Transparency, Corporate Governance, and Capital Markets

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 • The corollary to Gilson’s rule of value: • You get what you can measure. • The algebra of governance and disclosure: • You pay for what you get = you get what you can measure • Canceling yields: • You pay for what [you get] = [you get what] you can measure: • You pay for what you can measure! • The difference between disclosure and 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. Corporate Governance Roundtable