1. Corporate Governance Developments and Implications for Europe Prof. Florencio López-de-Silanes Yale University International Institute for Corporate Governance Paris, France October 21 st, 2003. © Florencio Lopez-de-Silanes

2. 2 Conflicts of Interest all Over  Recent experiences (e.g. Ahold in the Netherlands, ABB in Switzerland, Vivendi in France, Sibneft in Russia, SK Telecom in Korea, Enron in the US, or Toyota in Japan) show the need for a better understanding of related-party / self- interested transactions if we are to understand minority shareholder’s protection.  Conflicts of interest arise all over the world and are not exclusive of certain countries.

3. © Florencio Lopez-de-Silanes 3 Outline I.The Impact of US Corporate Governance scandals on Europe II.What do we know about Corporate Governance that can help? 1.What aspects should we concentrate on? 2.What about Judicial Enforcement? III. Challenges ahead

4. © Florencio Lopez-de-Silanes 4 Common Failures of Corporate Governace mCauses of recent Corporate Governance scandals: 1. Bridge of fiduciary duties (duty of loyalty and duty of care) a. Lack of independence b. Conflict of interests 2. Insuficient information on accounting and related transactions a. High rik accounting practices b. Off-the-books activities mConsequences: 1. Related transactions benefitting directors and controlling shareholders. 2. Excesive diretors’ compensation. 3. Auditors, lawyers, analists and financial intermediaries with divided loyalties.

5. © Florencio Lopez-de-Silanes 5 The Impact of US Scandals  US scandals generated a large regulatory reaction from all sides (Sarbanes-Oxley Act, NYSE & Nasdaq Regulations, etc..)  The new set of rules has 2 main impacts on Europe: 1.Raised the awareness of the relevance of Corporate Governance:  Shown that CG needs to be a continuous reform  Lifted the standards in many areas  Focused energy in two areas:  Accounting and Auditing  Conflicts of Interest, particularly relevant for countries with concentrated ownership and groups  So, European initiatives have been revitalized or accelerated

6. © Florencio Lopez-de-Silanes 6 The Impact of US Scandals  The new set of rules has 2 main impacts on Europe: 2.De facto Exported regulation for foreign listings in the US markets:  Applies to:  Firms with ADRs  Firms that file reports under SEC Act (including European firms filling Form 20-F)  So, close to 1000 non-US firms are affected:  469 non-US firms (185 European) list on NYSE  451 non-US firms (149 European) list on NASDAQ  ½ of UK’s FTSE 100 has a secondary listing

7. © Florencio Lopez-de-Silanes 7 The Impact of US Scandals  Regulatory spill-over is increasingly common in transatlantic arena:  European & US economies are so interwoven that it is difficult for the impact of the law to come to a complete halt at either border  Europe started its own process of reform in 1999 with the Financial Services Action plan towards the integration of EU capital markets: 1.International Accounting Standards Regulation by 2005 2.Prospectus Directive 3.Transparency Obligations Directive 4.Investment Services Directive 5.Market Abuse Directive 6.Takeover Directive  These, as European competition policy has, will also impact US firms

8. © Florencio Lopez-de-Silanes 8 Outline I.The Impact of US Corporate Governance scandals on Europe. II.What do we know about Corporate Governance that can help? 1.What aspects should we concentrate on? 2.What about Judicial Enforcement? III. Challenges ahead

9. © Florencio Lopez-de-Silanes 9 The Legal Approach to Corporate Governance mThe law and its enforcement are key mechanisms of investor protection. mWhen investors finance firms, they receive rights or powers in exchange. Without an ability to enforce rights, investors might end up with nothing. mImplication: Strong investor protection leads to deeper financial markets & better financing terms for firms. •Company law •Bankruptcy law •Securities law •Takeover law •Courts & Regulators •Protect Shareholders & Creditors •Force timely disclosure of accurate information

10. © Florencio Lopez-de-Silanes 10 Two Views On How Securities Laws May Matter mTwo complementary views on why securities laws are beneficial for the development of securities markets. m Private enforcement view. Financial contracts are too costly to enforce when regulated only by contract and tort law. oKey contribution to standardize contracts (e.g., mandatory disclosure rules) and simplify private litigation (e.g., describing obligations and liabilities of various parties and establishing the burden of the proof). m Public enforcement view. Private incentives to enforce contracts are insufficient (e.g., free-rider problems, development of precedents). oKey contribution is to create a public enforcer. oFocused and independent from political interference; with powers to obtain information and impose sanctions on issuers and market participants.

11. © Florencio Lopez-de-Silanes 11 Public Enforcement and Financial Markets coef =.25253782, (robust) se =.20541086, t = 1.23 Market Capitalization / GNP (all else equal) Public Enforcement (all else equal) -.534415.3508 -.530406.86197 JPN ZAF IRL NGA PAK AUT LKA ESP CHE NZL NOR KOR CHI EGY DNK FIN MEX ZWE ARG DEU GRC BEL TWA SWE ECU NID COL PRT BRA IND ITA GBR URY IDN KEN TUR VEN JOR THA PER CAN HKG USA MYS PHL ISR FRA SGP AUS

12. © Florencio Lopez-de-Silanes 12 Laws that Facilitate Private Enforcement  Deeper Financial Markets coef =.71131062, (robust) se =.15351288, t = 4.63 Market Capitalization / GNP (all else equal) Private Enforcement (all else equal) -.383308.433087 -.530406.86197 URY AUT ECU ARG CHI COL BRA DEU NOR VEN PAK SWE NZL FRA GRC EGY IRL ESP TUR ZWE PER GBR KEN FIN MEX PRT HKG JPN AUS ZAF CHE NGA ITA ISR LKA JOR IND BEL MYS SGP TWA DNK CAN IDN USA THA NID KOR PHL

13. © Florencio Lopez-de-Silanes 13 More Disclosure about Conflicts of Interest  Deeper Financial Markets coef =.58127359, (robust) se =.1376864, t = 4.22 Market Capitalization / GNP (all else equal) Disclosure Requirements (all else equal) -.49042.479462 -.530406.86197 URY ECU BRA AUT PER VEN CHI ESP GRC COL ARG PRT NOR PAK FIN ZWE NZL SWE KEN NID IRL DEU GBR EGY JPN AUS ISR DNK TUR BEL IDN ZAF NGA HKG CAN CHE FRA IND TWA LKA USA MEX MYS JOR ITA KOR SGP PHL THA

14. © Florencio Lopez-de-Silanes 14

15. © Florencio Lopez-de-Silanes 15 Shifting the Burden of Proof to the Accused  Deeper Financial Markets coef =.40931822, (robust) se =.13112176, t = 3.12 Market Capitalization / GNP (all else equal) Burden of Proof (all else equal) -.351049.576335 -.530406.86197 ARG COL DEU CHI AUT FRA URY SWE NOR MEX NZL PAK TUR EGY BRA ECU ITA VEN IRL HKG GBR JOR CHE THA LKA ZWE ZAF NGA JPN KEN GRC SGP AUS IND ESP MYS FIN ISR TWA PRT BEL PER KOR USA CAN DNK IDN NID PHL

16. © Florencio Lopez-de-Silanes 16

17. © Florencio Lopez-de-Silanes 17 Outline I.The Impact of US Corporate Governance scandals on Europe. II.What do we know about Corporate Governance that can help? 1.What aspects should we concentrate on? 2.What about Judicial Enforcement? III. Challenges ahead

18. © Florencio Lopez-de-Silanes 18 Higher Levels of Court Formalism  Longer Duration of Judicial Processes coef =.31096164, (robust) se =.05177885, t = 6.01 Log of Duration Formalism (all else equal) -2.416892.46151 -3.26529 1.75909 HKG BLZ ZMB ZAF TTO NZL TCA UGA AIA AUS GHA BMU JAM MWI MYS CAN TUR BRB KEN MLT NGA TWN ZWE GEO GIB BGD VNM GRD VGB IND SGP GBR IRL DNK THA USA CHN BRA ANT BELCYM MCO TZA RUS CIV PAK JOR UKR SWE NOR JPN LKA HUN NLD SWZ IDN FIN KOR VCT EGY ISR CHE FRA HRV NAM LVA MOZ DEU CYP TUN AUT DOM COL BWA LUX CZE ARE PRT URY POL ROM KWT GRC SEN EST BGR LTU ITA SLV SVN MAR KAZ BHR HND ISL CHL ECU PHL MEX LBN BOL CRI PER GTM ESP ARG PRY PAN VEN (all else equal)

19. © Florencio Lopez-de-Silanes 19 Higher Levels of Court Formalism  Lower Levels of Legal Fairness and Impartiality in the System coef = -.41804976, (robust) se =.06001672, t = -6.97 Legal System is Fair and Impartial -2.380212.21613 -1.64229 1.84195 BLZ ZAF TTO ZMB CAN MYS SGP TUR UGA GBR GHA USA MWI SWE KEN GEO BRA ZWE THA NGA BGD FRA IND RUS CHN HUN DEU HRV CIV UKR PAK EGY TZA NAM IDN PRT TUN URY CZE ITA DOM BWA COL POL SVN EST ROM LTU BGR CHL SLV SEN MEX KAZ HND ECU PHL ESP ARG CRI PER GTM BOL PAN VEN Formalism (all else equal) (all else equal)

20. © Florencio Lopez-de-Silanes 20 Outline I.The Impact of US Corporate Governance scandals on Europe. II.What do we know about Corporate Governance that can help? 1.What aspects should we concentrate on? 2.What about Judicial Enforcement? III. Challenges Ahead

21. © Florencio Lopez-de-Silanes 21 Challenges Ahead  The impact of the US Corporate Governance reforms will spill-over to impact the future of European markets.  The real problem is the fact that capital markets in US and Europe have become global institutions and thus act as transmission belts.  The challenge for Europe is complicated as it is in the middle of transformation, enlargement, and integration of its capital markets.

22. © Florencio Lopez-de-Silanes 22 Challenges Ahead  But more importantly, the evidence raised here suggests that there are 3 essential ingredients for the system to work in the long run: 1.Better investor rights in corporate laws, strong regulation on disclosure and accounting standards. 2.Regulations and laws that facilitate shareholder actions and private enforcement. 3.A well functioning judicial system which allows the functioning of financial markets and business transactions in general.

23. © Florencio Lopez-de-Silanes 23 Appendix

24. © Florencio Lopez-de-Silanes 24 The Rigas of Adelphia  Over $2.5 Billion co-borrowed by family entities.  $1.4 B used to buy shares in Adelphia.  $200 M to fund margin call payments on loans secured by Adelphia securities.  Guaranteed $120 M to Rigas entity controlling Buffalo Sabres hockey team.  $3.5 M in unsecured loans made to Rigas family.  $12 M to build golf course next to Rigas’ estate  Use of Adelphia-owned aircraft and apartments without charge for personal purposes.  Adelphia services provided free of charge to Rigas entities, e.g. advertising.

25. © Florencio Lopez-de-Silanes 25 Main Sarbanes-Oxley Requirements Applicable to Foreign Companies Listing in the US I.Directors and Executive Officers 1.CEO and CFO certification requirements 2.Prohibition on personal loans to executives 3.Code of ethics for senior financial officers 4.Forfeiture of bonuses and profits if accounting restatements 5.Prohibition of Improper influence on Auditor 6.May be barred from serving as officer or director if conduct is unfit II.Audit Committee  Have an audit committee comprised of independent directors and with someone with financial expertise, etc..  Audit committee hires, oversees & discharges independent auditors  Procedure for handling whistle blowers.

26. © Florencio Lopez-de-Silanes 26 Main Sarbanes-Oxley Requirements Applicable to Foreign Companies Listing in the US III.Auditors 1.Prohibition of Audit services if officer worked there 1 year before 2.Rotation of audit partner every 5 years certification requirements 3.Prohibition to give non-auditing services to the firm 4.Public Company Accounting Oversight Board: firms to register / be subject IV.Expanded Company Disclosures:  Restrictions on use of pro-forma financial information  Disclose all material off-balance sheet transaction  Management and Auditor assessment of Internal Controls  Real time disclosures V.Counsel’s Responsibility to report material violations VI.Criminalization of Misconduct for participants

27. © Florencio Lopez-de-Silanes 27 The Impact of US Scandals  SOX was created to protect US investors, so presumption is for no omission for foreign firms issuing in the US.  This has created a virulent European reaction:  61% European CEOs say they will turn their back to US markets  Porsche did decide not to cross-list in the US  Auditing and Legal firms are not pleased  “These are US solutions for US problems”  SEC has conceded some ground:  Concessions on independence of audit committees  Exemption to explain financial information not conforming to US-GAAP  But unlikely SEC will give in much more

28. © Florencio Lopez-de-Silanes 28 Challenges Ahead  The impact of the US Corporate Governance reforms will spill-over to impact the future of the European Union markets.  The real problem is the fact that capital markets in US and Europe have become global institutions and thus act as transmission belts.  The challenges for the EU are more complicated as it is in the middle of the transformation, enlargement, and integration of its capital markets.  The road to an integrated EU capital market by 2006 will require:  Agreement on a definition of a public offering for EU  EU “passport” for EU issuers across EU markets  Unique EU clearing and settlement system  Transparency and comparability of financial reporting

29. © Florencio Lopez-de-Silanes 29 coef = 4.7998059, (robust) se = 1.668115, t = 2.88 IPOs / Population (all else equal) Private Enforcement (all else equal) -.396779.364988 -4.74683 6.34918 URY ECU AUT COL ARG CHI BRA VEN DEU FRA NOR SWE PAK PER NZL TUR AUS GRC HKG KEN GBR EGY ZWE ESP PRT ISR IRL FIN MEX JOR ITA SGP MYS IND CHE NGA BEL LKA CAN ZAF JPN USA TWA THA IDN DNK NID KOR PHL Private Enforcement  More IPOs (Controlling for Public Enforcement)

30. © Florencio Lopez-de-Silanes 30 coef = 2.5366363, (robust) se =.6580322, t = 3.85 Access to Equity (all else equal) Private Enforcement (all else equal) -.287844.348567 -1.96349 1.2934 ECU ARG AUT COL BRA CHI VEN FRA DEU NOR SWE TUR PER AUS GRC NZL HKG GBR PRT ESP EGY ISR IRL MEX ZWE FIN ITA SGP JOR MYS CHE CAN BEL IND THA USA TWA ZAF IDN JPN DNK NID KOR PHL Private Enforcement  Greater Access to Equity (Controlling for Public Enforcement)