Corporate Governance Roundtable 1 Transparency, Corporate Governance, and Capital Markets Ronald J. Gilson Stanford & Columbia Universities Latin American Corporate Governance Roundtable São Paulo Brazil, April 26-28, 2000

Corporate Governance Roundtable 2 The Subject is Summarized in Three Simple Statements Equity investment requires good corporate governance. Good corporate governance requires credible disclosure by the issuer. The absence of credible disclosure by issuers will have macroeconomic effects: bank financing and conglomerate internal capital markets will not support the development of economically significant new industries.

Corporate Governance Roundtable 3 Step One: Corporate Governance is the Equity Contract We are all familiar with the debt contract: a detailed document specifies the interest rate, the repayment date, the debtor’s covenants, and the events of default. What is the equity contract? – The corporate governance system specifies the rights of an equity holder and the steps available if management breaches its responsibilities Gilson’s rule of value: you pay for what you get!

Corporate Governance Roundtable 4 Step Two: Good Governance Requires Credible Disclosure

Corporate Governance Roundtable 5 Step Three: The Effect of a Bad Equity Contract A bad equity contract – an issuer’s inability or unwillingness to make credible disclosure – makes it difficult for the market to distinguish good risks from bad. The increased cost of capital shifts financing and the capital market toward debt. Consequences: – Debt is ineffective at financing high risk, high return early stage investment. – The capital market will not support cutting edge industries.

Corporate Governance Roundtable 6 The Institutions Necessary to Support Credible Disclosure Legally Mandated Disclosure Requirements. Good Accounting Standards. Independent Auditors. Effective Enforcement.

Corporate Governance Roundtable 7 Legally Mandated Disclosure Requirements Problem: – How do we distinguish between those who disclose accurately and those who do not? Absent effective private intermediaries, a reputation model will not work. By imposing penalties on false disclosure, a legal mandate allows honest companies to distinguish themselves.

Corporate Governance Roundtable 8 Good Accounting Standards The critical characteristic is not the particular standard – the metaphysics of accounting – but that the form of disclosure allow users to rearrange the information to their own use. Good rule of thumb: an accounting system that has no use for the adjective “hidden.” Examples: – German hidden reserves. – U.S. debate over charging the value of employee stock options to earnings. – U.S. pooling vs. purchase accounting for acquisitions.

Corporate Governance Roundtable 9 Independent Auditors Credible disclosure requires honest, competent, and independent auditors. – The annual audit process is more effective than a government agency. The problem is independence. – What is the impact on auditor independence of the consolidation of the profession into 5 multi-national, multi- disciplinary professional service firms. What happens to independence when non-audit fees climb? Current focus of the U.S. Securities and Exchange Commission.

Corporate Governance Roundtable 10 Enforcement Mandatory disclosure is no more effective that the expectation that the rules will be enforced. We need: – A politically insulated regulatory agency with the independence to impose significant sanctions on the country’s largest economic actors. – An independent, effective judiciary. – Effective private enforcement.

Corporate Governance Roundtable 11 A Piggybacking Strategy How does a high quality firm establish its credibility while local disclosure institutions are developing? – Foreign stock listing. E.g., NYSE listing imposes on a foreign company – Governance standards imposed by contract. – U.S. regulatory standards triggered by listing. – Israeli companies going public on NASDAQ. – Strategy limited to larger companies.

Corporate Governance Roundtable 12 Summary Equity investment requires good corporate governance. Good corporate governance – the equity contract – requires credible disclosure by the issuer. The absence of credible disclosure by the issuer will have macroeconomic effects: bank financing and conglomerate internal capital markets will not support the development of economically significant new industries.