Regulation of good corporate governance practices in emerging capital markets Alejandro Ferreiro FIAP International Seminar 19th May 2006

Characteristics of emerging markets 1. High ownership concentration: determines the nature of potential conflicts of interest 2. Institutional weaknesses: the legal system, enforcement 3. Widespread existence of business groups (risk of lack of transparency in operations within companies belonging to the group) 4. Underdevelopment of private remedies 5. Growing importance of institutional investors. Fiduciary role. (“Buy and hold”)

Characteristics of emerging markets 6. Increasing valuation – and quantification – of the importance of good corporate governance 1.Mackinsey 2002, The premium that investors are prepared to pay for good corporate governance oscillates between 20 and 40% in emerging markets. 2.According to a study published by the Asian Development Bank Institute, companies situated in the top quartile, in terms of the effectiveness of their board of directors, register an improvement in value of between 13 and 15%. (ADBI, 2004) 3.Growing weighting of the quality of corporate governance in risk rating. 1.Lukoil (Russia), GS Caltex, SK Corporation, Korea. Have improved their rating through corporate governance. 2.Incidence in IPO, underwriters’ recommendations.

Some features of boards of directors in emerging markets Mackinsey Study, 2006: Mackinsey Study, 2006: –Very little independence (as a result of concentration) –Very little strategic focus –Small access to relevant information –Very little accountability and possibility of applying legal sanctions –And we ourselves could add:  Small use of tools of performance evaluation  HIGH POTENTIAL FOR IMPROVEMENT: THE ROLE OF INSTITUTIONAL INVESTORS IN REFORMED PENSION SYSTEMS

Priorities for Latin America (White Paper OECD, 2004) To take the right to vote seriously To take the right to vote seriously Fair treatment of shareholders in changes of control or closure of companies Fair treatment of shareholders in changes of control or closure of companies Completeness of financial information Completeness of financial information Transparency of operations with related parties Transparency of operations with related parties Development of effective boards of directors Development of effective boards of directors Improvements in the quality, efficacy and predictability of regulatory frameworks Improvements in the quality, efficacy and predictability of regulatory frameworks

Trends in C.G. Reform in Latin America (OECD, Lima 2005) 1. Legal reforms concentrated in 2000 and Current regulatory fatigue? Time to reinforce supervision and self-regulation 2. Unequal participation of the private sector in the definition and promotion of good practices: 1.Stock Exchanges 2.Businessmen’s Trade Associations 3.Institutes of Directors 4.Good Practice Codes

Trends in C.G. Reform in Latin America (OECD, Lima 2005) 3. Passivity of institutional shareholders. 4. Subsistence of shares with differing voting rights. 5. Tendency to converge towards IFRS 6. Improvement in regulation of operations between related parties. Complexity of identifying the final beneficiary. 7. Independent directors: conceptual debate. 8. Development of private remedies. Arbitration. Legal weakness.

Recent Legal Reforms in Chile’s Case Law on Opas and corporate governance (2000) Law on Opas and corporate governance (2000) –Committee of directors, preferably made up of independent directors. –Right to withdraw. –Associated civil action. –Mandatory OPA in a change of control with a premium. –Reinforcement of the role of the board of directors in transactions with related parties (Art. 44, LSA) –Voting rights for ADR holders.

Scenario for the regulation of corporate governance. Access to foreign capital, especially ADR. Access to foreign capital, especially ADR. Greater precision and visibility of best practice standards (OECD). Greater precision and visibility of best practice standards (OECD). –Financial Sector Assesment Program IMF and WB. –Rosc of WB: on published for Chile, Mexico, Peru, Colombia and Brazil. Introduction of the subject on national legislative agendas. The current challenge: implementation. Introduction of the subject on national legislative agendas. The current challenge: implementation. Evidences of market premiums. Credit risk Evidences of market premiums. Credit risk Counter-reform?: criticism of the “effectiveness cost” of SOX. Emphasis on the qualitative. Counter-reform?: criticism of the “effectiveness cost” of SOX. Emphasis on the qualitative. New models of supervision (RBS) and corporate governance. Emphasis on internal risk control. New models of supervision (RBS) and corporate governance. Emphasis on internal risk control.

Pension Funds and Corporate Governance AFPs in Latin America and Eastern Europe. A central role in the capital markets: AFPs in Latin America and Eastern Europe. A central role in the capital markets: –Main institutional investors –The pension funds “are exposed to” the highest risk of failure in corporate governance. How much damage can a corporate governance scandal cause when it affects the pension funds? –The expansion of investments into the corporate sector imposes special obligations. Ownership structure (concentration and predominance of structure in a business group) marks the type of conflict of interest and risk faced by the pension funds: expropiation of the value corresponding to minority shareholders. Ownership structure (concentration and predominance of structure in a business group) marks the type of conflict of interest and risk faced by the pension funds: expropiation of the value corresponding to minority shareholders.

Pension Funds and Corporate Governance Yield and security: the “full” interpretation of the AFPs’ legal mandate in their fiduciary role. Yield and security: the “full” interpretation of the AFPs’ legal mandate in their fiduciary role. Art. 45: “ Obtaining adequate yield and security shall be the sole aim of the investments made with resources belonging to a Pension Fund...” Art. 45: “ Obtaining adequate yield and security shall be the sole aim of the investments made with resources belonging to a Pension Fund...” Art. 147: “ The Administrators shall make all such efforts as may be necessary to ensure that adequate yield and security are obtained in the investments of the funds that they manage... Art. 147: “ The Administrators shall make all such efforts as may be necessary to ensure that adequate yield and security are obtained in the investments of the funds that they manage...

Pension Funds and Corporate Governance Markets with low liquidity. It is difficult to “vote with your feet”. Markets with low liquidity. It is difficult to “vote with your feet”. –Pension Funds are not short-term traders, but long-term owners. –Maximizing yield and safety in investments in the local corporate sector (bonds and shares) means encouraging best practices in corporate governance. This would seem to be a “policy” requirement and not merely a fiduciary one.

Pension Funds and Corporate Governance The law is important (very much so) but it is not enough. The law is important (very much so) but it is not enough. –At the end of the day, corporate governance matters are qualitative and are resolved in the board room. –Self-regulation, codes of good practices. Market rewards and penalities. Risk rating. –Pioneering experience: Case Studies of Good Corporate Governance from the Circle of Companies of the Latin American Round Table of Corporate Governance (2005) In developed markets, the pension funds are leaders in “minority shareholder activism”. What about the emerging markets? In developed markets, the pension funds are leaders in “minority shareholder activism”. What about the emerging markets? The imperative, complex challenge: measure to improve. Evaluate directors and boards. The imperative, complex challenge: measure to improve. Evaluate directors and boards. –How do the AFPs elect directors? On the basis of personal background. But is there any assessment of their performance? Is it explicit?