Many emerging-market companies are making concerted efforts to improve levels of transparency and disclosure to shareholders. Prashant Rao looks at how regulators and supranational agencies are helping to promote better corporate governance, and Euromoney reveals the best companies in the field across emerging markets. Research by Paul Pedzinski.
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IN NOVEMBER 1864, Abraham Lincoln wrote: “I see in the future a crisis approaching that unnerves me and causes me to tremble for the safety of my country… Corporations have been enthroned and an era of corruption in high places will follow… God grant that my suspicions may prove groundless.” Nearly 140 years later, Lincoln’s statement seems scarily prophetic, with scandals at Enron and WorldCom in the US and Parmalat in Europe having shaken investor confidence, the last of which revealed a €4 billion hole in the Italian company’s accounts, the biggest European corporate scandal to date.
Since then corporate governance has shot up the list of priorities for investors that seek assurances of how transparent a company is and how independent its board is. It plays an even bigger role, some say, in emerging markets, where under-resourced regulators are often trying to enforce inadequate laws, and minority shareholders need reassuring that their interests will be preserved.
“The further one gets from London or New York, the more corporate governance is a deal breaker, in the sense that the risk from the investor’s side is much higher,” says Stilpon Nestor, founder of Nestor Advisors, a corporate governance consultancy. “There is a much higher premium for companies with good corporate governance in emerging markets than in developed ones.”
The premium that Nestor mentions means that companies in emerging markets must work hard to win the trust of investors, some of whom refuse to invest in entire countries because of a lack of confidence in the corporate governance infrastructure.
The California Public Employees’ Retirement System, the biggest public pension fund in the US, with assets in excess of $182 billion, is one such example, and has been operating a permissible countries list for its emerging-markets equities team since 1989.
The list, comprising 27 countries, is reviewed annually on the basis of factors including political stability, transparency and labour market practices. Thailand and Sri Lanka were added this year. Calpers fund managers, which operate $3.9 billion in countries on the list, are not permitted to invest in any company based in a country not on it.
Not everybody in the industry believes that Calpers’ approach is the right one. “When Calpers announced its approach, it was unprecedented. In practice, you will find some countries just don’t get into some portfolios, but not on the basis of a list,” said Karina Litvack, head of governance and socially responsible investment at F&C Asset Management.
“It’s essential to look at governance practices when looking at emerging-market stocks,” she says. “But I wouldn’t necessarily rule out entire countries, because there may be individual companies that could be worthy of investment for a variety of reasons.”
George Dallas, global practice leader of corporate governance at Standard & Poor’s, characterizes the Calpers approach as “tarring everybody with the same brush… a crude brush.” He continues: “In our view, you need to do your homework on every company, and every company is case specific. What you miss is the opportunity to isolate companies that may be trying to do things the right way.
“Some investors find it to their advantage to seek out situations where specific companies might transcend national corporate governance weaknesses. It’s important, if not essential, to understand the country the company is operating in, but you should not constrain your assessment to the country.”
According to a Calpers spokesperson, the fund began using the list to “reduce risk to our portfolio, to safeguard our investments as much as possible”. The spokesperson also said that the fund lacked the resources to carry out case-by-case analysis and, therefore, country evaluations were “the next best thing”.
Indeed, the infrastructure built by a national government, as well as the means of enforcing any legislation that demands responsible corporate decision-making and transparency is itself an integral issue in the evaluation of the potential of a company based in an emerging market.
The European Bank for Reconstruction and Development will publish a report in November investigating abuse of shareholder rights in 26 former communist states in eastern Europe and central Asia.
The bank, by approaching local legal practitioners, attempts to chart how long it would take for a hypothetical 24% minority shareholder in an unlisted company to obtain documents pertaining to related party transactions in each of those countries by using the local judicial system.
Related party transactions are business deals between two parties that are related prior to the deal. US-listed companies are required to disclose all transactions with related parties in their annual reports. Although the majority of such transactions are benign, they present an inherent conflict of interest, where the priorities of the parties involved and the company’s shareholders diverge.
Legislation and application According to Michel Nussbaumer, head of the legal transition team at the EBRD, the results show a major discrepancy between the quality of a country’s corporate governance legislation and its application.
“It’s easy to pass a new law, but that’s only half of the story,” Nussbaumer says. “Changing mentalities takes more time. Some countries do have good legislation on the books, but when it comes to practice, it just doesn’t work well. It’s slow, complex and expensive.”
Estonia’s legislation, for example, is classified by the bank as having “high compliance” with OECD principles, regarded by many as the standard for corporate governance, in a report published earlier this year.
The EBRD report notes that it takes more than two years for a minority shareholder to obtain any information on a related-party transaction. It also notes that local practitioners find Estonia’s legislation particularly complex and cumbersome and enforceability is found to be a “substantial obstacle”.
Russia is listed as having “very high compliance” with OECD principles on corporate governance, but there appears to be some disconnect in the country in terms of the actual application of regulations.
“The Russian SEC doesn’t have a credible ability to punish wrong-doers,” says William Browder, CEO of the Hermitage Fund, which has $2 billion invested in the country. “The maximum fine that can be charged by the Russian SEC is a few thousand dollars.”
The survey concludes by stating that “reforms especially dedicated to judicial capacity and institution building should be implemented throughout the EBRD region if speed, enforceability, institutional environment and overall effectiveness of corporate governance are to improve.”
The OECD itself runs regional roundtables where companies and countries can exchange best practices. Daniel Blume, an expert on corporate governance at the OECD, finds the same discrepancy.
“In all regions, what we’ve found is that countries have a good legal and regulatory framework. They know what they have to do,” he says. “But it’s much more difficult on the enforcement side. It’s an ongoing struggle to achieve the level of enforcement necessary when you have courts that don’t function very quickly and governments that don’t have the resources.”
If dealing with poor and novice bureaucracies at home wasn’t enough for companies incorporated in emerging markets, several of them with plans to list in the US are now reconsidering because the costs of the Sarbanes-Oxley Act look likely to outweigh the potential benefits.
Corporación GEO, a Mexican construction company that ranked third in Euromoney’s emerging market corporate governance survey, has held internal discussions about a possible flotation in the US.
According to Eduardo Muniz, GEO’s investor relations manager, cost-benefit analyses have, however, shown that the costs incurred because of Sarbanes-Oxley would mean that it would not be beneficial for the company to list in the US, at least for now.
“A number of companies have talked about the onerous nature of Sarbanes-Oxley,” says Devan Kaloo, head of global emerging markets at Aberdeen Asset Management. “At the end of the day, though, the biggest pool of cash is in the US. Foreign companies will make attempts to rise to those standards.”
The legislation, introduced in 2002 in response to the scandals at Enron and WorldCom, applies the principle of extra-territoriality to US SEC regulations, meaning that any US-listed company must comply with American regulatory standards, regardless of where it is incorporated.
“In itself, Sarbanes-Oxley has some useful advice within it. The difficulty is the costs of demonstrating compliance with it,” says Colin Melvin, head of corporate governance at Hermes Asset Management. “Self-regulatory practices in Europe are seen as more business-friendly.”
It is that supposedly business-friendly regulatory environment, particularly in the UK, that has drawn criticism. Observers claim that post-Sarbanes-Oxley, more emerging-market companies will decide to list on the London Stock Exchange (LSE) instead of on its New York counterpart.
F&C’s Litvack believes that UK regulator the Financial Services Authority needs to increase the requirements for non-UK companies listed on the LSE to ensure good corporate governance.
“There are some additional constraints that apply to UK companies that don’t apply to foreign companies,” she says. “The Combined Code is something UK companies are expected to live up to, but we don’t get to have that level of governance in foreign companies. I take the view that if you come to London and seek capital, then you should uphold the same standards of disclosure and accountability. In actual fact, non-UK companies are not held to the same demanding standards as UK companies.”
According to Simon Gleeson, a partner in the regulatory group at law firm Allen & Overy, a company incorporated in an overseas country but listed on the LSE has to comply with certain requirements set by the FSA, but does not need to comply with UK company law.
“You can get, and frequently do get, companies listed in London that are incorporated in other places,” says Gleeson. “The company laws in some of those places do not tend to contain an awful lot of investor protections. In the old days, everybody worked on the simplified assumption that everything that would be listed on the LSE would be an English company. That’s no longer the case.”
Standards A spokesperson for the FSA disputed Litvack’s assertion, saying: “The disclosures that are applied to a company listing on the LSE are quite a high standard. We’re not responsible for corporate governance or its enforcement.”
A spokesperson for the Financial Reporting Council, the UK’s independent regulator of corporate reporting and governance, noted that while foreign-incorporated companies are not required to abide by the Combined Code, they are required to make a disclosure stating they are following “roughly similar practices”.
Jonathan Herbst, a partner at law firm Norton Rose, disagrees with Litvack, saying that the difference in approach is mirrored by a difference of perspective. “We have a less micro-managed approach in the UK,” he says. “There’s more flexibility for issuers. What conclusion you draw from that is a matter of opinion.”
What isn’t in doubt is the impact that good or bad corporate governance can have on a company’s share price. In January this year, for example, the SEC filed civil fraud charges against TV Azteca, a Mexican media company, and its chairman, Ricardo Salinas Pliego, alleging that Salinas Pliego reaped $109 million in related-party transactions completed in June 2003.
TV Azteca, according to one analyst, forms one half of the best example of corporate governance being priced into a share price, when compared with its competitor Grupo Televisa, the largest media company in the Spanish-speaking world.
In the past two years, in addition to the SEC filing against it, TV Azteca has seen the resignation of two board members, has had a fine of $2.3 million imposed on it by the Mexican Securities Exchange Commission, the CNBV, and has removed its US listing.
Two independent board members resigned in May of last year, four months after they, along with three other independent board members, launched an investigation of the related-party transaction that the SEC alleges made $109 million for Salinas Pliego.
This May, Salinas Pliego said that he wished to delist TV Azteca from the New York Stock Exchange.
The consistent flow of negative news for TV Azteca has been primarily responsible for a drop in its share price of 6.4% since the start of the year, compared with a rise of 8.8% for Grupo Televisa.
The chaos at TV Azteca contrasts with GEO, which one analyst characterizes as a “great story.”
GEO’s Muniz attributes the company’s strong corporate governance to the independence of its board and the power of its committees. All board-level committees in the company are chaired by an independent director, and of the 13 members of the board, four were independent members at the end of 2004, higher than the 25% prescribed by the CNBV as best practice.
It also adopted so-called tag-along rights before they were imposed by way of regulation in Mexico. Tag-along rights allow shareholders the opportunity to sell their stock, in the event of a takeover of the company, at the price quoted by the acquirer.
It is examples like GEO that illustrate the potential locked within emerging-market companies to uphold strong principles of corporate governance.
“What we’re seeing are companies that are attempting, in the best of spirits, to make policy and structural changes,” says S&P’s Dallas. “That’s moving in the right direction, but just because you’re on the right path doesn’t mean you’re there yet.”
