INTERNATIONAL
FINANCIAL
MANAGEMENT
Fifth Edition
EUN / RESNICK
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Corporate Governance
Around the World
4
Chapter Four
Chapter Objective:
This chapter discusses corporate governance
structures, which varies a great deal across
countries, reflecting divergent cultural, economic,
political, and legal environments.
4-1
Chapter Outline
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4-2
Governance and the Public Corporation: Key
Issues
The Agency Problem
Remedies (cures) for the Agency Problem
Law and Corporate Governance
Consequences of Law
Corporate Governance Reform
Governance and the Public Corporation:
Key Issues
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4-3
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
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4-4
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
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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.
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4-5
It’s easier to just sell your shares a.k.a. “The Wall Street
Walk”.
The Agency Problem
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4-6
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
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4-7
The manager often ends up acquiring most of this residual
contral rights. Result is: strong managers, and weak
shareholders.
Steve Jobs, the CEO of Apply has a 90$ million company
jet at his disposal.
Managers sometime can set up their own companies and
provede output below market price (transfer pricing)
They may invest unprofitable projects for their benefits,
and may take antitakeover measures.
The Agency Problem
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Having the 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.
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Consumption of lavish perquisites (free dividents) is one
example.
Outright stealing is another example.
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4-8
Some Russian oil companies are known to sell oil to managerowned trading companies at below market prices.
Even at that, they don’t always bother to collect the bills!
The Agency Problem at Enron
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4-9
Enron Corporation (former NYSE ticker symbol ENE) was an
American energy company based in Houston, Texas. Before
its bankruptcy in late 2001, Enron employed approximately 22,000 staff
and 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
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 did 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
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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 says that it 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
1.
2.
3.
4.
5.
6.
7.
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Board of Directors
Incentive Contracts
Concentrated ownership
Accounting transparancy
Debt
Overseas stock listings
Market for corporate control.
Remedies for the Agency Problem
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4-12
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
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The structure and legal charge of corporate boards
vary greatly across counties.
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In Germany the board is not legally charged with
representing the interests of shareholders, but is rather
charged with representing the interests of stakeholders
(e.g. workers, creditors, etc.) as well as shareholders.
In Japan, most corporate boards are insider-dominated
and primarily concerned with the welfare of the keiretsu
to which the company belongs.
Corporate Boards

The structure and legal charge of corporate boards
vary greatly across counties.
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4-14
In England, the majority of public companies
voluntarily abide by the Code of Best Practice on
corporate governance. (recommended by Cadbury
Committee)
It recommends there should be at least three outside
directors and the board chairman and the CEO
should be different individuals.
2. Incentive Contracts:
Immense managerial rights vs little cash flow rights
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It is difficult to design a compensation scheme that gives
executives an incentive to work hard at increasing shareholder
wealth.
A research shows that for every 1,000 shareholder wealth,
executives receive only $3; executive pay is nearly insensitive to
changes in shareholder wealth.
Incentive contracts have been so popular lately. However, senior
executives can abuse incentive contracts too.
Accounting-based schemes are subject to manipulation.
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Arthur Andersen’s involvement with the Enron debacle is an egregious
(very bad) example.
Executive stock options are an increasingly popular form of
incentive compatible compensation.
Executive Stock Options
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Executive Stock Options exist to align (to regulate) the interests of
shareholders and managers.
Executive Stock Options are call options on the employer’s shares.
The buyer of the option has the right, but not the obligation to buy an agreed
quantity of a financial instrument from the seller of the option at a certain time
Inalienable: the option can’t be sold.
 Typical maturity is 10 years.
Executive Stock Options give executives an important tax break:
grants of at-the-money options are not considered taxable
income. (Taxes are due if the option is exercised.)
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3.Concentrated Ownership
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4-17
Another way to alleviate the agency problem is to
concentrate shareholdings. (a few large investors
own significant portions of the company)
In the United States and the United Kingdom,
concentrated ownership is relatively rare.
Elsewhere in the world, however, concentrated
ownership is the norm.
Manegerial ownership may be good or bad
depending on their share in the corporation.
3.Concentrated Ownership
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4-18
According to a research
(for Fortune 500 US
companies) x is % 5
and y is 25.
However, this also can
be different in
different countries.
When managers are
large shareholders, they
don’t want to rob
themselves before or after a
percentage in their mind.
4. Accounting Transparency
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Major corporate scandals are associated with
massive accounting frauds.
A greater accounting transparency will reduce the
information asymmetry between corporate
insiders and the public and discourage manegerial
self dealings.
For a greater transperancy;
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4-19
Countries to reform the accounting rules
Companies to have an active and qualified audit
committee.
5. Debt
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4-20
If managers fail to pay interest and principal to creditors,
the company can be forced into bankruptcy and
managers may lose their jobs.
Borrowing (and the subsequent obligation to make
interest payment on time) can have a major disciplinary
effect on managers, motivating them to curb (restrain)
private perquisites (bonuses) and wasteful investments
and trim (cut) bloated (inflated) organizations.
Excessive debt creates its own agency problems,
however. (not taking risks etc.)
6. Overseas Stock Listing
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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.
Moving your listing from Italy to the USA will
be interpreted as signaling the company’s
committment to shareholder rights. (SEC is
serious about investor rights) .
7. The Market for Corporate Control
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4-22
Hostile takeovers can serve as a drastic governance
mechanism of the last resort. (and creates synergies)
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 feckless (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.
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4-23
English common law
French civil law (derived from Roman Law)
German civil law (derived from Roman Law)
Scandinavian civil law
Civil law is codification of legal rules. In contrast, English
common law is discrete rulings of independent judges on specific
disputes.
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.
Law and Corporate Governance
4-24
Consequences of Law
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Protection of investors’ rights has major economic
consequences.
These consequences include
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4-25
The pattern of corporate ownership and valuation.
Development of capital markets.
Economic growth.
Consequences of Law: Italy vs. U.K.
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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 (U.K.), the three largest shareholders own
58 percent (19 percent) of the company, on
average.
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4-26
Company ownership is thus highly concentrated in Italy
and more diffuse in the United Kingdom.
Consequences of Law: Italy vs. U.K.
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4-27
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 (harsh, absolute) contrast between the
two countries suggests that protection of
investors has significant economic
consequences.
Ownership and Control Pattern
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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, with concentrated ownership,
large shareholders can abuse smaller shareholders by
various schemes
1.
2.
3.
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Shares with superior voting rights
Pyramidal ownership structure
Interfirm cross holdings.
Pyramidal Ownership Structure
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4-29
H.W is 43.9 pct controlled by
another company. CKH and
CKH is also controlled 35% by
LKSF.
The cash flow rights of Li
Family is 15.4 %
(.35x.439=.154) but the control
rights in HW is 43.9 %.
Pyramidal Ownership Structure
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4-30
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
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25.23% x 25% x 25 = 1.56 cash flow right in the
company.
Pyramidal Ownership Structure
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The pyramidal ownership structure illustrated in
Exhibit 4.6 makes it possible for large investors to
acquire significant control rights with relatively
small investments.
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4-32
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
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4-33
AG. Robert Bosch can control up to 25 percent of
the voting rights of Daimler-Benz AG with only
securing the cooperation of 3 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.
Daimler-Benz
AG
Exhibit 4.6
28.3%
Deutsche
Bank
14%
Kuwait
government
25%
Widely Held
25%
Stella Automobil
Beteiligungsges
mbH
25%
Bayerische
Robert Bosch
Landesbank
GmbH
4-34
25.23%
MercedesAutomobil
Holding AG
25%
Stern Automobil
Beteiligungsges
mbH
25%
Kornet Automobil
Beteiligungsges
mbH
32.37%
Widely Held
50%
Widely Held
25%
Dresdner
Bank
Capital Markets and Valuation
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4-35
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
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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:
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4-36
It enhances savings.
It channels savings toward real investments in productive capacities.
It enhances the efficiency of investment allocation.
Corporate Governance Reform
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4-37
Scandal-weary (exhausted) 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 in July 2002
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Major components:
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Accounting regulation
Audit committee
Internal control assessment
Executive responsibility
Many companies find compliance onerous
(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.
The Cadbury Code of Best Practice
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Like the US, the UK was hit by corporate
scandals in the 1980s and early 1990s. So, the
British government appointed the Cadbury
Committee in 1991 to address corporate
governance problems in the UK.
The Committee prepared its Code of Best
Practice, voluntarly applicable.
LSE requires the companies “comply or explain”
which caused many companies to comply instead
of explain.
CFA Institute Ethical and Professional
Standards of Corporate Governance
Quality of Corporate Governance
• The Board:
Are they cozy with Mgt?
– Is it largely independent?
– Are the directors qualified?
– Do they have access to outside resources?
– How are they elected?
– Do any directors have cross-company relationships?
• Management: Are they vendors or customers?
– Do they have a code of ethics?
– Are there lots of perquisites?
– How is their compensation structured?
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Key Board Committees
• Audit Committee:
– Oversees financial reporting.
Should watch out for Accounting shenanigans (dishonest behaviours)
• Executive Compensation Committee:
– Approves compensation packages including bonuses,
stock options, severance, loans, etc.
What incentives are being created?
• Nominations Committee:
– Recruits and proposes new board members.
Are they “stacking” the board?
4-41
End Chapter Four
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