International Financial

Management

Corporate Governance

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 Corporate Governance….

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 Home De(s)pot

Home Depot’s chief executive, Robert Nardelli,

was removed after shareholders protested his pay.

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 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!!!

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 Home De(s)pot

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 Home De(s)pot

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

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 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.

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 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.

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 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

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 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.

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 Morck, Shleifer, and Vishny
(1988)
Firm Value

x y Manager Ownership (%)

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 Morck, Shleifer, and Vishny
(1988)
Firm Value

Alignment Entrenchment Alignment

x y Manager Ownership (%)

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 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.

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 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
country’s 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

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 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

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

Legal Origin Ownership External Domestic

Concentration Cap/GNP Firms/Population
English common 0.43 0.60 35.45
law
French civil law 0.54 0.21 10.00
German civil law 0.34 0.46 16.79

Scandinavian 0.37 0.30 27.26

civil law

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 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%.

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 Consequences of Law
 CapitalMarkets 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.

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 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.

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 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

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

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 Sarbanes Oxley
Many argue that SOX is hurting U.S. capital markets.
SOX undermines CEO’s 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
York’s standing as the world’s financial markets.

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 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…)

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 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.

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 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

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 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…

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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.jsp
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FTSE ISS CGI

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 Corporate Governance Around the
World
European Corporate Governance Institute
http://www.ecgi.org/codes/all_codes.php

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 Parmalat
Let’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.

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 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…

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