1 GOVERNANCE AND VALUE: EVIDENCE FROM EMERGING MARKETS

2 Questions Can companies compensate for poor laws by practicing good governance? do you believe standards of governance should be required through legal mandate or adopted at the discretion of the company based on recommended best practices and pressure from shareholders? do all firms in weak legal regimes suffer from poor corporate governance and do firms in strong legal regimes practice uniformly high-quality governance?

3 if so, is there a systematic pattern in which firms choose their quality of governance? what are the relevant firm attributes and how are they related to the observed governance practices? is the quality of governance priced in stock markets, and if so, should corporate decision makers take notice? Questions

4 Risk neutral controlling shareholder with ownership Interest rate = 0 measures investment profitability for firm i Endowment: j 1 Simple models

5 Quality of Governance Practices: 1 – d, where d = the proportion of cash flows that the controlling shareholder diverts for private benefits includes outright stealing, shirking, perks, tunneling high d = bad corporate governance low d = good corporate governance Simple model

6 c = cost of diversion = PV of legal costs/penalties and costs of diverting and converting corporate resources into cash equivalents fines, jail term, loss of reputation, bribes -high c in the U.S. -low c in Russia, China, India, Brazil The controlling shareholder will invest if: personal benefits from investment > net benefits from diversion Simple model

7 Investment opportunities In strong legal regimes, firms divert less and practice higher quality governance. Good rules and effective enforcement reduce thievery. Controlling shareholders of firms with more profitable investment opportunities divert less for private gains and practice higher- quality governance. One is less likely to commit crime if one has something valuable to lose

8 The impact of profitable investment opportunities on corporate governance is greater in weaker legal regimes. Good governance driven by private incentives becomes a more important complement to regulation when regulation is less effective. Investment opportunities

9 Controlling shareholders payoff as a function of diversion d Payoff = Sensitivity of d* w.r.t. is smaller in the U.S. than in Russia

10 Controlling shareholders of firms with higher cash flow ownership practice higher quality of governance. One does not steal from oneself The impact of ownership on governance is stronger in weaker legal regimes. Concentrated ownership becomes a more important tool to resolve agency conflict between controlling and minority shareholders in weaker legal regimes Ownership

11 External Financing For a given level of profitable investment opportunities, controlling shareholders of firms with greater dependence on external financing practice better governance. One does not spit into the well one drinks from The relation between reliance on external financing and governance is stronger in weaker legal environment. Firms in weak legal regimes have greater incentive to improve their governance practice to overcome the deleterious effects of poor legal protection on their ability to raise external financing.

12 Valuation Firms with better governance are valued higher. The effect of governance on valuation is stronger in weaker legal regimes. Good corporate governance is valued higher where it is scarce

Standard&Poors Governance Scores CLSA has lost quite a bit of corporate finance business. with companies that were assigned the worst corporate governance scores and that. CLSA may stop compiling the scores. - South China Morning Post: Hong Kong; Nov 2, 2001

14 CLSA Corporate Governance Scores in companies across 24 emerging markets Based on 57 questions in 7 categories Managerial Discipline (0-100) E.g., incentives towards a higher share price Transparency (0-100) E.g., timely release of annual reports Board Independence (0-100) E.g., Chairman who is independent from management Board Accountability (0-100) E.g., foreign nationals are present on the board Responsibility (0-100) E.g., share trading by managers is transparent Fairness (minority shareholders protection), PROTECT, (0-100) Measures to protect minority shareholders Composite score, COMP, (0-90) Social awareness (0-100) child labor practices, political legitimacy, environmental responsibility, equal opportunity employment policy

15 S&P Transparency Ranking in companies across 16 emerging markets and 3 developed countries Transparency and disclosure Ownership structure and investor relations (0-22) Financial transparency and information disclosure (0-34) Board and management structure and process (0-35) Aggregate, TRAN, (0-91) Comparing across the two data sets CLSA = 0.16 S&P + country and industry dummies [0.05] Governance scores

16 How reliable are CLSA scores? Is it just legal environment + noise? Look for governance scandals for 84 firms from 14 countries with at least 11 firms Lexis-Nexis, news search assets expropriation, accounting misreporting, share dilution, insider trading, undertaking illegal projects manually checked 29,320 articles 49 scandals Correlation between CLSAs COMP and SCAND is (p-val = 0.00) Control for legal environment, # of newspapers per capita (NEWS), and media attention(TOTAL) SCAND = COMP – LEGAL * NEWS TOTAL Governance scandals

17 Firms with more profitable investment opportunities and greater reliance on external financing practice higher quality governance and the relations are stronger in weaker legal regimes *** significant at 1% ** 5% * 10%

18 Firms with more concentrated cash flow ownership practice higher quality of governance and the relation is stronger in weaker legal regimes *** significant at 1% ** 5% * 10%

19 Firms with better of governance are valued higher and the relation is stronger in weaker legal regimes *** significant at 1% ** 5% * 10% CLSA COMPOSITE CLSA SOCIAL CLSA PROTECT S&P TRAN

20 Economic significance On average, a one standard deviation increase in CLSA composite score increases Q by 9% the relation between corporate governance and performance is stronger in weaker legal regime countries Mexico, LEGAL = 1 (de jure) * 3.33 (enforcement) = 3.33 increase in Q is 13.2% Hong Kong, LEGAL = 5 (de jure) * 8.33 (enforcement) = increase in Q is 4.6% May explain the previous mixed findings on U.S. data

21 Policy implications For policymakers to give the controlling shareholders greater incentives to improve governance practices pro-growth policies vs. re-distributive policies Convergence in governance with increasing globalization of trade, national boundaries and legal structures become less effective in defining corporate policy any debate over convergence must also consider firm-specific factors Social awareness is neither related to firm-specific factors, nor is it valued by investors.