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

17

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