1
International Corporate Governance
P f B E E kbProfessor B. Espen Eckbo
2010
Stock market evolution, 1913-2000(number of listed firms per million capita)
30
5
10
15
20
25
0
5
Argentina Brazil Japan US
Red: 1913 Yellow: 1980 Blue: 2000Eckbo (41) 2
2
Agency and control: Adam Smith (1776)
“..being managers rather of other people’s money than of their own it cannot be wellmoney than of their own, it cannot be well expected, that they should watch over [the firm] with the same anxious vigilance [as owners]…”
• Problem of conflicts of interest and wealth• Problem of conflicts of interest and wealth expropriation
• How does the modern corporation deal with this problem?
Eckbo (41) 3
Why shareholder = “owner”?
Payoff
Payoff to EquityFirm defaults
Value of Firm
Payoff to fixedclaimholders
F0Eckbo (41) 4
3
The minority report
• Outside minority shareholders emerged as a f th i ti f li it dconsequence of the invention of limited
liability
• Allows equity-holders to diversify risk
• Dramatically reduces cost of capital
Results in ownership dispersion• Results in ownership dispersion
• Problem: ownership dispersion transfers power to management
Eckbo (41) 5
Management as de facto owner
• Dispersed shareholders rationally do not i t l i htexercise control rights
• Unexercised control rights are appropriated by management
• Ineffective boards
Agents protecting agents• Agents protecting agents
• Politicians protecting agents
Eckbo (41) 6
4
Why focus on outside investor protection?
• Outside investors, in particular minority shareholders represent a “remote”shareholders, represent a remote corporate constituency
• They are “useful” to management only the few times it decides to raise external capital
• Other constituencies (employees, suppliers, dit ) ti ll f l dcreditors) are continually useful and
protected by strong contractual rights• Controlling shareholder’s interest may
conflict with minority’sEckbo (41) 7
Protection against what?
• Asset transfers and strippingDil ti i it i• Dilution via new equity issues
• Diversion of corporate opportunities• Hiring under-qualified family members• Overpaying executives• Perquisites consumption• Perquisites consumption• Bribes• etc…
Eckbo (41) 8
5
Direct evidence on expropriation
• US savings and loans crisis
• Currency crises in Asia and Mexico
• Case studies of asset tunneling in Western Europe
• State privatizations in Russia
• Japanese banking crisis
• Target defenses in hostile takeovers
• Some cases of executive compensationEckbo (41) 9
The 97-98 Asian crisis
• Governance problems most evident in times of crisistimes of crisis
• Research: Exchange rate and stock market declines greatest in countries with weakest investor protection
• Research: Weak investor protection a t l t f t f k tstronger explanatory factor for market
declines than all the usual macroeconomic arguments
Eckbo (41) 10
6
The Asian crisis
• Thailand: Money moved offshore
• China: Hong Kong liquidators unable to• China: Hong Kong liquidators unable to recover assets of bankrupt Chinese firms
• Indonesia: Hard to force liquidation
• Korea: Transfer of funds out of large firms
• Russia: Creditors and minority shareholders• Russia: Creditors and minority shareholders get virtually nothing
Eckbo (41) 11
The Asian crisis
• China:• Frequent transfers from listed firms toFrequent transfers from listed firms to
controlling shareholders• No efficient internal audit• Lack of accounting standards:
-The China National Audit Office stated 12/98 th t “ k d b k ” f d d12/98 that “cooked books”, fraud and irregularities in financial management are widespread
Eckbo (41) 12
7
Japan’s ongoing debt crisis
• A firm’s outstanding, distressed debt bl k it l i f iblocks new capital infusion
• Lack of new capital blocks new productive investments by the firm
• Lack of corporate investments leads to economic contractioneconomic contraction
• Only solution: Restructure firms with non-performing loans (NPLs)
Eckbo (41) 13
Long Term Capital Bank of Japan
• 2000: Ripplewood (Chris Flowers ) bought L T C it l B k ( Shi iLong Term Capital Bank (now Shinsei Bank)
• Government sold Ripplewood a put on bank’s NPLs as part of the deal
• 2001: Government appears to renege on• 2001: Government appears to renege on part of its obligation to absorb NPL’s
Eckbo (41) 14
8
Security design and investor rights protection
Contract specificationExplicit rights• Cash flow rights• Voting rights• Rights in bankruptcy• Option features• Allocation of decision
rights
Contract enforcement and control Implicit rights• Ownership structure• Internal control mechanisms• Incentive schemes• Market for corporate control• Legal/political environment• Transparency
InvestorInvestorRights Rights
ProtectionProtection
• Transparency• Allocation of decision rights
Financial Financial Contract Contract DesignDesign
Eckbo (41) 15
Legal families
• Common law (British, case-based) • French civil law (Roman/Napoleonic)• German civil law (derivative of French) • Scandinavian law (derivative of French)• Socialist law (weak individual property rights)
Eckbo (41) 16
9
Legal Origin Distribution
Legal OriginsE li h= English
= French
= German= Scandinavian= Socialist
Eckbo (41) 17
Financial market systems across legal families
C t t i t C it i tContractarian system Market based
Communitarian systemBank based
- Common law- Outsider-controlled- Dispersed ownership
- Civil law- Insider-controlled- Corporate cross-holdings
- Banks play minor role- Hostile takeovers - US, UK, Canada
p g- Concentrated ownership- Banks play major role- Japan, Germany
Eckbo (41) 18
10
Voting impediments in Europe1/3 of companies have one-share-one-vote deviations
Source: Deminor 2005Eckbo (41) 19
Control is valuable: Block Premium in Control Block Transactions
Block Premium (%)
.01
0.19
0.39
%
-0.
Japan
South A
frica
United K
ingdo
mTaiw
an
Canad
aFran
ce
Finlan
d
Australi
a
NorwaySpain
Hong K
ong,
China
United S
tates
Singap
ore
Netherl
ands
Sweden
Denmark
Egypt,
Arab
Rep
New Zeal
and
Mala
ysia
Thaila
nd
Indone
sia
Switzerl
and
Philippines
German
y
Turkey
Argenti
naPolan
dChil
e
Colombia
Italy
Korea, R
ep.Peru
Portugal
Israel
Venezu
ela, R
B
Czech R
epub
lic
Austria
Mex
icoBraz
il
Eckbo (41) 20
11
• Buyer and Seller both controlled by same shareholder (Mr James)
Potential for self-dealing in LEGAL(garden variety) transactions between firms
shareholder (Mr. James)
Mr. James owns 50% of Buyer Co. shares
Mr. James owns 90% of Seller Co. shares
Mr. James
Seller Co.Buyer Co. buys equipment from Seller Co.
Buyer Co.
Eckbo (41) 21
How to regulate garden-variety self-dealing?
1. Replicate conditions in an arm’s-length transaction• Laws requiring prior approval before—and immediate disclosure
after—the decision to enter the transactions has been made
2. Empower shareholders to seek remedy ex post• Laws that lowers shareholders’ litigation costs even if disclosure and
approval requirements are met
• Factors that affect the odds that the plaintiff prevails in court include liability standards and the right to compel evidence.
3. Fines and criminal sanctions to expropriators• Strength of public enforcement with fines and sanctions applicable to
Mr. James and those in charge of approving the transaction.
Eckbo (41) 22
12
Key to minority shareholder protection
• Disclosure• “Sunshine is the best disinfectant”
• Prior approval by disinterested parties
• Low cost of suing for restitution
• class action
• derivative suits
Eckbo (41) 23
La Porta et al. (2006)
• Suppose a controlling shareholder wants to enrich himself but also follow the law
All legal approvals and required disclosures are met
• How difficult is it for minority shareholders to thwart the deal before it goes through and to recover damages if it is carried out?and to recover damages if it is carried out?
• Creates an anti-self-dealing index for each of 108 countries representing 99.3% of total world market capitalization
Eckbo (41) 24
13
Anti-Self-Dealing Index and Block Premium
Mexico
Brazil.4
Netherlands
Venezuela
Philippines
Germany
Switzerland
Austria
Norway
SwedenSpain
Turkey
Korea (Rep.)
JapanDenmark
Czech Rep.
F
Argentina
United States
Portugal
PeruItaly
Chile
ColombiaS th Af i
Israel
New Zealand
Thailand
Hong KongSingapore
MalaysiaUnited King
0.2
Res
idual
blo
ck p
rem
ium
Egypt
pFrance
PolandFinland Taiwan IndonesiaSouth Africa
Canada
Thailand
Australia
-.2
-.4 -.2 0 .2 .4Residual anti-self-dealing index
coef = -.17912243, (robust) se = .07763217, t = -2.31
Eckbo (41) 25
Anti-Self-Dealing Index and Ln Firms / Pop
Romania
4
Tunisia
Netherlands
Ukraine
Venezuela
Ecuador
Panama
Jordan
Mexico
Uruguay
Egypt
GermanyHungary
PhilippinesSwitzerland
Iceland
Bolivia
GreeceLuxembourg
AustriaBrazil
KenyaCroatia
SwedenNorway
Latvia
Spain
France
Lithuania
El SalvadorDenmarkCzech Rep.
Jamaica
Japan
Argentina
Korea (Rep.)
Slovak Rep.
TurkeyPoland
Zimbabwe
Finland
Russia
KazahkstanBelgium
Italy
Portugal
Sri Lanka
Nigeria
Pakistan
United States
PeruTaiwan
India
Morocco
Chile
Ghana
Colombia
Canada
IndonesiaIreland
Israel
Bulgaria
South AfricaAustralia
China
New Zealand
Hong Kong
Thailand
Singapore
United Kingdom
Malaysia
-20
2es
idual
Ln(
firm
s-to
-pop
ulat
ion)
Uganda
-4R
e
-.6 -.4 -.2 0 .2 .4Residual anti-self-dealing index
coef = 1.0847465, (robust) se = .48839839, t = 2.22
Eckbo (41) 26
14
Anti-Self-Dealing Index and IPOs/GDP
Greece
TaiwanUnited Kingdo
6
NetherlandsJordan
Ecuador
Venezuela
Philippines
Germany
Egypt
Switzerland
KenyaSweden
Spain
Korea (Rep.)
F
Turkey
Zimbabwe
United States
B l i
Finland
Nigeria
Sri Lanka
Portugal
PakistanIndia
Italy
Peru
IrelandIndonesia
South Africa
Canada
Colombia
Hong Kong
Singapore
Australia
Thailand
Malaysia
20
24
Res
idual
IPO
s-to
-GD
P
Netherlands Venezuela
MexicoUruguay
Brazil
NorwayAustria
Japan
Denmark
FranceArgentina
Belgium Chile
IsraelNew Zealand-4-2
-.6 -.4 -.2 0 .2 .4Residual anti-self-dealing index
coef = 4.1412864, (robust) se = 1.7922779, t = 2.31
Eckbo (41) 27
Shareholder Activism – A Continuum
no exit
no voice
exitno
voice
no exit
(loud)voice
partialcontrol
change
control
change
passive passive active focus raider
no controlseek
change
raider
exitvoice
activeindex
trackerstockpicker
indextracker
fund
hedgefund
(buyoutfund)
hedgefund
stockpicker
Eckbo (41) 28
15
Role of market expectations
• Today’s stock price reflects the market’s valuation of a firm’s current and expected future governance characteristics
• Since inexpensive governance changes are anticipated, they produce no excess return (nofree lunch)free lunch)
• Costly governance changes (unanticipated) may produce risk-adjusted excess stock returnsEckbo (41) 29
Returns to shareholder activism
• Plenty of evidence that costly governance h d l tchanges produce large excess returns
• Hostile takeovers; LBOs; debt restructurings; etc.
• Much less evidence that “voice” strategies produce excess stock returnsproduce excess stock returns
• Governance principles; shareholder resolutions; etc.
Eckbo (41) 30
16
Return to passive stock picker(“no exit, no voice”)
• Gompers, Ishi, Metric (2003): Data on corporate governance provisions for1 350 NYSE/Amex firmsgovernance provisions for1,350 NYSE/Amex firms
• Governance Index (GI) = sum of the number of governance provisions for a given firm
• Short a portfolio of firma with weakest shareholder rights (lowest GI decile), and go ling in firms with strongest shareholder rights (highest GI decile)
Eckbo (41) 31
Portfolio returns, 1990-2000
• Use a four-factor model to adjust for portfolio systematic risk:
E(R) = alpha + aRM + bSMB + cHML + dMOM
• The long-short strategy produces an “alpha” of 71 bp per month, i.e., an abnormal stock return of 9% per yearof 9% per year
• What are alternative interpretations?
Eckbo (41) 32
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Active index trackers (“no exit (loud) voice”)
• Total global pension fund assets estimated to 15 trillion USDtrillion USD
• Hold 40% of US equities
• Hold 30-50% of the European equities
• Growth of global pension fund assets in 2005 was around 17 % in 2005
• Have doubled in size during the past ten years• Have doubled in size during the past ten years
• Global ownership is major and growing• 30% in the US held by foreign investors
• 30-40% in Europe held by foreign investorsEckbo (41) 33
More recent activism in the US and Europe
• Focus Funds
• Hedge Funds• Hedge Funds
• Opportunity Funds
• …
Engaging in
• “active ownership”
• “activist arbitrage”
• “raiding”Eckbo (41) 34
18
Spectrum of Hedge Fund Activism
Influence Decision
Takeovers
CorporateGovernance
ChangeBoard/
Management
CapitalStructure
ForceDivestitures
of assets
StrategicDirection
M&A
Making
Eckbo (41) 35
Recent studies of Hedge fund activism
• Brav, Alon, Wei Jiang, Frank Partnoy, and Randall Thomas (2006), “Hedge Fund Activism, Corporate Governance, and Firm Performance” http://www.fdic.gov/bank/analytical/cfr/2006/oct/hedge_fund.pdf
• Klein, April and Zur, Emanuel (2006), "Hedge Fund Activism" http://ssrn.com/abstract=913362
• Bratton William (2006) “Hedge Funds andBratton, William (2006), Hedge Funds and Governance Targets” http://ssrn.com/abstract=928689
• Becht, Marco, Julian Franks and Jeremy Grant (2007), “Active Ownership in Europe”. [work in progress].Eckbo (41) 36
19
Becht, Franks, Mayer, Rossi (2006)
Clinical Study of the Hermes U.K. Focus Fund
• Majority owned by BT Pension Scheme• Trustees have fiduciary duty to beneficiaries, not
BT management• Trustees set up the Focus Fund to reduce free
riding problem leading to passivityg p g p y• High-powered incentives for managing partners
linked to fund returns• Focus fund acts independently of fund promoter
Eckbo (41) 37
HUKFF Investment Strategy
Focus fund applies triple investment criterion
1 Is the company under performing?1. Is the company under-performing?
2. Can the fund engage the company successfully?
3. Does the fund expect it can get at least 20% more value over current share-price?
If t i l “ ”If triple “yes”
• Invest
• Engage (bring about governance/real change)
• DivestEckbo (41) 38
20
Engagement Objectives
• Board Changes• CEO• CEO• Chairman• introduction of > independence
• Financial Policies• payout policy • rights issues
• Restructuring • refocusing / asset sales• narrowing discount on investment funds
Eckbo (41) 39
HUKFF Excess Returns against Benchmark
R R t FTSE AllRelative to B h kRaw Return
(net of fees)
FTSE All
(raw return)
Benchmark
Arithmetic mean
Since Inception Oct 98 – Dec 2004
63.7% 22.4% 41.3%
Annual 8 2% 3 3% 4 9%Annual 8.2% 3.3% 4.9%
Source : Hermes Focus Asset Management
Eckbo (41) 40
21
Weak boards
• Director voting rules favor incumbents• Lack of director independenceLack of director independence
• CEO chairmanship• Mandatory employee representation• Legal/accounting consultants
• Lack of financial literacy• Lack of accounting transparency• Lack of accounting transparency• Largely misunderstood emphasis on
constituencies other than shareholders
Eckbo (41) 41