Emerging Capital Markets AG907 M.Sc. Investment & Finance M.Sc. International Banking & Finance Lecture 2 Corporate Governance in Emerging Capital Markets Ignacio Requejo Glasgow, 2010/2011
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 Emerging Capital Markets Ignacio Requejo 1
1. Introduction Corporate governance (CG) for long-term development in emerging economies Move from relationshipbased 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 Emerging Capital Markets Ignacio Requejo 2
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 Emerging Capital Markets Ignacio Requejo 3
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. Emerging Capital Markets Ignacio Requejo 4
Purpose of CG 1. Facilitate performance of corporations 2. Limit insiders abuse of power ( agency problems ) 3. Provide means to monitor managers behaviour Emerging Capital Markets Ignacio Requejo 5
3. Importance of CG for EMs CG long thought to be unimportant for emerging countries Different corporate ownership structures Publicly listed corporations vs. Unlisted companies (family-, state- or foreign-owned) 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 Emerging Capital Markets Ignacio Requejo 6
3.1. The expropriation problem Focus of CG on owner manager conflicts; other stakeholders protected contractually (US & UK) But in emerging economies Weak laws & enforcement Concentrated ownership Complex control structures Different agency problem controlling shareholder minority investors Use of complex ownership structures as substitute for development of financial markets Emerging Capital Markets Ignacio Requejo 7
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 other entities (e.g., individuals, state) control large parts of the economy Macroeconomic implications Corporate entrenchment Economic entrenchment (less innovation & less long-term economic growth) Emerging Capital Markets Ignacio Requejo 8
4. Basic Principles of CG Effective CG system: Internal discipline & External discipline To maximize performance To minimize risk To protect stakeholders interests The 2004 OECD Principles of Corporate Governance Emerging Capital Markets Ignacio Requejo 9
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 Emerging Capital Markets Ignacio Requejo 10
II. Rights of shareholders Corporate governance framework should protect and facilitate exercise of shareholders rights Secure ownership Information Participation Voting Share of profits Emerging Capital Markets Ignacio Requejo 11
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 Emerging Capital Markets Ignacio Requejo 12
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 Emerging Capital Markets Ignacio Requejo 13
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 Emerging Capital Markets Ignacio Requejo 14
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 Emerging Capital Markets Ignacio Requejo 15
Concerns of special importance to EMs OECD principles first adopted in 1999 Problem of ownership 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 Emerging Capital Markets Ignacio Requejo 16
The institutional environment Source: Adapted from La Porta et al. (1998) Developed Judicial system Rule of law Corruption Risk of expropriation Accounting standards 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 Emerging Capital Markets Ignacio Requejo 17
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 Emerging Capital Markets Ignacio Requejo 18
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 Emerging Capital Markets Ignacio Requejo 19
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 Emerging Capital Markets Ignacio Requejo 20
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 Emerging Capital Markets Ignacio Requejo 21
Main objectives Provide overview of CG practices of publicly traded firms in India Identify areas where governance practices are strong or weak Develop an Indian Corporate Governance Index (ICGI) Analyze relation between CG & firm value Emerging Capital Markets Ignacio Requejo 22
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-governmentcontrolled public firms Literature on CG indices and connection between governance & firm value Emerging Capital Markets Ignacio Requejo 23
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 Emerging Capital Markets Ignacio Requejo 24
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. Emerging Capital Markets Ignacio Requejo 25
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 Emerging Capital Markets Ignacio Requejo 26
Board composition & independence Percentages of different types of directors. Sample is 295 firms with board composition data which responded to India CG Survey 2006. Emerging Capital Markets Ignacio Requejo 27
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 Emerging Capital Markets Ignacio Requejo 28
Board practices & processes Required indicates items legally required or recommended. Emerging Capital Markets Ignacio Requejo 29
Board practices & processes Most firms use multiyear terms for executive & nonexecutive 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 Emerging Capital Markets Ignacio Requejo 30
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. Emerging Capital Markets Ignacio Requejo 31
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 obtainable but compensation threshold could constrain executive pay Emerging Capital Markets Ignacio Requejo 32
Shareholder rights Required column indicates items legally required or recommended. Emerging Capital Markets Ignacio Requejo 33
Shareholder rights Only 73% firms allow postal ballot despite requirement Fraction of 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 one share, one vote rule Emerging Capital Markets Ignacio Requejo 34
Related party transactions Approval requirements for related party transactions. Emerging Capital Markets Ignacio Requejo 35
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 Emerging Capital Markets Ignacio Requejo 36
Cross-listing & financial disclosure Sample is 301 Indian private firms which responded to India CG Survey 2006. Emerging Capital Markets Ignacio Requejo 37
Since when? Sample is 301 Indian private firms which responded to India CG Survey 2006. Emerging Capital Markets Ignacio Requejo 38
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 Emerging Capital Markets Ignacio Requejo 39
Is CG associated with firm value? Construction of Indian CG Index Emerging Capital Markets Ignacio Requejo 40
Is CG associated with firm value? Preliminary evidence Emerging Capital Markets Ignacio Requejo 41
Is CG associated with firm value? Full sample results Emerging Capital Markets Ignacio Requejo 42
Is CG associated with firm value? Sub-index results Emerging Capital Markets Ignacio Requejo 43
Main conclusions Positive association between CG & firm value Shareholder rights sub-index is significant, but not other 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 Emerging Capital Markets Ignacio Requejo 44
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. Emerging Capital Markets Ignacio Requejo 45