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Transparency, Corporate Governance, and Capital Markets. Ronald J. Gilson Stanford & Columbia Universities Latin American Corporate Governance Roundtable S ão Paulo Brazil, April 26-28, 2000. The Subject is Summarized in Three Simple Statements.

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Transparency corporate governance and capital markets

Transparency, Corporate Governance, and Capital Markets

Ronald J. Gilson

Stanford & Columbia Universities

Latin American Corporate Governance Roundtable

São Paulo Brazil, April 26-28, 2000

Corporate Governance Roundtable


The subject is summarized in three simple statements
The Subject is Summarized in Three Simple Statements

  • Equity investment requires good corporate governance.

  • Good corporate governance requires credible disclosure by the issuer.

  • The absence of credible disclosure by issuers will have macroeconomic effects: bank financing and conglomerate internal capital markets will not support the development of economically significant new industries.

Corporate Governance Roundtable


Step one corporate governance is the equity contract
Step One: Corporate Governance is the Equity Contract

  • We are all familiar with the debt contract: a detailed document specifies the interest rate, the repayment date, the debtor’s covenants, and the events of default.

  • What is the equity contract?

    • The corporate governance system specifies the rights of an equity holder and the steps available if management breaches its responsibilities

  • Gilson’s rule of value: you pay for what you get!

Corporate Governance Roundtable


Step two good governance requires credible disclosure
Step Two: Good Governance Requires Credible Disclosure

  • The corollary to Gilson’s rule of value:

    • You get what you can measure.

  • The algebra of governance and disclosure:

    • You pay for what you get = you get what you can measure

    • Canceling yields:

    • You pay for what [you get] = [you get what] you can measure:

      • You pay for what you can measure!

  • The difference between disclosure and credible disclosure.

Corporate Governance Roundtable


Step three the effect of a bad equity contract
Step Three: The Effect of a Bad Equity Contract

  • A bad equity contract – an issuer’s inability or unwillingness to make credible disclosure – makes it difficult for the market to distinguish good risks from bad.

  • The increased cost of capital shifts financing and the capital market toward debt.

  • Consequences:

    • Debt is ineffective at financing high risk, high return early stage investment.

    • The capital market will not support cutting edge industries.

Corporate Governance Roundtable


The institutions necessary to support credible disclosure
The Institutions Necessary to Support Credible Disclosure

  • Legally Mandated Disclosure Requirements.

  • Good Accounting Standards.

  • Independent Auditors.

  • Effective Enforcement.

Corporate Governance Roundtable


Legally mandated disclosure requirements
Legally Mandated Disclosure Requirements

  • Problem:

    • How do we distinguish between those who disclose accurately and those who do not?

      • Absent effective private intermediaries, a reputation model will not work.

      • By imposing penalties on false disclosure, a legal mandate allows honest companies to distinguish themselves.

Corporate Governance Roundtable


Good accounting standards
Good Accounting Standards

  • The critical characteristic is not the particular standard – the metaphysics of accounting – but that the form of disclosure allow users to rearrange the information to their own use.

  • Good rule of thumb: an accounting system that has no use for the adjective “hidden.” Examples:

    • German hidden reserves.

    • U.S. debate over charging the value of employee stock options to earnings.

    • U.S. pooling vs. purchase accounting for acquisitions.

Corporate Governance Roundtable


Independent auditors
Independent Auditors

  • Credible disclosure requires honest, competent, and independent auditors.

    • The annual audit process is more effective than a government agency.

  • The problem is independence.

    • What is the impact on auditor independence of the consolidation of the profession into 5 multi-national, multi-disciplinary professional service firms.

      • What happens to independence when non-audit fees climb?

      • Current focus of the U.S. Securities and Exchange Commission.

Corporate Governance Roundtable


Enforcement
Enforcement

  • Mandatory disclosure is no more effective that the expectation that the rules will be enforced. We need:

    • A politically insulated regulatory agency with the independence to impose significant sanctions on the country’s largest economic actors.

    • An independent, effective judiciary.

    • Effective private enforcement.

Corporate Governance Roundtable


A piggybacking strategy
A Piggybacking Strategy

  • How does a high quality firm establish its credibility while local disclosure institutions are developing?

    • Foreign stock listing.

      • E.g., NYSE listing imposes on a foreign company

        • Governance standards imposed by contract.

        • U.S. regulatory standards triggered by listing.

        • Israeli companies going public on NASDAQ.

    • Strategy limited to larger companies.

Corporate Governance Roundtable


Summary
Summary

  • Equity investment requires good corporate governance.

  • Good corporate governance – the equity contract – requires credible disclosure by the issuer.

  • The absence of credible disclosure by the issuer will have macroeconomic effects: bank financing and conglomerate internal capital markets will not support the development of economically significant new industries.

Corporate Governance Roundtable


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