Corporate Governance:
Impact and Enforcement
By
Stijn Claessens
World Bank
(Based on joint work with Erik Bërglof, SITE/SSE)
For Corporate Governance Leadership Program
July 14, Washington, D.C.
World Bank
1
Why does corporate governance
matter for growth and development?
1.
2.
3.
4.
5.
•
Increased access to financing  investment, growth,
employment
Lower cost of capital and higher valuation 
investment, growth
Better operational performance  better allocation of
resources, better management, creates wealth
Better relationship with stakeholders  environment,
social/labor relationships
All of it matters for growth, employment, poverty
Empirical evidence has documented these relationships
at the level of country, sector and individual firm and
from investor perspective using various techniques
2
Access to financing
•
•
•
Countries with better property rights, especially better
creditor rights and shareholder rights, have deeper and
more developed banking and capital markets
In these countries, firms have greater access to
financing, and as a consequence, firms invest more,
grow faster. E.g., difference between Quartile 1 and
Quartile 3 in financial development has been found to be
1 - 1.5 percentage points extra GDP growth per annum
Poor corporate governance (and underdeveloped
financial and legal systems and higher corruption) means
firm growth of smallest firms is most adversely affected
and less new, and particularly small firms, start up
3
Access to financing:
creditor rights and rule of law
0.9
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
1
2
3
4
Depth of the financial system
0.8
Creditor Rights * Rule of Law
4
Access to financing: quality of
shareholder protection
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Degree of capital market development
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Cost of capital and valuation
• Corporate governance affects cost of capital and valuation
– Cost of capital higher and valuation lower in weaker property
rights countries
– Outsiders less willing to provide financing, voting premium
higher in lower corporate governance countries, investors
apply discount for worse corporate governance firms and
countries (e.g., McKinsey survey)
• Conflicts between small and large shareholders greater in weaker
corporate governance settings
– Conflicts between control and ownership rights, leading to
higher cost of capital/lower valuation, greater in weaker
property rights countries, less investment
6
Median Voting Premium
Weak corporate governance translates
into higher cost of capital
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
1
2
3
4
5
6
Equity Rights
Excludes Brazil
7
Firms’ operational performance
• Better corporate governance improves performance
– Evidence for US and elsewhere suggests strongly that
better corporate governance leads not only to improved
rates on equity and higher valuation, but also to higher
profits and sales growth, more capital expenditures, etc.
• Operational performance is also better, but not so clearly
– Although access to financing better and valuation higher,
effects of governance on performance less pronounced
– Other factors likely affect operational performance: firms
may face better growth opportunities; a reporting bias
• Still, rates on return on investment exceed cost of capital
only in best corporate governance countries
8
Return on Assets
Better corporate governance translates
into somewhat higher returns on assets
8
7
6
5
4
3
2
1
0
1
2
3
4
5
6
Equity Rights
Excludes Mexico and Venezuela
9
Return on Investment relative to
Costs of Capital
But much better higher returns on
investment relative to cost of capital
1.1
1
0.9
1
2
3
4
5
6
0.8
0.7
0.6
0.5
Equity Rights
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Other stakeholders
• Besides principal (owner), public and private corporations face
many other stakeholders: banks, bondholders, labour, etc.
– Each will monitor, discipline, motivate and affect the
management/firm, in exchange for some control rights
• Each will have its own comparative advantage
– Banks: more, inside knowledge, state-contingent rights
– Debt and debt structure: important disciplining factor, limit
free cash flow/private benefits
– Labour: market for managers; employees; others
• Responsible towards all stakeholders can pay
– Social corporate responsible can be good business for all
and goes with good corporate governance
11
Developing countries’ challenges
• Often abundant in labor, but short in physical and
human capital
• Gap in capital per worker remains large because
private returns to investment low and risky
– Poor protection of investors
– Poor governance inside firms
– Poor incentives to accumulate human capital
• With rapid integration with international markets,
institutional weaknesses affect macro-stability
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Financial markets development
key to bridge gap
• Financial markets depend on legal environment
• Legal environment incomplete without enforcement
• But, enforcement part of development. North (1991): “single
most important determinant of economic performance”
• How to think of enforcement? Link to corporate governance?
– What are alternative enforcement mechanisms?
– What is enforcement problem in corporate governance?
– What are corporate governance mechanisms that can work
in weak contracting environments?
– What are the policy and new research issues?
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Capital markets and
corporate governance
• For capital markets, corporate governance key
– Provides commitment towards stakeholders, in
particular external investors (shareholders and
creditors)  affects firms’ external financing, cost
and volume (access)
– Mitigates moral hazard problems
– Facilitates collective action with multiple investors /
stakeholders
• But corporate governance is also about balancing
multiple stakeholders’ interests, so perfect enforcement
of every contract is not necessarily always first best
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Degree of capital market development
Capital markets and
corporate governance
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Corporate governance
and enforcement
• Corporate governance requires enforcement. Or even
stronger: corporate governance is enforcement
• Each mechanism (Concentrated shareholdings, Hostile
takeovers, Proxy fights, Board activity, Executive comp.,
Litigation, Bank monitoring, Public opinion and media,
Other stakeholders) depends (to differing extents) on
enforcement
• Enforcement more important than laws. Evidence:
– Laws: extensiveness vs. effectiveness
– Insider trading rules: adoption vs. prosecution
– Law and finance literature: suggestive
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Enforcement dominates
laws-on-the-books
y = 0.9366x - 4.1358
2
R = 0.3179
5
9
4.5
8
4
7
3.5
6
3
y = 0.0457x + 1.9126
2
R = 0.0037
5
2.5
4
2
3
1.5
2
1
1
0.5
0
0
8
9
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Rule of Law
10
11
12
13
14
15
log of GDP per capita
Antidirector Rights
Linear (Antidirector Rights)
16
17
Linear (Rule of Law)
Antidirector Rights
Rule of law
10
What enforcement mechanisms?
Continuum of alternative tools
• Private ordering
– Exception rather than norm
– Unilateral, bilateral and multilateral, with multilateral
mechanisms especially often used in finance
• Private law enforcement
– Litigation most important tool
• Public law/regulation enforcement
– Traditional view of enforcement
• State-ownership/control
– Has many problems, but may be considered
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Private ordering
• Unilateral mechanisms
– Create valuable assets, most common reputation,
involving sunk costs, e.g., advertising, or investments
– Needs repeated dealings for it to work
• Bilateral mechanisms
– Use reputation, others’ enforcement, e.g., auditors
– Self-enforcing agreements, e.g., split of functions,
delegating of actions; joint investments, such as in JVs,
vertical integration; hostages with firm-specific assets
– Shareholder agreements: can be more specific; have
covenants of hostage nature; and rely on other courts
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Private ordering
• Multilateral mechanisms
– Financial intermediaries, e.g., banks, investment banks,
rating agencies, clearing houses
– Self-regulatory associations, e.g., industry
organizations, codes of conduct/punishments (expel),
minority shareholders associations
– Self-regulatory organizations, e.g., stock exchanges,
with listing standards and penalties
– Arbitration, e.g., as in JVs, possibly backed up
internationally, e.g., through NY convention
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Private ordering: evidence
• Unilateral and bilateral mechanisms
– Can work, e.g., voluntary adoption of CG, FDI
– Up to a limit, however, as effectiveness depends on the
overall institutional environment, country vs. firm
• Multilateral mechanisms
– Can depend on size/number of market, scope for
entrenchment, degree of competition, multiple
equilibriums. Many practical issues, e.g., arbitration:
when to arbitrate and whom to use; which law?
– Private ordering can be the basis for public law
• Most need some form of public enforcement
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Private laws enforcement
• Either the government creates the rules, but
delegates the enforcement to others
– Delegation of public enforcement to SRO/SRAs (e.g.,
stock exchanges) can be more efficient if more
information, better tools/incentives
• Or initiation of enforcement lies with private
parties, with litigation the most important
– The norm in securities markets (LSV, 2005)
– Depends on standards set in the law, e.g., bright lines
– Depends on legal system and institutional setup, e.g.,
class action suits, role of stock exchanges depends on
competition, etc. especially with many constituencies
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Public law/regulation enforcement
• SEC, other regulator type of approach, with courts
– Seems less effective than private enforcement in
securities markets, especially when institutional
environment is weak
• Public law enforcement depends on
– Extensiveness and effectiveness of law: some laws are
easier enforced than others, affects scope for
enforcement and scope for misuse (bright line)
– Independence (financially, politically, tenure) of the
regulators and the checks and balances in the system
– Efficiency of the court system, since backup is needed
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Extensiveness of laws and origins
• What needs to be codified in the first place?
– How does codification vary with level of development,
social and economic features? How does codification
interacts with various enforcement mechanisms?
• Extensiveness of law affects enforcement problem
– With imprecise laws, private ordering and private
enforcement may be costly or uncertain, and the
benefits for parties to deviate may be too big
– But, broader laws allow for more evolution
• Transplanting of laws/systems
– Leads to less effective formal institutions, higher
legality with voluntary adoption
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State control
• State ownership
– Can be justified to deal with market failures,
externalities, public goods, coordination issues, etc
• Golden share
– A more targeted approach to certain concerns
• Regulations covering various areas have also corporate
governance functions, especially with other stakeholders
• Full control, through ownership or centrally planned
economy/lack of market economy
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Choice of enforcement technologies
• Overall environment
– Social and other norms, civic capital, general political
• Costs and benefits of each technology/issues
– Outside options vary; Multistage issues, need several
technologies; Public to back up
• Path dependence, certain technology can stick
– Technological progress can change choices
• Mix of technologies will always be used
– Vary by country, issue to be enforced
• Rules and political economy
– Tollbooth view: rules can create rent-seeking
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What enforcement mechanisms work
in securities markets?
• La Porta, Lopez-de-Silanes and Shleifer (2005), “What
works in securities laws?” construct:
– Private enforcement index = “Disclosure” and “Burden of
proof”
– Public enforcement index = “Supervisor”, “Investigative
powers”, “Orders” and “Criminal”
• Find for sample of 49 countries:
– Securities market development is more associated with
private enforcement index
– Public enforcement works in developed countries only
– More efficient institutional choice will often be private
enforcement of public rules
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Private enforcement often works better
in securities markets
Private enforcement and market capitalization
1.6
Stock market capitalization
1.4
1.2
1
0.8
0.6
0.4
0.2
0
-0.2
0
0.2
0.4
0.6
0.8
1
1.2
Private enforcement index
World Bank
Each point represents one of 49 countries. Data from LLS (2005).
28
Limits to what firms can do
when environment is weak
• Many consider corporate governance a firm specific issue.
True mostly in developed countries. But in many
developing countries, general enforcement environment is
weak and few traditional CG mechanisms are effective
• Almost all the variation in governance ratings across firms
in less developed countries is attributable to country
characteristics (only 50% in developed countries; rest is
firm characteristics) (Doidge, Karloyi, and Stulz, 2004)
• Access to global markets sharpens firm incentives to
improve governance, and decreases the importance of
home-country (formal) legal protection of minority
investors, but does not eliminate problem
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With weak enforcement
• Predominant form of corporate governance in weak
contracting environment is large blockholders and high
ownership/control concentration
• But this mechanism has important costs
– Main corporate governance conflict for public firms:
controlling owners vs. minority shareholders
– But also corporate governance weaknesses impact
private firms’ ability to raise financing and to grow
– Overall adverse impact on corporate governance
environment, institutional development
• Limited scope for policy intervention
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Large blockholders dominate, with costs
though and limited scope for policy
Corporate governance
mechanism
Private ordering
Private law enforcement
Public enforcement
Relative importance in
developing and transition
countries
Scope for policy intervention
World Bank
Large blockholders
Natural Outcome
Shareholders suits
Governance codes evolving
into corporate and securities
law
Likely to be the most
important governance
mechanism
Strengthen rules protecting
minority investors without
removing incentives to hold
controlling blocks
31
What is scope for other corporate
governance mechanisms?
• Ownership concentration the outcome, yet has costs.
• Most other mechanisms need some enforcement
technology and tools, e.g, exit, collateral, bankruptcy, etc.
• Will not work well with weak enforcement. What to do?
– What to expect from private ordering, private law
enforcement, public enforcement?
– What is relative importance of each mechanism in
developing countries?
– What policy interventions can help reduce costs and
reinforce specific mechanisms?
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Scope for policy interventions for other
corporate governance mechanisms
Corporate governance
mechanism
Large blockholders
Market for corporate
control
Proxy fights
Board activity
Scope for policy intervention
Strengthen rules protecting minority investors without removing
incentives to hold controlling blocks
Remove some managerial defenses; disclosure of ownership and
control; develop banking system
Technology improvements for communicating with and among
shareholders; disclosure of ownership and control
Introduce elements of independence of directors; training of
directors; disclosure of voting; cumulative voting possibly
Executive
compensation
Disclosure of compensation schemes, conflicts of interest rules
Bank monitoring
Strengthen banking regulation and institutions; encourage
accumulation of information on credit histories; develop supporting
credit bureaus and other information intermediaries;
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Scope for policy interventions for other
corporate governance mechanisms
Corporate governance
mechanism
Shareholder Activism
Scope for policy intervention
Encourage interaction among shareholders. Strengthen minority
Disclosure of information to employees; possibly require board
Employee monitoring
representation; assure flexible labor markets
Facilitate communication among shareholders; encourage classLitigation
action suits with safeguards against excessive litigation
Media and social Encourage competition in and diverse control of media; active public
control
campaigns can empower public
Reputation and self
Depend on growth opportunities and scope for rent seeking.
enforcement
Encourage competition in factor markets
Bilateral private
enforcement
Requiring functioning civil/commercial courts
mechanisms
Arbitration, auditors,
Facilitate the formation of private third party mechanisms
other multilateral
(sometimes avoid forming public alternatives); deal with conflicts of
mechanisms
interest; ensure competition
34
World Bank
Have to consider the political
economy of enforcement
• Laws and enforcement evolve under many
pressures
– Vested interests may block progress
– Wealth concentration hinders reform
• Enforcement is a difficult investment
– Long-term payoffs, many bodies, subject to many
parties, low political payoff
• Enforcement is a public good, with few champions
– Can be indirect effects of financial sector development,
changes in ownership structures, real sector reform on
desires for enforcement and institutional reform
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Implementation of the Acquis Communautaires
(company law)
10.0
9.0
8.0
Index
7.0
Bulgaria
Czech Republic
Estonia
Hungary
Latvia
Lithuania
Poland
Romania
Slovak Republic
Slovenia
6.0
5.0
4.0
3.0
2.0
1.0
0.0
1997
World Bank
1998
1999
2000
Year
2001
2002
2003
36
Variation in laws and in enforcement,
but change is possible
Country
InsideShares
Income
RelatedTrans
CGSection
ARDisclosure
ARDisclosure_dif
Owners
Bulgaria
1.00
0.00
0.50
1.00
0.00
2.50
-1.00
Czech Republic
0.50
0.50
0.50
1.00
0.00
2.50
0.31
Estonia
1.00
0.00
0.50
1.00
0.00
2.50
0.36
Hungary
0.00
0.50
0.00
1.00
0.00
1.50
0.13
Latvia
0.00
0.00
0.50
1.00
0.00
1.50
-0.06
Lithuania
1.00
0.50
0.50
1.00
0.00
3.00
-0.69
Poland
0.50
0.00
0.50
1.00
0.00
2.00
-0.38
Romania
0.00
0.00
0.50
1.00
0.00
1.50
-0.13
Slovak Republic
0.00
0.00
0.00
1.00
0.00
1.00
0.50
Slovenia
0.00
0.50
0.50
1.00
0.00
2.00
-0.14
Total (laws)
0.50
0.28
0.45
1.00
0.00
2.22
-0.14
Total (enforced)
0.42
0.30
0.39
0.86
0.11
2.08
World Bank
Source: Berglof and Pajuste (2005)
37
Possible research topics on enforcement
• Appropriate balance between private enforcement of public
standards and public enforcement in corporate governance in
different contexts
• Tradeoffs between the extensiveness of laws and their
effectiveness in different contexts
• Effectiveness of self-regulatory agencies and organizations
in encouraging better standards and greater enforcement
• Role of competition (factor markets and regulatory) in
improving the environment for enforcement
• Both case studies and cross-country research can help clarify
what is best suited to needs of different countries
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