Time for Transparency: What Will It Take to Improve Corporate Governance in the Middle East?

Last month, news broke that Nabil al-Boushi, an Egyptian brokerage owner based in Dubai, swindled his clients — including several celebrities — to the tune of millions of dollars. Among other things, he is thought to have used money from Egyptian investors to pay off investors in the United Arab Emirates, while falsely claiming to have had relationships with top government officials in the region. His doings brought to mind another person in the news: Bernard Madoff, the former chairman of the NASDAQ stock exchange, who has been charged with running a $50 billion Ponzi scheme and duping numerous well-heeled investors, both in the United States and elsewhere.

As al-Boushi’s dealings were brought to light, he was quickly termed the “Egyptian Madoff” in the press — and in both cases, the finger pointing began. As if that weren’t enough, investors in the region had already been spooked by the ongoing long-term probe into allegations of bribery and corruption at Dubai Islamic Bank and its subsidiaries, which sent more than 20 executives to jail.

To what extent might strong and enforceable financial regulations and good corporate governance standards have kept these frauds from happening — or at least limited their impact? How important are such regulations to help buoy investor confidence in the Middle East, especially since oil prices have taken a nose dive? Knowledge@Wharton asked several experts for their take on this timely issue.

Can’t Stop Believing

Just having rules in place — in the Middle East or elsewhere — doesn’t mean these things won’t happen, says Wharton legal studies and business ethics professor Ann Mayer. “The United States supposedly is well regulated, but we see that numerous huge Ponzi schemes have been conducted without detection in this country.” The Madoff scandal, for instance, happened despite numerous investigations into the funds in question, as reported in the press. “The Madoff [scheme] probably occurred because regulators didn’t do what they were supposed to,” notes Wharton finance professor N. Bulent Gultekin. “As long as people continue to ‘believe’ [the sales pitches], such scandals will continue to happen.”

In the Middle East, each country is at a different stage of development, explains Gultekin. “You often see such problems in financially-repressed markets, where there isn’t much room to maneuver. They are also common during the process of liberalization in the case of emerging markets or deregulation in more developed countries. It can be very easy to swindle people.”

Howard Pack, professor of business and public policy, economics and management at Wharton, says, “Given the huge amounts of capital account surpluses that have been accumulated in the Middle East, perhaps a trillion dollars, it would be difficult to enact regulation that would prevent Ponzi schemes or other malfeasance. It is unlikely that local expertise exists, any more than in the U.S., to enforce these regulations. Standard codes of conduct according to the OECD or other international sources would be difficult to enforce.”

Several countries in the region are trying to promote best practices, adds Gultekin. “Dubai is trying to bring more of an Anglo-Saxon structure to its financial markets. And in areas of the region [that are compliant with Islamic] Sharia laws, there may be fewer problems because some arbitrary structure has been conceived out of traditions. But people can always find ways to beat the system.”

Survey Findings

A 2008 survey covering corporate governance practices in the Middle East and North Africa (MENA) bears out the concerns of Wharton faculty and other experts. Conducted by the Washington, D.C.-based International Finance Corporation (IFC) and Hawkamah, a corporate governance institute in Dubai, the survey found that while the vast majority of publicly listed banks and companies in the MENA region believe corporate governance to be vitally important, more than half — 53% — of the participants did not know what the expression means; they confused corporate governance with corporate social responsibility or with corporate management.

Among the most significant findings of the IFC-Hawkamah report was that “not a single responding bank or listed company could claim to have applied corporate governance reforms holistically, i.e. to have followed a set of 32 indicators which could reasonably qualify a bank or listed company as following ‘best practice.’” The survey found that while not a single company followed best practices, only 3% had “good practices,” and more than 90% had emerging practices. (The latter are defined as firms that have implemented between eight and 15 of the 32 best practice indicators.) For example, among the companies surveyed, only 36.5% had a company level code for corporate governance or ethics policy.

The IFC-Hawkamah researchers recommended that in order to improve the state of corporate governance in the MENA region, several changes are needed. For starters, chairmen of the board and corporate CEOs “should set the tone at the top and champion corporate governance reforms, with the support of a professional company secretary,” they wrote. “The two largest barriers in implementing corporate governance reforms are a lack of internal corporate governance know-how, as well as the unavailability of external qualified specialists in the region.”

A Financial Times article about this survey noted that companies in the Middle East have often paid the price for poor corporate governance practices, which result in a lack of transparency. The newspaper quoted Ali Al Shihabi, head of Rasmala Investments, a Dubai-based asset manager, who identified opacity as “one of the main reasons why Gulf-wide stock markets have underperformed emerging markets indices over the past 12 months. Given our superior economic fundamentals, we should have outperformed other emerging markets, but the lack of transparency — both on a macro and micro level — erodes the confidence of investors,” he told the newspaper.

A Checklist for Investor Confidence

Wharton’s Gultekin believes that several standards are important for maintaining international investor confidence. “On the corporate side, full disclosure, international accounting standards and protection of minority shareholders are crucial. On the financial side, you need a good watchdog, such as the U.S. Securities and Exchange Commission.” He adds that the SEC failed to detect the Madoff scheme despite some advance warnings — which points to the weakness of the U.S. regulatory model. Still, for each Madoff scheme that might slip through the cracks, experts acknowledge that U.S. regulators do uncover several fraudulent activities each year and penalize their perpetrators.

Gultekin further notes the need for regulators to function with autonomy. “You also need the watchdog to be free of the political structures, and you need a framework for independent entities,” he explains. “If [culturally] people are not used to being independent of the political systems, this may be difficult to accomplish.” Moreover, autonomous organizations must exist to enforce the legal structures. “And you need to educate people. In many countries, the financial markets connote gambling, so you need strict rules. You need to keep private information private yet provide transparency — both are needed for a proper financial market.”

A small group of people may treat the market like a casino, notes Gultekin, but if everyone acts like a speculator, the markets will not function the way they should. “If people use the stock market for speculation decoupled from reality, how do you regulate it? Probably the same way you would regulate gambling.” The countries in the Middle East, Gultekin says, will need to have high standards to preserve investor confidence and keep the markets running effectively.

Standards vs. Behavior

Corporate governance is tricky, says Gultekin. “Just by applying laws themselves, you don’t achieve what you want. In the U.S., we have the Sarbanes-Oxley Act [which established standards for public companies and accounting firms], but if things worked correctly, we wouldn’t be in the financial mess we’re in. In the Middle East, my conjecture is that you need to involve the customs and cultures of the countries as well.”

Gultekin cites Japan as an example: “The country had a different corporate culture which reflected its value system and structure. Japan was successful for a long time, but it had trouble integrating its financial markets with the rest of the world.” A major issue is behavioral change. “Simply adopting rules without changing people’s behavior won’t get you anywhere. The laws are necessary but not sufficient.” In the Middle East, many companies are family held, and as a result, their governance structures are different than those of companies in the U.S. and elsewhere in the West. “Even within the region, there is little homogeneity,” notes Gultekin. “Bahrain is different from the U.A.E.; Saudi Arabia is different from Egypt. Ownership structures are different; the way people conduct business is different. For instance, in an environment where reputation is culturally crucial, it may be possible to encourage ethical behavior even beyond what is legally required.”

These factors may make it difficult to implement uniform corporate governance norms throughout the region. Still, some initiatives to drive change have already begun. In November, for example, IFC and Hawkamah, authors of the 2008 report, announced a partnership to offer advisory services in corporate governance to family-owned businesses in the MENA region. In addition, the Dubai-based Mudara Institute of Directors has launched an initiative to educate board members of companies about best practices in corporate governance.

If some of these initiatives pay off, companies and shareholders alike should benefit — as will the Middle East. They might not prevent future Madoffs and al-Boushis from ripping off investors, but they could at least ensure that such scandals are fewer in number.

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