Why Corporate Governance Matters for Vietnam: Importance for Listed Companies

OECD/World Bank Asia Roundtable on Corporate Governance_______________Ronald J. Gilson Stanford & Columbia Law Schools

Hanoi, VietnamDecember 6, 2004

The Starting PointCorporate Governance : Military Music Governance MusicThis is an exercise in production not democracy

ImplicationsCorporate governance is concerned with allocational efficiency: increasing the size of the pieReal governance, where there is political accountability, is concerned with distributional equity The standard for assessing corporate governance systems is therefore wealth creation: which structures, under which circumstances, create the most resources for society to divide?

Focus: Listed CorporationsMy focus today will be listed corporations. Only the involvement of external capital raises governance, as opposed to management, issues.Corporate governance as an investment contractThe investor gives , $, , ; what does the investor get?The answer to that question influences the corporations cost of capital.

Forms of External Capital: The Debt Contract vs. Equity ContractThe debt contract is hardIf the corporation violates the loan agreement, immediate legal action is possibleThe equity contract is softCommon stock holds the residual claimReturns are contingent on performance and strategyNo specific rules specifying amounts or timing of distributions to shareholdersCorporate governance is the equity contract: processes and general standards of behavior are substituted for the specific obligations of the debt contract

The Link between Corporate Governance and the Cost of CapitalIf a proposed debt contract gives the lender little protection, the interest rate the lender demands will increaseIf a nations corporate governance gives the equity investor little protection, investors will pay a lower price for corporate stock and the cost of equity capital will increaseDifferent national governance systems represent different approaches to protecting public equity investors

The Taxonomy of Corporate Governance SystemsPublic equity investors always confront a separation of ownership and controlSomeone else will be making the decisions that determine the value of their investmentAll systems that accept public equity investors must address the central corporate governance problemHow do equity investors make sure that managers perform well (the duty of care) and do not take private benefits for themselves (the duty of loyalty)?

The Critical Role of the Controlling ShareholderMost listed corporations in Asia have a controlling shareholder (CS)To understand the CS role, start with corporate governance in systems where listed corporations typically do not have a controlling shareholder the US and the UKRely on internal monitoring like independent directors and market mechanisms like hostile takeoversBoth techniques are effective but have limitationsGetting the incentives of independent directors rightHigh cost of hostile takeovers

Controlling Shareholders as an Alternative MonitorCS may better police managements duties of care and loyaltyLarge investment aligns the interests of CS and public equity investorsBut a system of CS as focused monitors come with its own costsPrivate benefits of control (PBC): benefits to the CS not provided to public shareholdersPublic shareholders will prefer a CS and the cost of equity capital will be reduced if the gains from better monitoring exceed the private benefits of control.

Controlling Shareholder Regimes: Good Law versus Bad LawTwo kinds of controlling shareholder regimesInefficient CS regimes where PBC > the gains from focused monitoringEfficient CS regimes where PBC < the gains from focused monitoringCost of equity capital depends on whether legal and cultural corporate governance standards effectively constrain PBC

Differential between controlling and minority shares in CS systems depends on the quality of law

Source: Nenova (2003); Dyck & Zingales (2002)

Implications of Distinguishing between CS Regimes: Value Differential in Efficient and Inefficient CS Regimes

Additional Evidence of Link Between PBC and Firm ValueIn Asian countries with CS regimes, firm value is related to the amount of PBC extracted by the CS (Classens et. al.; Black et. al.)Firm value increases as the equity share of the CS increasesFirm value decreases as the difference between the CSs control rights and its equity share increasesImplication: Firm value increases and decreases with the CS incentive to extract PBCIncrease in value of public equity in Korea following requirement of majority of independent directors despite no change in operating performanceImplication: A smaller portion of the same cash flow Is extracted as PBC

Implications of Distinguishing between CS Regimes: The Taxonomy is Wrong

Traditional approach distinguishes between regimes with widely distributed shareholdings (the US & UK) and CS systems (the rest of the world).Correct approachDistinguish between efficient and inefficient systems: are there effective constraints on CS extracting PBC?U.S. has a substantial number of listed companies with a CS

Diversity of Shareholding PatternsAn inefficient system will support only CS capital structuresAbsent constraints on PBC by a subsequent acquirer of control, an existing CS wont part with controlAn efficient system will support both CS and widely distributed capital structures

Diversity of Shareholding PatternsAbsent barriers, expect that shareholding patterns will differ within a jurisdiction depending onNature of industryNature of competitionRate of technology changePreferences of individual CSGeneration of CSIf bad law prevents giving up control, all companies should have CS

Diversity of Shareholding PatternsDistribution of Controlling Shareholders and Widely-held Companies in Sweden and ItalySource; Faccio & Lang (2003)OECD/Classens et. al. report Italy-like distribution for East Asia; Gompers et. al. reports diversity in U.S.

Controlling Shareholder(family)Widely-HeldSweden

46.94%39.18%Italy59.61%12.98%

Implications of Inefficient CS RegimesAbsence of diversity in inefficient CS regimes has macroeconomic implicationsFirms prevented from adopting most efficient organizational formHigher cost of equity capital in capital markets with significant frictions, capital structure mattersEliminates possibility of private equity/LBO recycling of underperforming companies

Eliminating Inefficient CS Regimes: Thoughts About ReformProblem is not CS regimes it is inefficient CS regimesObvious response is to improve law in such regimes, using the term to include soft law and non-legal institutions like the financial pressGood law requiresSubstantive statement of PBC limitsDisclosure that can trigger enforcementEffective private and pubic enforcement techniques

Eliminating Inefficient CS Regimes: Thoughts About ReformOECD White Paper finds that substantive standards are fineRecommends detailed reforms to improve disclosure and enforcementExpanding private enforcement and increasing regulatory resources and commitment take timeWhat to do while developing disclosure and enforcement capacity

Eliminating Inefficient CS Regimes: Thoughts About ReformExamples of interim reform measures more detail in OECD White PaperEliminate pyramidal ownershipNo economic justification for the structureExtremely difficult to police intra-pyramid transfer pricing Early U.S. law prohibited all interested transactions; prohibition gave way to judicial review as institutions developedDisclosure of affiliate/family relationshipsDevelop culture of independent directors Professor Jangs research suggests that independence can reduce the cost of capital in Asian CS regimes

::I want to be clear about an important premise on which my approach to corporate governance is built this is economics, not political science. For present purposes, I am just being descriptive, although I am quite prepared to defend the claim on political grounds. I do not want company boards of directors, who have no political responsibility, making social policy. Regardless of their makeup, they are not representative and they are wholly unaccountable.

I do recognize that there is another side to the argument. A capitalist system depends on broadly based support fot its fairness and effectiveness. This has always been for me the best argument in favor of prohibiting insider trading -- if investors dont trust the market, it undermines support for the system generally.For an example of that approach, Compare recent french position on the effort to update and broaden the OECDs principles of corporate governance standards. Existing draft states that worker involvement should be permitted; the French request, which has stalled the approval process, would change the language to state that labor should have a governance role. Floyd Norris, IHT, 3-27-28/04, p. 11. Need to defend that this creates more wealth. Not impossible, but needs to be done.Corporate governance is a coherent subject only with respect to public corporations. Contracts govern all other input providers contributions to the corporations, like a bond indenture, loan agreement, or supply contract. Corporate governance is the contract governing equitys investment.Leads to predictionsNot trying to be exhaustive See Merton