American, European and Asia-PacificCorporate Governance Models:

Differences and Convergence

Ray BallSidney Davidson Professor of Accounting

University of Chicago

Bangkok 25 July 2005

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Outline

What is corporate governance, and why is it important?The principal corporate governance models worldwide:

1. Common law (US,UK, Canada, Australia)2. Code law (Continental Europe, Latin America)3. Asia-Pacific (Japan, Korea, HK, PRC, Singapore)

The models differ in the roles of:Share markets, analysts and rating agenciesStakeholders (labor, banks, suppliers, customers)Groups of related companies (family groups, keiretsu)ManagersGovernments

Why is corporate governance currently an important issue?Recent scandalsGlobalization is causing some convergenceRecent realization that good governance adds value

There are important limits to convergenceDon’t take governance claims at face value

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What is Corporate Governance?

There are many different definitions of “corporate governance.”Most definitions reflect the special interest or perspective of

the person offering the definition.Examples:– “Balancing economic and social goals.”– “The organization's strategic response to risk.”– “Effective corporate leadership.”– “Promoting corporate fairness, transparency and

accountability.”– “The distribution of power in corporations.”– “The ways in which suppliers of finance to corporations

assure themselves of getting a return on their investment,”Shleifer and Vishny (Journal of Finance 1997 page 737)

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Corporate Governance Defined

My preference is to approach governance in terms of transactions cost economics.Corporate governance is the systematic, institutional way a corporation transacts with its suppliers (investors, lenders, managers, employees) and its customers.Important governance mechanisms include:

Board composition and rulesInternal controlsFinancial reporting and disclosureInternal audit and independent auditExternal analysts (security analysts, rating agencies, press)

Effective corporate governance engenders efficient contracting between all parties and the firm.Prime example: Effective governance gives security to investors and lenders andhence reduces the company’s cost of capital.Managers do not normally want governance that is too effective. It reduces their ability to act in their own interests, rather than in the interests of the firm as a whole.Examples: Effective governance reduces managers’ scope to take the easy path, make trophy acquisitions and investments, expropriate assets via related party transactions, etc.

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What Are Some Roles of Governance?

At a basic level: detect and deter expropriation via:TheftFraudCorruptionRelated party transactionsTransfer pricing

At a higher level: detect and deter bad decisions and their continuation:

StrategiesInvestmentsOperating decisions pricing

Stated positively: maximize firm value by engendering efficient contracting between the firm and all parties:

With managers especially (minimizing the “agency problem”).

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Why Is Governance Important?

Inefficient governance increases the cost of contracting between the firm and its investors, lenders, managers, employees, customers, suppliers etc.

-- including the cost of capital

Inefficient governance is a competitive disadvantage.-- for companies-- and for countries

Daimler-Benz in 1993 (now DaimlerChrysler) is a famous case of bad governance being a competitive disadvantage.

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Governance and the Cost of Capital

This effect is most easily observed in capital markets.For example, Financial Times reported on 21 July 2005: – Moody’s Investors Service raised the long term rating of South Korea’s SK

Corp., due to stronger finances and “SK Corp’s continued focus on improving its previously weak corporate governance standards.”

– Standard and Poor’s (S&P) stated that Volkswagen’s A- credit rating “was being held back by a chain of poor governance that … was perpetuating inefficiency in the company.”

Debt ratings directly affect the attractiveness of lending to a firm and reduce its borrowing costs. This reduces the cost of capital and increases firm value.Arthur Andersen provided a rare opportunity to see how

important good governance is (an economic “experiment” ).1. They threw away an audit business worth about $US 2 bln.2. Their clients’ share prices suffered (see next slide).

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Impact on Share Prices of Arthur Andersen Clients*

96/165-2.31%All Clients

84/150-2.04%Non-Houston

12/15-5.58%Houston Office

No. of Price Falls

Average Price Change

Clients

*All the S&P500 companies that were audited by Andersen

Price change is at the 10 January 2002 announcement that Enron documents were shredded, despite SEC order.

Source: Chaney and Philipich (2002), Journal of Accounting Research

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1. Common-Law“Shareholder Value” Modelof Corporate Governance

Rules of governance, securities markets, financial reporting are a private sector (market) responsibility:

Rules arise from common usageRules are enforced by litigationPenalty for violation is damages

Shareholders alone are represented in monitoring managers (corporate governance) → “shareholder value” model.

Intermediaries (e.g., unions) are not important: Labor markets, share ownership, banking are decentralized.

CEO is a decision-maker who selects advisors.

Information asymmetry is reduced by public disclosure, across the market. Parties presumed outsiders, “at arm’s-length.”

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Common LawFinancial Reporting

Important economic role of transparent financial reporting: timely public disclosure

Emphasis on timely recognition of losses, due to:Monitoring managers’ bad decisionsOffsets managers’ incentives to disclose good newsDebt contractsLitigation

•Earnings are widely used:Shareholders, analystsPricing and enforcing credit, LT debt Management compensation & corporate governance

Largely separate tax and accounting (“book”) earnings

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2. Code-Law“Stakeholder” Model

of Corporate GovernanceGovernance, securities, reporting rules: a public sector activityRules are codified by the governmentRules are enforced by the governmentCriminal penalty for violation: fine, jail

Politically powerful stakeholder groups are represented in both codifying and implementing governance:

Labor?Capital (equity and debt)ManagementMajor suppliers or customers?Government as an implicit or explicit stakeholder at the table

Intermediaries: Needs centralized union, bank, employer orgs.

CEO is a taker and implementer of consensus

Information asymmetry is reduced by direct (insider) access by representatives “across the table.” No arm’s-length presumption.

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Meaning of “Stakeholder”

All parties contracting with the firm are stakeholders in one sense.

Meaning: they have an interest in the performance of the firmExample: even the most lowly-paid employee has invested job search costs in dealing with the firm, and this is lost if the firm failsExample: employees own stock, options, 401 (k)In this sense, everyone is a stakeholder, in any country’s system

I use the term in a more stringent fashion, as the parties with a substantial voice in the firm’s governance:

Governance rules (e.g., corporation, labor and securities laws); and Governance implementation (e.g., board representation)

In code law countries, the parties that can obtain a substantialvoice are the principal organized groups in the country’s politics

Surviving governments must listen to these groups“Stakeholder” then obtains a political dimension

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Code LawFinancial Reporting

Earnings: the “pie” to be divided among stakeholders:Shareholders: dividendsLabor: bonusesManagement: bonusesGovernment: taxesLenders: “prudent” reinvestment for their “protection”

Disclosure is not the primary economic function of earnings.

Earnings become distorted to conform to short-term payout preferences (dividends, bonuses, taxes, creditor protection).

Losses are more likely to be “dribbled out” in earnings, not capitalized as timely “one time charges.”

Earnings has low volatility and low informativeness

“Earnings management” is legal, ethical, prudent, common

3. Asia-Pacific Modelof Corporate Governance

Generally an “insider access” model where:The insiders represent some type of corporate group structureLabor has little influence

There are substantial variants across the regionJapan grafted the German commercial code

and French accounting code onto a feudal economy:Major suppliers, customers represented in governanceCreating its keiretsu

Korea’s chaebol are another variantHong Kong’s family-controlled companies and

company networks reflect the centrality of kinship-based relationships in Chinese culture

Hong Kong retains a strong common law basisSingapore does to a much lesser extent

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Asia-Pacific Governance Model (contd.)

Capital is more likely to be group-suppliedCross-shareholdings are extensiveBoards are management-orientedGovernance relies substantially on mutual monitoring

Works well in efficiently implementing the group’s strategy and plans. Managers can co-operate closelyManagers can monitor each other in implementation

Problems if the aggregate group makes mistakesManagers are not efficient monitors of strategies they share in common

Problem of cross-subsidizationProblems of conflicts of interest across group cos.

Politics and business are closeOrganized labor, individual shareholders exerts

comparatively little influence, litigation is rareAccounting profession generally is weak, financial

reporting generally is low quality

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All Models Have Variants

Caution: There is variation within these groups.For example:

Germany, France and Italy among code law countriesU.S. grafted code onto common law with the passage of the Securities Acts in 1933-34As early as 1861, U.K. had passed the Companies Acts, though the City remained largely self-regulating until recentlyHong Kong historically has fused British common law with Chinese family-controlled businesses

Nevertheless, the common/code/Asia categories are descriptive and useful.

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Differences in Continental Europe:Stereotypes

France: Everything is permitted(except what is prohibited)

Germany: Everything is prohibited(except what is permitted)

Russia: Everything is prohibited(including what is permitted)

Italy: Everything is permitted(including what is prohibited)

… stereotypes don’t work

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Is There A “Best” Governance Model?

The optimal governance system depends on other institutional features, such as:

stockholder litigation rulesdepth of capital markets (groups as “internal” capital markets)Government’s role in the economy

The relative efficiencies of different governance models are likely to differ in periods of change and stability.Cost is an important issue, including:

compliance costsEffect on cross-listingseffects on decisions (e.g., causing excessive caution)

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Recent Interest in Governance:(1) Accounting Scandals

WorldComEnronWaste ManagementArizona Baptist FoundationXeroxConsecoTycoRite AidAOLCendantBristol MyersHealthSouthEurope: ParmalatThailand: Picnic

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WorldCom: A Caseof Bad Governance?

The largest financial restatement in U.S. historyDeliberate attempts to hide facts from the auditorsThe accounting fraud included simple transfers (total

$3.8b) from operating expenses to long term assets→ overstated income, operating cash flow, assets→ overcapacity, havoc in industryWorldCom’s fraud kept a loss-making company out

of bankruptcy for a while, and continued negative-NPV investments for too long.On a scale of 1-5 Enrons, the WorldCom fraud gets

the highest rating:

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WorldCom Governance: Board

Large: 11 members (16 after MCI merger)Insiders: 6/11Outsiders appointed by CEO Ebbers: 4/5CEO power:

Ebbers a Director since 1985By-laws provide for CEO/President, not COB, to run board meetings

Frequency: met 4 times in 2001

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WorldCom Governance: Audit

Audit committee:Frequency of meetings:

2000: 3 times (vs. 16 for compensation ctee)2001: 5 times (vs. 11 for compensation ctee)

Independence: 4/4 appointed by CEOQualifications: none with accounting or audit expertise

Auditor scrutinyArthur AndersenLong tenure: since incorporation2001 audit fees $4.4m; non-audit fees $12.4m (relevant?)

No large block shareholders

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Enron-Inspired Definitions

EBIT: Earnings Before Irregularities & Tampering

EBITDA: Earnings Before I Tricked The Dumb Auditor

CEO: Chief Embezzlement Officer

CFO: Corporate Fraud Officer

EPS: Earned Prison Sentence

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Recent Interest in Governance:(2) Globalization and Convergence

On paper, convergence generally is toward the common law model, for example:

Greater transparencyDisclose more compensation informationGreater board independenceGreater auditor independenceInternational Financial Reporting Standards (IFRS)

Most pundits attribute convergence to the political process, which is correct in part.

There also are powerful market forces at work:1. Poor corporate governance and financial reporting is a competitive

disadvantage (Daimler 1993). Global product market competition forces companies to adopt global best practices.

2. Cross-border transacting creates a demand for convergence.3. The “insider access” model is inefficient for cross-border transacting.

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Limits to Convergence

There are important limits to convergence occurring in fact (versus on paper), including:

Economic: Is it efficient to graft an “outsider” system onto an “insider” system?Political: Powerful interest groups can block convergence in fact.

The relative efficiencies of the governance models are likely to differ in periods of change and stability

Much of the recent appeal of the U.S. system lies in its capacity to force changeTechnological innovation and globalization have taken us through a period of substantial change for companiesChange does not last forever

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What Can Be Done to Improve Governance?

My first priority would be to strengthen the ability of the capital markets to monitor managers. This includes:

Adopting high quality accounting and auditing standards (e.g., IFRS).Strengthening auditor independence.Increased disclosure of non-financial information.More importantly, removing barriers to the enforcement of high quality financial reporting and disclosure standards – i.e., removing obstacles to shareholders and lenders suing managers and auditors.Strengthening shareholder litigation rights always is at the top of my governance agenda.

One cannot rely on governments or government agencies to effectively monitor managers. They (1) face political pressures and (2) have limited budgets, resources and talent.

Nor can we rely too much on non-executive (“independent”) board members ... .

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Truly Effective Independent Directors, Auditors and Analysts

Need “Three Eyes”

The common law model relies more heavily on independent monitorsof managers’ actions:

DirectorsAuditorsSecurity analysts

To be effective, independent monitors need to be:1. Informed2. Incented3. Independent

Problem:1. Being informed requires large amounts of time, which is costly and

makes the monitor close to the company and its mangers2. Being incented requires the monitor to have an interest in the

company’s outcomes3. In which case, it is difficult to be independent

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Governance Checklists

There now is an extensive industry worldwide, creating checklists that are either voluntary or mandatory.My objections include:

The false sense of security that compliance with a checklist can give to investors, lenders, etc.The incentive a checklist formula gives managers to “hide behind” a checklist that has been granted legitimate status. The legalistic and bureaucratic nature of the typical checklistThe absence of evidence (or even good economics) behind key items on the checklists.

It is easier to adopt -- and even to appear to comply with -- a checklist than it is to actually improve governance.Poorly governed companies can pass the checklist test, and well governed companies can fail it (e.g., Warren Buffet’s Berkshire Hathaway, which has no independent chairman).

Governance RulesVersus Incentives

There is less convergence than meets the eyeYou need to consider incentives, not rulesIt is almost costless to adopt the highest quality rules

and say one has high standardsAnd what countries will say “we have low standards”? It is another matter entirely to implement and actually

obtain high standardsThe economic term for this is “cheap talk”Successful implementation needs strong incentives to comply

Mandatory rules can cause superficial change

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Don’t Take Claims by Companies & Countries About Governance

Standards at Face Value

OUR VALUESRESPECT: We treat others as we would like to be treated ourselves. We do not tolerate abusive or disrespectful treatment. Ruthlessness, callousness, and arrogance don’t belong here.

INTEGRITY: We work with customers and prospects openly, honestly, and sincerely. When we say we will do something, we will do it; when we say we cannot or will not do something, then we won’t do it.

COMMUNICATION: We have an obligation to communicate. Here, we take the time to talk to one another … and to listen. We believe that information is meant to move and that information moves people.

EXCELLENCE: We are satisfied with nothing less than the very best in everything we do. We will continue to raise the bar for everyone. The great fun here will be for all of us to discover just how good we can really be.

Enron Corporation, 1998 Annual Report