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International Financial Management

International Financial Management. Corporate Governance. Corporate Governance…. Home De(s)pot. Home Depot’s chief executive, Robert Nardelli, was removed after shareholders protested his pay. . Home De(s)pot.

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International Financial Management

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  1. International Financial Management Corporate Governance

  2. Corporate Governance….

  3. Home De(s)pot Home Depot’s chief executive, Robert Nardelli, was removed after shareholders protested his pay.

  4. Home De(s)pot • Bob Nardelli took the helm at Home Depot in 2000, and sales soared from $46 billion in 2000 to $81.5 billion in 2005. • Profits more than doubled… • Stock price has lagged the market, and especially Lowes… • Bob Nardelli was paid $38.1 million from his last yearly contract. • He refused to accept even a reduction in his current stock package, and only agreed to give up a guarantee that he would receive a minimum $3 million bonus each year. • Board members asked him to more closely tie his future stock awards to shareholder gains, but he refused. • Nardelli claims that he cannot control the stock price, so his compensation should not be tied to it… • Shareholders threatened to riot at annual meeting in May, 2007. • Nardelli was asked to leave on January 2, 2007, with a $210 million retirement package!!!

  5. Home De(s)pot

  6. Home De(s)pot

  7. Agenda • Governance of the Public Corporation • Agency Problem • Law and Corporate Governance • Corporate Governance Reform • Sarbanes Oxley • Cadbury Code

  8. Governance of the Public Corporation • Corporate Governance – the economic, legal, and institutional framework in which corporate control and cash flow rights are distributed among shareholders, managers, and other stakeholders of the company. • Corporate scandals: Enron, WorldCom, Global Crossing, Daewoo Group, Parmalat, and HIH. • American executives “treat their companies like ATMs, awarding themselves millions of dollars in corporate perks.” (Harvard Business Review, 2003) • Corporate governance failures have detrimental effects on corporate valuations and the functioning of capital markets.

  9. Governance of the Public Corporation • Public ownership is associated with efficient risk sharing, access to low-cost capital, and the pursuit of risky investment projects. • Conflicts of interest between managers (agents) and shareholders (principals). • Shareholders elect the board of directors, who in turn hire and monitor managers. • Board composition (insiders/outsiders) • Shareholder monitoring (free-rider) • Conflicts of interest between controlling shareholders and outside shareholders.

  10. The Agency Problem • Incomplete contracts create room for agency problems, and managers often grab the residual control rights. • Perquisites • Steal funds • Divert funds • Waste funds • Managerial entrenchment • Free cash flows, Payout problems • Retain cash to avoid future capital raising • Size  Higher compensation • Size  Higher prestige

  11. Remedies for Agency Problem • Board of directors • Outside directors on board • CEO and chairman of board different people • Europe – union representation, two-tier boards • Incentive contracts • Stocks and stock options • Independent compensation committee • Concentrated ownership • Germany, France, Japan, China, Latin America • Morck, Shleifer, and Vishny (1988): Effect of managerial ownership (%) on firm value is likely non-linear and entrenchment dominates in 5-25% range for the US.

  12. Morck, Shleifer, and Vishny (1988) Firm Value y x Manager Ownership (%)

  13. Morck, Shleifer, and Vishny (1988) Firm Value Alignment Entrenchment Alignment y x Manager Ownership (%)

  14. Remedies for Agency Problem • Accounting Transparency • Accurate accounting information in a timely fashion • Debt • Less managerial discretion wrt payouts • Less flexibility for financing investment projects • Overseas Stock Listings • Credible bond to provide better investor protection (Doidge, Karolyi, and Stulz (2002)) • Market for Corporate Control • Disciplinary effect on managers and enhance company efficiency (US and UK) • Developing also in Germany, Japan, etc.

  15. Law and Corporate Governance • La Porta, Lopez-de-Silanes, Shleifer, and Vishny (LLSV) • Sharp differences among countries with respect to: • Corporate ownership structure • Depth and breadth of capital markets • Access of firms to external financing • Dividend policies • Explained by how well investors are protected from expropriation by managers and controlling shareholders and the origin of the country’s legal system. • English common law – discrete rulings, judicial precedent • French civil law – codification of legal rules (Roman) • German civil law – codification of legal rules (Roman) • Scandinavian civil law – codification/precedent

  16. Law and Corporate Governance • LLSV (1998) Invented the: Shareholder Rights Index and the Rule of Law Index • English common law countries rank highest on shareholder rights, while Scandinavian and German civil law countries rank highest on enforcement. • Why are they so different? • Glaesser and Shleifer (2002) argue the explanation dates back to the Middle Ages. • France – power of adjudication to the center (King) • England - power of adjudication to a local jury

  17. Consequences of Law • LLSV (1998) find that corporate ownership tends to be more concentrated in countries with weaker investor protection.

  18. Consequences of Law • Dominant investor may seek to acquire control rights in excess of cash flow rights • Shares with superior voting rights • Pyramidal ownership structure • Li Ka-Shing Family (Hutchison Whampoa) • Lee Keun-Hee (Samsung Electronics) • Robert Bosch GmbH (Daimler-Benz) • Interfirm cross-holdings • Private Benefits of Control • Nenova (2001) premium for voting shares: US 2.0%, Canada 2.8%, Brazil 23%, Germany 9.5%, Italy and Korea 29% and Mexico 36%... • Dyck and Zingales (2003) block premium: Canada US and UK 1%, Australia and Finland 2%, Brazil 65%, Czech Republic 58%, Israel 27%, Italy 37%, Korea 16%, and Mexico 34%.

  19. Consequences of Law • Capital Markets and Valuation • LLSV (1997) find that countries with strong shareholder protection tend to have more valuable stock markets and more companies listed on stock exchanges per capital than countries with weak protection. • Studies (e.g., Lins (2002)) show that higher insider cash flow rights are associated with higher valuations, while higher insider control rights are associated with lower valuations. • Johnson, Boon, Breach and Friedman (2000) find that stock markets declined more in countries with weaker investor protection during the Asian financial crisis 1997-1998. • Lemmon and Lins (2003) find that crisis period returns of firms in which managers have high levels of control rights, but have separated their control and cash flow ownership, are 10-20 percentage points lower than those of other firms. • Financial market development also promotes growth.

  20. Consequences of Law • Doidge, Karolyi, and Stulz (2004) • Almost all of the variation in governance ratings across firms in less developed countries is attributable to country characteristics rather than firm characteristics typically used to explain governance choices. • Firm characteristics explain more of the variation in governance ratings in more developed countries. • Access to global capital markets sharpens firm incentives for better governance, but decreases the importance of home-country legal protections of minority investors.

  21. Corporate Governance Reform • Late 1990s – Internal corporate governance mechanisms, auditors, regulators, banks, and institutional investors failed… • Strengthen the protection of outside shareholders against expropriation of managers and controling shareholders • Strengthening the independence of boards of directors with more outsiders • Enhancing the transparency and disclosure standard of financial statements • Energize the regulatory monitoring role of the stock market regulator and the exchanges • Modernize the legal framework

  22. Sarbanes Oxley • Accounting regulation • Public accounting oversight board • Restricting consulting/auditing • Audit committee • Independent financial experts • Internal control assessment • Assessment by auditors and company (Section 404) • Deemed costly and contested • Cross-listing elsewhere… • Executive responsibility • CEOs and CFOs must sign off on the company’s quarterly and annual financial statements. If fraud causes an overstatement of earnings, these officers must return any bonuses.

  23. Sarbanes Oxley • Many argue that SOX is hurting U.S. capital markets. • SOX undermines CEO’s appetites for risk • SOX is a full employment act for Accountants (404) • The Committee on Capital Markets Regulation, set up by U.S. Treasury Secretary Hank Paulson, advocates rolling back the Sarbanes-Oxley Act. • New York Governor-elect Eliot Spitzer, New York City Mayor Michael Bloomberg and U.S. Sen. Charles Schumer of New York have weighed in too, saying SOX is wrecking New York’s standing as the world’s financial markets.

  24. Sarbanes Oxley • Many propose: • Section 404 attestation provisions should be rolled back for small companies, with an internal control review every two years. • The bar should be raised on what constitutes a “material weakness” in internal controls. • It is particularly foreign companies that are balking at SOX. • New markets are appearing… • Chi-X a London-based joint venture that claims it will offer cheaper trading in European stocks • Equiduct, and all-electronic, Pan-European exchange based in Belgium • Goldman Sachs, Merrill Lynch, Morgan Stanley, Citigroup, Credit Suisse, UBS, and Deutsche Bank reportedly will form a consortium to trade equities across Europe (already announced the same for US…)

  25. Sarbanes Oxley • U.S. is losing out on new international listings… • London is beating the U.S. in the number of IPOs it draws. • Last year, the NYSE drew 192 IPOs and Nasdaq 126. • The LSE, often cited as the example of how SOX is chasing companies away, attracted a robust 617 IPOs, 510 of which were on the AIM, the exchanges small-cap market. • However, the U.S. IPOs are larger. • Of a total of $118.2 billion raised through IPOs in 2006 • $17.5 billion occurred on the LSE, $4.2 billion on AIM • $16.9 billion on the NYSE • $9.4 billion on Nasdaq • $0.2 billion on AMEX, according to Thomson Financial.

  26. NYSE Corporate Governance • Listed companies to have boards of directors with a majority of independents • The compensation, nominating, and audit committees to be entirely composed of independent directors • The publication of corporate governance guidelines and reporting of annual evaluation of the board and CEO

  27. Cadbury Code of Best Practice • Ferranti, Colorol Group, BCCI, and Maxwell Group… • Cadbury Code • Boards of directors of public companies include at least three outside (non-executive) directors • The positions of CEO and chairman of the board of these companies be held by two different individuals • Cadbury Code is not legislated into law • LSE requires companies to “comply or explain.” • Empirical research suggests the code has been effective despite not being enforceable in courts…

  28. Corporate Governance Indices • FTSE ISS Corporate Governance Index Series (CGI) • Quantifying the risk of corporate governance across international markets has posed a challenge for investors trying to deal with the increased recognition of the issue. • The new FTSE ISS Corporate Governance Index (CGI) Series assists you with company analysis, portfolio management and stock selection against selected companies with a proven standard in corporate governance. • The series is the result of a collaboration between FTSE and corporate governance experts ISS, two market leaders in their respective fields. The design incorporates ISS corporate governance ratings into a financial index. • You will now be able to track the financial performance of companies against the universal themes in corporate governance practice of: • Compensation systems for Executive and Non Executive Directors • Executive and Non-Executive stock ownership • Equity Structure • Structure and independence of the Board • Independence and integrity of the audit process • The series consists of six regional and country equity indices covering 24 developed countries as defined by the FTSE Global Equity Index Series. http://www.issproxy.com/institutional/cgi/index.jsp

  29. FTSE ISS CGI

  30. Corporate Governance Around the World • European Corporate Governance Institute • http://www.ecgi.org/codes/all_codes.php

  31. Parmalat • Let’s discuss Parmalat, p. 101-102, at the beginning of next class. • How was it possible for Parmalat managers to “cook the books” and hide it for so long? • Investigate and discuss the role that international banks and auditors might have played in Parmalat’s collapse. • Study and discuss Italy’s corporate governance regime and its role in the failure of Parmalat.

  32. Conclusions • Agency conflicts may arise between managers and controlling shareholders on the one hand and outside shareholders on the other hand. • Corporate governance: protecting shareholders against expropriation by managers and controlling shareholders. • Mechanisms to control agency problems: strengthening the independence of boards of directors, providing managers with incentive contracts, concentrating ownership, using debt, cross-listing to bond to better investor protection, and facilitating the market for corporate control. • The legal origin influences shareholder protection and enforcement of laws, and this in turn has consequences for corporate valuations. • Tradeoff concentrated ownership and lack of investor protection. • Corporate governance reform is an uphill battle…

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