INTERNATIONAL FINANCIAL MANAGEMENT

1. INTERNATIONAL FINANCIAL MANAGEMENT Lecture 4: Topics: Corporate Governance and Corporate Goals/Objective Models -- A Global View

2. Corporate Governance: Background • Recently has become an issue in this country and abroad. • Interest has been driven by three events: • Expanding shareholder base of corporations and the resulting separation of owners and manager. • Corporate abuses. • The globalization of companies into non-resident financial markets. • We will develop these themes throughout this lecture series.

3. What is Corporate Governance? • Bank for International Settlements definition: • “The system of rights, processes, and controls established internally and externally over the management of a business entity with the objective of protecting the interest of stakeholders". • Central Issue of corporate governance: How best to protect the interest of stakeholders. • But who are the relevant stakeholders that companies need to protect?

4. Possible Stakeholders • McDonalds: “good corporate governance is critical to fulfilling the Company’s obligation to shareholders.” • Honda: “Our [corporate governance] aim is to have our customers and society, as well as our shareholders and investors, place even greater trust in us and to ensure that Honda is a company that society wants to exist."

5. Why Might We Be Concerned About Corporate Governance? • Macro Implications: • Because corporations play a key role in the generation and allocation of a country’s resources. • Micro Implications: • In the increasing world of globalization, firms need to practice good corporate governance so as to: • Continue to attract consumers and workers • Have access to global financial markets! • Historically, corporate governance appears to have been of greater concern among developed country corporations than developing country corporation! • However, globalizations is forcing these developing country corporations to assess their corporate governance structures

6. Concerns of Different Stakeholders • In reality, it is likely that different stakeholder groups will focus on different criteria and elements in deciding what makes up good corporate governance as they see it. • Shareholders probably attach the greatest importance to maximizing the market value of the company’s shares. • The general public wants to be sure the corporation treats customers fairly and has sensitivity to its impact – socially and environmentally -- on the local community. • Corporate employees want assurances the company will compensate them properly, provide opportunities for advancement, offer training and career development assistance, and help with their retirement planning. • The issue then for managers is what stakeholders do we focus on. • This impacts on corporate goals and objectives. • Note the difference between McDonalds and Honda.

7. Early 20th Century History of Corporate Governance in the U.S. • In the decades leading up to the 20th century, most US corporations were dominated and controlled by wealthy individuals. • The Morgans, Rockefellers, Carnegies and du Ponts. • However by the 1920s/1930s, pattern of US ownership of corporate equities had changed from these entrepreneurs to a wide range of investors. • At that time it was recognized that there was a growing disparity between owners of firms and managers of firms. • And thus the issues of agency problems and agency costs became relevant.

8. Agency Problems and Agency Costs • Agency problems arise when a principal (owner) hires an agent (manager) to perform certain tasks, yet the agent does not share the principal's objective. • Issue of agency costs in corporations: • Refers to the potential conflict of interest between principals (shareholders) and agents (managers) in which agents have an incentive to act in their own self-interest because they bear less than the total costs of their actions.

9. State Statues to Address Corporate Governance • Because of the changing ownership of US corporations and the issue of agency costs. • The concept of corporate governance was addressed when a number of states, most notably Delaware, passed "enabling statutes" known as general corporation laws. • These state statutes created a legal framework for stockholders investing in corporations who were finding themselves increasingly separated from the managers of those corporations.

10. Key Element in Early 20th Century Corporate Governance • Boards of directors were seen as important to the agency cost issue. • Boards were set up to exercise control and management over the company; thus they were seen as representatives of the stockholders • It was argued that these boards had fiduciary (legal) duties of loyalty to owners and they should ensure the “wise management of the corporation in the best interests of its owners.” • A key element in this process was the “independence of directors” from undue influence by interested parties (including managers). • But were these boards truly independent?

11. The Stock Market Crash in 1929 • The stock market crash of 1929 brought the federal government into the regulation of corporate governance for the first time. • Congress passed the Securities Acts of 1933 and 1934 to restore confidence in the equity markets. • 1933: Established the Securities and Exchange Commission (SEC); requires registration with the SEC of securities offered for public sale and outlaws fraud in the sale of securities. • 1934: Regulates stock exchanges and requires corporate officers to report their trading in securities. • These acts also require that public companies undergo an annual independent audit of their financial statements.

12. The 1980s • The decade of the 1980s was characterized by a wave of hostile takeovers, leveraged buyouts, management buyouts, junk bond financing, "poison pills", and the general merger frenzy of those days. • Within this environment, shareholder interests again became an issue. • The corporate governance debate was revived. • But what was different now was the role and voice of large institutional investors as these institutions played an increasingly activist role as corporate shareholders.

13. The 1990s to the Present • In the United States, by 1990, the direct ownership of equities by households had fallen below 50%. • Thus, by the 1990s, it was primarily these institutional investors (e.g., banks, mutual funds, public and private pension funds) who were driving the issues of corporate control and accountability. • Their focus was (and currently is) on securing top performance from their investments. • Critical to this is the role of the “independent” board of directors. • Today, these institutional investors hold about 60% of all listed corporate stock in the United States (about 70% in the largest 1,000 corporations).

14. Impact of Corporate Abuses in the US on Corporate Governance • In recent years corporate governance has become (relatively) well defined in the United States. • Undoubtedly recent corporate abuses have contributed to this: • Waste Management and Sunbeam (1998) and Enron (2001). • Abuses resulted in passage of Sarbanes-Oxley Act (2002) • Among other requirements is the certification of financial reports by chief executive officers and chief financial officers • Assumes if companies are more transparent in what they are doing, managers will be less tempted to act in a way detrimental to owners. • But there is no similar regulation in foreign countries. • Issue of applying this act to foreign companies listed in the U.S

15. Global Corporate Governance • Globally, there are two major challenges to the development of “good” corporate governance. • First, there is a great diversity of national practices, traditions, laws, regulations, and political and market structures. • For example, common law versus civil law and differences in ownership patterns • Second, the possibilities for implementing "good corporate governance" are often constrained in a given country by legal, cultural, and/or economic factors. • For example, differences management models

16. Global Variationsin Ownership • Separation of ownership and management (i.e., potential control): • Varies widely among countries. • When measured by ownership concentration: Country Average ownership of 3 largest shareholders United States 20% United Kingdom 19% Italy 58% Germany 48% Brazil 57% Mexico 64% • United States and U.K. have a “diverse shareholder base.” In other countries, often founding families control the companies!

17. Ownership Impacts • If ownership is concentrated, it is likely that a small number of owners will find it easy and advantageous to monitor managers. • This may be the case of countries like Italy, Brazil and Mexico, but not the U.S. and the U.K. (see previous slide). • Agency cost may be reduced as owners and managers become better aligned due to ownership concentration. • Thus large shareholders may play a role in corporate governance. • Studies also suggest that concentration of ownership may have a positive impact on a company’s performance and value. • Japan (1995) and Germany (2000)

18. Legal Variations • Currently we can identify 4 main legal systems on a global basis: • English common law • French civil law • German civil law • Scandinavian civil law • Studies have suggested that variations in corporate governance from country to country can be attributed to differences in legal systems. • Why: Legal systems determine how well investors are protected.

19. Common Versus Civil Law • Common Law • Based on precedent, formed by the rulings of independent judges regarding specific disputes. • Originated in U.K. and spread throughout the world through British colonization (as well as independent adoption): • United States, Australia, Canada, India, South Africa, Singapore, New Zealand. • Civil Law • Codification of legal rulings. • Dominates legal systems globally. • France, Germany, Japan, Mexico, China, Latin America,

20. Shareholder Rights and the Legal System • Historically, in civil law countries, the “state” has played a greater role in regulating economic activity but a less active role in individual (e.g., private property) rights. • On the other hand, English common law appears to be more protective of private property and investor rights. • Conclusion for investors: English common law tends to offer the strongest protection for investors. • Studies also suggest that countries with strong shareholder protection have more company listings on stock markets and more value stock markets (capitalization of companies).

21. Law and Ownership Concentration • Civil law countries generally have greater ownership concentration ratios. Legal System Average ownership of 3 largest shareholders English Common 43% French Civil 54% • Perhaps higher concentration ratios are a response to relatively weak investor protection laws in civil law countries? Or perhaps of the high concentration ratios are seen as reducing the need for strong investor protection laws?

22. Corporate Goals • Corporate Goals: Specified targets which the company desires to achieve. • In the United States, companies tend to produce rather well defined financial goals. • For Example, FedEx Corporation • Grow revenue by 10% per year • Increase EPS by 10%-15% per year • The American company focus on these types of financial goals is driven by the corporate model which we use.

23. Differences in “Corporate Model” • We can identify 2 different corporate models in the world today: • Shareholder Wealth Structure (aka, Anglo-American or Anglo-Saxon) Model: • Believes that a firm’s objective should be to maximize shareholder wealth. • “Shareholder Wealth” countries include the US, Canada, Australia, United Kingdom. • Corporate Wealth Structure (aka, Non-Anglo-American) Model: • Believe that a firm’s objective should be to maximize corporate wealth (which includes all stakeholders; e.g., employees, community, banks, owners) • “Corporate Wealth” countries include the EU, Japan and Latin American countries.

24. Shareholder Wealth Model • This model focuses on the importance of shareholders to the corporate structure. • Wealth is seen as strictly “financial.” • Within this context, management tools measure impact of their decisions on equity (common stock) values. • Shareholder Wealth capital budgeting techniques include: • Net Present Value • Internal Rates of Return • These are aimed at securing returns greater than the firm’s cost of capital and thereby increasing returns to shareholders. • Within this model, there is a general acceptance of “hostile” takeovers to ensure appropriate financial performance. • Again this is seen as benefiting shareholders.

25. Corporate Wealth Model • The focus of the corporate wealth model is much broader than the Shareholder Wealth viewpoint. • Under the Corporate Wealth Model, consideration of corporate decisions is given to a wider range of parties, including human resources, community, state, shareholders, lenders... • The Corporate Wealth model came about because of distrust of unrestricted capitalism especially in Latin America and post World War II Europe (thus, the phrase a search for the “Third-Way”).

26. Corporate Wealth Model • In Continental Europe and Asia we see this model manifested in: • Advisory Committees (with labor representation): important in Europe as part of corporate structures and involved by law in corporate decisions. • Strict labor laws (e.g., on firing employees) in Europe. • Life time employment concept in Japan in early post war years. • Weakened substantially in Japan in the 1990s. • Less attention in Japan of Anglo Saxon capital budgeting techniques; especially equity cost of capital. • Friendly takeovers are the rule (although this is changing as well, in Japan and in Europe).

27. “Equity” Cultural Differences • Shareholder Wealth countries (U.S., U.K., Canada) • Historically have had a well developed equity culture • Within these countries there is an understanding and acceptance of ownership and, especially, equity capital risk. • Thus, this sector is an important source of funds for corporate financing. • But, perhaps, it also affects corporate goals. • Management tends to focus on shareholders.

28. “Equity” Cultural Differences • Corporate Wealth countries (Continental Europe and many Asian countries) • Historically, relatively less developed equity culture • Risk is not as well understood or tolerated. • Thus in these countries there has historically been a reliance on debt and bank financing. • Globalization is changing this!

29. The Future: Are the Two Models Finding a Middle Ground? • Starbucks, Corporate Social Responsibility: “… conducting business in ways that produces social, environmental, and economic benefits for the communities in which we operate.” • Many Japanese companies are now concern with Anglo-American financial performance. • Nissan hired “cost-cutter” Carlos Ghosn as their CEO in 1999 to turn the company around. • One year after he arrived, Nissan's net profit climbed to $2.7 billion from a loss of $6.1 billion in the previous year. • Sony hired an American, Howard Stringer as their CEO in 2005. • He has set operating profit margin goal of 5% for the company by 2008.

30. The Future: Are the Two Models Finding a Middle Ground? • Financial markets and financial organizations (e.g., central banks) around the world are working to become more transparent. • All central banks now publishes their web sites in English. • http://www.bis.org/cbanks.htm