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Emerging Market Finance:

Lecture 5: Corporate Governance Issues

Separation between ownership and control

How can property rights be protected for all shareholders?

Incentive issues: how to ensure that managers will make the

“right” decisions?

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Historically Speaking

Back in 1700 or even 1800, corporate governance was not a big problem, and necessary institutions were not demanding yet

Because ……there were mostly “family businesses”

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Ownership structures of public companies:which form is the “best”?

Diverse ownership with many small shareholders: extreme separation between ownership and control

Family-controlled: some separation between ownership and control, with a family being the controlling shareholder.

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Problems with Dispersed Ownership

The Enron example

The case of “Investment Privatization Funds” (IPF) in the Czech Republic and Russia

Key reason: it may not be worth any shareholder’s efforts to mind the firm’s business, because each shareholder holds too small a stake.

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Investors: Millions

Public Corp.Stock market

Regulators (SEC)

The Court

The Press & Mkt Partic.

Auditors & Others

The Board

But, the scale and scope of modern corp. requires large financing, even arm’s-length financing. It takes “a lot” to support publicly traded corporations or stock market!

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Internal governance design issue:Positive Incentives to Resolve Conflicts between

Management & Shareholders

Design 1: performance-based bonus

Design 2: give shares to CEO and other top executives

Design 3: stock options

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In the U.S., how much did the CEO get for each $10,000 of Shareholder Value Increase?

7. 5

25

36. 6

69. 1

0

40

80

Bonus Shares owned by

CEO

Stock Options owned by CEO

In Total

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Do Executive Incentives Make any Performance Difference?

1.20%

5.70%

0%

2%

4%

6%

Diff in ROE Diff in Stock Returns

Two groups of companies used: (1) public companies for which the board required the CEO to hold a minimum level of shares and (2) firms in the same

industry but without minimum shareholding requirement for CEO

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Absent of Reliable Institutions

What can the shareholders do?

---- One way is to have large shareholders or concentrated ownership, so that someone “cares”!

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Problems with concentrated ownership: The case of Long-Fa Corp in China

On May 25, 2000, there were two Legal-Person Share transfers:

10.7 million shares from the largest shareholder to Nan-Du Group at $4.38 per share (to become 3rd largest shareholder)

12.87 million shares to another firm at $2.19 per share (to become 2nd largest shareholder)

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Question: Why Pay More on Same Day?

Nan-Du Largest Shareholder

10.7 million shares @ $4.38

Another shareholder

Past 3rd Shareholder

12.87 million shares @ $2.19

(Paid $23.43 million more)

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The first related-party asset swap: Sept. 2000

Nan-Du Long-Fa Corp.

Sell 49.5% of Nan-Du Network: @ assessed value: 117.1 million.

Book value = 63.21 million

Sell Long-Fa Ski Resort: @ assessed value: 76.1 million.

Book value = 75.43 million

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Second related-party Transaction: May 2001

Nan-Du Long-Fa Corp.

Sell 37% of Nan-Du’s Cable Company:

@ assessed value: 83.72 million.

Book value = 35.93 million

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After the Tunneling Efforts …

Long-Fa Corp’s earnings dropped 25% from 2000 to 2001

Revenues dropped 15.2%Its ROE dropped to 2.56% in 2002.

After selling its worst assets to Long-Fa Corp. Nan-Du decided to sell its holdings of Long-Fa @ $2.8 per share, in March 2002.

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Another common problem

Voting (control) rights often do not correspond to cashflow rights:

you pay the same price for a share, but do not get the same “rights” as the controlling shareholder does on a per-dollar basis

The use of pyramid holding structure to commit the least cash but hold a controlling position

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Claessens, Djankov & Lang (2000, J. of Fin. Econ.)

Case of the Ayala family in the Phillipines

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Case of the Li family in Hong Kong

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Back to Dispersed Ownership: Any mechanisms to make shareholders more active?

Class action suits: an efficient way for outside shareholders to play a more active role

Market for corporate control: hostile takeovers