Chapter 2

1. Chapter 2 Financial Goals and Corporate Governance

2. The Goals of Chapter 2 • Introduce different types of ownership of firms • Discuss the goal of management, and introduce the Shareholder Wealth Maximization Model (SWM) and the Stakeholder Capitalism Model (SCM) • Introduce the goals and structures of corporate governance • Compare different corporate governance regimes • Discuss the failure of corporate governance and the reform of corporate governance in the U.S.

3. Who Owns the Business? 2-3

4. Who Owns the Business? • Most companies are created by entrepreneurs who are either individuals or a small set of partners • Usually, founders are often the members of a family • Most business begin their lives as 100% privately held, often by a family • Over time, however, some firms may choose to go public via an initial public offering (IPO) • Typically, only a relatively small percentage of the company shares is sold to the public in IPO (A to B in Exhibit 2.1) • Scenario 1: Sell more and more equity shares to investing public and become totally public traded firm (B to C or D in Exhibit 2.1) • Scenario 2: The private owners may choose to retain a major share, and the private owners can decide to have explicit control or not

5. Exhibit 2.1 Who Owns the Business? ※ The other impact of IPO is that firm becomes subject to many of the increased legal, regulatory, and reporting requirement in most countries ※ In late 2005, a very large private firm, Koch Industries (U.S.), purchased all outstanding shares of Georgia-Pacific (U.S.), a very large publicly traded forest products company, and took Georgia-Pacific private • Georgia-Pacificis one of the world's leading manufacturers and distributors of tissue, pulp, paper, packaging, and related chemicals [Insert Exhibit 2.1]

6. Who Owns the Business? • In the U.S. and U.K., most corporations in stock markets are characterized by widespread ownership of shares • In the rest of world, ownership of corporations is usually characterized by controlling shareholders • Typical controlling shareholders are as follows: • Government (e.g., privatized utilities) • Institutions (such as banks in Germany) • Family (such as in France and Asia) • France has the highest number of family businesses (about 65% of the CAC 40 firms are family owned)

7. Who Owns the Business? • Consortiums (財團)(such as keiretsus in Japan and chaebols in South Korea) • A consortium is a huge enterprise including banks, industry companies, suppliers, and manufacturers as component firms • Usually, the cross-shareholding strategy is adopted by the management to maintain the control power for the whole enterprise

8. Goal of Management 2-8

9. The Goal of Management • Maximization of shareholders’ wealth is the dominant goal of management in the Anglo-American world, which usually includes the U.S., the U.K., Canada, Australia, and New Zealand • In Anglo-American markets, this goal is realistic; in many other countries it is not because these exists some difference in corporate and investor philosophies • In this section, two kinds of models are introduced, the Shareholder Wealth Maximization Model (SWM) and the Stakeholder Capitalism Model (SCM)

10. Shareholder Wealth Maximization • In the Shareholder Wealth Maximization model (SWM), a firm should strive to maximize the return to shareholders, as measured by the sum of capital gains and dividends, for a given level of risk • In other words, the firm should minimize the level of risk to shareholders for a given rate of return • The SWM model assumes that the stock market is efficient such that the performance of managers can be reflected from the movement of stock prices quickly • That is, an equity share price is always correct because it incorporates new information quickly and thus reflects all the expectations of return and risk as perceived by investors

11. Shareholder Wealth Maximization • Risk is defined as the added risk that a firm’s shares bring into a diversified portfolio • Therefore the unsystematic should not be of concern to investors because it can be diversified • Investors care about only systematic risk, which cannot be eliminated through diversification • The change in ownership from 100% privately held toward an increased share of publicly traded shares brings another impact that a firm may be managed by hired professionals and not the owners • This raises the possibility that ownership and management may not be perfectly aligned in their business and financial objectives, the so called agency problem

12. Shareholder Wealth Maximization • Agency problems: Conflicts of interest between managers and stockholders • Empire building, avoid good but risky projects, or overconsume luxuries • Possible solutions: • Compensation plans (bonus linked with the performance of the stock or executive stock options) • Penalty for underperformance (the board of directors can replace the manager) • Specialist monitoring (analysts, fund managers, banks) • Discipline of the capital market (takeovers by other firms)

13. Shareholder Wealth Maximization • Long-term vs. short-term value maximization • Long-term value maximization can conflict with short-term value maximization as a result of compensation systems focused on near-term results • The other reason for seeking short-term value maximization for public firms is the requirement of periodical earning report (quarterly in the U.S.) • Short-term actions taken by management that are destructive over the long-term have been labeled impatient capitalism • In contrast to impatient capitalism is patient capitalism, which focuses on long-term SWM • Note that the long-term or short-term is a relative notion compared with a firm’s investment horizon (how long it takes for a firm’s actions, investments, and operations to result in earnings)

14. Stakeholder Capitalism Model • In the non-Anglo-American markets, controlling shareholders also strive to maximize long-term returns to equity • However, they are more constrained by other powerful stakeholders • For example, labor unions are more powerful than in France and South Korea, banks have significant influence on firms’ decision in Germany, etc. • In addition, governments interfere more in the market place to protect important stakeholder groups, such as local communities, the environment, and the employment • The SCM model does not assume that equity markets are either efficient or inefficient • The inefficiency does not really matter, because the firm’s financial goals are not exclusively shareholder-oriented due to the constraints imposed by other stakeholders

15. Stakeholder Capitalism Model • The SCM model assumes that long-term “loyal” shareholders–typically controlling shareholders–should influence corporate strategy, rather than the transient (short-term) portfolio investor • The SCM model assumes that total risk, which is reflected from both the operating and financial risks, does count • It is a specific corporate objective to generate growing earnings and dividends over the long run with as much certainty as possible • In this case, risk is measured more by product market variability than by short-term variation in earnings and share price

16. SWM vs. SCM • The SWM could nurture some short-run oriented and impatient capital, but SCM can avoid this flaw • In the SCM, trying to meet the desires of multiple stakeholders leaves management without a clear goal • The SWM gets increasing focus in recent years • As more non-Anglo-American countries try to privatize their industries, focusing on the shareholder wealth seems a better strategy to attract international capital • Many shareholder-based MNEs are increasingly dominating their industry

17. Operational Objectives for MNEs • The MNE must determine for itself proper balance between three common operational financial objectives: • Maximization of consolidated after-tax income (primary goal) • Minimization of the firm’s effective global tax burden • Correct positioning of the firm’s income, cash flows, and available funds as to country and currency • Consolidated income is the total amount of the incomes of all subsidiaries in different local currencies expressed in the currency of the parent company • These objectives are frequently incompatible, in that the pursuit of one may result in a less-desirable outcome in regard to another • E.g., the first objective focuses on the current earnings, but the third objective focuses on generating sustainable cash flows in the future

18. Goals and Structures of Corporate Governance 2-18

19. Failures in Corporate Governance • For any company the corporate governance is fundamental to its existence • Moreover, many studies have continued to show the linkages between good governance (at both country and corporate level) and the lower cost of capital and higher corporate profitability • Spectacular failures in corporate governance again highlighted the importance of the corporate governance, e.g., the accounting scandals and questionable ethics in Enron and WorldCom • Enron (2001) (referring to the Mini-case in Ch 2) • Enron was one of the world's leading electricity, natural gas, communications and pulp and paper companies, with claimed revenues of nearly $101 billion in 2000 • Using special purpose entities to hide debt in its own books

20. Failures in Corporate Governance • WorldCom (2002) • The U.S.’s second largest long distance phone company (after AT&T) • Classifying expenses as investments • Failures in corporate governance have become increasingly visible in recent years • In each case, prestigious auditing firms, such as Arthur Andersen, missed the accounting principle, possibly because of profitable consulting business with their client, that causes conflicts of interest with their original auditing business • The most strange is that top executives themselves should be responsible for mismanagement, but they still received overly generous compensation while destroying their firms

21. Goals of Corporate Governance • The most widely accepted statement of good corporate governance practices are established by the OECD (Organization for Economic Cooperation and Development) (經濟合作暨發展組織): • Protect shareholders’ rights • Ensure the equitable treatment of all shareholders, especially for minority and foreign shareholders • Recognize the right of stakeholders, and involve stakeholdersin corporate governance • Ensure that timely disclosure is made transparently on all matters regarding the corporation • Transparency is defined as the degree to which an investor can discern the true activities and value drivers of a company from the disclosures • Ensure the effective monitoring of management by the board and the board’s accountability to the company and the shareholders

22. Structure of Corporate Governance • The overview of various parties and their responsibilities associated with the corporate governance

23. Different Corporate Governance Regimes 2-23

24. Comparative Corporate Governance Regimes • The origins of the need for corporate governance • The separation of ownership from management • The significance of the roles of various stakeholders in different cultures ※ Firms facing different conditions of the above two factors will adopt different corporate governance regimes as follows

25. Comparative Corporate Governance Regimes • The preferred regimes are a function of at least four major factors as follows 1. Financial market development • The market that grows slowly (the emerging markets), or have industrialized rapidly by utilizing neighboring capital market (West Europe), might not form large public equity market systems • Thus, their ownership shares are highly concentrated such that major shareholders have enough power to monitor or affect the management, so few disciplined processes of governance are developed 2. Separation between management and ownership • In some countries, the ownership and the management is integrated, so the agency problem issues is not important • In some countries, the ownership is widely dispersed and separated from management, aligning the goal of management and stockholders is much more difficult

26. Comparative Corporate Governance Regimes 3. Disclosure and transparency • The disclosure regarding the operation and financial conditions and the transparency for the decision-making process vary across countries • Due to the degree of ownership that is public, the degree to which government protects stakeholders’ rights versus ownership rights, and the extent to which family-based and government-affiliated business remains central to the culture, the degrees of required disclosure and transparency are different 4. Historical development of the legal system • Investor protection is better in countries in which English common law is the basis of the legal system (in the U.S. and U.K.), compared to the codified civil law that is typical in France and Germany • In countries with weak investor protection, controlling shareholder ownership is often a substitute for a lack of legal protection • That is, the controlling shareholder can decide the direction of the firm or he is the management of the firm. In order to protect his interest, the controlling shareholder should maintain a well corporate governance and exploit his asset in the best way

27. Family Ownership and Corporate Governance • Although market-based regimes seem to be the mainstream of corporate governance, family-based regimes are more common than market-based regimes • In a study of 5,232 corporations in Western Europe in 2002, family-controlled (wildly-held) firms represented 44% (37%) of the sample • Opposed to popular belief, family-owned firms in some highly developed economies typically outperform publicly owned firms • In S&P 500, family firms outperform nonfamily firms, and a CEO from the family also perform better than those with outside-CEOs • In Norway, based on a 120-firm sample, founding-family-controlled firms are with higher value than non-founding-family-controlled firms, regardless of firm age, board independence, and number of share classes

28. Good Corporate Governance does Matter • A McKinsey study in 2002 surveyed more than 200 institutional investors as to the value they place on good governance ※ Generally speaking, for countries with less development of the corporate governance, institutional investors would like to pay more premium for the shares of corporations with good corporate governance

29. Good Corporate Governance does Matter • Exhibit 2.5 compares the premiums that shareholders are willing to pay for the voting right in selected markets with different ratings of accounting standard ※ The idea to examine the premium paid for voting shares is that if the country is perceived to have good corporate governance, investors would not need to obtain voting rights to try to protect their investment

30. Good Corporate Governance does Matter • Exhibit 2.6 compares the premiums that shareholders are willing to pay for the voting right in selected markets with different ratings of law enforcement ※ Generally speaking, for countries with better accounting standard and law enforcement, the premium paid for voting shares over non-voting shares decreases

31. Corporate Governance Reform 2-31

32. Corporate Governance Reform • Within the U.S. and U.K., the main corporate governance problem centers around the agency problem: with widespread share ownership, how can a firm align management’s interest with that of the shareholders? • Because individual shareholders do not have the resources or the power to monitor management, the U.S. and U.K. markets rely on regulators to assist in the agency monitoring task • Outside the U.S. and U.K., controlling shareholders are usually in the majority–these entities are able to monitor management in some ways better than the regulators can • After the failure of corporate governance of Enron and WorldCom, some regulatory reform of corporate governance started in 2002 in the U.S.

33. Corporate Governance Reform • The Sarbanes-Oxley Act was passed by the U.S. Congress, and signed by President George W. Bush during 2002 and has four major requirements: 1. CEOs of publicly traded companies must vouch for the veracity of published financial statements • This provision tried to instill a sense of responsibility and accountability in senior management • Many companies requires business unit managers and directors at lower levels to sign their financial statements as well 2. Corporate boards must have audit committees drawn from independent directors • In Germany, however, supervisory board must include employee representatives, but according to the U.S. law, employees are not independent

34. Corporate Governance Reform 3. Companies can not make loans to corporate directors 4. Companies must test their internal financial controls against fraud • In order to meeting the new regulations, firms spends too much on modifying internal controls to combat fraud, rather than operating the firm • The cost is disproportionately high especially for smaller firms • Thus, more smaller firms choose to stay private or to sell out to larger firms instead of going the initial public offering (IPO) route because it costs too much to comply the law for public firms • In summary, most of the terms in Sarbanes-Oxley Act are appropriate for the U.S. situation, but some terms do conflict with practices in other countries • As a consequence, this act hinders many foreign companies to list their shares on the exchanges in the U.S.

35. Corporate Governance Reform • Possible reforms for board structure and compensation issues (learned from European standards) • CEOs cannot be the chairman of the board • More than 80% of the companies in the Fortune 500, the CEO is also the chairman of the board • Adopt two-tiered structure in Germany • Supervisory board (mostly outside, non-executive directors and typically large, e.g., Siemens has 18 members) • Management board (predominantly inside, executive directors and smaller, e.g., Siemens has 8 members) • Change the compensation schemes to replace stock options with restricted stock shares • If the performance of stock is poor, the management with stock options will not feel any real loss since they just loss some potential future benefit

36. Corporate Governance Reform • Restricted stock to the management cannot be sold publicly until after a specified period of time • For poor stock performance, the recipient (the management) has actually lost money • The remaining problems of the accounting process • The U.S. system is characterized as strictly rule based, rather than conceptually based, as is common in Western Europe • There are constantly more clever accountants find ways to follow the rule, yet not meet the underlying purpose for which the rule were intended, e.g., using SPE in the Enron case • Another debate of the accounting process is the roles of the accounting firm and the companies itself • Is it logical for the current practice that companies pay accounting firms to investigate whether their reporting practices consistent with generally accepted accounting principles (GAAPs)?

37. Actions of Minority Shareholders • Minority shareholder rights