance of private enterprise, these concealment strategies have not been so necessary.
Formal regulation of private enterprise has adapted to these informal arrangements by legalizing their existence. From 2001, private entrepreneurs were invited to join the Chinese Communist Party. However, Party members continued to use the disguise of wearing a red hat as there remained political criticism of private entrepreneurs’ “spiritual pollution” and “bourgeois liberalization” and harassment by tax collectors and bureaucrats. Tsai (2006) gives an example of a furniture manufacturer in Hebei province that had run a state-owned enterprise as a Communist Party member for 12 years; he set up his own business in 1991 under the disguise of a red hat, registering it as a collective enterprise. He continued in the local People’s Congress and was heralded as an “upstanding red capitalist.”
Other strategies that firms have taken to build the legitimacy of their private enterprise include choosing geographical localities where it is known that private enterprise is more acceptable; by taking over ailing state-owned enterprises especially in poorer regions of the country in order to gain approval from both the provincial government and from the central government; through using very long-standing relations or clan ties which confer legitimacy; through reciprocal relation-building including giving gifts and holding receptions (Peng & Luo, 2000); allying with foreign firms whose legitimacy was already accepted and whose presence was welcomed; through establishing guanxi with local officials, party cadres, village committees, and the judiciary (Ahlstrom et al., 2008). For example, visits by senior government officials have been seen as conferring approval and have lead to preferential terms for bank loans and government support.
In terms of relationships between investors more generally and the firm, Chinese capital markets are under-developed and banks continue to be state-owned and dominated by local state funding priorities. Chinese family-owned firms rely heavily on informal sources of finance such as family networks (Appendix Table A1), particularly small private firms with lack of access to bank finance. Entrepreneurs go to unofficial and illegal credit institutions, not qualifying for credit from state-owned banks which favor strategically important firms at the expense of SMEs. Private credit and underground credit institutions have flourished, relying on personal connections and reputation and SMEs have to borrow from such illegal institutions at very high rates (Tian, 2007). Again these informal institutions are countenanced officially and are seen not to conflict with the aims of formal legal institutions.
India
In India, despite shareholder and creditor rights formally having been well set up, there are issues in terms of how effectively these rights are enforced. We noted that in part this is a regional issue, with some states having effective legal rights and in others (such as Bihar) the rule of law not being well established. Overall, as Table 3 shows, in terms of effectiveness, India fares poorly on the rule of law and corruption indices compared with the average in the sample, although the efficiency of the judiciary is good and the risk of expropriation is low. Lee and Oh (2007) distinguish between the pervasiveness and arbitrariness of corruption, arguing that pervasive corruption without arbitrariness does not detract from growth and investment, in that it is predictable and can be built into firms’ calculations of cost. Arbitrary corruption on the other hand, even with fairly low levels of pervasiveness, is off-putting to investors, especially foreign investors, in that its uncertainty and unpredictability make dealings more hazardous. They place China and India as both having pervasive corruption, but India having arbitrary corruption in addition, which would tend to undermine formal institutions and place greater onus on the role of the informal institutions in the governance of firms.
In India, we would argue that the most important informal institutions, to interact with these formal governance institutions, are those associated with business groups. We discussed above the extensive ownership and control of firms by families and business groups in many Asian countries, including India. The issue for this paper concerns what role these groups play—do they fill an institutional void by giving access to resources through informal, private networks, or do family-controlled firms discriminate against outside shareholders, have more difficult agency conflicts within the family, and lead to worse performance of firms from the point of view of shareholders? Douma and colleagues (2006) find positive effects on performance of concentrated corporate ownership by foreign and domestic corporations (as distinct from foreign or domestic financial institutions), in particular when affiliated to a business group. Peng and Jiang (2006) find that the net balance of benefits and costs of family ownership and control in large firms depends on the legal and regulatory institutions for investor protection: that high family ownership concentration is beneficial when formal legal institutions are weak. Heugens and colleagues (2009) supports this finding—that when there is less than perfect legal protection of minority shareholders, ownership concentration is an efficient corporate governance strategy. But they also find that a certain threshold level of institutional development is necessary to make concentrated ownership effective. Where owners can extract private benefits from the corporations they control, then such concentration is not beneficial to firm performance.
Li, Ramaswamy, and Pécherot Petitt (2006) argue that the business group structure is a horizontal strategy of diversification that is particularly suited for dealing with the market failures associated with failures in capital markets and in the managerial labor market. Capital markets in India fail because they are weak and shallow and limit any company’s potential to obtain money to fuel expansion and growth (Khanna & Palepu, 2005; Khanna & Yafeh, 2005). In most emerging economies, equity is a small part of capital raised and access to debt capital is controlled by a handful of banks which act according to government priorities in the industrial sector. Usually access to foreign capital is relatively limited as well, due to weak governance norms (Li et al., 2006). Large business groups overcome financing obstacles, creating an internal capital market and enabling the different firms within it to compete for funds.
This summary of the literature as well as our cases (Estrin & Prevezer, 2010) lead us to conclude that the informal institutions of corporate governance in India are substitutive—that they replace the largely ineffective formal legal framework and capital markets but have non-conflicting aims or goals with those of formal institutions. This applies mainly in those states where the rule of law, crime, and corruption are not so arbitrary as to create conflicting goals between the business groups and the formal legal framework.
Russia
Although Russia’s formal corporate governance codes on paper are comparable to OECD standards, its formal institutions are ineffective due to lack of enforcement and a gap between the “virtual economy” (Maddy & Ickes, 1998) reflected in official statistics and company reports and reality. In practice, the concentrated financial industrial groups (FIGs) owned by so-called “oligarchs” (Estrin, Poukiakova, & Shapiro, 2009) have been rent-seeking and stifling of entrepreneurship (Aidis, Estrin, & Mickiewicz, 2008) and have conflicting aims with the formal rules of the legal framework and institutions.
As Heugens and colleagues (2009) argue, for ownership concentration to be beneficial for the performance of firms, there needs to be a certain degree of institutional development as measured by the rule of law in the absence of strong legal protection of minority shareholders. In the case of Russia, the formal rule of law and protection of minority shareholders is undermined by lack of enforcement and arbitrary corruption. The identity of the concentrated shareholder also matters; Heugens and colleagues (2009) distinguish between market (arm’s-length) investors, stable investors such as affiliated firms or banks with multiple ties to the firm, and inside investors who combine concentrated ownership with managerial control. They find that different kinds of concentrated owners have different effects on performance. If there are strong formal institutions in the form of effective rule of law, then even if there is low protection for minority investors, there is a spread of returns between market and other investors as market investors can nevertheless rely on recourse to the courts to enforce their rights against tunneling. This is not the case in Russia, with insider investors, ineffective rule of law, and a weak judiciary. It is argued that even with a clear legal claim, there is a danger of losing assets through the corruption of the judicial system and administration. The Yukos affair illustrated the selectiveness of the application of the law and insecurity of shareholding rights (Luo, 2007).
The private benefits (tunneling) of concentrated shareownership and control can come in various ways: formal legal protection can be circumvented by dominant shareholders through the lack of capacity or willingness to monitor corporate governance. There may be opportunities for tunneling through corruption in enforcement of codes, in the recognition of formal ownership rights, in the operation of the courts, in the ability of the government to take on the dominant owners, or through transfer prices of assets being negotiable, or providers of assets or products being negotiable (Heugens et al., 2009).
Russian companies are characterized by inside investors, combining concentrated ownership with managerial control in part as a result of the way in which privatization occurred.
The failure of the rule of law in the 1990s, primarily due to non-enforcement, gave rise to enormous freedom for enterprise managers to conduct business. This allowed managers to enrich themselves by legitimate but also illegitimate means—through dishonesty, manipulation, and criminality (Puffer & McCarthy, 2003). Accountability for enterprise directors broke down in the 1990s and excesses and abuses have stemmed from that period. Privatization was carried out in 1993 and 1994—initially through a voucher system that was manipulated in favor of existing enterprise directors (Estrin & Wright, 1999) and managers were able to buy shares from workers and others at low prices which did not reflect the potential value of such ownership. Newly entrenched manager-owners were able to use their concentrated ownership to abuse minority shareholder rights and rights of joint venture partners through asset stripping and capital flight. These managers combined dominant ownership positions with managerial control and hence no constraints either on managerial behavior or on dominant inside shareholder power existed. There was privatization but with no supporting institutions to create a culture or mentality of accountability (Earle, Estrin, & Leshchenko, 1996). What Puffer and McCarthy (2003) call the nomenklatura stage in the late 1990s depicts the control over the economy going to the business-government elite with a number of privileged players enriching themselves and the emergence of a number of leading oligarchs. This consisted in a reciprocally lucrative alliance between bureaucrats and businessmen and the creation of powerful financial industrial groups including Menatep, Onexim, Inkombank, and Alfa (see Estrin et al., 2009).
Core shareholders have disproportionate influence on management and both are able to take advantage of minority shareholders. The abuses of shareholder rights have occurred in primitive ways such as not allowing shareholders to come to meetings, taking shareholders’ names off registers, and forcing them to fight it out in the Russian courts (Fyodorov, 2001), diluting capital by issuing stock to majority shareholders, non-compliance with disclosure requirements, unfair transfer pricing, unlawful transactions, and fictitious bankruptcies (Puffer & McCarthy, 2003). The loans-for-shares scheme in 1995 was a further abuse whereby leading oligarchs gained further shareholder power in exchange for supporting Yeltsin’s reelection. This is described as an incestuous relationship between top businessmen and government officials with no transparency, accountability, or disclosure (Puffer & McCarthy, 2003). Since the crisis of 1998, there has been increasing state involvement in business affairs. It is argued by Buck (2003) that this marks a return to centuries-old involvement and direction by the state in Russian business affairs and that the hostility to outside investors, especially foreign investors, also has long historical roots. It is rare for any company to have more than 20% of its shares in free float and available for purchase. State influence has consisted in strong personal links between private owners of the blue-chip mainly non-manufacturing companies and the government; the Ministry of State Property still remained a majority shareholder in over 12,000 state-owned enterprises and a minority shareholder in over 3,800 companies in 2002; the state held 38% of shares in Gazprom, valued at 8% of Russia’s GDP in 2002, and assets are managed via state boards composed of members of ministries and agencies (Buck, 2003).
Despite some signs of Putin attempting to restore greater accountability and protection of minority shareholders, since the early 2000s there has been a movement of additional government involvement as a solution to corporate governance abuses. However, government involvement in business affairs, despite passing a new code of corporate conduct in 2002, has led to further abuses of power and lack of independence of the judiciary from the state. The entanglement between the government and Yukos has increased the impression of corruption in corporate governance.
The distinctive similarity between China and Russia lies in the role of the state considered in both cases as a type of informal institution in the sense that the state’s rules are not clear, stable, codified, nor transparent in either case. But the difference between them lies in the non-conflicting complementary goals that the state has vis á vis company owners, in China—both company owners and local states are more interested in fostering economic growth and both will do or not do whatever is necessary to gain legitimacy to achieve this. This in large part means a de facto enforcement of ownership rights and various types of regulation. The Russian state does not have mutually complementary goals with most large concentrated owners of firms—its enforcement of laws is seen as arbitrary and hostile to the independent running of companies; there is a sometimes antagonistic relationship between the government and oligarchs and corruption takes the form of arbitrary inspections, asset stripping, lack of independence of the courts and their use for going after business leaders out of line with government policies. Moreover, large concentrated owners do not have complementary goals with minority shareholders. Corporate governance abuses therefore come from both the concentrated inside ownership with abuse of minority shareholders through asset stripping, capital flight, tunneling of benefits out of the firm, and through abuses by the Russian government in its involvement in business affairs and in its use of the rule of law vis á vis large oligarchic shareholders.
Brazil
Tables 2 and 3 indicate good formal corporate governance indices for Brazil comprising quite good shareholder rights, strong rule of law, and low risk of expropriation and there has been an improvement in corporate governance codes. However, there is a weak judiciary and weaker investor rights than the average for the sample. Nevertheless, corruption is not arbitrary (Appendix Table A3) although the judiciary is inefficient: Brazil’s laws allow many appeals so that even fairly trivial cases end up in high courts, with enormous backlogs and huge delays. Life is difficult for companies that pay taxes and comply with labor laws so Brazil has a large black economy. Companies in the formal economy are forced to abide by expensive and enforced rules (Economist, 2009).
All measures of regulation of firms and its enforcement place Brazilian firms as very highly regulated in the formal economy (Appendix Table A2), especially with regard to regulations over hiring and firing labor. This forms part of a wider corporate governance picture of tightly enforced formal laws and regulations leading to the rise of the informal economy with the aim of getting around those rules. The World Bank Doing Business survey ranked Brazil 150th out of 183 countries in ease of paying taxes, hiring and firing is complicated, and on ease of starting and closing a business Brazil placed 37 out of 43 countries surveyed by the World Bank (World Bank, 2005). Dyck and Zingales (2004) estimate the value of private benefits extracted by dominant shareholders across a sample of countries. Their estimates range from close to zero for most OECD countries (but not all) to 65% of firm equity in Brazil.
We conclude that the effectiveness of formal institutions in corporate governance in Brazil is high in that the rules are good and enforced. Our argument is that they are too tightly enforced and that this gives rise to the pervasive informal institution of the shadow economy—both companies opting out of formal legal obligations and entering the black economy and tunneling out of formal companies by shareholders in a position to do so. Thus the character of Brazil’s informal institutions derives from its large black economy and the role of informal institutions is to get around formal rules. Brazil therefore has accommodating informal institutions in that there are effective formal but incompatible goals between formal and informal institutions. What we mean by this is that informal institutions—of corruption, of the black economy—are engaged in getting around the formal rules that are perceived to be overly enforced and over-tight. They do not undermine the formal rules but find ways of reconciling the conflicting aims of one group with another.