1. Yale School of Management 1 Emerging Market Finance: Lecture 5: Corporate Governance Issues Separation between ownership and control How can property rights be protected for all shareholders? Incentive issues: how to ensure that managers will make the “right” decisions?

2. Yale School of Management 2 Historically Speaking Back in 1700 or even 1800, corporate governance was not a big problem, and necessary institutions were not demanding yet Because ……there were mostly “family businesses”

3. Yale School of Management 3 Ownership structures of public companies: which form is the “best”? Diverse ownership with many small shareholders: extreme separation between ownership and control Family-controlled: some separation between ownership and control, with a family being the controlling shareholder.

4. Yale School of Management 4 Problems with Dispersed Ownership The Enron example The case of “Investment Privatization Funds” (IPF) in the Czech Republic and Russia Key reason : it may not be worth any shareholder’s efforts to mind the firm’s business, because each shareholder holds too small a stake.

5. Yale School of Management 5 Investors: Millions Public Corp. Stock market Regulators (SEC) The Court The Press & Mkt Partic. Auditors & Others The Board But, the scale and scope of modern corp. requires large financing, even arm’s-length financing. It takes “a lot” to support publicly traded corporations or stock market!

6. Yale School of Management 6 Internal governance design issue : Positive Incentives to Resolve Conflicts between Management & Shareholders Design 1: performance-based bonus Design 2: give shares to CEO and other top executives Design 3: stock options

7. Yale School of Management 7 In the U.S., how much did the CEO get for each $10,000 of Shareholder Value Increase? Bonus Shares owned by CEO Stock Options owned by CEO In Total

8. Yale School of Management 8 Do Executive Incentives Make any Performance Difference? Diff in ROEDiff in Stock Returns Two groups of companies used: (1) public companies for which the board required the CEO to hold a minimum level of shares and (2) firms in the same industry but without minimum shareholding requirement for CEO

9. Yale School of Management 9 Absent of Reliable Institutions What can the shareholders do? ---- One way is to have large shareholders or concentrated ownership, so that someone “cares”!

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12. Yale School of Management 12 Problems with concentrated ownership: The case of Long-Fa Corp in China On May 25, 2000, there were two Legal-Person Share transfers:  10.7 million shares from the largest shareholder to Nan-Du Group at $4.38 per share (to become 3 rd largest shareholder)  12.87 million shares to another firm at $2.19 per share (to become 2 nd largest shareholder)

13. Yale School of Management 13 Question: Why Pay More on Same Day? Nan-Du Largest Shareholder 10.7 million shares @ $4.38 Another shareholder Past 3rd Shareholder 12.87 million shares @ $2.19 (Paid $23.43 million more)

14. Yale School of Management 14 The first related-party asset swap: Sept. 2000 Nan-DuLong-Fa Corp. Sell 49.5% of Nan-Du Network: @ assessed value: 117.1 million. Book value = 63.21 million Sell Long-Fa Ski Resort: @ assessed value: 76.1 million. Book value = 75.43 million

15. Yale School of Management 15 Second related-party Transaction: May 2001 Nan-Du Long-Fa Corp. Sell 37% of Nan-Du’s Cable Company: @ assessed value: 83.72 million. Book value = 35.93 million

16. Yale School of Management 16 After the Tunneling Efforts … Long-Fa Corp’s earnings dropped 25% from 2000 to 2001 Revenues dropped 15.2% Its ROE dropped to 2.56% in 2002. After selling its worst assets to Long-Fa Corp. Nan-Du decided to sell its holdings of Long-Fa @ $2.8 per share, in March 2002.

17. Yale School of Management 17 Another common problem Voting (control) rights often do not correspond to cashflow rights: you pay the same price for a share, but do not get the same “rights” as the controlling shareholder does on a per-dollar basis The use of pyramid holding structure to commit the least cash but hold a controlling position

18. Yale School of Management 18 Claessens, Djankov & Lang (2000, J. of Fin. Econ.) Case of the Ayala family in the Phillipines

19. Yale School of Management 19 Case of the Li family in Hong Kong

20. Yale School of Management 20 Back to Dispersed Ownership: Any mechanisms to make shareholders more active? Class action suits: an efficient way for outside shareholders to play a more active role Market for corporate control: hostile takeovers