Round table: The importance of being honest

US accounting scandals have done nothing to help the cause of better corporate governance in emerging markets. Despite the lack of a role model, corporate standards in developing countries are improving slowly – through better transparency, disclosure and accountability. And it is clear that investors and financial markets are starting to reward companies that have improved their governance – in Korea, Russia, India and elsewhere. But there is a long way still to go. To analyze what more needs to be done and how progress should best be monitored, Global Agenda asked a selection of experts in these and other emerging markets – investors, analysts, stock exchange regulators and academics – for their views –

GLOBAL AGENDA What is your definition of corporate governance?

HASUNG JANG Corporate governance is a system to ensure that management works in the best interests of all shareholders. Two fundamental pillars of good corporate governance are transparency and accountability.

MARK MOBIUS Corporate governance is simply fair play. It means that the management and controlling shareholders give fair treatment to all shareholders regardless of how small.

RAVI NARAIN Corporate governance is about conducting business in a fair, ethical and transparent manner within the ambit of regulatory requirements. The main thrust should be to protect the interest of the stakeholders including the shareholders, creditors and employees; to ensure there is no conflict of interest; and to ensure that adequate information is in the public domain at all times to ensure a fair and equitable valuation of the company.

GA How relevant is corporate governance to the future of emerging markets?

MOBIUS It is very relevant to the future of emerging markets since a lack of fair treatment of shareholders in emerging markets will result in a drying up of those markets. Investors, both local and foreign, will not invest in companies where they are consistently being cheated by controlling shareholders or management.

AMAR GILL It is extremely important. Investors need to be reassured that the economic value created by emerging market companies is shared equally, or it will not be worth their while to invest.

BILL BROWDER Corporate governance is the single biggest issue depressing valuations of Russian companies. In spite of positive press articles about a few specific companies, the general situation is still quite grim in Russia.

To put it in perspective, the Russian stock market is still one of the world’s cheapest stock markets, with a price/earnings ratio of 6.9, in spite of some of the best macroeconomic fundamentals in the world. This is particularly harmful to Russian companies because it makes the equity markets an unattractive place for companies to go for financing and it cuts off an important source of foreign investment.

NARAIN Corporate governance is relevant to all markets, as recent US experience has shown. However, for emerging markets it is even more important to adopt best practices in this area as these markets are in vigorous competition with other such markets for global capital. Companies that follow good governance practices increasingly will be priced globally while others will be priced locally.

GA What have emerging markets learnt from recent events in the US, in particular Enron and WorldCom?

MOBIUS The key lesson is that good corporate governance is not a monopoly of so-called developed markets and that all investors must be constantly aware of the potential dangers arising from faulty accounting practices and poor management.

JANG The events indicated that when there is no watchdog, US managers are no different from Korean managers in stealing minority shareholders’ money. It also confirmed that it is not a difference in culture or in human nature. Regulation and its enforcement make the difference.

BROWDER The US scandals have been bad news for emerging markets because there is now no proper role model for how companies and regulators should behave in emerging markets. It is very frustrating to hear Russian CEOs and government officials saying “everything is fine here” and “what is everybody complaining about in Russia? Look at the US”.

In the past there was always the feeling that there was a proper example for everyone to follow. That is why it will be crucial for both developed and emerging markets that the US comes up with rigid and well-grounded corporate governance practices.

DAVID GAIT To quote Warren Buffett: “Only when the tide goes out is it possible to see who is swimming naked.” The tide has gone out several times over the past few years in emerging markets, most notably during the Asian financial crisis of 1997-1998.

As a result many emerging markets have already seen the fallout, and learnt lessons from, their own Enrons and WorldComs, be it Daewoo, Hyundai or Sinar Mas. That said, the recently exposed vulnerability of corporate America has gone some way to help remove an inferiority complex that developed in the wake of the Asian crisis.

GILL Probably the wrong lessons – that corporate governance can be a big issue even with the largest US companies; and so it is disingenuous for investors to make comments about corporate governance in emerging markets as if it was particularly an issue for them.

Also the kinds of problems that destroyed large US companies may be seen as resulting from the fact that significant shareholders were not ultimately in charge of running the company and so management could hijack value in the form of options and by inflating short-term financials.

So there are advantages to having family-controlled companies that had not been fully appreciated.

NARAIN Clearly, everyone realizes and appreciates that what happened in the US is not a one-off case and that this could be repeated across various financial markets. The real lesson may be that this has to be a continuous exercise.

GA How can the interests of the controlling shareholders of family and state-controlled businesses be aligned to those of minority shareholders?

MOBIUS Through clear incentives for good corporate governance: transparency, having one class of shares where all shareholders have a vote, no golden shares, minority shareholder representation on the board of directors and severe punishments for false accounting.

BROWDER As long as there are improving economic conditions in Russia, we will continue to see an alignment of interests between private-sector majority shareholders and minority shareholders.

A good example of this is Yukos, an oil company that is owned by a prominent young billionaire, Mikhail Khordorkovsky. The more he behaves himself, the richer he gets on the stock market valuation of his company. The problem we have in Russia is with companies that are majority state owned, where the managers don’t have the same sets of motivations as private shareholders. In these cases, the managers often flagrantly disregard minority shareholders to pursue other agendas. In these cases, since the carrot doesn’t work, you need the stick, and for investors that stick has to be shareholder activism.

GILL For controlling family shareholders it is quite simple. As long as the value of what is held in the public listed company is higher than the interests owned privately, these controlling shareholders will be more concerned about their listed companies. Their interests are thus aligned with minorities (for example Li Ka-shing, or the Kadoorie family and so on).

But when the value of what the family owns in the listed company is less than the private interests, the controlling shareholders will naturally give a higher priority to the private interests. Similarly for government-controlled entities, the political interests of the government will almost always have a higher priority over the returns of privatized entities – and there is little that can change this permanently when the regulators and board appointments are in the hands of the government.

NARAIN In the case of a public listed company I believe that there should be no distinction between controlling shareholders, state-owned businesses or professionally managed companies. Once the company is listed, all shareholders should have equal rights, and information should be available to all the shareholders, whether they are controlling or minority shareholders.

The company cannot enjoy the benefits of listing and liquidity without it being transparent in its policies to the other shareholders. Institutional investors should be called on to play a more proactive role in the management of companies where they have a substantial shareholding.

Since minority shareholders neither possess the expertise nor substantial voting power, the institutional investors must take into account the interest of the minority shareholders. Institutional investors should keep this in mind when voting on resolutions particularly those involving buy-backs, schemes of amalgamation, takeovers, bonus issues and delistings from stock exchanges.

GAIT Financial regulation still often leaves much to be desired, while legislative protection for minorities is at a relatively undeveloped stage. Hostile takeover bids aimed at improving the lot of non-family shareholders are extremely rare. Thus minority investors are very much in the hands of the majority shareholder, be it a family or the state.

Good corporate governance is most likely to occur where the interests of professional management are aligned with those of minority shareholders. Ideally, professional managers will own company stock in their own right. Options are a step in the right direction but we prefer managers to own shares, as they are more effective in focusing executives’ attention on the downside risk as well as on the upside potential of their decisions.

JANG It would be against market principles to apply direct regulation on family ownership. However, if voting rights are not aligned with cashflow rights, as is the case in many emerging market companies, there should be regulations limiting the controlling family’s voting rights on issues that may have conflicts of interest. Another way to improve ownership structure is to impose diversity of ownership as a part of listing requirements.

GA What more can multilateral organizations such as the IMF and World Bank do to encourage corporate governance reform?

BROWDER I am always amazed at how much time and effort the multilaterals put into the theory of corporate governance without spending anything on useful implementation.

The problem in Russia is not a lack of recognition of the problem but a shortage of anyone willing to do anything about the abuses when they come up. I remember seeing 200 people attending an OECD/World Bank forum on corporate governance that must have cost the participants $500,000 in aggregate to attend.

Afterwards, it was hard to see any tangible benefit in improved corporate governance. I did the maths and if even 10% of the $500,000 had been spent on suing one of the many corporate governance abusers in a Russian court, it would have had a dramatically greater impact on corporate governance than all the theoretical talk that took place at the conference.

GAIT Although multilateral organizations are in a good position to emphasize to governments and institutions the importance of good corporate governance, it is ultimately up to investors themselves to persuade companies of the benefits.

GILL I do not expect much from the multilateral organizations. They might introduce cosmetic regulatory changes but these might then become notable for being breached rather than adhered to.

What is more important is a minimum set of standards to which international funds commit themselves. These can be shown to company managements to spell out the kinds of corporate practices that would prevent the funds from owning any shares in such companies. For example, if there is no audit committee, or if at least one-third of the board is not made up of independent directors nominated by minority shareholders.

JANG The IMF should adopt corporate governance as a part of the conditions on its rescue loans for troubled countries. The World Bank should also impose certain conditions on its investments and loans that might ensure good corporate governance.

The IMF’s prescriptions are focused too much on short-term controversial macroeconomic issues, neglecting microeconomic structural policy such as corporate governance. The IMF and World Bank should also provide more technical loans or assistance and research grants to help develop country-specific corporate governance systems in emerging markets.

MOBIUS The IMF and World Bank should institute programmes in emerging markets. These should have three aims:

to establish a fair and just legal system so that the presence of corrupt judges is eliminated, everyone has a right to a fair trial, and complainants can band together to have class-action lawsuits; to establish stock and bond exchange regulations that ensure protection of shareholders with all the recommendations as set forth in the OECD guidelines; and to give loans only to countries that encourage an active and transparent capital market for shares and bonds. NARAIN The multilateral agencies can be useful in encouraging the flow of knowledge and information of internationally accepted best practices across markets.

GA What more could/should equity investors and bondholders do to improve corporate governance?

BROWDER The most important thing that investors can do is to be active in protecting their interests. Unfortunately, that almost never happens. Most investors prefer to sit in closed conference rooms complaining among themselves rather than doing anything public to protect their interests.

When I ask “why don’t you fight?” I usually get some variation of the answer “we will sell if we don’t like what is going on”. Unfortunately that is a convenient excuse that is neither true nor helpful in protecting their interests.

Mutual funds and asset management firms almost never sell stocks during corporate governance scandals and almost never take any actions to protect their interests. This goes as far as not even voting their shares in shareholder meetings.

Having almost the entire investor class unwilling to fight when they have been ripped off and then continuing to hold the stocks creates a complete disconnect between the end investor in mutual funds and the issuers of securities. It also leaves a big opportunity for people to abuse the system.

GAIT In order to improve corporate governance, it is clearly necessary for investors to make corporate governance an integral part of their investment process. A willingness to deviate substantially from index weightings and to look past the next quarter’s returns towards sustainable long-term performance is essential in this regard.

In addition, when markets are rising the memories of both investors and companies are often shortened. It is up to investors consistently to engage companies on the subject of corporate governance in a respectable and non-confrontational manner. It is all too easy to end up lecturing companies rather than engaging constructively with them.

GILL The Institute of International Finance (IIF) has come up with minimum and best standards for companies to follow. These should be adopted by international funds publicly and made known to management and regulators. Companies that do not meet the minimum standards should not be invested in by the large international funds.

JANG Institutional investors should take a more active role in corporate governance in the companies in which they invest. This is in their best interests as well as the interests of other investors. It is often the case that corporate governance risk is larger than operating or financial risk in emerging market countries.

The majority of creditors and fund managers, however, ignore corporate governance risk. Fund managers often say that they will simply sell shares if they do not agree with management rather than taking an active role. If fund managers are complying with this simple rule as they claim, how come they still have a big exposure to many emerging market companies?

MOBIUS Be active. Take the time to vote in shareholder meetings. Join the company’s board of directors. Have a dialogue with the management and encourage them to treat minority shareholders in a fair and transparent way.

NARAIN Recently, an interesting trend of rating corporate governance practices has emerged, though it is in its nascent stage. Once the methodology stabilizes and the market starts paying attention to such ratings, it is possible that they could affect the valuation of the company.

GA What specific examples of improved corporate governance can you cite that have resulted in demonstrable benefits to either/both company and country?

BROWDER Our favourite example in Russia of improving corporate governance came from our firm’s efforts to expose the corruption of the former management of Gazprom, the world’s largest natural gas company.

In this case there were a lot of rumours about asset stripping by management, which had a negative impact on the share price. Nobody in Moscow wanted to talk about it openly and the government, which was the biggest shareholder, didn’t act.

After seeing this going on for a while, we decided we would do our own investigation into the assets that had gone missing and then share our findings with the media. Our study found specific and verifiable examples of management selling themselves assets from the company for little or no consideration.

The political scandal that our study created led to the firing of the CEO and a 150% rise in the stock price. It also proved that small investors can make a big difference if they are prepared to speak out.

GAIT We have been particularly encouraged by recent developments in Korea, where a significant amount of reform momentum is home-grown. The unstinting work of a local shareholder movement, the People’s Solidarity for Participatory Democracy (PSPD), headed by the indomitable Professor Jang, has been instrumental in persuading Korea’s domineering family-owned chaebols to pay more attention to minority shareholders. We have invested considerably more in Korea as a result, while the cost of capital for those Korean companies with good corporate governance has demonstrably fallen over recent years.

GILL Improving formal structures will not in itself lead to an inflow of funds when investors have concerns about commitment to these standards. But when regulators start getting tougher on those who breach regulations, changes in management are made so that those responsible for transgressions are booted out. Thus a clear difference is noticeable in the regulatory effort, which will encourage greater inflow of funds and improve market valuations.

JANG The most effective way to improve corporate governance is if the controlling family and management adopt good practices voluntarily. It is rare to witness such cases. One such instance, however, happened in Korea recently. Jae Hyun Lee, chairman of the CJ group, one of the country’s leading chaebols, had given up warrants he was entitled to that would let him buy new shares at a discount. He did it to avoid diluting minority shareholders’ value. The share price increased sharply as a result.

MOBIUS Probably the best example is Yukos, the Russian oil company. Since it instituted good corporate governance standards its share price has sky-rocketed.

NARAIN Corporate governance standards vary from company to company. Some are at the top end of the spectrum, some are at the bottom. The link between good corporate governance and valuation is more evident for companies at either end of the spectrum. The vast majority of companies are in the middle. Here, there is insufficient empirical evidence that demonstrates conclusively a link between good corporate governance and valuation. This is precisely the problem and we need to encourage more such research. This could be the most effective incentive structure for companies to follow good governance.