Stanford & Columbia Law Schools Hanoi, Vietnam December 6, 2004

Why Corporate Governance Matters for Vietnam: Importance for Listed CompaniesOECD/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

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?

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.

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

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

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”)?

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

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.

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

Mexico Italy Sweden ●PBC measured by difference in market price 36% 29% 1% ●PBC measured by control block premium 34% 37% 7% 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 Source: Nenova (2003); Dyck & Zingales (2002)

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

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

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

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

Diversity of Shareholding Patterns Distribution of Controlling Shareholders and Widely-held Companies in Sweden and Italy Source; Faccio & Lang (2003) OECD/Classens et. al. report Italy-like distribution for East Asia; Gompers et. al. reports diversity in 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

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

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

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

Stanford & Columbia Law Schools Hanoi, Vietnam December 6, 2004