1. Corporate Governance: Impact and EnforcementBy
Stijn Claessens
World Bank
(Based on joint work with Erik Bërglof, SITE/SSE)
For Corporate Governance Leadership Program
July 14, Washington, D.C.
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2. Why does corporate governance matter for growth and development?
Increased access to financing  investment, growth, employment
Lower cost of capital and higher valuation  investment, growth
Better operational performance  better allocation of resources, better management, creates wealth
Better relationship with stakeholders  environment, social/labor relationships
All of it matters for growth, employment, poverty
Empirical evidence has documented these relationships at the level of country, sector and individual firm and from investor perspective using various techniques

3. Access to financing
Countries with better property rights, especially better creditor rights and shareholder rights, have deeper and more developed banking and capital markets
In these countries, firms have greater access to financing, and as a consequence, firms invest more, grow faster. E.g., difference between Quartile 1 and Quartile 3 in financial development has been found to be percentage points extra GDP growth per annum
Poor corporate governance (and underdeveloped financial and legal systems and higher corruption) means firm growth of smallest firms is most adversely affected and less new, and particularly small firms, start up

4. Access to financing: creditor rights and rule of law
Depth of the financial system

5. Access to financing: quality of shareholder protection
Degree of capital market development

6. Cost of capital and valuation
Corporate governance affects cost of capital and valuation
Cost of capital higher and valuation lower in weaker property rights countries
Outsiders less willing to provide financing, voting premium higher in lower corporate governance countries, investors apply discount for worse corporate governance firms and countries (e.g., McKinsey survey)
Conflicts between small and large shareholders greater in weaker corporate governance settings
Conflicts between control and ownership rights, leading to higher cost of capital/lower valuation, greater in weaker property rights countries, less investment

7. Weak corporate governance translates into higher cost of capital
Excludes Brazil

8. Firms’ operational performance
Better corporate governance improves performance
Evidence for US and elsewhere suggests strongly that better corporate governance leads not only to improved rates on equity and higher valuation, but also to higher profits and sales growth, more capital expenditures, etc.
Operational performance is also better, but not so clearly
Although access to financing better and valuation higher, effects of governance on performance less pronounced
Other factors likely affect operational performance: firms may face better growth opportunities; a reporting bias
Still, rates on return on investment exceed cost of capital only in best corporate governance countries

9. Better corporate governance translates into somewhat higher returns on assets
Excludes Mexico and Venezuela

10. But much better higher returns on investment relative to cost of capital

11. Other stakeholders
Besides principal (owner), public and private corporations face many other stakeholders: banks, bondholders, labour, etc.
Each will monitor, discipline, motivate and affect the management/firm, in exchange for some control rights
Each will have its own comparative advantage
Banks: more, inside knowledge, state-contingent rights
Debt and debt structure: important disciplining factor, limit free cash flow/private benefits
Labour: market for managers; employees; others
Responsible towards all stakeholders can pay
Social corporate responsible can be good business for all and goes with good corporate governance

12. Developing countries’ challenges
Often abundant in labor, but short in physical and human capital
Gap in capital per worker remains large because private returns to investment low and risky
Poor protection of investors
Poor governance inside firms
Poor incentives to accumulate human capital
With rapid integration with international markets, institutional weaknesses affect macro-stability
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13. Financial markets development key to bridge gap
Financial markets depend on legal environment
Legal environment incomplete without enforcement
But, enforcement part of development. North (1991): “single most important determinant of economic performance”
How to think of enforcement? Link to corporate governance?
What are alternative enforcement mechanisms?
What is enforcement problem in corporate governance?
What are corporate governance mechanisms that can work in weak contracting environments?
What are the policy and new research issues?
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14. Capital markets and corporate governance
For capital markets, corporate governance key
Provides commitment towards stakeholders, in particular external investors (shareholders and creditors)  affects firms’ external financing, cost and volume (access)
Mitigates moral hazard problems
Facilitates collective action with multiple investors / stakeholders
But corporate governance is also about balancing multiple stakeholders’ interests, so perfect enforcement of every contract is not necessarily always first best
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15. Capital markets and corporate governance
Degree of capital market development
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16. Corporate governance and enforcement
Corporate governance requires enforcement. Or even stronger: corporate governance is enforcement
Each mechanism (Concentrated shareholdings, Hostile takeovers, Proxy fights, Board activity, Executive comp., Litigation, Bank monitoring, Public opinion and media, Other stakeholders) depends (to differing extents) on enforcement
Enforcement more important than laws. Evidence:
Laws: extensiveness vs. effectiveness
Insider trading rules: adoption vs. prosecution
Law and finance literature: suggestive
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17. Enforcement dominates laws-on-the-books
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18. What enforcement mechanisms? Continuum of alternative tools
Private ordering
Exception rather than norm
Unilateral, bilateral and multilateral, with multilateral mechanisms especially often used in finance
Private law enforcement
Litigation most important tool
Public law/regulation enforcement
Traditional view of enforcement
State-ownership/control
Has many problems, but may be considered
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19. Private ordering Unilateral mechanisms Bilateral mechanisms
Create valuable assets, most common reputation, involving sunk costs, e.g., advertising, or investments
Needs repeated dealings for it to work
Bilateral mechanisms
Use reputation, others’ enforcement, e.g., auditors
Self-enforcing agreements, e.g., split of functions, delegating of actions; joint investments, such as in JVs, vertical integration; hostages with firm-specific assets
Shareholder agreements: can be more specific; have covenants of hostage nature; and rely on other courts
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20. Private ordering Multilateral mechanisms
Financial intermediaries, e.g., banks, investment banks, rating agencies, clearing houses
Self-regulatory associations, e.g., industry organizations, codes of conduct/punishments (expel), minority shareholders associations
Self-regulatory organizations, e.g., stock exchanges, with listing standards and penalties
Arbitration, e.g., as in JVs, possibly backed up internationally, e.g., through NY convention
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21. Private ordering: evidence
Unilateral and bilateral mechanisms
Can work, e.g., voluntary adoption of CG, FDI
Up to a limit, however, as effectiveness depends on the overall institutional environment, country vs. firm
Multilateral mechanisms
Can depend on size/number of market, scope for entrenchment, degree of competition, multiple equilibriums. Many practical issues, e.g., arbitration: when to arbitrate and whom to use; which law?
Private ordering can be the basis for public law
Most need some form of public enforcement
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22. Private laws enforcement
Either the government creates the rules, but delegates the enforcement to others
Delegation of public enforcement to SRO/SRAs (e.g., stock exchanges) can be more efficient if more information, better tools/incentives
Or initiation of enforcement lies with private parties, with litigation the most important
The norm in securities markets (LSV, 2005)
Depends on standards set in the law, e.g., bright lines
Depends on legal system and institutional setup, e.g., class action suits, role of stock exchanges depends on competition, etc. especially with many constituencies
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23. Public law/regulation enforcement
SEC, other regulator type of approach, with courts
Seems less effective than private enforcement in securities markets, especially when institutional environment is weak
Public law enforcement depends on
Extensiveness and effectiveness of law: some laws are easier enforced than others, affects scope for enforcement and scope for misuse (bright line)
Independence (financially, politically, tenure) of the regulators and the checks and balances in the system
Efficiency of the court system, since backup is needed
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24. Extensiveness of laws and origins
What needs to be codified in the first place?
How does codification vary with level of development, social and economic features? How does codification interacts with various enforcement mechanisms?
Extensiveness of law affects enforcement problem
With imprecise laws, private ordering and private enforcement may be costly or uncertain, and the benefits for parties to deviate may be too big
But, broader laws allow for more evolution
Transplanting of laws/systems
Leads to less effective formal institutions, higher legality with voluntary adoption
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25. State control State ownership Golden share
Can be justified to deal with market failures, externalities, public goods, coordination issues, etc
Golden share
A more targeted approach to certain concerns
Regulations covering various areas have also corporate governance functions, especially with other stakeholders
Full control, through ownership or centrally planned economy/lack of market economy
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26. Choice of enforcement technologies
Overall environment
Social and other norms, civic capital, general political
Costs and benefits of each technology/issues
Outside options vary; Multistage issues, need several technologies; Public to back up
Path dependence, certain technology can stick
Technological progress can change choices
Mix of technologies will always be used
Vary by country, issue to be enforced
Rules and political economy
Tollbooth view: rules can create rent-seeking
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27. What enforcement mechanisms work in securities markets?
La Porta, Lopez-de-Silanes and Shleifer (2005), “What works in securities laws?” construct:
Private enforcement index = “Disclosure” and “Burden of proof”
Public enforcement index = “Supervisor”, “Investigative powers”, “Orders” and “Criminal”
Find for sample of 49 countries:
Securities market development is more associated with private enforcement index
Public enforcement works in developed countries only
More efficient institutional choice will often be private enforcement of public rules
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28. Private enforcement often works better in securities markets
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Each point represents one of 49 countries. Data from LLS (2005).

29. Limits to what firms can do when environment is weak
Many consider corporate governance a firm specific issue. True mostly in developed countries. But in many developing countries, general enforcement environment is weak and few traditional CG mechanisms are effective
Almost all the variation in governance ratings across firms in less developed countries is attributable to country characteristics (only 50% in developed countries; rest is firm characteristics) (Doidge, Karloyi, and Stulz, 2004)
Access to global markets sharpens firm incentives to improve governance, and decreases the importance of home-country (formal) legal protection of minority investors, but does not eliminate problem
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30. With weak enforcement
Predominant form of corporate governance in weak contracting environment is large blockholders and high ownership/control concentration
But this mechanism has important costs
Main corporate governance conflict for public firms: controlling owners vs. minority shareholders
But also corporate governance weaknesses impact private firms’ ability to raise financing and to grow
Overall adverse impact on corporate governance environment, institutional development
Limited scope for policy intervention
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31. Large blockholders dominate, with costs though and limited scope for policy
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32. What is scope for other corporate governance mechanisms?
Ownership concentration the outcome, yet has costs.
Most other mechanisms need some enforcement technology and tools, e.g, exit, collateral, bankruptcy, etc.
Will not work well with weak enforcement. What to do?
What to expect from private ordering, private law enforcement, public enforcement?
What is relative importance of each mechanism in developing countries?
What policy interventions can help reduce costs and reinforce specific mechanisms?
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33. Scope for policy interventions for other corporate governance mechanisms
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34. Scope for policy interventions for other corporate governance mechanisms
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35. Have to consider the political economy of enforcement
Laws and enforcement evolve under many pressures
Vested interests may block progress
Wealth concentration hinders reform
Enforcement is a difficult investment
Long-term payoffs, many bodies, subject to many parties, low political payoff
Enforcement is a public good, with few champions
Can be indirect effects of financial sector development, changes in ownership structures, real sector reform on desires for enforcement and institutional reform
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36. Implementation of the Acquis Communautaires
(company law)
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
10.0
1997
1998
1999
2000
2001
2002
2003
Year
Index
Bulgaria
Czech Republic
Estonia
Hungary
Latvia
Lithuania
Poland
Romania
Slovak Republic
Slovenia
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37. Variation in laws and in enforcement,
but change is possible
Country
Inside-Shares
Income
Related-Trans
Owners
CGSection
AR-Disclosure
AR-Disclosure_dif
Bulgaria
1.00
0.00
0.50
2.50
-1.00
Czech Republic
0.31
Estonia
0.36
Hungary
1.50
0.13
Latvia
-0.06
Lithuania
3.00
-0.69
Poland
2.00
-0.38
Romania
-0.13
Slovak Republic
Slovenia
-0.14
Total (laws)
0.28
0.45
2.22
Total (enforced)
0.42
0.30
0.39
0.86
0.11
2.08
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Source: Berglof and Pajuste (2005)

38. Possible research topics on enforcement
Appropriate balance between private enforcement of public standards and public enforcement in corporate governance in different contexts
Tradeoffs between the extensiveness of laws and their effectiveness in different contexts
Effectiveness of self-regulatory agencies and organizations in encouraging better standards and greater enforcement
Role of competition (factor markets and regulatory) in improving the environment for enforcement
Both case studies and cross-country research can help clarify what is best suited to needs of different countries
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