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Corporate Governance

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Title: Corporate Governance


1
Corporate Governance
  • Prof. Stephen Y.L. Cheung
  • Department of Economics Finance
  • City University of Hong Kong

2
Corporate Governance in Asia (I)
Source McKinsey, 2001
3
Corporate Governance in Asia (II)
  • Some commonly repeated cliches within the region
    (even in Hong Kong)
  • I do not need to raise any capital anytime soon.
    Why should I worry about corporate governance?
  • I would rather have a higher cost of capital
    than higher taxes that I would be forced to pay
    under greater disclosure
  • Why should I appoint independent non-executive
    directors? My company is well run.
  • Why should I own a bank if I cannot lend to
    myself?

4
Corporate Governance
  • Viewed as a flow concept
  • Check and balance in performance, decision-making
    and monitoring processes
  • Establish a legal and regulatory framework
  • promotes credible and effective governance
    practice for the benefit of economies and society
    as a whole

5
Become an Important Issue.
  • The Asian financial crisis
  • Commenced with devaluation of Thai baht in July
    1997
  • Weak corporate governance excessive
    over-leverage
  • Investors assumed a short-term outlook
  • Lone rogue traders
  • Barings Singapore (Nick Leeson)
  • Daiwa Bank (Toshihide Iguchi)
  • Sumitomo Corporation (Yasuo Hamanaka)
  • The collapse of Peregrine Investment of Hong Kong
    in 1998
  • Other well-developed countries
  • Enron and Long Term Credit Management in the US
  • Morgan Grenfell in Europe

6
Corporate Governance Models
  • Heavy reliance on statutory provisions, e.g. US
  • Promote self-regulation, e.g. U.K.
  • Monitored by market participants who are aware of
    their longer-term interests
  • Voluntary basis, market discipline and peer
    pressure
  • Low cost
  • Principle of caveat emptor - Let the buyer
    beware
  • shift the responsibility back to investors,
    enhancing their incentives to make use of
    information
  • minimizing the moral hazard of rigid regulation

7
Corporate Ownership
  • Concentration of shareholding affects the cash
    flow rights and control rights of shareholders

8
Systems of Corporate Governance
  • Outsider model
  • Insider model
  • Family/ state model

9
Outsider Model (I)
  • Features
  • Strong emphasis on the protection of minority
    investors in securities law and regulation
  • Strong requirements for disclosure
  • Market-based system
  • relies heavily on the capital market to influence
    behaviour
  • Legal and regulatory approach
  • build confidence among non-controlling investors

10
Outsider Model (II)
  • Disclosure-based
  • prevent communicating and sharing information
    among groups of shareholders without making known
    to all
  • Two channels of financial intermediation
  • Bank loan short-term, and maintain arms length
    relationships with banks
  • Equity finance relatively important with low
    debt equity ratios being the norm equities
    represent a high share of financial assets and a
    high share of GDP
  • Agency problem separation between ownership and
    management

11
Insider Model (I)
  • Ownership and control are relatively closely held
  • agency problem is of less importance
  • Insider group
  • has longer-term stable relationship with the
    company
  • small in size
  • their members are known to each other
  • have some connection to the company other than
    their financial investment, such as banks or
    suppliers
  • include some combination of family interests,
    allied industrial concern, banks and holding
    companies
  • control over the company

12
Insider Model (II)
  • Features
  • capital market is less developed
  • selective information sharing
  • regulatory policy only prohibit speculative
    activity rather than by insisting on strong
    disclosure
  • corporate structure pyramid structure,
    cross-shareholdings
  • ineffective voting procedure to prevent
    shareholders to vote
  • bank-centred
  • corporate finance is highly dependent on banks
    and high debt/equity ratio
  • banks have more complex and longer term
    relationship with corporate clients

13
Family/ State Model (I)
  • The founding families and their allies exercise
    control over an extensive network of listed and
    non-listed companies
  • Characteristics
  • Weak concept of limited liability
  • The important role of a small number of
    founding families of entrepreneurs in many
    areas of the economy
  • The entire infrastructure and large parts of
    heavy industry and the financial system are
    usually in the hands of the state, so that the
    state is able to counter concentrated power of
    these giants
  • Family-based businesses acquire political weight
    against state by branching out in many sectors
  • Outside financing bank-based

14
Family/ State Model (II)
  • Banks
  • Not capable of engaging in basic credit analysis
  • Inefficient credit rationing function
  • Weak corporate governance systems
  • Problems in the prudential supervision of banks
  • Shortcomings of foreign lenders
  • Deficient market exit arrangements
  • Benefit of the model
  • stability of ownership
  • high degrees of reinvestment of earnings
  • long-term commitment
  • firm-specific investment by stakeholders

15
Examples of Corporate Governance Initiatives (I)
  • The Organization for Economic Co-operation and
    Development Principles of Corporate Governance
    (OCED Principles)
  • Key factors that transcend both legal and
    national boundaries
  • Objectives, transparency, benchmarks,
    accountability, timely and readily accessible
    information
  • Adopted by the International Corporate Governance
    Network
  • Founded in 1995, whose members collectively
    manage assets estimated to be in excess of US10
    trillion
  • Commonwealth Association for Corporate Governance
    (CACG)
  • Established in April 1998
  • Aims at establishing self-sustaining
    institutional capacities for corporate governance
    in 53 Commonwealth countries within a five-year
    period

16
Examples of Corporate Governance Initiatives (II)
  • Corporate Governance Core Principles Guidelines
    by CalPERS in April 1998
  • the California Public Employees Retirement
    System, with assets in excess of US110 billion
  • The PECC Guidelines
  • Guidelines for Good Corporate Governance Practice
    by Pacific Economic Cooperation Council
  • Endorsed by the ministers represented at APEC
    meeting in Shanghai in October 2001
  • Implementing on a voluntary basis
  • 10 key elements the board, the chairman, the
    members of the board, independent non-executive
    directors, executive directors, board meetings,
    board committees, board issues, stakeholders and
    ethics

17
Elements of Corporate Governance (I)
  • Purpose
  • Clearly thought through, well-defined and
    understood, solid and not changing, clear
    financial aspects
  • Constitution
  • Well-conceived appropriate, clear, legal,
    autonomous
  • Board
  • An appropriate mix- owners, independents and
    full-time executives to approve strategies, adopt
    plans, monitor performance, make appropriate
    decisions and hire top executives

18
Elements of Corporate Governance (II)
  • Board (contd)
  • 4 sub-categories
  • Codes of best practice
  • Reduce market risk, minimum standards of
    accountability, governance and control
  • Board independence
  • Board members truly independent, appropriate
    skills and access to key corporate information
  • Split chairman/ chief executive
  • First enshrined in Britains Cadbury Committee
    Report (1992)
  • Co-ordinate the ouster of management
  • Protect the interests of all shareholders
  • Board committees
  • nominate directors and officers
  • oversee accounting procedures and the outside
    audit
  • decide the pay of corporate executives

19
Elements of Corporate Governance (III)
  • Executive
  • Develop strategies to meet the purpose
  • plan to achieve the strategies
  • recommend or make key decisions
  • demonstrate mutual respect in operating
    interdependence
  • Chief financial officer
  • Steer towards sound financial purpose, strategy,
    objectives and criteria
  • Judge plans and decisions from a financial
    viewpoint and from the perspective of other key
    functional directors

20
Elements of Corporate Governance (IV)
  • Criteria
  • Measuring tools for all elements of the business
    against which plan and performance can be
    objectively set to achieve desired success
  • Plans
  • judge against purpose and strategies
  • Contain objective criteria a high probability of
    achievement with sensitively test ? plan and
    identify the consequences of various scenarios
  • Decisions
  • Whether the consequent decision propels the
    organization forward

21
Elements of Corporate Governance (V)
  • Reporting
  • A regular stream of relevant, clearly absorbed
    information for monitoring
  • True, fair, comprehensive, transparent and
    meaningful
  • Shareholder relations
  • Well-defined purpose and independent
  • Autonomous structure allows accountability to
    pursue a defined purpose and a defined
    performance
  • Integrity
  • Meet ethical standards and progress the entity
  • Do not say yes when answer should clearly be
    no

22
Elements of Corporate Governance (VI)
  • Commercial/ financial/ price determination
  • Carefully conceived pricing policies
  • Sufficient revenue to cover all costs, service
    and retire appropriate levels of debt and reward
    the investors
  • High prudent commercial principles
  • Spell high reward on investment, high return on
    assets invested ? secure borrowing, higher
    gearing, higher shareholder return
  • Elements
  • Maximize return to shareholder, dividend, retain
    earnings
  • Optimize return on project, asset, revenue
  • Max min financing, loan, equity

23
Global Corporate Governance
  • Corporate governance
  • a process which is concerned about how
    corporations are managed, how managers are
    governed, what questions face boards of directors
    and the accountability a corporation has to
    shareholders.
  • Increase efficiency and effectiveness of
    companies
  • Elements of forming a trust on a company
  • accountability and transparency

24
Minority Shareholders
  • The interests, not the rights, of minority
    shareholders should be stressed
  • Controlling shareholders and management bodies
    treat the company and its resources as their own
  • Inadequate legal protection for the interests of
    shareholders

25
Control Management Opportunism
  • Four crucial pillars
  • Accountability
  • Transparency
  • Minority investor protection measures
  • Enforced regulations

26
Accountability (I)
  • Sense of responsibility to work towards the
    mission of the company and all shareholders
  • Credit Lyonnais Securities Asia (CLSA) report on
    corporate governance in emerging markets
  • The degree of accountability can be measured by
  • Independence and non-executive nature of board
    members
  • Presence of more than half non-executive board
    members
  • Presence of foreign nationals on the boards
  • Occurrence of regular full-board meetings
  • Opportunity for the members to exercise effective
    scrutiny
  • Presence of audit committees

27
Accountability (II)
  • CLSA report (contd)
  • Very important issues
  • Keep track of any mismanagement and take
    effective steps against those responsible
  • Have measures to protect the rights of minority
    shareholders
  • Ensure transparent share trading by board members
  • Maintain a board size that is effective and
    efficient

28
Transparency (I)
  • Two essential criteria of a fair market
  • Timely information to all players
  • The rules that govern the market are known to all
  • Conditions for good transparency
  • Full and prompt disclosure of information
    relating to the company
  • Timely disclosure of information
  • Disclosure of conflicts of interest of directors
    or majority shareholders
  • Adequate advance notice of meetings
  • High quality accounting standards of financial
    disclosure

29
Transparency (II)
  • Complete information
  • operating results
  • remuneration of the board and key executives
  • material foreseeable risk factors
  • material issues regarding employees and other
    shareholders
  • Transparency and accountability will not be
    effective if the information generated by markets
    is not adequate.

30
Minority Investor Protection Measures (I)
  • Tools
  • Voting rights one-share, one-vote principle
  • Strategy involved in decisions regarding
    fundamental corporate changes
  • Access to the vote
  • Anti-takeover devices
  • Independent board members
  • Pre-emptive rights for all existing shareholders
    to buy new shares at an equal price
  • For the related party transactions by controlling
    shareholders, only the minority shareholders
    should be allowed to vote
  • Minimum notice period of at least 30 days to call
    a shareholders meeting

31
Minority Investor Protection Measures (II)
  • Low shareholder activism in most countries
  • High costs of litigation
  • The legal systems may be riddled with corruption
    and inefficiency
  • Investors invest on a shorter-term basis
  • Key mechanism legal protection
  • Gang of Four comprising Prof. La Porta,
    Lopez-de-Silanes, Shleifer and Vishny
  • high concentration of ownership ? poor legal
    protection of investors ? smaller and narrower
    capital markets
  • Top ten families in each of the East Asian
    countries (excluding Japan) controlled 15-58
    percent of the total listed corporate assets

32
Enforced Regulations
  • Ensure implementation and enforcement with
    effective penalties for non-compliance
  • Ensure managers cannot overstep the powers given
    to them/ ignore the rights and interests of
    minority shareholders

33
Western vs. Eastern Firms
  • Western companies
  • A diverse mix of investors
  • Greater focus on the share performance, capital
    acquisition at a lower cost
  • Fear of litigation and criminal prosecution keeps
    boards and managers on their toes
  • Eastern companies
  • Family or state-owned, and directors have
    controlling shares
  • Concern corporate governance only when raising
    capital, and the company may return to bad
    governance practices afterward.
  • The HAMS Initiative Empowering Hong Kong
    Minority Shareholders by David Webb
  • Key point Honesty and fairness have no cultural,
    ethnic or national boundaries

34
Benefits of Good Corporate Governance (I)
  • To individual stocks
  • Better management
  • ? more prudent allocation of the companys
    resources
  • ? enhanced corporate performance
  • ? higher share price
  • ? increase the value of a shareholders holdings
    and increase the attractiveness of investing in a
    company
  • Facilitate to make investment decisions
  • Corporate governance premium
  • additional amount paid by investors for shares in
    companies which consistently display management
    competence and practise sound disclosure and
    accountability

35
Benefits of Good Corporate Governance (II)
  • Corporate governance premium is evidenced by
  • CLSA study Corporate governance in emerging
    markets Saints and Sinners
  • Strong correlations between higher corporate
    governance rankings and superior financial return
    ratios, as well as price-to-book ratio, higher
    valuation and medium-term share price
    outperformance.
  • National impact Flight to quality and
    price-earnings discount
  • Company impact A strong correlation between
    corporate governance and price performance of the
    largest stocks.
  • Across emerging markets Companies in the lowest
    corporate governance had a lower return on
    capital employed

36
Benefits of Good Corporate Governance (III)
  • Corporate governance premium is evidenced by
    (contd)
  • McKinsey Companys Investor Opinion Survey on
    Corporate Governance in June 2000
  • Survey on attitudes towards investing in Asia,
    Europe, US, and Latin America from September 1999
    to April 2000
  • 75 of respondents rated board practices as
    important as financial performance, especially in
    emerging markets
  • more than 80 are willing to pay more for the
    well-governed company
  • Similar results generated by a study of Russell
    Reynolds Associates

37
Benefits of Good Corporate Governance (IV)
  • To the market
  • Ensure the market are fair, efficient and
    transparent ? reduce systematic risks
  • Overall market confidence
  • International investors feel safer in terms of
    security for minority shareholders, quality
    management and even investment returns
  • Increase the supply of investment capital seeking
    to enter that market
  • Efficiency of international capital allocation
  • The renewal of countries industrial bases
  • Ultimately nationals overall wealth and welfare
  • Contribute positively to the development of
    financial markets
  • Barrier
  • social, cultural and economic diversity between
    countries

38
Effects of Poor Corporate Governance
  • Microeconomic view
  • If an investor is not satisfied, they simply sell
    out the stock, resulting in lower marketable
    price and liquidity
  • Macroeconomic view
  • A lack of core value of corporate governance does
    have a negative impact globally
  • The chain reaction that repels investment capital
  • Poor corporate governance ? Hurt the reputation
    of the whole market ? reduce investor confidence
    ? Investment becomes far less attractive ? reduce
    the investments price and liquidity ? those
    seeking investment capital have to pay more for
    it, i.e. higher cost of capital

39
Corporate Governance Practices in Emerging Markets
  • Only aware of the concept but ineffective
    implementation and removing the inertia
  • Little incentive to improve family-controlled
    businesses
  • Implementation
  • take into account the family-based nature of
    corporation
  • transform in a gradual and flexible manner
  • key not to take drastic steps and provide a
    supportive environment
  • The reforms needed are as follows
  • A change in attitude by governments and their
    officials
  • Full and complete disclosure of all corporate
    activity affecting the value of shareholders
    equity
  • The establishment of equal rights for all
    shareholders.
  • The rights of all shareholders need to be
    enforced rigorously.

40
Causes of Convergence of Corporate Governance
Systems
  • The globalization of markets
  • Path dependency and the politics of governance
  • Legal convergence

41
The Globalization of Markets
  • Investment by institutional investor
  • have expectations about shareholder value
  • require firms to establish profit targets and to
    produce competitive returns
  • insist that companies respect international norms
    of governance
  • companies adapt in order to be tap global capital
    market
  • New financial instruments, e.g. ADRs and GDRs
  • Deeper integration of markets
  • Stronger, international competition
  • Radical change in corporate finance landscape in
    a global way
  • A more propitious environment for international
    co-operation

42
Path Dependency and the Politics of Governance
  • Path dependent
  • Convergence is unlikely to be done in the medium
    term
  • Dont overestimated political and institutional
    resistance to alien concept
  • Citizens are increasingly open to foreign ideas
  • Acquisition of major industrial companies by
    foreign competitors does not caused any political
    problems
  • Top-down convergence
  • Increasing exposure of policy makers to regional
    and global policy fora
  • Ready availability of other countries experience
    and the wish to be part of an open world

43
Policy Maker
  • Balance between mandatory law and contract in
    each jurisdiction
  • Optimum mix between flexibility and
    predictability

44
END
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