Corporate Governance and Stakeholders

1. Corporate Governanceand Stakeholders E. Han Kim Ross School of Business University of Michigan Ann Arbor, Michigan Keynote speech at 2008 NTU International Conference on Finance, December 11, Taiwan

2. Corporate Governance • A nexus of implicit and explicit contracts among various stakeholders • Objectives • Maximize value creation for all stakeholders • Prevent value expropriation by controlling shareholders or management • Excessive compensation, tunneling, and/or stealing • Effectiveness of contracts enforcement • Priority given to shareholder value • Transparency • Board of directors • Institutional investors • Market for corporate control

3. Focus on shareholder value • Rationale: Stockholders are residual claimholders. • If the stakeholder with the most junior claim is taken care of, long-run interests of other stakeholders will also be served • Separation of control from ownership • Gives incentive for excessive private benefits of control • Diverting $100 for private uses provides a net gain of $98 to a CEO with 2% share ownership • Such misallocation of resources destroys value

4. Korean Chaebol • Kim and Kim (2008): Over 1997-2005, • Controlling families’ average share ownership = 22%, • But they control 69% of voting rights through cross- and circular-holdings • Bigger wedge before the 1997 Korean crisis • Kim, Kim, and Yi (1998): Over 1992-1996, • Only 27% of listed firms created or maintained shareholder value (the cumulative EVAs > 0) • The rest destroyed value during the five year period preceding the crisis • their average operating profits < cost of capital • How do we control such problems?

5. Law and Finance • Stronger legal protection of investors leads to: • Better corporate governance • Higher firm valuation • More reliance on external financing • Greater financial and economic development La Porta et al. (1997), Rajan and Zingales (1998), Demirguc-Kunt and Maksimovic (1998), Wurgler (2000), La Porta et al. (2002) • These studies focus only on investors and cross country variation, ignoring • Labor • Within country variation • How firm governance varies within a country? • What’s the labor’s role in governance?

6. Within country variation • Do all firms in weak legal environments have bad governance? • Do all firms in strong legal regimes practice good governance? • Wide within country variation in governance and disclosure practices • The variation increases as legal environment gets less investor-friendly

7. Explaining the Variations • The wider variation in weaker legal regimes is the result of some firms choosing good governance to mitigate harmful effects of weak investor protection • The Coase Theorem(1960), as applied to governance and investor protection • What kind of firms choose better governance? • Are better governed firms valued higher in stock markets? • Is it economically significant for corporate decision-makers to take notice?

8. A Model of Optimal Diversion • Durnev and Kim (2005) • A controlling shareholder with  ownership decides how much to divert (steal) • His total benefits =  (cash flows generated from investments ) + diversion - cost of diversion • Cost of diversion increases with the strength of legal investor protection. • He will invest only if a project increases His cash flows > Net benefits of diversion

9. Predictions • Better investment opportunities =>better governance. • More profitable investment opportunities increase the controlling shareholder’s cash flows => he will invest more and divert less • Firms choose better governance • When controlling shareholders have higher cash flow rights • When firms need more external financing • These relations are stronger in weaker legal regimes • Firms with better governance are valued higher • The effect is greater in weaker legal regimes

10. Empirical Results • Country random effects regressions with • CLSA corporate governance scores of 494 firms in 24 emerging markets • S&P Transparency ranking of 573 companies in 16 emerging markets and 3 developed countries, both in 2000 • Firms with • better investment opportunities • more external financing needs • greater controlling shareholder share ownership have higher governance and transparency rankings • Firms with bigger wedge in controlling shareholders’ voting rights and cash flow rights have lower governance and transparency ranking.

11. Valuation effects • Better governance and greater transparency increase firm value: • One standard deviation increase in governance ranking increases firm value by 9% • Valuation effects are greater in weaker investor protection countries: • Mexico, the weakest in the sample: Firm value increases by 13.2% for a standard deviation increase in corporate governance ranking • Hong Kong, the strongest: Firm value increase by 4.6% for the same increase

12. Implications • Investors should not assume all firms in weak investor protection countries are badly governed • Firms adapt to weak legal institutions to establish efficient governance • It pays to have good governance • Firms with better governance are rewarded with higher stock valuations and lower costs of capital

13. Labor • Law and finance focuses only on investor protection • The firm is where labor meets capital • Without workers, capital is of little use • Labor is an equally important stakeholder • Labor may influence governance • Board representation • Austria, China, Czech, Denmark, Egypt, Germany, Norway, Slovenia, and Sweden • Voting rights of shares held in ESOPs • Collective, industrial, and political actions

14. Is workers’ influence in governance desirable? • Positive effects, if • It restrains controlling shareholders or management from excessive compensation, payouts, and/or diversion of resources for private use • Participation in governance improves morale and team work, increasing worker productivity • Negative effects, if value creation is sacrificed to benefit worker welfare • Net effects on • Corporate decision making processes • Long term welfare of workers and investors

15. Restructuring decisions by firms suffering a sudden, sharp drop in operating performance • Atanassov and Kim (2009) • Conflicts among stakeholders become more acute when the economic pie shrinks • Restructuring in general increases shareholder value • The gains may come at the expense of workers • Two possible outcomes: • Workers may rally to improve save the firm • Conflicts between workers and investors may lead to further deterioration • Outcome depends on management • the agent between investors and workers

16. Managerial allegiance • To shareholders, if they are more influential • Value enhancing restructuring decisions are more likely. • To workers, if labor is influential enough to help retain underperforming management • May refrain from wage cuts and worker layoffs to garner worker support • May have to sell valuable assets to finance the current payroll • Such (in)actions may lead to further deterioration

17. Empirical Issues • How does the relative influence of investors vis-a-vis labor affect the likelihood of: • Large scale employee layoffs? • Top management turnover? • Major asset sales? • The relative influence is determined by social and political factors unique to each country • Proxy: The relative strength of legal institutions protecting investors and labor

18. Worker Layoffs and Management Turnover • Both may create conflicts between • Workers and investors • Management and investors • Layoffs and turnovers are more likely when investors’ legal rights are stronger • Mutual conflicts may lead to a worker-management alliance: • Labor may attempt to protect management • Management may refrain from layoffs and wage cuts to garner worker support • Strong union laws may help • Retainunderperforming management • Prevent layoffs

19. Asset sales • Generally considered value enhancing • Redeploying under-utilized assets to higher valued uses by other firms • May create conflicts with workers • Require strong investor protection • Can be a means to delay layoffs and wage cuts • Worker-friendly management may sell valuable assets to minimize payroll cuts • Will lead to further deterioration • Possible with weak investor protection

20. Summary statistics • 9,923 firms in 41 developing and developed countries, 1993-2004 • Sudden and sharp drop in EBITDA/TA • Initially, above the industry median • Drops 50% in the following year • Labor laws are negatively correlated with investor protection • All three types of restructuring increase • Layoffs and asset sales are positively correlated with each other • But not with top management turnover

21. Empirical design • Estimate the likelihood of each restructuring measure using Logit regressions with • time and industry fixed effects • country random effects • Explanatory variables: • Legal variables: • investor protection • union laws • employment contract laws • Firm-level variables: leverage, ownership concentration • Controls : size, previous year performance

24. Layoffs and management turnover • Strong investor protection makes employee layoffs and management turnover more likely • Strong labor laws reduce the likelihood of • employee layoffs • management turnover • Leverage • strengthens investors’ ability to force layoffs • weakens union’s ability to prevent layoffs • More concentrated ownership makes employee layoffs more likely • Not so for management turnover • Need to control for the manager-owner effect

26. Owner/managers vs. Hired-hands • Owner/managers are less likely • To be dismissed for poor performance • To undertake major asset sales • When top managers are hired-hands, • More concentrated ownership makes their dismissal and asset sales more likely • Asset sales are negatively related to investor protection • Are they harmful to investors?

28. Value effects of Asset sales • In top quartile investor protection countries • Asset sales improve subsequent operating performance • Asset sales are value enhancing • In bottom quartile investor protection countries • Asset sales worsen subsequent operating performance • Assets sales are value reducing

30. Likelihood of Asset sales • With strong investor protection, asset sales become more likely as • investor protection gets stronger • union power gets weaker • With weak investor protection, asset sales become more likely as • investor protection gets weaker • union power gets stronger Are these asset sales benefiting workers? • How do asset sales affect layoffs?

33. Union power on layoffs and management turnover • With strong investor protection • Asset sales lead to more layoffs • Union power has no effect on management turnover • With weak investor protection • Asset sales have no impact on layoffs • proceeds are used to maintain the payroll • Strong union laws protect under-performing managers

34. Management-Labor alliance • When unions are strong and investors are weak • Management facing possible dismissal for underperformance • refrain from cutting wages and laying off workers • by selling off valuable assets Leading to worse operating performance • Workers help retain such management through • their representatives on the board of directors • collective, industrial and/or political actions • voting with management during takeover contests • Such alliance destroys value and the firm’s sustainability

35. Conclusions on Labor • Studies of corporate governance must include labor • Workers play an important role in shaping governance • Legal protection of investors and labor should be studied together • They are closely intertwined in influencing firms’ responses to the conflicting interests between investors, labor, and management • Strong labor laws lead to undesirable consequences • Strong union laws protect under-performing management • Rigid employment contract laws discourage investments • Lead to more major asset sales during distress

36. Implications for Taiwan • Of the 41 countries we examined, • Taiwan ranks • 33th in union laws (only 7 have more flexible laws) • Helping Taiwan’s economic resilience • 20th in employment contract laws (19 have more flexible laws) • Can benefit from more flexible employment laws • 25th in investor protection (only 15 have weaker laws) • Strengthening legal protection will increase Taiwanese firm valuation and reduce their costs of capital

37. Robustness checks • Omitted variables affecting both the legal and the restructuring variables • Control for levels and changes in Log (GDP/capita), changes in unemployment levels • Asset sales to pay off debt • Replace leverage with changes in short term and total debt • Pre-existing conditions • Currency crisis: only 57 observations • Alternative definitions of the legal variables • Only the anti-director index or only the anti-self-dealing index is used to measure the protection of minority shareholders, instead of the sum of the two • Alternative sample selection criteria • Extending the base period for two years • 30% and 40% drop in EBITDA/TA in the distress year • Alternative definitions for the restructuring variables • Alternative measures of leverage and ownership concentration

38. Data • Financial, ownership, and restructuring data: • Worldscope, Amadeus, ISI emerging markets, local stock exchanges, company websites • Legal variables: • Financier protection • A combination of de-jure and de-facto legal variables • Sum of the revised anti-director index, the anti-self-dealing index by Djankov et al. (2005), the creditor index by La Porta et al. (1998), and the Law and Order index • Labor protection: Botero et al. (2004) • Employment contract laws (Emp_Cont): the rigidity of labor contracts • Collective relations laws (Union): labor union power

39. Definition of sharp drop in operating performance • Base year: (EBITDA/TA) is above the industry median • For management turnover • A relative measure • Distress year: (EBITDA/TA) is in the bottom industry quartile • For employee layoffs and asset sales • Distress year: 50% or more drop in EBITDA

40. Restructuring measures • Top management turnover • Change in the top two officers in the year of distress or the following year • Large scale layoffs • A drop by more than 20% in the number of employees • Major asset sales • A decrease by more than 15% in net plants, property, and equipments