1Malaysia Development Berhad (1MDB), a state-owned company purportedly established for the benefit of the Malaysian people, was a vehicle for former Prime Minister Najib Razak to steal billions of dollars over close to nine years. Called “kleptocracy at its worst” by then-U.S. Attorney General Jeff Sessions, the scandal raised the question of why Malaysian corporate law, modeled on international standards, failed to safeguard against expropriation of such magnitude. In my new article, I explore this question, highlighting how corporate governance frameworks can be strengthened to guard against similar debacles.
The Doing Business 2020 index ranks Malaysia as second highest in the world for the strength of its protections for minority shareholders. Likewise, an empirical measurement based on 60 shareholder protection variables using the Leximetric method from 1970 to 2005 found that Malaysian shareholder protection law was comparable in strength to that of the U.S. and other Western developed countries and improving. Nonetheless, evidence indicates that enforcement of these protections is relatively weak, and political interference has impeded investigations involving several high-profile politically-linked corporations.
Although Malaysian corporate law has been modeled on Anglo-Australian corporate law, Malaysia’s corporate ownership structures and political economy are distinctly different. The state maintains extensive ownership and control of corporations, estimated at 42 percent of the total market capitalization of corporations listed on Bursa Malaysia, and political influence is strengthened through state-controlled institutional investors (Gomez et al., 2018). Studies have revealed the inextricable relationship between politics and business in Malaysia, where redistribution policies have resulted in widespread political patronage (Brown, 2006). Controlling shareholders frequently depend on political patrons for contracts, licences, and other business opportunities and, in return, provide undisclosed benefits to political patrons (Gomez and Jomo, 2000).
Though state-owned corporations are common around the world (De La Cruz et al., 2019), international corporate governance standards do not address agency conflicts that arise in this context. Influential global indices such as the World Bank’s Doing Business rankings focus on the agency problems that arise in shareholding structures more commonly found in Western developed countries. Scholars highlight the greater risk of corruption in the governance of state-owned corporations (Milhaupt and Pargendler, 2017), but the governance of state-owned companies is the subject of separate, less prescriptive OECD guidelines. Importantly, the high-profile international rankings do not hold countries accountable for recommendations relating to state-owned corporations.
1MDB was incorporated as an unlisted public company, a legal entity subject to minimal disclosure requirements. The company was wholly-owned by the Minister of Finance (Incorporated). As former Prime Minister Najib was also the minister of finance, he was able to control the boards of 1MDB and its subsidiary, SRC. In the absence of any legal requirements that unlisted companies should publicly disclose their financial affairs, there were few external checks on fraudulent transactions. Further, there were no requirements that the management of state-owned companies be accountable to Parliament or that their financial affairs be otherwise subject to public scrutiny.
The scandal precipitated investigations across several continents and civil and criminal proceedings in various countries. Nonetheless, political obstruction of domestic investigations and the use of repressive laws to silence critics ensured that the Malaysian authorities did not bring enforcement proceedings in relation to 1MDB until the Najib administration fell in the May 2018 general elections. In the preceding years, Najib dismissed the attorney- general as he was about to file proceedings, classified as an official secret the initial investigation report into 1MDB that the cabinet had requested following allegations of impropriety, and imprisoned an opposition leader who attempted to reveal part of the classified report. Public discussion of 1MDB was suppressed through legislation that included the Communications and Multimedia Act 1998, Sedition Act 1948, and Anti-Fake News Act 2018.
The Need for Reforms
The 1MDB scandal brings to light the urgent need for regulatory reforms on several levels. The scandal highlights the failure of existing corporate regulatory frameworks to mitigate risks that arise in the context of state-owned corporations. Puchniak and Varottil (2019) similarly observe that current corporate governance prescriptions do not adequately address risks of abusive related-party transactions in state-owned corporations. Although the Santiago Principles are aimed at promoting better disclosure in sovereign wealth funds, the disclosure requirements are minimal, and compliance is voluntary. Khazanah Nasional Berhad, the state’s flagship investment arm, issues annual consolidated financial statements without revealing details of each of the many corporations and subsidiaries it controls.
The scandal also underscores the importance of strengthening regulatory enforcement and broader institutional reforms. These include ensuring that regulatory authorities are independent, free from political interference, and able to maintain an active role in enforcement proceedings. Studies reveal the correlation between well-governed state-owned corporations in Singapore and Norway and their reputations for “clean government and the rule of law” (Milhaupt and Pargendler, 2017) and “strong law enforcement against graft and corruption” (Chen, 2016).
In the Malaysian context, greater transparency and public accountability in the financial management of state-owned corporations could mitigate risks from the use of opaque unlisted companies to invest and manage public funds. Reforms that require disclosure of audited financial statements to Parliament following annual statutory audits of each state-owned corporation could promote better accountability. Likewise, disclosure of annual financial statements on the internet would enhance transparency, approximating the standards for corporations listed on Bursa Malaysia. Nonetheless, a turn of events that has seen the elected government displaced by former Prime Minister Najib’s allies and further use of repressive laws suggest that there is unlikely to be political appetite for such reforms.
Concerns over potential corruption through state-owned corporations extend beyond Malaysia. Political and economic interests are often intertwined in Asian developmental states (Chu, 2016), and state ownership of corporations is found in various countries. In countries where corporations law permits such public funds to be managed in secrecy, the risks remain that such corporate entities will provide a cover for fraudulent transactions.
More can be done at an international level to reduce risks of kleptocracy through state-owned corporations. Stronger measures aimed at mitigating risks of abusive related party transactions in state-owned corporations should be incorporated as an integral part of international prescriptions for corporate governance. While the Doing Business rankings have recently been criticized, they have provided countries impetus for adopting reforms as a means of maintaining a competitive edge in the global race for capital.
Empirical findings from my research indicate a gap between Malaysian shareholder protection law on the books and its effectiveness in practice, emphasizing the importance of incorporating evidence of effectiveness into the ranking methodologies. Reports indicate that formal Malaysian protections for minority shareholders are weakened by concentrated shareholding and the dominance of controlling shareholders over management, resulting in such protections being illusory at times. In addition to prescribing reforms through legislation and corporate governance codes, international rankings could make a significant difference by gauging the extent to which regulations have been effectively implemented and holding countries accountable for poor enforcement.
This post comes to us from Vivien Chen, a senior lecturer at Monash Business School. It is based on her recent article, ”Corporate Law and Political Economy in a Kleptocracy,” forthcoming in the American Journal of Comparative Law and available here.