Emerging Capital Markets AG907 M.Sc. Investment & Finance - - PowerPoint PPT Presentation

Emerging Capital Markets AG907

M.Sc. Investment & Finance M.Sc. International Banking & Finance Lecture 2 – Corporate Governance in Emerging Capital Markets

I g n a c i o R e q u e j o – G l a s g o w , 2 0 1 0 / 2 0 1 1

Overview of Lecture

• 1. Introduction
• 2. Definition of Corporate Governance
• 3. Importance of CG for Emerging Economies
• 4. Basic Principles of Corporate Governance
• 5. Who benefits from Corporate Governance?
• 6. Types of Corporate Governance Mechanisms

Empirical Evidence – CG: A Case Study of India

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• 1. Introduction
• Corporate governance (CG) for long-term development

in emerging economies ⇒ Move from relationship- based to rules-based institutions

• Beginnings: East Asian financial crisis of 1997-1998,

followed by those in Russia and Brazil ⇒ Problems of “crony capitalism” & poor CG in emerging economies

• Importance of CG for Emerging economies

Transformation Economic Political Rules-based system

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“Crony capitalism”

Capitalist economy in which success in business depends on close relationships between business people & government officials It may be exhibited by favouritism in the distribution of legal permits, government grants, special tax breaks and so forth

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• 2. Definition of CG

A country’s private and public institutions (formal & informal) which govern relationship between “corporate insiders” & other stakeholders Includes corporate laws, securities laws, accounting rules, generally accepted business practices, etc.

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Purpose of CG

• 1. Facilitate performance of corporations
• 2. Limit insiders’ abuse of power (“agency problems”)
• 3. Provide means to monitor managers’ behaviour

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• 3. Importance of CG for EMs
• CG long thought to be unimportant for emerging

countries ⇒ Different corporate ownership structures

• CG helps alleviate agency problems in firms from

emerging markets ⇒ Expropriation & Entrenchment

• Importance of CG also to achieve long-term economic

growth in emerging economies

Unlisted companies (family-, state- or foreign-owned) Publicly listed corporations vs.

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3.1. The expropriation problem

• Focus
• f

CG

• n
• wner–manager

conflicts;

• ther

stakeholders protected contractually (US & UK)

• But in emerging economies
• Different agency problem ⇒ controlling shareholder–

minority investors

• Use of complex ownership structures as substitute for

development of financial markets

Concentrated

• wnership

Weak laws & enforcement Complex control structures

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3.2. The entrenchment problem

• Entrenchment can occur in family firm successions ⇒

Incompetent heirs cannot be easily removed

• Incompetent CEO can potentially damage firm value
• In many emerging economies, few wealthy families or
• ther entities (e.g., individuals, state) control large

parts of the economy ⇒ Macroeconomic implications

• Corporate entrenchment ⇒ Economic entrenchment

(less innovation & less long-term economic growth)

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• 4. Basic Principles of CG
• Effective CG system:
• To maximize performance
• To minimize risk
• To protect stakeholders’ interests
• The 2004 OECD Principles of Corporate Governance

External discipline Internal discipline &

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• I. Basis for an effective CG framework

Sets the important context for the other principles

• Transparent & efficient markets
• Rule of law
• Clear division of responsibilities among authorities

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• II. Rights of shareholders

Corporate governance framework should protect and facilitate exercise of shareholders’ rights

• Secure ownership
• Information
• Participation
• Voting
• Share of profits

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• III. Equitable treatment of shareholders

Corporate governance framework should ensure the equitable treatment of all shareholders

• Equal voting rights
• Protection of minority & foreign shareholders
• No insider trading or self-dealing
• Voting
• Redress for violation of rights

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• IV. Role of stakeholders

Recognize the rights of stakeholders

• Respect for legal rights & agreements
• Co-operation between corporations & stakeholders
• Access to information
• Communication & redress for violations

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• V. Disclosure & transparency

Disclosure & transparency on all material matters

• Timely & accurate disclosure of material information
• Financial status, performance, ownership, governance
• Accounting standards
• Audits of financial statements

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• VI. Responsibilities of the Board

The responsibilities of the board include

• Strategic guidance
• Monitoring of management
• Accountability to the company & shareholders
• Duty of care
• Duty of loyalty

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Concerns of special importance to EMs

OECD principles first adopted in 1999 ⇒ Problem of

• wnership–control separation within corporations

Revision of OECD principles in 2004 ⇒ Two concerns

• Institutional framework for markets ⇒ appropriate

regulations & enforcement

• Protection of minority shareholders ⇒ to attract new

investors & allow sustainable growth

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The institutional environment

Source: Adapted from La Porta et al. (1998)

Judicial system Rule of law Corruption Risk of expropriation Accounting standards Developed North America

9.63 10.00 9.32 9.83 72.50

Europe

8.77 9.10 8.82 9.48 64.60

Asia Pacific

9.33 8.52 8.18 9.09 69.83

Mid East & Africa

10.00 4.82 8.33 8.25 64.00

All 25

9.02 8.86 8.69 9.37 66.54

Emerging Latin America

6.46 5.04 5.33 6.77 49.83

Europe

4.00 5.18 5.18 7.00 51.00

Asia Pacific

5.89 4.90 4.87 7.24 65.40

Mid East & Africa

6.53 4.02 4.85 6.03 51.00

All 21

6.17 4.71 5.03 6.73 55.33

Developed: Canada, US, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, UK, Australia, Hong Kong, Japan, New Zealand, Singapore, South Korea, Israel Emerging: Argentina, Brazil, Chile, Colombia, Ecuador, Mexico, Peru, Turkey, India, Indonesia, Malaysia, Philippines, Sri Lanka, Taiwan, Thailand, Egypt, Jordan, Kenya, Nigeria, Pakistan, South Africa

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• 5. Who benefits from CG?
• Companies ⇒ Relationships with stakeholders, firm

performance, cost of capital

• Shareholders ⇒ Protection of their rights, higher

liquidity, transparency

• Stakeholders & society ⇒ Employees, customers,

creditors, suppliers & communities

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• 6. Types of CG Mechanisms

Internal governance of firms

• Board of directors ⇒ independent directors
• Shareholders’ rights ⇒ self-dealing, insider trading,

related party transactions

• Reporting & internal controls ⇒ transparency, audits

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• 6. Types of CG Mechanisms

External governance of firms

• Factor & product markets ⇒ efficient allocation of

resources

• Stock markets ⇒ efficiency & liquidity
• Markets for corporate control ⇒ mergers & acquisitions

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‘The relation between firm-level corporate governance and market value: A case study of India’

Balasubramanian, N., Black, B.S. and Khanna, V. Emerging Markets Review 11 (2010) 319–340

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Main objectives

• Provide overview of CG practices of publicly traded

firms in India

• Identify areas where governance practices are strong
• r weak
• Develop an Indian Corporate Governance Index (ICGI)
• Analyze relation between CG & firm value

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Contributions

• Detailed ‘case study’ of firm-level governance practices

in India

• Second largest EM in population & GDP terms
• Largest EM with significant no. of non-government-

controlled public firms

• Literature on CG indices and connection between

governance & firm value

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Methodology & data sources

• Survey conducted in 2006 ⇒ ‘India CG Survey 2006’
• Sample coverage ⇒ large & small firms
• Final sample ⇒ 301 ‘Indian private firms’ (government-

& foreign-controlled firms excluded)

• 55% part of Indian business group
• 69% with a 40% or greater shareholder

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Final sample

Surveyed & responding firms. No. of firms approached &

• no. of respondents in different size ranges, for India CG

Survey 2006. Total row includes all firms in Prowess database of Indian public firms.

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Indian CG overview

• Indian CG rules ⇒ Company Law & ‘Clause 49’
• ‘Clause 49’
• Majority of independent directors
• At least 1/3 independent directors and splitting

chairman & CEO roles

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Board composition & independence

Percentages of different types of directors. Sample is 295 firms with board composition data which responded to India CG Survey 2006.

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Board composition & independence

• Larger firms have larger boards
• Separation of Chairman–CEO roles is common
• 13% firms do not comply with ‘Clause 49’
• Importance of political connections ⇒ lawyer, former

government official or former politician on the board

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Board practices & processes

‘Required’ indicates items legally required or recommended.

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Board practices & processes

• Most firms use multiyear terms for executive & non-

executive directors

• 8 firms did not meet 4 meetings per year rule
• Firms usually prepare minutes for meetings
• Half regularly evaluate CEO ⇒ how rigorously? No firm

replaced CEO & only 3 replaced other executives!

• 29% firms have CEO succession plan
• About 90% companies have code of conduct

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Compensation of exec. & non-exec.

Compensation is in lakhs (1 lakh ≈ $2000); options are in thousands of shares. “Required” column indicates items that are legally required.

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Compensation of exec. & non-exec.

• Executive compensation is modest by US standards
• Only 16% Indian private firms use stock options
• Indian

law requires government approval for compensation under specific circumstances

• Government

approval is usually

• btainable

but compensation threshold could constrain executive pay

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Shareholder rights

‘Required’ column indicates items legally required or recommended.

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Shareholder rights

• Only 73% firms allow postal ballot despite requirement
• Fraction
• f

shares vote at most recent annual shareholder meeting is small given predominance of controlling shareholders ⇒ minority investors often do not vote

• Shareholder resolutions are uncommon
• Limited use of arbitration as response to slow Indian

judicial system

• Indian firms do not use preferred shares & not violate
• ne share, one vote rule

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Related party transactions

Approval requirements for related party transactions.

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Related party transactions

• Related party transactions & other forms of self-dealing

are major concern in India

• Prevalence of tunneling within Indian business groups
• RPTs are frequent in Indian private firms (94%)
• Approval by non-conflicted directors and shareholders

is uncommon

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Cross-listing & financial disclosure

Sample is 301 Indian private firms which responded to India CG Survey 2006.

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Since when?

Sample is 301 Indian private firms which responded to India CG Survey 2006.

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Is CG associated with firm value?

Construction of Indian CG Index

49 firm attributes believed to be associated with ‘good’

• governance. Elements grouped in different sub-indices
• Board structure
• Disclosure
• Related party transactions
• Shareholders rights
• Board procedure

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Is CG associated with firm value?

Construction of Indian CG Index

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Is CG associated with firm value?

Preliminary evidence

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Is CG associated with firm value?

Full sample results

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Is CG associated with firm value?

Sub-index results

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Main conclusions

• Positive association between CG & firm value
• Shareholder rights sub-index is significant, but not
• ther sub-indices
• Board structure ⇒ India’s legal requirements are

sufficiently strict & no benefits in over-compliance

• RPTs are common but approval requirements for them

are often weak

• Benefits of particular CG practices vary across firms &

countries ⇒ Governance is not one-size fits all

• Combination of some mandatory minimum rules &

flexibility above the minimum level might be desirable

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Recommended Readings

• International Finance Corporation (IFC) & Organisation

for Economic Co-operation and Development (OECD) (2005): ‘Case studies of good corporate governance

• practices. Companies circle of the Latin American

Corporate Governance Roundtable’.

• Bris, A. and Cabolis C. (2006): ‘Integrating corporate

governance systems’. Financial Times.

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