International Corporate Governance

Reading: Chapter 1 (pages 3-21)

Lecture Outline
What is Corporate Governance? Internal Mechanisms External Mechanisms Convergence Measuring Corporate Governance Benefits of Good Governance What you need to remember

Introduction
Stage 1:
Equity
Voting Rights

Company founded (owned and managed) by individual, family, partnership, government or company. Stage 2:
Equity
Voting Rights

New Equity
Voting Rights

Debt

Company expands by issuing more equity and debt. New equity holders also get voting rights as to who manages the company.
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Introduction
Company founder must now choose between keeping control of the company or allowing the company to be managed by professional managers.
Equity
Voting Rights

New Equity
Voting Rights

Debt

If they keep control there is a potential conflict between the founders and other shareholders.

If they pass management to professional managers there is a potential conflict between owners and managers.
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What is Corporate Governance?

Corporate governance is about minimizing the loss of value that results from the separation of ownership and control. It deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment. While corporate governance has been a hot issue in recent years (Enron, Worldcomm, HIH and One.Tel) it is a problem that has been around for hundreds of years Adam Smith (1776).
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What is Corporate Governance?

Good corporate governance practices involve:
The corporate governance framework should protect shareholders rights. The corporate governance framework should ensure the equitable treatment of all shareholders. Stakeholders should be involved in corporate governance. Disclosure and transparency is critical. The board of directors should be monitored and held accountable for what guidance it gives.

Internal Mechanisms
Board of Directors
Board Size & Independence Chairman/CEO Positions Board Committees

Executive Compensation Ownership Structure

Concentrated versus Dispersed Ownership Identity of Owners Other Blockholders

External Mechanisms
External Auditors Debt & Equity Markets
Monitoring by debt holders Analysts Mergers & Acquisitions

Legal/Regulatory System
Common versus Civil Law Extent of Law Enforcement Recent Regulations Sarbanes Oxley Act, ASX Good Corporate Governance Principles
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International Differences

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Board of Directors
The board of directors is responsible for overseeing management and representing shareholders interests. US and Australia have single-tiered boards, headed by a Chairman of the Board. The CEO and other executives usually also sit on the board. Some other countries (Germany, Indonesia) have two-tiered boards. The roles and composition of the two boards can differ.

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Board Size
Boards should be an appropriate size not too big not too small. Depending on the size of the company within the range of 5-15 is normal. If the board is too small, there is a lack of monitoring. If the board is too big, there are problems reaching a consensus for decision making.

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Board Independence
Boards should have a majority/high proportion of outside/independent directors. Outside/independent directors should have no personal interest in the company and therefore are more effective monitors. But, it is also a good idea to have some company insiders (CEO, executives) on the board to provide the board with a better understanding of the companys operations.

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Chairman/CEO Positions
The Chairman of the Board is responsible for overseeing the board of directors. The CEO is responsible for the day-to-day running of the company. In family-controlled companies it is common for the same person or relatives to hold both of these positions. But, this concentrates power and reduces monitoring. Therefore, the positions of Chairman and CEO should be separated.
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Board Committees
The board of directors can delegate certain duties to board committees this can provide increased monitoring on specific issues. Audit committee responsible for internal audit function and appointment of external auditor. Remuneration committee responsible for setting appropriate compensation for directors and executives. Nomination committee responsible for finding appropriate directors and executives.
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Executive Compensation
Compensation of top executives can be used to tie the interests of the executives to those of shareholders. Variable performance packages are preferred:
If they perform well, they are rewarded. If they perform poorly, they are not rewarded or fired.

Alignment of interests is usually achieved through:

Stock ownership Stock options

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Ownership Structure
Australian and US companies are usually owned by widely-dispersed shareholders and controlled by professional managers. This means that no single party is in control of the company. However, in other nations around the world, ownership is usually concentrated in the hands of family groups or government entities. This means that one group is in control of the company and there is very little you can do (other than sell) if you dont like what theyre doing.
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Ownership Structure
Company BHP
Commonwealth Bank Westfield Singapore Air Formosa Plastics Hutchison Whampoa

Largest Shareholder 17.22%

8.70% 5.01% 56.76% 34.12% 51.79%

Shareholder Identity Nominee

Nominee Company Government Family Family

Top 20 Shareholders 74.48%

61.90% 23.53% 93.83% 45.04% 92.11%

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Ownership Structure
The identity of the controlling owner can also have corporate governance implications. Family-controlled companies use cross-holdings and pyramidal structures to gain effective control of the company with the least cash ownership. The market recognizes this and prices the increased risk of expropriation into the share price. Government-owned and widely-held companies are more likely to follow the rules.

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Ownership Structure
The presence of an non-management related blockholder of shares can increase monitoring of the firm. A blockholder usually holds at least 5% of the outstanding shares, therefore has a significant interest in the future performance of the company. Blockholders can be governments, financial institutions, individuals or other companies.

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External Auditors
Stock exchange listing requirements usually make it mandatory for companies to employ an external auditor to audit their financial statements (and internal controls). External auditor should be independent of management, but .

Tenure of auditor Tenure of audit partner

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Monitoring by Debt holders

Debt holders provide capital to the company usually with conditions:

Debt covenants Secured on assets

Therefore debt holders actively monitor management to ensure that companies are meeting debt conditions and that they wont default.

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Analysts
Securities analysts are professionals employed by investment banks / brokers / asset managers to monitor companies and provide stock recommendations (buy/sell), earnings forecasts, longterm growth forecasts, target prices etc. Provides an extra level of monitoring for investors. But, analysts incentives/conflicts of interest mean that not all of their output is trustworthy.
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Takeover Market
The merger and acquisition (M&A) market stands as a court of last resort for assets that are not being utilized to their full potential. If management are underperforming there is a good chance that this will be noticed by the market and other players will want to take control of the company. There are active takeover markets in Australia, US, UK, New Zealand, but few other countries.

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Intervening Variables
Measures put in place by companies that restrict shareholder rights and the effectiveness of takeover markets:
Staggered boards Limits to by-law/charter changes Supermajority requirements for mergers Poison pills Golden parachutes

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Legal Systems
Each countrys legal system has built in a certain degree of investor protection. However, there is a wide variation in protection and enforcement of these rules around the world. Common law countries provide highest protection and French civil law countries provide the least protection. Low investor protection seems to result in concentrated ownership and underdeveloped equity markets.
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Legal Systems
Country
Australia France Germany India Japan Korea Philippines Netherlands UK USA

Legal System
Common law French Civil law German Civil law Common law German Civil law German Civil law French Civil law French Civil law Common law Common law

Protection
4 2 1 5 4 2 3 2 5 5

Rule of Law
10 8.98 9.23 4.17 8.98 5.35 2.73 10 8.57 10
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Recent Regulations
In response to the Enron crisis in the US, the Sarbanes Oxley Act was passed in 2002. This has significantly increased governance practices and the personal liability of directors in the US. Most other nations have issued Corporate Governance Best Practice Guidelines to assist companies in improving their governance ASX Corporate Governance Guidelines & Best Practice Guide (on OLT site). But these are voluntary!
BHP website BHP Annual report

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Convergence?
Originally there were market-based, family-based, bank-based, government-affiliated systems. In recent years, most nations have started to promote US and UK best practice corporate governance guidelines. But not all companies are adopting these measures. There is evidence that family-controlled companies in particular are refusing to improve their corporate governance practices.
Asian Corporate Governance Association
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Measuring Corporate Governance

Understanding what good corporate governance is about is quite easy. However, it is difficult to measure whether companies are really committed to good governance. All we can do is measure if they have certain corporate governance mechanisms in place we dont know if they are effective or not! Organizations such as Standard and Poors and Credit Lyonnais Securities Asia have started providing corporate governance ratings in recent years.
S&P
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Benefits of Good Governance

Researchers have shown that companies with good corporate governance practices are valued more highly and run more effectively. So the benefits of good governance include:
Higher share price Lower cost of funds Greater international following

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What you need to remember

When investing it is worthwhile keeping in mind whether a company has committed to good corporate governance or not. You can use the mechanisms highlighted in this lecture or corporate governance ratings as a guide. Corporate governance becomes most important during stock market crashes and bad economic times. But, it is not a perfect science. Managers will always find a way to circumvent monitoring to achieve their own goals!
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