Why Corporate Governance
Matters for Vietnam:
Importance for Listed Companies
OECD/World Bank Asia Roundtable on
Corporate Governance
_______________
Ronald J. Gilson
Stanford & Columbia Law Schools
Hanoi, Vietnam
December 6, 2004
The Starting Point
Corporate Governance : Military Music
Governance
Music
This is an exercise in production not
democracy
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Implications
• Corporate governance is concerned with
allocational efficiency: increasing the size of the
pie
• Real governance, where there is political
accountability, is concerned with distributional
equity
• The standard for assessing corporate
governance systems is therefore wealth
creation: which structures, under which
circumstances, create the most resources for
society to divide?
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Focus: Listed Corporations
• My focus today will be listed corporations. Only
the involvement of external capital raises
governance, as opposed to management,
issues.
• Corporate governance as an investment
contract
– The investor gives €, $, £, ¥; what does the investor
get?
– The answer to that question influences the
corporation’s cost of capital.
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Forms of External Capital: The
Debt Contract vs. Equity Contract
• The debt contract is “hard”
– If the corporation violates the loan agreement,
immediate legal action is possible
• The equity contract is “soft”
– Common stock holds the residual claim
• Returns are contingent on performance and strategy
• No specific rules specifying amounts or timing of distributions
to shareholders
– Corporate governance is the equity contract:
processes and general standards of behavior are
substituted for the specific obligations of the debt
contract
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The Link between Corporate
Governance and the Cost of Capital
• If a proposed debt contract gives the lender little
protection, the interest rate the lender demands
will increase
• If a nation’s corporate governance gives the
equity investor little protection, investors will pay
a lower price for corporate stock and the cost of
equity capital will increase
• Different national governance systems represent
different approaches to protecting public equity
investors
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The Taxonomy of Corporate
Governance Systems
• Public equity investors always confront a
separation of ownership and control
– Someone else will be making the decisions that
determine the value of their investment
• All systems that accept public equity investors
must address the central corporate governance
problem
– How do equity investors make sure that managers
perform well (the “duty of care”) and do not take
private benefits for themselves (the “duty of loyalty”)?
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The Critical Role of the Controlling
Shareholder
• Most listed corporations in Asia have a
controlling shareholder (CS)
• To understand the CS role, start with corporate
governance in systems where listed
corporations typically do not have a controlling
shareholder – the US and the UK
– Rely on internal monitoring like independent directors
and market mechanisms like hostile takeovers
– Both techniques are effective but have limitations
• Getting the incentives of independent directors right
• High cost of hostile takeovers
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Controlling Shareholders as an
Alternative Monitor
• CS may better police management’s duties of
care and loyalty
– Large investment aligns the interests of CS and public
equity investors
• But a system of CS as focused monitors come
with its own costs
– Private benefits of control (PBC): benefits to the CS
not provided to public shareholders
• Public shareholders will prefer a CS – and the
cost of equity capital will be reduced – if the
gains from better monitoring exceed the private
benefits of control.
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Controlling Shareholder Regimes:
Good Law versus Bad Law
• Two kinds of controlling shareholder
regimes
– Inefficient CS regimes where PBC > the gains
from focused monitoring
– Efficient CS regimes where PBC < the gains
from focused monitoring
• Cost of equity capital depends on whether
legal and cultural corporate governance
standards effectively constrain PBC
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Implications of Distinguishing between
CS Regimes: Value Differential in
Efficient and Inefficient CS Regimes
Differential between controlling and minority
shares in CS systems depends on the quality of law
Mexico
Italy
Sweden
●PBC measured by
difference in market
price
36%
29%
1%
●PBC measured by
control block premium
34%
37%
7%
Source: Nenova (2003); Dyck & Zingales (2002)
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Additional Evidence of Link
Between PBC and Firm Value
• In Asian countries with CS regimes, firm value is
related to the amount of PBC extracted by the
CS (Classens et. al.; Black et. al.)
– Firm value increases as the equity share of the CS
increases
– Firm value decreases as the difference between the
CS’s control rights and its equity share increases
• Implication: Firm value increases and decreases with the CS’
incentive to extract PBC
– Increase in value of public equity in Korea following
requirement of majority of independent directors
despite no change in operating performance
• Implication: A smaller portion of the same cash flow Is
extracted as PBC
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Implications of Distinguishing between
CS Regimes: The Taxonomy is Wrong
• Traditional approach distinguishes between
regimes with widely distributed shareholdings
(the US & UK) and CS systems (the rest of the
world).
• Correct approach
– Distinguish between efficient and inefficient systems:
are there effective constraints on CS extracting PBC?
– U.S. has a substantial number of listed companies
with a CS
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Diversity of Shareholding Patterns
• An inefficient system will support only CS
capital structures
– Absent constraints on PBC by a subsequent
acquirer of control, an existing CS won’t part
with control
• An efficient system will support both CS
and widely distributed capital structures
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Diversity of Shareholding Patterns
• Absent barriers, expect that shareholding
patterns will differ within a jurisdiction depending
on
–
–
–
–
–
Nature of industry
Nature of competition
Rate of technology change
Preferences of individual CS
Generation of CS
• If bad law prevents giving up control, all
companies should have CS
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Diversity of Shareholding Patterns
Distribution of Controlling Shareholders and
Widely-held Companies in Sweden and Italy
Controlling
Shareholder
(family)
Widely-Held
Sweden
46.94%
39.18%
Italy
59.61%
12.98%
Source; Faccio & Lang (2003)
OECD/Classens et. al. report Italy-like distribution
for East Asia; Gompers et. al. reports diversity in
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U.S.
Implications of Inefficient CS
Regimes
• Absence of diversity in inefficient CS
regimes has macroeconomic implications
– Firms prevented from adopting most efficient
organizational form
– Higher cost of equity capital – in capital
markets with significant frictions, capital
structure matters
– Eliminates possibility of private equity/LBO
recycling of underperforming companies
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Eliminating Inefficient CS Regimes:
Thoughts About Reform
• Problem is not CS regimes – it is inefficient CS
regimes
• Obvious response is to improve “law” in such
regimes, using the term to include “soft” law and
non-legal institutions like the financial press
• Good law requires
– Substantive statement of PBC limits
– Disclosure that can trigger enforcement
– Effective private and pubic enforcement techniques
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Eliminating Inefficient CS Regimes:
Thoughts About Reform
• OECD White Paper finds that substantive
standards are fine
• Recommends detailed reforms to improve
disclosure and enforcement
– Expanding private enforcement and
increasing regulatory resources and
commitment take time
– What to do while developing disclosure and
enforcement capacity
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Eliminating Inefficient CS Regimes:
Thoughts About Reform
• Examples of interim reform measures – more
detail in OECD White Paper
– Eliminate pyramidal ownership
• No economic justification for the structure
• Extremely difficult to police intra-pyramid transfer pricing
• Early U.S. law prohibited all interested transactions;
prohibition gave way to judicial review as institutions
developed
– Disclosure of affiliate/family relationships
– Develop culture of independent directors – Professor
Jang’s research suggests that independence can
reduce the cost of capital in Asian CS regimes
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