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ECONOMICREFORM Feature Service® February 15, 2011

Modernization: Corporate Governance and Innovation Igor Belikov Director, Russian Institute of Directors Vladimir Verbitskiy First Deputy Director, Russian Institute of Directors Aleksey Ponomarev Professor, State University Higher School of Economics

Article at a glance • Russia’s experience shows that successful modernization must go beyond introducing new manufacturing technologies and focus equally on improving management and corporate governance practices. • Good corporate governance is crucial for effective management of enterprises as it determines whether managerial and technological innovations can be successfully implemented. • The improvement of management and corporate governance approaches in Russian enterprises, both private and state-owned, is the pre-requisite for modernizing the economy as a whole.

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The debate over Russia’s modernization policy and how to create a modern economic model and spur economic development began with the issue of how to modernize the country’s technical and technological infrastructure. Certainly, introducing new technological solutions – both domestic and foreign – and building a foundation for their long-term growth and adaptation are enormously important parts of this effort.1 However, experience in both the Soviet and post-Soviet periods demonstrates that a policy based primarily on implanting new technological solutions and manufacturing processes into the existing management and governance practices is not a recipe for success. Perhaps the clearest example of this is the automaker AvtoVAZ, which was considered to be an advanced manufacturing facility when it was acquired from Fiat. However, in a relatively short time, AvtoVAZ has lost the manufacturing quality standards that Fiat’s plants were known for. The Russian company demonstrated a total inability to grow its capacity to design and produce new car models that reflect contemporary international trends. This became clear by the early 1990s. In the nearly 20 years since the end of the Soviet Union, the situation has not only not improved – it has gotten worse. AvtoVAZ is stark reminder that advanced technologies and manufacturing processes do not work unless they are backed by similarly advanced management techniques. The overwhelming evidence is that the management practices at AvtoVAZ, if they have changed at all since the Soviet era, have not moved in the direction of effective international standards. Across various industries, many examples show that the key to successful modernization, both at the industry level and at the national level, is to combine advanced manufacturing technologies with effective management and governance practices. Similar examples can be found in industries where success is less dependent on the technical aspects and more on a creative approach, which is considered to be Russia’s biggest strength. Extensive data on management approaches and the

Modernization: Corporate Governance and Innovation

quality of management in the Russian economy indicate that technological innovations, whether domestic or acquired from abroad, succeed only when they are implemented along with modern management and governance practices. Several of the most illustrative cases are described below. Studies show that when the quality of a company’s management improves by one point (on a five-point scale), labor productivity and equity both increase by 65 percent.2 However, according to a study conducted by the Institute of Comprehensive Strategic Research (ICSI) in 2006 and 2008, only 5 percent of Russian companies surveyed are working systematically and consistently to improve management. Top executives at 56 percent of the companies surveyed stated that they had no plans to work on this issue.3 Only 2-7 percent of Russian companies are making systematic efforts to improve productivity, compared with 35-80 percent of American companies,4 at a time when labor productivity in the Russian economy is only 17 percent of the level in the United States. Therefore, we believe the decisive factor, on which the success of the policy to modernize and create a new model of the Russian economy depends, is the introduction of modern management technologies. The success or failure of this policy will determine the outcome of efforts to implement technological innovations: “The biggest thing holding us back is inefficient business processes, not obsolete equipment or technological processes. Poor management is 1.5 times more devastating than obsolete equipment.”5 It is hard to disagree with this statement. Management is a very broad term. It includes such diverse concepts as enterprise resource planning (ERP), customer relationship management (CRM), business intelligence, International Financial Reporting Standards (IFRS), international professional standards for internal audits, risk management, quality management systems, lean manufacturing technology, balanced scorecard, and key performance indicators. Moreover, we are convinced that modern corporate governance is key to effective management and determines whether –2–

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other management tools, including the ones described above, can be successfully implemented and whether technological innovations can be used efficiently. The reason is that corporate governance provides the system for developing key solutions, controlling their implementation, and making adjustments at the top level – the level at which the company’s shareholders and their agents exercise strategic management and control. Advanced corporate governance encompasses the following important processes, the quality of which are crucial to the successful growth of companies and, therefore, the entire economy: • Developing a business strategy with input from shareholders, stakeholders (groups significantly affected by the company’s actions, such as employees, creditors, customers, suppliers, and the public in surrounding areas), and the people who will be responsible for implementing the strategy (the company’s management); • Identifying and defining the set of indicators that will be used to evaluate the company’s performance and to create incentives for the management (including the use of advanced technological and management solutions);

Advanced manufacturing technologies do not work unless they are backed by similarly advanced management techniques. timeline for introducing other management tools and technical innovations, creates an incentive system for the people who are responsible for implementing them, and evaluates the performance of the company and its executives. A company’s corporate governance determines its management culture and decision-making style, which convey down to the level of executive and operational management. This creates new workplace practices and allows the company’s human resources at all levels to be more involved in management processes. The logical conclusion is that companies must pay attention to the substance of modernization as well as the manner in which it is carried out. The right process can be just as important as the substance.6 Russian companies in particular need a breakthrough in using human resources effectively and creating a new management culture. For the countries that have made great strides in modernization over the past decade, the primary factor in their success is introducing a critical mass of management techniques and technical innovations.

• Assessing the risks that the company could or even should take in order to become a leader in its industry, determining how to manage these risks effectively, and defining risks that are unacceptable; • Monitoring how well the management acts in accordance with the company’s goals and objectives and uses the company’s existing assets. The modern standards of corporate governance are designed precisely for these purposes and essentially play a key role in realizing these processes. Corporate governance is the level at which the company makes decisions about the scale and –3–

This economic and social effect is produced only by innovations that are applied on a massive scale, which can happen only when the proper management culture is in place and the company’s full human potential is brought to bear. Russian companies are experiencing especially serious problems in these areas. For example, lean manufacturing technologies, which are based on these factors, are being introduced in 80 percent of American companies but only in 5 percent of Russian companies.7

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Implementing advanced corporate governance principles involves the following key steps (see picture):

The most important step in creating a system of corporate governance is to establish a board of directors for a company or bank that has a good balance in terms of its members’ experience and professional skills and the structure of the board. One good practice is for the banks that are the company’s strategic creditors to be represented on the company’s board of directors. This became more common during the last economic crisis in Russia, but experts have recommended it before.8 The experience of leading companies in other countries shows that a board of directors is much more effective when it establishes committees. Committees assist the board by making a preliminary review of issues that require more in-depth analysis, closer monitoring, or special knowledge. As the foundation of an effective system of internal financial control and risk management, a company should also have internal audit staff that answers to the board of directors and a riskmanagement committee within its executive hierarchy.

Modernization: Corporate Governance and Innovation

Developing and implementing effective corporate governance policies is particularly important in these key areas: keeping records of shares held by shareholders; disclosure of information and transparency in the company (information policy); financial reporting and independent audit; payment of dividends (dividend policy); incentives (compensation) for executives and audit staff; company procurements; evaluating the performance of the board of directors, its committees, and the management; corporate social responsibility; and assessment of corporate governance (rating). The credit rating is a generally accepted indicator of the financial condition of a company (although the economic crisis has revealed serious problems with the way these ratings are calculated and assigned). A corporate governance rating should be used as an indicator of the overall quality of this set of management processes because, as we mentioned above, they are essential to the successful implementation of other management tools. A company’s corporate governance policies are implemented through corporate governance procedures (for example, a procedure for preparing and holding board meetings, rules for disclosing information, and bidding procedures for corporate purchasing of goods and services), which facilitate the effective operation of its management bodies. It should be emphasized that introducing modern corporate governance does not mean instantly creating all of the formal components listed above in the same way in all companies. Unfortunately, we have seen this approach in many companies. Rather, the goal is for each company to develop and implement the model of corporate governance that is most appropriate for it, based on factors such as the company’s stage of development in the corporate life cycle, the company’s strategy, the extent to which its major shareholders need to be involved in its management, the role of the company in their investment portfolio, and


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the amount and types of outside financing the company needs.

much more directly involved in the national economy in recent years; and second, companies and banks in which the government owns shares generally have worse corporate management practices than private companies of comparable size. The economic modernization policy should include supporting liquidity, stimulating demand, subsidizing research and development, and providing assistance in purchasing new technologies from abroad. This policy should also incorporate a strategy for introducing new management approaches, particularly in the field of corporate governance.

All of Russia’s major businesses face the need for significant improvements in the quality of their corporate governance. In recent years, corporate governance practices have improved in Russian companies, particularly in a small group of leading private companies and in certain companies in which the state has a controlling interest. Overall, however, serious problems persist in corporate governance practices. First, even in leading Russian companies, good practices have been implemented only to a superficial extent compared with leading Western companies, and only on a relatively modest scale – in perhaps the largest 100 companies.

If the government really wants to demonstrate its commitment to modernization, it should introduce effective management technologies in the companies and banks in which it owns shares, stop micro-managing them, and let them become leaders in their industries. In these businesses, the government has the opportunity to create boards of directors that understand the connection between management tools and technical innovation and can create the right system of incentives for top executives.

Companies that implement advanced corporate governance standards generally show improvement, including in their ability to introduce key management tools and technical innovations. However, these improvements are usually more modest than those seen in leading foreign companies in comparable industries. The main reasons for this are the serious defects in the macroeconomic and regulatory environment for doing business in our country, the most important of which are the high level of monopolization in many industries, the resulting lack of competition, and weak protections of private property rights.

Government agencies fully understand what their representatives on the boards of partially state-owned companies need to do. As Sergey Sobyanin, head of the Presidential Administration, said in an interview: “Government representatives in companies should demand that the management: (a) increase productivity; (b) use energy-efficient technology; (c) reduce costs; and (d) develop innovative products. I believe that setting these goals is the sacred duty of the people who represent the government in these companies.”9

In this environment, a small number of mostly big businesses can earn huge profits without really implementing good management practices or modernizing their production facilities. However, the majority of shareholders do not feel they can rely on the government to respect, much less protect, their property rights, so they are interested mainly in short-term performance and maximizing profits while minimizing costs and the hard work of running a company.

As an example, a significant portion (from 35 to 50 percent) of the annual compensation and most of the deferred (by 3-4 years) compensation paid to top executives should be based not only on the company’s financial results, but also on factors like changes in the percentage of the company’s revenue from goods and services produced using advanced technologies; changes in the company’s market share for these goods and services on domestic and

Special attention should be given to the need for significant improvements in corporate governance practices in companies and banks in which the government owns shares. This is important for several reasons. First, the government has become –5–

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Modernization: Corporate Governance and Innovation

foreign markets; introducing and effectively using the modern management techniques described above; the trend in productivity at the company in comparison with companies of similar size and in comparable industries that are leaders on world markets; creating an effective system to recruit and develop managers; and changes in the company’s corporate governance rating. If their compensation was actually linked to these performance indicators, executives would be motivated to develop and implement a system to achieve them. Boards of directors should review and evaluate the system. Perhaps the top executives of companies and banks in which the government owns shares should also be required to receive professional training (for example, managers in certain positions would be required to earn an MBA from a top Russian or foreign business school within three years). Using the board of directors as the key mechanism for innovation in management and technology is especially important in large companies in which the government has a controlling share and in government-owned companies. Since these businesses often have a monopoly or a near-monopoly on their markets, the power of market forces to stimulate innovation is very limited. Because companies and banks in which the government owns shares play such a large and important role in Russia’s economy, introducing advanced management approaches in them would have a major impact on the whole economy. If these companies and banks successfully implemented such technologies, they could then require their private sector partners to adopt advanced corporate governance standards and other advanced management practices as a condition of doing business together. This would create a multiplier effect, spreading the process of improving corporate governance and introducing new management tools to an ever-greater number of businesses.

Poor management is 1.5 times more likely to hold back the economy than obsolete equipment.

Generally, the main reason that private firms adopt corporate governance standards is to attract new shareholders and deal with general risks associated with the company’s business operations. By contrast, for companies and banks in which the state owns shares, including 100 percent stateowned businesses, the need to implement better corporate governance arises from the public nature of state property and the fact (which we often forget) that every citizen of the country is a coowner of the state’s property, in theory at least. The Organisation for Economic Co-operation and Development, to which Russia has applied for membership, emphasizes this issue and has issued a set of recommendations for corporate governance in state-owned companies.10 In 2008, for the first time, some Russian companies and banks in which the state has a controlling interest took steps to change their corporate governance practices, which had remained the same since at least the early 2000s. In several of these companies and banks, many of the government employees who served on the boards of directors were replaced with independent directors and professional attorneys. This trend became more widespread in 2009. In most of these companies and banks, between one-fifth and one-third of the seats on the board of directors are now held by independent directors elected with the votes of shares held by the state. In some companies, like AHML (Agency for Housing Mortgage Lending) and Svyazinvest (Russia’s largest telecom holding company), independent directors and professional attorneys have a majority on the board. –6–

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Changing the membership of boards of directors could be seen as the first step in changing the very management model the government uses in companies and banks in which it owns shares. Yet, that will only happen if this step is followed by comprehensive and ongoing efforts to improve corporate governance practices in these businesses. If bringing the institution of independent directors to state-owned companies and banks is seen as a sufficient change in itself, then these businesses will likely not succeed in becoming more effective, and the institution of independent directors will be discredited, at least with respect to state-owned companies and banks.


This article was originally published in Russian in Economic Strategies, No. 9/2010, pp. 22-27. It has been translated and re-printed by CIPE with the authors’ permission. _____________________________________________

Igor Belikov is the Director of the Russian Institute of Directors, member of the Expert Council on corporate governance at the Russian Federal Service on Financial Markets, and co-author of both the Russian Code of Corporate Governance and the first National White Paper on Corporate Governance. He also has served as a board member in several major Russian companies, including Lukoil, Uralsvyazinform, Akron, UTK, Sibirtelekom, and Astrahanenergo.

The systematic introduction of advanced management techniques in areas such as corporate governance is an important part of the overall modernization issue and the effort to bring about a qualitative breakthrough for the Russian economy and society as a whole.

Vladimir Verbitskiy is Deputy Director and head of the national registry of corporate directors and consulting services at the Russian Institute of Directors. He is also a member of the corporate governance committee at the Association of Regional Banks, the corporate governance and investment committee at the Association of Managers of Russia, and the board of the Russian Union of Industrialists and Entrepreneurs. Verbitskiy has served on boards in a number of Russian corporations and is also a member of the Presidential Committee on development of the future generation of management leaders. He has written extensively on corporate governance.

Endnotes Livanov D. Ponomarev A, “The three imperatives of the technological policy,” Ekspert 5 (2009). 2 Guriev S. Civinski O, “Foreign heads,” Vedomosti, February 16, 2010. 3 “The Minority of Frugal,” Vedomosti, March 3, 2010. 4 Krasnova V. “The Truth is in man-hours.” Ekspert 2, (2010): 51. 5 Guriev S. Civinski O, “Foreign heads,” Vedomosti. February 16, 2010. 6 “Modernization in proposed conditions,” Ekspert 1 (2010): 4. 7 “The Minority of Frugal,” Vedomosti, March, 3. 2010. 8 Belikov I, Verbitskiy V., “Attracting investment and corporate governance among medium companies,” Company Governance (2007): 4. 9 Sobyanin S. “Higher modernization compulsion,” Ekspert 43 (2009): 52. 10 OECD Corporate Governance Principles for State-Owned Enterprises, OECD (2005). 1

Aleksey Ponomarev is Deputy Minister of Education and Science of the Russian Federation. From 2001-2010 he has served as the scientific adviser of the Institute of Training and Re-training for specialists in defense complex. He is also a professor at the State University in the Higher


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School of Economics. Ponomarev graduated from the Moscow Institute of Physics and Technology (1982), the Military Academy of Peter the Great (1993), the State University - Higher School of Economics (1996), the State University - Higher School of Economics (Executive MBA, 2007). He has been awarded with the Order of Honor, ‘Honorable worker of science and technology of the Russian Federation’. The views expressed by the authors are their own and do not necessarily represent the views of the Center for International Private Enterprise (CIPE). CIPE grants permission to reprint, translate, and/or publish original articles from its Economic Reform Feature Service provided that (1) proper attribution is given to the original author and to CIPE and (2) CIPE is notified where the article is placed and a copy is provided to CIPE’s Washington office. The Economic Reform Feature Service is CIPE’s online and electronic article distribution service. It provides in-depth articles designed for a network of

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policymakers, business leaders, civic reformers, scholars, and others interested in the issues relating to economic reform and its connection to democratic development. Articles are e-mailed and posted online twice a month. If you would like to subscribe free of charge, please join the CIPE network by entering your e-mail at www.cipe. org. CIPE welcomes articles submitted by readers. Most articles run between 3-7 pages (1,000-3,000 words). All submissions relevant to CIPE’s mission will be considered based on merit. The Center for International Private Enterprise (CIPE) strengthens democracy around the globe through private enterprise and market-oriented reform. CIPE is one of the four core institutes of the National Endowment for Democracy. Since 1983, CIPE has worked with business leaders, policymakers, and journalists to build the civic institutions vital to a democratic society. CIPE’s key program areas include anti-corruption, advocacy, business associations, corporate governance, democratic governance, access to information, the informal sector and property rights, and women and youth.


Modernization: Corporate Governance and Innovation