Corporate Governance

1
International Financial Management

• Corporate Governance

2
Corporate Governance.
3
Home De(s)pot
Home Depots chief executive, Robert Nardelli,
was removed after shareholders protested his
pay.
4
Home De(s)pot

• Bob Nardelli took the helm at Home Depot in 2000,
  and sales soared from 46 billion in 2000 to
  81.5 billion in 2005.
• Profits more than doubled
• Stock price has lagged the market, and especially
  Lowes
• Bob Nardelli was paid 38.1 million from his last
  yearly contract.
• He refused to accept even a reduction in his
  current stock package, and only agreed to give up
  a guarantee that he would receive a minimum 3
  million bonus each year.
• Board members asked him to more closely tie his
  future stock awards to shareholder gains, but he
  refused.
• Nardelli claims that he cannot control the stock
  price, so his compensation should not be tied to
  it
• Shareholders threatened to riot at annual meeting
  in May, 2007.
• Nardelli was asked to leave on January 2, 2007,
  with a 210 million retirement package!!!

5
Home De(s)pot
6
Home De(s)pot
7
Agenda

• Governance of the Public Corporation
• Agency Problem
• Law and Corporate Governance
• Corporate Governance Reform
• Sarbanes Oxley
• Cadbury Code

8
Governance of the Public Corporation

• Corporate Governance the economic, legal, and
  institutional framework in which corporate
  control and cash flow rights are distributed
  among shareholders, managers, and other
  stakeholders of the company.
• Corporate scandals Enron, WorldCom, Global
  Crossing, Daewoo Group, Parmalat, and HIH.
• American executives treat their companies like
  ATMs, awarding themselves millions of dollars in
  corporate perks. (Harvard Business Review, 2003)
• Corporate governance failures have detrimental
  effects on corporate valuations and the
  functioning of capital markets.

9
(No Transcript)
10
Governance of the Public Corporation

• Public ownership is associated with efficient
  risk sharing, access to low-cost capital, and the
  pursuit of risky investment projects.
• Conflicts of interest between managers (agents)
  and shareholders (principals).
• Shareholders elect the board of directors, who in
  turn hire and monitor managers.
• Board composition (insiders/outsiders)
• Shareholder monitoring (free-rider)
• Conflicts of interest between controlling
  shareholders and outside shareholders.

11
The Agency Problem

• Incomplete contracts create room for agency
  problems, and managers often grab the residual
  control rights.
• Perquisites
• Steal funds
• Divert funds
• Waste funds
• Managerial entrenchment
• Free cash flows, Payout problems
• Retain cash to avoid future capital raising
• Size ? Higher compensation
• Size ? Higher prestige

12
Remedies for Agency Problem

• Board of directors
• Outside directors on board
• CEO and chairman of board different people
• Europe union representation, two-tier boards
• Incentive contracts
• Stocks and stock options
• Independent compensation committee
• Concentrated ownership
• Germany, France, Japan, China, Latin America
• Morck, Shleifer, and Vishny (1988) Effect of
  managerial ownership () on firm value is likely
  non-linear and entrenchment dominates in 5-25
  range for the US.

13
Morck, Shleifer, and Vishny (1988)
Firm Value
y
x
Manager Ownership ()
14
Morck, Shleifer, and Vishny (1988)
Firm Value
Alignment
Entrenchment
Alignment
y
x
Manager Ownership ()
15
Remedies for Agency Problem

• Accounting Transparency
• Accurate accounting information in a timely
  fashion
• Debt
• Less managerial discretion wrt payouts
• Less flexibility for financing investment
  projects
• Overseas Stock Listings
• Credible bond to provide better investor
  protection (Doidge, Karolyi, and Stulz (2002))
• Market for Corporate Control
• Disciplinary effect on managers and enhance
  company efficiency (US and UK)
• Developing also in Germany, Japan, etc.

16
Law and Corporate Governance

• La Porta, Lopez-de-Silanes, Shleifer, and Vishny
  (LLSV)
• Sharp differences among countries with respect
  to
• Corporate ownership structure
• Depth and breadth of capital markets
• Access of firms to external financing
• Dividend policies
• Explained by how well investors are protected
  from expropriation by managers and controlling
  shareholders and the origin of the countrys
  legal system.
• English common law discrete rulings, judicial
  precedent
• French civil law codification of legal rules
  (Roman)
• German civil law codification of legal rules
  (Roman)
• Scandinavian civil law codification/precedent

17
Law and Corporate Governance

• LLSV (1998) Invented the Shareholder Rights
  Index and the Rule of Law Index
• English common law countries rank highest on
  shareholder rights, while Scandinavian and German
  civil law countries rank highest on enforcement.
• Why are they so different?
• Glaesser and Shleifer (2002) argue the
  explanation dates back to the Middle Ages.
• France power of adjudication to the center
  (King)
• England - power of adjudication to a local jury

18
Consequences of Law

• LLSV (1998) find that corporate ownership tends
  to be more concentrated in countries with weaker
  investor protection.

19
Consequences of Law

• Dominant investor may seek to acquire control
  rights in excess of cash flow rights
• Shares with superior voting rights
• Pyramidal ownership structure
• Li Ka-Shing Family (Hutchison Whampoa)
• Lee Keun-Hee (Samsung Electronics)
• Robert Bosch GmbH (Daimler-Benz)
• Interfirm cross-holdings
• Private Benefits of Control
• Nenova (2001) premium for voting shares US 2.0,
  Canada 2.8, Brazil 23, Germany 9.5, Italy and
  Korea 29 and Mexico 36...
• Dyck and Zingales (2003) block premium Canada US
  and UK 1, Australia and Finland 2, Brazil 65,
  Czech Republic 58, Israel 27, Italy 37, Korea
  16, and Mexico 34.

20
Consequences of Law

• Capital Markets and Valuation
• LLSV (1997) find that countries with strong
  shareholder protection tend to have more valuable
  stock markets and more companies listed on stock
  exchanges per capital than countries with weak
  protection.
• Studies (e.g., Lins (2002)) show that higher
  insider cash flow rights are associated with
  higher valuations, while higher insider control
  rights are associated with lower valuations.
• Johnson, Boon, Breach and Friedman (2000) find
  that stock markets declined more in countries
  with weaker investor protection during the Asian
  financial crisis 1997-1998.
• Lemmon and Lins (2003) find that crisis period
  returns of firms in which managers have high
  levels of control rights, but have separated
  their control and cash flow ownership, are 10-20
  percentage points lower than those of other
  firms.
• Financial market development also promotes growth.

21
Consequences of Law

• Doidge, Karolyi, and Stulz (2004)
• Almost all of the variation in governance ratings
  across firms in less developed countries is
  attributable to country characteristics rather
  than firm characteristics typically used to
  explain governance choices.
• Firm characteristics explain more of the
  variation in governance ratings in more developed
  countries.
• Access to global capital markets sharpens firm
  incentives for better governance, but decreases
  the importance of home-country legal protections
  of minority investors.

22
Corporate Governance Reform

• Late 1990s Internal corporate governance
  mechanisms, auditors, regulators, banks, and
  institutional investors failed
• Strengthen the protection of outside shareholders
  against expropriation of managers and controling
  shareholders
• Strengthening the independence of boards of
  directors with more outsiders
• Enhancing the transparency and disclosure
  standard of financial statements
• Energize the regulatory monitoring role of the
  stock market regulator and the exchanges
• Modernize the legal framework

23
Sarbanes Oxley

• Accounting regulation
• Public accounting oversight board
• Restricting consulting/auditing
• Audit committee
• Independent financial experts
• Internal control assessment
• Assessment by auditors and company (Section 404)
• Deemed costly and contested
• Cross-listing elsewhere
• Executive responsibility
• CEOs and CFOs must sign off on the companys
  quarterly and annual financial statements. If
  fraud causes an overstatement of earnings, these
  officers must return any bonuses.

24
Sarbanes Oxley

• Many argue that SOX is hurting U.S. capital
  markets.
• SOX undermines CEOs appetites for risk
• SOX is a full employment act for Accountants
  (404)
• The Committee on Capital Markets Regulation, set
  up by U.S. Treasury Secretary Hank Paulson,
  advocates rolling back the Sarbanes-Oxley Act.
• New York Governor-elect Eliot Spitzer, New York
  City Mayor Michael Bloomberg and U.S. Sen.
  Charles Schumer of New York have weighed in too,
  saying SOX is wrecking New Yorks standing as the
  worlds financial markets.

25
Sarbanes Oxley

• Many propose
• Section 404 attestation provisions should be
  rolled back for small companies, with an internal
  control review every two years.
• The bar should be raised on what constitutes a
  material weakness in internal controls.
• It is particularly foreign companies that are
  balking at SOX.
• New markets are appearing
• Chi-X a London-based joint venture that claims it
  will offer cheaper trading in European stocks
• Equiduct, and all-electronic, Pan-European
  exchange based in Belgium
• Goldman Sachs, Merrill Lynch, Morgan Stanley,
  Citigroup, Credit Suisse, UBS, and Deutsche Bank
  reportedly will form a consortium to trade
  equities across Europe (already announced the
  same for US)

26
Sarbanes Oxley

• U.S. is losing out on new international listings
• London is beating the U.S. in the number of IPOs
  it draws.
• Last year, the NYSE drew 192 IPOs and Nasdaq 126.
• The LSE, often cited as the example of how SOX is
  chasing companies away, attracted a robust 617
  IPOs, 510 of which were on the AIM, the exchanges
  small-cap market.
• However, the U.S. IPOs are larger.
• Of a total of 118.2 billion raised through IPOs
  in 2006
• 17.5 billion occurred on the LSE, 4.2 billion
  on AIM
• 16.9 billion on the NYSE
• 9.4 billion on Nasdaq
• 0.2 billion on AMEX, according to Thomson
  Financial.

27
NYSE Corporate Governance

• Listed companies to have boards of directors with
  a majority of independents
• The compensation, nominating, and audit
  committees to be entirely composed of independent
  directors
• The publication of corporate governance
  guidelines and reporting of annual evaluation of
  the board and CEO

28
Cadbury Code of Best Practice

• Ferranti, Colorol Group, BCCI, and Maxwell Group
• Cadbury Code
• Boards of directors of public companies include
  at least three outside (non-executive) directors
• The positions of CEO and chairman of the board of
  these companies be held by two different
  individuals
• Cadbury Code is not legislated into law
• LSE requires companies to comply or explain.
• Empirical research suggests the code has been
  effective despite not being enforceable in courts

29
Corporate Governance Indices

• FTSE ISS Corporate Governance Index Series (CGI)
• Quantifying the risk of corporate governance
  across international markets has posed a
  challenge for investors trying to deal with the
  increased recognition of the issue.
• The new FTSE ISS Corporate Governance Index (CGI)
  Series assists you with company analysis,
  portfolio management and stock selection against
  selected companies with a proven standard in
  corporate governance.
• The series is the result of a collaboration
  between FTSE and corporate governance experts
  ISS, two market leaders in their respective
  fields. The design incorporates ISS corporate
  governance ratings into a financial index.
• You will now be able to track the financial
  performance of companies against the universal
  themes in corporate governance practice of
• Compensation systems for Executive and Non
  Executive Directors
• Executive and Non-Executive stock ownership
• Equity Structure
• Structure and independence of the Board
• Independence and integrity of the audit process
• The series consists of six regional and country
  equity indices covering 24 developed countries as
  defined by the FTSE Global Equity Index Series.

http//www.issproxy.com/institutional/cgi/index.js
p
30
FTSE ISS CGI
31
Corporate Governance Around the World

• European Corporate Governance Institute
• http//www.ecgi.org/codes/all_codes.php

32
Parmalat

• Lets discuss Parmalat, p. 101-102, at the
  beginning of next class.
• How was it possible for Parmalat managers to
  cook the books and hide it for so long?
• Investigate and discuss the role that
  international banks and auditors might have
  played in Parmalats collapse.
• Study and discuss Italys corporate governance
  regime and its role in the failure of Parmalat.

33
Conclusions

• Agency conflicts may arise between managers and
  controlling shareholders on the one hand and
  outside shareholders on the other hand.
• Corporate governance protecting shareholders
  against expropriation by managers and controlling
  shareholders.
• Mechanisms to control agency problems
  strengthening the independence of boards of
  directors, providing managers with incentive
  contracts, concentrating ownership, using debt,
  cross-listing to bond to better investor
  protection, and facilitating the market for
  corporate control.
• The legal origin influences shareholder
  protection and enforcement of laws, and this in
  turn has consequences for corporate valuations.
• Tradeoff concentrated ownership and lack of
  investor protection.
• Corporate governance reform is an uphill battle