2 Corporate governance in the Baltics

How hard law and soft law shape governance in Estonia, Latvia and Lithuania, which Board models companies use, and how shareholders set out their expectations.

In this chapter

2.1 Hard law and soft law

Legal acts entrench the most important and obligatory principles of corporate governance. The provisions of laws (hard law) typically establish minimum mandatory standards for the corporate governance system. Soft law is based on various instruments that are not legally binding (recommendations, guidelines, codes of conduct and similar) and provide higher, voluntarily applied standards for better corporate governance. The main aspects of hard law and soft law can be summarised as follows:

Additional sources of soft law include various corporate governance principles, recommendations, guidelines and codes, such as the G20/OECD Principles of Corporate Governance, the OECD Guidelines on Corporate Governance of State‑Owned Enterprises and national corporate governance codes.¹

2.2 Corporate governance models

There is no single model of good corporate governance. Board structures and procedures vary both within and among countries. Some countries have two-tier Boards that separate the supervisory function and the management function into different bodies. Such systems typically have a Supervisory Board (in the Baltic states also called the Council) composed of non-executive members and a Management Board composed entirely of executives. Other countries have “unitary” (one-tier) Boards, which bring together executive and/or non-executive members.

Some of the differences between the two models:

In the Modified structure CEO is a separate compulsory body. The particular features of the corporate governance models in each of the Baltic states:

2.3 Shareholders’ letter of expectations

Shareholders have specific expectations of what kind of business the company should be, what goals it should reach and how it should behave. These expectations can be written down in a document called the shareholders’ letter of expectations. This letter is important because it helps the shareholders and the company’s Board, which is responsible for achieving the shareholders’ goals, to understand each other and work together effectively. The letter outlines the shared expectations and priorities of the shareholders and provides guidance to the Board in order to maximise long-term value and ensure that the company’s activities benefit the shareholders, the communities and society as a whole. A shareholders’ letter of expectations is usually more applicable to state-owned and municipally owned enterprises (SOEs and MOEs) and other companies with a relatively small number of shareholders, and less applicable to listed and other companies with very dispersed ownership. In the latter case, the definition of the purpose and long-term goals lies with the Board. In the case of SOEs and MOEs, the shareholders’ letter of expectations, which should be publicly available on the company’s website, plays an important role in protecting the Board and the company against political interference.

Several items are considered key in formulating the shareholders’ letter of expectations:

• Shareholders’ plans to hold the shares in the company
• Purpose, strategic destination and ultimate goal(s)
• Financial commitment and contingency planning
• Targeted returns (return on equity – ROE, required rate of return – RRR, dividends, value growth)
• Role of the company as a part of the economy and society

Through the shareholders’ letter of expectations, the shareholder(s) determine the direction of the company’s development. As the possible approaches can be mutually exclusive, one should be selected.

1. Increasing long-term value. Profits are invested in long-term value creation: R&D, patents, the development of unique ideas and the building of synergies. This also implies that shareholders are not concerned with fast returns or rapid growth in market share; they are willing to invest in the development of a particular service or product without expecting a return in the short term.
2. Maximising growth. In taking this path, shareholders focus on future value rather than present value and prioritise future investment. Profits are used as a source of finance for growth, and an important financial objective is to increase turnover.
3. Maximising profits. In this case, shareholders target the withdrawal of dividends from the profits generated through increased efficiency and business development.

While setting out one of these three directions, the shareholders’ letter of expectations should also include expectations regarding financial and non-financial objectives.

1. Financial objectives arise from the selected development direction and include expectations related to capital structure (leverage) and expected return.
2. Non-financial objectives:
   1. environmental responsibility – integrating environmental responsibility into company operations, adopting environmentally friendly practices, promoting energy efficiency and reducing carbon emissions;
   2. social responsibility – engaging in activities that benefit the community, such as supporting local initiatives, investing in community development programmes, promoting social inclusion and contributing to the overall well-being of residents;
   3. stakeholder engagement – actively engaging with residents, community organisations and other stakeholders to understand their needs, concerns and expectations;
   4. innovation and technological advancement – embracing innovation and using technology to enhance service delivery, operational efficiency and customer experience;
   5. corporate governance – upholding high standards of corporate governance, transparency and accountability, ensuring fair and ethical business practices and complying with legal and regulatory requirements;
   6. for public sector enterprises, other non-financial objectives (public policy objectives) may be defined; these should be financed by the state in a clear and transparent way.

The shareholders’ letter of expectations should be defined for a period longer than the company’s strategy and should be updated if there are significant changes in the shareholders’ expectations, but not too often. It is bad practice for shareholders to update their letter of expectations every year or every two years, because the Board would then have to adapt the company’s strategy each time.

The Board is entitled to propose changes to the owners’ expectations where there is an evident and very important need.

It is good practice for SOEs and MOEs to disclose the shareholders’ letter of expectations and make it publicly available on the company’s website and in its reports.

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