Challenges in Implementing Corporate Governance

Whose Business is it Anyway?

John Zinkin

• Publisher: Wiley
• Year: 2011
• Print ISBN:
  9780470825228
• Edition: 1
• eBook ISBN:
  9781118222997
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

"John Zinkin's new book on Challenges in Implementing Corporate Governance is a welcome addition for board members and senior management on how to improve corporate governance in the post-crisis period. John correctly identifies that most boards on underperforming companies have three elements of failure: a lack of proper understanding of the business and its strategy; a total lack of appreciation of both the strategic and systemic risks created by new product markets; and a total failure by boards to ensure that the incentive structures for top management reflect long-term needs rather than short-term profits, thereby putting the company's future at risk. John has written a useful and practical handbook that is a must read for all board members on how to improve corporate governance."
—Datuk Seri Panglima Andrew Sheng, Chief Adviser, China Banking Regulatory Commission and the Boards of the Qatar Financial Centre Regulatory Authority , Sime Darby Berhad and Khazanah Nasional

"This timely book will interest those wanting to improve corporate governance and risk management. It should also appeal to anyone curious about what caused banks to fail in a number of markets in recent times, and the values which led to this failure. In considering principles which are essential to good governance, ACCA recognizes that corporate governance evolves and improves over time. We accept that organizations in different sectors and across the world operate in diverse environments in terms of culture, regulation, legislation and enforcement. What is appropriate, in terms of governance, for one type of organization will not be appropriate to all organizations. John Zinkin's book seeks to address this challenge, analyzing the essential cultural and behavioral issues which sit at the heart of the challenges."
—Paul Moxey, Head of Risk Management and Corporate Governance,  Association of Chartered Certified Accountants

"A scholarly combination of practical guidelines and strategic vision."
—Lady Sylvia Jay CBE, Vice-Chairman, L'Oreal UK; Independent Director, Alcatel-Lucent, Compagnie de Saint Gobain, Lazard Limited and Carrefour

"This is a highly topical and timely publication. Globally, the crisis that has gripped the financial services sector following the failure of well known global banks in recent years has focused attention on corporate governance. To restore confidence in the financial services sector is a long-term goal and effective corporate governance, together with the closely associated topic of risk management, has gripped not only governments and banks, but the public too. In this book, John Zinkin clearly asserts that financial institutions need to exert their responsibilities beyond their shareholders and far more into the wider group of stakeholders, including employees and wider society. In considering issues globally, John provides a book that is not only thought-provoking but pragmatic and useful at a time when stakeholders in our banks need to see real change in transparent, practical ways from those charged with governing our banks."
—Ruth Martin, Managing Director,  The Chartered Institute of Securities and Investment

CHAPTER 1

DO WESTERN CODES OF CORPORATE GOVERNANCE APPLY IN ASIA?

This chapter makes the case that good corporate governance (CG) does matter, but that adopting Western codes of CG without understanding the underlying differences in market structures, types of ownership and culture may lead to unexpected problems in implementation within the board in many Asian markets.

Why CG Matters

As a general principle, CG matters because investors are vulnerable to conflicts of interest and managerial incompetence. They are not well protected by contract and so have to rely on the law to protect them from conflicts of interest and on good CG to protect them from managerial incompetence.1 If good CG protects shareholders from managerial incompetence, it should lead to better performance, justifying any interest third parties have in how the company is run.

Although there is a fair amount of evidence to suggest that good CG does have a positive impact, there is also evidence to the contrary.2 On balance, it seems that good CG does in fact lead to better results in terms of higher profits and better dividends. Also the cost of debt (using bond yield spreads as a proxy) would appear to be lower the more independent the board3—one of the indicators of good CG.

When investors think of the benefits created for them by good CG, they split into three groups:

• The first group believes that companies with good CG will perform better over time—that over the long term good CG will translate into higher stock prices, yielding higher upside potential. Studies in the US,4 Germany5 and, most recently, India6 tend to support this point of view.
• The second group sees good CG as a means of limiting or reducing the risks to which a company is exposed. They believe the existence of good CG will reduce the chances of bad things happening to the company and, if they do materialize, the company will recover faster because it has good CG in place to deal with the problems as they arise.
• The third group recognizes the importance of self-fulfilling prophecies. They regard CG as a fad, but go along with it because so many investors increasingly think it matters, and therefore they expect share prices to reflect this fact.7

Perhaps the most convincing reason for believing that good CG leads to superior shareholder value comes from an American study which argues that companies can be thought of as republics.8 Those companies that had boards that felt less accountable to the shareholders did less well than the companies where boards took their responsibilities to shareholders more seriously. Companies can choose to be like democracies—granting great powers to the voters; or they can choose to be like dictatorships—protecting the management from being accountable to the voters. Consequently, the study looked at the “democracies” and compared how they have performed in contrast to the “dictatorships.” The “democracies”—the companies with the lowest management power and the highest shareholder rights—appear to have outperformed the “dictatorships” by a “statistically significant 8.5 percent per year” in firm valuations.9

In addition, firms with lower shareholder rights were less profitable and had lower sales growth than other firms in their industry. The study also shows that a dollar invested on September 1, 1990 would have grown to US$3.39 in the “dictatorship” portfolio by December 31, 1999, but would have grown to US$7.07 in the “democracy” portfolio—representing an annual growth rate in value of 14 percent and 23.3 percent, respectively, with the “democracies” outperforming “dictatorships” by 9.3 percent per annum.10 Two possible factors contributing to these findings might be:

• Bad investment decisions: The more firmly entrenched the managers are, the more protected they are from hostile takeover and the more likely they are to invest unwisely from a shareholder’s perspective.11
• Agency costs: One of the most important sets of agency costs arise as a result of acquisitions, where the acquiring firm is subjected to negative returns. So value-destroying capital expenditure for acquisitions may be one of the reasons for the poorer performance of “dictatorships,” particularly when some of the other agency problems are found to be caused by low managerial ownership, high free cash flow and diversifications.12 Indeed, the evidence suggests that during the 1990s the “dictatorship” firms did in fact indulge in inefficient acquisitions, not so much to create empires but, rather, in an apparent attempt to stave off imminent collapse.13 Presumably, shareholders in the “democracies” would not have agreed.

German experience14 supports this, as follows:

• Firms with higher governance ratings delivered higher market-to-book ratios, with an increase in the firm’s corporate governance index of three points (out of a total of 30) leading to an increase in the firm’s market capitalization of 2.8 percent. This translated into a 12.5 percent increase of market capitalization of the company’s book asset value.
• Buying high corporate-governance rated (CGR) firms and shorting low CGR firms would have earned higher returns of around 12 percent per year during the period under review.
• Firm-specific CG affects asset pricing because it is treated as a risk premium for which investors require added returns to compensate for the risk they take. Firms with better CG and engaged investors can deliver lower ROE and still interest shareholders.15

The Indian study supported these findings with the following conclusions.16 Provided companies exceeded a certain CG threshold score then:

• The better-governed firms command a higher market valuation and are less leveraged and have higher interest cover.
• They provide higher return on net worth and capital employed and their profit margins are more stable.
• Their P/E ratios and dividend yields were higher than those in firms whose CG scores are lower.

Portfolio Turnover Affects the Value Placed on CG . . .

However, there is an important caveat: good CG does not interest all shareholders equally. Investors with a low portfolio turnover—defined as selling between 0 and 40 percent of their portfolio in the space of a year—were willing to pay a 12 percent premium on average. The reason for this is that they were in the stock for longer, and good governance pays off over the longer term. Investors who regard the market as a casino are “punting” on a stock, and they are only interested in the very short term. In markets where there are no capital gains taxes, investors can quite literally buy and sell a stock several times in a day. Thus investors with a high turnover rate—defined as selling between 41 percent and 100 percent—were only willing to pay a 7 percent premium. As long as their profits exceed their commission costs, they are ahead.17 “Stir-frying,” as this activity is called in Hong Kong for example, is not about good governance; it is about gambling.

. . . as does the Asset-Management Philosophy

Value investors are interested in the long term and so are more likely to appreciate good CG than growth investors where the growth in the company can hide failures of CG. Although these errors might cause profits to be lower than they otherwise should be, this does not matter so much when there are high price-earnings multiples justified by prospective profit growth. In fact, the difference in the two attitudes is best illustrated by the two quotes below, cited in a McKinsey research paper:18

Value investor: “A good board may help lift an underperforming stock and capture hidden value.”

Growth investor: “One major shareholder . . . said that he did not want to talk about governance or anything else and had bought our stock only because of a growth trend he foresaw in the industry as a whole.”

It is perhaps no accident that the greatest CG failures have occurred either in markets that were growing rapidly—ASEAN before the 1997 Asian Financial Crisis, China in the period 1995–200319—or in sectors where growth was taken for granted, as in IT, telecoms and energy in the US before the crunch time when failures in CG were discovered to have been systemic and occurring over a period of several years before the economy turned down.20 The 2007–08 financial crisis followed the same pattern, with unbelievable rates of growth in asset-backed securities and credit-default swaps hiding the basic flaws of CG in the system.21

We can conclude that CG does matter to investors for the following reasons:

• It provides them with some protection they otherwise would not have, other than through expensive legal recourse.
• There is some evidence to suggest that good CG delivers better shareholder value over the long term within given markets.
• There is also evidence to suggest that markets with a better reputation for CG require a lower risk premium than those that have a less good image.

However, other things being equal, the importance attached to good CG depends on the time horizons of investors—a function of their assets, portfolios and investment philosophies—and whether they are growth investors or value investors. Growth investors care less about CG than value investors, as growth can compensate for failures of CG.

Yet this does not deal with the more difficult question; namely, does a system of good CG developed in one jurisdiction work well in another or are there additional factors that must be taken into account for good CG to happen?

Anglo-Saxon CG may not Apply Everywhere

The Anglo-Saxon system of CG depends on three pillars being in place: self-discipline, market discipline, and regulatory discipline.

Self-discipline

Of these three pillars, self-discipline is the most important as it is the foundation of ethical business practices. At the heart of the Anglo-Saxon capitalist system were the concepts of deferred gratification (the basis of any investment decision), savings and reciprocity or mutual trust, best expressed in the phrase “My word is my bond.” These foundations of the capitalist system ...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Foreword
• Acknowledgments
• Introduction
• Chapter 1: Do Western Codes of Corporate Governance Apply in Asia?
• Chapter 2: What is the Business of Business?
• Chapter 3: The Role of the Board
• Chapter 4: The Role of Board Members
• Chapter 5: Why Boards Fail and How to Avoid Failure
• Chapter 6: From Good Governance to Good Results
• Chapter 7: Managing Risk
• Chapter 8: What We Measure and Reward
• Chapter 9: Saving Capitalism from the Capitalists
• Appendices
• Index