Corporate Governance

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Corporate Governance

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

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Corporate Governance in Asia (I)
Source McKinsey, 2001
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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?

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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

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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

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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

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Corporate Ownership

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

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Systems of Corporate Governance

• Outsider model
• Insider model
• Family/ state model

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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Control Management Opportunism

• Four crucial pillars
• Accountability
• Transparency
• Minority investor protection measures
• Enforced regulations

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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

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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

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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

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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.

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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.

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Causes of Convergence of Corporate Governance
Systems

• The globalization of markets
• Path dependency and the politics of governance
• Legal convergence

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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

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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

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Policy Maker

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

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END