1. Corporate Finance MLI28C060 Lecture 10 Friday 23 October 2015

2. Corporate governance III: Anglo-Saxon versus Continental European versus Japanese business models Structure: - Anglo-Saxon market model of corporate governance -Continental European models of governance -German bank-based system -French Dirigisme model -Italian family model - Japanese keiretsu model

3. Anglo-Saxon market model of corporate governance

4. What is the Goal of Management? As firm becomes more deeply committed to multinational operations, a new constraint develops – one that springs from divergent worldwide opinions and practices as to just what the firms’ overall goal should be: – Shareholder Wealth Maximization – As characterized by Anglo-American markets – Stakeholder Capitalism Model – As characterized by Continental European and Japanese markets

5. The Goal of Management Shareholder Wealth Maximization – A firm should strive to maximize the return to shareholders (those individuals owning equity shares in the firm) – This view defines risk in a very strict financial sense – Risk is defined as the added risk a firm’s shares bring to a diversified portfolio (a fully diversified portfolio represents systematic risk) – The added firm-specific risk is known as unsystematic risk Agency Theory – the study of how shareholders (SH) can motivate management to act in SH best interests Long-term versus short-term value maximization – Impatient capitalism focuses on the short-term sometimes at the expense of long-term value – Exacerbated by improper management incentives from SH

6. Stakeholder Capitalism Model A view that all a corporations stakeholders (employees, management, suppliers, local community, local/national government and creditors) need to be considered in addition to the equity holders The goal is to earn as much as possible in the long run, but to retain enough to increase the corporate wealth for the benefit of all The definition of corporate wealth is much broader than just financial wealth, it includes technical, market and human resources as well Doesn’t make an issue of market efficiency because long- term loyal SH should be more influential than transient SH

7. Stakeholder Capitalism Model Risk – Total risk, both operating and financial risk, is important Single versus Multiple Goals – Avoids the problem of impatient capital but fails to give clear expectations about tradeoffs among different groups of stakeholders The Score Card – Firms worldwide are moving more toward the SWM model

8. Corporate Governance The relationship among stakeholders used to determine and control the strategic direction and performance of an organization is termed corporate governance The corporate governance of the organization is therefore the way in which order and process is established to ensure that decisions are made and interests are represented – for all stakeholders - properly

9. Corporate Governance The single overriding objective of corporate governance in the shareholder wealth model is the optimization over time of the returns to shareholders The most widely accepted statement of good corporate governance (established by the OECD) focus on the following principles; – The rights and equitable treatment of shareholders – The role of stakeholders in corporate governance – Disclosure and transparency – The responsibilities of the board

10. The Structure of Corporate Governance

11. Continental European models of governance: German bank-based system French Dirigisme model Italian family model)

12. Corporate Governance The origins of the need for a corporate governance process arise from the separation of ownership from management, and from the varying views by culture of who the stakeholders are and of what significance A governance regime (system) is a function of; – Financial market development – The degree of separation between management and ownership – The concept of disclosure and transparency

13. Comparative Corporate Governance Regimes

14. 1)Models of Corporate Governance i.Insider / Outsider ii.Relationship – based / Arm’s length iii.Civil law / Common law 2)International comparison i.Germany ii.United States iii.Italy iv.Japan v.Islamic system

15. Insider / Outsider (1): ownership and control (Franks and Mayer, 2001; Becht and Mayer, 2001)‏ INSIDEROUTSIDER Equity marketfew listed companywide market Share ownershipconcentratedDispersed Voting power high concentration (pyramids, non- voting shares, multiple voting) low concentration, separation between ownership and control Main shareholder families, banks, other companies, governement institutional investors, individual shareholders Corporate control market low level of takeover high activity in corporate control market Informationprivatepublic Composition of BoD large number of directors appointed by the main blockholder presence of outside directors Control on Management highlow

16. Insider / Outsider (2): efficiency trade-off Private control bias Management or market control bias High blockholder power Low blockholder power Low ownership concentration High ownership concentration from: Becht and Mayer, 2001

17. Relationship / Arm's length (1): relationship between the financer and the firm (Rajan and Zingales, 1998)‏ RELATIONSHIP BASEDARM’S LENGTH Financier power “Ensure a return to the financier by granting her some form of power over the firm being financed” “The financier is protected by explicit contracts: contracts and associated prices determine the transactions that are undertaken” Legal enforcement Self-enforcing and self-governing: reputation “Prompt and unbiased enforcement of contracts by courts” Transparency Needs opacity Production of credible and diffused information Innovation Tends to support incumbents; fear of outsiders and technological revolution Easier access to finance for new comers Management Common education (technical or administrative), or non professional Long term managers Rarely foreign-born Business/financial education High turnover of management Presence of foreign-born or international experienced individuals BoD High presence of insiders Representation of stakeholders Active control of management Presence of outsiders

18. Differences in Legal system Civil Code vs. Common Law

19. Common Law / Civil Law (Morck and Steier 2005, La Porta et. Al 1998) Common law systems: aim of protecting the weak from the strong better environment for self-regulation Common law stronger protection of shareholders Civil law systems: aim of enforcing the edict of the State. Civil law low investors’ protection weak public equity markets; high concentration of share ownership Agency problem shifted: shareholders/ blockholder private benefit problem

20. Features of Civil Code law (as opposed to common law) - Inquisitorial (vs. accusatorial) - Code-based (vs. case law) - History: Roman Law - Branches: public / private – criminal / civil - Career judges - Written proceedings (vs. oral proceedings)

21. The Civil Law System as it exists and functions in the Modern Era Public Law – Private Law Dichotomy. -Private law  relationships between individuals -Public law  relationships between individuals (citizens, companies) and the state - Public law is not part of the civil codes. More fluid. Private law-matter ordinary courts - Legal practice Public law-mater administrative courts

22. Ordinary Courts - adjudicates the majority of civil and criminal cases. - apply law found in the civil, commercial and penal codes. Administrative courts - specialized courts or sections to deal with administrative cases. - independent jurisdiction from ‘ordinary courts’: rules specifically designed for administrative cases Problems when deciding the proper court for a case

23. Comparison of Civil-Law and Common-Law Systems (I) Corpus Juris Civilis influence - Civil-Law → significant - Common-Law → modest Codification Process - Civil-Law → comprehensive codes from single drafting event. - Common-Law → codes reflecting rules of enunciated judicial decisions.

24. Comparison of Civil-Law and Common-Law Systems (II) Equity law (no comparable law) - Civil-Law → originated in Rome to be applied to non-Roman peoples - Common-Law → originated in England to soften the rigor of Common-Law Creation of law: role of judicial decisions - Civil-Law → negligible - Common-Law → supreme prominence

25. Comparison of Civil-Law and Common-Law Systems (III) Manner of legal reasoning - Civil-Law → Deductive - Common-Law → Inductive Structure of Courts - Civil-Law → Integrated Court system - Common-Law → Specialty Court system Trial process - Civil-Law → Extended process - Common-Law → Single-event trial

26. Comparison of Civil-Law and Common-Law Systems (IV) Judges - Role in trials. * Civil-Law → elevated role * Common-Law → «referee» - Judicial attitudes. *Civil-Law → mere appliers of the law * Common-Law → search creatively for an answer - Selection and training. * Civil-Law → a part of the civil service * Common-Law → selected from a political process

27. Main problems of abstracting a model of Corporate Governance Companies are multidimensional: different model can apply to one national experience Convergence and imitation EfficiencyCONVERGENCE History Path dependence HETEROGENEITY Does a “best model” exist?

28. Market-orientated governance systems (e.g. US/ UK/ Canada/ New Zealand/ Australia)

29. USA (Monks and Minow 2001, Mallin 2007) Main businness form Public companies (stock corporation) Predominant ownership structure Institutional investors, financial institutions Dispersed ownership and vote rights: absence of big blockholders Legal systemCommon law Board structureUnitary board High presence of outsiders; however: interlocks Equity marketWell-developed, high rate of market capitalisation to GDP Take-overHigh activity Defence from management: poison pills ManagementHigh level of independence; financial background; more foreign born. Agency problem: often CEO/Chairman are the same person; CEOs higly Influence directors nomination StakeholdersTheir protection is mainly guaranteed through contracts and regulation

30. Bank-based governance systems (e.g. Germany)

31. Germany (Becht and Bohmer 2003, Franks and Mayer 2001)‏ Main businness form Public or private companies limited by shares Predominant ownership structure Concentrated ownership: families, other non-financial companies, banks Large voting block, absence of other voting block Legal systemCivil law Board structure Dual board system; Employees representatives in the supervisory board Some directors comes from other companies (i.e. Pi ë ch - Porsche) Equity marketIncreasing market capitalisation and corporate debt issues Take-over Low activity (increasing - i.e. recent overturn of “ Volkswagen law ” ) Little regulation of anti-takeover until 1998 Control and Transparency Law (KonTraG) ManagementCommon technical background; few foreign born individuals Stakeholders Co-determination (i.e. Volkswagen wage freeze in 2004) Banks representation as a result of proxy votes

32. Improving take over activity (Cioffi 2002) Control and Transparency Law 1998 Fiscal reform 2000 (Steuerreform) “abolished capital gain taxes on the liquidation of cross-shareholdings”. Volkswagen law overturned on October, the 23 rd by European Court of Justice, (Financial Times, 23/10/2007) Stakeholder representation:  does it lead to empasse?  Volkswagen case;  roots in communitarian German culture (Monks and Minow 2001). Germany (2)

33. Italian Family model

34. Italy (1) (Mallin, Bianchi, Bianco, Enriques) Main business formLimited liability companies, partnership Predominant ownership structure Non – financial / holding companies, families Predominant voting structureVoting blocks / shareholders’ agreement Legal systemCivil law Board structureUnitary + Board of auditors Equity market Increasing capitalization, derivatives market and corporate debt issues Take - over Not common, but increasing as a consequence of privatization ManagementLong-term managers, rarely foreign born StakeholdersTrade Unions

35. Italy (2) (Mallin 2006, Melis, Bianchi, Bianco, Enriques 2001) Response to the Great Depression nationalist solution No predominant role of financial institutions Draghi Law (1998) and Preda Code (1998) enhancement of minority protection and transparency Company Act (2004) A sort of State – family capitalism Pyramidal structure ownership very limited degree of separation between ownership and control Italian structure allows Italian listed companies to choose between a two – tier board structure and the traditional

36. Figure: Family Businesses Use Less Debt

37. Operational Goals Public/Private Hybrids – 33% of all companies in the S&P 500 are family businesses – 40% of the 250 largest companies in Germany and France are family businesses Why do family businesses outperform non-family businesses? – Longer-term focus – Better alignment of management and shareholder interests – Stronger focus on the core business of the firm

38. Figure: The Superior Performance of Family

39. Japanese keiretsu model

40. Japan (1) (Suto and Hashimoto 2006) Main business form Public limited company Predominant ownership structure Keiretsu / Predominant role of financial institutions Legal system Civil law Board structure Dual Large presence of insider Equity market Immature capital market Take - over Strong takeover barriers Management “Internalism”: common educational background/ on-the-job training, co- ordination between manager and employees Stakeholders Society as whole

41. Japan (2) Relationship – based system Key role of banks Keiretsu Revision of Commercial Law in 2001 and in 2002 Commercial Code Revision on Board (2003) two corporate governance structures: corporate auditors’ system and a committees system Case of study: Toyota vs. Sony

42. Islamic model

43. Values of good governance are central to Islam Accountability to God raises level of awareness Quranic code of ethics Best practices of corporate governance − Accountability and obligation to shareholders − Integrity and ethical behaviour − Fiduciary role and responsibility of board − Vicegerent concept of accountability (2:30) − Honest fulfilment of contracts (5:1) − Prohibition against betraying any trusts (8:27) − Prohibition against deriving income from cheating, dishonesty or fraud (4:29) − Prohibition against bribery (2:188) − Prohibition against concealing evidence (2:283) − Disclosure and transparency Islamic system

44. prohibited sectors NGOs not-for-profits SOCIAL IMPERATIVE ZONE OF SUSTAINABILITY Islamic businesses ECONOMIC IMPERATIVE Market-driven yet values-based Gradualist and evolutionary nature Symbiotic and synergistic relationship with mainstream finance Islamic Financial Institutions are positioned in a “zone of sustainability” Islamic finance characteristics: Islamic system

45. Corporate Governance Reform

46. Within the U.S. and U.K., the main corporate governance problem centers around the agency problem: with widespread share ownership, how can a firm align management’s interest with that of the shareholders? Because individual shareholders do not have the resources or the power to monitor management, the U.S. and U.K. markets rely on regulators to assist in the agency monitoring task Outside the U.S. and U.K., controlling shareholders are usually in the majority–these entities are able to monitor management in some ways better than the regulators can After the failure of corporate governance of Enron and WorldCom, some regulatory reform of corporate governance started in 2002 in the U.S.

47. Corporate Governance Reform The Sarbanes-Oxley Act was passed by the U.S. Congress, and signed by President George W. Bush during 2002 and has four major requirements: 1. CEOs of publicly traded companies must vouch for the veracity of published financial statements This provision tried to instill a sense of responsibility and accountability in senior management Many companies requires business unit managers and directors at lower levels to sign their financial statements as well 2. Corporate boards must have audit committees drawn from independent directors In Germany, however, supervisory board must include employee representatives, but according to the U.S. law, employees are not independent

48. Corporate Governance Reform 3. Companies can not make loans to corporate directors 4. Companies must test their internal financial controls against fraud In order to meeting the new regulations, firms spends too much on modifying internal controls to combat fraud, rather than operating the firm The cost is disproportionately high especially for smaller firms Thus, more smaller firms choose to stay private or to sell out to larger firms instead of going the initial public offering (IPO) route because it costs too much to comply the law for public firms In summary, most of the terms in Sarbanes-Oxley Act are appropriate for the U.S. situation, but some terms do conflict with practices in other countries – As a consequence, this act hinders many foreign companies to list their shares on the exchanges in the U.S.

49. Corporate Governance Reform Possible reforms for board structure and compensation issues (learned from European standards) – CEOs cannot be the chairman of the board More than 80% of the companies in the Fortune 500, the CEO is also the chairman of the board – Adopt two-tiered structure in Germany Supervisory board (mostly outside, non-executive directors and typically large, e.g., Siemens has 18 members) Management board (predominantly inside, executive directors and smaller, e.g., Siemens has 8 members) – Change the compensation schemes to replace stock options with restricted stock shares If the performance of stock is poor, the management with stock options will not feel any real loss since they just loss some potential future benefit

50. Corporate Governance Reform Restricted stock to the management cannot be sold publicly until after a specified period of time For poor stock performance, the recipient (the management) has actually lost money The remaining problems of the accounting process – The U.S. system is characterized as strictly rule based, rather than conceptually based, as is common in Western Europe There are constantly more clever accountants find ways to follow the rule, yet not meet the underlying purpose for which the rule were intended, e.g., using SPE in the Enron case – Another debate of the accounting process is the roles of the accounting firm and the companies itself Is it logical for the current practice that companies pay accounting firms to investigate whether their reporting practices consistent with generally accepted accounting principles (GAAPs)?