FINANCE, LAW AND MARKETS:THE INSTITUTIONAL ELEMENTS OF CORPORATE GOVERNANCE

SESSION 3

Outline

Origins and development of different corporate governance systems.

The critical influence of finance, law and markets in sustaining

alternative corporate governance values, structures and practices.

Distinctiveness and viability of market and relationship based systems of governance.

Impact of the new emerging force in corporate governance represented by the increasing vastness of the institutional investors

The Distribution of Outstanding Listed Equity Among Different Categories of Shareholders

United States1996

Japan2001

Germany1996

France1994

UK1994

Italy1994

Sweden1996

Australia1996

Korea1996

Financial sector 46 40 39 8 68 8 30 37 26

Of which

Banks + Financial Institutions

7 30 10 4 10 5 1 4 12

Insurance +Pension Funds

28 10 12 2 50 3 14 25 6

Investment Funds 12 0 8 2 8 0 15 8 8

Non-Financial Sector 54 60 70 92 32 92 70 63 74

Of which

Non-financial enterprises

0 22 42 58 1 25 11 11 21

Individuals 49 20 15 19 21 50 19 20 34

Public Authorities 0 1 4 4 1 8 8 0 7

Foreign 5 18 9 11 9 9 32 32 12

Total 100 100 100 100 100 100 100 100 100

Note: Due to rounding, these figures may not add up to the total. Pension Funds in Japan are managed by trust banks and Insurance companies. Division between banks and insurance companies are estimated. No data available on the extend to which mutual funds own shares. Security Australian figures are for the end of September1996.

Source: OECD (2004), “ Corporate Governance a Survey of OECD Countries”

Trends in Financial Assets of Institutional Investors (1998-2007)

8.9 10.015.9

27.14.0

7.5

14.6

22.7

4.05.2

8.7

17.6

0.0

17.5

35.0

52.5

70.0

87.5

1998 2001 2004 2007

Deposits Debt Securities Equity Securities

US

$

Tri

llio

ns

% of Total Financial Assets 20

%22%

27%

32%

13%

21%

18%

10 year compoundAnnual growth rate

17.0

22.7

39.1

67.4

The Evolution of Corporate Governance Forms and Democratic Governance (Gomez & Korine 2003)

Era 19th Century – 1920

1920 – 1970 1970 – 21st Century

Form of capitalism

Family capitalism Managerial capitalism Popular capitalism

Elements of DemocraticGovernance

Equality of rights to

ownership

Implementation: Creation of rights to ownership independent of social standing.

Reinforcement: Strengthened by corporate law; protection for quoted corporation

Reinforcement: Strengthened by new rules on the right to vote; protection of minority interests

Separation of ownership /

control

No. Implementation: Generalization of the limited liability corporation, with general meetings, boards, executives.

Reinforcement: Increasing board control over managers

Representation with

public debate

No. No. Implementation: Mass ownership; stakeholder activism

Separation of Ownership and Control

Almost complete ownership control

Majority control

Control through a legal device without majority of ownership

Minority control

Management control

Revised Berle and Means Model of Ownership and Control

Board of Directors

Share

pric

e in

form

atio

n

Quarterly reports

Vo

tin

gp

ow

er

Dir

ect

con

sult

atio

n

Dividends

Corporation(management andphysical capital)

LendersEmployees

CustomersCustomers

Interest payments(market rates)

Suppliers

Labour

Inputs

Supervisory power

Board of Directors

Securities markets

SHAREHOLDERS

Vo

tin

gp

ow

er

Dir

ect

con

sult

atio

n

Corporation(management andphysical capital)

LendersEmployees

CustomersCustomer

Dept capitalWages

(market rates)

SuppliersNational &

LocalGovernment

TA

XE

S

PU

BLIC

GO

OD

S

Market price

Goods & Services

Mar

ket P

rice

InstitutionalInvestors

Adapted from: M. Blair, Ownership and Control (1995)

Source: Adapted from Blair M. (1995).

The Development of Law and Regulation

Law influencing conduct of corporate governance: Financial markets regulation (securities law) Corporate law Labour law

The US legal structure in order to achieve market liquidity and shareholder value with highly developed securities market law:

The SEC regulates the capital market Corporate law is developed by the independent states

The European approach:

Less emphasis on capital markets, which have

traditionally been less important in this system Favours internal regulation of the firm Corporate and labour law plays a much greater role The controlling interests of majority shareholders protect

management from capital market fluctuations.

The Development of Law and Regulation

Bank, Majority and Market Based Finance

Market for corporate control

Majority group control

Hostile takeovers

Number of Takeovers by Region

Number of announced uncontested takeovers

0

200

400

600

800

1000

1200

1400

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

US

Ex UK

EU 15

UK TotalCanada

Other

Australia

(252) Under the Thomson Financial Data (TFSD) definition a tender offer that was recommended by board of the target company to its shareholders

252

Source: Becht, Bolton and Roell (2002).

Number of Takeovers by Region

Number of announced contested takeovers

0

10

20

30

40

50

60

70

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

EU 15

US

UK Total

AUST

Canada

OtherEX UK

(253) Under the TFSD definition a tender offer that was initially rejected by the board of the target company.

253

Source: Becht, Bolton and Roell (2002).

Corporate Governance Regimes

Forms of Control

Control by Debt

Control by the Securitiesmarket

Control by Shares

Nature of control and basis of evaluation

Solvency prime rate + bank riskpremium

Market for control (take-over bid; public offer of exchange) market price/private evaluation of

the firm’s potential

Financial evaluation of performance (EVA/MVA)

Style of Governance and constraints on the company

Long-term commitment Solvency constrain

Threat to oust the controlling groupMaximization of share price

Charters of governanceMaximization of the financial return on equity

Types of capitalism

Corporative Predator Shareholder value

Source: Aglietta M. and Breton R. (2001).

Corporate Governance Alternative Systems

Feature Anglo-Saxon Germanic Latin Japanese

Orientation Market oriented (an active external market for corporate control)

Market-oriented (relatively oligarchic, influenced by networks of shareholders, families and banks)

Network-oriented Network-oriented

Representative countries USA, UK, Canada, Australia, NZ Germany, Netherlands, Switzerland, Sweden, Austria, Denmark, Norway, Finland

France, Italy, Spain, Belgium, Brazil, Argentina

Japan

Prevailing concept of the firm

Instrumental (as a means for creative shareholder value)

Institutional (autonomous economic units coming out of a coalition of shareholders, corporate managers, suppliers of goods and debts, and customers)

Institutional Institutional

The Board system One-tier (governance with one level of directors, making no distinction but executives and non-executives

Two-tier (executive and supervisory board, the latter monitoring, appointing or dismissing managers; large shareholders on the Board and high pressure from banks)

Optional (France) in general one-tier

Board of directors, offices of representative directors, of auditors, de facto one-tier

Main stakeholders to exert influence on managerial decision-

making

Shareholders Industrial banks (mainly in Germany; in general, oligarchic group inclusive of employees’ representatives)

Financial holdings, the government, families, in general oligarchic groups

City banks, other financial institutions, employees in general oligarchic groups

Importance of stock and bond markets

High (requiring continued action and performance)

Moderate or high (legal and regulatory bias against non-bank finance)

Moderate or poor High (legal and regulatory bias against non-bank finance)

Is there a market for corporate control?

Yes No No No

Ownership concentration

Low Moderate or high (very high in Germany) High Low or moderate

Compensation based on performance

High Low Moderate Low

Time horizon of economic relationships

Short-termism (management and governance myopia)

Long termism Long termism Long termism

Strengths Dynamic market orientation, fluid capital, internationalization extensive

Long-term industrial strategy, very stable capital, robust governance procedures

Very long-term industrial strategy, stable capital, major overseas investment

Weaknesses Volatile, short-termism, inadequate Internationalisation more difficult, lack of flexibility, inadequate investment for new industries

Financial speculation, secretive governance procedures, weak accountability.

Sources: Adapted from Keenan J. and Aggestam M.(2001); and Clarke T. and Bostock R. (1994)

Reputational Intermediaries for Sound Corporate Governance (Apreda 2003)

Disclosure Securities laws on full disclosure of financial results and self-dealing transactions

Ownership disclosure rules

One-share, one-vote rule. In general, rules to prevent or restrict pyramid ownership structures

Strong publicly enforced civil and criminal sanctions against insiders for violating the disclosure and self-dealing rules

Civil liability risk for insiders

Honest, sophisticated and well-functioning courts.

Honest, sophisticated securities agency and prosecutors for criminal cases both furnished with staff, skills and budget to accomplish their tasks efficiently

Board of Directors

Independent directors who can control self-dealing transactions

Procedural controls on self-dealing transactions with review by independent directors, non- interested shareholders, or both

Civil liability risk for independent directors who approve gross self-dealing transactions.

Independent directors on auditing and compensations committees

Market Environment

Market transparency rules (time, quantity and price of trades promptly disclosed to investors)

Investor property rights protection

Stock exchange with reliable listing standards and active surveillance of insider trading to fine or de-list trespassers.

Enforced ban on market manipulation

A culture of disclosure (“concealing bad news is a recipe for trouble”)

Active financial press and securities analysts profession

Reliable judiciary system and widespread law enforcement

Reputational Intermediaries for Sound Corporate Governance

Accountants

•Good accounting and auditing rules•Accounting review of self dealing transactions•Civil liability risk for accountants•An institution with competence and independence to write accounting rules•Sophisticated accounting profession

•Securities lawyers to ensure issuers abide by the law and rules of disclosure•Civil discovery rules and class action procedure to protect minority rights•Liability risk•Lawyers review of self-dealing transactions

Lawyers

Investment bankers •Sophisticated banking profession to investigate the issuers of securities•Civil liability risk for investment bankers

Other Reputational Intermediaries

•Rating agencies that furnish not only credit-risk rating but also country-risk ratings worldwide• Venture capital funds that allow new enterprises to be financed and monitored, and also provide them with reputational capital•Public regulators like central banks and securities exchange commissions•Self regulatory organizations (SRO), either voluntary or mandatory, subject to regulatory oversight•Corporate monitoring firms (Latham, 1999)

How Efficient are the various Methods of Controlling Managers?

Source: Inspired by Bebchuk & Fried (2003)

Device Rationale Limits

Incentive Pay

Indexing wage on performance Aligning managers’ and rank-and-file workers’ interests

Possible manipulation of performance by managers

Bonus linked to profit Aligning managers’ interests and firm strategy

Stock options Aligning CEO interest with shareholders’ wealth

Still a major gap between CEOand shareholders’ interests

Attribution of stock of the company Aligning CEO interest with shareholders’ wealth

Loosely correlated with CEO strategy and large benefits during financial bubble

Transparency

Public disclosure of CEO’s remuneration Trigger outrage from shareholders and institutional investors

Camouflage tactic by managers in spite of statements in favor of transparency

Remuneration setting

Creation of an independent remuneration committee

Prevent self-determination of remuneration by CEOs

The CEO may largely control the committee

Large number of independent members of the board

Prevent excessive remuneration by the detriment of shareholders

The income of members may depend on their generosity to the manager

Survey by consultant firms of CEO remuneration

Set an objective benchmark The reference to average or median remuneration induces spill-over and excessive pay increases

Market for corporate governance

Firing of CEOs Incentive to commitment Exceptional configuration in the past

Threat of takeover Puts a limit on CEO opportunism Golden parachute for losers CEO income may increase even if shareholders suffer value destruction

Pension Funds and Life Insurance Assets (selected OECD Economies 2003-2004)

0

2

4

6

8

10

12

14

16

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

Investment Funds

Insurance Companies

Pension Funds

Other forms of

Institutional Savings

OECD (17) total (in billions of US dollars)

19952005Average annual Growth

Source: OECD Recent Trends in Institutional Investors Statistics: Gonnard,et.al. (2008).

Pension Fund Allocation Around the World

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Ireland UK Hong Kong Australia* US Canada Netherlands Switzerland* France Germany* Japan

Equities Bonds and cash Property Other

Source: Watson Wyatt “ The role of equities in pension funds” 2005 * Allocations as at Dec 31 2003, Switzerland .Other includes cash

High

Low

None

YEARS

Imp

ort

ance

of

Co

rpo

rate

Go

vern

an

ce

Hedge Funds

Mutual Funds Private

investors

Life Assurers

Pension Funds

Time Horizons

Source: Morley Fund Management (2003).

Institutional Investor Concern for CG

Monitoring Activities by Institutional Investors

Mild Activism,Most Prevalent

.

.

Mild Activism,Most Prevalent

.

.

Public criticism, law suits, proxy battles

Aggressive activism,least prevalent

Source: ACGA Ltd, 2005

Public engagement,Attending AGMs

Voting “focus funds”

Private Engagement with Management

Source: ACGA 2005

Investment Fund Managers Role in Corporate Governance

INVESTORCLIENT

FUNDMANAGER

Enhanced returns/Reduced risks

INVESTMENT DECISIONS

OWNERSHIP DECISIONS

Accountability

Engagement FUNDS &

MANDATES COMPANY

Source: AMP Henderson Global Investors

Source: The Mays Report (2003).

Number of CG Proposals per year

0 10 20 30 40 50 60 70 80

2000 2001 2002 2003

Dividend payment

Board governance

Strategic alternatives

Expense stock options

Auditor independence

Director compensation/

Stock ownership

Board leadership

Director/ Board independence

Shareholders rights

Director nomination

Voting

Board elections- terms

limits / Declassify

Poison pill

Executive compensation

Dividend payment

Board governance

Strategic alternatives

Expense stock options

Auditor independence

Director compensation/

Stock ownership

Board leadership

Director/ Board independence

Shareholders rights

Director nomination

Voting

Board elections- terms

limits / Declassify

Poison pill

Executive compensation

Source: Monks, R et al (2004).

Resolutions Not Supported By AMP Capital Investors July –December 2005

0

5

10

15

20

25

30

35

Non-Salary¹comp

DirectorRemuneration

DirectorElection

Routine² Capitalisation³ Other RemunerationReports

30% not supported, reasons include:• Poor or non existent performance hurdles• Too short /term• Includes both non executive director and

company executives in same plan• Excessive quality/ too generous• Poor disclosure of terms• Non recourse financing

16% not supported, reasons include:• New fee levels were too high• Boards too large or ‘poorly’

composed

7% not supported, reasons include:• Too many affiliates• No independents• Poor committee composition• Need for more relevant skills• Board too large

3% not supported

0% not supported1% not supported

[1] Relates to employees stock and option plans, various long term incentive plans, retirement plans etc[2] Accepting financial statements, general amendments to constitution, appointing auditors, etc.[3] Approval or ratification for DRP share issues placements, etc.[4] Shareholders resolutions (self nominated directors), re-organizations and mergers, anti-takeover provisions

4

31% not supported, reasons include:• Concerns regarding terms of non-

salary compensation.• Poor disclosure• Unsatisfactory director refinement

and executive termination benefits.

BINDING VOTES NON BINDING VOTES

Source: AMP (2006) Corporate Governance: Why Bother?, Corporate Governance Report AMP Capital Investors

Source: AMP Capital Investors’ Corporate Governance (2006).

AFA

APRA

ASIC

AISTASA

ASFA

AIMRFPA

IAA

AFMA

IFSA

CMSF

SIA

ASX

InstitutionsInvestors Trustees

Master Trusts

Insurance Companies

Financial Markets

Regulatory

ATO

AFA

APRA

ASIC

AISTASA

ASFA

AIMRFPA

IAA

AFMA

IFSA

CMSF

SIA

ASX

InstitutionsInstitutionsInvestorsInvestors TrusteesTrustees

Asset Consultants

Asset Consultants

Master TrustsMaster Trusts

Insurance CompaniesInsurance

CompaniesFinancial Markets

Financial Markets

RegulatoryRegulatory

ATO

Source: UTS Centre for Corporate Governance 2002

The Complex Governance and RegulatoryRelationships of the Institutional Investors