Strengthening Corporate Governance with the OECD Principles: An Outcomeoriented Approach

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Strengthening Corporate Governance with the OECD
Principles An Outcome-oriented Approach

• Dr. William Witherell
• Director for Financial and Enterprise Affairs
• Organization for Economic Cooperation and
  Development (OECD)
• Academy of European Law Seminar
• Corporate Governance Legal Implications for
  Europe and the United States
• Trier, Germany 7-8 March, 2005

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BACKGROUND AND OVERVIEW

• After Asian Crisis, corporate governance reform
  seen as a priority for emerging markets.
• OECD Principles agreed in 1999 and soon became
  the international benchmark.
• More recent wave of corporate scandals and large
  failures in major OECD advanced market economies
  undermined investor confidence and has lead to
  wide-spread governance reforms.
• OECD in 2003-4 carried out a review and updating
  of the Principles in light of recent experience.

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But why do national and international
policy-makers care about corporate governance??

• The dominance of the joint-stock corporation
• Institution building in less developed countries
• The growth of the private corporate sector
• The growth of equity markets
• The growth of international private capital flows

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Corporate Governance influences the outcomes at
all stages of the investment process

• The mobilization or raising of capital (in both
  domestic and international markets)
• The allocation of capital to its most effect uses
• The monitoring of how capital is employed

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Why core principles?

• Enormous variation in ownership and control
  structures in the world
• No single model of good corporate governance but
  need for a global language
• Detailed codes, best practices should be
  established at national and regional levels
• Objective to identify common elements or core
  principles underlying good corporate governance
  across the different systems a multilateral
  policy framework

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Implications of core principles
outcome-oriented

• The Principles cover the general features or
  functions to be in place, e.g. high level of
  accounting standards, diligent and capable
  directors.
• These are termed outcomes.
• They involve functional equivalence they can be
  achieved in many different ways and with
  different institutions.
• Principles need, therefore, to be adapted to the
  legal and institutional environment of each
  country.

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The OECD Principles are based on a wide
interpretation of corporate governance, which
emphasises resource inputs

• Corporate governance involves a set of
  relationships between a companys management, its
  board, its shareholders and other stakeholders.
  Corporate governance also provides the structure
  through which the objectives of the company are
  set, and the means of attaining those objectives
  and monitoring performance are determined.

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Moreover,

• Good corporate governance should provide proper
  incentives for the board and management to pursue
  objectives that are in the interests of the
  company and shareholders and should facilitate
  effective monitoring, thereby encouraging firms
  to use resources more efficiently.

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Two implications for the desirable
characteristics (outcomes) of a corporate
governance system

• Checks and balances
• A structure of incentives that is compatible with
  the checks and balances and with achieving the
  objectives of the company

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Intended uses of the Principles

• Primarily aimed to provide a conceptual framework
  for governments.
• Guidance also for stock exchanges, investors,
  corporations, commissions.
• A benchmark that facilitates convergence.

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The Principles are the international benchmark

• Endorsed by the Financial Stability Forum as one
  of 12 Key Standards for Sound Financial Systems
• Used as the basis of the corporate governance
  component of the World Bank/IMF Reports on the
  Observance of Standards and Codes (ROSC)
• Recommended by the Emerging Markets Committee of
  the International Organization of Securities
  Commissions (IOSCO)
• Provide a basis for numerous national or
  sector-specific codes and listing requirements.

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The objectives of international co-operation
under OECD-World Bank Corporate Governance
Partnership

• To build the rudiments of a global normative
  framework
• To build a corporate governance culture among
  corporations and investors
• To marshal human and financial resources at a
  global level in order to help regional and local,
  private and public efforts bear their fruits.

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OECD-World Bank Regional Corporate Governance
Roundtables

• Public-Private regional dialogue.
• Participants are senior policy- makers,
  regulators, corporations, investor, professional
  organizations, labor, and others.
• OECD Principles are a framework for the dialogue.

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Non-OECD Countries in the Roundtables

• Asia Bangladesh, China, HK (China), India,
  Indonesia, Malaysia, Pakistan, Philippines,
  Singapore, Sri Lanka, Chinese Taipei, Thailand,
  Viet Nam
• Latin America Argentina, Bolivia, Brazil, Chile,
  Columbia, El Salvador, Peru, Uruguay, Venezuela
• Eurasia Armenia, Azerbaijan, Georgia,
  Kazakhstan, Kyrgyz Rep., Mongolia, Ukraine,
  Uzbekistan
• South Eastern Europe Albania, Bosnia-Herzegovina,
  Bulgaria, Croatia, FYR of Macedonia, Serbia and
  Montenegro, Romania
• Russia

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Objectives of the Roundtables

• Improve understanding through peer discussion and
  exchange
• Identify areas for improvement and formulate
  reform agenda the White Papers
• Facilitate regional participation in global
  dialogue on corporate governance
• Identify needs and facilitate provision of
  technical assistance.

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Core Elements of the OECD Principles

• Assuring an effective framework(1)
• The rights of shareholders
• The equitable treatment of shareholders
• The role of stakeholders
• Disclosure and transparency
• The responsibility of the boards

(1) This chapter added in 2004
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Setting the new Chapter 1 aside until later, let
us look briefly at chapters II to VI in reverse
order to better understand the overall logic of
the original Principles.
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VI. The responsibilities of the boardThe
corporate governance framework should ensure the
strategic guidance of the company, the effective
monitoring of management by the board, and the
boards accountability to the company and the
shareholders.

• Thus the board serves as the fulcrum, balancing
  the ownership rights enjoyed by shareholders with
  the discretion granted to managers to run the
  business.

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V. Disclosure and transparencyThe corporate
governance framework should ensure that timely
and accurate disclosure is made on all material
matters regarding the corporation, including the
financial situation, performance, ownership, and
governance of the company.

• The process of disclosure and the integrity of
  the accounting and financial reporting systems
  should be overseen by the board.
• Disclosure should include information about the
  control structures and ownership of the firm
  which should make potential conflicts of interest
  (i.e. the incentive structure) transparent.

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Principles II, III and IV concern shareholders
and stakeholders, who have an important role in
effecting checks and balances

• II. The rights of shareholders
• The corporate governance framework should
  protect shareholders rights.
• III. The equitable treatment of shareholders
• The corporate governance framework should
  ensure the equitable treatment of all
  shareholders, including minority and foreign
  shareholders. All shareholders should have the
  opportunity to obtain effective redress for
  violation of their rights.

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Stakeholders include employees, creditors,
depositors, pensioners

• IV. The role of stakeholders in corporate
  governance
• The corporate governance framework should
  recognize the rights of stakeholders as
  established by law and encourage active
  co-operation between corporations and
  stakeholders in creating wealth, jobs, and the
  sustainability of financially sound enterprises.

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In sum,

• The Principles thus comprise checks and balances
  the board oversees management and is in turn
  overseen by shareholders, creditors and
  stakeholders who must be sufficiently informed to
  do this.
• Information should also make it possible to
  understand the incentive structure facing the
  board and management and thus make the checks and
  balances effective.

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The 2002 call by OECD Ministers for an
assessment/review of the Principles
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Policy concerns and driving forces

• Corporate scandals and large failures.
• New awareness of links between corporate
  governance arrangements and growth
• Revealed need for improving
• Implementation and enforcement
• Transparency and disclosure
• Alignment of incentives
• Monitoring by boards
• Shareholder rights

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Recent Legal or Regulatory Changes in G-7
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OECD Ministers at their 2002 Annual Meeting

• Observed that the integrity of corporations,
  financial institutions and markets is essential
  to maintain confidence and economic activity and
  to protect the interests of stockholders.
• Agreed to implement best practices in corporate
  and financial governance which entails an
  appropriate mix of incentives, balanced between
  government regulations and self regulation,
  backed by effective enforcement.
• Agreed to survey recent experience and assess the
  Principles of Corporate Governance.

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The Review Process

• OECDs Steering Group on Corporate Governance
  carried out the Review (30 OECD Governments,
  World Bank, IMF, IOSCO, BIS, Basel Banking
  Committee, BIAC, and TUAC)
• Consultations held with a wider group of
  interested parties, with non-OECD countries, and
  with several high-level roundtables chaired by
  the Secretary-General
• A survey of corporate governance developments in
  OECD countries since 1999, and a summary of
  experiences in non-OECD countries were produced.
• Draft revisions placed on web for comment.
• 2004 Revision of the Principles endorsed by OECD
  Ministers in May 2004

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The key reference

• OECD PRINCIPLES OF CORPORATE GOVERNANCE - 2004
• Available for free download at www.oecd.org/corpor
  ate

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And for developments in the OECD and non-OECD
countries

• CORPORATE GOVERNANCE A SURVEY OF OECD COUNTRIES
  2004
• EXPERIENCE FROM THE REGIONAL CORPORATE GOVERNANCE
  ROUNDTABLES 2003
• Also available at WWW.OECD.ORG/CORPORATE

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Five sets of issues at the forefront of
discussions

• Ensuring an adequate regulatory framework for
  corporate governance, taking account of costs
• The effective exercise of share ownership and the
  increasing role of institutional investors
• The changing nature and role of the board
• Dealing with conflicts of interest
• Stakeholder concerns

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Issue 1 Ensuring an adequate regulatory
framework for corporate governance, taking
account of costs
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Implementation and enforcement of laws,
regulations and codes

• Enacting laws, regulations and codes that meet
  international standards is the easy step
  effective implementation and enforcement is much
  more difficult.
• Scope and content of self regulation is under
  scrutiny incentives facing the professions may
  conflict with their integrity and credibility to
  uphold and enforce expected standards.
• Capacity and independence of regulatory and
  enforcement authorities are a serious concern,
  especially in emerging market and transition
  countries.
• Legal and regulatory framework should provide
  shareholders opportunity for effective legal
  redress.

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Key elements of disclosure and transparency

• Major share ownership and voting rights
• Material foreseeable risk factors
• Full financial disclosure
• Governance structure and policies
• Information should be prepared audited and
  disclosed in accordance with high standards of
  accounting, audit and non-financial disclosure
• Regular disclosure

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The integrity of the disclosure process and of
transparency have been called into question

• Rules-based accounting leads to show me I cant
  do it mentality.
• Holes such as derivative, pension and options
  accounting are too wide.
• Audit independence called into question. They
  think they are employed by management.
• Standards of the big 4 not what they were
  expected. Peer review failed.

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Reactions

• Auditor independence strengthened both
  structurally and by rules.
• Move effective responsibility to another organ
  than management
• Convergence of accounting standards -- but
  implementation an issue.
• Greater consideration of disclosure of material
  information
• More calls for non-financial disclosure

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Auditors in G-7
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• IOSCO released (Oct. 2002) principles for
  national standards covering auditor independence
  and auditor oversight.
• Reflect a growing international consensus.
• Many in OECD consider these principles to be
  minimum requirements.
• Importance of audit firms establishing internal
  monitoring and control systems.
• Auditors should be subject to an independent
  auditor oversight body, or if a professional body
  plays that role, it should be overseen by an
  independent body.

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The Financial Stability Forum has underscored
the importance of progress towards a single set
of high quality principles-based accounting
standards, with due regard to financial stability
concerns.

• US moving closer to a principles-based system.
• Process in place to work towards convergence of
  IAS and US GAP.
• EU (including its candidate states), Australia,
  NZ, Hong Kong, Russia, Singapore to adopt IAS.
• Indeed, GAAP Convergence 2002 survey of 59
  countries indicated that all but three ( Japan,
  Saudi Arabia and Iceland) intend to converge
  with IAS.

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• A number of countries have moved to require
  better disclosure of board and executive
  compensation
• Nomination and appointment of the board is a key
  corporate governance decision transparent and
  even-handed nomination and recruitment process is
  needed.
• Remuneration including information on the
  structure of compensation schemes and termination
  conditions relevant not only for financial
  implications but also for assessing incentives
  and performance.
• Some countries call for disclosure of individual
  remuneration others ask for only aggregate board
  compensation.
• NYSE and NASDAQ have proposed independent
  compensation committees codes and principles in
  other countries go in same direction.

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• Ensuring that corporate service providers work
  in the interests of shareholders
• In exercising ownership rights, shareholders have
  to rely on agents (brokers, investment advisors,
  analysts, rating agencies) for information.
• Recently a number of cases of serious conflicts
  of interest and inappropriate incentives have
  come to light.
• Responses include changes in stock exchange rules
  and professional codes of conduct, structural
  changes such as firewalls, and increased
  disclosure, e.g., of material conflicts of
  interest.

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The Principles Ensuring an adequate regulatory
framework for corporate governance, taking
account of costs ( A new Chapter 1)

• Clear objectives for policy in establishing a
  system leading to transparent and efficient
  markets.
• Legal and regulatory instruments to be
  transparent and enforceable.
• Clear division of responsibilities between
  domestic authorities
• Supervisory, regulatory and enforcement
  authorities should have authority, integrity and
  resources to fulfil duties.
• Greater role for shareholders and improved
  transparency
• Improved financial market integrity (see next
  slide)

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Also assuring financial market integrity

• Better disclosure by the company including
  related party transactions
• Boards to focus on overseeing internal controls
  and major accounting assumptions through
  independent audit committee.
• More emphasis on auditor independence and
  reference to IOSCO standards.
• Accountability of external auditors to
  shareholders and duty of professional care to the
  company
• Those providing analysis and advice to be free of
  conflicts of interest

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Issue 2 The effective exercise of share
ownership and the increasing role of
institutional investors
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The corporate governance framework should protect
shareholders rights

• Right to have shares registered and secure
• Should be able to take part in shareholder
  meetings and in major decisions concerning the
  firm
• Equitable treatment of all shareholders, foreign
  and minority especially
• Should not be abused by insiders

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But in practice the rights are often weak and
redress is difficult

• Need for greater voice through strengthened
  voting rights and information
• More active institutional investors and
  disclosure of their conflicts of interest
• In presence of major shareholders improve
  protection of minority shareholders
• Takeovers often blocked

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Improving Shareholder voice

• The ability of shareholders to elect board
  members of their choice, to table proposals and
  ask questions of directors is, in reality, very
  limited in a number of countries.
• Should shareholders be given more decision rights
  with respect to board and executive compensation?
• Need to avoid shareholders second guessing
  management

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Ownership and shareholding structures

• The transparency of ownership and shareholding
  structures, including pyramids that result in
  control rights being greater than cash flow
  rights, is limited in many cases.
• The Regional Roundtables have called for
  improvements in the disclosure of beneficial
  ownership to assist in efforts to curb abusive
  related party transactions.
• Beneficial ownership information also is
  important for the battle against international
  financial crime

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• Regional Roundtables on shareholder rights and
  equitable treatment
• Typically high degree of concentrated ownership,
  with control through pyramids and cross-holdings,
  combined with weak shareholder protection and
  insufficient disclosure equitable treatment of
  shareholders is a pivotal issue.
• Need to facilitate the exercise of shareholder
  rights.
• Minority shareholder rights in relation to
  changes in capital structure, in corporate
  control and delisting a concern (lack of
  pre-emptive or tag-along rights, etc.)
• Voting of depository receipts.
• Frequent abuse of related party transactions
  improved disclosure needed.

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• Improving and facilitating the exercise of
  voting rights
• Exercise of voting rights varies widely
• VOTES CAST BY INVESTORS AS A OF TOTAL
• U.S. Japan
  U.K.
• 83 71-80
  50
• Greater use of electronic communications?
• Institutional investors that act as fiduciaries
  being pressed to be more active.
• Legal and practical problems to cross-border
  voting widespread among the OECD countries.

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Over The Past Two Decades Institutional
Investors Have Grown Significantly In Size and
Importance
Source OECD Institutional Investors Statistical
Yearbook 2003
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Financial assets of institutional investors as a
per cent of GDP Some individual countries
Source OECD Institutional Investor Yearbook 2003
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The rights and responsibilities of institutional
investors.

• While institutional ownership is growing in size
  and importance, institutional investors typically
  play a limited role in corporate governance.
• The issue is not always to add to their already
  established rights as shareholders. The problem
  is that they do not make use of them.
• This is partly due to a lack of proper incentives
  and sometimes due to restrictions on their
  ability to set aside sufficient resources to
  carry out key ownership functions in an informed
  way.

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Should those who act as fiduciaries disclose
their voting policies? If they do, it would also
be natural to ask that they disclose how they, in
practice, will implement these policies for
example what resources will they set aside to
carry out their ownership functions
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The Principles The effective exercise of share
ownership and the increasing role of
institutional investors

• Call for effective shareholder participation in
  key decisions such as the nomination and election
  of board members, proposing resolutions and
  making views known on compensation policy
• Improved possibilities for shareholders to
  consult with each other on key governance issues.
  
• Eliminating impediments to cross border voting
• Call for institutional investors acting in a
  fiduciary capacity to declare voting policies and
  how they are handling conflict of interests

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Also control abuse between related companies

• Clear statement on fiduciary duties of board
  members to the company and not to the company
  group.
• Explicit statement that boards to review related
  party transactions using independent directors
• Stronger annotations on disclosure of related
  party transactions
• Stronger principle on board and executive
  disclosure of material interests
• Stronger call for protection of minority
  shareholders

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Issue 3 The changing nature and role of the board
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Hes becoming insufferably More transparent than
thou!
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• Towards independent and more effective boards
• Moves towards increasing not only the number of
  non-executive directors but also ensuring they
  are independent
• 1. UK - Higgs Report
• 2. Japan new company law
• 3. US
• Commission on Public Trust and Private
  Enterprise NYSE
• Sarbanes-Oxley
• Independence of judgement and independence from
  management.

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Board Integrity Issues

• Responsibility to Whom? Is it Clear?
• Duty of Loyalty / Duty of Care
• Status of Independent Directors
• Legal Status of Committees
• Alternate / Supplementary Directors

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Legal requirements for boards in the G-7
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The Principles The changing nature and role of
the board

• More general statement of board independence to
  cover those in a position to influence the
  company and not just management
• Greater possibilities for shareholders to
  question boards and to participate
• Tightening of fiduciary responsibility of boards
• Strengthened principle calling for boards to
  establish ethical guidelines and effective
  compliance procedures

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The board (continued)

• Boards to oversee internal controls and provide
  confidential access to whistleblowers
• Disclosure of mandate, working procedures and
  composition of board committees
• Boards to align key executive and board
  remuneration with the longer terms interests of
  company and shareholders and establish a
  remuneration policy

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Issue 4Dealing with conflicts of interest
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The Principles Dealing with conflicts of
interest

• Institutional investors called on to disclose
  conflicts of interest and how they manage them.
• Providers of advice to investors, such as
  analysts and brokers, should provide advice free
  from conflicts of interest
• Tighter conditions specified to ensure no
  material conflict of interest by auditors and
  thereby guard auditor independence
• Tightened disclosure standards to the board and
  to the market

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Issue 5 Stakeholder Concerns
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The role of stakeholders in corporate governance

• Stakeholders include creditors, depositors and
  employees
• Encourage active co-operation between between
  company and stakeholders
• Performance enhancing mechanisms should be
  available
• Redress for violation of legal rights
• Access to relevant information

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Stakeholders Issues are complex and difficult.
Best to consider two major groups- creditors and
employees separately

• Creditor rights are important for the terms and
  conditions of finance
• These rights arise from bankruptcy and other
  laws, but in some countries these rights are
  deficient and/or the courts are poorly structured
  to enforce them.
• Recent reforms in Germany, Japan and Italy.
• Reorganization procedures and the rights of
  creditors to remove management vary widely.
• World Bank and UNCITRAL developing principles.

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• Regional Roundtables have stressed their
  concerns about corporate practices that impede
  the opportunities for employees
• to seek redress for violation of their rights.
• To communicate their concerns about illegal or
  unethical transactions they have observed or
  asked to undertake.
• Such complaints can provide important
  information to shareholders.

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The Principles The role of stakeholders

• Recognise the role of stakeholders to creating
  value and therefore corporate governance
  framework should recognise their interests.
• Whistleblower protection is now a principle
  covering individuals and their organisations
• Better disclosure to stakeholders and of company
  policy towards them.
• Improved powers for shareholders and greater
  pressure for institutions to disclose voting
  policies important for pensions.
• Principle that board should set company ethics
  and establish a compliance policy will benefit
  employees

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Summary of steps toward implementing more robust
corporate governance regimes

• Review regulatory costs of any proposed measure
  and whether there are any more effective
  instruments at hand.
• Strengthen market disciplines as they are the
  most effective continuing discipline on
  management. Give emphasis to getting incentives
  aligned properly.
• Strengthen the ownership function of
  shareholders.
• Monitor the governance system particularly the
  effects of new measures.