THE INSTITUTIONAL ELEMENTS OF CORPORATE GOVERNANCE SESSION 3 FINANCE, LAW AND MARKETS: THE INSTITUTIONAL ELEMENTS OF CORPORATE GOVERNANCE

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 States 1996 Japan 2001 Germany France 1994 UK Italy Sweden Australia Korea Financial sector 46 40 39 8 68 30 37 26 Of which Banks + Financial Institutions 7 10 4 5 1 12 Insurance + Pension Funds 28 2 50 3 14 25 6 Investment Funds 15 Non-Financial Sector 54 60 70 92 32 63 74 Non-financial enterprises 22 42 58 11 21 Individuals 49 20 19 34 Public Authorities Foreign 18 9 Total 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) US$ Trillions % of Total Financial Assets 20% 22% 27% 32% 13% 21% 18% 10 year compound Annual 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 Democratic Governance 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 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 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 Development of Law and Regulation 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.

Bank, Majority and Market Based Finance Market for corporate control Majority group control Hostile takeovers

Number of Takeovers by Region 252 US Other EU 15 Ex UK Canada UK Total Australia (252) Under the Thomson Financial Data (TFSD) definition a tender offer that was recommended by board of the target company to its shareholders Source: Becht, Bolton and Roell (2002).

Number of Takeovers by Region 253 US EU 15 UK Total AUST Canada EX UK Other (253) Under the TFSD definition a tender offer that was initially rejected by the board of the target company. Source: Becht, Bolton and Roell (2002).

Corporate Governance Regimes Forms of Control Control by Debt Control by the Securities market Control by Shares Nature of control and basis of evaluation Solvency prime rate + bank risk premium 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 constrain Threat to oust the controlling group Maximization of share price Charters of governance Maximization 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 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 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 Ownership concentration Low Moderate or high (very high in Germany) High Low or moderate Compensation based on performance Moderate Time horizon of economic relationships Short-termism (management and governance myopia) 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 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 Accountants 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 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) Other Reputational Intermediaries

How Efficient are the various Methods of Controlling Managers? 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 CEO and shareholders’ interests Attribution of stock of the company 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 Source: Inspired by Bebchuk & Fried (2003)

Pension Funds and Life Insurance Assets (selected OECD Economies 2003-2004) Source: OECD Recent Trends in Institutional Investors Statistics: Gonnard,et.al. (2008).

Pension Fund Allocation Around the World

Institutional Investor Concern for CG High Life Assurers Pension Funds Corporate Governance Importance of Low Mutual Funds Private investors Hedge Funds None Time Horizons YEARS Source: Morley Fund Management (2003).

Monitoring Activities by Institutional Investors Source: ACGA 2005

Investment Fund Managers Role in Corporate Governance Source: The Mays Report (2003).

Number of CG Proposals per year Source: Monks, R et al (2004).

Resolutions Not Supported By AMP Capital Investors July –December 2005 Source: AMP Capital Investors’ Corporate Governance (2006).

The Complex Governance and Regulatory Relationships of the Institutional Investors AFA APRA ASIC AIST ASA ASFA AIMR FPA IAA AFMA IFSA CMSF SIA ASX Institutions Investors Trustees Master Trusts Insurance Companies Financial Markets Regulatory ATO Asset Consultants Source: UTS Centre for Corporate Governance 2002