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GOVERNANCE AND VALUE: EVIDENCE FROM

EMERGING MARKETS

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Questions

Can companies compensate for poor laws by practicing good governance?

do you believe standards of governance should be required through legal mandate or adopted at the discretion of the company based on recommended best practices and pressure from shareholders?

do all firms in weak legal regimes suffer from poor corporate governance and do firms in strong legal regimes practice uniformly high-quality governance?

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if so, is there a systematic pattern in which firms choose their quality of governance?

what are the relevant firm attributes and how are they related to the observed governance practices?

is the quality of governance priced in stock markets, and if so, should corporate decision makers take notice?

Questions

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Risk neutral controlling shareholder with ownership Interest rate = 0 measures investment profitability for firm iEndowment:

F

jj 1)(1

jj

1

1

*j

D

Simple models

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Quality of Governance Practices: 1 – d, where

d = the proportion of cash flows that the controlling shareholder diverts for private benefits includes outright stealing, shirking, perks, tunneling

high d = bad corporate governance low d = good corporate governance

Simple model

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( ( ))1 1 j c

c = cost of diversion = PV of legal costs/penalties and costs of diverting and converting corporate resources into cash equivalents

fines, jail term, loss of reputation, bribes

- high c in the U.S.- low c in Russia, China, India, Brazil

The controlling shareholder will invest if:

personal benefits from investment > net benefits from diversion

Simple model

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Investment opportunities

In strong legal regimes, firms divert less and practice higher quality governance.

Good rules and effective enforcement reduce thievery.

Controlling shareholders of firms with more profitable investment opportunities divert less for private gains and practice higher-quality governance.

One is less likely to commit crime if one has something valuable to lose

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The impact of profitable investment opportunities on corporate governance is greater in weaker legal regimes.

Good governance driven by private incentives becomes a more important complement to regulation when regulation is less effective.

Investment opportunities

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Controlling shareholder’s payoff as a function of diversion d

DcMV )1(

Russiafor 3.0

for U.S. 6.0

c

Payoff =

Sensitivity of d* w.r.t. is smaller in the U.S. than in Russia

prof.high 2.2

prof. low 0.2

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diversion d

RUSSIA, LOW PROF.

RUSSIA, HIGH PROF.

US, LOW PROF

US, HIGH PROF.

dHRUS dL

RUS

dHUS dL

US

DdUS=dHUS-dL

US

DdRUS=dHRUS-dL

RUS

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Controlling shareholders of firms with higher cash flow ownership practice higher quality of governance.

One does not steal from oneself

The impact of ownership on governance is stronger in weaker legal regimes.

Concentrated ownership becomes a more important tool to resolve agency conflict between controlling and minority shareholders in weaker legal regimes

Ownership

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External Financing

For a given level of profitable investment opportunities, controlling shareholders of firms with greater dependence on external financing practice better governance.

One does not spit into the well one drinks from

The relation between reliance on external financing and governance is stronger in weaker legal environment.

Firms in weak legal regimes have greater incentive to improve their governance practice to overcome the deleterious effects of poor legal protection on their

ability to raise external financing.

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Valuation

Firms with better governance are valued higher.

The effect of governance on valuation is stronger in weaker legal regimes.

Good corporate governance is valued higher where it is scarce

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1. 2.Standard&Poor’s

Governance Scores

CLSA has lost quite a bit of corporate financebusiness. with companies that were assigned the worst corporate governance scores and that.

CLSA may stop compiling the scores.

- South China Morning Post: Hong Kong; Nov 2, 2001

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CLSA Corporate Governance Scores in 2000

494 companies across 24 emerging marketsBased on 57 questions in 7 categories

Managerial Discipline (0-100)E.g., incentives towards a higher share price

Transparency (0-100)E.g., timely release of annual reports

Board Independence (0-100)E.g., Chairman who is independent from management

Board Accountability (0-100)E.g., foreign nationals are present on the board

Responsibility (0-100)E.g., share trading by managers is transparent

Fairness (minority shareholders protection), PROTECT, (0-100)

Measures to protect minority shareholdersComposite score, COMP, (0-90)

Social awareness (0-100)child labor practices, political legitimacy, environmental responsibility,

equal opportunity employment policy

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S&P Transparency Ranking in 2000573 companies across 16 emerging markets and 3

developed countries

Transparency and disclosure Ownership structure and investor relations (0-22)

Financial transparency and information disclosure (0-34)

Board and management structure and process (0-35)

Aggregate, TRAN, (0-91)

Comparing across the two data sets

CLSA = 0.16S&P + country and industry dummies

[0.05]

Governance scores

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How reliable are CLSA scores? Is it just legal environment + noise?Look for governance scandals for 84 firms from 14 countries with at least 11 firmsLexis-Nexis, news search

• assets expropriation, accounting misreporting, share dilution, insider trading, undertaking illegal projects

• manually checked 29,320 articles• 49 scandals

Correlation between CLSA’s COMP and SCAND is -0.36 (p-val = 0.00)

Control for legal environment, # of newspapers per capita (NEWS), and media attention(TOTAL)

SCAND = -0.017 COMP – 0.015 LEGAL + 0.017 * NEWS + 0.088 TOTAL

Governance scandals

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Firms with more profitable investment opportunities and greater reliance on external financing practice higher quality governance and the relations are stronger in weaker legal regimes

*** significant at 1%** 5%* 10% 

CORP GOV INV OPP EXT F IN LEGAL INV OPP LEGAL EXT F IN LEGAL

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1 2 1 2 3

1 1

1

CLSA COMPOSITE CLSA PROTECT CLSA SOCIAL S&P TRAN

INV_OPP 14.089*** 21.270** 6.421 35.737***EXT_FIN 4.363* 16.223*** -9.900* 9.154LEGAL 0.490*** 1.013*** -0.091 0.352***INV_OPP* LEGAL -0.525*** -0.579* -0.466 -1.125***EXT_FIN* LEGAL -0.083 -0.443** 0.258 -0.302

SIZE 0.879* -3.325*** 1.137 1.235***R&D 19.874 -22.812 139.853** 12.503EXPORT -6.240* 0.943 9.981 -13.629***ADR DUMMY 6.668*** 2.576 2.142 0.553CONSOL. DUMMY 6.420*** 4.333 -12.992*** 3.653**

R 2 24.00% 22.40% 13.70% 23.10%Number of Companies 439344

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Firms with more concentrated cash flow ownership practice higher quality of governance and the relation is stronger in weaker legal regimes

CLSA COMPOSITE CLSA PROTECT CLSA SOCIAL S&P TRAN

OWN_CASH 0.575** 1.691*** -0.595 0.192(OWN_CASH)^2 -0.005** -0.015*** 0.005 -0.001WEDGE -0.829 -8.640* 1.371 -0.803LEGAL 0.864*** 1.447*** -0.220 0.599***OWN_CASH* LEGAL -0.010 -0.030* -0.017 -0.005

SIZE 1.085 -1.973 1.804 0.411R&D -92.774 -546.453 -71.505 22.817EXPORT -0.388 13.545 6.594 -24.857***ADR DUMMY 4.515 -8.561 11.907 -1.962CONSOL. DUMMY 2.442 4.567 -8.333 0.238

R 2 44.20% 32.60% 11.80% 34.40%Companies 240173

*** significant at 1%** 5%* 10%

CORP GOV OWN CASH OWN CASH WEDGE LEGAL

OWN CASH LEGAL Z d

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k k jc

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Firms with better of governance are valued higher and the relation is stronger in weaker legal regimes

*** significant at 1%** 5%* 10% 

CORPORATE GOV 1.950* 1.711** 0.436 0.905**LEGAL 0.010 0.005 0.001 0.016CORP.GOV.* LEGAL -0.026* -0.012 0.030 -0.006***

INV_OPP 0.820*** 0.840*** 0.888** 0.843***SIZE -0.104** -0.074 -0.098*** -0.113***R&D 5.711* 6.371* 4.292 5.071***EXPORT 1.795*** 1.629*** 1.479*** 1.226***ADR DUMMY -0.137 -0.081 -0.044 -0.037CONSOL. DUMMY -0.513*** -0.422*** -0.228 0.104R 2 34.40% 32.80% 36.10% 28.20%Companies 438344

CLSA COMPOSITE CLSA SOCIAL

Q CORP GOV LEGAL CORP GOV LEGAL Z djc

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CLSA PROTECT S&P TRAN

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Economic significance

On average, a one standard deviation increase in CLSA composite score increases Q by 9%

the relation between corporate governance and performance is stronger in weaker legal regime countries

Mexico, LEGAL = 1 (de jure) * 3.33 (enforcement) =

3.33 increase in Q is 13.2%

Hong Kong, LEGAL = 5 (de jure) * 8.33 (enforcement) =

41.65 increase in Q is 4.6%

May explain the previous mixed findings on U.S. data

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Policy implicationsFor policymakers to give the controlling shareholders greater incentives to improve

governance practices• pro-growth policies vs. re-distributive policies

Convergence in governance with increasing globalization of trade, national boundaries and

legal structures become less effective in defining corporate policy any debate over convergence must also consider firm-specific

factors

Social awareness is neither related to firm-specific factors, nor is it valued by investors.