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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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