Corporate Governance

Corporate Governance

International Financial Management

1

Corporate Governance….

2

Home Depot’s chief executive, Robert Nardelli, was removed after shareholders protested his pay.

Home De(s)pot

3

Home De(s)potBob 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!!!

4

Home De(s)pot

5

Home De(s)pot

6

AgendaGovernance of the Public CorporationAgency ProblemLaw and Corporate GovernanceCorporate Governance Reform

Sarbanes OxleyCadbury Code

7

Governance of the Public CorporationCorporate 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.

8

9

Governance of the Public CorporationPublic 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.

10

The Agency ProblemIncomplete contracts create room for

agency problems, and managers often grab the residual control rights.PerquisitesSteal fundsDivert fundsWaste fundsManagerial entrenchment

Free cash flows, Payout problemsRetain cash to avoid future capital raisingSize Higher compensationSize Higher prestige

11

Remedies for Agency ProblemBoard of directors

Outside directors on boardCEO and chairman of board different peopleEurope – union representation, two-tier boards

Incentive contractsStocks and stock optionsIndependent compensation committee

Concentrated ownershipGermany, France, Japan, China, Latin AmericaMorck, 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.

12

Morck, Shleifer, and Vishny (1988)

x y Manager Ownership (%)

Firm

Val

ue

13

Morck, Shleifer, and Vishny (1988)

x y Manager Ownership (%)

Firm

Val

ue

Alignment Entrenchment Alignment

14

Remedies for Agency ProblemAccounting Transparency

Accurate accounting information in a timely fashion

DebtLess managerial discretion wrt payoutsLess flexibility for financing investment

projectsOverseas Stock Listings

Credible bond to provide better investor protection (Doidge, Karolyi, and Stulz (2002))

Market for Corporate ControlDisciplinary effect on managers and enhance

company efficiency (US and UK)Developing also in Germany, Japan, etc.

15

Law and Corporate GovernanceLa Porta, Lopez-de-Silanes, Shleifer, and Vishny (LLSV) Sharp differences among countries with respect to:

Corporate ownership structureDepth and breadth of capital marketsAccess of firms to external financingDividend policies

Explained by how well investors are protected from expropriation by managers and controlling shareholders and the origin of the country’s legal system.English common law – discrete rulings, judicial

precedentFrench civil law – codification of legal rules (Roman)German civil law – codification of legal rules (Roman)Scandinavian civil law – codification/precedent

16

Law and Corporate GovernanceLLSV (1998) Invented the: Shareholder Rights

Index and the Rule of Law IndexEnglish 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

17

Consequences of Law LLSV (1998) find that corporate ownership tends to be

more concentrated in countries with weaker investor protection.

Legal Origin Ownership Concentration

External Cap/GNP

Domestic Firms/Population

English common law

0.43 0.60 35.45

French civil law 0.54 0.21 10.00

German civil law

0.34 0.46 16.79

Scandinavian civil law

0.37 0.30 27.26

18

Consequences of LawDominant investor may seek to acquire control

rights in excess of cash flow rightsShares with superior voting rightsPyramidal ownership structure

Li Ka-Shing Family (Hutchison Whampoa)Lee Keun-Hee (Samsung Electronics)Robert Bosch GmbH (Daimler-Benz)

Interfirm cross-holdingsPrivate 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%.

19

Consequences of LawCapital 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.

20

Consequences of LawDoidge, 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.

21

Corporate Governance ReformLate 1990s – Internal corporate governance

mechanisms, auditors, regulators, banks, and institutional investors failed…

Strengthen the protection of outside shareholders against expropriation of managers and controling shareholdersStrengthening the independence of boards of

directors with more outsidersEnhancing the transparency and disclosure

standard of financial statementsEnergize the regulatory monitoring role of the

stock market regulator and the exchangesModernize the legal framework

22

Sarbanes OxleyAccounting regulation

Public accounting oversight boardRestricting consulting/auditing

Audit committeeIndependent financial experts

Internal control assessmentAssessment by auditors and company (Section

404)Deemed costly and contestedCross-listing elsewhere…

Executive responsibilityCEOs and CFOs must sign off on the company’s

quarterly and annual financial statements. If fraud causes an overstatement of earnings, these officers must return any bonuses.

23

Sarbanes OxleyMany argue that SOX is hurting U.S. capital

markets.SOX undermines CEO’s appetites for riskSOX 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 York’s standing as the world’s financial markets.

24

Sarbanes OxleyMany 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 stocksEquiduct, and all-electronic, Pan-European exchange

based in BelgiumGoldman 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…)

25

Sarbanes OxleyU.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.

26

NYSE Corporate GovernanceListed companies to have boards of

directors with a majority of independentsThe 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

27

Cadbury Code of Best PracticeFerranti, 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 lawLSE requires companies to “comply or explain.”Empirical research suggests the code has been

effective despite not being enforceable in courts…

28

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.jsp29

FTSE ISS CGI

30

Corporate Governance Around the WorldEuropean Corporate Governance Institutehttp://www.ecgi.org/codes/all_codes.php

31

ParmalatLet’s 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 Parmalat’s collapse.

Study and discuss Italy’s corporate governance regime and its role in the failure of Parmalat.

32

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…

33