Transparency, Corporate Governance, and Capital Markets

1
Transparency, Corporate Governance, and Capital
Markets

• Ronald J. Gilson
• Stanford Columbia Universities
• Latin American Corporate Governance Roundtable
• São Paulo Brazil, April 26-28, 2000

2
The Subject is Summarized in Three Simple
Statements

• Equity investment requires good corporate
  governance.
• Good corporate governance requires credible
  disclosure by the issuer.
• The absence of credible disclosure by issuers
  will have macroeconomic effects bank financing
  and conglomerate internal capital markets will
  not support the development of economically
  significant new industries.

3
Step One Corporate Governance is the Equity
Contract

• We are all familiar with the debt contract a
  detailed document specifies the interest rate,
  the repayment date, the debtors covenants, and
  the events of default.
• What is the equity contract?
• The corporate governance system specifies the
  rights of an equity holder and the steps
  available if management breaches its
  responsibilities
• Gilsons rule of value you pay for what you get!

4
Step Two Good Governance Requires Credible
Disclosure

• The corollary to Gilsons rule of value
• You get what you can measure.
• The algebra of governance and disclosure
• You pay for what you get you get what you can
  measure
• Canceling yields
• You pay for what you get you get what you
  can measure
• You pay for what you can measure!
• The difference between disclosure and credible
  disclosure.

5
Step Three The Effect of a Bad Equity Contract

• A bad equity contract an issuers inability or
  unwillingness to make credible disclosure makes
  it difficult for the market to distinguish good
  risks from bad.
• The increased cost of capital shifts financing
  and the capital market toward debt.
• Consequences
• Debt is ineffective at financing high risk, high
  return early stage investment.
• The capital market will not support cutting edge
  industries.

6
The Institutions Necessary to Support Credible
Disclosure

• Legally Mandated Disclosure Requirements.
• Good Accounting Standards.
• Independent Auditors.
• Effective Enforcement.

7
Legally Mandated Disclosure Requirements

• Problem
• How do we distinguish between those who disclose
  accurately and those who do not?
• Absent effective private intermediaries, a
  reputation model will not work.
• By imposing penalties on false disclosure, a
  legal mandate allows honest companies to
  distinguish themselves.

8
Good Accounting Standards

• The critical characteristic is not the particular
  standard the metaphysics of accounting but
  that the form of disclosure allow users to
  rearrange the information to their own use.
• Good rule of thumb an accounting system that has
  no use for the adjective hidden. Examples
• German hidden reserves.
• U.S. debate over charging the value of employee
  stock options to earnings.
• U.S. pooling vs. purchase accounting for
  acquisitions.

9
Independent Auditors

• Credible disclosure requires honest, competent,
  and independent auditors.
• The annual audit process is more effective than a
  government agency.
• The problem is independence.
• What is the impact on auditor independence of the
  consolidation of the profession into 5
  multi-national, multi-disciplinary professional
  service firms.
• What happens to independence when non-audit fees
  climb?
• Current focus of the U.S. Securities and Exchange
  Commission.

10
Enforcement

• Mandatory disclosure is no more effective that
  the expectation that the rules will be enforced.
  We need
• A politically insulated regulatory agency with
  the independence to impose significant sanctions
  on the countrys largest economic actors.
• An independent, effective judiciary.
• Effective private enforcement.

11
A Piggybacking Strategy

• How does a high quality firm establish its
  credibility while local disclosure institutions
  are developing?
• Foreign stock listing.
• E.g., NYSE listing imposes on a foreign company
• Governance standards imposed by contract.
• U.S. regulatory standards triggered by listing.
• Israeli companies going public on NASDAQ.
• Strategy limited to larger companies.

12
Summary

• Equity investment requires good corporate
  governance.
• Good corporate governance the equity contract
  requires credible disclosure by the issuer.
• The absence of credible disclosure by the issuer
  will have macroeconomic effects bank financing
  and conglomerate internal capital markets will
  not support the development of economically
  significant new industries.