Corporate Governance 2001: New rules of good behaviour

Methodology

Emerging market company respondents

Developed market company respondents

Top 25 in Asia

Troika Dialog profiles of Russian companies

For some hard-bitten corporate executives and the more cynical investors, the concept of corporate governance is doubtless too nebulous and idealistic to bother with. But for many it has acquired sufficient substance to serve as a kind of benchmark for how well, or badly, companies are run, and thus to influence global investment decisions.

Corporate governance became a hot topic from 1998 on in the aftermath of the Asian economic crisis. At first, the discussion was primarily in the public policy and activist realm. But the OECD, the World Bank, the International Corporate Governance Network (ICGN) and numerous regional and national committees have now opened up the debate globally.

An international standard of corporate governance was produced in May 1999 when OECD ministers adopted five fundamental principles, covering the rights of the shareholder, the equitable treatment of shareholders, the role of stakeholders, disclosure and transparency, and the responsibilities of the board. These principles have become one of the 12 international financial stability standards along with the Basle accords, international accounting standards and so on.

“Everybody now recognizes the importance of benchmarking their efforts to a global benchmark,” says Stilpon Nestor, the OECD’s head of corporate affairs. “People argued that corporate governance was local and cultural, now nobody puts these arguments forward any more. Everybody now recognizes the cost of bad corporate governance.”

It’s one thing to proclaim good corporate governance, another actually to deliver it. Many want to be branded as corporate governance good guys. Eugene Shvidler, president and chief executive of Russian oil company Sibneft, one of the converts, says: “As capital markets become increasingly competitive, companies which practise sound corporate governance will have a strong competitive advantage over other companies which have failed to understand its importance. This is especially true of emerging markets such as Russia, where investors are already exposed to risk in a wide variety of forms, and they do not want to have to worry about company risk on top of everything else.”

No country lacks corporate governance horror stories, even the US, which lays down the strictest standards. Instilling corporate governance practice is a matter of raising overall standards, but for these to stick the market needs to get interested and actively involved. There are signs of this happening.

“In the beginning,” says Nestor, “corporate governance was a public policy concern about the stability of the global financial system. And now this is changing and the impetus

is moving back towards the markets, as it should be. There is more and more market activity related to corporate governance, focusing, identifying and pricing corporate governance risk.”

Crises provide the impetus

Financial crises have driven much of the change of heart on corporate governance.

In east Asia countries, for example, heady growth took place in an environment where good practice was often disregarded. South Korea’s chaebol (conglomerate) structure breaks nearly every principle of corporate governance, from lack of transparency to opaque cross-holdings, yet it was an engine of growth for nearly 30 years. Change comes when times are hard.

“If anything the emerging-market crises of the late 1990s spurred a lot of people’s attention towards emerging markets and the huge gaps in governance there,” says George Dallas, managing director of Standard and Poor’s Governance and Advisory Services. In 1998 Standard and Poor’s began work on a product to rate corporate governance among companies in emerging markets. The trial started in Russia.

Russia’s path to better governance was curious. “Russia privatized 15,000 companies in two years, some 80% of the industrial economy, without setting up all the procedures, regulations, and enforcement regulations most countries have,” points out William Browder, managing director at Hermitage Capital Management, a Russia-focused investment firm.

Yet Russia did not wholeheartedly commit itself to reform until the oligarchs had carved this huge empire up between themselves and given the sprawling economy some form. “Partly it has got better in Russia because the assets have been distributed, there are no loose assets to go for as there were in the mid to late 1990s,” says Christopher Weafer, head of research at Troika Dialog.

Concepts such as corporate governance are undeniably western. But they are having a wide impact on the cultures of companies, even family-controlled businesses in Latin America or Asia.

“There is a wave of people returning from the US, or France or wherever with MBAs who bring with them great corporate management attitudes, and that’s had an effect in some markets,” says Tim Leask, a client portfolio manager with JP Morgan Asset Management.

One notable example is Jung-Tae Kim, chief executive of H&CB bank of South Korea, which tops Euromoney’s corporate governance ranking (see page 50). His first step at the bank in 1998 was to pay himself one won a month in salary in exchange for stock options. He shocked the country’s traditionally secretive banking community by admitting the existence of bad debts that pushed the bank into a loss in his first year. Despite this, the bank’s share price rose 12-fold in that first year.

Kim says: “I was lucky in a way in that I took over the position of CEO during the Asian financial crisis, and at a time when people were asking if the bank would survive. I also had the considerable advantage of having looked at Korean banks from the outside and being able to distinguish the wood from the trees. So I was very clear in what I wanted to do and the bank management was in a mood to embrace change. So some of the first things we did – such as separate the board and management – were readily accepted and, in most cases, enthusiastically adopted.”

Other reforms took longer to implement. “For example, I have been pushing for very transparent reporting so that management knows exactly how much money is being made by each unit of the bank,” says

Kim. “Although we have made significant improvements over the past three years, the numbers were never completely transparent until we introduced a new tool in the form

of Raroc [risk adjusted return on capital] which makes management reporting truly transparent.

“Another element of corporate governance is performance-based pay and promotion. Although this was something I wanted to implement as soon as I joined the bank, it has taken three years to phase it in because it required a complete change in mindset of several thousand people. But I would rather implement it this way and have it accepted than implement it rapidly and have it rejected.”

Shareholder activism within emerging markets is increasing. David Webb, editor of the Webb-site.com, sets out to expose malpractice and is pressuring the Hong Kong government to set up a Hong Kong Association of Minority Shareholders (Hams). This would lobby for legal reforms, mount quasi-class action suits on behalf of shareholders, and score companies on corporate governance performance.

Activism spreads

In South Korea the outspoken professor Jang-Ha Sung has established a civic action group called the People’s Solidarity for Participatory Democracy (PSPD). And in Singapore David Gerald, a former government prosecutor, formed the Securities Investors Association (Singapore) which boasts 52,000 members.

Meanwhile, in Brazil, where the local institutional investors have been privatized, many are copying activists overseas.

In India the Investment Information and Credit Rating Service is soon to launch India’s first ratings, based on the OECD’s governance principles, in association with Moody’s Investors Service. The South Korean ministry of finance and economy has recently introduced a similar system and it intends to institute a corporate governance reform committee. And last September the Russian Federal Securities Commission, the stock market watchdog, agreed to produce a full guide.

It is not just in the realm of policy that governments are behaving differently. A year ago Malaysia paid scant regard to minority shareholders during the government’s buy-out of Malaysian Airline System (MAS). But

a recent government offer for United Engineers Malaysia (UEM) is paying them due attention.

It was of course Malaysia that bemused international investors when it froze capital withdrawals at the height of the Asia crisis. This marked a direct attack on the free movement of capital, perhaps the greatest force driving improvements in international corporate governance,

With increasing globalization there is a fiercer competition for capital between companies. It is not surprising then that the companies that now appear to be paying the most attention to corporate governance are among those that are hungriest for investment capital. VimpelCom, one of Russia’s two major wireless providers, is a good example.

VimpelCom went first for a listing in New York in 1996, which raised the level of disclosure and accounting that the company had to institute. Then it got a major investment from Norwegian telecom operator Telenor. “When Telenor became an investor they raised the bar for corporate governance,” agrees Maurice Worsfold, chief financial officer of VimpelCom.

And it is not just capital that speeds around the globe but also information. “The penalty functions associated with doing something that is outside normal market practice are becoming by the day higher and higher,” says George Handjinicolaou, Merrill Lynch’s head of global debt emerging markets.

The impediments

Even so progress is not inevitable and results are still patchy. Nestor at the OECD identifies several obstacles. First are vested interests that have thrived on the lack of transparency and accountability. These can take the form of small groups of rich families that exercise power through controlling interests or they can be state bureaucrats incumbent on boards. “These people are powerful and they don’t want things to change,” he warns.

Recent attacks on the independence of equity analysts raise the question of who will blow the whistle on these transgressors. Webb says bluntly, “too many fund managers are linked with commercial or investment banks and it is not good business to criticise corporate clients”. Even those that are independent worry about their access to information flow because family-controlled and state-controlled companies are often secretive. Hence analysts need to keep good relations so as to get more information from company visits.

As Ed Baker, CEO of Alliance Capital Limited, argues, “Unfortunately bad managements are still able to get capital. But if investors were willing to say I am not going to invest in your company if you do the following or you don’t do the following, I think it would make a difference.”

Last June, consultancy group McKinsey&Co published a report on a number of investor surveys it had carried out in co-operation with the World Bank and Institutional Investor’s regional institutes. Among the results they highlighted was that board practices are at least as important to investors as financial performance when evaluating a company. And more that 80% of investors said they would pay more for the shares of a well-governed company than for those of a poorly governed company with comparable results. Although the premium investors said they would pay for well-governed companies varied according to the standards of the country, it still ranged from 18% in the UK to 22% in Italy and up to 27% in Venezuela or Indonesia.

Hugh Young, managing director at Aberdeen Asset Management, believes investors only pay lip service to corporate governance. “If they can be persuaded that this company is totally appalling, but the price is going to go from one dollar to two dollars, they buy”, he says.

Regional emerging market funds have led the corporate governance challenge, and when and if local investors join them then they will exhibit real strength. But investors, traders and speculators know they don’t get paid for going on crusades and a corporate governance tussle just means they will sell.

Alliance Capital’s Baker says: “We will talk to management, we’ll let them know our opinions, but if they do things that disappoint us we are not going to hold on and play an active role in trying to change the board composition or trying to change board practices. It is just too difficult.” He adds: “In many emerging markets there is nothing you can do, except sell your shares.”

It remains to be seen whether a falling share price is sufficient punishment for bad corporate governance to induce improvements. Shvidler at Sibneft says: “Companies need incentives to improve their corporate governance performance. They have a carrot in the shape of cheaper access to capital, but they also need a stick in the form of penalties for a failure to meet minimum standards.”

It’s at the macro level that the downside of bad corporate governance is clear. There is a vicious cycle – funds that place a greater emphasis on corporate governance may shun an entire market since they don’t see it as their role to battle to get good practice imposed.

Putting the onus on investors

Webb identifies the proliferation of index funds as one potentially limiting factor on shareholder activism. Even active managers who measure themselves relative to their peer groups may have little incentive to agitate for corporate governance. He says: “If you are just looking at relative performance then you don’t mind that the overall market is dragged down by poor corporate governance. You are all going to be pedalling into the same headwinds.”

Rodrigo Trevino, chief financial officer at Mexican cement company Cemex, lectures investors about this. “If you don’t vote with your money and you are willing to invest money in a company that doesn’t have good corporate governance, just because you have liquidity and just because you have to invest in a specific sector or in a specific country, then you are responsible for slowing the process towards corporate governance.

“We would like investors to discriminate or put an increasing weight on good corporate governance versus not as good corporate governance. We don’t think that has happened,” says Trevino.

One interesting development has been the creation of the Novo Mercado in Brazil, a new market for companies that agree to abide by good corporate governance principles. The most significant distinction between it and the main market is that Novo Mercado companies may not issue non-voting shares. But for the moment the Novo Mercado has attracted more media attention than interest from companies seeking to list.

Hot spots

As a market, Russia provides probably the best example of what corporate governance advances can achieve for companies, and the tremendous cost of bad corporate governance.

Leask cites the example of Yukos “which about 18 months ago investors simply weren’t interested in.” He continues: “The oligarch who runs the company has over the last 12 months introduced proper accounting, reporting and really tried to revamp the corporate governance image. It is also perceived that the company talks. As a result of that its share price has quadrupled in the past 12 months.”

Last January, in a study for the World Economic Forum, Troika Dialog suggested that Russian firms would be worth a total of $50 billion more if they were based in another eastern European or EMEA country.

And Nestor gives credence to a study that argues that there would be a sevenfold increase in company values if corporate governance issues were addressed properly in the country.

For the Russian government, which owns large amounts of this equity, this a multi-billion-dollar incentive to get corporate governance right. Browder says: “The most important developments for corporate governance in Russia are that certain majority shareholders are starting to see that they can make more money by having a stock that trades at 10 times earning than stealing that year’s earnings.”

Still, Weafer warns: “Russian accounting standards (RAS) differ quite a bit from international accounting standards and US GAAP and it offers a great deal of scope for companies to play with cashflows and with their asset valuations. That is an area that we identify where there could potentially be the next phase of corporate governance abuse.”

At Value Partners Limited in Hong Kong, Renee Hung, assistant fund manager, believes that China has been improving the professionalism of its corporate governance. For example many people had seen a mismatch in Chinese companies, where managers had been managing companies worth billions of dollars on a salary of only a few thousand dollars. “But now we can see more and more Chinese companies have incentive schemes putting the management on the same grounds as the minority shareholders.”

Even so Nestor warns: “in places like China, this enormous new market is largely retail based which makes it very fickle and very unreliable as a lever of improving corporate governance in local markets.”

Yet improving corporate governance should be what the capital markets do by their very nature. After all, corporate governance is about aligning the interests of management with that of shareholders. Good corporate governance behaviour and determination to create shareholder value are intertwined. It is now for the market to exhibit to governments and companies that it can measure and rate corporate governance to its own satisfaction.

Jung-Tae Kim CEO at H&CB says: “One trend we are seeing in Korea is the demand by foreign investors for a guarantee that management has the same aims as investors do – the maximization of value. Given the losses that many investors have suffered in Asia through investing in poorly governed companies, I believe that the premium for well-governed companies will increase. And no CEO likes to see his stock trading at a discount.”

He adds: “In the end, the main challenges in implementing corporate governance lie in changing the way people think and act. The flip side of that, of course, is that once good governance is implemented, it doesn’t go backwards.”