Strengthening Corporate Governance with the OECD Principles: An Outcome-oriented Approach

1. Strengthening Corporate Governance with the OECD Principles: An Outcome-oriented Approach Dr. William Witherell Director for Financial and Enterprise Affairs Organization for Economic Cooperation and Development (OECD) Academy of European Law Seminar Corporate Governance: Legal Implications for Europe and the United States Trier, Germany 7-8 March, 2005

2. BACKGROUND AND OVERVIEW • After Asian Crisis, corporate governance reform seen as a priority for emerging markets. • OECD Principles agreed in 1999 and soon became the international benchmark. • More recent wave of corporate scandals and large failures in major OECD advanced market economies undermined investor confidence and has lead to wide-spread governance reforms. • OECD in 2003-4 carried out a review and updating of the Principles in light of recent experience.

3. But why do national and international policy-makers care about corporate governance?? • The dominance of the joint-stock corporation • Institution building in less developed countries • The growth of the private corporate sector • The growth of equity markets • The growth of international private capital flows

4. Corporate Governance influences the outcomes at all stages of the investment process • The mobilization or raising of capital (in both domestic and international markets) • The allocation of capital to its most effect uses • The monitoring of how capital is employed

5. Why “core principles”? • Enormous variation in ownership and control structures in the world • No single model of good corporate governance: but need for a global language • Detailed codes, best practices should be established at national and regional levels • Objective: to identify common elements or core principles underlying good corporate governance across the different systems: a multilateral policy framework

6. Implications of “core principles”: outcome-oriented • The Principles cover the general features or functions to be in place, e.g. high level of accounting standards, diligent and capable directors. • These are termed outcomes. • They involve functional equivalence: they can be achieved in many different ways and with different institutions. • Principles need, therefore, to be adapted to the legal and institutional environment of each country.

7. The OECD Principles are based on a wide interpretation of corporate governance, which emphasises resource inputs : “Corporate governance … involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.”

8. Moreover, • “Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and shareholders and should facilitate effective monitoring, thereby encouraging firms to use resources more efficiently”.

9. Two implications for the desirable characteristics (outcomes) of a corporate governance system • Checks and balances • A structure of incentives that is compatible with the checks and balances and with achieving the objectives of the company

10. Intended uses of the Principles • Primarily aimed to provide a conceptual framework for governments. • Guidance also for stock exchanges, investors, corporations, commissions. • A benchmark that facilitates convergence.

11. The Principles are the international benchmark • Endorsed by the Financial Stability Forum as one of 12 Key Standards for Sound Financial Systems • Used as the basis of the corporate governance component of the World Bank/IMF Reports on the Observance of Standards and Codes (ROSC) • Recommended by the Emerging Markets Committee of the International Organization of Securities Commissions (IOSCO) • Provide a basis for numerous national or sector-specific codes and listing requirements.

12. The objectives of international co-operation under OECD-World Bank Corporate Governance Partnership • To build the rudiments of a global normative framework • To build a corporate governance culture among corporations and investors • To marshal human and financial resources at a global level in order to help regional and local, private and public efforts bear their fruits.

13. OECD-World Bank Regional Corporate Governance Roundtables • Public-Private regional dialogue. • Participants are senior policy- makers, regulators, corporations, investor, professional organizations, labor, and others. • OECD Principles are a framework for the dialogue.

14. Non-OECD Countries in the Roundtables • Asia: Bangladesh, China, HK (China), India, Indonesia, Malaysia, Pakistan, Philippines, Singapore, Sri Lanka, Chinese Taipei, Thailand, Viet Nam • Latin America:Argentina, Bolivia, Brazil, Chile, Columbia, El Salvador, Peru, Uruguay, Venezuela • Eurasia: Armenia, Azerbaijan, Georgia, Kazakhstan, Kyrgyz Rep., Mongolia, Ukraine, Uzbekistan • South Eastern Europe: Albania, Bosnia-Herzegovina, Bulgaria, Croatia, FYR of Macedonia, Serbia and Montenegro, Romania • Russia

15. Objectives of the Roundtables • Improve understanding through peer discussion and exchange • Identify areas for improvement and formulate reform agenda: the White Papers • Facilitate regional participation in global dialogue on corporate governance • Identify needs and facilitate provision of technical assistance.

16. Core Elements of the OECD Principles • Assuring an effective framework(1) • The rights of shareholders • The equitable treatment of shareholders • The role of stakeholders • Disclosure and transparency • The responsibility of the boards (1) This chapter added in 2004

17. Setting the new Chapter 1 aside until later, let us look briefly at chapters II to VI in reverse order to better understand the overall logic of the original Principles.

18. VI. The responsibilities of the board“The corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders.” Thus the board serves as the fulcrum, balancing the ownership rights enjoyed by shareholders with the discretion granted to managers to run the business.

19. V. Disclosure and transparency“The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company.” • The process of disclosure and the integrity of the accounting and financial reporting systems should be overseen by the board. • Disclosure should include information about the control structures and ownership of the firm which should make potential conflicts of interest (i.e. the incentive structure) transparent.

20. Principles II, III and IV concern shareholders and stakeholders, who have an important role in effecting checks and balances II. The rights of shareholders “The corporate governance framework should protect shareholders’ rights.” III. The equitable treatment of shareholders “The corporate governance framework should ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights.”

21. “Stakeholders” include employees, creditors, depositors, pensioners • IV. The role of stakeholders in corporate governance “The corporate governance framework should recognize the rights of stakeholders as established by law and encourage active co-operation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.”

22. In sum, • The Principles thus comprise checks and balances: the board oversees management and is in turn overseen by shareholders, creditors and stakeholders who must be sufficiently informed to do this. • Information should also make it possible to understand the incentive structure facing the board and management and thus make the checks and balances effective.

23. The 2002 call by OECD Ministers for an assessment/review of the Principles

24. Policy concerns and driving forces • Corporate scandals and large failures…. • New awareness of links between corporate governance arrangements and growth • Revealed need for improving: • Implementation and enforcement • Transparency and disclosure • Alignment of incentives • Monitoring by boards • Shareholder rights

25. Recent Legal or Regulatory Changes in G-7

26. OECD Ministers at their 2002 Annual Meeting • Observed that the integrity of corporations, financial institutions and markets is essential to maintain confidence and economic activity and to protect the interests of stockholders. • Agreed to implement best practices in corporate and financial governance which entails an appropriate mix of incentives, balanced between government regulations and self regulation, backed by effective enforcement. • Agreed to survey recent experience and assess the Principles of Corporate Governance.

27. The Review Process • OECD’s Steering Group on Corporate Governance carried out the Review (30 OECD Governments, World Bank, IMF, IOSCO, BIS, Basel Banking Committee, BIAC, and TUAC) • Consultations held with a wider group of interested parties, with non-OECD countries, and with several high-level roundtables chaired by the Secretary-General • A survey of corporate governance developments in OECD countries since 1999, and a summary of experiences in non-OECD countries were produced. • Draft revisions placed on web for comment. • 2004 Revision of the Principles endorsed by OECD Ministers in May 2004

28. The key reference OECD PRINCIPLES OF CORPORATE GOVERNANCE - 2004 Available for free download at www.oecd.org/corporate

29. And for developments in the OECD and non-OECD countries: • CORPORATE GOVERNANCE – A SURVEY OF OECD COUNTRIES – 2004 • EXPERIENCE FROM THE REGIONAL CORPORATE GOVERNANCE ROUNDTABLES – 2003 Also available at WWW.OECD.ORG/CORPORATE

30. Five sets of issues at the forefront of discussions • Ensuring an adequate regulatory framework for corporate governance, taking account of costs; • The effective exercise of share ownership and the increasing role of institutional investors; • The changing nature and role of the board; • Dealing with conflicts of interest • Stakeholder concerns

31. Issue 1: Ensuring an adequate regulatory framework for corporate governance, taking account of costs

32. Implementation and enforcement of laws, regulations and codes • Enacting laws, regulations and codes that meet international standards is the easy step; effective implementation and enforcement is much more difficult. • Scope and content of self regulation is under scrutiny; incentives facing the professions may conflict with their integrity and credibility to uphold and enforce expected standards. • Capacity and independence of regulatory and enforcement authorities are a serious concern, especially in emerging market and transition countries. • Legal and regulatory framework should provide shareholders opportunity for effective legal redress.

33. Key elements of disclosure and transparency • Major share ownership and voting rights • Material foreseeable risk factors • Full financial disclosure • Governance structure and policies • Information should be prepared audited and disclosed in accordance with high standards of accounting, audit and non-financial disclosure • Regular disclosure

34. The integrity of the disclosure process and of transparency have been called into question • Rules-based accounting leads to “show me I cant do it mentality”. • Holes such as derivative, pension and options accounting are too wide. • Audit independence called into question. They think they are employed by management. • Standards of the big 4 not what they were expected. Peer review failed.

35. Reactions • Auditor independence strengthened both structurally and by rules. • Move effective responsibility to another organ than management • Convergence of accounting standards -- but implementation an issue. • Greater consideration of disclosure of material information • More calls for non-financial disclosure

36. Auditors in G-7

37. IOSCO released (Oct. 2002) principles for national standards covering auditor independence and auditor oversight…. • Reflect a growing international consensus. • Many in OECD consider these principles to be minimum requirements. • Importance of audit firms establishing internal monitoring and control systems. • Auditors should be subject to an independent auditor oversight body, or if a professional body plays that role, it should be overseen by an independent body.

38. The Financial Stability Forum has “…underscored the importance of progress towards a single set of high quality principles-based accounting standards, with due regard to financial stability concerns.” • US moving closer to a principles-based system. • Process in place to work towards convergence of IAS and US GAP. • EU (including its candidate states), Australia, NZ, Hong Kong, Russia, Singapore to adopt IAS. • Indeed, GAAP Convergence 2002 survey of 59 countries indicated that all but three ( Japan, Saudi Arabia and Iceland) intend to converge with IAS.

39. A number of countries have moved to require better disclosure of board and executive compensation… • Nomination and appointment of the board is a key corporate governance decision; transparent and even-handed nomination and recruitment process is needed. • Remuneration including information on the structure of compensation schemes and termination conditions relevant not only for financial implications but also for assessing incentives and performance. • Some countries call for disclosure of individual remuneration; others ask for only aggregate board compensation. • NYSE and NASDAQ have proposed independent compensation committees; codes and principles in other countries go in same direction.

40. Ensuring that corporate service providers work in the interests of shareholders… • In exercising ownership rights, shareholders have to rely on agents (brokers, investment advisors, analysts, rating agencies) for information. • Recently a number of cases of serious conflicts of interest and inappropriate incentives have come to light. • Responses include changes in stock exchange rules and professional codes of conduct, structural changes such as firewalls, and increased disclosure, e.g., of material conflicts of interest.

41. The Principles: Ensuring an adequate regulatory framework for corporate governance, taking account of costs ( A new Chapter 1) • Clear objectives for policy in establishing a system leading to transparent and efficient markets. • Legal and regulatory instruments to be transparent and enforceable. • Clear division of responsibilities between domestic authorities • Supervisory, regulatory and enforcement authorities should have authority, integrity and resources to fulfil duties. • Greater role for shareholders and improved transparency • Improved financial market integrity (see next slide)

42. Also assuring financial market integrity • Better disclosure by the company including related party transactions • Boards to focus on overseeing internal controls and major accounting assumptions through independent audit committee. • More emphasis on auditor independence and reference to IOSCO standards. • Accountability of external auditors to shareholders and duty of professional care to the company • Those providing analysis and advice to be free of conflicts of interest

43. Issue 2: The effective exercise of share ownership and the increasing role of institutional investors

44. The corporate governance framework should protect shareholders rights • Right to have shares registered and secure • Should be able to take part in shareholder meetings and in major decisions concerning the firm • Equitable treatment of all shareholders, foreign and minority especially • Should not be abused by insiders

45. But in practice the rights are often weak and redress is difficult • Need for greater voice through strengthened voting rights and information • More active institutional investors and disclosure of their conflicts of interest • In presence of major shareholders improve protection of minority shareholders • Takeovers often blocked

46. Improving Shareholder voice… • The ability of shareholders to elect board members of their choice, to table proposals and ask questions of directors is, in reality, very limited in a number of countries. • Should shareholders be given more decision rights with respect to board and executive compensation? • Need to avoid shareholders second guessing management

47. Ownership and shareholding structures • The transparency of ownership and shareholding structures, including pyramids that result in control rights being greater than cash flow rights, is limited in many cases. • The Regional Roundtables have called for improvements in the disclosure of beneficial ownership to assist in efforts to curb abusive related party transactions. • Beneficial ownership information also is important for the battle against international financial crime

48. Regional Roundtables on shareholder rights and equitable treatment… • Typically high degree of concentrated ownership, with control through pyramids and cross-holdings, combined with weak shareholder protection and insufficient disclosure: equitable treatment of shareholders is a pivotal issue. • Need to facilitate the exercise of shareholder rights. • Minority shareholder rights in relation to changes in capital structure, in corporate control and delisting a concern (lack of pre-emptive or tag-along rights, etc.) • Voting of depository receipts. • Frequent abuse of related party transactions; improved disclosure needed.

49. Improving and facilitating the exercise of voting rights… • Exercise of voting rights varies widely VOTES CAST BY INVESTORS AS A % OF TOTAL U.S.JapanU.K. 83% 71-80% 50% • Greater use of electronic communications? • Institutional investors that act as fiduciaries being pressed to be more active. • Legal and practical problems to cross-border voting widespread among the OECD countries.

50. Over The Past Two Decades Institutional Investors Have Grown Significantly In Size and Importance Source: OECD Institutional Investors Statistical Yearbook 2003