Although the corporate governance of Gulf Cooperation Council-based companies has improved over the past decade, it remains below international best practices, according to S&P Global Ratings.
Issues arising from board independence and board member skills, along with risk management weaknesses, are a common feature in the GCC's major governance failures.
As the GCC continues to import capital, conditions imposed by institutional investors are likely to help further strengthen governance practices, financial transparency, and sustainability reporting.
While there have been relatively few governance-related negative rating actions to date for rated GCC issuers, governance-related bankruptcies have been more prevalent in the larger market.
Governance practices in S&P Global Ratings view are stronger for GCC financial institutions and larger nonfinancial companies active in the capital markets as they are subject to greater regulatory scrutiny, disclosure, and market discipline. Similarly, government ownership appears to bring closer supervision of certain basic governance practices.
Many GCC companies operate with concentrated shareholder profiles with relatively limited institutional investor participation. In addition, S&P Global Ratings notes that, compared with best practices elsewhere, GCC boards are often less independent from ownership. S&P Global Ratings also note that board members themselves may have less experience and fewer qualifications than similarly positioned directors elsewhere. S&P Global Ratings also observe that in-business controls and risk management appear weak in certain sectors. These weaknesses have, in S&P Global Ratings view, contributed to governance failures in the GCC.
Nevertheless, GCC-based banks generally have stronger governance practices given the multiple layers of supervision and their more frequent interaction with external capital markets.
Similarly, governance practices and financial transparency appear to be more developed for nonfinancial corporates and insurance companies whose shares are listed, or that issue debt, on the capital markets.
As the GCC continues to import capital and attract institutional investment to support recovery from the pandemic and long-term economic diversification, S&P Global Ratings believe that stronger governance practices, financial transparency, and sustainability reporting will take firmer hold.
The large economic footprint of governments and their related entities is a common feature of GCC countries. Although it is growing, the GCC's private sector is relatively underdeveloped and dominated by family groups that have increased the diversification of their businesses over the years by tapping into growth sectors.
These businesses are important contributors to the GCC's non-oil economy.
Many of these have now transitioned from their founders to second and third-generation managers. Their funding remains based on relationships and is dominated by local banks.
That partly explains why the GCC's capital markets remain relatively small. From 2003 to 2008, governments used them to distribute oil wealth via IPOs of some government-related entities.
However, since the correction amid the global financial crisis at that time, the overall contribution of GCC capital markets to regional economies has been limited.
For example, over the past five years, the funds raised via IPOs on GCC-based stock exchanges was limited, outside the $25.6 billion raised via the Saudi Aramco (unrated) deal in late 2019. In addition to a relatively limited
number of IPOs from 2015 to date, we have also seen a number of high-profile delistings over the same period.
Many GCC-based companies are controlled by one or two key shareholders, even in the case of GCC-listed entities. A 2020 report found that a small number (averaging 2.8) of significant shareholders (parties with more than 5% of a company's voting rights) represented on average 52.7% of the shareholding of listed GCC companies as of 2015 (see Related Research).
S&P Global Ratings believe this finding has implications for corporate governance as strong key shareholders can disproportionately influence key organisational decisions, including the appointment of board members.
Concentrated shareholding is not unique to GCC companies. For instance, most Swedish companies are still controlled by their founding families though they have stronger corporate governance checks and balances than most GCC companies. In other cases, public and state-related entities are important owners of listed companies such as in Saudi Arabia, China, and Norway. In some of these countries, concentrated ownership was mitigated by higher requirements for checks and balances in regulation or the business environment.
In other countries, a well-diversified base of shareholders that includes a large share of institutional investors can foster best practices in governance. Typically, sophisticated long-term investors such as pension funds and life insurance companies have an active interest in the long-term performance of companies in which they invest. As such, this type of investor will often hold the board accountable for sound governance practices, ask for strong disclosure requirements, and promote long-term risk management processes.
That said, the mere listing of a company's shares or the presence of institutional investors is not necessarily sufficient to guarantee best practices, as has been seen in the case of London-listed UAE-based health care operator NMC Health PLC (unrated), where a material amount of previously unreported liabilities was discovered in early 2020.
COMMON GOVERNANCE FAILURES
While this is not unique to the GCC, management or shareholder fraud and financial reporting shortcomings are the two most common corporate governance failures we have observed there over the past 15 years.
The origins of these shortcomings include, in our view, ineffective board oversight and a weak risk assessment culture, sometimes accompanied by ineffective external oversight. The lack of disclosure and weak market discipline were also contributing factors.
Abraaj Group collapsed in 2019 after allegations surfaced that the Group diverted client funds to cover both the Group's operational expenses and its founder's other, unrelated, businesses. The Group's regulator, the Dubai Financial Services Authority, imposed a $315 million fine on the company in July 2019 for misuse of investor funds.
In the case of NMC Health PLC, a US-based investment firm issued a report criticising NMC's financials. Thereafter, an independent review identified certain undisclosed financing arrangements and potential discrepancies in the reporting of cash balances. It also came to light that NMC failed to disclose transactions in NMC shares by its two largest shareholders as well as loans to a shareholder secured by their NMC shares. The company and its other board members (excluding the shareholders) were reportedly unaware of the loans and pledges. On March 2, 2020, NMC announced that it was asking for continued support and an informal standstill of existing facilities from its lenders while later that month NMC disclosed an additional $4 billion of previously unreported debt. In April 2020, NMC declared insolvency, went into administration, and had its listing on the London Stock Exchange suspended.
Among other things, the NMC case illustrates the difficulty of forming an accurate picture of an entity's governance by looking at only its reported metrics and behavior. While NMC Health was London-listed, had a high-profile board containing a number of non-executive and independent board members, and reportedly adhered to best practices in corporate governance, it did not, in practice, have effective institutional checks and balances for detecting the activities that led to its insolvency.
A prominent corporate governance failure in the insurance sector involved Arab Insurance Group (Arig)
, a Bahrain-based reinsurer whose shareholders included several governments in the region.
In early 2019, the Central Bank of Bahrain uncovered some significant deficiencies in Arig's internal controls, a lack of strategic direction as some key positions remained vacant for a prolonged period, and a fraud at one of its subsidiaries that had led to high losses.
Consequently, Arig ceased writing new business in 2020 after operating for more than 36 years.
LACK OF BOARD INDEPENDENCE AND EFFECTIVENESS
Controlling shareholders can also weaken the independence and effectiveness of the board.
Moreover, the weakness can extend to the composition of board committees, and hiring of board members, and can lead to undue influence by the controlling shareholders on management and organisational and strategic decisions.
Ultimately, such situations engender a culture of weaker checks and balances at the executive level. While the board's fiduciary duty is to serve the best interests of a range of stakeholders, including minority investors, the interests of key sponsors can prevail.
Secondly, ineffective board oversight due to time constraints and potential conflicts of interest are other issues we have observed in the GCC. If directors also sit on boards of companies, there may be an increased likelihood of conflict of interest depending on whether the related companies are in the same sector or otherwise compete.
Third, S&P Global Ratings have observed that the presence of board members with the right skills and competencies can be uneven. In some cases, this may be due to board appointments being made based on other factors than their skills and experience. In several cases, directors sitting on the boards of several companies, where they may not be able to contribute significantly or challenge leadership.
This factor is, in S&P Global Ratings experience, often accompanied by a more general lack of diversity, particularly by nationality or gender. Nevertheless, we see progress on gender diversity and expect to see more female involvement in senior management and board positions. For example, in January 2021, First Abu Dhabi Bank appointed its first female CEO.
S&P Global Ratings believe that companies with less effective boards are less likely to set a clear strategic direction, hold management accountable, or help management implement and cascade a strong risk assessment culture. This lack of board effectiveness increases, in our view, the potential for management fraud and financial reporting incidents like those we have described above.
LACK OF DISCLOSURE AND MARKET DISCIPLINE
These phenomena vary from one industry to another and often depend on the degree and type of regulation, supervision, and the sourcing of a company's external financing. For banks and insurers, for example, accounts are reported under IFRS and the quality of disclosure tends to be relatively good. For nonbank financial institutions and for corporates that do not actively issue capital market instruments such as bonds or equities, the quality of disclosure is generally weaker. An additional challenge for the GCC is to step up disclosure requirements about environment, social, and governance (ESG) factors now that more investors are requiring alignment with ESG principles before committing funds.
CORPORATE GOVERNANCE PRACTICES
Despite improvements over the past several years, governance practices are generally not a strength for nonfinancial corporates in the GCC, many of which are controlled by their founding families with limited financial transparency.
Generally, governance practices are stronger for those companies tapping the capital markets through bonds and sukuk or whose shares are listed on regional or international exchanges. In S&P Global Ratings view, this is because those companies are often subject to higher regulatory scrutiny, disclosure requirements, and market discipline. Similarly, government ownership of a company often results in higher levels of supervision that bring with them at least basic governance practices.
Banks tend to have more established and robust governance frameworks and financial transparency versus nonbank financial and nonfinancial corporates. GCC banks often have stronger linkages with international investors (through interbank lines, external deposits, and bonds or sukuk issuance). Moreover, as they collect deposits, banks are, by definition, subject to higher regulatory scrutiny and requirements than other corporates in the region. In our view, the quality of regulation and supervision, across the GCC, is comparable with international standards.
It is also more advanced than in other regions like, for example, Russia and the Commonwealth of Independent States, where we believe weaker management and governance practices contributed to the failure of some banks (see "How Management And Governance Lapses Contributed To Bank Failures In Russia And The CIS," Oct. 12, 2017). S&P Global Ratings regard Kuwaiti banks' corporate governance and transparency as weaker than other GCC banking systems. S&P Global Ratings see room for improvement in terms of transparency and disclosure quality, compared with their peers'. Nevertheless, we see the Kuwait central bank's requirement that banks host earnings review calls and publish call transcripts as a positive development.
Greater regulatory scrutiny may also explain why, in the several cases of corporate governance failures over the past 15 years, the number of banks was small and often confined to fraud cases that various stakeholders could not detect. By contrast, nonbank financial institutions are generally subject to less stringent requirements and, as such, featured more prominently in cases of corporate governance failures.
To meet the requirements of new and more stringent risk-based regulations, insurers in most GCC countries have further strengthened their governance and internal controls in recent years. The governance arrangements and internal controls of most GCC insurers we rate are adequate, based on their current size and complexity and are neutral for their ratings. That said, we have observed some governance weaknesses, particularly regarding financial reporting standards, at certain smaller primary insurers as well as regional reinsurers, resulting in qualified audit opinions or even temporary license suspensions over the past five years.
From 2016-2020, we took negative rating actions on around 20% of the approximately 32 rated insurers in the region either because of a weaker governance assessment or governance-related matters that in some way weakened the insurer's financial risk profile.
ATTRACTING FOREIGN INVESTMENT
Well-directed foreign direct investment (FDI) tends to contribute to a "stickier" form of funding frequently associated with boosting longer-term growth prospects.
In a region like the GCC where the costs of promoting new economic activity have typically rested on the public sector, ambitious economic diversification plans imply a substantial fiscal cost. Government balance sheets have weakened markedly since oil prices crashed in 2014, and given continued low oil prices, regional policy changes indicate a growing interest in more diverse and less fiscally burdensome funding.
While stocks of FDI and portfolio investment in the GCC are among the lowest globally, demand-side dynamics are only part of the story. There are important differences within the GCC, but the existing regulatory landscape is relatively restrictive regarding foreign investment and ownership. Moreover, the narrow structure and slow diversification of GCC economies present limited investment opportunities. What's more, there has been ample liquidity at home. In some instances, local wealth funds actively restrict the amount they invest in their domestic economy, in part to limit their amount of GDP creation.
Saudi Arabia and the United Arab Emirates stand out as regional magnets for foreign investment.
Nevertheless, the low stock of FDI in the GCC more generally is partly due, in S&P Global Ratings view, to the suboptimal governance practices. New measures to improve transparency and governance standards are in part designed to attract FDI and support gradual economic liberalisation.
Together, Saudi Arabia and the United Arab Emirates account for about 80% of the total GCC stock (58% and 33% respectively) of FDI, from around the globe. Flows into the UAE, in particular, have grown faster than for the rest of the GCC in the past decade. This partly reflects a more diverse economic base that provides greater opportunities, but also increasingly a country that encourages engagement with foreign business.
S&P Global Ratings expect Saudi Arabia and the United Arab Emirates to continue attracting more FDI than their GCC peers. Through 2023, however, S&P Global Ratings expect that investment inflows to the GCC will fall slightly because of pandemic-related factors and low oil prices, which can reduce investor confidence and, thus, the amount of new projects signed. This slowdown also suggests that opening GCC economies, even with its companies adopting better governance standards, will likely take time.
IMPROVING REGULATORY PICTURE
Conscious of best practices worldwide, particularly in the ESG sphere, various GCC regulators have initiated several revisions of their regulatory requirements. For example, over the past couple of years, the UAE, Saudi Arabia, and Qatar strengthened corporate governance requirements including in areas such as listing standards. Moreover, regulators in these countries have relaxed foreign ownership rules.
In early 2020, the Securities and Commodities Authority of the UAE adopted a new corporate governance framework for public joint stock companies. This framework clarifies the duties of the board of directors. It adds a requirement to establish a code of conduct applicable to board members, employees, and auditors. It also establishes mechanisms to avoid conflicts of interest, and more deeply embeds compliance and its role and responsibilities. S&P Global Ratings have also seen some moves to adopt sustainability principles and disclosure guidelines, with the aim of attracting more ESG investment.
There remains more to be done to increase the awareness of corporates about sustainability. Banks appear again more advanced than corporates in the GCC, but they are further behind leading players in integrating ESG factors in strategy, decision making, and risk management.
Nevertheless, the ESG momentum appears to be building. Abu Dhabi General Market, for example, has adopted a sustainable finance agenda focused on four pillars: the integration of sustainability in their regulatory framework, enhancing cooperation with stakeholders inside and outside the country, increasing communication and awareness, and the creation of a sustainable finance ecosystem. Similarly, Dubai Financial Market (DFM) assumed a leadership role in the region and, among other initiatives, has been promoting sustainability reporting for listed companies. To further promote best practices in the market, DFM and the Dubai International Financial Centre (DIFC) launched a Dubai Sustainable Finance Working Group in 2019 and Sustainability Strategic Plan 2025 to promote best practices in this area. In the nongovernmental sphere, DIFC's Hawkamah Institute has been working with the GCC's financial and nonfinancial companies as well as with regulatory authorities and governments to promote best practices and deliver several governance-specific training programmes. -- Tradearabia News Service
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