1. Corporate Governance Around the World
This chapter discusses corporate governance structures, which vary a great deal across countries, reflecting divergent cultural, economic, political, and legal environments.
Corporate Governance Around the World
Chapter Four
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Outline Governance and the Public Corporation: Key Issues
The Agency Problem
Remedies for the Agency Problem
Law and Corporate Governance
Consequences of Law
Corporate Governance Reform
The Dodd-Frank Act
Summary
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-2

3. Governance and the Public Corporation: Key Issues
The public corporation, which is jointly owned by a multitude of shareholders protected with limited liability, is a major organizational innovation of vast economic consequences.
It is an efficient risk sharing mechanism that allows corporations to raise large amounts of capital.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-3

4. Governance and the Public Corporation: Key Issues (continued)
A key weakness is the conflict of interest between managers and shareholders.
In principle, shareholders elect a board of directors, who in turn hire and fire the managers who actually run the company.
In reality, management-friendly insiders often dominate the board of directors, with relatively few outside directors who can independently monitor the management.
4-4
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.

5. Governance and the Public Corporation: Key Issues (concluded)
In the case of Enron and other dysfunctional corporations, the boards of directors grossly failed to safeguard shareholder interests.
Furthermore, with diffused ownership, most shareholders have strong enough incentive to incur the costs of monitoring management themselves.
It’s easier to just sell your shares, a.k.a. “The Wall Street Walk.”
4-5
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.

6. The Agency Problem
Shareholders allocate decision-making authority to the managers.
That’s why the managers are hired in the first place.
Many shareholders are not qualified to make complex business decisions.
A shareholder with a diversified portfolio would not have the time to devote to making the numerous decisions at each of his many companies anyway.
4-6
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.

7. The Agency Problem
Having short-term control of the firm’s assets, managers might be tempted to act in the manager’s short-term best interest instead of the shareholder’s long-term best interest.
Consumption of lavish benefits is one example.
Outright stealing is another example.
Some Russian oil companies are known to sell oil to manager-owned trading companies at below-market prices.
Even at that, they don’t always bother to collect the bills!
4-7
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.

8. The Agency Problem at Enron
Enron had about 3,500 subsidiaries and affiliates. Many of these were run and partly owned by Enron executives.
In retrospect, conflict of interest should have been an obvious concern.
The partnerships performed hundreds of millions of dollars of transactions with Enron itself, in some cases buying assets from the company or selling assets to it.
The problem is this: Where did the executives' loyalties lie? Are they trying to negotiate the best deal for the company that employs them and the shareholders who own the company, or the best deal for the partnership where they had an ownership stake?
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-8

9. The Agency Problem at Enron
The board of directors claimed that these partnerships with executive ownership allowed the firm to speed up contracting.
To protect itself in dealings with these partnerships, the company supposedly set up safeguards that required top company officers and the board to review and approve deals between Enron and the partnerships.
Clearly these safeguards were insufficient.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-9

10. Remedies for the Agency Problem
In the U.S., shareholders have the right to elect the board of directors.
If the board remains independent of management, it can serve as an effective mechanism for curbing the agency problem.
4-10
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.

11. Corporate Boards: Germany
The structure and legal charge of corporate boards vary greatly across counties.
In Germany the board is not legally charged with representing the interests of shareholders, but is instead charged with representing the interests of stakeholders (e.g. workers, creditors, etc.).
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-11

12. Corporate Boards: England
The structure and legal charge of corporate boards vary greatly across counties.
In England, the majority of public companies voluntarily abide by the Code of Best Practice on corporate governance. It recommends that there should be at least three outside directors and that the board chairman and the CEO should be different individuals.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-12

13. Corporate Boards: Japan
The structure and legal charge of corporate boards vary greatly across counties.
In Japan, most corporate boards are insider-dominated and primarily concerned with the welfare of the keiretsu to which the company belongs.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-13

14. Incentive Contracts
It is difficult to design a compensation scheme that gives executives an incentive to work hard at increasing shareholder wealth.
Accounting-based schemes are subject to manipulation.
Arthur Andersen’s involvement with the Enron debacle is an egregious example.
Executive stock options are an increasingly popular form of incentive compatible compensation.
Executive stock options exist to align the interests of shareholders and managers.
Executive stock options are call options (technically warrants) on the employer’s shares.
Inalienable: the option can’t be sold.
Typical maturity is 10 years.
Typical vesting period is three years.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-14

15. Concentrated Ownership
Another way to alleviate the agency problem is to concentrate shareholdings.
In the United States and the United Kingdom, concentrated ownership is relatively rare.
Elsewhere in the world, however, concentrated ownership is the norm.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-15

16. EXHIBIT 4.1: The Alignment vs Entrenchment Effects of Managerial Ownership
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-16

17. Shareholder Rights Index
EXHIBIT 4.2 Classification of Countries by Legal Origins: English common law
Country
Shareholder Rights Index
Rule of Law Index
Australia 4 10
Canada 5
Hong Kong
8.22
India
4.17
Ireland
7.8
Israel 3
4.82
Kenya
5.42
Malaysia
6.78
New Zealand
Nigeria
2.73
Pakistan
3.03
Singapore
8.57
South Africa
4.42
Sri Lanka
1.9
Thailand 2
6.25
United Kingdom
United States
Zimbabwe
3.68
English-origin average
6.46
Shareholder rights index scales from 0 (lowest) to 6 (highest). Rule of law index scales from 0 (lowest) to 10 (highest).
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-17

18. Shareholder Rights Index
EXHIBIT 4.2 Classification of Countries by Legal Origins: French civil law
Country
Shareholder Rights Index
Rule of Law Index
Argentina 4
5.35
Belgium 10
Brazil 3
6.32
Chile 5
7.02
Colombia
2.08
Ecuador 2
6.67
Egypt
4.17
France
8.98
Greece
6.18
Indonesia
3.98
Italy 1
8.33
Jordan
4.35
Mexico
Netherlands
Peru
2.5
Philippines
2.73
Portugal
8.68
Spain
7.8
Turkey
5.18
Uruguay
Venezuela
6.37
French-origin average
2.33
6.05
Shareholder rights index scales from 0 (lowest) to 6 (highest). Rule of law index scales from 0 (lowest) to 10 (highest).
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-18

19. Shareholder Rights Index
EXHIBIT 4.2 Classification of Countries by Legal Origins: German civil law
Country
Shareholder Rights Index
Rule of Law Index
Austria 2 10
Germany 1
9.23
Japan 4
8.98
South Korea
5.35
Switzerland
Taiwan 3
8.52
German-origin average
2.33
8.68
Shareholder rights index scales from 0 (lowest) to 6 (highest). Rule of law index scales from 0 (lowest) to 10 (highest).
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-19

20. EXHIBIT 4.2 Classification of Countries by Legal Origins: Scandinavian civil law
Country
Shareholder Rights Index
Rule of Law Index
Denmark 2 10
Finland 3
Norway 4
Sweden
Scandinavian-origin average
Shareholder rights index scales from 0 (lowest) to 6 (highest). Rule of law index scales from 0 (lowest) to 10 (highest).
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-20

21. Differences in Legal Protection of Investors
There is a marked difference in the legal protection of investors between the two most influential legal systems: English common law and French civil law.
Why is the English common law system more protective of investors than the French civil law system?
The state historically has played a more active role in regulating economic activities and has been less protective of property rights in civil law countries than in common law countries.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-21

22. Law and Corporate Governance
Commercial legal systems of most countries derive from a relatively few legal origins.
English common law
French civil law
German civil law
Scandinavian civil law
Thus the content of law protecting investors’ rights varies a great deal across countries.
It should also be noted that the quality of law enforcement varies a great deal across countries.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-22

23. Consequences of Law
Protection of investors’ rights has major economic consequences.
These consequences include:
The pattern of corporate ownership and valuation.
Development of capital markets.
Economic growth.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-23

24. Ownership Concentration Domestic Firms/Population
EXHIBIT 4.4 Consequences of Law: Ownership and Capital Markets: English Common Law
Country
Ownership Concentration
External Cap/GNP
Domestic Firms/Population
Australia
0.28
0.49
63.55
Canada
0.4
0.39
40.86
Hong Kong
0.54
1.18
88.16
India
0.31
7.79
Ireland
0.27 20
Israel
0.51
0.25
127.6
Kenya na
2.24
Malaysia
1.48
25.15
New Zealand
0.48 69
Nigeria
1.68
Pakistan
0.37
0.18
5.88
Singapore 80
South Africa
0.52
1.45 16
Sri Lanka
0.6
0.11
11.94
Thailand
0.47
0.56
6.7
United Kingdom
0.19 1
35.68
United States
0.2
0.58
30.11
Zimbabwe
0.55
5.81
English-origin average
0.43
35.45
Ownership concentration measures the average share ownership by three largest shareholders.
External Cap/GNP is the ratio of the stock market capitalization held by minority shareholders (other than three shareholders) to the gross national product for Domestic Firms/Population is the ratio of the number of domestic firms listed in a given country to its population (million) in 1994.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-24

25. Ownership Concentration Domestic Firms/Population
EXHIBIT 4.4 Consequences of Law: Ownership and Capital Markets: French Civil Law
Country
Ownership Concentration
External Cap/GNP
Domestic Firms/Population
Argentina
0.53
0.07
4.58
Belgium
0.54
0.17
15.5
Brazil
0.57
0.18
3.48
Chile
0.45
0.8
19.92
Colombia
0.63
0.14
3.13
Ecuador na
13.18
Egypt
0.62
0.08
France
0.34
0.23
8.05
Greece
0.67
21.6
Indonesia
0.58
0.15
1.15
Italy
3.91
Jordan
23.75
Mexico
0.64
0.22
2.28
Netherlands
0.39
0.52
21.13
Peru
0.56
0.4
9.47
Philippines
0.1
2.9
Portugal
19.5
Spain
0.51
9.71
Turkey
0.59
2.93
Uruguay 7
Venezuela
4.28
French-origin average
0.21 10
Ownership concentration measures the average share ownership by three largest shareholders.
External Cap/GNP is the ratio of the stock market capitalization held by minority shareholders (other than three shareholders) to the gross national product for Domestic Firms/Population is the ratio of the number of domestic firms listed in a given country to its population (million) in 1994.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-25

26. Ownership Concentration
EXHIBIT 4.4 Consequences of Law: Ownership and Capital Markets: German Civil Law
Country
Ownership Concentration
External Cap/GNP
Domestic Firms/
Population
Austria
0.58
0.06
13.87
Germany
0.48
0.13
5.14
Japan
0.18
0.62
17.78
South Korea
0.23
0.44
15.88
Switzerland
0.41
33.85
Taiwan
0.86
14.22
German-origin average
0.34
0.46
16.79
Ownership concentration measures the average share ownership by three largest shareholders.
External Cap/GNP is the ratio of the stock market capitalization held by minority shareholders (other than three shareholders) to the gross national product for Domestic Firms/Population is the ratio of the number of domestic firms listed in a given country to its population (million) in 1994.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-26

27. Ownership Concentration
EXHIBIT 4.4 Consequences of Law: Ownership and Capital Markets: Scandanavian Civil Law
Country
Ownership Concentration
External Cap/GNP
Domestic Firms/
Population
Denmark
0.45
0.21
50.4
Finland
0.37
0.25 13
Norway
0.36
0.22 33
Sweden
0.28
0.51
12.66
Scandinavian-origin average
0.3
27.26
Ownership concentration measures the average share ownership by three largest shareholders.
External Cap/GNP is the ratio of the stock market capitalization held by minority shareholders (other than three shareholders) to the gross national product for Domestic Firms/Population is the ratio of the number of domestic firms listed in a given country to its population (million) in 1994.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-27

28. Consequences of Law: Italy vs. the United Kingdom
Italy has a French civil law tradition with weak shareholder protection, whereas the United Kingdom, with its English common law tradition, provides strong investor protection.
In Italy the three largest shareholders own 58 percent of the company, on average. In the U.K. the three largest shareholders own 19 percent of the company, on average.
Company ownership is thus highly concentrated in Italy and more diffuse in the United Kingdom.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-28

29. Consequences of Law: Italy vs. the United Kingdom (concluded)
In addition, as of 1999 only 247 companies are listed on the stock exchange in Italy, whereas 2,292 companies are listed in the United Kingdom.
In the same year, the stock market capitalization as a proportion of the annual GDP was 71 percent in Italy but 248 percent in the United Kingdom.
The stark contrast between the two countries suggests that protection of investors has significant economic consequences.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-29

30. Ownership and Control
Companies domiciled in countries with weak investor protection many need to have concentrated ownership as a substitute for legal protection.
This is not without costs. In companies with concentrated ownership, large shareholders can abuse smaller shareholders.
4-30
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.

31. Capital Markets and Valuation
Investor protection promotes the development of external capital markets.
When investors are assured of receiving fair returns on their funds, they will be willing to pay more for securities.
Thus, strong investor protection will be conducive to large capital markets.
Weak investor protection can be a factor in sharp market declines during a financial crisis.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-31

32. Economic Growth
The existence of well-developed financial markets, promoted by strong investor protection, may stimulate economic growth by making funds readily available for investment at low cost.
Several studies document this link.
Financial development can contribute to economic growth in three ways:
It enhances the efficiency of investment allocation.
It channels savings toward real investments in productive capacities.
It enhances savings.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-32

33. Pyramidal Ownership Structure
Exhibit 4.6 illustrates the pyramidal ownership structure for Daimler-Benz, a German company, at the beginning of the 1990s.
The company has three major block holders: Deutsche Bank (28.3 percent), Mercedes-Automobil Holding AG (25.23 percent), and the Kuwait government (14 percent). The remaining percent of shares are widely held.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-33

34. Pyramidal Ownership Structure
The pyramidal ownership structure illustrated in Exhibit 4.6 makes it possible for large investors to acquire significant control rights with relatively small investments.
For example, Robert Bosch GmbH controls 25 percent of Stella Automobil, which in turn owns 25 percent of Mercedes-Automobil Holding, which controls 25 percent of Daimler-Benz.
AG. Robert Bosch can possibly control up to 25 percent of the voting rights of Daimler-Benz AG with only 1.56 percent cash flow rights in the company.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-34

35. EXHIBIT 4.6 Ownership Structure of Daimler-Benz AG, 1990
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-35

36. Pyramidal Ownership Structure
AG. Robert Bosch can control up to 25 percent of the voting rights of Daimler-Benz AG with only securing the cooperation of three other firms.
At least two of these three: Bayerische Landesbank, Kornet Automobil Beteiligungsges mbH, or Dresdner Bank.
And Stern Automobil Beteiligungsges mbH.
Not bad for only directly controlling 1.56% of the company.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-36

37. Debt
If managers fail to pay interest and principal to creditors, the company can be forced into bankruptcy and managers may lose their jobs.
Borrowing can have a major disciplinary effect on managers, motivating them to curb private benefits and wasteful investments and trim bloated organizations.
However, excessive debt creates its own agency problems.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-37

38. Overseas Stock Listing
Companies domiciled in countries with weak investor protection can bond themselves credibly to better investor protection by listing their stocks in countries with strong investor protection.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-38

39. The Market for Corporate Control
If a management team is really out-of-control, over time the share price will decline.
At some point, a corporate raider will buy up enough shares to gain control of the board.
Then the raider either fires the incompetent managers and turns the firm around or he sells everything in sight for the break-up value.
Either way, the old managers are out of a job.
The threat of this unemployment may keep them in line.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-39

40. Corporate Governance Reform
Scandal-weary investors around the world are demanding corporate governance reform.
It’s not just the companies’ internal governance mechanisms that failed; auditors, regulators, banks, and institutional investors also failed in their respective roles.
Failure to reform corporate governance will damage investor confidence, stunt the development of capital markets, raise the cost of capital, distort capital allocation, and even shake confidence in the capitalist system itself.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-40

41. The Sarbanes-Oxley Act
Major components of the Sarbanes-Oxley Act include:
Accounting regulation.
Audit committee.
Internal control assessment.
Executive responsibility.
Many companies find compliance burdensome, costing millions of dollars.
Some foreign firms have chosen to list their shares on the London Stock Exchange instead of U.S. exchanges to avoid costly compliance.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-41

42. CFA Institute Ethical and Professional Standards of Corporate Governance
The Board:
– Is it largely independent?
– Are the directors qualified?
– Do they have access to outside resources?
– How are they elected?
– Do any directors have cross-company relationships?
Management:
– Do they have a code of ethics?
– Are there lots of perquisites?
– How is their compensation structured?
Are they “cozy” with Mgmt?
Copyright 2006 CFA Institute
Are they vendors or customers?
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-42

43. The Cadbury Code of Best Practice
The Cadbury Code of Best Practice is an ethical standard, without the force of law. However, the London Stock Exchange requires listed firms to either comply or explain why they cannot.
About 90 percent of LSE-listed firms comply with the code.
4-43
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.

44. The Cadbury Code of Best Practice
Requires the board of directors of firms to:
Meet regularly.
Retain full and effective control over the company.
Monitor executive management.
The code says that there should be a clearly accepted division of responsibilities at the head of a company, such that no one person has unfettered power.
The board should include non-executive directors in sufficient number for their views to carry weight.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-44

45. The Dodd-Frank Act
The Dodd-Frank Wall Street Reform and Consumer Protection Act passed in reaction to the financial crisis of
Volker Rule: Deposit-taking banks will be banned from proprietary trading and from owning more than a small fraction of hedge funds and private equity firms.
Resolution Authority: The government can seize and dismantle a large bank if the bank faces impending failure.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-45

46. The Dodd-Frank Act
Derivatives: OTC derivatives trading will move to electronic exchanges, with contracts settled through a clearinghouse.
Systematic Risk Regulation: Systematically important firms will be identified and their financial condition will be monitored.
Consumer Protection: A new, independent Consumer Financial Protection Bureau will be set up to monitor mortgages and other loan products.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-46

47. Summary
This chapter provides an overview of corporate governance issues, with the emphasis on intercountry differences in the governance mechanisms. The public corporation, is a major organizational innovation.
This efficient risk-sharing mechanism allows large amounts of capital to be raised at low cost and diverse investment projects to be profitably undertaken, boosting economic growth.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-47

48. Summary (continued)
The public corporation has a major weakness: the agency problem.
To protect shareholder rights, curb managerial excesses, and restore confidence in capital markets, it is important to strengthen corporate governance.
The central issue in corporate governance is: how to best protect outside investors from expropriation by managers and controlling insiders.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-48

49. Summary (continuing) The agency problem can be alleviated by
(a) strengthening the independence of boards
(b) providing managers with incentive contracts, to better align the interests of managers with those of shareholders
(c) concentrated ownership;
(d) using debt to induce managers to disgorge free cash flows to investors;
(e) listing stocks on the London or New York stock exchange where shareholders are better protected; and
(f) inviting hostile takeover bids.
Legal protection of investor rights systematically varies across countries.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-49

50. Summary (conclusion)
Protecting the rights of investors has major economic consequences.
Outside the U.S. and the U.K., large shareholders tend to control managers and expropriate small outside shareholders.
Corporate governance reform efforts should be focused on how to better protect outside investors from expropriation by controlling insiders. Often, controlling insiders resist reform efforts, as they do not like to lose their private benefits of control.
Copyright © 2018 by the McGraw-Hill Companies, Inc. All rights reserved.
4-50