Corporate Governance: Impact and Enforcement By Stijn Claessens World Bank (Based on joint work with Erik Bërglof, SITE/SSE) For Corporate Governance Leadership Program July 14, Washington, D.C. World Bank

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

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 1 - 1.5 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

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

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

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

Weak corporate governance translates into higher cost of capital Excludes Brazil

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

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

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

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

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 World Bank

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? World Bank

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 World Bank

Capital markets and corporate governance Degree of capital market development World Bank

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 World Bank

Enforcement dominates laws-on-the-books World Bank

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 World Bank

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 World Bank

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 World Bank

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 World Bank

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 World Bank

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 World Bank

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 World Bank

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 World Bank

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 World Bank

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 World Bank

Private enforcement often works better in securities markets World Bank Each point represents one of 49 countries. Data from LLS (2005).

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 World Bank

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 World Bank

Large blockholders dominate, with costs though and limited scope for policy World Bank

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? World Bank

Scope for policy interventions for other corporate governance mechanisms World Bank

Scope for policy interventions for other corporate governance mechanisms World Bank

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 World Bank

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 World Bank

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 World Bank Source: Berglof and Pajuste (2005)

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 World Bank