Legal Reform and Corporate Governance

Raju M.S. Malla, Kathmandu

Governance:Governance is the manner in which power is exercised in the management of a country's economic and social resources for development. In the development community, ' governance' came to mean a government's capacity to manage social and economic resources to attain development.' Good governance' came to mean effective government plus non-arbitrary decision making governance by rules, accountability, transparency and participation. Governance with "good order" denotes in the sense of having a system, based on abstract rules, which are actually applied, and on functioning institutions, which ensure the application of such rules. The system of rules and institutions is reflected in the concept of the 'rule of law', generally known in different legal systems and often expressed in the familiar phrase of government of law and not of men. The widespread absence of good governance emerged as a central social problem.

Corporate Governance: 'Corporate Governance' is a set of rules by which management of a company is directed and controlled. It includes a set of relationship between a Company's management, its boards, its shareholders and other stakeholders. Proper corporate governance goes beyond mere accountability and extends to include the protection of shareholders rights, the equitable treatment of all shareholders, the recognition of the rights of shareholders, the provision of timely and accurate information on all matters regarding the company, and the board's accountability to the company and to shareholders.

Good Corporate Governance standards are essential for a conducive investment framework and sustainable inflows of private capital. In particular, setting and enforcement of internationally accepted accounting and auditing standards, disclosures of financial and other information necessary for sound business decisions, prevention of insider dealing by management of companies or those privy to confidential information, protection of minority shareholders and their empowerment to prevent abuse of power, as well an efficient payment system need to be urgently promoted to instill investor confidence for growth of the financial sector.

The poor corporate governance practices including inadequate disclosures, lack of independent oversight and weak minority shareholders rends to discourage investment and weaken incentives for efficient management. The development of strong corporate governance is fundamental in the process of change.

Nepal's legal and regulatory environment is highly fragmented and inconsistent. This is particularly true of leading activities, which are regulated by various laws. The various laws governing the financial sector are not consistent and often in conflict with commercial and corporate and legislation in particular the companies law. This causes a high degree of in-transparency laws, rules and regulations allow for discretionary interpretation and lead to excessively high business transaction cost and lower private sector competitiveness. So as to there is an obvious need to streamline legislation in some important areas, such as companies, insolvency and Secured Transactions, are not adequately covered and require to reform to meet the needs of the market economy.

During a consultation mission for the CFG project in November and December 2000, ADB and HMG/N have agreed as mentioned below for the reform of Company, Insolvency and Secured Transaction Laws:

a) Reform of Company Law will include strengthening disclosure requirements for companies, introduction of provisions to regulate self-dealing by directors and controlling shareholders and strengthening minority shareholder's rights including allowing representative actions by minority shareholders to enforce good corporate governance.

b) Reform of Insolvency and Secured Transaction Laws will also contribute to good corporate governance as the potential use of efficient insolvency and debt enforcement procedures will discipline firms to only contract debts that they can service.

Legal Reform: In the wake of the worldwide trends to market liberalization and public sector restructuring has become a belated recognition of the need for a substantial reorientation of the role of the state in developing countries and in particular for the modernization of legal systems to ensure their inconsistency with the thrust of the macroeconomic reforms. A legal system supportive of private sector development permits the emergence of an agile and responsive private sector able to respond to the opportunities brought about by the new development strategies of developing countries. In providing the conditions for domestic business activity to flourish, the legal system also creates a climate of stability and predictability leading in turn to increased foreign investment in the economy.

The promotion of an active domestic private sector and the encouragement of foreign investment in developing countries require that the state assume responsibility for the development of a supportive legal environment capable of fostering the formulation and growth of private businesses and guaranteeing the integrity of contracts.

In this paradox lies the challenge of legal reform in developing countries. The design and implementation of legal reform in a market economy requires a governmental capacity in short supply. It requires a capacity to dismantle the old controls, restrain the bureaucrats, and develop laws and institutions, which are permissive rather than interventionist. And at the same time it requires that governmental processes become transparent and that the rules of the private sector development be stable and consistent.

To develop a legal environment characterized by respect for property tights by a law-making process capable of integrating business-oriented laws within the prevailing legal system and minimizing regulatory intervention and by legal institutions capable of implementing those laws in an efficient and transparent manner.

In countries with mature and well developed legal systems, the preparation of draft laws follows a high-level decision by the executive branch and is under-taken either by the responsible ministry or a centralized law drafting unit located in the Ministry of Law. In this way, reconciliation takes place of the conflicting interests of different ministries so that a single draft is adopted by the executive branch for consideration by the legislature.

The tradition of drafting laws is very different in most developing countries undergoing the transition to a market economy. A law is more likely to be promoted by a ministry as a means of acquiring power through the ability to control the terms of subsequent implementation by issuing rules or directives. The result is that little attempt is made to ensure consistency with the existing law or to provide clear and comprehensive standards. Instead, laws are often brief and ambiguous statements of policy and poorly harmonized with other laws or with any overall legal reform strategy.

In the reform phase, many of the new business laws do not have a natural constituency amongst the ministries. The consequence is that a struggle develops between ministries for control of the emerging area of influence. It is common for radically different legislative proposals to be put forward by one ministry or another in an attempt to capture the reform process. Unfortunately, this tendency is frequently exacerbated by a lack of coordination amongst bilateral and multilateral donors offering legal reform assistance. The goal of legal reform is to bring about a process of evolution of laws and institutions to support the development of an efficient private sector. The reform process is also linked with other factors critical to its success. The manner in which reforms are designed and implemented has profound implications for the sustainability of the reforms themselves and sends a clear signal to the private sector as to the governments' commitment to the quality and integrity of the legal system. So a careful approach to reform involving wide consultation with the private sector and a willingness to consider openly the merits of solutions achieved in other countries will significantly increase the confidence of domestic and foreign investors in the resultant changes. Conversely, the preparation of business laws without interaction with private sector representatives or a careful search for the best solution may delay rather than advance the reform program. Poorly designed reforms may fail to deal with the principal obstacles faced by the private sector. And they will as a result cast doubts on the government's commitment to promoting the rule of law.

Problems of Legal Reform: The successful adoption of complex elements of business law from advanced market economies and their incorporation into a non-market oriented legal system is particularly difficult to achieve. Such laws did not develop in isolation in market economies, but often grew organically over time through a process of interpretation and application. A body of law such as contract law has numerous components, which must interact with each other and with other large complex bodies of law such as securities law, corporate and labor law. Laws are also adapted to the existing institutions in a society. Business laws as those dealing with bills of exchange, securities markets and the prevention of unfair competition will be a "dead letter" without the capacity to develop institutions and processes required to implement those laws.

Imported laws reflect the intricate legal and socio-economic environment in which they evolved. When they are transplanted to a country with different value, the results may be different from those in the host country. Economic laws do not by and large work through a heavy reliance on sanctions imposed either administratively or through the courts, but rather operate as a permissive framework to encourage market participants to adapt their behavior. If the law is not compatible with existing legal and social norms, t is likely that the parties will either prefer to choose other informal alternatives or, to the extent that they choose to comply, recognize that enforcement is problematic.

In developing countries where the skills to translate policy decisions into effective laws are particularly scarce, the approach to legal reform should focus upon modest incremental change, using the existing body of laws to the greater possible extent in the transition. Wherever possible, existing laws should be modified rather than replaced, so that officials, lawyers and judges have a frame of reference to start the process of implementation.

Paper presented by the author at a seminar organized by CDG and Focal Point for Financial Sector Reforms in Kathmandu on June 21, 2002. Thanks to Dr. B. K. Maskey of the CDG. Chief editor.

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