CHAPTER 4 CORPORATE GOVERNANCE AROUND THE WORLD SUGGESTED ANSWERS TO END-OF-CHAPTERQUESTIONS AND PROBLEMS Questions 1. The majority of major corporations are franchised as public corporations. Discuss the key strength and weakness of the ‘public corporation’. When do you think the public corporation as an organizational form is unsuitable? Answer: The key strength of the public corporation lies in that it allows for efficient risk sharing among investors. As a result, the public corporation may raise a large sum of capital at a relatively low cost. The main weakness of the public corporation stems from the conflicts of interest between managers and shareholders. If this problem, known as the agency problem, becomes severe with the entrenched management, resulting in misallocation of resources and destruction of shareholder wealth, the public corporation becomes unviable. 2. The public corporation is owned by multitude of shareholders but managed by professional managers. Managers can take self-interested actions at the expense of shareholders. Discuss the conditions under which the so-called agency problem arises. Answer: The agency problem arises when managers have control rights but insignificant cash flow rights. This wedge between control and cash flow rights motivates managers to engage in self-dealings at the expense of shareholders. 3. Following corporate scandals and failures in the U.S. and abroad, there is a growing demand for corporate governance reform. What should be the key objectives of corporate governance reform? What kind of obstacles can there be thwarting reform efforts? Answer: The key objectives of corporate governance reform should be to strengthen shareholder rights and protect shareholders from expropriation by corporate insiders, whether managers or dominant shareholders. Controlling shareholders or managers do not wish to lose their control rights and thus resist reform efforts. 4. Studies show that the legal protection of shareholder rights varies a great deal across countries. Discuss the possible reasons why the English common law tradition provides the strongest and the French civil law tradition the weakest protection of investors. Answer: In civil law countries, the state historically has played an active role in regulating economic activities and has been less protective of property rights. In England, control of the court passed from the crown to the parliament and property owners in seventeenth century. English common law thus became more protective of property owners, and this protection was extended to investors over time. 5. Explain ‘the wedge’ between the control and cash flow rights and discuss its implications for corporate governance. Answer: When there is a separation of ownership and control, managers have control rights with insignificant cash flow rights, whereas shareholders have cash flow rights but no control rights. This wedge gives rise to the conflicts of interest between managers and shareholders. The wedge is the source of the agency problem. 6. Discuss different ways that dominant investors use to establish and maintain the control of the company with relatively small investments. Answer: Dominant investors may use: (i) shares with superior voting rights, (ii) pyramidal ownership structure, and (iii) inter-firm cross-holdings. 7. The Cadbury Code of the Best Practice adopted in the United Kingdom led to a successful reform of corporate governance in the country. Explain the key requirements of the Code and discuss how it may have contributed to the success of reform. Answer: The Code requires that chairman of the board and CEO be held by two different individuals, and that there should be at least three outside board members. The recommended board structure helped to strengthen the monitoring function of the board and reduce the agency problem. 8. Many companies grant stocks or stock options to the managers. Discuss the benefits and possible costs of using this kind of incentive compensation scheme. Answer: Stock options can be useful for aligning the interest of managers with that of shareholders and reduce the wedge between managerial control rights and cash flow rights. But at the same time, stock options may induce managers to distort investment decisions and manipulate financial statements so that they can maximize their benefits in the short run. 9. It has been shown that foreign companies listed in the U.S. stock exchanges are valued more than those from the same countries that are not listed in the U.S. Explain the reasons why U.S.-listed foreign firms are valued more than those which are not. Also explain why not every foreign firm wants to list stocks in the United States. Answer: Foreign companies domiciled in countries with weak investor protection can bond themselves credibly to better investor protection by listing their stocks in U.S. exchanges that are known to provide a strong investor protection. Managers of some companies may not wish to list shares in U.S. exchanges, subjecting themselves to stringent disclosure and monitoring, for fear of losing their control rights and private benefits. 10. Explain “free cash flows.” Why do managers like to retain free cash flows instead of distributing it to shareholders? Discuss what mechanisms may be used to solve this problem? Answer: Free cash flow represents a firm’s internally generated fund in excess of the amount needed to undertake all profitable investment projects. Managers may want to keep free cash flows to undertake unprofitable projects at the expense of shareholders to benefit themselves. Having some debt can impose disciplining effect on the managers and induce them to reduce waste of firm’s resources. Minicase. Parmalat: Europe’s Enron Discussion points. 1. How was it possible for Parmalat managers to “cook the books” and hide it for so long? 2. Investigate and discuss the role that international banks and auditors might have played in Parmalat’s collapse. 3. Study and discuss Italy’s corporate governance regime and its role in the failure of Parmalat. Suggested Answers: 1. Parmalat was able to cook the books mainly due to the fact that Italy has a low level of accounting transparency. 2. Apparently, international banks and auditors failed to do the due diligence, perhaps unintentionally contributing to the failure of Parmalat. 3. Italy has a weak corporate governance regime that does not provide a strong protection of outside shareholders. The majority of public firms are dominated by large controlling shareholders who are often the founding families. The lack of independent board of directors also contributed to the implosion of Parmalat. Corporate Governance Around the World Chapter Four Chapter Outline • Governance and the Public Corporation: Key Issues • The Agency Problem • Remedies for the Agency Problem • Law and Corporate Governance • Consequences of Law • Corporate Governance Reform • The Dodd-Frank Act Governance and the Public Corporation: Key Issues • The public corporation, which is jointly owned by a multitude of shareholders protected with limited liability, is a major organizational innovation of vast economic consequences. • It is an efficient risk sharing mechanism that allows corporations to raise large amounts of capital. Governance and the Public Corporation: Key Issues • A key weakness is the conflict of interest between managers and shareholders. • In principle, shareholders elect a board of directors, who in turn hire and fire the managers who actually run the company. • In reality, management-friendly insiders often dominate the board of directors, with relatively few outside directors who can independently monitor the management. Governance and the Public Corporation: Key Issues • In the case of Enron and other dysfunctional corporations, the boards of directors grossly failed to safeguard shareholder interests. • Furthermore, with diffused ownership, most shareholders have strong enough incentive to incur the costs of monitoring management themselves. – It’s easier to just sell your shares, a.k.a. “The Wall Street Walk.” The Agency Problem • Shareholders allocate decision-making authority to the managers. • That’s why the managers are hired in the first place. • Many shareholders are not qualified to make complex business decisions. • A shareholder with a diversified portfolio would not have the time to devote to making the numerous decisions at each of his many companies anyway. The Agency Problem • Having short-term control of the firm’s assets, managers might be tempted to act in the manager’s short-term best interest instead of the shareholder’s long-term best interest. – Consumption of lavish benefits is one example. – Outright stealing is another example. • Some Russian oil companies are known to sell oil to manager-owned trading companies at below-market prices. • Even at that, they don’t always bother to collect the bills! The Agency Problem at Enron • Enron had about 3,500 subsidiaries and affiliates. Many of these were run and partly owned by Enron executives. • In retrospect, conflict of interest should have been an obvious concern. – The partnerships performed hundreds of millions of dollars of transactions with Enron itself, in some cases buying assets from the company or selling assets to it. • The problem is this: Where did the executives' loyalties lie? Are they trying to negotiate the best deal for the company that employs them and the shareholders who own the company, or the best deal for the partnership where they had an ownership stake? The Agency Problem at Enron • The board of directors claimed that these partnerships with executive ownership allowed the firm to speed up contracting. • To protect itself in dealings with these partnerships, the company supposedly set up safeguards that required top company officers and the board to review and approve deals between Enron and the partnerships. • Clearly these safeguards were insufficient. Remedies for the Agency Problem • In the U.S., shareholders have the right to elect the board of directors. • If the board remains independent of management, it can serve as an effective mechanism for curbing the agency problem. Corporate Boards • The structure and legal charge of corporate boards vary greatly across counties. – In Germany the board is not legally charged with representing the interests of shareholders, but is instead charged with representing the interests of stakeholders (e.g. workers, creditors, etc.). Corporate Boards • The structure and legal charge of corporate boards vary greatly across counties. – In England, the majority of public companies voluntarily abide by the Code of Best Practice on corporate governance. It recommends that there should be at least three outside directors and that the board chairman and the CEO should be different individuals. Corporate Boards • The structure and legal charge of corporate boards vary greatly across counties. – In Japan, most corporate boards are insiderdominated and primarily concerned with the welfare of the keiretsu to which the company belongs. Incentive Contracts • It is difficult to design a compensation scheme that gives executives an incentive to work hard at increasing shareholder wealth. • Accounting-based schemes are subject to manipulation. – Arthur Andersen’s involvement with the Enron debacle is an egregious example. • Executive stock options are an increasingly popular form of incentive compatible compensation. Concentrated Ownership • Another way to alleviate the agency problem is to concentrate shareholdings. • In the United States and the United Kingdom, concentrated ownership is relatively rare. • Elsewhere in the world, however, concentrated ownership is the norm. Pyramidal Ownership Structure • Exhibit 4.6 illustrates the pyramidal ownership structure for Daimler-Benz, a German company, at the beginning of the 1990s. • The company has three major block holders: Deutsche Bank (28.3 percent), MercedesAutomobil Holding AG (25.23 percent), and the Kuwait government (14 percent). The remaining 32.37 percent of shares are widely held. Pyramidal Ownership Structure • The pyramidal ownership structure illustrated in Exhibit 4.6 makes it possible for large investors to acquire significant control rights with relatively small investments. – For example, Robert Bosch GmbH controls 25 percent of Stella Automobil, which in turn owns 25 percent of Mercedes-Automobil Holding, which controls 25 percent of Daimler-Benz. – AG. Robert Bosch can possibly control up to 25 percent of the voting rights of Daimler-Benz AG with only 1.56 percent cash flow rights in the company. Pyramidal Ownership Structure • AG. Robert Bosch can control up to 25 percent of the voting rights of Daimler-Benz AG with only securing the cooperation of three other firms. – At least two of these three: Bayerische Landesbank, Kornet Automobil Beteiligungsges mbH, or Dresdner Bank. – And Stern Automobil Beteiligungsges mbH. • Not bad for only directly controlling 1.56% of the company. Debt • If managers fail to pay interest and principal to creditors, the company can be forced into bankruptcy and managers may lose their jobs. • Borrowing can have a major disciplinary effect on managers, motivating them to curb private benefits and wasteful investments and trim bloated organizations. • However, excessive debt creates its own agency problems. Overseas Stock Listing • Companies domiciled in countries with weak investor protection can bond themselves credibly to better investor protection by listing their stocks in countries with strong investor protection. The Market for Corporate Control • If a management team is really out-of-control, over time the share price will decline. • At some point, a corporate raider will buy up enough shares to gain control of the board. • Then the raider either fires the incompetent managers and turns the firm around or he sells everything in sight for the break-up value. • Either way, the old managers are out of a job. • The threat of this unemployment may keep them in line. Law and Corporate Governance • Commercial legal systems of most countries derive from a relatively few legal origins. – English common law – French civil law – German civil law – Scandinavian civil law • Thus the content of law protecting investors’ rights varies a great deal across countries. • It should also be noted that the quality of law enforcement varies a great deal across countries. Consequences of Law • Protection of investors’ rights has major economic consequences. • These consequences include: – The pattern of corporate ownership and valuation. – Development of capital markets. – Economic growth. Consequences of Law: Italy vs. the United Kingdom • Italy has a French civil law tradition with weak shareholder protection, whereas the United Kingdom, with its English common law tradition, provides strong investor protection. • In Italy the three largest shareholders own 58 percent of the company, on average. In the U.K. the three largest shareholders own 19 percent of the company, on average. – Company ownership is thus highly concentrated in Italy and more diffuse in the United Kingdom. Consequences of Law: Italy vs. the United Kingdom • In addition, as of 1999 only 247 companies are listed on the stock exchange in Italy, whereas 2,292 companies are listed in the United Kingdom. • In the same year, the stock market capitalization as a proportion of the annual GDP was 71 percent in Italy but 248 percent in the United Kingdom. • The stark contrast between the two countries suggests that protection of investors has significant economic consequences. Ownership and Control • Companies domiciled in countries with weak investor protection many need to have concentrated ownership as a substitute for legal protection. • This is not without costs. In companies with concentrated ownership, large shareholders can abuse smaller shareholders. Capital Markets and Valuation • Investor protection promotes the development of external capital markets. • When investors are assured of receiving fair returns on their funds, they will be willing to pay more for securities. • Thus, strong investor protection will be conducive to large capital markets. • Weak investor protection can be a factor in sharp market declines during a financial crisis. Economic Growth • The existence of well-developed financial markets, promoted by strong investor protection, may stimulate economic growth by making funds readily available for investment at low cost. • Several studies document this link. • Financial development can contribute to economic growth in three ways: – It enhances savings. – It channels savings toward real investments in productive capacities. – It enhances the efficiency of investment allocation. Corporate Governance Reform • Scandal-weary investors around the world are demanding corporate governance reform. • It’s not just the companies’ internal governance mechanisms that failed; auditors, regulators, banks, and institutional investors also failed in their respective roles. • Failure to reform corporate governance will damage investor confidence, stunt the development of capital markets, raise the cost of capital, distort capital allocation, and even shake confidence in the capitalist system itself. The Sarbanes-Oxley Act • Major components of the Sarbanes-Oxley Act include: – Accounting regulation. – Audit committee. – Internal control assessment. – Executive responsibility. • Many companies find compliance burdensome, costing millions of dollars. • Some foreign firms have chosen to list their shares on the London Stock Exchange instead of U.S. exchanges to avoid costly compliance. CFA Institute Ethical and Professional Standards of Corporate Governance • The Board: Are they “cozy” – Is it largely independent? with Mgmt? – Are the directors qualified? – Do they have access to outside resources? – How are they elected? – Do any directors have cross-company relationships? • Management: – Do they have a code of ethics? Are they vendors – Are there lots of perquisites? or customers? – How is their compensation structured? The Cadbury Code of Best Practice • The Cadbury Code of Best Practice is an ethical standard, without the force of law. However, the London Stock Exchange requires listed firms to either comply or explain why they cannot. – About 90 percent of LSE-listed firms comply with the code. The Cadbury Code of Best Practice • Requires the board of directors of firms to: – Meet regularly. – Retain full and effective control over the company. – Monitor executive management. • The code says that there should be a clearly accepted division of responsibilities at the head of a company, such that no one person has unfettered power. • The board should include non-executive directors in sufficient number for their views to carry weight. The Dodd-Frank Act • The Dodd-Frank Wall Street Reform and Consumer Protection Act passed in reaction to the financial crisis of 2007-2009. – Volker Rule: Deposit-taking banks will be banned from proprietary trading and from owning more than a small fraction of hedge funds and private equity firms. – Resolution Authority: The government can seize and dismantle a large bank if the bank faces impending failure. The Dodd-Frank Act – Derivatives: OTC derivatives trading will move to electronic exchanges, with contracts settled through a clearinghouse. – Systematic Risk Regulation: Systematically important firms will be identified and their financial condition will be monitored. – Consumer Protection: A new, independent Consumer Financial Protection Bureau will be set up to monitor mortgages and other loan products. Solution Manual for International Financial Management Cheol S. Eun, Bruce G. Resnick 9780077861605
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