INTERNATIONAL FINANCIAL MANAGEMENT

1. INTERNATIONAL FINANCIAL MANAGEMENT Lecture 4: Topics: Corporate Governance and Corporate Goals/Objective Models -- A Global View

2. What is Corporate Governance? • Bank for International Settlements definition: • “The system of rights, processes, and controls established internally and externally over the management of a business entity with the objective of protecting the interest of stakeholders". • Central Issue of corporate governance: How best to protect the interest of stakeholders. • Another Issue: who are the relevant stakeholders that need protection?

3. Corporate Governance: Background • Recently corporate governance has become an issue in this country and abroad. • Interest has been driven by three events: • Expanding shareholder base of corporations and the resulting separation of owners and manager. • Corporate abuses. • The globalization of companies into non-resident financial markets. • With the aim of raising capital in those markets. • We will develop these themes throughout this lecture series.

4. Possible Stakeholders • McDonalds: “good corporate governance is critical to fulfilling the Company’s obligation to shareholders.” • Honda: “Our [corporate governance] aim is to have our customers and society, as well as our shareholders and investors, place even greater trust in us and to ensure that Honda is a company that society wants to exist."

5. Importance of Corporate Governance? • Macro Implications: • Because corporations play a key role in the generation and allocation of a country’s resources. • Micro Implications: • In the increasing world of globalization, firms need to practice good corporate governance so as to: • Continue to attract consumers and workers • Have access to global financial markets! • Historically, corporate governance appears to have been of greater concern among developed country corporations than developing country corporation! • However, globalizations is forcing developing country corporations to assess their corporate governance structures

6. Concerns of Different Stakeholders • In reality, it is likely that different stakeholder groups will focus on different criteria in deciding what constitutes good corporate governance. • Shareholders probably attach the greatest importance to maximizing the market value of the company’s shares. • The general public wants to be sure the corporation treats customers fairly and has sensitivity to its impact – socially and environmentally -- on the local community. • Corporate employees want assurances the company will compensate them properly, provide opportunities for advancement, offer training and career development assistance, and help with their retirement planning. • The issue for managers is what stakeholders to focus on. • This impacts on corporate decisions, goals and objectives. • Note the difference between McDonalds and Honda.

7. Early 20th Century History of Corporate Governance in the U.S. • In the decades leading up to the 20th century, most US corporations were dominated and controlled by wealthy individuals. • The Morgans, Rockefellers, Carnegies and du Ponts. However by the 1920s/1930s, the pattern of US ownership of corporate equities had changed from these entrepreneurs to an expanding group of individual investors. • At that time it was also recognized that there was a growing disparity between owners of firms and managers of firms. • Thus the issues of agency problems and agency costs became relevant.

8. Agency Problems and Agency Costs • Agency problems arise when a principal (i.e., owner or shareholder) hires an agent (i.e., manager) to perform certain tasks, yet the agent does not share the principal's objective(s). • Agency costs in corporations refers to the potential conflict of interest between principals (owners or shareholders) and agents (managers) in which agents have an incentive to act in their own self-interest.

9. State Statues to Address Corporate Governance • In response to the early 20th century changing ownership patterns of US corporations and the potential issue of agency costs a number of states, most notably Delaware, passed "enabling statutes" known as general corporation laws. • These state statutes created a legal framework for stockholders investing in US corporations. • Today, 50% of all U.S. publicly-traded companies and 58% of the Fortune 500 are chartered through the state of Delaware.

10. Key Element in Early 20th Century Corporate Governance • Boards of directors were seen as a potential solution to the agency cost issue. • Thus, boards of directors were set up to exercise control over a company and they were seen as representing the interest of the stockholders. • It was argued that these boards had fiduciary (i.e., legal) duties of loyalty to owners (shareholders) and they should ensure the “wise management of the corporation in the best interests of its owners.” • A key element in this process was the “independence of directors” from undue influence by interested parties (including managers). • But were these early boards truly independent?

11. The Stock Market Crash in 1929 • The stock market crash of 1929 brought the Federal Government into the issue corporate governance for the first time. • Congress passed the Securities Acts of 1933 and 1934 to restore confidence in the equity markets. • 1933 Act: Established the Securities and Exchange Commission (SEC); requires registration with the SEC of securities offered for public sale and outlaws fraud in the sale of securities. • 1934 Act: Regulates stock exchanges and requires corporate officers to report their trading in securities. • These acts also require that public companies undergo an annual independent audit of their financial statements.

12. The 1980s • In the 1980s, the focus on corporate government shifted. • The decade of the 1980s was characterized by a wave of hostile takeovers, leveraged buyouts, management buyouts, junk bond financing, "poison pills", and a general merger frenzy. • Within this environment, shareholder interests again became an issue. • But what was different in the 1980s was the growing role of large institutional investors -- banks, mutual funds, public and private pension funds. • These institutions were taking on an increasingly activist role as corporate shareholders.

13. The 1990s to the Present • By 1990, the direct ownership of equities by households had fallen below 50% in the United States. • And in the 1990s it was primarily institutional investors who were driving the issues of corporate control and accountability. • Their focus was (and currently still is) on securing top performance from their investments. • Today, these institutional investors hold about 60% of all listed corporate stock in the United States (about 70% in the largest 1,000 corporations).

14. Impact of Corporate Abuses in the US on Corporate Governance • In recent years, corporate governance legislation has become even more focused in the United States. • Undoubtedly corporate abuses have contributed to this: • Waste Management and Sunbeam (1998) and Enron (2001). • Abuses resulted in passage of Sarbanes-Oxley Act (2002) • This act requires the certification of financial reports by chief executive officers and chief financial officers • Act assumes if companies are more transparent in what they are doing, managers will be less tempted to act in a way detrimental to owners. • There is no similar regulation in foreign countries so there is also the issue of applying this act to foreign companies listed in the U.S

15. Global Corporate Governance • Globally, there are major challenges to the development of “good” (or at least uniform) corporate governance. • These challenges stem from the fact among countries there is a wide diversity of laws, regulations, society norms, business cultures, attitudes towards business, ownership concentration, and political and market structures. • Thus, the ability for implementing what we in the US might view as "good corporate governance" is often constrained by these differences.

16. Differences in Ownership Concentrations • Globally, ownership concentration varies widely. Country Average ownership of 3 largest shareholders United States 20% United Kingdom 19% Italy 58% Germany 48% Brazil 57% Mexico 64% • United States and U.K. have a “diverse shareholder base.” In other countries, often founding families control the companies. • Question: Does concentration have an impact on control and oversight of managers (agents)?

17. Ownership Impacts • If ownership is concentrated, it is more likely that a small number of owners will find it relatively easy and advantageous to be involved in the direct monitoring of managers. • Thus, in countries like Italy, Brazil and Mexico, a few large shareholders may play a significant role in corporate governance; but this is not necessarily the case in the U.S. and the U.K. (see previous slide). • Therefore, in high concentration countries, agency cost may be reduced as owners and managers become better aligned.

18. Differences in Legal Systems • Currently, it is possible to identify 2 major legal systems: • Common Law • Based on precedent, formed by the rulings of independent judges regarding specific disputes. • Originated in U.K. and spread throughout the world through British colonization (as well as independent adoption): • United States, Australia, Canada, India, South Africa, Singapore, New Zealand. • Civil Law • Codification of legal rulings. • Dominates legal systems globally. • France, Germany, Japan, Mexico, China, Latin America,

19. Legal Variations and Corporate Governance • Studies have suggested that differences in legal systems may have in impact in variations in corporate governance. • Reason: Legal systems vary in how well investors are protected.

20. Shareholder Rights and the Legal System • In civil law countries, the “state” has historically played a greater role in regulating economic activity but a less active role in protecting individual (e.g., private property) rights. • On the other hand, English common law is more protective of private property and investor rights. • Conclusion for investors: English common law offers the strongest protection for investors.

21. Law and Ownership Concentration • Civil law countries generally have greater ownership concentration ratios. Legal System Average ownership of 3 largest shareholders English Common 43% French Civil 54% • Perhaps these higher concentration ratios are a response to relatively weaker investor protection laws in civil law countries? • Or perhaps of the high concentration ratios are seen as alleviating the need for strong investor protection laws?

22. Corporate Goals • Corporate goals are specified targets which a company desires to achieve. • In the United States, companies tend to produce rather well defined financial goals. • For Example, FedEx Corporation • Grow revenue by 10% per year • Increase EPS by 10% -15% per year • American company focus on financial goals is undoubtedly driven by the corporate model used in this country.

23. Differences in “Corporate Model” • There are 2 major corporate models in use in the world today: • Shareholder Wealth Structure (aka, Anglo-American or Anglo-Saxon) Model: • Believes that a firm’s objective should be to maximize shareholder wealth. • “Shareholder Wealth” countries include the US, Canada, Australia, United Kingdom. • Corporate Wealth Structure (aka, Non-Anglo-American) Model: • Believe that a firm’s objective should be to maximize corporate wealth (which includes all stakeholders; e.g., employees, community, banks, owners) • “Corporate Wealth” countries include the EU, Japan and Latin American countries.

24. Shareholder Wealth Model • This model focuses on the importance of shareholders to the corporate structure. • Wealth is seen as strictly “financial.” • Within this context, management tools measure impact of their decisions on equity (common stock) values. • Shareholder Wealth capital budgeting techniques include: • Net Present Value • Internal Rates of Return • These are aimed at securing returns greater than the firm’s cost of capital and thereby increasing returns to shareholders. • Within this model, there is a general acceptance of “hostile” takeovers to ensure appropriate financial performance. • Again this is seen as benefiting shareholders.

25. Corporate Wealth Model • The focus of the corporate wealth model is much broader than the Shareholder Wealth viewpoint. • Under the Corporate Wealth Model, consideration of corporate decisions is given to a wider range of interests, including employees, the community, the country, shareholders, lenders... • The Corporate Wealth model came about because of distrust of “unrestricted” capitalism especially in Latin America and post World War II Europe (thus, the phrase in search of a “Third-Way” – a middle ground between capitalism and socialism).

26. Corporate Wealth Model • In Continental Europe and Asia we the corporate wealth model includes: • Advisory Committees (with labor representation): important in Europe as part of corporate structures and involved by law in corporate decisions. • Strict labor laws (e.g., on firing employees) in Europe. • Life time employment concept in Japan in early post war years. • Weakened substantially in Japan in the 1990s. • Less attention in Japan of Anglo Saxon capital budgeting techniques; especially equity cost of capital. • Payback analysis preferred. • Friendly takeovers are the rule in corporate wealth countries. • Although this is changing somewhat, e.g., in Japan and in Europe we are beginning to see hostile takeovers.

27. Mergers and Acquisitions in Japan and Germany: Historical Data • Japan: Between 1985 and 1989, mergers and acquisitions accounted for just over 3% of the total market capitalization, and all were friendly transactions. • Germany: Between 1985 and 1989, only 2.3% of the market value of listed stocks were involved in mergers and acquisitions, compared with more than 40% in the U.S. • Historically, in both Japan and Germany mergers have tended to be friendly, arranged deals, rather than hostile takeovers.

28. “Equity” Cultural Differences • Shareholder Wealth countries (U.S., U.K., Australia, Canada) • Have a well developed equity culture: • There is an understanding and acceptance of ownership and, especially, equity capital risk. • Thus, equity capital is an important source of funds for corporate financing in these countries. • But, perhaps, the equity culture also affects corporate goals and management decisions. • Management tends to focus on shareholders.

29. “Equity” Cultural Differences • Corporate Wealth countries (Continental Europe and many Asian countries) • Historically, relatively less developed equity culture. • In Japan and Germany the percent of households holding common stock (in direct form) is roughly half that of the US. • Risk is not as well understood or tolerated. • Thus in these countries there has historically been a reliance on debt and bank financing. • Bond financing important in Japan and commercial bank financing in Germany. • These countries also tend to develop interlocking relationships. • Banks own approximately 14% of shares of German corporations, while roughly 40% are owned by other German corporations. • Keiretsu in Japan and Chaebol in South Korea

30. The Future: Are the Two Models Finding a Middle Ground? • Starbucks, Corporate Social Responsibility: • “… conducting business in ways that produces social, environmental, and economic benefits for the communities in which we operate.” • Many Japanese companies are now concern with Anglo-American financial performance. • In 1999, Nissan hired a Frenchman, Carlos Ghosn (known as the “cost cutter”) as their CEO to turn the company around. • One year after he arrived, Nissan's net profit climbed to $2.7 billion from a loss of $6.1 billion in the previous year. • In 2005, Sony hired an American, Howard Stringer as their CEO. • He has set an operating profit margin goal of 5% for the company by 2008.

31. Governance and Transparency Among the World’s Central Banks • Financial markets and financial organizations (e.g., central banks) around the world are also working to become more transparent. • All central banks now publish their web sites in English. • http://www.bis.org/cbanks.htm