Why Corporate Governance Matters for Vietnam: Importance for Listed Companies OECD/World Bank Asia Roundtable on Corporate Governance _______________ Ronald J. Gilson

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Why Corporate Governance Matters for Vietnam
Importance for Listed CompaniesOECD/World Bank
Asia Roundtable on Corporate Governance__________
_____Ronald J. Gilson

• Stanford Columbia Law Schools
• Hanoi, Vietnam
• December 6, 2004

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The Starting Point
Corporate Governance Military Music
Governance Music
This is an exercise in production not democracy
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Implications

• Corporate governance is concerned with
  allocational efficiency increasing the size of
  the pie
• Real governance, where there is political
  accountability, is concerned with distributional
  equity
• The standard for assessing corporate governance
  systems is therefore wealth creation which
  structures, under which circumstances, create the
  most resources for society to divide?

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Focus Listed Corporations

• My focus today will be listed corporations.
  Only the involvement of external capital raises
  governance, as opposed to management, issues.
• Corporate governance as an investment contract
• The investor gives , , , what does the
  investor get?
• The answer to that question influences the
  corporations cost of capital.

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Forms of External Capital The Debt Contract vs.
Equity Contract

• The debt contract is hard
• If the corporation violates the loan agreement,
  immediate legal action is possible
• The equity contract is soft
• Common stock holds the residual claim
• Returns are contingent on performance and
  strategy
• No specific rules specifying amounts or timing of
  distributions to shareholders
• Corporate governance is the equity contract
  processes and general standards of behavior are
  substituted for the specific obligations of the
  debt contract

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The Link between Corporate Governance and the
Cost of Capital

• If a proposed debt contract gives the lender
  little protection, the interest rate the lender
  demands will increase
• If a nations corporate governance gives the
  equity investor little protection, investors will
  pay a lower price for corporate stock and the
  cost of equity capital will increase
• Different national governance systems represent
  different approaches to protecting public equity
  investors

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The Taxonomy of Corporate Governance Systems

• Public equity investors always confront a
  separation of ownership and control
• Someone else will be making the decisions that
  determine the value of their investment
• All systems that accept public equity investors
  must address the central corporate governance
  problem
• How do equity investors make sure that managers
  perform well (the duty of care) and do not take
  private benefits for themselves (the duty of
  loyalty)?

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The Critical Role of the Controlling Shareholder

• Most listed corporations in Asia have a
  controlling shareholder (CS)
• To understand the CS role, start with corporate
  governance in systems where listed corporations
  typically do not have a controlling shareholder
  the US and the UK
• Rely on internal monitoring like independent
  directors and market mechanisms like hostile
  takeovers
• Both techniques are effective but have
  limitations
• Getting the incentives of independent directors
  right
• High cost of hostile takeovers

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Controlling Shareholders as an Alternative Monitor

• CS may better police managements duties of care
  and loyalty
• Large investment aligns the interests of CS and
  public equity investors
• But a system of CS as focused monitors come with
  its own costs
• Private benefits of control (PBC) benefits to
  the CS not provided to public shareholders
• Public shareholders will prefer a CS and the
  cost of equity capital will be reduced if the
  gains from better monitoring exceed the private
  benefits of control.

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Controlling Shareholder Regimes Good Law versus
Bad Law

• Two kinds of controlling shareholder regimes
• Inefficient CS regimes where PBC gt the gains from
  focused monitoring
• Efficient CS regimes where PBC lt the gains from
  focused monitoring
• Cost of equity capital depends on whether legal
  and cultural corporate governance standards
  effectively constrain PBC

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Implications of Distinguishing between CS
Regimes Value Differential in Efficient and
Inefficient CS Regimes
Differential between controlling and minority
shares in CS systems depends on the quality of
law
Source Nenova (2003) Dyck Zingales (2002)
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Additional Evidence of Link Between PBC and Firm
Value

• In Asian countries with CS regimes, firm value is
  related to the amount of PBC extracted by the CS
  (Classens et. al. Black et. al.)
• Firm value increases as the equity share of the
  CS increases
• Firm value decreases as the difference between
  the CSs control rights and its equity share
  increases
• Implication Firm value increases and decreases
  with the CS incentive to extract PBC
• Increase in value of public equity in Korea
  following requirement of majority of independent
  directors despite no change in operating
  performance
• Implication A smaller portion of the same cash
  flow Is extracted as PBC

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Implications of Distinguishing between CS
Regimes The Taxonomy is Wrong

• Traditional approach distinguishes between
  regimes with widely distributed shareholdings
  (the US UK) and CS systems (the rest of the
  world).
• Correct approach
• Distinguish between efficient and inefficient
  systems are there effective constraints on CS
  extracting PBC?
• U.S. has a substantial number of listed companies
  with a CS

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Diversity of Shareholding Patterns

• An inefficient system will support only CS
  capital structures
• Absent constraints on PBC by a subsequent
  acquirer of control, an existing CS wont part
  with control
• An efficient system will support both CS and
  widely distributed capital structures

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Diversity of Shareholding Patterns

• Absent barriers, expect that shareholding
  patterns will differ within a jurisdiction
  depending on
• Nature of industry
• Nature of competition
• Rate of technology change
• Preferences of individual CS
• Generation of CS
• If bad law prevents giving up control, all
  companies should have CS

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Diversity of Shareholding Patterns
Distribution of Controlling Shareholders and
Widely-held Companies in Sweden and Italy
Controlling Shareholder (family) Widely-Held
Sweden 46.94 39.18
Italy 59.61 12.98
Source Faccio Lang (2003)
OECD/Classens et. al. report Italy-like
distribution for East Asia Gompers et. al.
reports diversity in U.S.
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Implications of Inefficient CS Regimes

• Absence of diversity in inefficient CS regimes
  has macroeconomic implications
• Firms prevented from adopting most efficient
  organizational form
• Higher cost of equity capital in capital
  markets with significant frictions, capital
  structure matters
• Eliminates possibility of private equity/LBO
  recycling of underperforming companies

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Eliminating Inefficient CS Regimes Thoughts
About Reform

• Problem is not CS regimes it is inefficient CS
  regimes
• Obvious response is to improve law in such
  regimes, using the term to include soft law and
  non-legal institutions like the financial press
• Good law requires
• Substantive statement of PBC limits
• Disclosure that can trigger enforcement
• Effective private and pubic enforcement techniques

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Eliminating Inefficient CS Regimes Thoughts
About Reform

• OECD White Paper finds that substantive standards
  are fine
• Recommends detailed reforms to improve disclosure
  and enforcement
• Expanding private enforcement and increasing
  regulatory resources and commitment take time
• What to do while developing disclosure and
  enforcement capacity

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Eliminating Inefficient CS Regimes Thoughts
About Reform

• Examples of interim reform measures more detail
  in OECD White Paper
• Eliminate pyramidal ownership
• No economic justification for the structure
• Extremely difficult to police intra-pyramid
  transfer pricing
• Early U.S. law prohibited all interested
  transactions prohibition gave way to judicial
  review as institutions developed
• Disclosure of affiliate/family relationships
• Develop culture of independent directors
  Professor Jangs research suggests that
  independence can reduce the cost of capital in
  Asian CS regimes